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Practical Connection Assignment

Practical Connection Assignment:

Provide a reflection of at least 500 words (or 2 pages double spaced) of how the knowledge, skills, or theories of Managerial Accounting have been applied, or could be applied, in a practical manner to your current work environment. If you are not currently working, share times when you have or could observe these theories and knowledge could be applied to an employment opportunity in your field of study.

Please find the attached text book for the managerial accounting course.

Requirements:

Provide a 500 word (or 2 pages double spaced) minimum reflection.
Use of proper APA formatting and citations. If supporting evidence from outside resources is used those must be properly cited.
Share a personal connection that identifies specific knowledge and theories from this course.
Demonstrate a connection to your current work environment. If you are not employed, demonstrate a connection to your desired work environment.
You should NOT, provide an overview of the assignments assigned in the course. The assignment asks that you reflect how the knowledge and skills obtained through meeting course objectives were applied or could be applied in the workplace.

immediateAPA Format500 words

Managerial
Accounting
Creating Value in a
Dynamic Business Environment
Tenth Edition
Ronald W. Hilton
Cornell University
David E. Platt
University of Texas at Austin
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MANAGERIAL ACCOUNTING: CREATING VALUE IN A DYNAMIC BUSINESS ENVIRONMENT,
TENTH EDITION
Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2014 by McGraw-Hill
Education. All rights reserved. Printed in the United States of America. Previous editions © 2011, 2009, and 2008.
No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or
retrieval system, without the prior written consent of McGraw-Hill Education including, but not limited to, in any
network or other electronic storage or transmission, or broadcast for distance learning.
Some ancillaries, including electronic and print components, may not be available to customers outside the
United States.
This book is printed on acid-free paper.
1 2 3 4 5 6 7 8 9 0 RJC/RJC 1 0 9 8 7 6 5 4 3
ISBN 978-0-07-802566-2
MHID 0-07-802566-4
Senior Vice President, Products & Markets: Kurt L. Strand
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Cover Image: (main) © Volker Moehrke/Corbis; (top to bottom) © Aaron Roeth Photography;
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Printer: R. R. Donnelley
Material from the Uniform CPA Examination, Questions and Unofficial Answers, Copyright 1978, 1979, 1980,
1981, 1982, 1983, 1984, 1987, 1990, 1991 by the American Institute of Certified Public Accountants, Inc. is
adapted with permission.
Material from the Certificate in Management Accounting Examinations, Copyright 1977, 1978, 1979, 1980, 1981,
1982, 1983, 1984, 1987, 1990, 1991, 1992, 1993, 1994, 1995, 1996, 1997, 1998, 1999, 2000 by the Institute of
Management Accountants is adapted with permission.
Logos from Whole Foods Market, Inc., Caterpillar, Inc., Walmart, and Southwest Airlines Co. appear in this text
with permission from those companies.
All credits appearing on page or at the end of the book are considered to be an extension of the copyright page.
Library of Congress Cataloging-in-Publication Data
Hilton, Ronald W.
Managerial accounting : creating value in a dynamic business environment/Ronald W. Hilton,
Cornell University, David E. Platt, University of Texas at Austin.—Tenth edition.
pages cm
Includes index.
ISBN 978-0-07-802566-2 (alk. paper)
ISBN 0-07-802566-4 (alk. paper)
1. Managerial accounting. I. Platt, David E. II. Title.
HF5657.4.H55 2014
658.15’11—dc23
2013013379
The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not
indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee
the accuracy of the information presented at these sites.
www.mhhe.com
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Ronald W. Hilton:
To Meg, Brad, Tim, Kerry, and Liliana.
David E. Platt:
To Nancy, Evan, and Hannah.
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v
Praise for MANAGERIAL ACCOUNTING
“Extremely comprehensive, easy to read managerial accounting textbook that provides well-designed integrated
examples along with coverage of service-based companies. ”
—Angela Sandberg, Jacksonville State University
“I am loving the book, and I see the students learning the concepts a lot quicker than my previous experience.”
— Patti Brown, The University of Texas at Austin
“I would describe it as the Cadillac of core management accounting textbooks. ”
— Bill Wempe, Texas Christian University
“This is an excellent text—well balanced, well organized, and up to date with current topics, including service
industries and state-of-the-art manufacturing environments. I highly recommend it also for the excellent examples
and illustrations through focus companies and contrasting companies. ”
— John C. Anderson, San Diego State University
“I’ve been using this text since its second edition, and it gets better each year with continuous improvement.”
— Steve G. Green, United States Air Force Academy
“ Well written with good explanations of the ‘why’ and ‘how’ ”
— Christa Morgan, Georgia Perimeter College
“Major strength is how it relates managerial accounting to the general management function and reveals the
managerial accountant as an important member of the management team. ”
— Linda C. Bowen, University of North Carolina–Chapel Hill
“The book goes beyond covering the basics and organizes and integrates contemporary topics nicely. ”
— Harrison McCraw, State University of West Georgia
“ Well written, well organized and excellent end of chapter problems.”
— Kathleen Sevigny, Boston College
“The technology supplements and instructor resources are top-notch and very appropriate for our students.”
— Marilyn Okleshen, Minnesota State University–Mankato
“The book is very thorough, well written, and still remains student-friendly. The supplements are outstanding.”
— Ben Baker, Davidson College
“A solid, well-written, user-friendly book; can’t go wrong with it! ”
— Rochelle Greenberg, Florida State University
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VI Preface
After Nine Editions of Innovation and
Excellence, Hilton Managerial Accounting
becomes Hilton & Platt.
Keeping pace with the speed of modern business, the authors combine their experience and
expertise to make sure Managerial Accounting is the most relevant, accurate, and up-to-date
textbook in the field.
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Preface VII
About the Authors
Ronald W. Hilton is a Professor of Accounting at Cornell
University. With bachelor’s and master’s degrees in accounting from
The Pennsylvania State University, he received his PhD from The Ohio
State University.
A Cornell faculty member since 1977, Professor Hilton also has
taught accounting at Ohio State and the University of Florida, where
he held the position of Walter J. Matherly Professor of Accounting.
Prior to pursuing his doctoral studies, Hilton worked for Peat, Mar-
wick, Mitchell and Company and served as an officer in the United
States Air Force.
Professor Hilton is a member of the Institute of Management
Accountants and has been active in the American Accounting Asso-
ciation. He has served as associate editor of The Accounting Review
and as a member of its editorial board. Hilton also has served on the editorial board of the Journal of Manage-
ment Accounting Research. He has been a member of the resident faculties of both the Doctoral Consortium
and the New Faculty Consortium sponsored by the American Accounting Association.
With wide-ranging research interests, Hilton has published articles in many journals, including the Journal of
Accounting Research, The Accounting Review, Management Science, Decision Sciences, the Journal of Economic
Behavior and Organization, Contemporary Accounting Research, and the Journal of Mathematical Psychology. He
also has published a monograph in the AAA Studies in Accounting Research series, and he is a co-author of Cost
Management: Strategies for Business Decisions, Budgeting: Profit Planning and Control, and Cost Accounting:
Concepts and Managerial Applications. Professor Hilton’s current research interests focus on contemporary cost
management systems and international issues in managerial accounting. In recent years, he has toured manufac-
turing facilities and consulted with practicing managerial accountants in North America, Europe, Asia, and Australia.
David E. Platt is the Associate Dean for Undergraduate Pro-
grams at the McCombs School of Business, University of Texas at
Austin. He earned his BS in Economics from the Wharton School at
the University of Pennsylvania, his MBA in Marketing from Syracuse
University, and his PhD in Accounting from Cornell University. He
received his CPA while working for Pricewaterhouse Coopers,
followed by several years doing financial and product management
in a supply chain systems integrator. Professor Platt has taught in the
McCombs School of Business BBA, MPA, MBA and Executive MBA
programs, receiving teaching awards at both the undergraduate and
graduate levels. From 2000 until 2012, he directed UT-Austin’s Center
for International Business Education and Research (CIBER) and has
served as chairman of the Partnership in International Management, a
consortium of leading graduate business schools with 57 member schools in 35 countries. He has been a visit-
ing lecturer at the Sorbonne Graduate Business School, and has delivered training for Dell and other companies
in the U.S., Europe, Latin America, and China.
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VIII Preface
Managerial Accounting.
Business is changing dramatically, with a global marketplace for goods and services,
a worldwide supply chain, and dramatic increases in technological innovation. To keep
up, managers must be able to interpret the rapid fl ow of information and make the right
decisions. Assisted by the tools of managerial accounting, and by managerial account-
ing professionals, managers will work side by side in global cross-functional teams to
make the complex decisions that today’s dynamic business environment requires of
them. The goal of Managerial Accounting is to acquaint students of business with the
fundamental tools of managerial accounting and to promote their understanding of the
dramatic ways in which business is
changing. The emphasis through-
out the text is on using account-
ing information to help manage an
organization. Students should not
only be able to produce accounting
information, but also understand
how managers are likely to use and
react to the information in a range
of businesses.
“It is a well-written book with numerous
well-selected cases, allowing students to
see the contemporary business opera-
tions and practices in the real world.”
— Dennis Hwang, Bloomsburg University
How Does Hilton & Platt 10e Prepare Students for
the Businesses of Today and Tomorrow?
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Preface IX
Relevant.
Focus Companies provide a powerful strategy for
fostering learning, and the integration of Focus
Companies throughout the Hilton & Platt text is
unmatched by any other managerial accounting
book. Each chapter introduces important manage-
rial accounting topics within the context of a realis-
tic company. Students see the immediate impact of
managerial accounting decisions on companies and
gain exposure to different types of organizations.
“The company story acts as a hook to get
students interested in the chapter material.”
— Michele Matherly, University of North
Carolina at Charlotte
“I like the mix of company types.”
— Barbara Durham, University of Central
Florida
“A nice intro textbook, with multiple
perspectives on the behavioral aspects
of managerial accounting. Touches many
modern issues facing the field.”
Theodore Rodgers, Emory University
“Balanced, time-proven approach to
managerial accounting.”
— Michael Flores, Wichita State University
“Perhaps what sets Hilton & Platt apart
from the competition is its recognition that
the world consists of more than manufac-
turing firms and that managerial account-
ing plays a significant role in service and
not-for-profit organizations.”
— Lanny Solomon, University of
Missouri–Kansas City
Balanced.
Hilton & Platt Managerial Accounting offers the most
balanced coverage of service and manufacturing com-
panies. The authors recognize that students will be work-
ing in a great variety of business environments and will
benefi t from exposure to diverse types of companies. A
wide variety of examples from retail, service, manufac-
turing, and nonprofi t organizations are included.
Contemporary.
Hilton & Platt continues to be the leader in present-
ing the most contemporary coverage of managerial
accounting topics. The traditional tools of managerial
accounting such as budgeting and product costing
have been updated with current approaches. Emerg-
ing topics such as environmental cost management,
monetizing the Internet, and capacity management
are also covered.
Flexible.
Managerial Accounting is written in a modular format allowing topics to be covered in the order
you want. For example, some instructors prefer to cover contribution-margin approaches to
decision making and/or relevant costs early in the course. So Chapter 6 (cost behavior and
estimation), Chapter 7 (CVP), and Chapter 14 (relevant costs) are written so they can be covered
immediately after Chapter 2, which introduces basic cost concepts. A table showing the text’s
fl exibility is in the Introduction to the Instructor’s Manual.
“Very current with managerial account-
ing topics (bar codes, RFID, . . . , ABC,
outsourcing, decision making).”
— Maggie Houston, Wright State University
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X Preface
How Does Hilton & Platt 10e Help Students
Learn Managerial Accounting in the Context
of Business?
FOCUS COMPANIES
Students need to see the relevance of man-
agerial accounting information in order to
actively engage in learning the material. Ron
Hilton and Dave Platt use Focus Companies
to illustrate concepts, and students immedi-
ately see the significance of the material and
become excited about the content.
Whenever the Focus Company is
presented in the chapter, its logo is shown
so the student sees its application to the
text topic.
1
THIS CHAPTER’S FOCUS COMPANY is The Walt Disney Company. This
entertainment services company is a giant in the industry with theme parks,
feature film studios, animation studios, television broadcasting, hotels and resorts, and retail
stores. Using The Walt Disney Company as an illustration, we will introduce the field of managerial
accounting and its major themes. Some of you are excited about studying accounting.
But even more of you are asking, “Why do I need to study managerial accounting? I’m
not going to be an accountant!” That is a good question. We will explore how mana-
gerial accountants work in partnership with managers to add value to the organization,
and how managers also use managerial accounting tools to make their decisions.
FOCUS COMPANY >>>
The Changing Role of
Managerial Accounting
in a Dynamic Business
Environment
Each chapter is built around a focus company, in which the chapter’s key points are illustrated. This
chapter’s focus is on The Walt Disney Company. The focus companies in subsequent chapters are
not real companies, but they are realistic scenarios built on actual company practices. Whenever the
focus company is discussed in the chapter, the company logo appears in the margin.
hiL25664_ch01_002-033.indd 2 19/04/13 10:34 PM
In contrast to the entertainment services setting of The Walt Disney Company,
we will turn our attention to Whole Foods Market, Inc. This fast-growing food
retailer has over 300 stores around North America and Europe. A leader in the area of corpo-
rate social responsibility, Whole Foods Market is frequently faced with challenging decisions
that require them to balance the need to run a profitable business and satisfy their investors
against the cost of their much-publicized commitment to organic foods and sustainable
production. We will explore managerial accounting’s contribution to Whole Foods Market’s
efforts to sell products that are more costly to produce in a competitive market while still
achieving appropriate returns for investors.
<<< IN CONTRAST Each chapter also includes a contrast company. In most cases, the contrast company will present a key chapter topic in an industry that is different from that of the focus company. In this chapter, the focus company (Walt Disney) is an entertainment services company, whereas the contrast company (Whole Foods Market) is a food retailer. hiL25664_ch01_002-033.indd 3 19/04/13 10:35 PM CONTRAST COMPANIES A Contrast Company is also introduced in each chapter. In most cases these high- light an industry different from that of the Focus Company. This feature allows even greater emphasis on service-industry firms and other nonmanufacturing envi- ronments. The complete list of Focus Companies and Contrast Companies is featured on the inside back cover. “I like the ‘Focus on the Company’ at the begin- ning of each chapter and this type of boxed info throughout each chapter”. — Anna Cianci, Drexel University hiL25664_fm_i-1.indd xhiL25664_fm_i-1.indd x 7/24/13 2:00 AM7/24/13 2:00 AM Final PDF to printer Preface XI Real-World Examples The Hilton & Platt text provides a variety of thought-provoking, real-world examples to focus students on managerial accounting as an essential part of the management process. Featured organizations include Amazon.com, Ford Motor Company, Southwest Airlines, Whole Foods Market, General Electric, FedEx, and many others. These companies are high- lighted in blue in the text. In Their Own Words Quotes from both practicing managers and managerial accountants are included in the margins throughout the text. These actual quotes show how the field of management accounting is changing, emphasize how the concepts are actually used, and demonstrate that management accountants are key players in most companies’ management teams. Management Accounting Practice The managerial accounting practices of well- known, real-world organizations are highlighted in these boxes. They stimulate student inter- est and provide a springboard for classroom discussion. Focus on Ethics This feature is included in most chapters. Focus on Ethics poses an ethical dilemma, then asks tough questions that underscore the importance of ethical management. Some of these are based on real-world incidents while others are fictional but based on well- established anecdotal evidence. Ford, Renault, and Nissan M A P anagement ccounting ractice MANAGING THE COSTS OF UNUSED CAPACITY IN THE AUTO INDUSTRY: A GLOBAL CHALLENGE Most companies cannot easily adjust their production capacity to match demand. Once a manufacturer of automobiles has invested in a factory, its options for increasing or decreasing that capacity and related costs are limited. If sales are low, management can reduce the hours of production, but the facility costs remain. Moreover, labor costs often cannot easily be adjusted because of national labor laws, union rules, and practical con- cerns such as training costs and employee loyalty. So, if the costs of unused capacity cannot be adjusted to match demand, how can a company manage capacity to avoid the drain on income that comes with unused capac- ity? The solution involves isolating the capacity problem: (1) shift production between facilities to maximize utilization of capacity in selected primary facilities while creating additional unused capacity in secondary facilities, and (2) sell or find alternative uses for the now-vastly-underutilized secondary facilities. American automaker Ford Motor Co. followed exactly this approach in addressing their profitability problems in the European market. “We know what it takes to be profitable in Europe We’ll work to match capacity with demand while accelerating new product hiL25664_ch01_002-033.indd 22 6/22/13 9:02 PM Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment 107 Focus on Ethics DID BOEING EXPLOIT ACCOUNTING RULES TO CONCEAL COST OVERRUNS AND PRODUCTION SNAFUS? Aircraft manufacturers use job-order costing to determine the cost of an airplane. As this chapter discusses, sup- ply chain management and production controls are also important tools used by manufacturers to manage pro- duction costs. As BusinessWeek reports, however, things don’t always go according to plan. For three years, Boeing ’s top management had been seeking a merger with McDonnell-Douglas Corpora- tion , whose board of directors was reluctant to approve the deal. Finally, the deal went through, and the world’s largest aerospace company was born—“the first manufacturer ever with the ability to build everything that flies, from helicopters and fighter jets to space stations.” Unfortunately, “a disaster was quietly unfolding inside Boeing’s sprawling factories—one that would ultimately i d ti billi f d ll l In May of 2002, BusinessWeek reported the results of its three-month investigation, which “reconstructed this hidden chapter in the company’s history—and analyzed its current implications.” The BusinessWeek article alleges that “new details supplied by several inside witnesses indi- cate that Boeing did more than simply fail to tell investors about its production disaster. It also engaged in a wide variety of aggressive accounting techniques that papered over the mess. Critics say the company should have taken charges for the assembly-line disaster in the first half of 1997, even if it meant jeopardizing the McDonnell merger. They also claim that Boeing took advantage of the unusual flexibility provided by program accounting —a system that allows the huge upfront expense of building a plane to be spread out over several years—to cover up cost over- runs and to book savings from efficiency initiatives that never panned out. ‘Boeing managed its earnings to the point where it got caught,’ says Debra A. Smith, a part- ner at Constraints Management, a Seattle-area manufac- turing consultancy and a former senior auditor at Deloitte hiL25664_ch03_078-131.indd 107 5/3/13 5:35 PM cross-functional teams. Panel B of Exhibit 1–4 depicts several plausible cross-functional teams formed to address a variety of hypothetical business problems at The Walt Disney Company. Notice that each of these teams pulls together individuals from a variety of specialties, such as marketing, operations, general management, customer relations, and the general counsel’s office (legal issues). Given Disney’s overall business strategy, creative talent is almost always present in these cross-functional teams; moreover, mana- gerial accountants play an important role as well. Physical Location Finally, where do managerial accountants actually do their work? The answer is “just about everywhere.” As Panel C of Exhibit 1–4 highlights, managerial accountants are not sequestered in some remote corner of the business. To the contrary, they are located in every part of an enterprise, from corporate headquarters to the locations where goods and services are being produced. At Disney, for example, managerial accountants would be present on location when a feature film is being produced, near the ESPN production studio when decisions are made about deploying sports commentators, and in the various Disney hotels, such as the Disney Ambassador Hotel in Tokyo. “Most of the people . . . are decentralized and actually are co-located with the people that they support. That’s our approach and we’re moving more and more toward that and less and less toward a central group that provides information.” (1j) Boeing hiL25664_ch01_002-033.indd 16 6/22/13 9:02 PM to the hospital. The value chain for The Walt Disney Studios would include upstream contributions such as screenwriting, film studio construction and maintenance, set design and construc- tion, costume design and production, travel arrangements for shooting scenes on loca- tion, lighting technicians, film crews, and acting talent. Once the film has been produced, the downstream contributions include advertising personnel; TV, radio, and print media; film distributors; theater companies such as AMC Entertainment; DVD producers; online video providers such as Netflix ; and DVD retailers such as Amazon.com . Let’s turn our attention now to this chapter’s contrast company, Whole Foods Market, Inc. A fast-growing food retailer headquartered in Austin, Texas, Whole Foods Market has over 300 stores in the U.S. and Europe. Whole Foods Market is owned by its stock- holders, and its stock is publicly traded on the NASDAQ market. As its website explains, Whole Foods Market’s managers and accountants work to earn a profit for stockholders by maintaining a reputation as a seller of quality, sustain- ably produced products and a fun place to shop. Each of these factors must be considered by the company’s managers as they make decisions about the design of their value chain. Making the right decisions about a value chain can be the difference between success and failure for a company, and the decisions for Whole Foods Market include answering critical questions like: • Which value chain activities must a grocery store include? • Are there activities that other grocery stores don’t include in their value chain hiL25664_ch01_002-033.indd 18 19/04/13 10:35 PM “Great graphics, exhibits and illustrations to keep the computer generation interested.” — Kathy Sevigny, Boston University “Good extras within chapters—ethics at the end of each chapter, MAPs throughout chapter, the Focus vs. In Contrast real world examples.” — Mike Thomas, Humboldt State University hiL25664_fm_i-1.indd xihiL25664_fm_i-1.indd xi 7/24/13 2:00 AM7/24/13 2:00 AM Final PDF to printer XII Preface End-of-Chapter Assignment Material Each chapter includes an extensive selection of assignment material, including Review Questions, Exercises, Problems, and Cases. Our problem and case material conforms to AECC and AACSB recommendations and facilitates class discussions and projects. Review Problems present both a problem and a complete solution, allowing students to review the entire problem-solving process. How Can My Students Use Hilton & Platt 10e to Master the Concepts of Managerial Accounting? cost per unit is the total cost for whatever quantity is produced, divided by the number of units produced. Review Problems on Cost Classifications Problem 1 Several costs incurred by Myrtle Beach Golf Equipment, Inc. are listed below. For each cost, indicate which of the following classifications best describe the cost. More than one classification may apply to the same cost item. For example, a cost may be both a variable cost and a product cost. Cost Classifications a. Variable b. Fixed c. Period d. Product e. Administrative f. Selling hiL25664_ch02_034-077.indd 59 26/04/13 10:23 PM Key Terms For each term’s definition refer to the indicated page, or turn to the glossary at the end of the text. activity base, 88 actual costing, 100 actual manufacturing overhead, 94 applied manufacturing overhead, 93 bill of materials, 86 cost distribution (sometimes called cost allocation), 102 cost of goods manufactured, 97 cycle time, 101 departmental overhead centers, 102 departmental overhead rate, 102 job-cost record, 84 job-order costing, 83 material requisition form, 85 normal costing, 98 overapplied overhead, 96 overhead application (or absorption), 87 plantwide overhead rate, 102 predetermined overhead rate, 88 process-costing system, 84 product-costing system, 80 proration, 96 schedule of cost of goods manufactured, 97 schedule of cost of goods sold, 97 service department cost allocation, 102 service departments, 102 source document, 86 supply chain, 86 throughput time, 101 time record, 87 two-stage cost allocation, 102 underapplied overhead, 95 volume-based cost driver, 88 hiL25664_ch03_078-131.indd 110 5/3/13 5:35 PM Review Questions 2–1. Distinguish between product costs and period costs. 2–2. Why are product costs also called inventoriable costs? 2–3. What is the most important difference between a manu- facturing firm and a service industry firm, with regard to the classification of costs as product costs or period costs? 2–4. List several product costs incurred in the production of a backpack. 2–5. List, describe, and give an example of each of the four different types of production processes. 2–6. Why is the cost of idle time treated as manufacturing overhead? 2–7. Explain why an overtime premium is included in manu- facturing overhead. 2–8 What is meant by the phrase “different costs for differ- 2–14. Would each of the following characteristics be a vol- ume-based or an operations-based cost driver in a col- lege: ( a ) number of students, ( b ) number of disciplines offered for study, and ( c ) urban versus rural location? 2–15. List three direct costs of the food and beverage depart- ment in a hotel. List three indirect costs of the department. 2–16. List three costs that are likely to be controllable by a city’s airport manager. List three costs that are likely to be uncontrollable by the manager. 2–17. Which of the following costs are likely to be control- lable by the chief of nursing in a hospital? a. Cost of medication administered. b. Cost of overtime paid to nurses due to scheduling errors. c. Cost of depreciation of hospital beds. hiL25664_ch02_034-077.indd 61 26/04/13 10:23 PM Key Terms are bolded in the text and repeated at the end of the chapter with page references. The book also includes a complete Glossary of Key Terms. Review Questions, Exercises, Problems, and Cases are comprehensive in covering the points in the chapter. They exhibit a wide range of difficulty, and the Instructor’s Manual provides guidance for the instructor on the difficulty level and time required for each problem. Numerous adapted CMA and CPA problems are included. “Best selection of problems of any text: a large number of problems, problems at all levels, including many interesting, different problems that challenge students, and often interesting real world applications.” — Lynda Thoman, Purdue University hiL25664_fm_i-1.indd xiihiL25664_fm_i-1.indd xii 7/24/13 2:00 AM7/24/13 2:00 AM Final PDF to printer Preface XIII EXCEL Spreadsheets Spreadsheet applications are essential to contemporary accounting practice. Students must recognize the power of spreadsheets and know how accounting data are presented in them. Excel applications are discussed where appropriate in the text. Several exercises and problems in each chapter include an optional requirement for students to Build a Spreadsheet to develop the solution. Budgeted manufacturing overhead: $993,300 Budgeted selling and administrative expenses: $417,000 Actual manufacturing overhead: Depreciation ........................................................................................................................................ $225,000 Property taxes ..................................................................................................................................... 19,000 Indirect labor ....................................................................................................................................... 79,000 Supervisory salaries ............................................................................................................................. 210,000 Utilities ................................................................................................................................................ 58,000 Insurance ............................................................................................................................................ 32,000 Rental of space ................................................................................................................................... 295,000 Indirect material (see data below .......................................................................................................... 79,000 Indirect material: Beginning inventory, January 1 ............................................................................................................. 46,000 Purchases during the year .................................................................................................................... 95,000 Ending inventory, December 31 ............................................................................................................ 62,000 Required: 1. Compute the firm’s predetermined overhead rate, which is based on direct-labor hours. 2. Calculate the overapplied or underapplied overhead for the year. 3. Prepare a journal entry to close out the Manufacturing Overhead account into Cost of Goods Sold. 4. Build a spreadsheet: Construct an Excel spreadsheet to solve requirements (1) and (2) above. Show how the solution will change if the following data change: budgeted manufacturing overhead was $990,000, property taxes were $25,000, and purchases of indirect material amounted to $97,000. ■ Exercise 3–36 hiL25664_ch03_078-131.indd 114 5/3/13 5:35 PM using the two cost drivers used in the text illustration. Problems Vermont Clock Works manufactures fine, handcrafted clocks. The firm uses a job-order costing sys- tem, and manufacturing overhead is applied on the basis of direct-labor hours. Estimated manufacturing overhead for the year is $260,000. The firm employs 10 master clockmakers, who constitute the direct- labor force. Each of these employees is expected to work 2,000 hours during the year, which represents each employee’s practical capacity. The following events occurred during October. a. The firm purchased 2,900 board feet of mahogany veneer at $12 per board foot. b. Twenty brass counterweights were requisitioned for production. Each weight cost $27. c. Five gallons of glue were requisitioned for production. The glue cost $25 per gallon. Glue is treated as an indirect material. d. Depreciation on the clockworks building for October was $7,000. e. A $300 utility bill was paid in cash. f. Time cards showed the following usage of labor: Job number G60: 12 grandfather’s clocks, 950 hours of direct labor Job number C81: 15 cuckoo clocks, 500 hours of direct labor The master clockmakers (direct-labor personnel) earn $22 per hour. g. The October property tax bill for $890 was received but not yet paid in cash. h. The firm employs laborers who perform various tasks such as material handling and shop cleanup. Their wages for October amounted to $3,100. i. Job number G60, which was started in July, was finished in October. The total cost of the job was $15,100. j. Nine of the grandfather’s clocks from job number G60 were sold in October for $1,600 each. Required: 1 Calculate the firm’s predetermined overhead rate for the year ■ Problem 3–42 Basic Job-Order Costing; Journal Entries (LO 3-4, 3-5) 1. Predetermined overhead rate: $13 per hour All applicable Problems are available with McGraw-Hill’s Connect Accounting ®. hiL25664_ch03_078-131.indd 116 5/3/13 5:35 PM Icons identify key business areas in the Problems and Cases in each chapter: Ethical Issues International Setting Group Work Business Communication Internet Research Excel Template Ex Many problems can be solved using the Excel spreadsheet templates found on the text’s website. An Excel logo appears in the margin next to these problems for easy identification. “Good description of managerial accounting tools. Easy to read and understand. Strength is in the end-of-chapter problems—good variety and lots of them.” — Priscilla Wisner, Thunderbird, the Garvin School of International Management “Use of spreadsheets [is a strength].” — Ralph Greenberg, Temple University hiL25664_fm_i-1.indd xiiihiL25664_fm_i-1.indd xiii 7/24/13 2:00 AM7/24/13 2:00 AM Final PDF to printer XIV Preface What’s New in the Tenth Edition? New and Updated Focus Companies Chapter 9, which covers budgeting, features an all new focus company, Snowcap Music Festivals. This company produces and manages destination music events worldwide. Chapter 8, which cov- ers absorption and variable costing, also has a new focus company, FitDat.com. This firm produces fitness monitors. Several other focus companies have been updated to make them more current and relevant than ever. New Contrast Companies Several chapters include new contrast companies, which provide a balance in each chapter between different industries. Among the new contrast companies are Whole Foods Market (retail grocery chain) and FestiChair.com (outdoor chair manufacturer). Updated Pedagogy Many chapters include revisions of pedagogy, streamlined and condensed explanations, and the addition of more current examples and references from the popular business press. For example, in Chapter 9 we now first present the budget in a nonmanufacturing context for a simpler view of the overall flow of budget schedules. Then, using the chapter’s contrast company, we turn to a manu- facturing example with the added complexity of inventory costs and schedules. End-of-Chapter Assignment Material The end-of-chapter assignment material has been very heavily revised. Virtually all of the quantitative exercises, problems, and cases contain data different from that used in the ninth edition. In addition, the authors updated many of the products and services produced by the companies featured both in the text and in the assignment material. Build a Spreadsheet This popular feature has been completely revised for the tenth edition. Several exercises and problems in each chapter include an optional requirement to build an Excel spreadsheet to solve the problem. Service Industry Examples As the service industry plays a significant role in the economy, even greater emphasis has been devoted to providing examples throughout the text on real-world service-industry firms using managerial accounting information. In Their Own Words Many of the quotations in this popular feature are new in this edition. These quotes from practicing managers and managerial accountants portray the important role managerial accounting plays in today’s dynamic business environment. Management Accounting Practice Many of these real-world examples have been revised and updated to make them more current, and several new examples have been added. hiL25664_fm_i-1.indd xivhiL25664_fm_i-1.indd xiv 7/24/13 2:00 AM7/24/13 2:00 AM Final PDF to printer Preface XV Your feedback is crucial in improving each new edition of Managerial Accounting. In response to your suggestions, you will find revised coverage of key topical areas, new pedagogy for the most challenging topics, and new assignment material in the tenth edition, as well as several key CHAPTER-BY-CHAPTER CHANGES Chapter 1: This chapter now features Whole Foods Market as the contrast company. In addition, the focus company example, Walt Disney Company, has been substantially updated to reflect changes in the company structure and to include recognizable subsidiaries like ESPN. A new Management Accounting Practice ( MAP ) piece has been added and the chapter streamlined to focus on how companies operate. Chapter 2: The classification of manufacturing operations has been revised, and a new MAP has been added. Chapter 3: New material is included on the use of technology in managerial accounting for manufacturing operations. Chapter 5: The material on just-in-time (JIT) production and inventory management has been moved to the Inventory Management appendix at the end of the book. Chapter 8: In order to better balance chapter length and the organization of topics, two sec- tions previously located in Chapter 12 have been moved to this chapter and expanded: Costs of Assuring Quality (formerly Total Quality Management) and Costs of Environmental Sustainability (formerly Environmental Cost Management). Chapter 9: Completely revised for this edition, budgeting is now illustrated with a new focus company, Snowcap Music Festivals, that will resonate with students. A new contrast company, FestiChair.com, is then introduced to show the incremental budget schedules required to address the manufacturing environment. A new MAP is also added. Chapter 9 also places Chapters 9 through 11 in a broad Financial Planning and Analysis (FP&A) context. Chapter 10: In this edition, we introduce the usage-based direct-material price variance to allow for a complete decomposition of the difference between actual and standard costs. (The purchased- quantity version is maintained for comparison.) The sections on Operational Performance Measures and the Balanced Scorecard are moved to Chapter 12, where they fit comfortably with other perfor- mance measurement material. Chapter 11: The application of overhead is now discussed in terms of activity level, rather than the more restrictive process hours. Chapter 14: A new MAP has been added discussing the decision that some companies are now making to insource key business processes and return to onshoring of production operations. Chapter 15: The MAP on Internet pricing has been revised. hiL25664_fm_i-1.indd xvhiL25664_fm_i-1.indd xv 7/24/13 2:00 AM7/24/13 2:00 AM Final PDF to printer XVI Preface How Can Technology Help Improve Student Success? McGraw-Hill Connect ® Accounting McGraw-Hill Connect Accounting is an online assignment and assessment solution that connects students with the tools and resources necessary to achieve success through faster learning, more efficient studying, and higher retention of knowledge. Intelligent Response Technology (IRT) IRT is a redesigned student interface for our end- of-chapter assessment content. The benefits include improved answer acceptance to reduce students’ frustration with formatting issues (such as rounding) and select questions that have been redesigned to test students’ knowledge more fully. They now include tables for students to work through rather than requiring that all calcu- lations be done offline. Online Assignments McGraw-Hill Connect Accounting helps students learn more effi- ciently by providing feedback and practice material when and where they need it. Connect Accounting grades homework automatically and students benefit from the immediate feedback that they receive, particularly on any questions they may have missed. Furthermore, algorithmic questions provide students with unlimited opportunities for practice. hiL25664_fm_i-1.indd xvihiL25664_fm_i-1.indd xvi 7/24/13 2:00 AM7/24/13 2:00 AM Final PDF to printer Preface XVII Student Library The Connect Accounting Stu- dent Library gives students access to additional resources such as recorded lectures, online practice materials, and a searchable, media- rich eBook. Using this resource, students can highlight and take and share notes, and study assets from the Online Learning Center, all from one convenient location. McGraw-Hill Connect Accounting Features Less Managing. More Teaching. Greater Learning. McGraw-Hill Connect Accounting offers a number of powerful tools and features to make managing assignments easier, so faculty can spend more time teaching. With Connect Accounting, students can engage with their coursework anytime, anywhere, making the learning process more accessible and efficient. McGraw-Hill Connect ® Accounting for Instructors Simple Assignment Management and Smart Grading Connect Accounting enables you to: • Create and deliver assignments easily with selectable end-of-chapter questions and test bank items. • Go paperless with the eBook and online submission and grading of student assignments. • Have assignments scored automatically, giving students immediate feedback on their work and side-by-side comparisons with correct answers. • Access and review each response; manually change grades or leave comments for students to review. • Reinforce classroom concepts with practice tests and instant quizzes. Instructor Library The Connect Accounting Instructor Library is your repository for addi- tional resources to improve student engage- ment in and out of class. You can select and use any asset that enhances your lecture. The Connect Accounting Instructor Library includes access to the textbook’s: • Solutions manual • Test Bank • Instructor PowerPoint ® slides • Instructor’s Manual • Excel Spreadsheet Solutions • Supplementary Chapter Solutions • Media-rich eBook Student Reports McGraw-Hill Connect Accounting keeps instructors informed about how each student, section, and class is per- forming, allowing for more productive use of lecture and office hours. The Reports tab enables you to: • View scored work immediately and track individual or group performance with assignment and grade reports. hiL25664_fm_i-1.indd xviihiL25664_fm_i-1.indd xvii 7/24/13 2:00 AM7/24/13 2:00 AM Final PDF to printer XVIII Preface • Access an instant view of student or class performance relative to learning objectives. • Collect data and generate reports required by many accreditation organizations, such as AACSB and AICPA. McGraw-Hill Connect ® Plus Accounting McGraw- Hill reinvents the textbook learning experience for the modern student with Connect Plus Accounting, which provides a seamless integration of the eBook and Connect Accounting. Connect Plus Accounting provides all of the Connect Accounting features, as well as: • An integrated eBook, allowing for anytime, anywhere access to the textbook. • Dynamic links between the problems or questions you assign to your students and the location in the eBook where the concept related to that problem or question is covered. • A powerful search function to pinpoint and connect key concepts in a snap. • Highlighting, note-taking and sharing, and other media-rich capabilities. For more information about Connect Accounting, go to www.mcgrawhillconnect .com, or contact your local McGraw-Hill sales representative. Tegrity Campus: Lectures 24/7 Tegrity Campus, a new McGraw-Hill company, provides a service that makes class time avail- able 24/7 by automatically capturing every lecture. With a simple one-click start-and-stop process, you capture all computer screens and corresponding audio in a format that is eas- ily searchable, frame by frame. Students can replay any part of any class with easy-to-use browser-based viewing on a PC or Mac, an iPod, or other mobile device. Educators know that the more students can see, hear, and experience class resources, the better they learn. In fact, studies prove it. Tegrity Campus’s unique search feature helps students efficiently find what they need, when they need it, across an entire semester of class recordings. Help turn your students’ study time into learning moments immediately supported by your lec- ture. With Tegrity Campus, you also increase intent listening and class participation by easing students’ concerns about note-taking. Lecture Capture will make it more likely you will see students’ faces, not the tops of their heads. To learn more about Tegrity, watch a 2-minute Flash demo at http://tegritycampus .mhhe.com. McGraw-Hill Campus™ McGraw-Hill Campus™ is a new one-stop teaching and learning experience available to users of any learning management system. This institutional service allows faculty and students to enjoy single sign-on (SSO) access to all McGraw-Hill Higher Education materi- als, including the award winning McGraw-Hill Connect platform, from directly within the insti- tution’s website. McGraw-Hill Campus provides hiL25664_fm_i-1.indd xviiihiL25664_fm_i-1.indd xviii 7/24/13 2:00 AM7/24/13 2:00 AM Final PDF to printer Preface XIX faculty with instant access to all McGraw-Hill Higher Education teaching materials (e.g. eTextbooks, test banks, PowerPoint slides, ani- mations and learning objects), allowing them to browse, search, and use any instructor ancillary content in our vast library. Students enjoy SSO access to a variety of free (e.g. quizzes, flash cards, narrated presentations) and subscription based products (e.g. McGraw-Hill Connect ). With McGraw-Hill Campus, faculty and stu- dents will never need to create another account to access McGraw-Hill products and services. McGraw-Hill Customer Experience At McGraw-Hill, we understand that getting the most from new technology can be challenging. That’s why our services don’t stop after you purchase our book. You can e-mail our product specialists 24 hours a day, get product train- ing online, or search our knowledge bank of Frequently Asked Questions on our support Website. For Customer experience, call 800- 331-5094 or visit www.mhhe.com/support. One of our Technical Support Analysts will assist you in a timely fashion. You also can take advantage of the new “Contact Publisher” link within Connect Accounting. McGraw-Hill Create TM Your course evolves over time. Shouldn’t your course material? Customize your own high- quality, well-designed, full-color textbook in print or eBook format in a few simple steps at http://create.mcgraw-hill.com. Search thousands articles and cases to rearrange, add, and/or remove content to match better the way you teach your course. You even can add your own material, such as a syllabus or handout. Personalize your book’s appearance by select- ing the cover and adding your name, school, and course information. Order a Create book and you’ll receive a complimentary print review copy in 3–5 business days or a complimentary electronic review copy (eComp) via e-mail in about one hour. hiL25664_fm_i-1.indd xixhiL25664_fm_i-1.indd xix 7/24/13 2:00 AM7/24/13 2:00 AM Final PDF to printer XX Preface Instructor Supplements Assurance of Learning Ready Many educational institutions today are focused on the notion of assurance of learning, an important element of some accreditation stan- dards. Managerial Accounting, 10e is designed specifically to support your assurance of learning initiatives with a simple, yet powerful, solution. Each test bank question for Managerial Accounting, 10e maps to a specific chapter learning outcome/objective listed in the text. You can use our test bank software, EZ Test, and Connect to easily query for learning outcomes/ objectives that directly relate to the learning objectives for your course. You can then use the reporting features of EZ Test and Connect to aggregate student results in similar fashion, making the collection and presentation of assur- ance of learning data simple and easy. AACSB Statement McGraw- Hill Education is a proud corporate member of AACSB International. Recognizing the importance and value of AACSB accredita- tion, we have sought to recognize the curricula guidelines detailed in AACSB standards for business accreditation by connecting selected questions in Hilton & Platt 10e with the general knowledge and skill guidelines found in the AACSB standards. The statements contained in Hilton & Platt 10e are provided only as a guide for the users of this text. The AACSB leaves con- tent coverage and assessment clearly within the realm and control of individual schools, the mis- sion of the school, and the faculty. The AACSB does also charge schools with the obligation of doing assessment against their own content and learning goals. While Hilton & Platt 10e and its teaching package make no claim of any specific AACSB qualification or evaluation, we have labeled selected questions according to the six general knowledge and skills areas. The labels or tags within Hilton & Platt 10e are as indicated. There are, of course, many more within the test bank, the text, and the teaching package which might be used as a “standard” for your course. However, the labeled questions are suggested for your consideration. McGraw-Hill Connect ® Accounting McGraw-Hill Connect Accounting offers a number of powerful tools and features to make managing your classroom easier. Connect Accounting with Hilton & Platt 10e offers enhanced features and technology to help both you and your students make the most of your time inside and outside the classroom. See page XVI for more details. Online Learning Center ( www.mhhe.com/hilton10e ) The password-protected instructor side of the book’s Online Learning Center (OLC) houses all the instructor resources you need to administer your course, including: • Solutions Manual • Test Bank • Instructor PowerPoint ® slides • Instructor’s Manual • Excel Spreadsheet Solutions • Supplementary Chapter Solutions • Sample syllabus hiL25664_fm_i-1.indd xxhiL25664_fm_i-1.indd xx 8/2/13 1:12 PM8/2/13 1:12 PM Final PDF to printer XXIPreface If you choose to use Connect Accounting with Hilton & Platt 10e, you will have access to these same resources via the Instructor Library. Instructor’s Manual This comprehensive manual includes step- by-step, explicit instructions on how the text can be used to implement alternative teaching methods. It also provides guidance for instruc- tors who use the traditional lecture method. The guide includes lesson plans and demon- stration problems with student work papers, as well as solutions. Available on the password-protected Instructor side of the Online Learning Center and the Connect Instructor Library. Solutions Manual Prepared by the authors, the solutions manual contains complete solutions to all the text’s end-of-chapter review questions, exercises, problems, and cases. The solutions manual also includes a discussion of the issues in each of the chapter-by-chapter Focus on Ethics pieces. Available on the password-protected Instructor side of the Online Learning Center and the Connect Instructor Library. Excel Spreadsheet Templates This resource includes solutions to spreadsheet problems found in the text end-of- chapter material. Available on the password-protected Instructor side of the Online Learning Center and the Connect Instructor Library. PowerPoint Presentations A complete set of Instructor PowerPoints, following the chapter-by-chapter content. Available on the password-protected Instructor side of the Online Learning Center and the Connect Instructor Library. Test Bank This test bank contains multiple choice questions, essay questions, and short problems. Each test item is coded for level of diffculty, learning objective, AACSB, AICPA and Bloom’s. EZ Test Online McGraw-Hill’s EZ Test is a flexible electronic testing program. The program allows instructors to create tests from book-specific items and accommodates a wide range of question types. Ex “The available website accompanying the text offers some challenging and helpful aids for students.” —Melvin Houston, Wayne State University hiL25664_fm_i-1.indd xxihiL25664_fm_i-1.indd xxi 7/24/13 2:00 AM7/24/13 2:00 AM Final PDF to printer XXII Preface Student Supplements McGraw-Hill Connect ® Accounting and Connect Plus Accounting McGraw-Hill Connect Accounting helps prepare you for your future by enabling faster learning, more efficient studying, and higher retention of knowledge. See page XVI for more details. CourseSmart CourseSmart is a new way to find and buy eTextbooks. At CourseSmart you can save up to 60 percent off the cost of a print textbook, reduce your impact on the envi- ronment, and gain access to powerful Web tools for learning. CourseSmart has the largest selec- tion of eTextbooks available anywhere, offering thousands of the most commonly adopted text- books from a wide variety of higher education publishers. CourseSmart eTextbooks are avail- able in one standard online reader with full text search, notes and highlighting, and e-mail tools for sharing notes between classmates. Online Learning Center and Connect Student Library www.mhhe.com/hilton10e The Online Learning Center (OLC) and Connect Student Library follow Managerial Accounting chapter by chapter, offering all kinds of supple- mentary help for you as you read. The following resources are available to help you study more efficiently: • Online Quizzes • Student PowerPoint Presentations • Excel Templates • Supplemental Chapters (listed below) • Check Figures • Company Websites • Narrated PowerPoints (included in Connect Library only) Student PowerPoint Presentations Presentation Slides are located on the text’s Online Learning Center and the Connect Library. Excel Templates These templates are tied to selected end-of-chapter material and are designated in the text by the Excel icon. McGraw-Hill’s Connect Accounting See page XVI for details. Supplementary Chapters Supplementary chapters on special topics are more accessible than ever. These supple- ments, located on the Online Learning Center at www.mhhe.com/hilton10e, include: • FIFO Method of Process Costing • Process Costing in Sequential Production Departments: Weighted- Average Method • Statement of Cash Flows • Analyzing Financial Statements The Solutions Manual for each supplement can be found on the password-protected Instructor’s side of the Online Learning Center. Ex hiL25664_fm_i-1.indd xxiihiL25664_fm_i-1.indd xxii 7/24/13 2:01 AM7/24/13 2:01 AM Final PDF to printer Preface XXIII Tenth Edition Reviewers Linda Brown, St. Ambrose University Russell Calk, New Mexico State University Chiaho Chang, Montclair State University Anna Cianci, Drexel University Deb Cosgrove, University of Nebraska at Lincoln William Eichenauer, Northwest State Community College Amanda Farmer, University of Georgia Leslie Fletcher, Georgia Southern University Waqar Ghani, Saint Joseph’s University Marybeth Govan, Sinclair Community College Ralph Greenberg, Temple University Rochelle Greenberg, Florida State University Maggie Houston, Wright State University Melvin Houston, Wayne State University Dennis Hwang, Bloomsburg University Mike Metzcar, Indiana Wesleyan University Christa Morgan, Georgia Perimeter College Karl Putnam, University of Texas at El Paso Theodore Rodgers, Emory University Casey Rowe, Purdue University, West Lafayette Angela Sandberg, Jacksonville State University Kathleen Sevigny, Boston College Lynda Thoman, Purdue University Michael Thomas, Humboldt State University Past Edition Reviewers John C. Anderson, San Diego State University Jeffrey Archambault, Marshall University Florence Atiase, University of Texas at Austin Rowland Atiase, University of Texas at Austin Ben Baker, Davidson College K. R. Balachandran, Stern School of Business, New York University Frederick Bardo, Shippensburg University Joseph Beams, University of New Orleans Michael Blue, Bloomsburg University Linda Bowen, University of North Carolina Richard Brody, University of New Haven Wayne Bremser, Villanova University Richard Campbell, University of Rio Grande Gyan Chandra, Miami University Marilyn Ciolino, Delgado Community College Paul Copley, James Madison University Maureen Crane, California State University, Fresno Stephen Dempsey, University of Vermont Patricia Derrick, George Washington University Martha Doran, San Diego State University Allan Drebin, Northwestern University Barbara Durham, University of Central Florida James Emig, Villanova University Robert Eskew, Purdue University Andrew Felo, Pennsylvania State University at Great Valley Michael Flores, Wichita State University Kimberly Frank, University of Nevada at Las Vegas Alan Friedberg, Florida Atlantic University Steve G. Green, United States Air Force Academy Edward Goodhart, Shippensburg University Denise Guithues Amrhein, Saint Louis University Sueann Hely, West Kentucky Community & Technical College Susan B. Hughes, University of Vermont Paul Juras, Wake Forest University Sherrie Koechling, Lincoln University Stacey Konesky, Kent State University Christy Larkin, Bacone College James Lasseter, Jr. University of South Florida Angelo Luciano, Columbia College Lois Mahoney, Eastern Michigan University Ana Marques, University of Texas at Austin We Are Grateful We would like to express our appreciation to the many people who have provided assistance in the development of this textbook. First, our gratitude goes to the thousands of managerial accounting students we have had the privilege to teach over many years. Their enthusiasm, comments, and questions have challenged us to clarify our thinking about many topics in managerial accounting. Second, we express our sincere thanks to the following professors who provided extensive reviews for this edition and past editions: Acknowledgments hiL25664_fm_i-1.indd xxiiihiL25664_fm_i-1.indd xxiii 7/24/13 2:01 AM7/24/13 2:01 AM Final PDF to printer XXIV Preface Scott Martens, University of Minnesota Maureen Mascha, Marquette University Michele Matherly, University of North Carolina at Charlotte Harrison McCraw, State University of West Georgia Sanjay Mehrotra, Northwestern University Jamshed Mistry, Worcester Polytechnic Institute Hamid Mohammadi, St. Xavier University Cynthia Nye, Bellevue University Marilyn Okleshen, Minnesota State University Mohamed Onsi, Syracuse University Samuel Phillips, Shenandoah University Thomas H. Ramsey, Wake Forest University Frederick Rankin, Washington University Roy Regel, University of Montana at Missoula Laura Rickett, Kent State University Don Samelson, Colorado State University Angela Sandberg, Jacksonville State University Rebecca Sawyer, University of North Carolina at Wilmington Pamela Schwer, St. Xavier University Thomas Selling, Thunderbird, the Garvin School of International Management Lanny Solomon, University of Missouri at Kansas City Wendy Tietz, Kent State University Ralph Tower, Wake Forest University Mark Turner, Stephen F. Austin State University Michael Tyler, Barry University Bill Wempe, T exas Christian University James Williamson, San Diego State University Priscilla Wisner, Thunderbird, the Garvin School of International Management Richard Young, Ohio State University We want to thank Ilene Persoff and Helen Roybark for their thorough checking of the text and solu- tions manual for accuracy and completeness. The supplements are a great deal of work to prepare. We appreciate the efforts of those who devel- oped them, since these valuable aids make teaching the course easier for everyone who uses the text. Angela Sandberg of Jacksonville State University prepared the Test Bank, PowerPoints, and Instructor’s Manual. Linda Schain of Hofstra University prepared the Excel Spreadsheet templates and solutions. We thank Helen Roybark of Radford University for her thorough accuracy checking of the Test Bank, Quizzes, PowerPoints and the Instructor’s Manual. We acknowledge the Institute of Management Accountants for permission to use problems from Certified Management Accountant (CMA) examinations. We also acknowledge the American Institute of Certified Public Accountants for permission to use problems from the Uniform CPA Examinations, Questions, and Unofficial Answers. We are indebted to Professors Roland Minch, Michael Maher, and David Solomons for allowing the use of their case materials in the text. The source for the actual company information in Chapters 1 and 2 regarding The Walt Disney Company, Whole Foods Market, Caterpillar, Walmart, and Southwest Airlines is the companies’ published annual reports and other public materials available on their company web sites. Finally, we wish to express our gratitude to the fine people at McGraw-Hill who so professionally guided this book through the publication process. In particular, we wish to acknowledge Donna Dillon, Tim Vertovec, Kathleen Klehr, Katie Jones, Emily Kline, Lisa King, Joanne Mennemeier, Christine Vaughan, Laurie Entringer, and Michael McCormick. Ronald W. Hilton David E. Platt hiL25664_fm_i-1.indd xxivhiL25664_fm_i-1.indd xxiv 7/24/13 2:01 AM7/24/13 2:01 AM Final PDF to printer This page intentionally left blank xxvixxvi Brief Contents 1 The Changing Role of Managerial Accounting in a Dynamic Business Environment 2 2 Basic Cost Management Concepts 34 3 Product Costing and Cost Accumulation in a Batch Production Environment 78 4 Process Costing and Hybrid Product-Costing Systems 132 5 Activity-Based Costing and Management 164 6 Activity Analysis, Cost Behavior, and Cost Estimation 224 7 Cost-Volume-Profit Analysis 266 8 Variable Costing and the Costs of Quality and Sustainability 316 9 Financial Planning and Analysis: The Master Budget 350 10 Standard Costing and Analysis of Direct Costs 408 11 Flexible Budgeting and Analysis of Overhead Costs 452 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard 498 13 Investment Centers and Transfer Pricing 542 14 Decision Making: Relevant Costs and Benefits 586 15 Target Costing and Cost Analysis for Pricing Decisions 638 16 Capital Expenditure Decisions 678 17 Allocation of Support Activity Costs and Joint Costs 732 Appendix I: The Sarbanes-Oxley Act, Internal Controls, and Management Accounting 760 Appendix II: Compound Interest and the Concept of Present Value 766 Appendix III: Inventory Management 774 References for “In Their Own Words” 781 Glossary 784 Photo Credits 796 Index of Companies and Organizations 797 Index of Subjects 799 hiL25664_fm_i-1.indd xxvihiL25664_fm_i-1.indd xxvi 8/2/13 1:12 PM8/2/13 1:12 PM Final PDF to printer xxvii Contents 1 The Changing Role of Managerial Accounting in a Dynamic Business Environment 2 Managerial Accounting: A Business Partnership with Management 5 Managing Resources, Activities, and People 5 Decision Making 6 Planning 6 Directing Operational Activities 6 Controlling 6 How Managerial Accounting Adds Value to the Organization 6 Objectives of Managerial Accounting Activity 7 M.A.P. Using Managerial Accounting to Monetize the Internet 8 The Balanced Scorecard 9 Managerial versus Financial Accounting 10 Managerial Accounting in Different Types of Organizations 12 Where Do We Find Managerial Accountants in an Organization? 12 Organization Chart 14 Cross-Functional Deployment 16 Physical Location 16 The Operational Context of Managerial Accounting 17 Managerial Accounting and the Value Chain 18 Capacity and Capacity Costs 20 M.A.P. Managing the Costs of Unused Capacity in the Auto Industry: A Global Challenge 22 Cost Management Systems 23 Managerial Accounting as a Career 23 Professional Organizations 23 Professional Certification 24 Managerial Accounting and the Ethical Climate of Business 24 Focus on Ethics: IMA Statement of Ethical Professional Practice 26 Chapter Summary 27 Key Terms 28 Review Questions 28 Exercises 28 Problems 29 Cases 31 2 Basic Cost Management Concepts 34 What Do We Mean by a Cost? 36 Product Costs, Period Costs, and Expenses 37 Costs on Financial Statements 38 Income Statement 38 Balance Sheet 40 Manufacturing Operations and Manufacturing Costs 41 Assembly Manufacturing 42 Manufacturing Costs 42 Manufacturing Cost Flows 44 Production Costs in Service Industry Firms and Nonprofit Organizations 44 Note: Entries printed in blue denote topics that emphasize contemporary issues in managerial accounting and cost management. hiL25664_fm_i-1.indd xxviihiL25664_fm_i-1.indd xxvii 8/8/13 5:38 PM8/8/13 5:38 PM Final PDF to printer xxviii Contents Basic Cost Management Concepts: Different Costs for Different Purposes 46 The Cost Driver Team 47 Variable and Fixed Costs 47 M.A.P. Understanding Exploding Health Care Costs 50 The Cost Management and Control Team 50 M.A.P. How Airlines Spend your Airfare 52 The Outsourcing Action Team 52 Costs and Benefits of Information 55 Costs in the Service Industry 56 Focus on Ethics: Was WorldCom’s Controller Just Following Orders? 57 Chapter Summary 59 Review Problems on Cost Classifications 59 Key Terms 61 Review Questions 61 Exercises 62 Problems 65 Cases 75 3 Product Costing and Cost Accumulation in a Batch Production Environment 78 Product and Service Costing 80 Product Costing in Nonmanufacturing Firms 81 Flow of Costs in Manufacturing Firms 81 Types of Product-Costing Systems 83 Job-Order Costing Systems 83 Process-Costing Systems 84 Summary of Alternative Product-Costing Systems 84 Accumulating Costs in a Job-Order Costing System 84 Job-Cost Record 84 Direct-Material Costs 85 Direct-Labor Costs 87 Manufacturing-Overhead Costs 87 M.A.P. Supply Chain Management 88 Summary of Event Sequence in Job-Order Costing 89 Illustration of Job-Order Costing 89 Purchase of Material 91 Use of Direct Material 91 Use of Indirect Material 91 Use of Direct Labor 92 Use of Indirect Labor 92 Incurrence of Manufacturing-Overhead Costs 92 Application of Manufacturing Overhead 93 Summary of Overhead Accounting 94 Selling and Administrative Costs 94 Completion of a Production Job 95 Sale of Goods 95 Underapplied and Overapplied Overhead 95 Schedule of Cost of Goods Manufactured 97 Schedule of Cost of Goods Sold 97 Posting Journal Entries to the Ledger 98 Further Aspects of Overhead Application 98 Actual and Normal Costing 98 Choosing the Cost Driver for Overhead Application 101 Departmental Overhead Rates 101 Two-Stage Cost Allocation 102 Project Costing: Job-Order Costing in Nonmanufacturing Organizations 103 Changing Technology in Manufacturing Operations 105 EDI and XML 105 Use of Bar Codes and RFID Systems 106 M.A.P. Radio Frequency Identification Systems (RFID) 106 Focus on Ethics: Did Boeing Exploit Accounting Rules to Conceal Cost Overruns and Production Snafus? 107 Chapter Summary 108 Review Problem on Job-Order Costing 108 Key Terms 110 Review Questions 110 Exercises 110 Problems 116 Cases 128 hiL25664_fm_i-1.indd xxviiihiL25664_fm_i-1.indd xxviii 7/24/13 2:01 AM7/24/13 2:01 AM Final PDF to printer Contents xxix Activity-Based Costing System 168 ABC Stage One 169 ABC Stage Two 170 Interpreting the ABC Product Costs 173 The Punch Line 175 Why Traditional, Volume-Based Systems Distort Product Costs 175 M.A.P. Cost Distortion at Rockwell International 177 Activity-Based Costing: Some Key Issues 178 Cost Drivers 178 M.A.P. Cost Distortion at DHL Express 179 Collecting ABC Data 180 Activity Dictionary and Bill of Activities 181 Activity-Based Management 182 Two-Dimensional ABC 182 Using ABM to Identify Non-Value-Added Activities and Costs 182 Customer-Profitability Analysis 185 Illustration of Customer-Profitability Analysis 185 M.A.P. Customer Profitability Analysis at Bank One Corp. 187 Activity-Based Costing in the Service Industry 188 Activity-Based Costing at Delaware Medical Center 189 Interpreting the Primary Care Unit’s ABC Information 190 Focus on Ethics: Ethical Issues Surrounding Activity-Based Costing 192 Chapter Summary 193 Review Problems on Cost Drivers and Product-Cost Distortion 194 Key Terms 195 Review Questions 196 Exercises 196 Problems 202 Cases 220 4 Process Costing and Hybrid Product-Costing Systems 132 Comparison of Job-Order Costing and Process Costing 134 Flow of Costs 134 Differences Between Job-Order and Process Costing 136 Equivalent Units: A Key Concept 136 Equivalent Units 136 Illustration of Process Costing 138 Basic Data for Illustration 139 M.A.P. New York Wine Industry 140 Weighted-Average Method of Process Costing 141 Other Issues in Process Costing 145 Actual versus Normal Costing 145 Other Cost Drivers for Overhead Application 145 Subsequent Production Departments 145 Hybrid Product-Costing Systems 146 Operation Costing for Batch Manufacturing Processes 146 Chapter Summary 149 Review Problem on Process Costing 150 Key Terms 151 Review Questions 151 Exercises 151 Problems 154 Case 163 5 Activity-Based Costing and Management 164 Traditional, Volume-Based Product-Costing System 167 Trouble in Denver 167 hiL25664_fm_i-1.indd xxixhiL25664_fm_i-1.indd xxix 7/24/13 2:01 AM7/24/13 2:01 AM Final PDF to printer xxx Contents 7 Cost-Volume-Profit Analysis 266 Illustration of Cost-Volume-Profit Analysis 269 Projected Expenses and Revenue 269 The Break-Even Point 270 Contribution-Margin Approach 270 Equation Approach 271 Graphing Cost-Volume-Profit Relationships 272 Interpreting the CVP Graph 273 Alternative Format for the CVP Graph 275 Profit-Volume Graph 275 Target Profit 276 Contribution-Margin Approach 276 Equation Approach 276 Graphical Approach 277 Applying CVP Analysis 277 Safety Margin 277 Changes in Fixed Expenses 277 Changes in the Unit Contribution Margin 278 Predicting Profit Given Expected Volume 279 Interdependent Changes in Key Variables 280 CVP Information in Published Annual Reports 281 M.A.P. Airlines Keep a Close Eye on Break- Even Load Factors 281 CVP Analysis with Multiple Products 282 Assumptions Underlying CVP Analysis 284 Role of Computerized Planning Models and Electronic Spreadsheets 284 CVP Relationships and the Income Statement 285 Traditional Income Statement 285 Contribution Income Statement 285 Comparison of Traditional and Contribution Income Statements 286 6 Activity Analysis, Cost Behavior, and Cost Estimation 224 Cost Behavior Patterns 227 Variable Costs 227 Step-Variable Costs 228 Fixed Costs 229 Step-Fixed Costs 229 Semivariable Cost 231 Curvilinear Cost 232 Using Cost Behavior Patterns to Predict Costs 233 M.A.P. Is Direct Labor a Variable or a Fixed Cost? 234 Engineered, Committed, and Discretionary Costs 235 Cost Behavior in Other Industries 236 Cost Estimation 236 Account-Classification Method 236 Visual-Fit Method 237 High-Low Method 239 Least-Squares Regression Method 240 Multiple Regression 242 Data Collection Problems 242 Engineering Method of Cost Estimation 243 Effect of Learning on Cost Behavior 243 Focus on Ethics: Cisco Systems, Walmart, Taco Bell, Starbucks, U-Haul, General Dynamics, and Farmer’s Insurance: Is Direct Labor a Variable Cost? 245 Chapter Summary 245 Review Problems on Cost Behavior and Estimation 246 Key Terms 247 Appendix to Chapter 6: Least-Squares Regression Using Microsoft ® Excel 248 Review Questions 250 Exercises 250 Problems 255 Cases 262 hiL25664_fm_i-1.indd xxxhiL25664_fm_i-1.indd xxx 7/24/13 2:01 AM7/24/13 2:01 AM Final PDF to printer Contents xxxi M.A.P. Six Sigma for Quality Management and Cost Reduction 330 ISO 9000 Standards 330 Section 3: Costs of Environmental Sustainability 332 Classifying Environmental Costs 332 Managing Private Environmental Costs 333 ISO 14000 Standards and the GRI Sustainability Reporting Framework 335 Focus on Ethics: Incentive to Overproduce Inventory 336 Chapter Summary 337 Review Problem on Absorption and Variable Costing 338 Key Terms 339 Review Questions 340 Exercises 340 Problems 343 Cases 348 9 Financial Planning and Analysis: The Master Budget 350 Financial Planning and Analysis (FP&A) Systems 352 Purposes of Budgeting 353 Types of Budgets 354 The Master Budget: A Planning Tool 354 Sales of Services or Goods 354 Sales Forecasting 355 Operational Budgets 356 Financing Budgets 357 M.A.P. The Budget: Valuable Planning Tool or Costly Waste of Time? 358 Budgeted Financial Statements 359 Activity-Based Budgeting 359 Developing the Master Budget 360 Sales Budget 362 Purchases Budget 363 Direct Labor Budget 363 Cost Structure and Operating Leverage 287 Operating Leverage 288 M.A.P. Operating Leverage Helps Web Companies to be Profitable 289 Cost Structure and Operating Leverage: A Cost-Benefit Issue 290 M.A.P. Health-Care Costs and Operating Leverage 291 CVP Analysis, Activity-Based Costing, and Advanced Manufacturing Systems 291 A Move Toward JIT and Flexible Manufacturing 292 Chapter Summary 294 Review Problem on Cost-Volume-Profit Analysis 295 Key Terms 296 Appendix to Chapter 7: Effect of Income Taxes 296 Review Questions 298 Exercises 299 Problems 302 Cases 313 8 Variable Costing and the Costs of Quality and Sustainability 316 Section 1: Absorption and Variable Costing 318 Fixed Manufacturing Overhead: The Key 319 Illustration of Absorption and Variable Costing 320 Absorption-Costing Income Statements 320 Variable-Costing Income Statements 321 Reconciling Income under Absorption and Variable Costing 321 Cost-Volume-Profit Analysis 323 Evaluation of Absorption and Variable Costing 324 M.A.P. IRS: Unique Product Packaging is an Inventoriable Cost 325 Section 2: Costs of Assuring Quality 325 Measuring and Reporting Quality Costs 325 Changing Views of Optimal Product Quality 327 hiL25664_fm_i-1.indd xxxihiL25664_fm_i-1.indd xxxi 8/8/13 5:38 PM8/8/13 5:38 PM Final PDF to printer xxxii Contents Setting Standards 412 Methods for Setting Standards 412 Participation in Setting Standards 412 Perfection versus Practical Standards: A Behavioral Issue 413 Use of Standards by Service Organizations 413 Cost Variance Analysis 414 Direct-Material Standards 414 Direct-Labor Standards 415 Standard Costs Given Actual Output 415 Analysis of Cost Variances 416 Direct-Material Variances 417 Direct-Labor Variances 419 M.A.P. Parker Hannifin Corporation’s Brass Products Division 421 Multiple Types of Direct Material or Direct Labor 421 Allowing for Production Loss 422 Significance of Cost Variances 422 A Statistical Approach 425 Behavioral Impact of Standard Costing 425 Controllability of Variances 426 Interaction among Variances 427 Standard Costs and Product Costing 427 Evaluation of Standard Costing Systems 428 Advantages of Standard Costing 428 Criticisms of Standard Costing in Today’s Manufacturing Environment 429 M.A.P. Working with Suppliers to Manage Costs 430 Focus on Ethics: Sacrificing Quality to Cut Standard Costs 431 Chapter Summary 432 Review Problem on Standard Costing and Analysis of Direct Costs 432 Key Terms 434 Appendix to Chapter 10: Use of Standard Costs for Product Costing 435 Review Questions 437 Exercises 437 Problems 439 Cases 448 Production Overhead and SG&A Budgets 365 Financing Budgets 366 Budgeted Financial Statements 369 Summary: Key Features of a Master Budget 370 Extending the Master Budget for a Manufacturing Firm 371 Production Budget 372 Direct-Material Budget 373 Budgeted Schedule of Cost of Goods Manufactured and Sold 375 Budgeted Balance Sheet 376 Assumptions and Predictions Underlying the Master Budget 377 Financial Planning Models 378 Budget Administration 378 M.A.P. Budget Administration at Cornell University 379 International Aspects of Budgeting 380 Behavioral Impact of Budgets 380 Budgetary Slack: Padding the Budget 381 Participative Budgeting 381 Focus on Ethics: Is Padding the Budget Unethical? 382 Chapter Summary 382 Review Problem on Preparing Master Budget Schedules 383 Key Terms 385 Review Questions 385 Exercises 386 Problems 390 Cases 401 10 Standard Costing and Analysis of Direct Costs 408 Managing Costs 410 Management by Exception 411 hiL25664_fm_i-1.indd xxxiihiL25664_fm_i-1.indd xxxii 7/24/13 2:01 AM7/24/13 2:01 AM Final PDF to printer Contents xxxiii 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard 498 Responsibility Centers 500 Illustration of Responsibility Accounting 501 Performance Reports 504 Budgets, Variance Analysis, and Responsibility Accounting 506 Cost Allocation 506 Cost Allocation Bases 506 Allocation Bases Based on Budgets 506 Activity-Based Responsibility Accounting 507 Behavioral Effects of Responsibility Accounting 508 Information versus Blame 508 Controllability 508 Motivating Desired Behavior 508 Segmented Reporting 509 Segments versus Segment Managers 510 Key Features of Segmented Reporting 511 Customer-Profitability Analysis and Activity-Based Costing 511 Operational Performance Measures in Today’s Production Environment 512 Gain-Sharing Plans 514 The Balanced Scorecard 515 M.A.P. The Balanced Scorecard 517 Lead and Lag Measures: The Key to the Balanced Scorecard 518 Linking the Balanced Scorecard to Organizational Strategy 519 M.A.P. Linking The Balanced Scorecard to Organizational Strategy 520 Focus on Ethics: Short-Sighted View of Cost Cutting 522 11 Flexible Budgeting and Analysis of Overhead Costs 452 Overhead Budgets 454 Flexible Budgets 455 Advantages of Flexible Budgets 455 The Activity Measure 456 Flexible Overhead Budget Illustrated 457 Formula Flexible Budget 457 Overhead Application in a Standard-Costing System 459 Choice of Activity Measure 460 Criteria for Choosing the Activity Measure 460 Cost Management Using Overhead Cost Variances 461 Variable Overhead 462 Fixed Overhead 465 Overhead Cost Performance Report 467 Activity-Based Flexible Budget 468 M.A.P. Cost Management Systems in Germany 469 Flexible Budgeting in the Service Industry 470 Focus on Ethics: Misstated Standards Affect Accuracy of Reports 472 Chapter Summary 473 Review Problem on Flexible Budgeting and Analysis of Overhead Costs 474 Key Terms 475 Appendix A to Chapter 11: Standard Costs and Product Costing 475 Appendix B to Chapter 11: Sales Variances 477 Review Questions 478 Exercises 479 Problems 482 Cases 494 hiL25664_fm_i-1.indd xxxiiihiL25664_fm_i-1.indd xxxiii 7/24/13 2:01 AM7/24/13 2:01 AM Final PDF to printer xxxiv Contents Negotiated Transfer Prices 564 Cost-Based Transfer Prices 565 Standard versus Actual Costs 566 Undermining Divisional Autonomy 566 An International Perspective 566 M.A.P. Transfer Pricing and Tax Issues 567 Transfer Pricing in the Service Industry 568 Behavioral Issues: Risk Aversion and Incentives 568 Goal Congruence and Internal Control Systems 569 Chapter Summary 570 Review Problems on Investment Centers and Transfer Pricing 570 Key Terms 572 Review Questions 572 Exercises 572 Problems 575 Cases 581 14 Decision Making: Relevant Costs and Benefits 586 The Managerial Accountant’s Role in Decision Making 588 Steps in the Decision-Making Process 589 Quantitative versus Qualitative Analysis 589 Obtaining Information: Relevance, Accuracy, and Timeliness 590 Relevant Information 591 Unique versus Repetitive Decisions 591 Importance of Identifying Relevant Costs and Benefits 592 Identifying Relevant Costs and Benefits 592 Sunk Costs 592 Irrelevant Future Costs and Benefits 595 Opportunity Costs 595 Summary 596 Analysis of Special Decisions 596 Accept or Reject a Special Offer 596 Outsource a Product or Service 598 Chapter Summary 523 Review Problems on Responsibility Accounting and Operational Performance Measures 523 Key Terms 525 Review Questions 525 Exercises 526 Problems 529 Cases 537 13 Investment Centers and Transfer Pricing 542 Delegation of Decision Making 544 Obtaining Goal Congruence: A Behavioral Challenge 545 Adaptation of Management Control Systems 545 Measuring Performance in Investment Centers 546 Return on Investment 546 Residual Income 548 Economic Value Added 551 M.A.P. Pay for Performance Based on Eva 552 Measuring Income and Invested Capital 553 Invested Capital 553 Measuring Investment-Center Income 556 Inflation: Historical-Cost versus Current-Value Accounting 557 Other Issues in Segment Performance Evaluation 557 Alternatives to ROI, Residual Income, and Economic Value Added (EVA) 557 Importance of Nonfinancial Information 558 Measuring Performance in Nonprofit Organizations 558 Transfer Pricing 559 Goal Congruence 559 General Transfer-Pricing Rule 560 Transfers Based on the External Market Price 563 hiL25664_fm_i-1.indd xxxivhiL25664_fm_i-1.indd xxxiv 7/24/13 2:01 AM7/24/13 2:01 AM Final PDF to printer Contents xxxv Economic Profit-Maximizing Pricing 642 Total Revenue, Demand, and Marginal Revenue Curves 642 Total Cost and Marginal Cost Curves 644 Profit-Maximizing Price and Quantity 644 Price Elasticity 647 Limitations of the Profit-Maximizing Model 647 Costs and Benefits of Information 647 Role of Accounting Product Costs in Pricing 648 Cost-Plus Pricing 648 Absorption-Cost Pricing Formulas 649 Variable-Cost Pricing Formulas 650 Determining the Markup 650 M.A.P. Real Time Price Wars 652 Cost-Plus Pricing: Summary and Evaluation 652 Strategic Pricing of New Products 653 Target Costing 653 M.A.P. Dynamic Pricing on the Internet by “E-Tailers” 654 A Strategic Profit and Cost Management Process 654 Activity-Based Costing and Target Costing 656 Product-Cost Distortion and Pricing: The Role of Activity-Based Costing 656 Value Engineering and Target Costing 657 Time and Material Pricing 658 Competitive Bidding 659 Effect of Antitrust Laws on Pricing 662 Chapter Summary 663 Review Problem on Cost-Plus Pricing 663 Key Terms 665 Review Questions 665 Exercises 665 Problems 668 Cases 675 16 Capital Expenditure Decisions 678 Section 1: Discounted-Cash-Flow Analysis 681 Net-Present-Value Method 682 Internal-Rate-of-Return Method 682 M.A.P. Insourcing Makes a Come-Back 599 Add or Drop a Service, Product, or Department 601 M.A.P. Adding a Service 603 Special Decisions in Manufacturing Firms 603 Joint Products: Sell or Process Further 603 Decisions Involving Limited Resources 605 Uncertainty 607 Activity-Based Costing and Today’s Advanced Manufacturing Environment 608 Conventional Outsourcing (Make-or-Buy) Analysis 609 Activity-Based Costing Analysis of the Outsourcing Decision 610 Other Issues in Decision Making 611 Incentives for Decision Makers 611 Short-Run versus Long-Run Decisions 612 Pitfalls to Avoid 612 Focus on Ethics: Effects of Decision to Close a Department and Outsource 613 Chapter Summary 614 Review Problem on Relevant Costs 614 Key Terms 615 Appendix to Chapter 14: Linear Programming 616 Review Questions 618 Exercises 619 Problems 622 Cases 634 15 Target Costing and Cost Analysis for Pricing Decisions 638 Major Influences on Pricing Decisions 640 Customer Demand 641 Actions of Competitors 641 Costs 641 Political, Legal, and Image-Related Issues 642 hiL25664_fm_i-1.indd xxxvhiL25664_fm_i-1.indd xxxv 8/8/13 5:38 PM8/8/13 5:38 PM Final PDF to printer xxxvi Contents 17 Allocation of Support Activity Costs and Joint Costs 732 Section 1: Service Department Cost Allocation 734 Direct Method 737 Step-Down Method 737 Reciprocal-Services Method 738 Fixed versus Variable Costs 739 M.A.P. Cost Reimbursement in the Health Care Industry 741 Dual Cost Allocation 741 Allocate Budgeted Costs 743 Today’s Advanced Manufacturing Environment 743 The Rise of Activity-Based Costing 744 Section 2: Joint Product Cost Allocation 744 Allocating Joint Costs 745 M.A.P. Joint Cost Allocation in the Petroleum Industry 746 Chapter Summary 747 Review Problem on Service Department Cost Allocation 748 Key Terms 749 Appendix to Chapter 17: Reciprocal-Services Method 749 Review Questions 751 Exercises 751 Problems 753 Cases 758 Appendix I: The Sarbanes-Oxley Act, Internal Controls, and Management Accounting 760 Appendix II: Compound Interest and the Concept of Present Value 766 Appendix III: Inventory Management 774 References for “In Their Own Words” 781 Glossary 784 Photo Credits 796 Index of Companies and Organizations 797 Index of Subjects 799 Comparing the NPV and IRR Methods 685 Assumptions Underlying Discounted-Cash-Flow Analysis 685 Choosing the Hurdle Rate 686 Depreciable Assets 687 Comparing Two Investment Projects 687 Managerial Accountant’s Role 690 Postaudit 690 Real Option Analysis 691 Section 2: Income Taxes and Capital Budgeting 691 After-Tax Cash Flows 691 Accelerated Depreciation 694 Modified Accelerated Cost Recovery System (MACRS) 695 Gains and Losses on Disposal 697 Investment in Working Capital 698 Extended Illustration of Income-Tax Effects in Capital Budgeting 699 M.A.P. Big Pharma Uses Capital Budgeting in Developing New Drugs 702 Ranking Investment Projects 702 Section 3: Alternative Methods for Making Investment Decisions 704 Payback Method 704 Accounting-Rate-of-Return Method 706 Estimating Cash Flows: The Role of Activity-Based Costing 708 Justification of Investments in Advanced Manufacturing Technology 709 Focus on Ethics: Dysfunctional Focus on Early Cash Flows 710 Chapter Summary 711 Review Problems on Capital Expenditure Decisions 712 Key Terms 713 Appendix A to Chapter 16: Future Value and Present Value Tables 714 Appendix B to Chapter 16: Impact of Inflation 716 Review Questions 718 Exercises 719 Problems 722 Cases 728 hiL25664_fm_i-1.indd xxxvihiL25664_fm_i-1.indd xxxvi 8/8/13 5:38 PM8/8/13 5:38 PM Final PDF to printer Managerial Accounting Creating Value in a Dynamic Business Environment hiL25664_fm_i-1.indd 1hiL25664_fm_i-1.indd 1 7/24/13 2:01 AM7/24/13 2:01 AM Final PDF to printer 1 THIS CHAPTER’S FOCUS COMPANY is The Walt Disney Company. This entertainment services company is a giant in the industry with theme parks, feature film studios, animation studios, television broadcasting, hotels and resorts, and retail stores. Using The Walt Disney Company as an illustration, we will introduce the field of managerial accounting and its major themes. Some of you are excited about studying accounting. But even more of you are asking, “Why do I need to study managerial accounting? I’m not going to be an accountant!” That is a good question. We will explore how mana- gerial accountants work in partnership with managers to add value to the organization, and how managers also use managerial accounting tools to make their decisions. FOCUS COMPANY >>>
The Changing Role of
Managerial Accounting
in a Dynamic Business
Environment
Each chapter is built around a focus company, in which the chapter’s key points are illustrated. This
chapter’s focus is on The Walt Disney Company. The focus companies in subsequent chapters are
not real companies, but they are realistic scenarios built on actual company practices. Whenever the
focus company is discussed in the chapter, the company logo appears in the margin.
hiL25664_ch01_002-033.indd 2hiL25664_ch01_002-033.indd 2 7/12/13 8:19 PM7/12/13 8:19 PM
Final PDF to printer

In contrast to the entertainment services setting of The Walt Disney Company,
we will turn our attention to Whole Foods Market, Inc. This fast-growing food
retailer has over 300 stores around North America and Europe. A leader in the area of corpo-
rate social responsibility, Whole Foods Market is frequently faced with challenging decisions
that require them to balance the need to run a profitable business and satisfy their investors
against the cost of their much-publicized commitment to organic foods and sustainable
production. We will explore managerial accounting’s contribution to Whole Foods Market’s
efforts to sell products that are more costly to produce in a competitive market while still
achieving appropriate returns for investors.
<<< IN CONTRAST Each chapter also includes a contrast company. In most cases, the contrast company will present a key chapter topic in an industry that is different from that of the focus company. In this chapter, the focus company (Walt Disney) is an entertainment services company, whereas the contrast company (Whole Foods Market) is a food retailer. hiL25664_ch01_002-033.indd 3hiL25664_ch01_002-033.indd 3 6/22/13 9:02 PM6/22/13 9:02 PM Final PDF to printer 4 After completing this chapter, you should be able to: Many different kinds of organizations affect our daily lives. Manufacturers, retail- ers, service industry firms, agribusiness companies, nonprofit organizations, and government agencies provide us with a vast array of goods and services. All of these organizations have two things in common. First, every organization has a set of goals or objectives. An airline, such as Quantas or Southwest Airlines, might specify prof- itability and customer service as its goals. The New York Police Department ’s goals would include public safety and security coupled with cost minimization. Second, in pursuing an organization’s goals, managers need information. The information needs of management range across financial, production, marketing, legal, and environmental issues. Generally, the larger the organization is, the greater is management’s need for information. Managerial accounting is the process of identifying, measuring, analyzing, inter- preting, and communicating information in pursuit of an organization’s goals. Manage- rial accounting is an integral part of the management process, and managerial accountants are important strategic partners in an organization’s management team. But note that the actions listed above are not done just by accountants: all managers use the tools of managerial accounting. That is why you are here—even if you are not planning to be an accountant! In this chapter, we will explore the role of managerial accounting within the overall management process. In the remaining chapters, we will expand our study by exploring the many concepts and tools used in managerial accounting. 1-1 Define managerial accounting and describe its role in the management process. 1-2 Explain four fundamental management processes that help organizations attain their goals. 1-3 List and describe five objectives of managerial accounting activity. 1-4 Explain the major differences between managerial and financial accounting. 1-5 Describe the accounting and finance structure in an organization. 1- 6 Describe the roles of an organization’s chief financial officer (CFO) or controller, treasurer, and internal auditor. 1- 7 Understand and explain the value chain concept. 1-8 Explain how investments in capacity affect managerial decision making. 1-9 Discuss the professional organizations and certifications in the field of managerial accounting. 1-10 Describe the ethical responsibilities and ethical standards that apply to managerial accounting. Learning Objectives highlight the key top- ics to be covered in the chapter. They are repeated in the margin of the text where they are discussed. Also, each end-of-chapter assignment lists its learning objectives in the margin. Learning Objective 1-1 Define managerial accounting and describe its role in the management process. hiL25664_ch01_002-033.indd 4hiL25664_ch01_002-033.indd 4 6/22/13 9:02 PM6/22/13 9:02 PM Final PDF to printer Chapter 1 The Changing Role of Managerial Accounting in a Dynamic Business Environment 5 1 In Their Own Words Throughout the text, you will find these quotes from both practicing managers and managerial accountants. Collectively they portray the important role managerial accounting plays in today’s dynamic business environment. The references for these quotes appear at the end of the text, beginning on page 781. The references are organized by chapter; thus reference (1a) relates to the first quote in Chapter 1, and so forth. 2 Gary Siegel, “The Image of Corporate Accountants,” Strategic Finance 82, no. 2 (August 2000), p. 71. 3 The Walt Disney Company, which is discussed in this chapter, is, of course, a real company. However, the subse- quent focus organizations around which chapters are built are not real organizations. They are, however, realistic settings in which to discuss business and managerial accounting issues. In most cases, they are based on real organi- zations. Similarly, each chapter includes a discussion of a contrast company. Some of these contrast companies, such as food retailer Whole Foods Market, Inc., in this chapter, are real companies. Others, however, are fictitious companies that are based on real organizations. These realistic illustrations and scenarios are intended to help stu- dents connect the business and managerial accounting issues discussed in this book to everyday life. Managerial Accounting: A Business Partnership with Management An organization’s management team seeks to create value for the organization by man- aging resources, activities, and people to achieve the organization’s goals effectively. Managerial accounting provides tools and perspectives that help managers accomplish this, and for that reason it is important that every business student should study it. Managerial accountants are specialists in using the tools of managerial accounting to help the organization and its managers run the operation effectively. Their knowledge builds from the material in this textbook to include advanced tools as well as knowledge and techniques specific to a company and its industry. The role of managerial accounting is very different now than it was years ago. In the past, managerial accountants were organized into support departments, often physically separated from the managers for whom they provided reports and information. Now, rather than isolate managerial accountants in a separate department, companies usually locate them in the operating departments where they are working with other managers to make decisions and resolve operational problems. Managerial accountants, often carrying the job title of “analyst,” take on leadership roles on their teams and are sought out for the valuable information they provide. The role of the accountant in leading-edge companies “has been transformed from number cruncher and financial historian to being business partner and trusted advisor.” 2 And the tools of managerial accounting are used by all managers. Managing Resources, Activities, and People The owners, directors, or trustees of an organization set its goals, generally with the help of management. For example, The Walt Disney Company ’s goals are set by its board of directors, who are elected by the company’s stockholders. The overall goal of The Walt Disney Company, according to a recent annual report, may be expressed as a commit- ment to creative excellence and corporate citizenship coupled with strict financial disci- pline in order to maximize value to the company’s shareholders. 3 In pursuing its goals, an organization acquires resources (for example, funding, pat- ents, and buildings), hires people, and then engages in an organized set of activities. It is up to the management team to make the best use of the organization’s resources, activi- ties, and people in achieving the organization’s goals. The day-to-day work of the man- agement team comprises four activities: Managerial Accounting: A Business Partnership with Management Managing Resources, Activities, and People “We are looked upon as business advisors, more than just accountants, and that has a lot to do with the additional analysis and the forward-looking goals we are setting.” (1a) 1 Caterpillar • Decision making • Planning • Directing operational activities • Controlling Learning Objective 1-2 Explain four fundamental man- agement processes that help organizations attain their goals. hiL25664_ch01_002-033.indd 5hiL25664_ch01_002-033.indd 5 7/12/13 8:19 PM7/12/13 8:19 PM Final PDF to printer 6 Chapter 1 The Changing Role of Managerial Accounting in a Dynamic Business Environment Decision Making Several years ago, Disney’s board of directors decided as one of the company’s growth objectives to expand its theme park operations in Florida. It was not imme- diately clear, however, what would be the best way to accomplish that goal. Would it be best to expand one of the company’s three existing theme parks—the Magic Kingdom, Epcot, or Disney’s Hollywood Studios ? Or should the company branch out in an entirely new direction with a brand new theme park attraction? How would each of these alternative courses of action mesh with the company’s other goals of bringing the best in creative entertainment to its customers and maintaining sound financial discipline? Disney’s top management team had to make a decision about the best way to expand the company’s Florida operations, which entailed choosing among the available alternatives. Planning Disney’s top management team decided to expand the company’s Florida operations by building an entirely new theme park named Disney’s Animal Kingdom. Created and designed by Walt Disney’s Imagineering Division, this 500-acre theme park would offer guests wide-ranging adventures and tell the fascinating stories of all animals—ancient and present-day, real and imagined. Now the detailed planning phase began. How would the Animal Kingdom’s many attractions designed by the Imagineering Division be laid out and organized? What food and beverage operations would be appropriate? How many employees would be needed on a day-to-day basis? What supplies would be required to run the park? How much would electricity and other utilities cost? How much would running the park during a typical year cost? Finally, how should the park’s admission be priced given predicted attendance? Disney’s management team had to plan for run- ning the Animal Kingdom, which meant developing a detailed financial and operational description of anticipated operations. Directing Operational Activities Now the theme park has been built, equipped, and staffed. How many cashiers should be on duty on Saturday morning? How much food should be ordered each day? How much cash will be needed to meet the payroll, pay the utility bills, and buy mainte- nance supplies next month? All of these questions fall under the general heading of directing operational activities, which means running the organization on a day-to- day basis. Controlling The theme park has operated for several years now. Is the company’s goal being accom- plished? More specifically, have the theme park’s operations adhered to the plans devel- oped by management for achieving the goal? In seeking to answer these questions, management is engaged in control, which means ensuring that the organization operates in the intended manner and achieves its goals. How Managerial Accounting Adds Value to the Organization Managers need information for all of the managerial activities described in the preceding section. That information comes from a variety of sources, including economists, finan- cial experts, marketing and production personnel, accountants, and the organization’s managerial accounting system. How Managerial Accounting Adds Value to the Organization In Their Own Words These quotes are from practicing managers or managerial accountants. The quotes show how various managerial accounting concepts are actually used and that managerial accountants are key players in most companies. “The accounting people are expected to do things that are much more strategic and much more forward looking than [they] have been expected to do in the past.” (1b) Caterpillar hiL25664_ch01_002-033.indd 6hiL25664_ch01_002-033.indd 6 6/22/13 9:02 PM6/22/13 9:02 PM Final PDF to printer Chapter 1 The Changing Role of Managerial Accounting in a Dynamic Business Environment 7 Objectives of Managerial Accounting Activity Managerial accounting activity comprises a set of tools, systems and perspectives that add value to an organization by supporting five major objectives: 1. Providing information for decision making and planning. 2. Assisting managers in directing and controlling operational activities. 3. Motivating managers and other employees toward the organization’s goals. 4. Measuring the performance of activities, subunits, managers, and other employ- ees within the organization. 5. Assessing the organization’s competitive position, and working with other man- agers to ensure the organization’s long-run competitiveness in its industry. Although financial data make up a large part of the inputs and outputs of a manage- rial accounting system, there is a strong trend toward the presentation of nonfinancial data as well. Managerial accounting systems supply all kinds of information to management in support of management’s role in directing the organization’s activities. Measuring, managing, and continually improving operational activities are critical to an organiza- tion’s success. As we will see in subsequent chapters, contemporary managerial account- ing systems are focusing more and more on the activities that occur at all levels of the organization. To illustrate the objectives of managerial accounting activity, let us continue with the example of Disney’s Animal Kingdom. Providing Information for Decision Making and Planning For virtually all major decisions, Disney’s management team would rely heavily on managerial account- ing information. For example, the decision to establish the new theme park would be influenced by estimates of the costs of building the Animal Kingdom and maintaining it throughout its life. The theme park’s managers also would rely on managerial accounting data in formulating plans for the park’s operations. Prominent in those plans would be a budget detailing the projected revenues and costs of providing entertainment. Because of the complexity and importance of this decision, Disney’s managerial accountants were key participants in the management team as decisions were made and plans formulated for the theme park’s operations. Assisting Managers in Directing and Controlling Operational Activities Direct- ing and controlling day-to-day operations require a variety of data about the process of providing entertainment services. For example, in directing operational activities, the park’s management team would need data about customer food-service demand patterns in order to make sure appropriate staffing was provided in the theme park’s various food venues. In controlling operations, management would compare actual costs incurred with those specified in the budget. Managerial accounting information often assists management through its attention- directing function . Managerial accounting reports rarely solve a decision problem. However, managerial accounting information often directs managers’ attention to an issue that requires their skills. To illustrate, suppose Disney’s Animal Kingdom incurred electricity costs that significantly exceeded the budget. This fact does not explain why the budget was exceeded, nor does it tell management what action to take, but it does direct management’s attention to the situation. Suppose that upon further investigation, the accounting records reveal that Disney’s electric rates have increased substantially. This information will help management in framing the decision problem. Should steps be taken to conserve electricity? Should they seek out a different electric power provider? Perhaps management should consider investing in a more sophisticated air conditioning system to manage the Florida heat. Learning Objective 1-3 List and describe five objectives of managerial accounting activity. “In five years [we will become] even more strategic. Really understand- ing the ins and outs of all the organizations, and really trying to be visionary— understanding what is hap- pening to our business.” (1c) Hewlett-Packard What we’re seeing is less transactional and more decision support type of work. More analytical, more . . . option analysis. Looking at the whole spec- trum of options in helping management make decisions.” (1d) Boeing hiL25664_ch01_002-033.indd 7hiL25664_ch01_002-033.indd 7 6/22/13 9:02 PM6/22/13 9:02 PM Final PDF to printer 8 Chapter 1 The Changing Role of Managerial Accounting in a Dynamic Business Environment Motivating Managers and Other Employees Toward the Organization’s Goals Organizations have goals. However, organizations also are made up of people who have goals of their own. The goals of individuals are diverse, and they do not always match those of the organization. A key purpose of managerial accounting is to motivate managers and Facebook, Walmart, Amazon.com, Coursera, and edX M A P anagement ccounting ractice 4 Steven Russolillo and Kaitlyn Kiernan, “MarketBeat: Facebook Shares Fall Below $30,” Wall Street Journal, May 29, 2012. 5Andrew Tonner, “What Does Facebook’s Redesign Mean for Investors?” The Motley Fool, March 7, 2013, http:// www.fool.com/investing/general/2013/03/07/what-does-facebooks-redesign-mean-for-investors.aspx. 6 M. Bustillo and G. A. Fowler, “Wal-Mart Uses Its Stores To Get an Edge Online,” The Wall Street Journal, December 15, 2009, p. B1. 7 Alistair Barr, “Wal-Mart Sees Sales Lift from Pay With Cash, Search,” Reuters.com , June 6, 2012. 8Tamar Lewin, “Students Rush to Web Classes, But Profits May Be Much Later,” New York Times, January 7, 2013, p. A1. The managerial account- ing practices of well- known, real-world organizations are high- lighted in these boxes. You’ll see how topics in the chapter are actually used. Actual compa- nies are indicated in blue whenever they are referenced. USING MANAGERIAL ACCOUNTING TO MONETIZE THE INTERNET Monetizing the Internet means finding a way to generate revenues from users in order to make a profit after the costs of providing the Internet service or content. Creating a successful revenue model is one of the biggest challenges faced by Internet companies. Here are some examples of how companies are using managerial accounting to try to monetize the Internet. Facebook Four months after Facebook’s initial public offering (IPO) of its stock on May 18, 2012, with its shares trading more than 50% below their $38 per share initial offer- ing price, investors were demanding answers to a question they had begun ask- ing soon after the IPO: “How will [Facebook] continue to monetize its more than 900 million users on a consistent basis?” 4 Many changes in Facebook’s site during the following months were intended to do exactly that, with managerial accountants analyzing the costs and benefits of different courses of action. For example, design changes in March 2013 were intended to “help the company increase monetization by improving its ability to target content to users with increased precision based on ‘likes.’”5 Walmart Walmart was slow to embrace internet sales because of their investment in bricks-and- mortar stores. But now they use it in conjunction with their stores to provide what compet- itor Amazon.com cannot. “Customers who buy some of the more than 1.5 million products on Walmart.com can have them shipped free to a local Walmart, where new service desks at the front of some stores make it easier for customers to retrieve their stuff.” 6 A mana- gerial accounting cost analysis showed the initiative to be profitable, so Walmart is now experimenting with other innovations to take advantage of their retail infrastructure. For example, “Pay with Cash” allows customers to pay at the store when the merchandise is picked up. “30% of these customers are new to WalMart.com . . . [which] suggests a lot of Wal-Mart customers are still concerned about using credit and debit cards online.” 7 The payoff: Walmart.com is now one of the top e-commerce sites. Higher Education Many view the Internet as the solution to the high cost of higher education, and companies like Coursera and edX have sprung up to deliver MOOCs (massive open online courses). While their effectiveness is yet to be proven, their efficiency in bringing content to thou- sands of users appeals to many. But there is one unsolved problem: even if it proves to be effective, no one has yet figured out how to monetize MOOCs! “All of this could well add up to the future of higher education—if anyone can figure out how to make money.”8 hiL25664_ch01_002-033.indd 8hiL25664_ch01_002-033.indd 8 6/22/13 9:02 PM6/22/13 9:02 PM Final PDF to printer Chapter 1 The Changing Role of Managerial Accounting in a Dynamic Business Environment 9 other employees to direct their efforts toward achieving the organization’s goals. One means of achieving this purpose is through budgeting. In establishing a budget for Disney’s Animal Kingdom, top management indicates how resources are to be allocated and what activities are to be emphasized. When actual operations do not conform to the budget, the managerial accounting system will highlight the deviation from plan, and managerial accounting tools will help the theme park’s managers to analyze and explain the reasons for the deviation. Measuring the Performance of Activities, Subunits, Managers, and Other Employees Within the Organization One means of motivating people toward the organization’s goals is to measure their performance in achieving those goals. Such mea- surements then can be used as the basis for rewarding performance through positive feed- back, promotions, and pay raises. For example, most large corporations compensate their executives, in part, on the basis of the profit achieved by the subunits they manage. In other organizations, managers are rewarded on the basis of operational measures, such as prod- uct quality, sales, or on-time delivery. At Disney’s Animal Kingdom, for example, man- agement could be rewarded, in part, on the basis of growth in attendance at the theme park. In addition to measuring the performance of people, the managerial accounting sys- tem measures the performance of an organization’s subunits, such as divisions, product lines, geographical territories, and departments. These measurements help the subunits’ managers obtain the highest possible performance level in their units. Such measurements also help top management decide whether a particular subunit is a viable economic invest- ment. For example, it may turn out that a particular attraction at Disney’s Animal Kingdom is too costly an activity to continue, despite the efforts of a skilled management team. Assessing the Organization’s Competitive Position, and Working with Other Managers to Ensure the Organization’s Long-Run Competitiveness in Its Industry The business environment often changes very rapidly. These changes result from global competition, rapidly advancing technology, and improved communication systems, such as social media. The activities that make an enterprise successful today may no longer be sufficient next year. A crucial role of managerial accounting is to con- tinually assess how an organization stacks up against the competition, with an eye toward continuously improving. Among the questions asked in assessing an organization’s com- petitive position are the following: • How well is the organization doing in its internal operations and business processes? • How well is the organization doing in the eyes of its customers? Are their needs being served as well as possible? • How well is the organization doing from the standpoint of innovation, learn- ing, and continuously improving operations? Is the organization a trendsetter that embraces new products, new services, and new technology? Or is it falling behind? • How well is the organization doing financially? Is the enterprise viable as a con- tinuing entity? The Balanced Scorecard One example of a managerial accounting tool that is used to assess competitive position and ensure long-run competitiveness is a management framework called the balanced scorecard. 9 Depicted in Exhibit 1–1 for The Walt Disney Company, the balanced score- card is a model of business performance evaluation that includes several types of finan- cial and non-financial performance measures. You want to be on the team. You want to be the business consultant. You want to be thought of as a value-adding department versus just someone who closes the books.” (1e) Qwest (now part of CenturyLink) 9 The balanced scorecard concept was developed by Robert S. Kaplan and David P. Norton. See Robert S. Kaplan and David P. Norton, The Strategy-Focused Organization: How Balanced Scorecard Companies Thrive in the New Business Environment (Boston: Harvard Business School Press, 2001). hiL25664_ch01_002-033.indd 9hiL25664_ch01_002-033.indd 9 6/22/13 9:02 PM6/22/13 9:02 PM Final PDF to printer 10 Chapter 1 The Changing Role of Managerial Accounting in a Dynamic Business Environment If an organization is to remain viable in a changing and ever more competitive busi- ness environment, its managers need to continually ask the questions emphasized in the balanced scorecard. The Walt Disney Company is no exception. • Disney’s management team must be concerned with the quality of the compa- ny’s business processes as well as its entertainment services. • Management must continually monitor the needs of its customers and assess their level of satisfaction with the services provided. • The company’s overall financial strength also must be prominent in manage- ment’s thinking. • Management must ask if the company possesses the skills it needs to continually adapt as the entertainment industry changes. The balanced scorecard is an important managerial accounting concept. We will provide an extensive discussion of the balanced scorecard in Chapter 12. Managerial versus Financial Accounting Take another look at the major objectives of managerial accounting activity. Notice that the focus in each of these objectives is on managers. Thus, the focus of managerial accounting is on the needs of managers within the organization, rather than interested parties outside the organization. Financial accounting, by contrast, is the use of accounting information for report- ing to parties outside the organization. The annual report distributed by McDonald’s Corporation or Facebook to its stockholders is an example of the output from a finan- cial accounting system. Users of financial accounting information include current and prospective stockholders, lenders, investment analysts, unions, consumer groups, and government agencies. Exhibit 1–1 Balanced Scorecard Measurement Categories Applied to The Walt Disney Company Internal Business Process Perspective Goals Measures Learning and Growth Perspective Goals Measures Financial Perspective Goals Measures Customer Perspective Goals Measures How does The Walt Disney Company look to its shareholders? How can The Walt Disney Company continually improve and create value? What do customers think of the entertainment services provided by The Walt Disney Company? In which activities must The Walt Disney Company excel? Learning Objective 1-4 Explain the major differences between managerial and financial accounting hiL25664_ch01_002-033.indd 10hiL25664_ch01_002-033.indd 10 7/12/13 8:19 PM7/12/13 8:19 PM Final PDF to printer Chapter 1 The Changing Role of Managerial Accounting in a Dynamic Business Environment 11 Exhibit 1–2 Managerial Accounting, Financial Accounting, and Cost Accounting There are many similarities between managerial accounting information and finan- cial accounting information because they both draw upon data from an organization’s core accounting system. This is the system of procedures, personnel, and computers used to accumulate and store financial data in the organization. One part of the over- all accounting system is the cost accounting system, which accumulates data about the costs of producing goods and services. These data are used in both managerial and finan- cial accounting. For example, production cost data typically are used in helping managers evaluate the pricing of different products or services, which is a managerial accounting use. However, production cost data also are used to value inventory on a manufacturer’s balance sheet, which is a financial accounting use. Exhibit 1–2 depicts the relationships among an organization’s core accounting sys- tem, its cost accounting system, and uses of the data for managerial accounting and finan- cial accounting purposes. Although similarities do exist between managerial and financial accounting, the differences are even greater. Exhibit 1–3 lists the most important differences. Accounting System (one part of the organization’s management information system) Accumulates data for use in both financial and managerial accounting Cost Accounting System (one part of the organization’s overall accounting system) Accumulates cost information Managerial Accounting Information for decision making, planning, directing, and controlling an organization’s operations, and assessing its competitive position Financial Accounting Published financial statements and other financial reports External Users of Information Stockholders, financial analysts, lenders, unions, consumer groups, and governmental agencies Internal Users of Information Managers at all levels in the organization hiL25664_ch01_002-033.indd 11hiL25664_ch01_002-033.indd 11 6/22/13 9:02 PM6/22/13 9:02 PM Final PDF to printer 12 Chapter 1 The Changing Role of Managerial Accounting in a Dynamic Business Environment Exhibit 1–3 Differences between Managerial and Financial Accounting. Managerial Accounting in Different Types of Organizations Organizations need information the way humans need food: without this basic fuel, they cannot sustain the activities that make them vital. This is true whether they are profit- seeking or nonprofit enterprises and regardless of the activities they pursue. As a result, managerial accounting information is vital in all types of organizations. Ford (manu- facturing), J.Crew (retail), GoDaddy.com (Internet), American Airlines (transportation), Marriott Hotels (tourism), Goldman Sachs (financial services), The University of Texas (education), The American Red Cross (nonprofit), M. D. Anderson Cancer Center (health care), and the U.S. Department of Defense (government) all have managerial accountants who provide information to management. Moreover, the five basic purposes of manage- rial accounting activity are relevant in each of these organizations, and all managers in those companies and industries are using managerial accounting tools. Where Do We Find Managerial Accountants in an Organization? As we discussed earlier, every manager must have an understanding of basic manage- rial accounting concepts and tools. However, complex decisions such as the one to open Disney’s Animal Kingdom usually receive the support of expert managerial accountants. To have a good understanding of where these experts can be found in a large organization, we must answer three questions: • Where are managerial accountants located in an organization chart? • How are managerial accountants deployed to support decision making? • In what physical location do managerial accountants actually do their work? Although most business schools have separate departments dedicated to teaching the skills of accounting and finance, in companies accounting and finance personnel are often part of the same organizational units. Take a look at Exhibit 1–4 , which portrays the organization, deployment, and physical location of the accounting and finance organization, including managerial accountants, in The Walt Disney Company. Where Do We Find Managerial Accountants in an Organization? “[We are] a partner with all of the other functions in the business here. We are an equal partner with our prod- uct groups, with the engi- neering and manufacturing cohorts in making sure this business is a success.” (1f) Caterpillar Managerial Accounting Financial Accounting Users of Information Managers, within the organization. Regulation Not required and unregulated, since it is intended only for management. Source of Data Almost exclusively drawn from the organi- zation’s core accounting system, which accu- mulates financial information. Nature of Reports and Procedures Reports focus on the enterprise in its entirety. Based almost exclusively on historical trans- action data. Required and must conform to generally accepted accounting principles. Regulators include the International Accounting Standards Board, the Financial Accounting Standards Board (U.S.), and the U.S. Securities and Exchange Commission. The organization’s core accounting system, plus various other sources, provide financial data as well as nonfinancial data such as product defect rates, quantities of material and labor used in production, occupancy rates in hotels, and average take-off delays in airlines. Reports often focus on subunits within the organization, such as departments, divisions, geographical regions, or product lines. Based on a combination of historical data, estimates, and projections of future events. Interested parties, outside the organization. Learning Objective 1-5 Describe the accounting and finance structure in an organization. hiL25664_ch01_002-033.indd 12hiL25664_ch01_002-033.indd 12 6/22/13 9:02 PM6/22/13 9:02 PM Final PDF to printer Exhibit 1–4 Managerial Accountants in The Walt Disney Company Senior Executive VP Chief Financial Officer Senior accounting and finance staff from Operating Units report both within the Operating Unit and to the CFO or the Sr. VP for Planning and Control Executive VP Corporate Real Estate, Sourcing, and Treasurer Senior VP Global Security Senior VP Planning and Control Executive VP Corporate Communications Senior Executive VP General Counsel Executive VP Human Resources Disney Consumer Products President Disney Interactive Media Group President Operating Units ESPN, Inc. President TOP MANAGEMENT STAFF POSITIONS LINE POSITIONS A. Organization Chart for The Walt Disney Company Walt Disney Company Operating Units Disney/ABC Television Group President Operating Units Operating Units Operating Units Operating Units Executive VP Corporate Strategy and Business Development The Walt Disney Studios Chairman Walt Disney Parks and Resorts Worldwide Chairman Disney Media Networks Executive Chairman Board of Directors Chairman of the Board and Chief Executive Officer hiL25664_ch01_002-033.indd 13 hiL25664_ch01_002-033.indd 13 7/12/13 8:19 P M 7/12/13 8:19 P M Final PD F to printer 14 Chapter 1 The Changing Role of Managerial Accounting in a Dynamic Business Environment “[Managerial accountants] need to be strongly part- nered with the line man- agement. They need to be proactive. They need to have a broad sense of business. It’s not strictly accounting. It’s looking at the full spec- trum and range of business.” (1g) Boeing B. Deployment of Managerial Accountants in Cross-Functional Management Teams Hypothetical Planning Team for New Attractions at California’s Disneyland Resort Assistant General Manager, Disneyland Resort Operations Manager, Disneyland Resort Manager of Customer Relations, Walt Disney Parks and Resorts Worldwide Managerial Accountants, Disneyland Resort Creative Talent, Walt Disney Imagineering Hypothetical Decision-Making Team for a New Line of Disney Products to Be Sold at Disney Stores Marketing Manager, Disney Consumer Products Operations Manager, Disney Consumer Products Creative Talent, Walt Disney Imagineering Managerial Accountants, Disney Consumer Products Marketing Personnel, Disney Interactive Media Group Hypothetical Decision-Making Team for Hotel to Be Built near the Tokyo Disney Resort Assistant General Manager, Tokyo Disney Resort Assistant General Manager for Disney Yacht Club Resort at Walt Disney World Creative Talent, Walt Disney Imagineering Managerial Accountants, Walt Disney Parks and Resorts Worldwide and Tokyo Disney Resort Staff Lawyers, Office of the General Counsel Hypothetical Planning Team for Disney’s Animal Kingdom Marketing Manager, Walt Disney Parks and Resorts Worldwide Creative Talent, Walt Disney Imagineering Managerial Accountants, Walt Disney World Resort Operations Manager, Walt Disney World Resort Organization Chart First, let’s focus on panel A of the exhibit, which depicts The Walt Disney Company’s organization structure. 10 Notice that the company is led by its board of directors, which represent the interests of the company’s stockholders. The company’s leading executive is its chief executive officer (CEO). The CEO is generally a member of the Board of Directors and sometimes, as at Disney, also serves as the Chairman of the Board of Direc- tors. Other times, a board member who is not part of company management will hold the position of Chairman. Line and Staff Positions The other positions in Disney’s organization chart are of two types: line positions and staff positions. Managers in line positions are directly involved in the provision of goods or services. For example, Disney’s line positions include the president of Disney Consumer Products (producing and selling products based on the Disney brand and characters), the president of the ESPN sports cable channel , and the chairman of Walt Disney Parks and Resorts Worldwide (operating Disney’s theme parks around the world and its cruise line). Also in line positions would be the thousands of Exhibit 1–4 continued 10 The information for the organization chart comes from The Walt Disney Company Fact Book, available at http:// thewaltdisneycompany.com/investors/shareholder-information . hiL25664_ch01_002-033.indd 14hiL25664_ch01_002-033.indd 14 6/22/13 9:02 PM6/22/13 9:02 PM Final PDF to printer Chapter 1 The Changing Role of Managerial Accounting in a Dynamic Business Environment 15 managers in the various operating units of the divisions shown in the organization chart. For example, the general manager of Disney’s Animal Kingdom in the Walt Disney World Resort, the production manager for SportsCenter on ESPN, and the manager of the Disney Store in the Mall of America in Minnesota, would all be in line positions. Managers in staff positions supervise activities that support Disney’s overall mis- sion, but they are only indirectly involved in operational activities. Disney’s staff posi- tions include the general counsel, the executive VP for human resources, and the chief financial officer (CFO), among others. CFO or Controller In many organizations, the designation given to the executive responsible for all accounting and finance functions is the chief financial officer (CFO) . Sometimes called the controller in smaller companies or the comptroller in nonprofit or governmental organizations, the CFO is the organization’s top managerial and finan- cial accountant. The CFO has responsibility for supervising the accounting and finance specialists throughout the company and for preparing the information and reports used in both managerial and financial accounting. As the organization’s chief managerial accountant, the CFO interprets accounting information for line managers and participates as an integral member of the management team. Most CFOs and controllers are involved in planning and decision making at all levels and across all functional areas of the enter- prise. This broad role has enabled many managerial accountants to rise to the top of their organizations. Former accountants have served as top executives in such companies as General Motors, Singer, General Electric, and Fruehauf. C. Managerial Accountants Physically Located Throughout the Enterprise The Walt Disney Company Corporate Headquarters, Burbank, California Walt Disney Parks and Resorts Worldwide Disney Media Networks Tokyo Disney Resort ESPN Advertising Sales ESPN, Inc.Disney Ambassador Hotel Tokyo, Japan Disney Interactive Media Group Production teams for a new Internet gaming site On location for the shooting of a feature film Food and Beverage Department, Disney Ambassador Hotel, Tokyo The Walt Disney Studios Disney Consumer Products The Disney Store, Times Square, NYC Learning Objective 1-6 Describe the roles of an orga- nization’s chief financial officer (CFO) or controller, treasurer, and internal auditor. Exhibit 1–4 continued hiL25664_ch01_002-033.indd 15hiL25664_ch01_002-033.indd 15 6/22/13 9:02 PM6/22/13 9:02 PM Final PDF to printer 16 Chapter 1 The Changing Role of Managerial Accounting in a Dynamic Business Environment In addition to the CFO or controller for the entire corporation, most companies, including The Walt Disney Company, have divisional controllers. Thus, Disney’s detailed organization chart would show a controller for Disney/ABC Television Group, Disney- land Paris, The Walt Disney Studios, and so forth. In recent years, an increasing awareness of the importance of planning, budgeting, and analysis of performance has caused some larger organizations to adopt a variation on the model just described. In this alternate structure, a subset of the managerial accounting functions relating to financial planning and analysis are overseen by a chief performance analyst. Sometimes the chief performance analyst reports to the CFO. But often, as in the case of Disney’s chief performance analyst, the Sr. VP for Planning and Control, the unit is separate from the CFO (see the Disney organization chart). Treasurer The treasurer typically is responsible for raising capital and safeguarding the organization’s assets. In addition, the treasurer is responsible for the organization’s assets, the management of its investments, its credit policy, and its insurance coverage. Internal Auditor Most large corporations and governmental agencies have an internal auditor. An organization’s internal auditor, who in larger organizations is the director of an internal audit department, is responsible for reviewing the account- ing procedures, records, and reports in both the managerial and financial accounting areas of responsibility. The auditor then expresses an opinion to top management and the organization’s board of directors regarding the effectiveness of the organization’s accounting system and its system of internal controls. In some organizations, the inter- nal auditor’s role is much more extensive than this and can include a broad assessment of company operations. Cross-Functional Deployment On a formal organization chart, accountants generally are in a staff capacity, as explained in the preceding section. However, managerial accountants are increasingly being deployed in cross-functional management teams. Managerial accountants work with executives from top management, marketing and sales personnel, design engineers, operations man- agers, legal experts, quality-control personnel, and virtually every other specialized type of employee in an organization. Managerial teams are formed to make decisions, engage in planning exercises, or address operational problems from many perspectives. Since financial and other managerial accounting issues often are critically important in address- ing business problems, managerial accountants routinely play a major role in these cross-functional teams. Panel B of Exhibit 1–4 depicts several plausible cross-functional teams formed to address a variety of hypothetical business problems at The Walt Disney Company. Notice that each of these teams pulls together individuals from a variety of specialties, such as marketing, operations, general management, customer relations, and the general counsel’s office (legal issues). Given Disney’s overall business strategy, creative talent is almost always present in these cross-functional teams; moreover, mana- gerial accountants play an important role as well. Physical Location Finally, where do managerial accountants actually do their work? The answer is “just about everywhere.” As Panel C of Exhibit 1–4 highlights, managerial accountants are not sequestered in some remote corner of the business. To the contrary, they are located in every part of an enterprise, from corporate headquarters to the locations where goods and services are being produced. At Disney, for example, managerial accountants would be present on location when a feature film is being produced, near the ESPN production studio when decisions are made about deploying sports commentators, and in the various Disney hotels, such as the Disney Ambassador Hotel in Tokyo. “Historically the career path in finance had been very linear across the traditional finance roles. . . . It’s not linear anymore.” (1i) IBM “Most of the people . . . are decentralized and actually are co-located with the people that they support. That’s our approach and we’re moving more and more toward that and less and less toward a central group that provides information.” (1j) Boeing “One role [of the CFO] is classic finance to focus Intel on driving profits and com- pliance with all laws world- wide. The other role is to be a sounding board for me and other senior managers in terms of our strategies and opportunities.” (1h) Intel Corp. hiL25664_ch01_002-033.indd 16hiL25664_ch01_002-033.indd 16 6/22/13 9:02 PM6/22/13 9:02 PM Final PDF to printer Chapter 1 The Changing Role of Managerial Accounting in a Dynamic Business Environment 17 Managerial accounting information is vital in all types of organizations. Managerial accountants act as strategic business partners in support of management’s roles in decision making and directing operational activities. Pictured here are a manufacturer, a financial services firm, a retailer, and a nonprofit municipal fire department. How would managerial accounting be important in each of these organizations? The Operational Context of Managerial Accounting As we have discussed, managerial accounting concepts and techniques are applied throughout an organization, sometimes by professional managerial accountants and other times by managers in other fields who are using managerial accounting techniques. This means that managerial accounting concepts and techniques are applied in every imagin- able part of a company’s operations. This includes the obvious accounting and finance areas, but also sales, marketing, production and operations, customer service, product development, and human resource management. We can put these many and varied applications of managerial accounting into con- text by thinking of the organization as the sum of the activities it performs to produce its goods and services and the decisions that need to be made to support each of those activities. The Operational Context of Managerial Accounting hiL25664_ch01_002-033.indd 17hiL25664_ch01_002-033.indd 17 6/22/13 9:02 PM6/22/13 9:02 PM Final PDF to printer 18 Chapter 1 The Changing Role of Managerial Accounting in a Dynamic Business Environment Managerial Accounting and the Value Chain How are the goods and services that we all consume created? Usually many activities are involved in securing basic raw materials and turning them into valuable products or services. The set of linked, value-creating activities, ranging from securing basic raw materials and energy to the ultimate delivery of products and services, is called the value chain . Different companies define their value chains in different ways, depending on their strategies, but the bottom line is this: Customers must “value” the activities in the value chain, because unless customers are willing to pay the cost of those activities plus an appropriate amount of profit, the company will fail. Although there may be only one organization involved in a particular value chain, usually there are many. San Francisco General Hospital ’s value chain, for example, would include not only the hospital but also the suppliers of pharmaceutical products and medical supplies, the manufacturers of diagnostic equipment, the private-practice physi- cians whose patients use the hospital, and the ambulance services that transport patients to the hospital. The value chain for The Walt Disney Studios would include upstream contributions such as screenwriting, film studio construction and maintenance, set design and construc- tion, costume design and production, travel arrangements for shooting scenes on loca- tion, lighting technicians, film crews, and acting talent. Once the film has been produced, the downstream contributions include advertising personnel; TV, radio, and print media; film distributors; theater companies such as AMC Entertainment; DVD producers; online video providers such as Netflix ; and DVD retailers such as Amazon.com . Let’s turn our attention now to this chapter’s contrast company, Whole Foods Market, Inc. A fast-growing food retailer headquartered in Austin, Texas, Whole Foods Market has over 300 stores in the U.S. and Europe. Whole Foods Market is owned by its stock- holders, and its stock is publicly traded on the NASDAQ market. As its website explains, Whole Foods Market’s managers and accountants work to earn a profit for stockholders by maintaining a reputation as a seller of quality, sustain- ably produced products and a fun place to shop. Each of these factors must be considered by the company’s managers as they make decisions about the design of their value chain. Making the right decisions about a value chain can be the difference between success and failure for a company, and the decisions for Whole Foods Market include answering critical questions like: • Which value chain activities must a grocery store include? • Are there activities that other grocery stores don’t include in their value chain that would provide a competitive advantage? • Which activities must they provide themselves and which can be outsourced to others? • How much can each value chain activity cost? The major steps in the value chain for Whole Foods Market, Inc. are depicted in Exhibit 1–5 . They include the following: • Supplier development (sustainable, organic, and local suppliers). • Agricultural and nonagricultural production. • Managing and distributing inventory. • Marketing and customer service. • In-store production. • Store retail operations. • Community stewardship. Notice that Whole Foods Market does not execute every step in this value chain itself. Except for in-store production, like prepared meals and baked goods, Whole Foods Mar- ket does not produce what it sells. As the company’s website explains “We are not a fully Learning Objective 1-7 Understand and explain the value chain concept. hiL25664_ch01_002-033.indd 18hiL25664_ch01_002-033.indd 18 6/22/13 9:02 PM6/22/13 9:02 PM Final PDF to printer Chapter 1 The Changing Role of Managerial Accounting in a Dynamic Business Environment 19 self-sustaining ecosystem. There are hundreds of other businesses that we depend on to assist us in creating an outstanding retail shopping experience for our customers.” What Whole Foods Market does do is to establish the variety and standards for its products, outsource the production of those products, market the products, and distribute them to retail stores where they are sold, in some cases adding value through in-store production. Now compare in your mind the Whole Foods Market value chain to the one for your biggest local grocery chain. Would its supplier development and community stewardship efforts be so large and significant that they warrant being included as the first and last steps in the value chain? This is a strategic choice that Whole Foods Market has made, and as a result it has to generate profits from customers that are adequate to support sig- nificant and costly efforts in these areas. For example, their website notes that the Whole Foods Market Local Producer Loan Program “provides up to $10 million in low-interest loans to small, local producers,” and that “Overall, our community giving well exceeds 5% of our total net profits each year.” But these elements of the value chain have to be supported by customer spending because “We recognize that profits are essential to creat- ing capital for growth, prosperity, opportunity, job satisfaction and job security.” 11 Supporting these elements of the value chain while still making a profit is why Whole Foods Market is sometimes jokingly called “Whole Paycheck”! But by understanding their customers and the value chain activities that they are willing to pay for, Whole Foods Market consistently covers its costs and makes a nice return for stockholders. In order for any organization to most effectively achieve its goals, it is important for its managers to understand the entire value chain in which their organization partici- pates. This understanding can help managers ask, and answer, important questions about their organization’s strategy. Should the company concentrate on only a narrow link in the value chain, such as retail operations? Or should it expand its operational scope to include in-store production? Are there opportunities to acquire suppliers, and good rea- sons to do so? 11 The quotes in these paragraphs are from the Whole Foods Market website at www.wholefoodsmarket.com . Exhibit 1–5 The Whole Foods Market value chain consists of a myriad of activities, from production through sales, and beyond. Supplier development Agricultural and non-agricultural production Managing and distributing inventory Marketing and customer service In-store production and retailing Community stewardship hiL25664_ch01_002-033.indd 19hiL25664_ch01_002-033.indd 19 7/12/13 8:19 PM7/12/13 8:19 PM Final PDF to printer 20 Chapter 1 The Changing Role of Managerial Accounting in a Dynamic Business Environment These questions involve fundamental, strategic issues about how an organization can best meet its goals. Although many factors affect such decisions, one important factor concerns the costs incurred when companies compete based on the same set of value chain activities. In order for a company to achieve a sustainable competitive advantage, it must either (1) perform one or more activities in the value chain at the same quality level as its competitors, but at a lower cost, or (2) perform its value chain activities at a higher quality level than its competitors, but at no greater cost. Understanding the value chain, and the factors that cause costs to be incurred in each activity in the value chain, is a crucial step in the development of a firm’s strategy. These cost-causing factors are called cost drivers, and we will have much more to say about them throughout the text. The overall recognition of the importance of cost relationships among the activities in the value chain, and the process of managing those cost relationships to the firm’s advantage, is called strategic cost management. Issues in strategic cost management will arise in a variety of contexts as we pursue our study of managerial accounting. Capacity and Capacity Costs A key challenge in providing useful managerial accounting information is understand- ing and correctly analyzing an organization’s capacity and the costs of providing that capacity. By capacity we mean the upper limit on the amount of goods or services that an organization can produce in a specified period of time. For example, how many iPads can Apple manufacture in a month? Or how many people can Disney’s Magic Kingdom effectively accommodate in a day? Or how many cell phone calls or text messages can Verizon process in an hour? Managers at Whole Foods Market must make many decisions about the amount of capacity to provide. Each activity in their value chain brings capacity challenges, from how many supplier development managers to hire, to the size of the next store to be opened, to the staffing levels in each existing store. For example, the company must spend money to train and employ cashiers. Every dollar spent on cashiers is a dollar of profit that will not be earned for stockholders, so Whole Foods Market does not want to schedule one hour more of cashier time than it has to. But if shoppers find checkout lines that are too long because there are not enough cashiers available to work, they will not find the shopping environment to be enjoyable and might go elsewhere to shop for groceries. Every grocery item that they buy some- where else represents lost profit to Whole Foods Market. But how to balance the lost profit on groceries against the cost of providing cashiers, especially when hiring and ori- enting a new employee and then training that employee as a cashier is such a significant investment? This is the capacity dilemma faced by Whole Foods Market’s managers and accountants. We will develop some tools in a later chapter to help describe this problem more precisely and to make this decision. But let’s begin in this chapter by considering a very simple example of how to think about the costs of capacity. There are various concepts of an organization’s capacity. Theoretical capacity refers to the upper limit on production of goods or services if everything works perfectly. This means that no cashiers miss time for illness, no cash registers break down, there are no unexpected interruptions such as power outages or severe storms, and so forth. Most man- agers believe that a more useful measure of capacity is practical capacity , which allows for normal occurrences such as cash register downtime and cashier fatigue or illness. Important questions for the managerial accounting system to address are: (1) What is an organization’s practical capacity? (2) What are the costs of the resources supplied to provide that capacity? and (3) How have those resources been used? To explore these issues, let’s focus on a familiar scenario, the pizza business. Some of Whole Foods Market’s bigger stores include a “pizza bar,” where pizzas can be pur- chased whole or by the slice. Let’s suppose you have taken a job there making pizzas. You work the 6:00 to 8:00 PM shift three evenings a week, Monday, Wednesday, and Learning Objective 1-8 Explain how investments in capacity affect managerial decision making. “One of the problems today is that we rely on all these computer reports—we know what customers buy, and how rapid the sell- through is on any given item—but no report will tell you how much they would have bought if things had been different.” (1k) Macy’s hiL25664_ch01_002-033.indd 20hiL25664_ch01_002-033.indd 20 6/22/13 9:02 PM6/22/13 9:02 PM Final PDF to printer Chapter 1 The Changing Role of Managerial Accounting in a Dynamic Business Environment 21 Friday. In addition to the obvious fringe benefit of getting to eat the occasional free slice of pizza with your favorite toppings, you receive a wage of $8 an hour. So each evening that you work, you make $16. After some training and a little experience, you can make a pizza in about six min- utes. This includes picking up a premeasured lump of pizza dough, patting it out, twirling it ostentatiously over your head a few times, putting it down, covering it with pizza sauce, applying the cheese and other toppings, and tossing it in the oven. Making a pizza with “the works” takes longer than a plain cheese pizza, but for the typical combination of piz- zas made on a typical evening, it averages out to six minutes. Also, the six-minute average time required per pizza allows for occasional mistakes, retrieving more toppings from the deli when they run out, taking short cell-phone calls, and other normal disruptions. You have no scheduled break during your short two-hour shift, so on a busy evening you could make as many as 20 pies (120 minutes available ÷ the average 6 minutes per pizza). So, using the terminology discussed above, the cost of the labor resources supplied for your two-hour shift is $16, and the practical capacity of that two-hour shift is 20 piz- zas made. Now suppose that during the first week of October, you experience very different lev- els of demand on your three evening shifts. Monday night football causes a steady demand for pizzas, and you make 20 pies that evening. Wednesday evening is pretty slow, and you make just 10 pies. Friday evening, which is normally very busy, is unusually slow because of a traffic jam that keeps many customers from reaching the store. You make just one pie. Now we can calculate the cost of your labor for a pizza during each of your three shifts. One fairly simple answer is to divide your labor cost per shift by the number of pizzas you made in each shift, as follows: Shift Labor Cost Pizzas Made Cost per Pizza Monday $16.00 20 $ .80 Wednesday 16.00 10 1.60 Friday 16.00 1 16.00 Let’s stop and think about this. Does this analysis make any sense? Most accountants and managers would argue that it does not make much sense to say that Monday’s pizzas cost $.80 each for your labor, Wednesday’s cost $1.60 each, and the one you made Friday cost $16.00! This result highlights the problem of confusing the cost of a resource sup- plied with the cost of a resource used. The cost of your labor resource supplied during each shift was $16.00, but the cost of your labor resource used varied from shift to shift due to widely different demand levels. The cost of your labor resource used should be computed as shown in column (c) of the following table. Moreover, the cost of your labor resource used per pizza is a constant $.80 per pizza, regardless of demand, as calculated in column (d). Finally, the cost of your labor resource unused (i.e., the cost of unused capacity) is calculated in column (e). To best understand the table, start with column (a) and work across. (a) Shift (b) Cost of Labor Resource Supplied (2 hours × $8.00 per hour) (c) Cost of Labor Resource Used [$16.00 × (pizzas made ÷ pizzas in practical capacity)] (d) Cost of Labor Resource Used per Pizza [cost of labor resource used ÷ pizzas made] (e) Cost of Labor Resource Unused (i.e., cost of unused capacity) [$16.00 − cost of labor resource used] Monday $16.00 $16.00 [$16 × (20 ÷ 20)] $.80 ($16.00 ÷ 20) $ .00 Wednesday 16.00 8.00 [$16 × (10 ÷ 20)] .80 ($8.00 ÷ 10) 8.00 Friday 16.00 .80 [$16 × (1 ÷ 20)] .80 ($.80 ÷ 1) 15.20 hiL25664_ch01_002-033.indd 21hiL25664_ch01_002-033.indd 21 6/22/13 9:02 PM6/22/13 9:02 PM Final PDF to printer 22 Chapter 1 The Changing Role of Managerial Accounting in a Dynamic Business Environment Ford, Renault, and Nissan M A P anagement ccounting ractice 12 Keith Naughton, “Ford Profit Squeezed by Excess Plant Capacity in Europe,” Bloomberg.com , July 19, 2012; and Keith Naughton and Alex Webb, “Ford to Cut 5,700 Jobs with Three European Plan Closings,” Bloomberg.com , October 25, 2012. 13 David Pearson, “Renault Mulls Making Nissan Cars,” Wall Street Journal, January 18, 2013. 14 This is, of course, a very simple illustration, because it focuses on a single resource, i.e., the cost of one employ- ee’s labor. Even an operation as simple as making pizzas involves many resources, such as pizza ingredients, mul- tiple employees, buildings and equipment, and advertising. Imagine how much more complicated capacity issues are for a major airline or a large manufacturer. Nevertheless, by exploring the concepts of capacity and the cost of capacity in a very simple scenario, you should have an initial understanding of this critical issue. For an example, see D. Welch and I. Rowley, “Risky Business at Nissan,” BusinessWeek, November 2, 2009, p. 34. Seems obvious, doesn’t it? But it is not uncommon for managers to mistakenly act like all the money spent on production should be divided up over the products or services produced, without considering whether some of that spending was for resources supplied but unused. The moral of the story is that it is very important to distinguish among the cost of resources supplied [column (b) above], the cost of resources used [column (c) above], and the cost of resources unused [column (e) above], which is the same as the cost of unused capacity. An important task for any management team, including the one at Whole Foods Market, is to understand and manage the cost of capacity. Providing them data about the costs of unused capacity gives them an important tool. 14 MANAGING THE COSTS OF UNUSED CAPACITY IN THE AUTO INDUSTRY: A GLOBAL CHALLENGE Most companies cannot easily adjust their production capacity to match demand. Once a manufacturer of automobiles has invested in a factory, its options for increasing or decreasing that capacity and related costs are limited. If sales are low, management can reduce the hours of production, but the facility costs remain. Moreover, labor costs often cannot easily be adjusted because of national labor laws, union rules, and practical con- cerns such as training costs and employee loyalty. So, if the costs of unused capacity cannot be adjusted to match demand, how can a company manage capacity to avoid the drain on income that comes with unused capac- ity? The solution involves isolating the capacity problem: (1) shift production between facilities to maximize utilization of capacity in selected primary facilities while creating additional unused capacity in secondary facilities, and (2) sell or find alternative uses for the now-vastly-underutilized secondary facilities. American automaker Ford Motor Co. followed exactly this approach in addressing their profitability problems in the European market. “We know what it takes to be profitable in Europe. . . . We’ll work to match capacity with demand while accelerating new-product development.” A few months after that statement, Ford announced that it would move production of vehicles and components from three underutilized plants in Europe to other facilities and close the plants. “The closings include . . . a 48-year-old plant in Genk [Belgium] that builds cars and minivans. . . . Production of those models will shift to Ford’s plant in Valencia, Spain.” 12 Renault SA and Nissan Motor Co., French and Japanese companies, respectively, have used their unusual alliance to manage capacity across the two companies. Each com- pany owns a substantial portion of the other, and they share a CEO, Carlos Ghosn. Nis- san recently began manufacturing a vehicle for the U.S. market at “a Renault Samsung Motors plant in Busan, South Korea . . . [that had] been operating at half of its capacity of 300,000 vehicles a year.” Meanwhile, with Renault struggling with decreased demand in Europe due to weakness in that market, Nissan is considering “shifting some of its [production] workload to Renault’s underutilized French facilities” as a way of absorbing strong demand for their products elsewhere. 13 hiL25664_ch01_002-033.indd 22hiL25664_ch01_002-033.indd 22 6/22/13 9:02 PM6/22/13 9:02 PM Final PDF to printer Chapter 1 The Changing Role of Managerial Accounting in a Dynamic Business Environment 23 Cost Management Systems The explosion in technology we are experiencing, coupled with significant worldwide competition, is forcing managers to produce high-quality goods and services, provide outstanding customer service, and do so at the lowest possible cost. To help managers cope with this high-pressure environment, many companies have moved away from a historical cost accounting perspective and toward a proactive cost management perspec- tive. A cost management system is a management planning and control system with the following objectives. • Measure the cost of the resources consumed in performing the organization’s significant activities and measure the unused capacity of those resources. • Identify and eliminate non-value-added costs. These are the costs of activities that can be eliminated with no deterioration of product quality, performance, or perceived value. • Determine the efficiency and effectiveness of all major activities performed in the enterprise. • Identify and evaluate new activities that can improve the future performance of the organization. Notice the emphasis of a cost management system on the organization’s activities. This emphasis, sometimes called activity accounting , is crucial to the goal of producing quality goods and services at the lowest possible cost. In keeping with the focus on activi- ties, managerial accountants have developed a system for determining the cost of produc- ing goods or services called activity-based costing (ABC) . In an ABC system, the costs of the organization’s significant activities are accumulated and then assigned to goods or services in accordance with how the activities are used in the production of those goods and services. An ABC system helps management understand the causal linkages between activities and costs. Using an activity-based costing system to improve the operations of an organization is called activity-based management , or ABM . We will have considerably more to say about activity-based costing, activity-based management, and the role of cost manage- ment systems throughout the text. Managerial Accounting as a Career As we have discussed, managerial accountants are found throughout the organization and, as such, they are often in touch with its many practices and procedures. In most businesses, managerial accountants interact frequently with sales personnel, finance specialists, production staff, and managers at all levels. To perform their duties effec- tively, managerial accountants must be knowledgeable not only in accounting but in the other major business disciplines as well. Moreover, strong oral and written com- munication skills are becoming increasingly important for success as a managerial accountant. Professional Organizations Many managerial accountants and members of the corporate finance and accounting team are Certified Public Accountants (CPAs) and members of the American Institute of CPAs. However, the CPA designation was designed primarily to assure the competence of those working outside of companies and passing judgments about the reliability of accounting reports for the “public,” particularly investors and regulators. To focus on best practices and new developments in accounting and finance inside of companies, the managerial accounting profession also has its own certifications and Managerial Accounting as a Career Learning Objective 1-9 Discuss the professional organizations and certifications in the field of managerial accounting. hiL25664_ch01_002-033.indd 23hiL25664_ch01_002-033.indd 23 6/22/13 9:02 PM6/22/13 9:02 PM Final PDF to printer 24 Chapter 1 The Changing Role of Managerial Accounting in a Dynamic Business Environment organizations. The largest of these in the U.S. is the Institute of Management Accountants (IMA). The IMA has over 60,000 members and publishes two journals, entitled Management Accounting Quarterly and Strategic Finance. Other professional organiza- tions in which managerial accountants hold membership include the Financial Executives Institute (for senior financial executives), the Institute of Internal Auditors, and the Ameri- can Accounting Association (for academics). The primary professional association for managerial accountants outside of the U.S. is the Chartered Institute of Management Accountants (CIMA). CIMA has offices throughout Europe and Asia, and it publishes educational e-journals for its members, which number almost 200,000 in 176 countries. There are also associations for the certified managerial accountants of various countries, including the Certified Manage- ment Accountants of Canada and the Institute of Certified Management Accountants in Australia. Professional Certification In keeping with the importance of their role and the specialized knowledge they must possess, managerial accountants can earn a professional certification similar to the CPA. Since 1972, the IMA has administersed the Certified Management Accountant (CMA) program. 15 Requirements for becoming a CMA include meeting specified edu- cational requirements and passing the rigorous CMA examination. 16 Canada, Great Britain, and many other countries also have professional certification programs for their managerial accountants. In addition to validation of their skills, the CMA and other certifications bring managerial accountants a very tangible benefit: a 2010 study of practicing managerial accountants showed that, “Professionals who hold some form of certification can earn nearly $22,000 more in average total compensation than non- certified peers.” 17 Managerial Accounting and the Ethical Climate of Business Who among us is not shocked and dismayed by the seemingly endless stream of cor- porate and investment scandals that we have experienced over the past decade? The effects of the near total collapse of the U.S. and world banking and financial systems are still being felt. And the headlines keep on coming. Many of the cases involve mis- management, some are characterized by alleged ethical lapses, and in some instances there is alleged criminal behavior. Who is to blame? According to most observers, there is plenty of blame to go around: greedy corporate executives, managers who make overreaching business deals, lack of oversight by various companies’ boards of directors (particularly the boards’ audit committees), substandard work by external auditors, lack of sufficient probing by Wall Street analysts and the financial press, and some accountants who have been all too willing to push the envelope on aggressive Managerial Accounting and the Ethical Climate of Business 15 In 2012, the American Institute of CPAs teamed with CIMA to introduce a certification called the Chartered Global Management Accountant (CGMA). Designed as an add-on to the CPA, the CGMA can be awarded after two to three years of accounting experience in business or government. Although backed by powerful accounting organi- zations, it remains to be seen if the new certification has enough substance to achieve market acceptance in the U.S. 16 For information about the CMA program, visit the IMA website at imanet.org . 17 www.imanet.org/cma_certification.aspx , citing survey results published in ”2010 IMA Salary Survey,” Strategic Finance (June 2011), pp. 27–46. Learning Objective 1-10 Describe the ethical responsibilities and ethical standards that apply to managerial accounting. hiL25664_ch01_002-033.indd 24hiL25664_ch01_002-033.indd 24 6/22/13 9:02 PM6/22/13 9:02 PM Final PDF to printer Chapter 1 The Changing Role of Managerial Accounting in a Dynamic Business Environment 25 accounting to (or beyond) the edge. Several financial executives have filed guilty pleas on felony charges. Others have been convicted by juries. Some are serving time in prison. Some observers have wondered if the confidence of the investing public can ever be regained. One important lesson from these scandals is that not only is unethical behavior in business wrong in a moral sense, but it also can be disastrous from the standpoint of the economy. We cannot have businesspeople lying, stealing, perpetrating frauds, and mak- ing up accounting rules as they go without seriously disrupting business. Thus, ethical behavior by businesspeople in general, and accountants in particular, is not a luxury or a discretionary “good thing to do.” It is an absolute necessity to the smooth functioning of the economy. Sorting out the details of the major scandals mentioned above would take us well beyond the subject matter of this text. Most of the purely accounting issues in these cases involve financial accounting (external reporting) rather than managerial account- ing (internal reporting). But remember we said earlier that in a company’s finance and accounting organization many of the same individuals are involved in both types of accounting. In the notorious Enron case, for example, the courts concluded that a mas- sive fraud was perpetrated on the investing public by creating so-called related parties with names like Raptor for the sole purpose of hiding debt and overstating earnings. Yet the same alleged fraud must have been perpetrated on many at Enron itself. Surely not all of the company’s thousands of employees knew of these accounting schemes. So ultimately, what may have been largely financial (external) accounting misstate- ments almost certainly resulted in misstated managerial (internal) accounting reports as well. 18 The chaos in corporate governance and accounting spawned a movement for reform. Congress passed the Sarbanes-Oxley Act in 2002, which, among other things, requires companies to establish, assess, and regularly report on their internal controls over finan- cial reporting. This legislation also created the Public Company Accounting Oversight Board (PCAOB) to establish auditing standards and provide for an audit quality review process. Appendix I on pages 760 through 765, covers the Sarbanes-Oxley Act and its implications for managerial accounting. For many in the accounting profession, the scandals have served as a wake-up call to concentrate more on ethical issues in practicing and teaching accounting. 19 To this end, a significant ethical issue in managerial accounting will be addressed at the end of most chapters. The goal of these Focus on Ethics pieces is to help you see that although legiti- mate ethical issues do arise in the daily practice of business and accounting, guidelines for addressing these problems do exist and can be applied. With this in mind our Focus on Ethics piece for this chapter will be a summary of the Institute of Management Accoun- tants ’ Statement of Ethical Professional Practice. All financial professionals, including managerial accountants and others practic- ing managerial accounting techniques, have an obligation to themselves, their col- leagues, and their organizations to adhere to high standards of ethical conduct. In recognition of this obligation, the IMA has developed the following ethical standards for its members. Focus on Ethics (next page) These scenarios dis- cuss ethical issues and underscore the impor- tance of ethical behavior in mangerial accounting. For easy reference in future Focus on Ethics examples, as well as problems and cases that include ethical issues to be resolved, the IMA Statement of Ethical Professional Practice can also be found in the back of the book. “If you ask someone what a superstar CFO is today, one of the things they’ll say is impeccable integrity and role model for the rest of the company.” (1I) Former CFO, E-Trade Financial 18 Greg Stohr, “Enron’s Skilling Rejected by Top U.S. Court on Conviction,” Bloomberg (April 16, 2012), http:// www.bloomberg.com/news/2012-04-16/enron-s-skilling-rejected-by-top-u-s-court-on-conviction.html . 19 Joann Lublin and Kara Scannell, “Critics See Some Good from Sarbanes-Oxley,” The Wall Street Journal, July 30, 2007, p. B1; and John Hodowanitz and Steven A. Solieri, “Guarding the Guardians,” Strategic Finance 87, no. 2 (August 2005), pp. 47–53. hiL25664_ch01_002-033.indd 25hiL25664_ch01_002-033.indd 25 7/12/13 8:19 PM7/12/13 8:19 PM Final PDF to printer Focus on Ethics IMA STATEMENT OF ETHICAL PROFESSIONAL PRACTICE Members of IMA shall behave ethically. A commitment to ethical professional practice includes overarching prin- ciples that express our values and standards that guide our conduct. Principles IMA’s overarching ethical principles include: Honesty, Fairness, Objectivity, and Responsibility. Members shall act in accordance with these principles and shall encour- age others within their organizations to adhere to them. Standards A member’s failure to comply with the following standards may result in disciplinary action. I. Competence Each member has a responsibility to: 1. Maintain an appropriate level of professional expertise by continually developing knowledge and skills. 2. Perform professional duties in accordance with rel- evant laws, regulations, and technical standards. 3. Provide decision support information and rec- ommendations that are accurate, clear, concise, and timely. 4. Recognize and communicate professional limita- tions or other constraints that would preclude responsible judgment or successful performance of an activity. II. Confidentiality Each member has a responsibility to: 1. Keep information confidential except when dis- closure is authorized or legally required. 2. Inform all relevant parties regarding appropri- ate use of confidential information. Monitor subordinates’ activities to ensure compliance. 3. Refrain from using confidential information for unethical or illegal advantage. III. Integrity Each member has a responsibility to: 1. Mitigate actual conflicts of interest. Regularly communicate with business associates to avoid apparent conflicts of interest. Advise all parties of any potential conflicts. 2. Refrain from engaging in any conduct that would prejudice carrying out duties ethically. 3. Abstain from engaging in or supporting any activity that might discredit the profession. IV. Credibility Each member has a responsibility to: 1. Communicate information fairly and objectively. 2. Disclose all relevant information that could rea- sonably be expected to influence an intended user’s understanding of the reports, analyses, or recommendations. 3. Disclose delays or deficiencies in information, timeliness, processing, or internal controls in conformance with organization policy and/or applicable law. Resolution of Ethical Conflict In applying the Standards of Ethical Professional Practice, you may encounter problems identifying unethical behav- ior or resolving an ethical conflict. When faced with ethical issues, you should follow your organization’s established policies on the resolution of such conflict. If these policies do not resolve the ethical conflict, you should consider the following courses of action: 1. Discuss the issue with your immediate supervi- sor except when it appears that the supervisor is involved. In that case, present the issue to the next level. If you cannot achieve a satisfactory resolution, submit the issue to the next manage- ment level. If your immediate superior is the chief executive officer or equivalent, the acceptable reviewing authority may be a group such as the audit committee, executive committee, board of directors, board of trustees, or owners. Contact with levels above the immediate superior should be initiated only with your superior’s knowledge, assuming he or she is not involved. Communica- tion of such problems to authorities or individu- als not employed or engaged by the organization is not considered appropriate, unless you believe there is a clear violation of the law. 2. Clarify relevant ethical issues by initiating a con- fidential discussion with an IMA Ethics Coun- selor or other impartial advisor to obtain a better understanding of possible courses of action. 3. Consult your own attorney as to legal obliga- tions and rights concerning the ethical conflict. 26 Chapter 1 The Changing Role of Managerial Accounting in a Dynamic Business Environment hiL25664_ch01_002-033.indd 26hiL25664_ch01_002-033.indd 26 6/22/13 9:02 PM6/22/13 9:02 PM Final PDF to printer Chapter Summary LO1-1 Define managerial accounting and describe its role in the management process. Manage- rial accounting is the process of identifying, measuring, analyzing, interpreting, and communicating information in pursuit of an organization’s goals. Managerial accounting concepts and tools are used by all managers, and professional managerial accountants are important strategic partners in an organiza- tion’s management team. LO1-2 Explain four fundamental management processes that help organizations attain their goals. In pursuing its goals, an organization acquires resources, hires employees, and then engages in an organized set of activities. It is up to the management team to make the best use of the organiza- tion’s resources, employees, and activities in achieving the organization’s goals. The four fundamental management processes are decision making, planning, directing operational activities, and controlling. LO1-3 List and describe five objectives of managerial accounting activity. Five objectives of man- agerial accounting activity are (1) providing information for decision making and planning, (2) assist- ing managers in directing and controlling operations; (3) motivating managers and other employees to achieve the organization’s goals; (4) measuring the performance of activities, subunits, managers, and other employees within the organization; and (5) assessing the organization’s competitive position and working with other managers to ensure the organization’s long-run competitiveness in its industry. LO1-4 Explain the major differences between managerial and financial accounting. The users of managerial accounting information are managers inside the organization. Managerial accounting infor- mation is not mandatory, is unregulated, and draws on data from the core accounting system as well as other data sources. The users of financial accounting information are interested parties outside the organization. Financial accounting information is required, is regulated, and is based almost entirely on historical transaction data. LO1-5 Describe the accounting and finance structure in an organization. Every manager must understand basic managerial accounting concepts and tools. Managerial accounting specialists, called managerial accountants or analysts, occupy staff positions in an organization chart. They are deployed as members of cross-functional teams, which address a variety of managerial decisions. Managerial accountants are physically located throughout an enterprise alongside the managers with whom they work closely. LO1-6 Describe the roles of an organization’s chief financial officer (CFO) or controller, trea- surer, and internal auditor. The organization’s top managerial and financial accountant is called the chief financial officer or controller. The treasurer is responsible for raising capital and safeguarding the organization’s assets. An organization’s internal auditor is responsible for reviewing the accounting procedures, records, and reports and sometimes makes a broad performance evaluation of management. LO1-7 Understand and explain the value chain concept. The value chain is the set of linked, value- creating activities, ranging from securing basic raw materials and energy to the ultimate delivery of products and services. Understanding the value chain, its activities, and the costs and strategic benefits of those activities is a crucial step in the development of an organization’s strategy. LO1-8 Explain how investments in capacity affect managerial decision making. Capacity is the upper limit on the amount of goods or services that an organization can produce in a specified period of time. Practical capacity of resources supplied takes into account normal work disruptions, and based on this number the cost of resources used and unused can be measured. Costs information may be distorted if no adjustment is made for unused capacity. LO1-9 Discuss the professional organizations and certifications in the field of managerial account- ing. As professionals, managerial accountants may undergo a process to certify their expertise and, if successful, may enjoy the benefits of membership in one or more professional organizations, such as the Institute of Management Accountants (IMA). LO1-10 Describe the ethical responsibilities and ethical standards that apply to managerial accounting. Managerial accountants are expected to display a commitment to ethical professional practice characterized by the overarching principles of honesty, fairness, objectivity, and responsibility. These principles, which are codified in the “IMA Statement of Ethical Professtional Practice,” can be applied to all managerial accounting concepts and practices. Chapter 1 The Changing Role of Managerial Accounting in a Dynamic Business Environment 27 Each chapter’s sum- mary is built around the learning objectives, which appear at the beginning of the chapter. hiL25664_ch01_002-033.indd 27hiL25664_ch01_002-033.indd 27 6/22/13 9:02 PM6/22/13 9:02 PM Final PDF to printer Key Terms For each term’s definition refer to the indicated page, or turn to the glossary at the end of the text. activity accounting, 23 activity-based costing (ABC), 23 activity-based management (ABM), 23 attention-directing function, 7 balanced scorecard, 9 capacity, 20 Certified Management Accountant (CMA), 24 chief financial officer (CFO), 15 controller (or comptroller), 15 cost accounting system, 11 cost driver, 20 cost management system, 23 financial accounting, 10 internal auditor, 16 line positions, 14 managerial accountants, 5 managerial accounting, 4 non-value-added costs, 23 practical capacity, 20 staff positions, 15 strategic cost management, 20 treasurer, 16 value chain, 18 Review Questions 1–1. According to some estimates, the volume of electronic commerce transactions exceeds $3 trillion. Business- to-business transactions account for almost half of this amount. What changes do you believe are in store for managerial accounting as a result of the explosion in e-commerce? 1–2. List two plausible goals for each of these organizations: Amazon.com , American Red Cross, General Motors, Walmart, the City of Seattle, and Hertz. 1–3. List and define the four basic management activities. 1–4. Give examples of each of the four primary management activities in the context of a national fast-food chain such as Burger King. 1–5. Give examples of how each of the objectives of mana- gerial accounting activity would be important in an airline company such as American Airlines. 1–6. List and describe four important differences between managerial and financial accounting. 1–7. Distinguish between cost accounting and managerial accounting. 1–8. Distinguish between line and staff positions. Give two examples of each in a university setting. 1–9. Distinguish between the following two accounting posi- tions: controller and treasurer. 1–10. How could your college or university use the concepts in the balanced scorecard? List two possible perfor- mance measures that would be relevant to a college or university, for each of the balanced scorecard’s four areas. 1–11. What does the following statement by a managerial accountant at Caterpillar imply about where in the orga- nization the managerial accountants are located? “[We] are a partner with all of the other functions in the busi- ness here.” (Reference 1a at end of text.) 1–12. What is meant by the following statement? “Managerial accounting often serves an attention-directing role.” 1–13. What is the chief difference between manufacturing and service industry firms? 1–14. Explain the following terms: practical capacity, cost of resources supplied, cost of resources used, and cost of resources unused. 1–15. Evaluate the following statement: “If a resource has unused capacity, that capacity is lost forever.” 1–16. Define and explain the significance of the term CMA. 1–17. Briefly explain what is meant by each of the following ethical standards for managerial accountants: compe- tence, confidentiality, integrity, and credibility. 1–18. What is meant by the term non-value-added costs? 1–19. Managerial accounting is an important part of any enterprise’s management information system. Name two other information systems that supply information to management. 1–20. Can managerial accounting play an important role in a nonprofit organization? Explain your answer. 1–21. A large manufacturer of electronic machinery stated the following as one of its goals: “The company s hould become the low-cost producer in its industry.” How can managerial accounting help the company a chieve this goal? 1–22. What do you think it means to be a professional? In your view, are managerial accountants professionals? 1–23. Name several activities in the value chain of ( a ) a man- ufacturer of cotton shirts and ( b ) an airline. 1–24. Define the term strategic cost management. Exercises For each of the following activities, explain which of the objectives of managerial accounting activity is involved. In some cases, several objectives may be involved. 1. Measuring the cost of the inventory of tablet computers on hand in a retail electronics store. 2. Estimating the annual operating cost of a newly proposed branch bank. ■ Exercise 1–25 Objectives of Managerial Accounting Activity (LO 1-3, 1-4) All applicable Exercises are available with McGraw-Hill’s Connect Accounting ®. 28 Chapter 1 The Changing Role of Managerial Accounting in a Dynamic Business Environment hiL25664_ch01_002-033.indd 28hiL25664_ch01_002-033.indd 28 6/22/13 9:02 PM6/22/13 9:02 PM Final PDF to printer Problems A division manager is responsible for each of Resolute Electronics Corporation’s (REC) divisions. Each division’s controller, assigned by the corporate controller’s office, manages the division’s accounting system and provides analysis of financial information for the division manager. The division manager evaluates the performance of the division controller and makes recommendations for salary increases and promotions. However, the final responsibility for promotion evaluation and salary increases rests with the corporate controller. Each of REC’s divisions is responsible for product design, sales, pricing, operating expenses, and profit. However, corporate management exercises tight control over divisional financial operations. For example, all capital expenditures above a modest amount must be approved by corporate management. The method of financial reporting from the division to corporate headquarters provides further evidence of the degree of financial control. The division manager and the division controller submit to corporate headquarters separate and independent commentary on the financial results of the division. Corporate management states that the division controller is there to provide an independent view of the division’s operations, not as a spy. Required: 1. Discuss the concepts of line and staff activities, using REC as a context for the discussion. 2. The division manager for Resolute Electronics Corporation has a “dual reporting” responsibility. ■ Problem 1–28 Role of the Division Controller (LO 1-4, 1-6) All applicable Problems are available with McGraw-Hill’s Connect Accounting ®. The balance icon identifies an ethical issue , and the pen icon indicates that a written response is needed. Chapter 1 The Changing Role of Managerial Accounting in a Dynamic Business Environment 29 3. Measuring the following costs incurred during one month in a hotel owned by a national hospitality-industry firm. a. Wages of table-service personnel. b. Property taxes. 4. Comparing a hotel’s room rate structure, occupancy rate, and restaurant patronage with industry averages. 5. Developing a bonus reward system for the managers of the various offices run by a large travel agency. 6. Comparing the actual and planned cost of a consulting engagement completed by an engineering firm. 7. Determining the cost of manufacturing a tennis racket. Give an example of managerial accounting information that could help a manager make each of the fol- lowing decisions. 1. The production manager in an automobile plant is deciding whether to have routine maintenance performed on a machine weekly or biweekly. 2. The manager of a discount department store is deciding how many security personnel to employ for the purpose of reducing shoplifting. 3. The county board of representatives is deciding whether to build an addition onto the county library. 4. The president of a rental car agency is deciding whether to add luxury cars to the rental car fleet. Use the Internet to access the website for one of the following companies, or any other company of your choosing. American Airlines www.aa.com Coca-Cola www.coca-cola.com Deere and Company www.deere.com IBM www.ibm.com Google www.google.com Required: Find the management discussion and analysis portion of the firm’s most recent on-line annual report. Then briefly discuss how managerial accounting can contribute to the company’s finan- cial goals. ■ Exercise 1–26 Managerial Accounting and Decision Making (LO 1-2, 1-3) ■ Exercise 1–27 Contributions of Managerial Accounting; Use of Internet (LO 1-1, 1-3, 1-5) This icon indicates use of the Internet. hiL25664_ch01_002-033.indd 29hiL25664_ch01_002-033.indd 29 7/12/13 8:19 PM7/12/13 8:19 PM Final PDF to printer 30 Chapter 1 The Changing Role of Managerial Accounting in a Dynamic Business Environment The controller is responsible both to the division manager, who makes recommendations on salary and promotion, and to the corporate controller, who has the final say in such matters. a. Identify and discuss the factors that make the division controller’s role difficult in this type of situation. b. Discuss the effect of the dual reporting relationship on the motivation of the division controller. (CMA, adapted) Jay Maxey retired a few years ago at age 48, courtesy of the numerous stock options he had been granted while president of e-shops.com, an Internet start-up company. He soon moved to Montana to follow his dream of living in the mountains and Big-Sky country. Maxey, always the entrepreneur, began a sport- ing goods store shortly after relocating. The single store soon grew to a chain of four outlets throughout the sparsely populated state. As Maxey put it, “I can’t believe how fast we’ve expanded. It’s basically uncontrolled growth—growth that has occurred in spite of what we’ve done.” Although business has been profitable, the chain did have its share of problems. Store traffic was somewhat seasonal, with a slowdown occurring as winter approached. Maxey therefore added ski equip- ment and accessories to his product line. The need to finance required inventories, which seemed to be bulging, left cash balances at very low levels, occasionally giving rise to short-term bank loans. Part of Maxey’s operation focused on canoe building and white-water rafting trips. Reports from the company’s financial accounting system seemed to indicate that these operations were losing money because of increasing costs, although Maxey could not be sure. “The traditional income statement is not too useful in assessing the problem,” he noted. “Also, my gut feeling is that we are not dealing with the best suppliers in terms of quality of goods, delivery reliability, and prices.” Additional complications were caused by an increasingly competitive marketplace, with many former customers now buying mer- chandise and booking river excursions via the Internet, through catalogs received in the mail, or through businesses that advertised heavily in outdoor magazines. Maxey’s background is marketing, and he appeared somewhat puzzled on how to proceed. The company’s chief financial officer (CFO) would be an obvious asset in terms of addressing these prob- lems. Unfortunately, she knew her numbers but lacked key knowledge of general business operations. The same could be said for other executives who managed somewhat in “silos,” becoming experts in a narrow facet of the company but, in general, lacking a big-picture outlook for the firm. Required: 1. As a group, discuss how the CFO and managerial accounting could assist Maxey in addressing the company’s problems. 2. Would a cross-functional team be useful here? Briefly discuss. 3. Many resources in the sporting-goods company would present significant capacity issues. List three such resources and describe their capacity issues in light of the company’s operations. Stereo Technology, Inc. manufactures printed circuits for stereo amplifiers. A common product defect is a “drift” caused by failure to maintain precise heat levels during the production process. Rejects from the 100 percent testing program can be reworked to acceptable levels if the defect is drift. However, in a recent analysis of customer complaints, Marie Allen, the assistant controller, and the quality control engineer determined that normal rework does not bring the circuits up to standard. Sampling showed that about half of the reworked circuits will fail after extended amplifier operation. The incidence of failure in the reworked circuits is projected to be about 10 percent over five years. Unfortunately, there is no way to determine which reworked circuits will fail, because testing will not detect the problem. The rework process could be changed to correct the problem, but the cost-benefit analysis for the suggested change indicates that it is not economically feasible. Stereo Technology’s marketing analyst has indicated that this problem will have a significant impact on the company’s repu- tation and customer satisfaction. Consequently, the board of directors would interpret this problem as having serious negative implications for the company’s profitability. Allen included the circuit failure and rework problem in her report prepared for the upcoming quar- terly meeting of the board of directors. Due to the potential adverse economic impact, Allen followed a long-standing practice of highlighting this information. After reviewing the reports to be presented, the plant manager and his staff complained to the controller that he should control his people better. “We can’t upset the board with this kind of material. Tell Allen to tone that down. Maybe we can get it by the ■ Problem 1–29 Managing a Business Cross- Functional Teams; Capacity (LO 1-4, 1-5, 1-6, 1-8) ■ Problem 1–30 Quality Control; Ethical Behavior (LO 1-6, 1-7, 1-9, 1-10) This icon indicates group work. hiL25664_ch01_002-033.indd 30hiL25664_ch01_002-033.indd 30 6/22/13 9:02 PM6/22/13 9:02 PM Final PDF to printer Chapter 1 The Changing Role of Managerial Accounting in a Dynamic Business Environment 31 board in this meeting and have some time to work on it. People who buy those cheap systems and play them that loud shouldn’t expect them to last forever.” The controller called Allen into his office and said, “Marie, you’ll have to bury this one. The prob- able failure of reworks can be mentioned briefly in the oral presentation, but it should not be mentioned or highlighted in the advance material mailed to the board.” Allen feels strongly that the board will be misinformed on a potentially serious loss of income if she follows the controller’s orders. Allen discussed the problem with the quality control engineer, who simply remarked, “That’s your problem, Marie.” Required: 1. Discuss the ethical considerations that Marie Allen should recognize in deciding how to proceed. 2. Explain what ethical responsibilities should be accepted by: (a) the controller, (b) the quality con- trol engineer, and (c) the plant manager. 3. What should Marie Allen do? Explain your answer. (CMA, adapted) Angella Lopez, a consultant with Deloitte & Young, has just begun an engagement at Olympic Airways, which is based in Seattle. The company has fallen on hard times of late despite record profits for the rest of the airline industry. Management is somewhat set in its ways and could probably use some ”new blood,” as the most recent hire to the firm’s executive team was 12 years ago. In Lopez’s first meeting with the team, Olympic’s chief executive officer commented that “all that mattered in this industry were load factors—the percentage of seats sold on scheduled flights. If load factors were adequate, everything else would take care of itself.” Lopez noted that while this measure was important, other, broader facets of operation were significant as well. She asked if any of the man- agement team had heard of the balanced scorecard, and received dead silence as a response. Based on her experiences with other engagements, including two that involved airlines, Lopez was convinced that the balanced scorecard could provide benefits in helping to solve Olympic’s woes. After a presentation about the philosophy of the balanced scorecard, Olympic’s management team accepted her idea, feeling that a shift in operating philosophy was needed for survival. Required: 1. What is a balanced scorecard, and what are its typical key elements? 2. Lopez wants to assemble a committee to prepare the airline’s balanced scorecard. List several of the company’s functional areas (e.g., marketing) that should be represented on the committee. 3. Identify a number of measures to evaluate the key elements that you specified in requirement (1). Measures would include items such as load factors, number of passenger complaints, percentage of on-time arrivals, and so forth. 4. Do you see any problems with management’s prior focus on only one measure (i.e., load factor)? Briefly explain. ■ Problem 1–31 Balanced Scorecard (LO 1-3, 1-8) SofTech, Inc., a developer and distributor of business applications software, has been in business for five years. SofTech’s sales have increased steadily to the current level of $25 million per year. The company has 250 employees. Jennifer Nolan joined SofTech approximately one year ago as accounting manager. Nolan’s duties include supervision of the company’s accounting operations and preparation of the com- pany’s financial statements. No one has noticed that in the past six months SofTech’s sales have ceased to rise and have actually declined in the two most recent months. This unexpected downturn has resulted in cash shortages. Compounding these problems, SofTech has had to delay the introduction of a new product line due to delays in documentation preparation. SofTech contracts most of its printing requirements to Web Graphic Inc., a small company owned by Rob Borman. Borman has dedicated a major portion of his printing capacity to SofTech’s require- ments because SofTech’s contracts represent approximately 50 percent of Web Graphic’s business. Nolan has known Borman for many years; as a matter of fact, she learned of SofTech’s need for an accounting manager through Borman. ■ Case 1–32 Disclosure of Confidential Information; Ethics (LO 1-1, 1-3, 1-6, 1-7, 1-9, 1-10) Cases hiL25664_ch01_002-033.indd 31hiL25664_ch01_002-033.indd 31 6/22/13 9:02 PM6/22/13 9:02 PM Final PDF to printer 32 Chapter 1 The Changing Role of Managerial Accounting in a Dynamic Business Environment While preparing SofTech’s most recent financial statements, Nolan became concerned about the company’s ability to maintain steady payments to its suppliers; she estimated that payments to all ven- dors, normally made within 30 days, could exceed 75 days. Nolan is particularly concerned about pay- ments to Web Graphic; she knows that SofTech had recently placed a large order with Web Graphic for the printing of the new product documentation, and she knows that Web Graphic will soon be placing an order for the special paper required for SofTech’s documentation. Nolan is considering telling Borman about SofTech’s cash problems; however, she is aware that a delay in the printing of the documentation would jeopardize SofTech’s new product. Required: 1. As a group, discuss Nolan’s ethical responsibilities in this situation. 2. Independent of your answer to requirement (1), assume that Nolan learns that Borman of Web Graphic has decided to postpone the special paper order required for SofTech’s printing job; Nolan believes Borman must have heard rumors about SofTech’s financial problems from some other source because she has not talked to Borman. Should Nolan tell the appropriate SofTech officials that Borman has postponed the paper order? Explain your answer. 3. Independent of your answers to the first two requirements, assume that Borman has decided to postpone the special paper order because he has learned of SofTech’s financial problems from some source other than Nolan. In addition, Nolan realizes that Jim Grason, SofTech’s purchasing manager, knows of her friendship with Borman. Now Nolan is concerned that Grason may suspect she told Borman of SofTech’s financial problems when Grason finds out Borman has postponed the order. Describe the steps that Nolan should take to resolve this situation. (CMA, adapted) Working in a group, use the Internet to identify a company that has been the subject of significant public discussion due to one or more ethical lapses in the last decade. Required: As a group, research what happened and then make a presentation to the class which addresses the following points: (1) Describe the company’s situation prior to the ethical problem. (2) Explain what happened with questionable ethics. (3) Was there any alleged illegal activity? (4) Do you see any implications in the case for the company’s managerial accountants? Explain. (5) Were any of the ethical standards in the “IMA Statement of Ethical Professional Practice” violated? Explain. ■ Case 1–33 The Ethical Climate in Business (LO 1-9, 1-10) hiL25664_ch01_002-033.indd 32hiL25664_ch01_002-033.indd 32 7/12/13 8:19 PM7/12/13 8:19 PM Final PDF to printer This page intentionally left blank 2 THIS CHAPTER’S FOCUS COMPANY is the Comet Computer Company, which produces computers in its Dallas, Texas, plant. Most of the com- pany’s sales are made online through its website, cometcomp.com. This manufacturer combines many standardized components in different ways to produce several computer models popular with its customer base. In this chapter, we will explore the many different issues involved in under- standing the costs of running any business. FOCUS COMPANY >>>
Basic Cost Management
Concepts
COmetcomp.com
COmet
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In contrast to the manufacturing setting of the Comet Computer Com-
pany, we explore the cost issues covered in the chapter in the context
of Midas, Inc. One of the world’s largest automotive service companies, Midas has nearly
2,300 company-owned or franchised automotive service locations on five continents.
Midas’ management, like that of any other company, must understand its costs in order to
be successful in a competitive business environment.
<<< IN CONTRAST hiL25664_ch02_034-077.indd 35hiL25664_ch02_034-077.indd 35 6/27/13 1:38 AM6/27/13 1:38 AM Final PDF to printer 36 The process of management involves formulating strategy, planning, control, decision making, and directing operational activities. Managers can perform each of these func- tions more effectively with managerial accounting information. Much of this informa- tion focuses on the costs incurred in the organization. For example, in formulating its overall strategy, Southwest Airlines ’ management team considered the cost savings that result from being a low-cost, no-frills airline. In planning Southwest’s routes and flight schedules, managers must consider aircraft fuel costs, salaries of flight crews, and air- port landing fees. Controlling the costs of manufacturing heavy equipment requires that Caterpillar ’s managerial accountants carefully measure and manage production costs. In making decisions about locating a new store, Walmart managers need information about the cost of building, maintaining, equipping, and staffing the store. Finally, to direct oper- ational activities, managers in all three of these companies need information about the cost of salaries, utilities, security, and a host of other goods and services. 2-1 Explain what is meant by the word cost. 2-2 Distinguish among product costs, period costs, and expenses. 2-3 Describe the role of costs in published financial statements. 2-4 List and describe four types of manufacturing operations. 2-5 Give examples of three types of manufacturing costs. 2-6 Prepare a schedule of cost of goods manufactured, a schedule of cost of goods sold, and an income statement for a manufacturer. 2-7 Understand the importance of identifying an organization’s cost drivers. 2-8 Describe the behavior of variable and fixed costs, in total and on a per-unit basis. 2-9 Distinguish among direct, indirect, controllable, and uncontrollable costs. 2-10 Define and give examples of an opportunity cost, an out-of-pocket cost, a sunk cost, a differential cost, a marginal cost, and an average cost. After completing this chapter, you should be able to What Do We Mean by a Cost? Each of the examples in the preceding paragraph focuses on costs of one type or another. An important first step in studying managerial accounting is to gain an understanding of the various types of costs incurred by organizations and how those costs are actively managed. At the most basic level, a cost may be defined as the sacrifice made, usually mea- sured by the resources given up, to achieve a particular purpose. If we look more care- fully, though, we find that the word cost can have different meanings depending on the context in which it is used. Cost data that are classified and recorded in a particular way for one purpose may be inappropriate for another use. For example, the costs incurred in producing gasoline last year are important in measuring ExxonMobil ’s income for the year. However, those costs may not be useful in planning the company’s refinery What Do We Mean by a Cost? Learning Objective 2-1 Explain what is meant by the word cost. hiL25664_ch02_034-077.indd 36hiL25664_ch02_034-077.indd 36 6/27/13 1:38 AM6/27/13 1:38 AM Final PDF to printer Chapter 2 Basic Cost Management Concepts 37 operations for the next year if the cost of oil has changed significantly or if the methods of producing gasoline have improved. The important point is that different cost concepts and classifications are used for dif- ferent purposes. Understanding these concepts and classifications enables the managerial accountant to provide appropriate cost data to the managers who need it. The purpose of this chapter is to enable the users of this textbook to gain a firm grasp of the cost termi- nology used in managerial accounting, which will be used throughout the book. Product Costs, Period Costs, and Expenses An important issue in both managerial and financial accounting is the timing with which the costs of acquiring assets or services are recognized as expenses. An expense is defined as the cost incurred when an asset is used up or sold for the purpose of generat- ing revenue. The terms product cost and period cost are used to describe the timing with which various expenses are recognized. A product cost is a cost assigned to goods that were either purchased or manufac- tured for resale. The product cost is used to value the inventory of manufactured goods or merchandise until the goods are sold. In the period of the sale, the product costs are recognized as an expense called cost of goods sold. The product cost of merchandise inventory acquired by a retailer or wholesaler for resale consists of the purchase cost of the inventory plus any shipping charges. The product cost of manufactured inventory includes all of the costs incurred in its manufacture. For example, the labor cost of a production employee at Texas Instruments is included as a product cost of the calculators manufactured. Exhibit 2–1 illustrates the relationship between product costs and cost-of- goods-sold expense. “We are expected to say, ‘Here are the costs, and this is why the costs are what they are, and this is how they compare to other things, and here are some suggestions where we could possibly improve.’” (2a) Caterpillar Learning Objective 2-2 Distinguish among product costs, period costs, and expenses. Year 1 Year 2 Time Merchandise is acquired: product cost is equal to the cost of purchase plus transportation cost. Merchandise is sold: expense called cost of goods sold is equal to the product cost identified with the merchandise sold. Goods are manufactured: product cost is equal to manufacturing costs of direct material, direct labor, and manufacturing overhead. Goods are sold: expense called cost of goods sold is equal to the product cost identified with the goods sold. At the end of Year 1, any inventory on hand is an asset, which is valued at its product cost. At the end of Year 1, any inventory on hand is an asset, which is valued at its product cost. Manufacturer Retailer or Wholesaler Exhibit 2–1 Product Costs and Cost of Goods Sold hiL25664_ch02_034-077.indd 37hiL25664_ch02_034-077.indd 37 6/27/13 1:38 AM6/27/13 1:38 AM Final PDF to printer 38 Chapter 2 Basic Cost Management Concepts Another term for product cost is inventoriable cost, since a product cost is stored as the cost of inventory until the goods are sold. In addition to retailers, wholesalers, and manufacturers, the concept of product cost is relevant to other producers of inventoriable goods. Agricultural firms, lumber companies, and mining firms are examples of nonman- ufacturers that produce inventoriable goods. Apples, timber, coal, and other such goods are inventoried at their product cost until the time period during which they are sold. All costs that are not product costs are called period costs. These costs are identified with the period of time in which they are incurred rather than with units of purchased or produced goods. Period costs are recognized as expenses during the time period in which they are incurred. All research and development, selling, and administrative costs are treated as period costs. This is true in manufacturing, retail, and service industry firms. Research and development costs include all costs of developing new products and services. The costs of running laboratories, building prototypes of new products, and test- ing new products are all classified as research and development (or R&D) costs. Selling costs include salaries, commissions, and travel costs of sales personnel and the costs of advertising and promotion. Administrative costs refer to all costs of running the organiza- tion as a whole. The salaries of top-management personnel and the costs of the account- ing, legal, and public relations activities are examples of administrative costs. Exhibit 2–2 illustrates the nature of period costs. Year 1 Year 2 Time Period costs, such as selling and administrative costs, incurred in Year 1 are recognized as expenses in Year 1. Period costs are treated the same way in all types of companies: retailers and wholesalers, manufacturers, and service industry firms. Period costs incurred in Year 2 are recognized as expenses in Year 2. Exhibit 2–2 Period Costs Costs on Financial Statements The distinction between product costs and period costs is emphasized by examining financial statements from three different types of firms. Income Statement Exhibit 2–3 displays recent income statements, in highly summarized form, from Southwest Airlines, Caterpillar, and Walmart. These companies are from three differ- ent industries. Representing the service industry is Southwest Airlines, a major airline based in the southwestern United States. Caterpillar is a heavy equipment manufac- turer. Walmart is a large retail firm with merchandising operations throughout most of the nation. Costs on Financial Statements Learning Objective 2-3 Describe the role of costs in published financial statements. hiL25664_ch02_034-077.indd 38hiL25664_ch02_034-077.indd 38 6/27/13 1:38 AM6/27/13 1:38 AM Final PDF to printer Chapter 2 Basic Cost Management Concepts 39 Selling and administrative costs are always period costs on any type of company’s income statement. For example, Caterpillar lists $5.203 billion of selling, general, and administrative expenses on its income statement in Exhibit 2–3 . For Caterpillar, the costs of manufactured inventory are product costs. All costs incurred in manufacturing finished products are stored in inventory until the time period when the products are sold. Then the product costs of the inventory sold become cost of goods sold, an expense on the income statement. CATERPILLAR, INC. Statement of Income for a Recent Year Value measured by product costs Sales revenue ........................................................................................... $60,138,000 Less: Cost of goods sold ............................................................................ 43,578,000 Gross profit .............................................................................................. $16,560,000 Less: Operating costs Selling, general, and administrative expenses ......................................... $ 5,203,000 Research and development expenses .................................................... 2,297,000 Interest expense of financial products .................................................... 826,000 Other operating expenses ...................................................................... 1,081,000 Total operating costs ................................................................................. $ 9,407,000 Operating profit ......................................................................................... $ 7,153,000 Less: Other expenses ................................................................................ 428,000 Consolidated profit before taxes ................................................................. $ 6,725,000 Provision for income taxes ......................................................................... 1,720,000 Profit of consolidated companies ............................................................... $ 5,005,000 SOUTHWEST AIRLINES COMPANY Statement of Income for a Recent Year Operating revenue: Passenger ............................................................................................ $14,735,000 Freight ................................................................................................. 139,000 Other ................................................................................................... 784,000 Total operating revenue ......................................................................... $15,658,000 Less: Operating expenses: Salaries, wages, and benefits ................................................................ $ 4,371,000 Fuel and oil .......................................................................................... 5,644,000 Maintenance materials and repairs ........................................................ 955,000 Aircraft rentals ...................................................................................... 308,000 Landing fees and other rentals .............................................................. 959,000 Depreciation and amortization ............................................................... 715,000 Acquisition and integration .................................................................... 134,000 Other operating expenses ...................................................................... 1,879,000 Total operating expenses ....................................................................... $14,965,000 Operating income ..................................................................................... $ 693,000 Other expenses (income): Interest expense ................................................................................... $ 194,000 Capitalized interest ............................................................................... (12,000) Interest income ..................................................................................... (10,000) Other (gains) losses, net ........................................................................ 198,000 Total other expenses (income) ................................................................ $ 370,000 Income before income taxes ...................................................................... $ 323,000 Provision for income taxes ......................................................................... 145,000 Net income ............................................................................................... $ 178,000 Exhibit 2–3 Income Statements from Three Different Industries (all figures in thousands of dollars) (continues) hiL25664_ch02_034-077.indd 39hiL25664_ch02_034-077.indd 39 6/27/13 1:38 AM6/27/13 1:38 AM Final PDF to printer 40 Chapter 2 Basic Cost Management Concepts WALMART STORES, INC. Statement of Income for a Recent Year Value measured by product costs Sales revenue .......................................................................................... $ 421,849,000 Less: Cost of sales ................................................................................... 315,287,000 Gross profit ............................................................................................. $106,562,000 Less: Operating, selling, general, and administrative expenses .................... 81,020,000 Operating income .................................................................................... $ 25,542,000 Less: Interest expense .............................................................................. 2,004,000 Income from continuing operations before income taxes ............................. $ 23,538,000 Provision for income taxes ........................................................................ (7,579,000) Income from discontinued operations, net of tax ........................................ 1,034,000 Consolidated net income .......................................................................... $ 16,993,000 Exhibit 2–3 (concluded) Product costs for Walmart include all costs of acquiring merchandise inventory for resale. These product costs are stored in inventory until the time period during which the merchandise is sold. Then these costs become cost of sales (or cost of goods sold). There are no inventoried product costs at Southwest Airlines. Although this firm does engage in the production of air transportation services, its service output is consumed as soon as it is produced. Service industry firms, such as Southwest Airlines, JPMorganChase, Sheraton Hotels, Nationwide Insurance, and Burger King, generally refer to the costs of producing services as operating expenses. Operating expenses are treated as period costs and are expensed during the period in which they are incurred. Southwest Airlines includes costs such as employee wages, aviation fuel, and aircraft maintenance in operating expenses for the period. Balance Sheet Since retailers, wholesalers, and manufacturers sell inventoriable products, their balance sheets are also affected by product costs. Exhibit 2–4 displays the current-assets section from recent balance sheets of Caterpillar and Walmart. Included in the current-assets section of each of these balance sheets is inventory. Manufacturers, such as Caterpillar, “What we should become is a business partner who helps people understand what the financials are saying.” (2b) Qwest (now CenturyLink) CATERPILLAR, INC. Partial Balance Sheet at the End of a Recent Year Current assets: Cash and cash equivalents .................................................................... $ 3,057,000 Value measured by product costs Accounts receivable (net) ...................................................................... 17,953,000 Inventories ........................................................................................... 14,544,000 Other current assets ............................................................................. 2,574,000 Total current assets ............................................................................... $38,128,000 WALMART STORES, INC. Partial Balance Sheet at the End of a Recent Year Current assets: Value measured by product costs Cash and cash equivalents .................................................................... $ 7,395,000 Receivables (net) .................................................................................. 5,089,000 Inventories ........................................................................................... 36,318,000 Prepaid expenses and other current assets ............................................ 3,091,000 Total current assets ............................................................................... $51,893,000 Exhibit 2–4 Partial Balance Sheets for a Manufacturer and a Retailer (all figures in thousands of dollars) hiL25664_ch02_034-077.indd 40hiL25664_ch02_034-077.indd 40 6/27/13 1:38 AM6/27/13 1:38 AM Final PDF to printer Chapter 2 Basic Cost Management Concepts 41 have three types of inventory. Raw-material inventory includes all materials before they are placed into production. Work-in-process inventory refers to manufactured prod- ucts that are only partially completed at the date when the balance sheet is prepared. Finished-goods inventory refers to manufactured goods that are complete and ready for sale. The values of the work-in-process and finished-goods inventories are measured by their product costs. On the Walmart balance sheet, the cost of acquiring merchandise is listed as the value of the merchandise inventories. “Now the accountants are not only the interpreters. They drive management toward the proper response to what the numbers are telling us.” (2c) ITT Automotive Manufacturing Operations and Manufacturing Costs Although there are tens of thousands of manufacturing firms, their basic production pro- cesses can be classified into four generic types. The nature of the manufacturing process can affect the manufacturing costs incurred. Therefore, the management team is in a bet- ter position to manage these costs if the relationship of the production process to the types of costs incurred is understood. Exhibit 2–5 defines and describes the four generic manufacturing processes. 1 We will study the role of managerial accounting and cost management in each of these manufacturing processes. This chapter will focus on an assembly operation. Chapter 3 will examine managerial accounting techniques used in job-shop and batch-processing operations. Chapter 4 will focus on the cost accumulation and cost management pro- cesses in a continuous-flow production environment. Manufacturing Operations and Manufacturing Costs Learning Objective 2-4 List and describe four types of manufacturing operations. 1The exhibit is based on the well-known and widely used Hayes-Wheelwright production process matrix. A variant of the assembly process is mass customization, in which the manufacturer uses inventoried parts to build products to customer specification. This approach was popularized by Dell Computer, which for many years built computers to customer specification, often taking the orders on line. Due to competitive pressures in more recent years, however, Dell has retreated from the mass customization approach in favor of stocking several popular computer configurations. Type of Production Process Description of Process Example of Manufacturer Multiple products; low volume. Caterpillar (batch production of heavy equipment ). A few major products; higher volume. Ford (automobile assembly line ). High production volume; highly standardized commodity products. ExxonMobil (production of gasoline, a continuous-flow product ). Continuous Flow Assembly Batch Job Shop Low production volume; little standardization; one-of-a-kind products. Major film studios, such as Universal Pictures (a scene from the box office hit Les Misérables). Exhibit 2–5 Types of Production Processes hiL25664_ch02_034-077.indd 41hiL25664_ch02_034-077.indd 41 6/27/13 1:38 AM6/27/13 1:38 AM Final PDF to printer 42 Chapter 2 Basic Cost Management Concepts Assembly Manufacturing To illustrate an assembly production environment, let’s focus on Comet Computer Corpo- ration, a manufacturer of computers and peripheral devices. 2 Comet purchases computer parts such as motherboards, computer chips, and power units and then assembles these parts into a variety of devices, such as tablet computers, laptops, and desktop computers. Comet sells many models of computers mainly through its website, cometcomp.com. Let’s turn our attention to the types of manufacturing costs incurred by Comet and other manufacturers. Manufacturing Costs To assist managers in planning, decision making, and cost management, managerial accountants classify costs by the functional area of the organization to which costs relate. Some examples of functional areas are manufacturing, marketing, administration, and research and development. Manufacturing costs are further classified into the following three categories: direct material, direct labor, and manufacturing overhead. Direct Material Raw material that is consumed in the manufacturing process, is phys- ically incorporated in the finished product, and can be traced to products relatively easily is called direct material. Examples include the sheet metal in a Subaru automobile and the semiconductors in a Comet computer. Some students are confused by the seemingly interchangeable use of the terms raw material and direct material. However, there is a difference in the meaning of these terms. Before material is entered into the production process, it is called raw material. After it enters production, it becomes direct material. Direct Labor The cost of salaries, wages, and fringe benefits for personnel who work directly on the manufactured products is classified as direct-labor cost. Examples include the wages of personnel who assemble Comet computers and who operate the equipment in a Royal Dutch Shell refinery. The cost of fringe benefits for direct-labor personnel, such as employer-paid health- insurance premiums and the employer’s pension contributions, also should be classified as direct-labor costs. Manufacturing Overhead All other costs of manufacturing are classified as manufacturing overhead, which includes three types of costs: indirect material, indirect labor, and other manufacturing costs. Indirect Material The cost of materials that are required for the production process but do not become an integral part of the finished product are classified as indirect material costs. An example is the cost of drill bits used in a metal-fabrication depart- ment at Ford Motor Company. The drill bits wear out and are discarded, but they do not become part of the product. Materials that do become an integral part of the finished product but are insignificant in cost are also often classified as indirect material. Materi- als such as glue or paint may be so inexpensive that it is not worth tracing their costs to specific products as direct materials. COmet COmetcomp.com 2As mentioned at the beginning of Chapter 1, the focus organizations around which Chapters 2 through 17 are built are not real organizations. They are, however, realistic settings in which to discuss business and managerial account- ing issues. In most cases they are based on real organizations. These realistic illustrations are intended to help stu- dents connect the business and managerial accounting issues discussed in this book to the management process and to everyday life. “[Management accountants] will be more analytical . . . and more of a partner with the operational side of the business.” (2d) ITT Automotive Learning Objective 2-5 Give examples of three types of manufacturing costs. hiL25664_ch02_034-077.indd 42hiL25664_ch02_034-077.indd 42 6/27/13 1:38 AM6/27/13 1:38 AM Final PDF to printer Chapter 2 Basic Cost Management Concepts 43 Indirect Labor The costs of personnel who do not work directly on the product, but whose services are necessary for the manufacturing process, are classified as indirect labor. Such personnel include production department supervisors, custodial employees, and security guards. Other Manufacturing Costs All other manufacturing costs that are neither material nor labor costs are classified as manufacturing overhead. These costs include deprecia- tion of plant and equipment, property taxes, insurance, and utilities such as electricity, as well as the costs of operating service departments. Service departments or support departments are those that do not work directly on manufacturing products but are nec- essary for the manufacturing process to occur. Examples include equipment-maintenance departments and computer-aided-design (CAD) departments. In some firms, departments are referred to as work centers. Other manufacturing overhead costs include overtime premiums and the cost of idle time. An overtime premium is the extra compensation paid to an employee who works beyond the time normally scheduled. Suppose a technician who assembles Comet computers earns $16 per hour. The technician works 48 hours during a week instead of the scheduled time of 40 hours. The overtime pay scale is time and a half, or 150 percent of the regular wage. The technician’s compensation for the week is classi- fied as follows: Direct-labor cost ($16 3 48) ............................................................................................ $768 Overhead (overtime premium: ½ 3 $16 3 8) .......................................................................... 64 Total compensation paid ................................................................................................. $832 Only the extra compensation of $8 per hour is classified as overtime premium. The regu- lar wage of $16 per hour is treated as direct labor, even for the eight overtime hours. Idle time is time that is not spent productively by an employee due to such events as equipment breakdowns or new setups of production runs. Such idle time is an unavoid- able feature of most manufacturing processes. The cost of an employee’s idle time is classified as overhead so that it may be spread across all production jobs, rather than being associated with a particular production job. Suppose that during one 40-hour shift, a machine breakdown resulted in idle time of 1½ hours and a power failure idled workers for an additional ½ hour. If an employee earns $14 per hour, the employee’s wages for the week will be classified as follows: Direct-labor cost ($14 3 38) ............................................................................................ $532 Overhead (idle time: $14 3 2) .......................................................................................... 28 Total compensation paid ................................................................................................. $560 Overtime premiums and the cost of idle time should be classified as manufacturing overhead, rather than associated with a particular production job, because the particular job on which idle time or overtime may occur tends to be selected at random. Suppose several production jobs are scheduled during an eight-hour shift, and the last job remains unfinished at the end of the shift. The overtime to finish the last job is necessitated by all of the jobs scheduled during the shift, not just the last one. Similarly, if a power failure occurs during one of several production jobs, the idle time that results is not due to the job that happens to be in process at the time. The power failure is a random event, and the resulting cost should be treated as a cost of all of the department’s production. To summarize, manufacturing costs include direct material, direct labor, and manu- facturing overhead. Direct labor and overhead are often called conversion costs, since they are the costs of “converting” raw material into finished products. Direct material and direct labor are often referred to as prime costs. “If you just simply have [an employee] performing an [assembly] operation, that’s direct labor. But when you put in a robot to do the job, which we’re all doing, then you’ve got to have an engineer to make sure the [robot] is programmed right. So now it becomes indirect labor.” (2e) Chrysler hiL25664_ch02_034-077.indd 43hiL25664_ch02_034-077.indd 43 6/27/13 1:38 AM6/27/13 1:38 AM Final PDF to printer 44 Chapter 2 Basic Cost Management Concepts Manufacturing Cost Flows Direct material, direct labor, and manufacturing overhead are the three types of produc- tion costs incurred by manufacturers. These costs are product costs because they are stored in inventory until the time period when the manufacturer’s products are sold. Man- ufacturers have product-costing systems to keep track of the flow of these costs from the time production begins until finished products are sold. This flow of manufacturing costs is depicted in Exhibit 2–6 . As direct material is consumed in production, its cost is added to work-in-process inventory. Similarly, the costs of direct labor and manufacturing over- head are accumulated in work in process. When products are finished, their costs are transferred from work-in-process inven- tory to finished-goods inventory. The total cost of direct material, direct labor, and manufacturing overhead transferred from work-in-process inventory to finished-goods inventory is called the cost of goods manufactured. The costs then are stored in finished goods until the time period when the products are sold. At that time, the product costs are transferred from finished goods to cost of goods sold, which is an expense of the period when the sale is made. Exhibit 2–6 concentrates on the conceptual basis of a product- costing system. The detailed procedures and accounts used to keep track of product costs are covered in Chapters 3 and 4. Manufacturers generally prepare a schedule of cost of goods manufactured and a schedule of cost of goods sold to summarize the flow of manufacturing costs during an accounting period. These schedules are intended for internal use by management and are generally not made available to the public. The Excel spreadsheets in Exhibit 2–7 show these two schedules along with an income statement for Comet Computer Corporation. 3 Notice the extremely low inventories of raw material, finished goods, and work in pro- cess in these schedules. With annual sales of $700 million, Comet’s year-end inventory of raw material is only $5,020,000, which is less than 1 percent of sales. Work-in-process inventory ($100,000) and finished-goods inventory ($190,000) are even lower. These low inventories, relative to sales volume, are characteristic of manufacturers using the direct- sales approach. Production Costs in Service Industry Firms and Nonprofit Organizations Service industry firms and many nonprofit organizations are also engaged in production. What distinguishes these organizations from manufacturers is that a service is consumed Manufacturing Cost Flows “In my mind, cost accoun- tants are going to be busi- ness analysts.” (2f) Boeing Direct Material Direct Labor Work-in-Process Inventory Finished-Goods Inventory Cost of Goods Sold Manufacturing Overhead Product costs . . . . . . are stored in inventory . . . . . . until the products are sold. Exhibit 2–6 Flow of Manufacturing Costs 3Some numerical displays in the text will be presented as Excel spreadsheets, since this tool is widely used in business. Learning Objective 2-6 Prepare a schedule of cost of goods manufactured, a schedule of cost of goods sold, and an income statement for a manufacturer. COmet COmetcomp.com hiL25664_ch02_034-077.indd 44hiL25664_ch02_034-077.indd 44 6/27/13 1:38 AM6/27/13 1:38 AM Final PDF to printer Chapter 2 Basic Cost Management Concepts 45 Exhibit 2–7 Manufacturing Cost Schedules COmet COmetcomp.com (continues) hiL25664_ch02_034-077.indd 45hiL25664_ch02_034-077.indd 45 6/27/13 1:38 AM6/27/13 1:38 AM Final PDF to printer 46 Chapter 2 Basic Cost Management Concepts as it is produced, whereas a manufactured product can be stored in inventory. Such busi- nesses as Westin Hotels, Bank of America, United Airlines, the Chicago Bulls, and Cole Muffler are in the business of producing services. Similarly, nonprofit organizations such as the American Red Cross and the Greater Miami Opera Association also are engaged in service production. While less commonly observed in service firms, the same cost classifications used in manufacturing companies can be applied. For example, Air France produces air transportation services. Direct material includes such costs as jet fuel, air- craft parts, and food and beverages. Direct labor includes the salaries of the flight crew and the wages of aircraft-maintenance personnel. Overhead costs include depreciation of baggage-handling equipment, insurance, and airport landing fees. The process of recording and classifying costs is important in service industry firms and nonprofit organizations for the same reasons as in manufacturing firms. Cost analysis is used in pricing banking and insurance services, locating travel and car- rental agencies, setting enrollment targets in universities, and determining cost reim- bursements in hospitals. As such organizations occupy an ever-growing role in our economy, applying managerial accounting to their activities will take on ever-greater importance. Exhibit 2–7 (concluded) COmet COmetcomp.com Basic Cost Management Concepts: Different Costs for Different Purposes An understanding of cost concepts is absolutely critical to cost management. Moreover, different perspectives on costs are important in different managerial situations. The phrase different costs for different purposes is often used to convey the notion that differ- ent characteristics of costs can be important to understand in a variety of managerial cir- cumstances. In this section, we will briefly discuss the work of several cross-functional management teams at Comet Computer Corporation, each of which is focusing on a particular management challenge. Through our discussion of these cost management teams’ work, we will explore some of the key cost terms and concepts used in managerial accounting and cost management. Basic Cost Management Concepts: Different Costs for Different Purposes hiL25664_ch02_034-077.indd 46hiL25664_ch02_034-077.indd 46 6/27/13 1:38 AM6/27/13 1:38 AM Final PDF to printer Chapter 2 Basic Cost Management Concepts 47 The Cost Driver Team One of the most important cost classifications involves the way a cost changes in relation to changes in the activity of the organization. Activity refers to a measure of the orga- nization’s output of products or services. The number of automobiles manufactured by General Motors, the number of days of patient care provided by Massachusetts General Hospital, and the number of insurance claims settled by Allstate are all measures of activ- ity. The activities that cause costs to be incurred are also called cost drivers. One of Comet Computer Corporation’s cost manage- ment teams was formed to examine the various costs incurred by Comet. The team consisted of an engineer, a pro- duction manager, a purchasing manager, and a managerial accountant. After identifying the various costs incurred by Comet, the team was charged to go on to identify the cost drivers upon which various types of costs depend. 4 A cost driver is a characteristic of an activity or event that causes costs to be incurred by that activity or event. In most organizations, different types of costs respond to widely differ- ing cost drivers. For example, in a manufacturing firm, the cost of assembly labor would be driven by the quantity of products manufactured as well as the number of parts in each product. In contrast, the cost of machine setup labor would be driven by the number of production runs. The cost of material-handling labor would be driven by material-related factors such as the quantity and cost of raw material used, the number of parts in various products, and the number of raw-material shipments received. In identifying a cost driver, the managerial accountant should consider the extent to which a cost or pool of costs varies in accordance with the cost driver. The higher the correlation between the cost and the cost driver, the more accurate will be the resulting understanding of cost behavior. Another important consideration is the cost of measur- ing the cost driver. Thus, there is a cost-benefit trade-off in the identification of cost drivers. As the number of cost drivers used in explaining an organization’s cost behavior increases, the accuracy of the resulting information will increase. However, the cost of the information will increase also. The concept of a cost driver will be an important aspect of many of the topics discussed in subsequent chapters. Variable and Fixed Costs After identifying costs and cost drivers for Comet Computer Corporation’s operations, the cost driver team went on to examine the relationship of various costs to the activities performed. Such a relationship is referred to as cost behavior and will be the focus of Chapter 6. At this juncture, though, let’s look at two types of cost behavior identified at Comet Computer Corporation: variable and fixed costs. Variable Costs A variable cost changes in total in direct proportion to a change in the level of activity (or cost driver). If activity increases by 20 percent, total variable cost increases by 20 percent also. For example, the cost of sheet metal used by Chrysler will increase by approximately 5 percent if automobile production increases by 5 percent. The Learning Objective 2-7 Understand the importance of identifying an organization’s cost drivers. Learning Objective 2-8 Describe the behavior of vari- able and fixed costs, in total and on a per-unit basis. 4Such cost driver teams have been established by many companies. For descriptions of such efforts at Deere and Company and Hewlett-Packard Corporation, see the management cases: John Deere Component Works and Hewlett-Packard-Queensferry Telecommunications Division (Harvard Business School). Cost drivers in the airline industry are complex. The capacity of an airplane and its passenger load drive costs, but so do a variety of other factors related to the airline’s operations. hiL25664_ch02_034-077.indd 47hiL25664_ch02_034-077.indd 47 6/27/13 1:38 AM6/27/13 1:38 AM Final PDF to printer 48 Chapter 2 Basic Cost Management Concepts Exhibit 2–8 Variable Cost COmet COmetcomp.com Total variable cost (power bus assemblies) $3,000 $2,000 $1,000 10 20 30 Activity (or cost driver): units produced A. Graph of Total Variable Cost Activity (or cost driver) Variable Cost per Unit Total Variable Cost 1 .....................................$100 .................................... $ 100 4 ..................................... 100 .................................... 400 18 ..................................... 100 .................................... 1,800 30 ..................................... 100 .................................... 3,000 B. Tabulation of Variable Cost cost of napkins and other paper products used at a Pizza Hut will increase by roughly 10 percent if the restaurant’s patronage increases by 10 percent. At Comet Computer Corporation, the cost management team identified direct mate- rial as a variable cost. One purchased component, a power bus assembly, costs $100 per computer manufactured. The cost behavior for this direct material cost is graphed and tabulated in Exhibit 2–8 . Panel A of Exhibit 2–8 displays a graph of this variable cost. As this graph shows, total variable cost increases proportionately with activity. When activity doubles, from 10 to 20 units, total variable cost doubles, from $1,000 to $2,000. However, the variable cost per unit remains the same as activity changes. The variable cost associated with each unit of activity is $100, whether it is the first unit, the fourth, or the eighteenth. The table in panel B of Exhibit 2–8 illustrates this point. To summarize, as activity changes, total variable cost increases or decreases propor- tionately with the activity change, but unit variable cost remains the same. Fixed Costs A fixed cost remains unchanged in total as the level of activity (or cost driver) varies. If activity increases or decreases by 20 percent, total fixed cost remains the same. Examples of fixed costs include depreciation of plant and equipment at a Nike fac- tory, the cost of property taxes at a Ramada Inn, and the salary of a subway train operator employed by the New York Transit Authority. Comet Computer Corporation’s cost driver team identified the salary of the manager of Web sales operations as a fixed cost. Her $150,000 annual salary does not vary with the number of units produced or sold. This fixed cost is graphed in panel A of Exhibit 2–9 . From the graph in Exhibit 2–9 , it is apparent that total fixed cost remains unchanged as activity changes. When activity triples, from 10 to 30 units, total fixed cost remains hiL25664_ch02_034-077.indd 48hiL25664_ch02_034-077.indd 48 6/27/13 1:39 AM6/27/13 1:39 AM Final PDF to printer Chapter 2 Basic Cost Management Concepts 49 Exhibit 2–9 Fixed Cost COmet COmetcomp.com C. Graph of Unit Fixed Cost Unit fixed cost $150,000 $100,000 $ 50,000 Activity (or cost driver): units produced10 20 30 A. Graph of Total Fixed Cost Total fixed cost (Web sales manager’s salary) 10 20 30 Activity (or cost driver): units produced $150,000 constant at $150,000. However, the fixed cost per unit does change as activity changes. If the activity level is only 1 unit, then the fixed cost per unit is $150,000 per unit ($150,000 4 1). If the activity level is 10 units, then the fixed cost per unit declines to Activity (or cost driver) Fixed Cost per Unit Total Fixed Cost 1 .................................. $150,000 .............................. $150,000 2 .................................. 75,000 ................................ 150,000 5 .................................. 30,000 ................................ 150,000 10 .................................. 15,000 ................................ 150,000 11 .................................. 13,636* ............................... 150,000 20 .................................. 7,500 ................................ 150,000 21 .................................. 7,143* ............................... 150,000 30 .................................. 5,000 ................................ 150,000 *Rounded B. Tabulation of Fixed Cost hiL25664_ch02_034-077.indd 49hiL25664_ch02_034-077.indd 49 6/27/13 1:39 AM6/27/13 1:39 AM Final PDF to printer 50 Chapter 2 Basic Cost Management Concepts UNDERSTANDING EXPLODING HEALTH CARE COSTS As health care costs spin out of control and occupy an ever-greater share of GDP, an understanding of these costs takes on greater and greater importance. One area of misunderstanding is which of these costs are variable and which ones are largely fixed. According to two leading cost experts, it is a myth that most health care costs are fixed. “Many health care system participants, including economists and accountants, believe that most costs in health care are fixed because so much care is delivered using shared staff, space and equipment. The result of this misguided thinking is that cost reduction efforts tend to focus on only the small fraction of costs seen as variable.” But a focus on only the costs that are clearly variable, such as drugs and supplies, cannot make enough headway in solving the overall cost management problem in health care. A careful analysis of costs reveals that personnel costs, occupying at least 50 percent of health care costs, are not fixed, as they are widely believed to be. “Hospital executives can set the quantity, mix and compensation of their employees each year. Personnel costs are fixed only when executives allow them to be.” Another prominent health-care cost is space, and according to these two cost analysts, space costs are also not fixed, although they are widely believed to be. “If demand for space is reduced, units can be consolidated into smaller space, and excess space can be repurposed, sold, or subleased. Similarly, equipment costs can be avoided if changes in processes, treatment protocols, or patient mix eliminate the demand for the resources.” The bottom line is that if health care costs are to be controlled, they must first be understood. And that understanding includes the correct classification of costs as vari- able or fixed. Close to 95 percent of the costs that health care professionals judge to be fixed are actually variable.5 Health Care Industry M A P anagement ccounting ractice 5Robert S. Kaplan and Michael E. Porter, “How to Solve the Crisis in Health Care,” Harvard Business Review, September 2011, p. 60. $15,000 per unit ($150,000 4 10). The behavior of total fixed cost and unit fixed cost is illustrated by the table in panel B of Exhibit 2–9 . Another way of viewing the change in unit fixed cost as activity changes is in a graph, as shown in panel C of Exhibit 2–9 . Unit fixed cost declines steadily as activity increases. Notice that the decrease in unit fixed cost when activity changes from 1 to 2 units is much larger than the decrease in unit fixed cost when activity changes from 10 to 11 units or from 20 to 21 units. Thus, the amount of the change in unit fixed cost declines as the activity level increases. To summarize, as the activity level increases, total fixed cost remains constant but unit fixed cost declines. As you will see in subsequent chapters, it is vital in managerial account- ing to thoroughly understand the behavior of both total fixed costs and unit fixed costs. The Cost Management and Control Team An important objective of managerial accounting is to assist managers in managing and controlling costs. Sometimes cost management is facilitated by tracing costs to the department or work center in which the cost was incurred. Such tracing of costs to depart- ments is known as responsibility accounting. Comet Computer Corporation formed a cost management and control team to refine the company’s responsibility accounting system. The team consisted of an engineer, the production scheduling manager, the assistant manager of quality control, the manager of hiL25664_ch02_034-077.indd 50hiL25664_ch02_034-077.indd 50 6/27/13 1:39 AM6/27/13 1:39 AM Final PDF to printer Chapter 2 Basic Cost Management Concepts 51 human resources, and a managerial accountant. The ultimate objective of the team was to develop a responsibility accounting system that would assist management in manag- ing and controlling costs as well as reducing costs whenever possible. We will study cost management systems and cost reduction in considerable detail in Chapter 5 and responsi- bility accounting in Chapter 12. For now, let’s focus on a couple of cost concepts that are useful in these areas of managerial accounting. Direct and Indirect Costs An entity, such as a particular product, service, or depart- ment, to which a cost is assigned is called a cost object. A cost that can be traced to a particular cost object is called a direct cost of that cost object. For example, the salary of an auto mechanic is a direct cost of the automotive service department in a Sears department store. The cost of paint used in the painting department of a Toyota plant is a direct cost of the painting department. A cost that is not directly traceable to a particular cost object is called an indirect cost of that cost object. For example, the costs of national advertising for Walt Disney World are indirect costs of each of the departments or subunits of the recreational complex, such as the Magic Kingdom and Epcot. The salary of a General Electric Company plant man- ager is an indirect cost of each of the plant’s production departments. The plant manager’s duties are important to the smooth functioning of each of the plant’s departments, but there is no way to trace a portion of the plant manager’s salary cost to each department. Whether a cost is a direct cost or an indirect cost of a department often depends on which department is under consideration. A cost can be a direct cost of one department or subunit in the organization but an indirect cost of other departments. While the salary of a General Electric Company plant manager is an indirect cost of the plant’s departments, the manager’s salary is a direct cost of the plant. Comet Computer Corporation’s cost management and control team determined that many of the company’s costs were traceable to various departments or to spe- cific activities of those departments. In the purchasing department, for example, costs were traced not just to the department, but to the specific activities of identifying ven- dors, qualifying vendors, securing design specifications from the engineering design department, negotiating prices, placing orders, expediting orders, receiving materials and components, inspecting materials, and releasing materials to the material-handling operation. An important objective of a cost management system is to trace as many costs as possible directly to the activities that cause them to be incurred. Sometimes called activ- ity accounting, this process is vital to management’s objective of eliminating non-value- added costs. These are costs of activities that can be eliminated without deterioration of product quality, performance, or perceived value. (We will study the elimination of non- value-added costs in greater detail in Chapter 5.) Controllable and Uncontrollable Costs Another cost classification that can be help- ful in cost control involves the controllability of a cost item by a particular manager. If a manager can control or heavily influence the level of a cost, then that cost is classified as a controllable cost of that manager. Costs that a manager cannot influence significantly are classified as uncontrollable costs of that manager. Many costs are not completely under the control of any individual. In classifying costs as controllable or uncontrollable, managerial accountants generally focus on a manager’s ability to influence costs. The question is not, Who controls the cost? but, Who is in the best position to influence the level of a cost item? Exhibit 2–10 lists several cost items along with their typical classifi- cation as controllable or uncontrollable. Comet Computer’s cost management and control team was able to designate many of Comet’s costs as controllable or uncontrollable by various managers. Take the cost of raw materials and components, for example. The team determined that the quantity of materials used was largely controllable by the production supervisor, but the price of the materials was influenced more by the purchasing manager. “The flight crew’s salaries on a flight, say from Atlanta to St. Louis, would be con- sidered a direct cost of that flight. The salaries of the flight scheduling folks, on the other hand, would be an indirect cost of any given flight.” (2g) Delta Air Lines Learning Objective 2-9 Distinguish among direct, indirect, controllable, and uncontrollable costs. hiL25664_ch02_034-077.indd 51hiL25664_ch02_034-077.indd 51 6/27/13 1:39 AM6/27/13 1:39 AM Final PDF to printer 52 Chapter 2 Basic Cost Management Concepts The Outsourcing Action Team Another of Comet Computer Corporation’s interdisciplinary management teams was formed to take a close look at which of the raw materials and components used in Comet’s products should be manufactured by Comet and which ones should be out- sourced (purchased from outside vendors). 7 This team consisted of the assistant manager of purchasing, a product design engineer, a product group sales manager, and a manage- rial accountant. As the team pursued its assignment, its members soon found that they were once again dealing with several different cost concepts. In addition to accounting cost classifications, such as product costs and period costs, the team’s members also found themselves using economic concepts in classifying costs. Such concepts are often useful in helping managerial accountants decide what cost infor- mation is relevant to the decisions faced by the organization’s managers. Several of the most important economic cost concepts are discussed next. Cost Item Manager Classification Cost of raw material used to produce computer chips in an Intel factory Supervisor of the production department for computer chips Controllable (The production supervisor can exercise some control over the quantity of material used by ensuring that waste and defective units are minimized.) Cost of food used in a Subway restaurant Restaurant manager Controllable (The restaurant manager exercises some control over the quantity of food used by scheduling production to ensure that excess food is not produced and wasted.) Cost of national advertising for the Alamo car rental company Manager of the Alamo rental agency at the Orlando airport Uncontrollable Cost of national accounting and data processing operations for Target Manager of a Target store in Gainesville, Florida Uncontrollable Exhibit 2–10 Controllable and Uncontrollable Costs Learning Objective 2-10 Define and give examples of an opportunity cost, an out-of-pocket cost, a sunk cost, a differential cost, a marginal cost, and an average cost. HOW AIRLINES SPEND YOUR AIRFARE Understanding costs is crucial in running any business. This is particularly true in the air- line industry, which is beset by high fuel costs, looming pilot shortages, and intense com- petition to keep airfares low. The Wall Street Journal recently asked US Airways “to crunch airline expenses down to the percentages that an individual passenger pays, taking a hard look at the costs of running an airline. US Airways created a hypothetical flight of 100 passengers. Each one paid the average $146 fare for a domestic flight plus $18 each in fees and add-ons.” The airline’s bottom line was that “there is very little wiggle room on the plane for profit.” In this hypothetical flight of 100 passengers, “it takes fares and fees from 99 seats to cover all costs.” The breakdown was this: It takes 29 seats to cover fuel costs, 20 seats for salaries, 16 seats to cover the costs of ownership, 14 for government fees and taxes, 11 seats for maintenance, and 9 seats to cover other assorted costs. That leaves a meager one passenger’s seat to cover the airline’s profit.6 US Airways M A P anagement ccounting ractice 6Scott McCartney, “How Airlines Spend Your Airfare,” The Wall Street Journal, June 7, 2012, pp. D1, D2. As this book went to press, American Airlines and US Airways were involved in merger discussions. 7The outsourcing decision, as well as several other common management decisions, is covered in detail in Chapter 14. hiL25664_ch02_034-077.indd 52hiL25664_ch02_034-077.indd 52 6/27/13 1:39 AM6/27/13 1:39 AM Final PDF to printer Chapter 2 Basic Cost Management Concepts 53 Opportunity Costs An opportunity cost is defined as the benefit that is sacrificed when the choice of one action precludes taking an alternative course of action. If beef and fish are the available choices for dinner, the opportunity cost of eating beef is the forgone pleasure associated with eating fish. Opportunity costs arise in many business decisions. For example, suppose a baseball manufacturer receives a special order for softballs from the city of Boston. If the firm accepts the softball order, it will not have enough productive capacity (labor and machine time) to produce its usual output of baseballs for sale to a large chain of sporting-goods stores. The opportunity cost of accepting the softball order is the forgone benefit from the baseball production that cannot be achieved. This forgone benefit is measured by the potential revenue from the baseball sales minus the cost of manufacturing the baseballs. Opportunity costs also arise in personal decisions. The opportunity cost of a stu- dent’s college education includes the salary that is forgone as a result of not taking a full- time job during the student’s years in college. From an economic perspective, a dollar of opportunity cost associated with an action should be treated as equivalent to a dollar of out-of-pocket cost. Out-of-pocket costs are those that require the payment of cash or other assets as a result of their incurrence. The out-of-pocket costs associated with the softball order consist of the manufacturing costs required to produce the softballs. In making the decision to accept or reject the softball order, the firm’s management should consider both the out-of-pocket cost and the oppor- tunity cost of the order. Studies by behavioral scientists and economists have shown that many people have a tendency to ignore or downplay the importance of opportunity costs. For example, in one study people were asked if they would pay $500 for two tickets to the Super Bowl. Most people responded that they would not. However, many of the same people said that they would not sell the Super Bowl tickets for $500 if they were given the tickets free of charge. These people refused to incur the $500 out-of-pocket cost of buying the Super Bowl tickets. However, they were willing to incur the $500 opportunity cost of going to the game rather than sell the tickets. In each case, a couple that attends the game ends up $500 poorer than a couple that does not attend the game. (Try surveying your friends with this scenario.) Behavior such as that illustrated in the Super Bowl example is economically incon- sistent. Ignoring or downplaying the importance of opportunity costs can result in incon- sistent and faulty business decisions. Comet Computer’s outsourcing action team found that the opportunity cost of using constrained production resources (such as space, machine time, and employee time) to produce a computer component in-house was an important factor to consider in deciding whether to outsource the component. 8 Sunk Costs Sunk costs are costs that have been incurred in the past. Consequently, they do not affect future costs and cannot be changed by any current or future action. Examples of such costs include the acquisition cost of equipment previously purchased and the manufacturing cost of inventory on hand. Regardless of the current usefulness of the equipment or the inventory, the costs of acquiring them cannot be changed by any prospective action. Hence, these costs are irrelevant to all future decisions. Suppose, for example, that a university’s traffic department purchased a computer to assist in the vehicle registration process. A year has passed, the computer’s warranty has expired, and the computer is not working well. An investigation reveals that this brand of computer is very sensitive to humidity and temperature changes. The traffic department is located in an old building with poor heating and no air-conditioning. As a result, the computer works only intermittently, repair bills have been high, and the 8The details of the outsourcing decision, including its relevant costs and the role of opportunity costs, are covered in Chapter 14. hiL25664_ch02_034-077.indd 53hiL25664_ch02_034-077.indd 53 6/27/13 1:39 AM6/27/13 1:39 AM Final PDF to printer 54 Chapter 2 Basic Cost Management Concepts office staff is fed up. The office manager requests that the department director junk the computer and instruct the staff to return to the old manual registration system. The direc- tor responds by insisting, “We can’t afford to junk the computer! We paid $3,400 for it.” This illustration is a typical example of the inappropriate attention paid to sunk costs. The $3,400 paid for the computer is sunk. No future decision about the computer or the office’s procedures can affect that cost. Future decisions should be based on future costs, such as the computer repair bills or the costs of upgrading the building’s heating and air- conditioning systems. Although it is incorrect, from an economic perspective, to allow sunk costs to affect future decisions, people often do so. It is human nature to attempt to justify past deci- sions. When there is a perceived need to demonstrate competence, either to themselves or to others, managers may seek to justify their decisions. The response of the traffic depart- ment director that “We can’t afford to junk the computer!” may represent the director’s need to justify the past decision to purchase the computer. It is important for managerial accountants to be aware of such behavioral tendencies. Such an awareness enables the accountant to prepare the most relevant data for managers’ decisions and, sometimes, to assist the managers in using the information. Comet Computer’s outsourcing action team encountered a sunk cost as it considered outsourcing production of a component called a monitor interface unit (MIU). The team discovered that the automatic insertion robot used to insert components into the MIU was difficult to maintain and expensive to operate. Nevertheless, the department supervisor was inclined to keep the robot and continue in-house production of the MIU, because, as he put it, “Comet paid an arm and a leg for this robot.” The team was able to demonstrate that the robot’s acquisition cost was a sunk cost and was irrelevant to the outsourcing decision. We will explore sunk costs in more detail in Chapter 14. Differential Costs A differential cost is the amount by which the cost differs under two alternative actions. Suppose, for example, that a county government is considering two competing sites for a new landfill. If the northern site is chosen, the annual cost of transporting refuse to the site is projected at $85,000. If the southern site is selected, annual transportation charges are expected to be $70,000. The annual differential cost of transporting refuse is calculated as follows: Annual cost of transporting refuse to northern site ....................................................................... $85,000 Annual cost of transporting refuse to southern site ...................................................................... 70,000 Annual differential cost .................................................................................................... $15,000 The increase in cost from one alternative to another is called an incremental cost. In the landfill example, the annual incremental cost of refuse transportation is $15,000 if the site is moved from the southern location to the northern location. Differential or incre- mental costs are found in a variety of economic decisions. The additional cost incurred by Gulliver’s Travels, a travel agency, in locating a new office in the suburbs is the incre- mental cost of the new business location. The difference in the total cost incurred by the travel agency with or without the suburban location is the differential cost of the decision whether to establish the new office. Decisions about establishing new airline routes, add- ing additional shifts in a manufacturing firm, or increasing the nursing staff in a hospital all involve differential costs. At Comet Computer, the outsourcing action team estimated that the differential cost between outsourcing the production of the MIU (monitor interface unit) and producing it in-house would be $200,000 annually in favor of outsourcing, based on current projec- tions of annual production. Marginal Costs and Average Costs A special case of the differential-cost concept is the marginal cost, which is the extra cost incurred when one additional unit is produced. The additional cost incurred by Comet Computer when one additional high-performance hiL25664_ch02_034-077.indd 54hiL25664_ch02_034-077.indd 54 6/27/13 1:39 AM6/27/13 1:39 AM Final PDF to printer Chapter 2 Basic Cost Management Concepts 55 laptop computer is made is the marginal cost of manufacturing the computer. The table in Exhibit 2–11 shows how marginal cost can change across different ranges of production quantities. Marginal costs typically differ across different ranges of production quantities because the efficiency of the production process changes. At Comet Computer, the mar- ginal cost of producing a laptop computer declines as output increases. It is much more efficient for the company to manufacture 101 computers than to make only one. It is important to distinguish between marginal costs and average costs. In the Comet Computer example, the marginal cost of the second computer is $1,900. However, the average cost per unit when two laptops are manufactured is $3,900 divided by 2, or $1,950. Similarly, the marginal cost of the eleventh laptop is $1,690, but the average cost per unit when 11 laptops are produced is $1,790 (calculated by dividing $19,690 by 11). What is the marginal cost of the 101st laptop computer? The average cost per unit when 101 laptops are manufactured? 9 To summarize, the marginal cost of production is the extra cost incurred when one more unit is produced. The average cost per unit is the total cost, for whatever quantity is manufactured, divided by the number of units manufactured. Marginal costs and aver- age costs arise in a variety of economic situations. A Princeton University administrator might be interested in the marginal cost of educating one additional student, and a Toyota executive might want to know the marginal cost of producing one more Toyota van. A Greyhound route manager might be interested in the average cost per mile on the Pitts- burgh to New York City route. Costs and Benefits of Information Many different cost concepts have been explored in this chapter. An important task of the managerial accountant is to determine which of these cost concepts is most appropriate in each situation. Then the accountant strives to communicate the cost information to the user in the most effective manner possible. The accountant attempts to structure the organization’s accounting information system to record data that will be useful for a variety of purposes. The benefits of measuring and classifying costs in a particular way are realized through the improvements in planning, control, and decision making that the information facilitates. Another important task of the managerial accountant is to weigh the benefits of pro- viding information against the costs of generating, communicating, and using that infor- mation. Some accountants, eager to show that they have not overlooked anything, tend to provide too much information. But when managers receive more data than they can utilize effectively, information overload occurs. Struggling to process large amounts of information, managers may be unable to recognize the most important facts. In deciding how much and what type of information to provide, managerial accountants should con- sider these human limitations. 9Marginal cost of 101st laptop computer is $995 (from Exhibit 2–11). Average cost per unit when 101 laptops are produced is $1,495 ($150,995 4 101). “If you can’t communicate information to the individual, then the information is . . . lost. So, your communication skills are very important.” (2h) Abbott Labs Exhibit 2–11 Marginal Cost of Producing Laptop Computers at Comet Computer Corporation COmet COmetcomp.com Number of Laptop Computers Produced Total Cost of Producing Laptops Marginal Cost of Producing a Laptop 1 .............. 2 .............. $ 2,000 3,900 Difference is $1,900 Marginal cost of 2nd laptop is $1,900 10 ............. . 11 .............. 18,000 19,690 Difference is $1,690 Marginal cost of 11th laptop is $1,690 100 .............. 101 .............. 150,000 150,995 Difference is $995 Marginal cost of 101st laptop is $995 hiL25664_ch02_034-077.indd 55hiL25664_ch02_034-077.indd 55 6/27/13 1:39 AM6/27/13 1:39 AM Final PDF to printer 56 Chapter 2 Basic Cost Management Concepts Costs in the Service Industry The cost terms and concepts that we have studied in this chapter are just as relevant in the service industry as in a manufacturing firm like Comet Computer Corporation. Here we will explore those cost issues in the context of a well-known automotive service company. Midas, Inc. is one of the world’s largest providers of automotive service, including exhaust system, brakes, steering, suspension, and routine maintenance services. There are close to 1,500 franchised and company-owned Midas locations in the United States and Canada and nearly 800 licensed and franchised locations in 12 other countries on five continents. In recent years, Midas has undergone some significant changes. First, the company intentionally transitioned from an under-car repair specialist to a full-service automotive repair and maintenance provider. Second, Midas has sold its exhaust system manufacturing business to concentrate fully on automotive service provision. To this end, Midas has established relationships with automobile parts vendors who distribute their products directly to Midas auto service shops. A typical Midas automotive maintenance and repair shop has approximately 4,000 square feet and six service bays. A company-owned shop usually is staffed with a man- ager, an assistant manager, and three to four automotive service technicians. Midas supports the franchise dealer network with 34 business managers and four regional managers. Each business manager covers approximately 39 franchised Midas shops and assists franchisees with operations, retail initiatives, training, and monitoring of the fran- chise agreement. 10 Now let’s think about a typical Midas-owned auto service shop to explore the various cost issues we have studied in a service-industry environment. Product and Period Costs Midas purchases auto parts and supplies, such as exhaust pipes, brake pads, oil filters, and engine oil, from vendors. These costs are stored in inventory as product costs (or inventoriable costs ) until the time period when they are consumed in the repair process. At that time, these product costs become part of cost of goods sold, an expense. All of Midas’ other costs are period costs, and they Costs in the Service Industry 10Recent Midas, Inc. annual reports and the company’s website. hiL25664_ch02_034-077.indd 56hiL25664_ch02_034-077.indd 56 6/27/13 1:39 AM6/27/13 1:39 AM Final PDF to printer Chapter 2 Basic Cost Management Concepts 57 are expensed as operating expenses during the period they are incurred. Examples of these period costs include employee salaries and wages, utilities, and depreciation on equipment and facilities. Variable and Fixed Costs The costs incurred in the Midas service shop that vary directly with activity are variable costs. For example, the cost of lubricant, engine oil, and oil filters is a variable cost, because it varies in proportion to the number of lube- oil-filter (LOF) jobs the shop provides. Thus, a likely cost driver for this cost would be the number of LOF jobs performed. In contrast, any costs that do not tend to vary with service activity are fixed costs. Examples include the Midas shop’s managerial salaries, depreciation on equipment and facilities, insurance, and property taxes. Direct and Indirect Costs Consider a typical service and repair job. The customer has requested a routine lube-oil-filter job and an exhaust system repair, which requires a new muffler. The direct costs of this service and repair job (the cost object ) include the parts and supplies used (lubricant, engine oil, oil filter, and a new muffler) and the wages of the automotive service technician for the time spent on this job. The many indirect costs of this service job include the shop manager’s salary, the depreciation on the build- ing, and national media advertising purchased nationwide by Midas, Inc. Now consider a different cost object—this Midas shop. For this cost object, the shop manager’s salary is a direct cost of the Midas shop. However, the Midas CEO’s salary is an indirect cost of this particular shop. Controllable and Uncontrollable Costs Costs that are controllable by the manager of this Midas auto shop include local advertising, assuming the shop manager is responsible for such local ad buys. A cost that is partially controllable by the manager might include heating costs. Although the manager has little control over electricity or heating oil prices, the manager can ensure that the shop’s heating system is properly maintained and the win- dows and doors have the proper weather stripping. Many of the shop’s costs are largely uncontrollable by the shop manager. The depreciation, insurance, and property taxes on the building, for example, are the result of decisions made higher up in the Midas organization. Opportunity, Out-of-Pocket, and Sunk Costs These cost types all are represented in the Midas auto service business. Suppose the Midas shop manager decides to shut down one of the service bays on a particular day to inspect and maintain the lift and other equipment. Any customer business that is lost that day due to a shortage of service bays would be an opportunity cost of the shut-down decision. (Note that such an opportunity cost does not necessarily mean the shut-down decision was a poor one. The opportunity cost of any lost business could well be exceeded by the additional operating costs that could be incurred if the service bay was not properly maintained.) The wages paid to ser- vice technicians and utility costs are examples of out-of-pocket costs. The money spent last year to replace an auto lift is an example of a sunk cost. Differential, Marginal, and Average Costs Suppose the Midas shop owns a small van to make short runs to pick up auto parts needed on short notice. The van needs to be replaced, and two vehicles are under consideration. The difference in the cost of these two alternative vehicles is a differential cost of the vehicle replacement decision. The cost of performing one additional lube-oil-filter (LOF) job in a given time period is the mar- ginal cost of that type of service. The total cost of all LOF jobs in a time period, divided by the number of jobs, is the average cost of an LOF job. To summarize, although manufacturers, like Levi Strauss, Motorola, or Nike, and service-industry firms, like Allstate, Enterprise Rent-a-Car, or Midas, are in very differ- ent businesses, they all must understand their costs in order to be successful in a competi- tive environment. hiL25664_ch02_034-077.indd 57hiL25664_ch02_034-077.indd 57 6/27/13 1:39 AM6/27/13 1:39 AM Final PDF to printer 58 Chapter 2 Basic Cost Management Concepts 11Jared Sandberg, Rebecca Blumenstein, and Shawn Young, “WorldCom Admits $3.8 Billion Error in Its Accounting— Firm Ousts Financial Chief and Struggles for Survival; SEC Probe Likely to Widen,” The Wall Street Journal, June 26, 2002, p. A1; Jared Sandberg, Deborah Solomon, and Rebecca Blumenstein, “Disconnected: Inside WorldCom’s Unearthing of a Vast Accounting Scandal,” The Wall Street Journal, June 27, 2002, p. A1; and Jared Sandberg, “Lead- ing the News: Was Ebbers Aware of Accounting Move at His WorldCom?” The Wall Street Journal, July 1, 2002, p. A3. 12Devlin Barrett, “Ex-WorldCom Exec Pleads Guilty,” Associated Press, September 27, 2002 (as it appeared in the Ithaca Journal). See also Kurt Eichenwald and Simon Romero, “Plea Deals Are Seen for Three WorldCom Execu- tives,” The New York Times, August 29, 2002, pp. C1, C4. 13T. Richardson, “Worldcom CFO Lied, He Admits in Court,” The Register, February 17, 2005, www.theregister .co.uk. 14A. Latour, S. Young, and L. Yuan, “Ebbers Is Convicted in Massive Fraud,” The Wall Street Journal, March 16, 2005, p. A1. Focus on Ethics WAS WORLDCOM’S CONTROLLER JUST FOLLOWING ORDERS? Through a series of mergers and acquisitions, WorldCom, Inc. grew to become the nation’s second-largest long- distance telecommunications company. WorldCom’s core communication services included network data transmis- sion over public and private networks. Trouble arose for WorldCom because of the immense overcapacity in the telecommunications industry due to overly optimistic growth projections during the Internet boom. The combi- nation of overcapacity, decreased demand, and high fixed costs still poses a serious problem for many of the major players in the industry. In June 2002, the company disclosed that it had overstated earnings for 2001 and the first quarter of 2002 to the tune of $3.8 billion. The overstatement arose because the company incorrectly classified period expenses as capital expenditures. This maneuver had two major effects on the company’s financial statements: the company’s assets were artificially inflated and the capitalization allowed the company to spread the rec- ognition of its expenses into the future, which increased net income in the current period. The expenses in ques- tion related to line costs—the fees that WorldCom pays outside providers for access to their communications networks. In addition, the company announced in July 2002 that it had also manipulated reserve accounts, which affected another $3.8 billion in earnings in 1999 and 2000. The problems at WorldCom were discovered dur- ing an internal audit and brought to the attention of the company’s new auditors, KPMG. Arthur Andersen served as WorldCom’s auditors during the period covered by the alleged accounting scandal. Arthur Andersen main- tained that the details of the accounting fraud were kept from them by senior WorldCom management. The firm’s controller and chief financial officer (CFO), who was a former KPMG employee, were fired after the alleged accounting frauds were revealed. WorldCom’s CEO maintained that he knew nothing of the accounting deci- sions made by the CFO, but many observers question how almost $8 billion in expenses could slip by senior management.11 According to an Associated Press article that ran on September 27, 2002, “the former controller of WorldCom, Inc. pleaded guilty to securities fraud charges, saying he was instructed by ‘senior management,’ to falsify records. His plea was the first admission of guilt” to come out of what was at the time the largest corporate accounting scandal in U.S. history.12 Subsequently, Worldcom’s CFO pleaded guilty to his part in the accounting scandal.13 In March of 2005, the company’s CEO was convicted by a jury of nine criminal counts in the accounting fraud, including conspiracy and securities fraud.14 The CFO and controller were the top two financial and managerial accountants in the WorldCom orga- nization. They were ultimately responsible for all of the company’s financial and managerial accounting reports. (Note that this case also involves the alleged intentional misclassification of period costs.) What ethical issues are involved here? What do you make of the control- ler’s assertion that he was just following orders given by senior management? What steps should WorldCom’s controller have taken? (Review the Institute of Manage- ment Accountants’ Statement of Ethical Professional Practice on page 26.) hiL25664_ch02_034-077.indd 58hiL25664_ch02_034-077.indd 58 6/27/13 1:39 AM6/27/13 1:39 AM Final PDF to printer Chapter 2 Basic Cost Management Concepts 59 LO2-1 Explain what is meant by the word cost. The word cost can have a variety of meanings in dif- ferent situations. In general, a cost is the sacrifice made, usually measured by the resources given up, to achieve a particular purpose. LO2-2 Distinguish among product costs, period costs, and expenses. A product cost is a cost assigned to manufactured or purchased goods. Period costs are those associated with the period of time in which they are incurred. An expense is the cost incurred when an asset is used up for the purpose of generating revenue. LO2-3 Describe the role of costs in published financial statements. The cost of goods sold is an expense on the income statement. Inventory on the balance sheet is measured at its cost, as are all assets. LO2-4 List and describe four types of manufacturing operations. The four basic types of manu- facturing operations are job shop, batch, assembly line, and continuous flow. In a mass-customization production environment, many standardized components are used to manufacture customized products to customer order. LO2-5 Give examples of three types of manufacturing costs. Manufacturing costs are categorized as direct-material, direct-labor, and manufacturing-overhead. LO2-6 Prepare a schedule of cost of goods manufactured, a schedule of cost of goods sold, and an income statement for a manufacturer. These accounting schedules, which are illustrated in the chap- ter, provide information to management about the costs incurred in a production operation. LO2-7 Understand the importance of identifying an organization’s cost drivers. A cost driver is any activity or event that causes costs to be incurred. Understanding the cost drivers in an organization is an essential component of managing those costs. LO2-8 Describe the behavior of variable and fixed costs, in total and on a per-unit basis. As activ- ity in an organization increases, a variable cost increases proportionately to activity in total, but remains constant on a per-unit basis. In contrast, as activity in an organization increases, a fixed cost remains constant in total but decreases on a per-unit basis. LO2-9 Distinguish among direct, indirect, controllable, and uncontrollable costs. Direct and indi- rect costs refer to the ability of the accountant to trace costs to various departments in the organization. The terms controllable and uncontrollable are used to describe the extent to which a manager can influ- ence a cost. LO2-10 Define and give examples of an opportunity cost, an out-of-pocket cost, a sunk cost, a differential cost, a marginal cost, and an average cost. An opportunity cost is the benefit forgone because the choice of one action precludes another action. An out-of-pocket cost requires the payment of cash or other assets. Sunk costs are costs incurred in the past that cannot be altered by a current or future decision. A differential (or incremental) cost refers to the difference in the costs incurred under two alternative actions. A marginal cost is the cost of producing one additional unit. Finally, the average cost per unit is the total cost for whatever quantity is produced, divided by the number of units produced. Chapter Summary Review Problems on Cost Classifications Problem 1 Several costs incurred by Myrtle Beach Golf Equipment, Inc. are listed below. For each cost, indicate which of the following classifications best describe the cost. More than one classification may apply to the same cost item. For example, a cost may be both a variable cost and a product cost. Cost Classifications a. Variable b. Fixed c. Period d. Product e. Administrative f. Selling hiL25664_ch02_034-077.indd 59hiL25664_ch02_034-077.indd 59 7/11/13 10:20 PM7/11/13 10:20 PM Final PDF to printer 60 Chapter 2 Basic Cost Management Concepts g. Manufacturing h. Research and development i. Direct material j. Direct labor k. Manufacturing overhead Cost Items 1. Metal used in golf clubs. 2. Salary of the plant manager. 3. Cost of natural gas used to heat factory. 4. Commissions paid to sales personnel. 5. Wages paid to employees who assemble golf bags. 6. Salary of an engineer who is working on a prototype of a new solar-powered golf cart. 7. Depreciation on the word processing equipment used by the company president’s secretary. Problem 2 Listed below are several costs incurred in the loan department of Suwanee Bank and Trust Company. For each cost, indicate which of the following classifications best describe the cost. More than one clas- sification may apply to the same cost item. Cost Classifications a. Controllable by the loan department manager b. Uncontrollable by the loan department manager c. Direct cost of the loan department d. Indirect cost of the loan department e. Differential cost f. Marginal cost g. Opportunity cost h. Sunk cost i. Out-of-pocket cost Cost Items 1. Salary of the loan department manager. 2. Cost of office supplies used in the loan department. 3. Cost of the department’s desktop computers purchased by the loan department manager last year. 4. Cost of general advertising by the bank, which is allocated to the loan department. 5. Revenue that the loan department would have generated for the bank if a branch loan office had been located downtown instead of in the next county. 6. Difference in the cost incurred by the bank when one additional loan application is processed. Solutions to Review Problems Problem 1 1. a, d, g, i 2. b, d, g, k 3. a, d, g, k 4. a, c, f 5. a, d, g, j 6. b, c, h 7. b, c, e hiL25664_ch02_034-077.indd 60hiL25664_ch02_034-077.indd 60 6/27/13 1:39 AM6/27/13 1:39 AM Final PDF to printer Chapter 2 Basic Cost Management Concepts 61 Key Terms Problem 2 1. b, c, i 2. a, c, i 3. a, c, h 4. b, d, i 5. g 6. e, f For each term’s definition refer to the indicated page, or turn to the glossary at the end of the text. activity, 47 average cost per unit, 55 controllable cost, 51 conversion costs, 43 cost, 36 cost driver, 47 cost object, 51 cost of goods manufactured, 44 cost of goods sold, 37 differential cost, 54 direct cost, 51 direct-labor cost, 42 direct material, 42 expense, 37 finished-goods, 41 fixed cost, 48 idle time, 43 incremental cost, 54 indirect cost, 51 indirect labor, 43 indirect material, 42 inventoriable cost, 38 manufacturing overhead, 42 marginal cost, 54 operating expenses, 40 opportunity cost, 53 out-of-pocket costs, 53 overtime premium, 43 period costs, 38 prime costs, 43 product cost, 37 raw material, 41 schedule of cost of goods manufactured, 44 schedule of cost of goods sold, 44 service departments (or support departments), 43 sunk costs, 53 variable cost, 47 work-in-process, 41 Review Questions 2–1. Distinguish between product costs and period costs. 2–2. Why are product costs also called inventoriable costs? 2–3. What is the most important difference between a manu- facturing firm and a service industry firm, with regard to the classification of costs as product costs or period costs? 2–4. List several product costs incurred in the production of a backpack. 2–5. List, describe, and give an example of each of the four different types of production processes. 2–6. Why is the cost of idle time treated as manufacturing overhead? 2–7. Explain why an overtime premium is included in manu- facturing overhead. 2–8. What is meant by the phrase “different costs for differ- ent purposes”? 2–9. Give examples to illustrate how the city of Tampa could use cost information in planning, controlling costs, and making decisions. 2–10. Distinguish between fixed costs and variable costs. 2–11. How does the fixed cost per unit change as the level of activity (or cost driver) increases? Why? 2–12. How does the variable cost per unit change as the level of activity (or cost driver) increases? Why? 2–13. Distinguish between volume-based and operations- based cost drivers in the airline industry. 2–14. Would each of the following characteristics be a vol- ume-based or an operations-based cost driver in a col- lege: ( a ) number of students, ( b ) number of disciplines offered for study, and ( c ) urban versus rural location? 2–15. List three direct costs of the food and beverage depart- ment in a hotel. List three indirect costs of the department. 2–16. List three costs that are likely to be controllable by a city’s airport manager. List three costs that are likely to be uncontrollable by the manager. 2–17. Which of the following costs are likely to be control- lable by the chief of nursing in a hospital? a. Cost of medication administered. b. Cost of overtime paid to nurses due to scheduling errors. c. Cost of depreciation of hospital beds. 2–18. Distinguish between out-of-pocket costs and opportu- nity costs. 2–19. Define the terms sunk cost and differential cost. 2–20. Distinguish between marginal and average costs. 2–21. Think about the process of registering for classes at your college or university. What additional information w ould you like to have before you register? How would it help you? What sort of information might create i nformation overload for you? 2–22. Two years ago the manager of a large department store purchased new bar code scanners costing $39,000. A hiL25664_ch02_034-077.indd 61hiL25664_ch02_034-077.indd 61 6/27/13 1:39 AM6/27/13 1:39 AM Final PDF to printer 62 Chapter 2 Basic Cost Management Concepts salesperson recently tried to sell the manager a new computer-integrated checkout system for the store. The new system would save the store a substantial amount of money each year. The recently purchased scanners could be sold in the secondhand market for $19,000. The store manager refused to listen to the salesperson, saying, “I just bought those scanners. I can’t get rid of them until I get my money’s worth out of them.” What type of cost is the cost of purchasing the old bar code scanners? What common behavioral tendency is the manager exhibiting? 2–23. Indicate whether each of the following costs is a direct cost or an indirect cost of the restaurant in a hotel. a. Cost of food served. b. Chef’s salary and fringe benefits. c. Part of the cost of maintaining the grounds around the hotel, which is allocated to the restaurant. d. Part of the cost of advertising the hotel, which is allocated to the restaurant. Consider the following costs that were incurred during the current year: 1. Advertising costs of Nike. 2. Straight-line depreciation on factory machinery of Airbus Industrie. 3. Wages of assembly-line personnel of Amana. 4. Delivery costs on customer shipments of Ben & Jerry’s ice cream. 5. Newsprint consumed in printing the Philadelphia Inquirer. 6. Plant insurance costs of Levi Strauss. 7. Glass costs incurred in light-bulb manufacturing of General Electric. 8. Tire costs incurred by Subaru. 9. Sales commissions paid to the sales force of Apple . 10. Wood glue consumed in the manufacture of Thomasville furniture. 11. Hourly wages of refinery security guards employed by Exxon Corporation. 12. The salary of a financial vice president of Microsoft. Required: Evaluate each of the preceding and determine whether the cost is ( a ) a product cost or a period cost, ( b ) variable or fixed in terms of behavior, and ( c ) for the product costs only, whether the cost is properly classified as direct material, direct labor, or manufacturing overhead. Item 8 is done as an example: Tire costs: Product cost, variable, direct material For each case below, find the missing amount. Case I Case II Case III Beginning inventory of finished goods ............................ ? $ 18,000 $ 3,500 Cost of goods manufactured during period ...................... $104,750 142,500 ? Ending inventory of finished goods ................................ 24,500 12,000 10,500 Cost of goods sold .................................................... 101,250 ? 152,000 An employee of Olentangy Foundry, Inc. worked a normal 40-hour shift, but four hours were idle due to a small fire in the plant. The employee earns $16 per hour. Required: 1. Calculate the employee’s total compensation for the week. 2. How much of this compensation is a direct-labor cost? How much is overhead? A loom operator in a Carolina Textiles factory earns $17 per hour. The employee earns $22 for overtime hours. The operator worked 43 hours during the first week of May, instead of the usual 40 hours. ■ Exercise 2–24 Cost Terminology (LO 2-2, 2-5, 2-8) ■ Exercise 2–25 Cost of Goods Manufactured and Sold; Missing Data (LO 2-1, 2-3, 2-6) ■ Exercise 2–26 Idle Time (LO 2-5) ■ Exercise 2–27 Overtime Cost (LO 2-5) Exercises All applicable Exercises are available with McGraw-Hill’s Connect Accounting ®. hiL25664_ch02_034-077.indd 62hiL25664_ch02_034-077.indd 62 6/27/13 1:39 AM6/27/13 1:39 AM Final PDF to printer Chapter 2 Basic Cost Management Concepts 63 Required: 1. Compute the loom operator’s compensation for the week. 2. Calculate the employee’s total overtime premium for the week. 3. How much of the employee’s total compensation for the week is direct-labor cost? How much is overhead? Alhambra Aluminum Company, a manufacturer of recyclable soda cans, had the following inventory balances at the beginning and end of 20x1. Inventory Classification January 1, 20x1 December 31, 20x1 Raw material . . . . . . . . . . . . . . . . . . . . . $ 55,000 . . . . . . . . . . . . $ 75,000 Work in process . . . . . . . . . . . . . . . . . . . 110,000 . . . . . . . . . . . . 125,000 Finished goods . . . . . . . . . . . . . . . . . . . . 160,000 . . . . . . . . . . . . 155,000 During 20x1, the company purchased $240,000 of raw material and spent $420,000 for direct labor. Manufacturing overhead costs were as follows: Indirect material . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 12,000 Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,000 Depreciation on plant and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110,000 Utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,000 Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,000 Sales revenue was $1,210,000 for the year. Selling and administrative expenses for the year amounted to $105,000. The firm’s tax rate is 35 percent. Required: 1. Prepare a schedule of cost of goods manufactured. 2. Prepare a schedule of cost of goods sold. 3. Prepare an income statement. 4. Build a spreadsheet: Construct an Excel spreadsheet to solve all of the preceding requirements. Show how both cost schedules and the income statement will change if the following data change: direct labor is $410,000 and utilities cost $24,000. Find The Boeing Company ’s website on the Internet, www.boeing.com . Required: Read on the company’s website about how Boeing operates and serves its customers. Then briefly explain what type of manufacturing process would be best for Boeing. Mighty Muffler, Inc. operates an automobile service facility that specializes in replacing mufflers on com- pact cars. The following table shows the costs incurred during a month when 700 mufflers were replaced. Muffler Replacements 600 700 800 Total costs: Fixed costs ..................................................................................................... a $56,000 b Variable costs .................................................................................................. c 28,000 d Total costs .................................................................................................. e $84,000 f Cost per muffler replacement: Fixed cost ....................................................................................................... g h i Variable cost ................................................................................................... j k l Total cost per muffler replacement ............................................................... m n o Required: Fill in the missing amounts, labeled ( a ) through ( o ), in the table. ■ Exercise 2–28 Schedules of Cost of Goods Manufactured and Sold; Income Statement (LO 2-1, 2-3, 2-6) ■ Exercise 2–29 Alternative Production Processes; Use of Internet (LO 2-4) ■ Exercise 2–30 Fixed and Variable Costs; Automobile Service; Missing Data (LO 2-1, 2-8) hiL25664_ch02_034-077.indd 63hiL25664_ch02_034-077.indd 63 6/27/13 1:39 AM6/27/13 1:39 AM Final PDF to printer 64 Chapter 2 Basic Cost Management Concepts Thomas Cleverly purchased a vacant lot outside of London for £17,200, because he heard that a shop- ping mall was going to be built on the other side of the road. He figured that he could make a bundle by putting in a fast-food outlet on the site. As it turned out, the rumor was false. A sanitary landfill was located on the other side of the road, and the land was worthless. (£ denotes the British monetary unit, pounds sterling. Although the Euro generally is used in European markets, day-to-day business in the United Kingdom is still conducted in pounds sterling.) Required: What type of cost is the £17,200 that Thomas paid for the vacant lot? A hotel pays the phone company $200 per month plus $.15 for each call made. During January 7,000 calls were made. In February 8,000 calls were made. Required: 1. Calculate the hotel’s phone bills for January and February. 2. Calculate the cost per phone call in January and in February. 3. Separate the January phone bill into its fixed and variable components. 4. What is the marginal cost of one additional phone call in January? 5. What was the average cost of a phone call in January? The state Department of Education owns a computer system, which its employees use for word process- ing and keeping track of education statistics. The governor’s office recently began using this computer also. As a result of the increased usage, the demands on the computer soon exceeded its capacity. The director of the Department of Education was soon forced to lease several personal computers to meet the computing needs of her employees. The annual cost of leasing the equipment is $12,500. Required: 1. What type of cost is this $12,500? 2. Should this cost be associated with the governor’s office or the Department of Education? Why? Suppose you paid $75 for a ticket to see your university’s football team compete in a bowl game. Some- one offered to buy your ticket for $100, but you decided to go to the game. Required: 1. What did it really cost you to see the game? 2. What type of cost is this? Global Communications, Inc. manufactures communications satellites used in TV signal transmission. The firm currently purchases one component for its satellites from a European firm. A Global Commu- nications engineering team has found a way to use the company’s own component, part number A200, instead of the European component. However, the Global Communications component must be modi- fied at a cost of $650 per part. The European component costs $9,100 per part. Global Communications’ part number A200 costs $4,900 before it is modified. Global Communications currently uses 15 of the European components per year. Required: Calculate the annual differential cost between Global Communications’ two production alternatives. List the costs that would likely be included in each of the following marginal-cost calculations. 1. The marginal cost of adding a flight from Syracuse to Miami. 2. The marginal cost of keeping a travel agency open one additional hour on Saturdays. 3. The marginal cost of manufacturing one additional pair of water skis. 4. The marginal cost of one additional passenger on a jet flight. 5. The marginal cost of serving one additional customer in a restaurant. ■ Exercise 2–31 Economic Characteristics of Costs (LO 2-1, 2-10) ■ Exercise 2–32 Fixed, Variable, Marginal, and Average Costs; Hotel (LO 2-1, 2-8, 2-10) ■ Exercise 2–33 Computing Costs; Government Agency (LO 2-1, 2-9, 2-10) ■ Exercise 2–34 Economic Characteristics of Costs (LO 2-1, 2-10) ■ Exercise 2–35 Differential Cost (LO 2-1, 2-10) ■ Exercise 2–36 Marginal Costs (LO 2-1, 2-10) This icon indicates international setting. hiL25664_ch02_034-077.indd 64hiL25664_ch02_034-077.indd 64 6/27/13 1:39 AM6/27/13 1:39 AM Final PDF to printer Chapter 2 Basic Cost Management Concepts 65 All applicable Problems are available with McGraw-Hill’s Connect Accounting ®. Problems The following cost data for the year just ended pertain to Heartstrings, Inc., a greeting card manufacturer: Service department costs * . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 50,000 Direct labor: wages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242,500 Direct labor: fringe benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47,500 Indirect labor: fringe benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000 Fringe benefits for production supervisor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,500 Total overtime premiums paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27,500 Cost of idle time: production employees § . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 Administrative costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75,000 Rental of office space for sales personnel † . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,500 Sales commissions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500 Product promotion costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 Direct material used . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,050,000 Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49,500 Depreciation on factory building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57,500 Cost of finished-goods inventory at year-end . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57,500 Indirect labor: wages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,000 Production supervisor’s salary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,500 *All services are provided to manufacturing departments. § Cost of idle item is an overhead item; it is not included in direct-labor wages given above. † The rental of sales space was made necessary when the sales offices were converted to storage space for raw material. Required: 1. Compute each of the following costs for the year just ended: ( a ) total prime costs, ( b ) total manu- facturing overhead costs, ( c ) total conversion costs, ( d ) total product costs, and ( e ) total period costs. 2. One of the costs listed above is an opportunity cost. Identify this cost, and explain why it is an opportunity cost. Kaleidoscope Cutlery manufactures kitchen knives. One of the employees, whose job is to cut out wooden knife handles, worked 49 hours during a week in January. The employee earns $14 per hour for a 40-hour week. For additional hours the employee is paid an overtime rate of $19 per hour. The employee’s time was spent as follows: Regular duties involving cutting out knife handles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 hours General shop cleanup duties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 hours Idle time due to power outage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 hour s Required: 1. Calculate the total cost of the employee’s wages during the week described above. 2. Determine the portion of this cost to be classified in each of the following categories: a. Direct labor b. Manufacturing overhead (idle time) c. Manufacturing overhead (overtime premium) d. Manufacturing overhead (indirect labor) Consider the following cost items: 1. Current year’s depreciation on a ship owned by a cruise line. 2. The cost of chemicals and paper used during the period by a producer of film products. 3. Assembly-line wage cost incurred by a bicycle manufacturer. ■ Problem 2–37 Cost Terminology (LO 2-2, 2-5, 2-10) 1(b) Total manufacturing overhead: $267,000 ■ Problem 2–38 Direct and Indirect Labor (LO 2-1, 2-3, 2-5, 2-9) 2. Direct labor: $574 ■ Problem 2–39 Content of Financial State- ments and Reports; Mass Customization (LO 2-3, 2-4) hiL25664_ch02_034-077.indd 65hiL25664_ch02_034-077.indd 65 8/8/13 5:41 PM8/8/13 5:41 PM Final PDF to printer 66 Chapter 2 Basic Cost Management Concepts 4. Year-end production in process of a computer manufacturer. 5. The cost of products sold to customers of a department store. 6. The cost of products sold to distributors of a carpet manufacturer. 7. Salaries of players on a professional baseball club. 8. Year-end completed goods of a clothing manufacturer. 9. Executive compensation costs of a mass-market retailer. 10. Advertising costs of an electronics manufacturer. 11. Costs incurred during the period to insure a manufacturing plant against fire and flood losses. Required: 1. Evaluate the costs just cited, and determine whether the associated dollar amounts would be found on the firm’s balance sheet, income statement, or schedule of cost of goods manufactured. ( Note: In some cases, more than one answer will apply.) 2. What major asset will normally be insignificant for service enterprises and relatively substantial for retailers, wholesalers, and manufacturers? Briefly discuss. 3. Briefly explain the major differences between income statements of service enterprises versus those of retailers, wholesalers, and manufacturers. 4. Picture the operations of a firm such as Comet Computer, one that is involved in direct sales and mass customization of products. What would be the major difference in the balance sheet of this type of organization versus the balance sheet of a company that engages in more traditional manu- facturing activities, that is, producing goods and waiting for customer orders to arrive? Indicate for each of the following costs whether it is a product cost or a period cost. 1. Cost of grapes purchased by a winery. 2. Depreciation on pizza ovens in a pizza restaurant. 3. Cost of plant manager’s salary in a computer production facility. 4. Wages of security personnel in a department store. 5. Cost of utilities in a manufacturing facility. 6. Wages of aircraft mechanics employed by an airline. 7. Wages of drill-press operators in a manufacturing plant. 8. Cost of food in a microwavable dinner. 9. Cost incurred by a department store chain to transport merchandise to its stores. For each of the following costs, indicate whether the amount is a direct or indirect cost of the equipment maintenance department. Also indicate whether each cost is at least partially controllable by the depart- ment supervisor. 1. Cost of electricity used in the maintenance department. 2. Depreciation on the building space occupied by the maintenance department. 3. Idle time of maintenance department employees. 4. Cost of plant manager’s salary, which is allocated to the maintenance department. 5. Cost of property taxes allocated to the maintenance department. LaJolla Airways operates commuter flights in California. Due to a political convention held in San Diego, the airline added several extra flights during a two-week period. Additional cabin crews were hired on a temporary basis. However, rather than hiring additional flight attendants, the airline used its current attendants on overtime. Monica Gaines worked the following schedule on August 10. All of Gaines’s flights on that day were extra flights that the airline would not normally fly. Regular time: 2 round-trip flights between San Diego and Fresno (8 hours) Overtime: 1 one-way flight from San Diego to Sacramento (3 hours) ■ Problem 2–40 Product Costs and Period Costs (LO 2-1, 2-2, 2-3) ■ Problem 2–41 Direct, Indirect, Controllable, and Uncontrollable Costs (LO 2-1, 2-9) ■ Problem 2–42 Overtime Premiums and Fringe Benefit Costs; Airline (LO 2-1, 2-5, 2-9, 2-10) hiL25664_ch02_034-077.indd 66hiL25664_ch02_034-077.indd 66 6/27/13 1:39 AM6/27/13 1:39 AM Final PDF to printer Chapter 2 Basic Cost Management Concepts 67 Gaines earns $14 per hour plus time and a half for overtime. Fringe benefits cost the airline $4 per hour for any hour worked, regardless of whether it is a regular or overtime hour. Required: 1. Compute the direct cost of compensating Gaines for her services on the flight from San Diego to Sacramento. 2. Compute the cost of Gaines’s services that is an indirect cost. 3. How should the cost computed in requirement (2) be treated for cost accounting purposes? 4. Gaines ended her workday on August 10 in Sacramento. However, her next scheduled flight departed San Diego at 11:00 a.m. on August 11. This required Gaines to “dead-head” back to San Diego on an early-morning flight. This means she traveled from Sacramento to San Diego as a passenger, rather than as a working flight attendant. Since the morning flight from Sacramento to San Diego was full, Gaines displaced a paying customer. The revenue lost by the airline was $87. What type of cost is the $87? To what flight, if any, is it chargeable? Why? The following data refer to Laredo Luggage Company for the year 20x2: Sales revenue .................................................................................................................................. $475,000 Work-in-process inventory, December 31 .......................................................................................... 15,000 Work-in-process inventory, January 1 ............................................................................................... 20,000 Selling and administrative expenses .................................................................................................. 75,000 Income tax expense ......................................................................................................................... 45,000 Purchases of raw material ................................................................................................................ 90,000 Raw-material inventory, December 31 ............................................................................................... 12,500 Raw-material inventory, January 1 .................................................................................................... 20,000 Direct labor ..................................................................................................................................... 100,000 Utilities: plant ................................................................................................................................... 20,000 Depreciation: plant and equipment .................................................................................................... 30,000 Finished-goods inventory, December 31 ............................................................................................ 25,000 Finished-goods inventory, January 1 ................................................................................................. 10,000 Indirect material used ....................................................................................................................... 5,000 Indirect labor ................................................................................................................................... 7,500 Other manufacturing overhead .......................................................................................................... 40,000 Required: 1. Prepare Laredo Luggage’s schedule of cost of goods manufactured for the year. 2. Prepare Laredo Luggage’s schedule of cost of goods sold for the year. 3. Prepare Laredo Luggage’s income statement for the year. 4. Build a spreadsheet: Construct an Excel spreadsheet to solve all of the preceding requirements. Show how both cost schedules and the income statement will change if raw-material purchases amounted to $92,000 and indirect labor was $9,000. The following selected information was extracted from the 20x1 accounting records of Surgical Products, Inc.: Raw-material-purchases ...................................................................................................................... $350,000 Direct labor ......................................................................................................................................... 508,000 Indirect labor ....................................................................................................................................... 218,000 Selling and administrative salaries ........................................................................................................ 266,000 Building depreciation * .......................................................................................................................... 160,000 Other selling and administrative expenses ............................................................................................. 380,000 Other factory costs ............................................................................................................................... 688,000 Sales revenue ($260 per unit) .............................................................................................................. 2,990,000 * Seventy-five percent of the company’s building was devoted to production activities; the remaining 25 percent was used for selling and administrative functions. ■ Problem 2–43 Schedules of Cost of Goods Manufactured and Sold; Income Statement (LO 2-1, 2-3, 2-5, 2-6) 1. Total manufacturing costs: $300,000 Ex ■ Problem 2–44 Financial-Statement Elements: Manufacturer (LO 2-5, 2-6) 4. Gross margin: $1,137,200 This icon indicates that an Excel spreadsheet template is provided on the text’s website. hiL25664_ch02_034-077.indd 67hiL25664_ch02_034-077.indd 67 6/27/13 1:39 AM6/27/13 1:39 AM Final PDF to printer 68 Chapter 2 Basic Cost Management Concepts Inventory data: January 1 December 31 Raw material ....................................................................................................... $ 31,600 $ 36,400 Work in process ................................................................................................... 71,400 124,200 Finished goods * ................................................................................................... 222,200 195,800 *The January 1 and December 31 finished-goods inventory consisted of 1,350 units and 1,190 units, respectively. Required: 1. Calculate Surgical Products’ manufacturing overhead for the year. 2. Calculate Surgical Products’ cost of goods manufactured. 3. Compute the company’s cost of goods sold. 4. Determine net income for 20x1, assuming a 40% income tax rate. 5. Determine the number of completed units manufactured during the year. 6. Build a spreadsheet: Construct an Excel spreadsheet to solve all of the preceding requirements. Show how the solution will change if the following data change; indirect labor is $221,000 and other factory costs amount to $679,000. Determine the missing amounts in each of the following independent cases. Case A Case B Case C Sales ? ? $240,000 Beginning inventory, raw material ........................................................... ? $ 60,000 7,500 Ending inventory, raw material ............................................................... $ 180,000 ? 15,000 Purchases of raw material ..................................................................... 200,000 255,000 ? Direct material used .............................................................................. 140,000 285,000 ? Direct labor .......................................................................................... ? 300,000 62,500 Manufacturing overhead ........................................................................ 500,000 ? 80,000 Total manufacturing costs ...................................................................... 1,040,000 1,035,000 170,000 Beginning inventory, work in process ...................................................... 70,000 60,000 ? Ending inventory, work in process .......................................................... ? 105,000 2,500 Cost of goods manufactured .................................................................. 1,050,000 ? 175,000 Beginning inventory, finished goods ....................................................... 100,000 120,000 ? Cost of goods available for sale .............................................................. ? ? 185,000 Ending inventory, finished goods ............................................................ ? ? 12,500 Cost of goods sold ................................................................................ 1,090,000 990,000 ? Gross margin ........................................................................................ 510,000 510,000 ? Selling and administrative expenses ....................................................... ? 225,000 ? Income before taxes .............................................................................. 300,000 ? 45,000 Income tax expense .............................................................................. 80,000 135,000 ? Net income ........................................................................................... ? ? 27,500 Scranton Refrigeration Corporation began operations at the beginning of the current year. One of the company’s products, a compressor, sells for $370 per unit. Information related to the current year’s activities follows. Variable costs per unit: Direct material ................................................................................................................................ $ 40 Direct labor .................................................................................................................................... 74 Manufacturing overhead ................................................................................................................. 96 Annual fixed costs: Manufacturing overhead ................................................................................................................. $1,200,000 Selling and administrative ............................................................................................................... 1,720,000 Sales and production activity: Sales (units) ................................................................................................................................... 20,000 Production (units) ............................................................................................................................ 24,000 Scranton Refrigeration carries its finished-goods inventory at the average unit cost of production and is subject to a 40% income tax rate. There was no work in process at year-end. ■ Problem 2–46 Financial Statement Elements; Cost Behavior (LO 2-5, 2-6, 2-8) 2. Gross margin: $2,200,000 ■ Problem 2–45 Incomplete Data; Manufacturing Costs (LO 2-2, 2-5) Case A: Cost of goods available for sale: $1,150,000 Ex hiL25664_ch02_034-077.indd 68hiL25664_ch02_034-077.indd 68 6/27/13 1:39 AM6/27/13 1:39 AM Final PDF to printer Chapter 2 Basic Cost Management Concepts 69 Required: 1. Determine the cost of the December 31 finished-goods inventory. 2. Compute Scranton Refrigeration’s net income for the current year ended December 31. 3. If next year’s production decreases to 22,500 units and general cost behavior patterns do not change, what is the likely effect on: a. The direct-labor cost of $74 per unit? Why? b. The fixed manufacturing overhead cost of $1,200,000? Why? c. The fixed selling and administrative cost of $1,720,000? Why? d. The average unit cost of production? Why? On May 10, after the close of business, Fresno Furniture Company had a devastating fire that destroyed the company’s work-in-process and finished-goods inventories. Fortunately, all raw materials escaped damage because materials owned by the firm were stored in another warehouse. The following informa- tion is available: Sales revenue through May 10 ................................................................................................................... $495,000 Income before taxes through May 10 .......................................................................................................... 102,000 Direct labor through May 10 ....................................................................................................................... 180,000 Cost of goods available for sale, May 10 ...................................................................................................... 412,500 Work-in-process inventory, January 1 ......................................................................................................... 31,500 Finished-goods inventory, January 1 ........................................................................................................... 55,500 Fresno Furniture Company’s accountants determined that the cost of direct materials used normally averages 25 percent of prime costs (i.e., direct material + direct labor). In addition, manufacturing overhead is 50 percent of the firm’s total production costs. The gross margin is 30 percent of sales. Required: The company is in the process of negotiating a settlement with its insurance company. Prepare an estimate of the cost of work-in-process and finished-goods inventories that were destroyed by the fire. Thermal Technology, Inc. manufactures a special chemical used to coat certain electrical components that will be exposed to high heat in various applications. The company’s annual fixed production cost is $500,000. Required: 1. Draw a graph of the company’s fixed production cost showing the total cost at the following pro- duction levels of the chemical: 50,000 liters, 100,000 liters, 150,000 liters, and 200,000 liters. 2. Prepare a table that shows the unit cost and the total cost for the firm’s fixed production costs at the following production levels: 1 liter, 50 liters, 50,000 liters, and 200,000 liters. 3. Prepare a graph that shows the unit cost for the company’s fixed production cost at the following production levels: 50,000 liters, 100,000 liters, 150,000 liters, and 200,000 liters. Air Frame Technology, Inc. incurs a variable cost of $16 per kilogram for raw material to produce a special alloy used in manufacturing aircraft. Required: 1. Draw a graph of the firm’s raw material cost, showing the total cost at the following production levels: 50,000 kilograms, 100,000 kilograms, and 150,000 kilograms. 2. Prepare a table that shows the unit cost and total cost of raw material at the following production levels: 1 kilogram, 50 kilograms, and 5,000 kilograms. Nantucket Tee manufactures T-shirts and decorates them with custom designs for retail sale on the premises. Several costs incurred by the company are listed below. For each cost, indicate which of the following classifications best describe the cost. More than one classification may apply to the same cost item. ■ Problem 2–47 Inventory Estimates; Partial Data (LO 2-5, 2-6) Cost of goods-manufactured: $357,000 ■ Problem 2–48 Fixed Costs; Graphical and Tabular Analyses (LO 2-7, 2-8) 2. 50,000 liters, unit fixed cost: $10 per liter ■ Problem 2–49 Variable Costs; Graphical and Tabular Analyses (LO 2-7, 2-8) 2. 50 kilograms, total cost: $800 ■ Problem 2–50 Cost Classifications; Manufacturer (LO 2-5, 2-8, 2-9) hiL25664_ch02_034-077.indd 69hiL25664_ch02_034-077.indd 69 6/27/13 1:39 AM6/27/13 1:39 AM Final PDF to printer 70 Chapter 2 Basic Cost Management Concepts Cost Classifications a. Variable b. Fixed c. Period d. Product e. Administrative f. Selling g. Manufacturing h. Research and development i. Direct material j. Direct labor k. Manufacturing overhead Cost Items 1. Wages of T-shirt designers and painters. 2. Salaries of sales personnel. 3. Depreciation on sewing machines. 4. Rent on the building. Part of the building’s first floor is used to make and paint T-shirts. Part of it is used for the retail sales shop. The second floor is used for administrative offices and storage of raw material and finished goods. 5. Cost of daily advertisements in local media. 6. Salaries of designers who experiment with new fabrics, paints, and T-shirt designs. 7. Cost of hiring a pilot to fly along the beach pulling a banner advertising the shop. 8. Salary of the owner’s secretary. 9. Cost of repairing the gas furnace. 10. Cost of health insurance for the production employees. 11. Cost of fabric used in T-shirts. 12. Wages of shirtmakers. 13. Cost of new sign in front of retail T-shirt shop. 14. Wages of the employee who repairs the firm’s sewing machines. 15. Cost of electricity used in the sewing department. Refer to Exhibit 2–3 , and answer the following questions. Required: 1. List the major differences between the income statements shown for Caterpillar, Walmart, and Southwest Airlines . 2. Explain how cost-accounting data were used to prepare these income statements. 3. On the income statement for Southwest Airlines , where would the airline’s ticket agents’ salaries be shown? Where would the costs of the computer equipment used to keep track of reservations be included on the statement? 4. On the income statement for Walmart , where would the cost of newspaper advertising be shown? How about the cost of merchandise? 5. Refer to the income statement for Caterpillar . Where would the salary of the brand manager who plans advertising for Caterpillar equipment be shown? How about the salary of a production employee? Where would the cost of the raw materials used in the company’s products be included on the statement? ■ Problem 2–51 Interpretation of Accounting Reports (LO 2-1, 2-3) hiL25664_ch02_034-077.indd 70hiL25664_ch02_034-077.indd 70 6/27/13 1:39 AM6/27/13 1:39 AM Final PDF to printer Chapter 2 Basic Cost Management Concepts 71 The Department of Natural Resources is responsible for maintaining the state’s parks and forest lands, stocking the lakes and rivers with fish, and generally overseeing the protection of the environment. Several costs incurred by the agency are listed below. For each cost, indicate which of the following classifications best describe the cost. More than one classification may apply to the same cost item. Cost Classifications a. Variable b. Fixed c. Controllable by the department director d. Uncontrollable by the department director e. Differential cost f. Marginal cost g. Opportunity cost h. Sunk cost i. Out-of-pocket cost j. Direct cost of the agency k. Indirect cost of the agency l. Direct cost of providing a particular service m. Indirect cost of providing a particular service Cost Items 1. Cost of the fish purchased from private hatcheries, which are used to stock the state’s public waters. 2. The difference between ( a ) the cost of purchasing fish from private hatcheries and ( b ) the cost of running a state hatchery. 3. Cost of producing literature that describes the department’s role in environmental protection. This literature is mailed free, upon request, to schools, county governments, libraries, and private citizens. 4. Cost of sending the department’s hydroengineers to inspect one additional dam for stability and safety. 5. Cost of operating the state’s computer services department, a portion of which is allocated to the Department of Natural Resources. 6. Cost of administrative supplies used in the agency’s head office. 7. Cost of providing an 800 number for the state’s residents to report environmental problems. 8. The cost of replacing batteries in sophisticated monitoring equipment used to evaluate the effects of acid rain on the state’s lakes. 9. Cost of a ranger’s salary, when the ranger is giving a talk about environmental protection to ele- mentary school children. 10. Cost of direct-mailing to 1 million state residents a brochure explaining the benefits of voluntarily recycling cans and bottles. 11. The cost of producing a TV show to be aired on public television. The purpose of the show is to educate people on how to spot and properly dispose of hazardous waste. 12. Cost of the automobiles used by the department’s rangers. These cars were purchased by the state, and they would otherwise have been used by the state police. 13. Cost of live-trapping and moving beaver that were creating a nuisance in recreational lakes. 14. The department director’s salary. 15. Cost of containing naturally caused forest fires, which are threatening private property. ■ Problem 2–52 Cost Classifications; Government Agency (LO 2-8, 2-9, 2-10) hiL25664_ch02_034-077.indd 71hiL25664_ch02_034-077.indd 71 6/27/13 1:39 AM6/27/13 1:39 AM Final PDF to printer 72 Chapter 2 Basic Cost Management Concepts Toledo Toy Company incurred the following costs during 20x4. The company sold all of its products manufactured during the year. Direct material .................................................................................................................................... $4,500,000 Direct labor ........................................................................................................................................ 3,300,000 Manufacturing overhead: Utilities (primarily electricity) ............................................................................................................ 210,000 Depreciation on plant and equipment ............................................................................................... 345,000 Insurance ....................................................................................................................................... 240,000 Supervisory salaries ........................................................................................................................ 450,000 Property taxes ................................................................................................................................ 315,000 Selling costs: Advertising ..................................................................................................................................... 292,500 Sales commissions ......................................................................................................................... 135,000 Administrative costs: Salaries of top management and staff .............................................................................................. 558,000 Office supplies ................................................................................................................................ 60,000 Depreciation on building and equipment ........................................................................................... 120,000 During 20x4, the company operated at about half of its capacity, due to a slowdown in the econ- omy. Prospects for 20x5 are slightly better. Jared Lowes, the marketing manager, forecasts a 30 percent growth in sales over the 20x4 level. Required: Categorize each of the costs listed above as to whether it is most likely variable or fixed. Forecast the 20x5 cost amount for each of the cost items listed above. Several costs incurred by Cape Cod Hotel and Restaurant are given in the following list. For each cost, indicate which of the following classifications best describe the cost. More than one classification may apply to the same cost item. Cost Classifications a. Direct cost of the food and beverage department b. Indirect cost of the food and beverage department c. Controllable by the kitchen manager d. Uncontrollable by the kitchen manager e. Controllable by the hotel general manager f. Uncontrollable by the hotel general manager g. Differential cost h. Marginal cost i. Opportunity cost j. Sunk cost k. Out-of-pocket cost Cost Items 1. The wages earned by table-service personnel. 2. The salary of the kitchen manager. 3. The cost of the refrigerator purchased 14 months ago. The unit was covered by a warranty for 12 months, during which time it worked perfectly. It conked out after 14 months, despite an origi- nal estimate that it would last five years. 4. The hotel has two options for obtaining fresh pies, cakes, and pastries. The goodies can be pur- chased from a local bakery for approximately $1,550 per month, or they can be made in the hotel’s kitchen. To make the pastries on the premises, the hotel will have to hire a part-time pastry chef. This will cost $500 per month. The cost of ingredients will amount to roughly $850 per month. Thus, the savings from making the goods in the hotel’s kitchen amount to $200 per month. 5. The cost of dishes broken by kitchen employees. ■ Problem 2–53 Fixed and Variable Costs; Forecasting (LO 2-7, 2-8) 20x5 Direct labor forecast: $4,290,000 ■ Problem 2–54 Cost Classifications; Hotel (LO 2-1, 2-3, 2-9, 2-10) hiL25664_ch02_034-077.indd 72hiL25664_ch02_034-077.indd 72 6/27/13 1:39 AM6/27/13 1:39 AM Final PDF to printer Chapter 2 Basic Cost Management Concepts 73 6. The cost of leasing a computer used for reservations, payroll, and general hotel accounting. 7. The cost of a pool service that cleans and maintains the hotel’s swimming pool. 8. The wages of the hotel’s maintenance employees, who spent nine hours (at $13.50 per hour) repairing the dishwasher in the kitchen. 9. The cost of general advertising by the hotel, which is allocated to the food and beverage department. 10. The cost of food used in the kitchen. 11. The difference in the total cost incurred by the hotel when one additional guest is registered. 12. The cost of space (depreciation) occupied by the kitchen. 13. The cost of space (depreciation) occupied by a sauna next to the pool. The space could otherwise have been used for a magazine and book store. 14. The profit that would have been earned in a magazine and book store, if the hotel had one. 15. The discount on room rates given as a special offer for a “Labor Day Getaway Special.” Maria Chavez makes custom mooring covers for boats in Tumpa, Florida. Each mooring cover is hand sewn to fit a particular boat. If covers are made for two or more identical boats, each successive cover generally requires less time to make. Chavez has been approached by a local boat dealer to make moor- ing covers for all of the boats sold by the dealer. Chavez has developed the following cost schedule for mooring covers made to fit 17-foot outboard power boats. Mooring Covers Made Total Cost of Covers 1 .................................................................... $ 675 2 .................................................................... 1,275 3 .................................................................... 1,815 4 .................................................................... 2,310 5 .................................................................... 2,775 Required: Compute the following: 1. Marginal cost of second mooring cover. 2. Marginal cost of fourth mooring cover. 3. Marginal cost of fifth mooring cover. 4. Average cost if two mooring covers are made. 5. Average cost if four mooring covers are made. 6. Average cost if five mooring covers are made. The following terms are used to describe various economic characteristics of costs. a. Opportunity cost b. Out-of-pocket cost c. Sunk cost d. Differential cost e. Marginal cost f. Average cost Required: Choose one of the terms listed above to characterize each of the amounts described below. 1. The management of a high-rise office building uses 3,100 square feet of space in the building for its own management functions. This space could be rented for $335,000. What economic term describes this $335,000 in lost rental revenue? 2. The cost of building an automated assembly line in a factory is $700,000. The cost of building a manually operated assembly line is $475,000. What economic term is used to describe the differ- ence between these two amounts? ■ Problem 2–55 Marginal Costs and Average Costs (LO 2-7, 2-10) 4. Average cost: $637.50 ■ Problem 2–56 Economic Characteristics of Costs (LO 2-4, 2-10) hiL25664_ch02_034-077.indd 73hiL25664_ch02_034-077.indd 73 6/27/13 1:39 AM6/27/13 1:39 AM Final PDF to printer 74 Chapter 2 Basic Cost Management Concepts 3. Referring to the preceding question, what economic term is used to describe the $700,000 cost of building the automated assembly line? 4. The cost incurred by Apple Computer to produce one more unit in its most popular line of laptop computers. 5. The cost of feeding 400 children in a public school cafeteria is $740 per day, or $1.85 per child per day. What economic term describes this $1.85 cost? 6. The cost of including one extra child in a day-care center. 7. The cost of merchandise inventory purchased two years ago, which is now obsolete. Piedmont Industries currently manufactures 40,000 units of part JR63 each month for use in produc- tion of several of its products. The facilities now used to produce part JR63 have a fixed monthly cost of $165,000 and a capacity to produce 74,000 units per month. If the company were to buy part JR63 from an outside supplier, the facilities would be idle, but its fixed costs would continue at $45,000. The variable production costs of part JR63 are $12 per unit. Required: 1. If Piedmont Industries continues to use 40,000 units of part JR63 each month, it would realize a net benefit by purchasing part JR63 from an outside supplier only if the supplier’s unit price is less than what amount? 2. If Piedmont Industries is able to obtain part JR63 from an outside supplier at a unit purchase price of $14, what is the monthly usage at which it will be indifferent between purchasing and making part JR63? (CMA, adapted) The controller for Oneida Vineyards, Inc. has predicted the following costs at various levels of wine output. Wine Output (.75 Liter Bottles) 10,000 Bottles 15,000 Bottles 20,000 Bottles Variable production costs ................................................... $ 44,400 $ 66,600 $ 88,800 Fixed production costs ....................................................... 120,000 120,000 120,000 Fixed selling and administrative costs .................................. 48,000 48,000 48,000 Total .................................................................................. $212,400 $234,600 $256,800 The company’s marketing manager has predicted the following prices for the firm’s fine wines at various levels of sales. Wine Sales 10,000 Bottles 15,000 Bottles 20,000 Bottles Sales price per .75 liter bottle ........................................... $21.60 $18.00 $14.40 Required: 1. Calculate the unit cost of wine production at each level of output. At what level of output is the unit cost minimized? 2. Calculate the company’s profit at each level of production. Assume that the company will sell all of its output. At what production level is profit maximized? 3. Which of the three output levels is best for the company? 4. Why does the unit cost of wine decrease as the output level increases? Why might the sales price per bottle decline as sales volume increases? ■ Problem 2–57 Variable and Fixed Costs; Make or Buy a Component (LO 2-8, 2-10) ■ Problem 2–58 Unit Costs; Profit-Maximizing Output (LO 2-7, 2-8) 1. 20,000 output bottles, unit cost: $12.84 hiL25664_ch02_034-077.indd 74hiL25664_ch02_034-077.indd 74 6/27/13 1:39 AM6/27/13 1:39 AM Final PDF to printer Chapter 2 Basic Cost Management Concepts 75 Cases You just started a summer internship with the successful management consulting firm of Kirk, Spock, and McCoy. Your first day on the job was a busy one, as the following problems were presented to you. Required: Supply the requested comments in each of the following independent situations. 1. Alderon Enterprises is evaluating a special order it has received for a ceramic fixture to be used in aircraft engines. Alderon has recently been operating at less than full capacity, so the firm’s management will accept the order if the price offered exceeds the costs that will be incurred in producing it. You have been asked for advice on how to determine the cost of two raw materials that would be required to produce the order. a. The special order will require 900 gallons of endor, a highly perishable material that is pur- chased as needed. Alderon currently has 1,300 gallons of endor on hand, since the material is used in virtually all of the company’s products. The last time endor was purchased, Alderon paid $10.00 per gallon. However, the average price paid for the endor in stock was only $9.50. The market price for endor is quite volatile, with the current price at $11.00. If the special order is accepted, Alderon will have to place a new order next week to replace the 900 gallons of endor used. By then the price is expected to reach $11.50 per gallon. Using the cost terminology introduced in Chapter 2, comment on each of the cost figures mentioned in the preceding discussion. What is the real cost of endor if the special order is produced? b. The special order would also require 1,400 kilograms of tatooine, a material not normally required in any of Alderon’s regular products. The company does happen to have 1,900 kilo- grams of tatooine on hand, since it formerly manufactured a ceramic product that used the material. Alderon recently received an offer of $28,000 from Solo Industries for its entire supply of tatooine. However, Solo Industries is not interested in buying any quantity less than Alderon’s entire 1,900-kilogram stock. Alderon’s management is unenthusiastic about Solo’s offer, since Alderon paid $40,000 for the tatooine. Moreover, if the tatooine were purchased at today’s market price, it would cost $22.00 per kilogram. Due to the volatility of the tatooine, Alderon will need to get rid of its entire supply one way or another. If the material is not used in production or sold, Alderon will have to pay $2,000 for each 500 kilograms that is trans- ported away and disposed of in a hazardous waste disposal site. Using the cost terminology introduced in Chapter 2, comment on each of the cost figures men- tioned in the preceding discussion. What is the real cost of tatooine to be used in the special order? 2. CopyFast Company, a specialist in printing, has established 500 convenience photo copying cen- ters throughout the country. In order to upgrade its services, the company is considering three new models of laser copying machines for use in producing high-quality copies. These high-quality copies would be added to the growing list of products offered in the CopyFast shops. The selling price to the customer for each laser copy would be the same, no matter which machine is installed in the shop. The three models of laser copying machines under consideration are: 1500S, a small- volume model; 1500M, a medium-volume model; and 1500L, a large-volume model. The annual rental costs and the operating costs vary with the size of each machine. The machine capacities and costs are as follows: Photocopier Model 1500S 1500M 1500L Annual capacity (copies) ........................................................................... 80,000 300,000 600,000 Costs: Annual machine rental ......................................................................... $ 4,000 $ 5,500 $ 10,000 Direct material and direct labor cost per copy ........................................ .010 .010 .010 Variable overhead costs per copy .......................................................... .060 .035 .015 a. Calculate the volume level in copies where CopyFast Company would be indifferent to acquir- ing either the small-volume model laser copier, 1500S, or the medium-volume model laser copier, 1500M. ■ Case 2–59 Understanding Cost Concepts (LO 2-7, 2-8, 2-10) hiL25664_ch02_034-077.indd 75hiL25664_ch02_034-077.indd 75 6/27/13 1:39 AM6/27/13 1:39 AM Final PDF to printer 76 Chapter 2 Basic Cost Management Concepts b. The management of CopyFast Company is able to estimate the number of copies to be sold at each establishment. Present a decision rule that would enable management to select the most profitable machine without having to make a separate cost calculation for each establishment. (Hint: To specify a decision rule, determine the volume at which CopyFast Company would be indifferent between the small and medium copiers. Then determine the volume at which the company would be indifferent between the medium and large copiers.) 3. A local PBS station has decided to produce a TV series on state-of-the-art manufacturing. The director of the TV series, Justin Tyme, is currently attempting to analyze some of the projected costs for the series. Tyme intends to take a TV production crew on location to shoot various high-tech manufacturing scenes as they occur. If the four-week series is shown in the 8:00–9:00 p.m. prime-time slot, the station will have to cancel a wildlife show that is currently scheduled. Manage- ment projects a 10 percent viewing audience for the wildlife show, and each 1 percent is expected to bring in donations of $20,000. In contrast, the manufacturing show is expected to be watched by 15 percent of the viewing audience. However, each 1 percent of the viewership will likely generate only $10,000 in donations. If the wildlife show is canceled, it can be sold to network television for $50,000. Using the cost terminology introduced in Chapter 2, comment on each of the financial amounts mentioned in the preceding discussion. What are the relative merits of the two shows regarding the projected revenue to the station? (CMA, adapted) Pinellas Printer Company manufactures printers for use with home computing systems. The firm cur- rently manufactures both the electronic components for its printers and the plastic cases in which the devices are enclosed. Jim Cassanitti, the production manager, recently received a proposal from Universal Plastics Corporation to manufacture the cases for the printers. If the cases are purchased out- side, Pinellas Printer Company will be able to close down its Printer Case Department. To help decide whether to accept the bid from Universal Plastics Corporation, Cassanitti asked Pinellas’ controller to prepare an analysis of the costs that would be saved if the Printer Case Department were closed. Included in the controller’s list of annual cost savings were the following items: Building rental (The Printer Case Department occupies one-sixth of the factory building, which Pinellas rents for $180,600 per year.) .......................................................... $30,100 Salary of the Printer Case Department supervisor ................................................................................. $48,000 In a lunchtime conversation with the controller, Cassanitti learned that Pinellas Printer Company was currently renting space in a warehouse for $41,000. The space is used to store completed printers. If the Printer Case Department were discontinued, the entire storage operation could be moved into the factory building and occupy the space vacated by the closed department. Cassanitti also learned that the supervisor of the Printer Case Department would be retained by Pinellas even if the department were closed. The supervisor would be assigned the job of managing the assembly department, whose super- visor recently gave notice of his retirement. All of Pinellas Printer Company’s department supervisors earn the same salary. Required: 1. You have been hired as a consultant by Cassanitti to advise him in his decision. Write a memo to Cassanitti commenting on the costs of space and supervisory salaries included in the controller’s cost analysis. Explain in your memo about the “real” costs of the space occupied by the Printer Case Department and the supervisor’s salary. What types of costs are these? 2. Independent of your response to requirement (1), suppose that Pinellas Printer Company’s control- ler had been approached by his friend Jack Westford, the assistant supervisor of the Printer Case Department. Westford is worried that he will be laid off if the Printer Case Department is closed down. Westford has asked his friend to understate the cost savings from closing the department, in order to slant the production manager’s decision toward keeping the department in operation. Comment on the controller’s ethical responsibilities. ■ Case 2–60 Economic Characteristics of Costs; Closing a Department; Ethics (LO 2-10) hiL25664_ch02_034-077.indd 76hiL25664_ch02_034-077.indd 76 6/27/13 1:39 AM6/27/13 1:39 AM Final PDF to printer This page intentionally left blank 3 THIS CHAPTER’S FOCUS COMPANY is Adirondack Outfitters, a small manufacturer of canoes and small boats near Lake Placid, New York. Adirondack Outfitters uses job-order costing to accumulate the costs of each of its products. Job-order costing is well suited to compa- nies like Adirondack Outfitters that manufacture relatively small numbers of distinct products. In a job-order costing system, direct material, direct labor, and manufacturing overhead are first assigned to each production job, such as a set number of canoes of a particular type. Then the cost of the production job is averaged across the number of units in the job. FOCUS COMPANY >>>
ADIRONDACK
OUTFITTERS
Product Costing and Cost
Accumulation in a Batch
Production Environment
hiL25664_ch03_078-131.indd 78hiL25664_ch03_078-131.indd 78 6/22/13 8:06 PM6/22/13 8:06 PM
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In contrast to the manufacturing setting of Adirondack Outfitters, we explore
job-order costing in a service industry environment. Midtown Advertising
Agency is a small firm in Cincinnati, Ohio. The ad agency has two manag-
ing partners, six artistic staff personnel, and an office support staff. Midtown Advertising
Agency calculates predetermined overhead rates based on two cost drivers: partner direct
professional labor and artistic staff direct professional labor. The ad agency’s cost of com-
pleting the work for an advertising contract with Super Scoop Ice Cream Company includes
direct material, direct professional labor for both partner and artistic staff time, and applied
overhead.
<<< IN CONTRAST hiL25664_ch03_078-131.indd 79hiL25664_ch03_078-131.indd 79 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer 80 Product and Service Costing A product-costing system accumulates the costs incurred in a production process and assigns those costs to the organization’s final products. Product costs are needed for a variety of purposes in financial accounting, managerial accounting, and cost management. Use in Financial Accounting In financial accounting, product costs are needed to value inventory on the balance sheet and to compute cost-of-goods-sold expense on the income statement. Under generally accepted accounting principles, inventory is valued at its cost until it is sold. Then the cost of the inventory becomes an expense of the period in which it is sold. Use in Managerial Accounting In managerial accounting, product costs are needed to help managers with planning and to provide them with data for decision making. Deci- sions about product prices, the mix of products to be produced, and the quantity of output to be manufactured are among those for which product cost information is needed. Use in Cost Management It is hard to imagine how management can control or reduce production costs if management does not have a clear idea of how much it costs to make its product. Thus, product costs provide crucial data for a variety of cost manage- ment purposes. Many of the cost management uses of product-costing information will be covered throughout this book. Product and Service Costing Learning Objective 3-1 Discuss the role of product and service costing in manufacturing and nonmanufacturing firms. 3-1 Discuss the role of product and service costing in manufacturing and non- manufacturing firms. 3-2 Diagram and explain the flow of costs through the manufacturing accounts used in product costing. 3-3 Distinguish between job-order costing and process costing. 3-4 Compute a predetermined overhead rate and explain its use in job-order costing for job-shop and batch-production environments. 3-5 Prepare journal entries to record the costs of direct material, direct labor, and manufacturing overhead in a job-order costing system. 3-6 Prepare a schedule of cost of goods manufactured, a schedule of cost of goods sold, and an income statement for a manufacturer. 3-7 Describe the two-stage allocation process used to assign manufacturing overhead costs to production jobs. 3-8 Describe the process of project costing used in service industry firms and non- profit organizations. After completing this chapter, you should be able to: hiL25664_ch03_078-131.indd 80hiL25664_ch03_078-131.indd 80 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment 81 Use in Reporting to Interested Organizations In addition to financial statement preparation and internal decision making, there is an ever-growing need for product cost information in relationships between firms and various outside organizations. Public utilities, such as electric and gas companies, record product costs to justify rate increases that must be approved by state regulatory agencies. Hospitals keep track of the costs of medical procedures that are reimbursed by insurance companies or by the federal govern- ment under the Medicare program. Manufacturing firms often sign cost-plus contracts with the government, where the contract price depends on the cost of manufacturing the product. Product Costing in Nonmanufacturing Firms The need for product costs is not limited to manufacturing firms. Merchandising com- panies include the costs of buying and transporting merchandise in their product costs. Producers of inventoriable goods, such as mining products, petroleum, and agricultural products, also record the costs of producing their goods. The role of product costs in these companies is identical to that in manufacturing firms. For example, the pineapples grown and sold by Dole are inventoried at their product cost until they are sold. Then the product cost becomes cost-of-goods-sold expense. Service Firms and Nonprofit Organizations The production output of service firms and nonprofit organizations consists of services that are consumed as they are pro- duced. Since services cannot be stored and sold later like manufactured goods, there are no inventoriable costs in service industry firms and nonprofit organizations. How- ever, such organizations need information about the costs of producing services. Banks, insurance companies, restaurants, airlines, law firms, hospitals, and city governments all record the costs of producing various services for the purposes of planning, cost con- trol, and decision making. For example, in making a decision about adding a flight from Chicago to Houston, United Airlines ’ management needs to know the cost of flying the proposed route. Before building a new branch bank, Wells Fargo ’s management would want to know the cost of maintaining the branch, as well as the additional revenue to be generated. A Los Angeles city manager can make a better decision as to whether the city government should begin a drug counseling program if the cost of providing similar, existing services is known. Flow of Costs in Manufacturing Firms Manufacturing costs consist of direct material, direct labor, and manufacturing over- head. The product-costing systems used by manufacturing firms employ several man- ufacturing accounts. As production takes place, all manufacturing costs are added to the Work-in-Process Inventory account. Work in process is partially completed inven- tory. A debit to the account increases the cost-based valuation of the asset represented by the unfinished products. As soon as products are completed, their product costs are transferred from Work-in-Process Inventory to Finished-Goods Inventory. This is accomplished with a credit to Work in Process and a debit to Finished Goods. Dur- ing the time period when products are sold, the product cost of the inventory sold is removed from Finished Goods and added to Cost of Goods Sold, which is an expense of the period in which the sale occurred. A credit to Finished Goods and a debit to Cost of Goods Sold completes this step. Cost of Goods Sold is closed into the Income Summary account at the end of the accounting period, along with all other expenses and revenues of the period. Exhibit 3–1 depicts the flow of costs through the manufac- turing accounts. Flow of Costs in Manufacturing Firms Learning Objective 3-2 Diagram and explain the flow of costs through the manufactur- ing accounts used in product costing. “We recognized that our key competitors were overseas. We realized that in order to compete, we had to be extremely cost conscious.” (3a) Micrus (joint venture of IBM and Cirrus Logic, now part of NXP Semiconductor) “The closer we get to the client physically, the more likely it is that we’re going to have an opportunity to par- ticipate in what’s going on in the business. The more remote you are from where the business decision mak- ers are, the less likely they are to think about you.” (3b) Qwest (now CenturyLink) hiL25664_ch03_078-131.indd 81hiL25664_ch03_078-131.indd 81 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer 82 Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment Exhibit 3–1 Flow of Costs through Manufacturing Accounts Work-in-Process Inventor y Finished-Goods Inventory Direct-material cost Product cost transferred Direct-labor cost Manufacturing overhead when product is finished Product cost transferred when product is sold Cost of Goods Sold* Income Summary Expense closed into Income Summary at end of accounting period *Cost of Goods Sold is an expense. Although it is more descriptive, the term “cost-of-goods-sold expense” is not used as much in practice as the simpler term “cost of goods sold.” Example of Manufacturing Cost Flows Suppose that the Bradley Paper Company incurred the following manufacturing costs during 20x1. Direct material ...................................................................................................... $30,000 Direct labor .......................................................................................................... 20,000 Manufacturing overhead ............................................................................................ 40,000 During 20x1, products costing $60,000 were finished and products costing $25,000 were sold for $32,000. Exhibit 3–2 shows the flow of costs through the Bradley Paper Work-in-Process Inventor y Direct-material cost 30,000 Direct-labor cost 20,000 60,000 Manufacturing overhead 40,000 Balance 30,000 Finished-Goods Inventory 60,000 25,000 Balance 35,000 Cost of Goods Sold Sales Revenue 32,000 Bradley Paper Company Partial Balance Sheet As of December 31, 20x1 Current assets: Cash . . . . . . . . . . . . . . . xxx Accounts receivable . . . . xxx Inventory: Raw material . . . . . . . xxx Work in process. . . . . Finished goods . . . . . Bradley Paper Company Partial Income Statement For the Year 20x1 Sales revenue . . . . . . . . . . $32,000 Less: Cost of goods sold. . . 25,000 Gross margin . . . . . . . . . . . $ 7,000 25,000 $30,000 35,000 Exhibit 3–2 Example of Manufacturing Cost Flows for Bradley Paper Company hiL25664_ch03_078-131.indd 82hiL25664_ch03_078-131.indd 82 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment 83 Company’s manufacturing accounts and the effect of the firm’s product costs on its bal- ance sheet and income statement. Types of Product-Costing Systems The detailed accounting procedures used in product-costing systems depend on the type of industry involved. Two basic sets of procedures are used: job-order costing and pro- cess costing. Job-Order Costing Systems Job-order costing is used by companies with job-shop operations or batch-production operations. In a job-shop environment, products are manufactured in very low volumes or one at a time. Examples of a job-shop environment include feature film production, custom house building, ship building, aircraft manufacture, and custom machining opera- tions. In a batch-production environment, multiple products are produced in batches of relatively small quantity. Examples include furniture manufacture, printing, agricultural equipment, and pleasure boat production. In job-order costing, each distinct batch of production is called a job or job order. The cost-accounting procedures are designed to assign costs to each job. Then the costs assigned to each job are averaged over the units of production in the job to obtain an average cost per unit. For example, suppose that AccuPrint worked on two printing jobs during October, and the following costs were incurred. Job A27 (1,000 campaign posters) Job B39 (100 wedding invitations) Direct material................................. $100 $ 36 Direct labor .................................... 250 40 Manufacturing overhead ...................... 150 24 Total manufacturing cost ...................... $500 $100 The cost per campaign poster is $.50 per poster ($500 divided by 1,000 posters), and the cost per wedding invitation is $1.00 ($100 divided by 100 invitations). Procedures similar to those used in job-order costing also are used in many service industry firms, although these firms have no work-in-process or finished-goods invento- ries. In a public accounting firm, for example, costs are assigned to audit engagements in much the same way they are assigned to a batch of products by a furniture manufacturer. Similar procedures are used to assign costs to “cases” in health care facilities, to “pro- grams” in government agencies, to research “projects” in universities, and to “contracts” in consulting and architectural firms. Types of Product-Costing Systems Learning Objective 3-3 Distinguish between job-order costing and process costing. The cost-accounting system keeps track of production costs as they flow from raw material, through work in process and finished goods, and into cost of goods sold. “We have to be the best in cost throughout the world.” (3c) Micrus (now part of NXP Semiconductor) hiL25664_ch03_078-131.indd 83hiL25664_ch03_078-131.indd 83 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer 84 Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment Process-Costing Systems Process costing is used by companies that produce large numbers of identical units. Firms that produce chemicals, microchips, gasoline, beer, fertilizer, textiles, processed food, and electricity are among those using process costing. In these kinds of firms, there is no need to trace costs to specific batches of production, because the products in the different batches are identical. A process-costing system accumulates all the production costs for a large number of units of output, and then these costs are averaged over all of the units. For example, suppose the Silicon Valley Company produced 40,000 microchips during November. The following manufacturing costs were incurred in November. Direct material ................................................................................................................................................. $1,000 Direct labor ...................................................................................................................................................... 2,000 Manufacturing overhead ................................................................................................................................... 3,000 Total manufacturing cost .................................................................................................................................. $6,000 The cost per microchip is $.15 (total manufacturing cost of $6,000 4 40,000 units produced). Summary of Alternative Product-Costing Systems The distinction between job-order and process costing hinges on the type of production process involved. Job-order costing systems assign costs to distinct production jobs that are significantly different. Then an average cost is computed for each unit of product in each job. Process-costing systems average costs over a large number of identical (or very similar) units of product. The remainder of this chapter examines the details of job-order costing. The next chapter covers process costing. Accumulating Costs in a Job-Order Costing System To illustrate job-order costing, we will focus on Adirondack Outfitters, Inc. This small company, nestled in the hills outside Lake Placid, New York, manufactures canoes and small boats. In a job-order costing system, costs of direct material, direct labor, and manufactur- ing overhead are assigned to each production job. These costs comprise the inputs of the product-costing system. As costs are incurred, they are added to the Work-in-Process Inventory account in the ledger. To keep track of the manufacturing costs assigned to each job, a subsidiary ledger is maintained. The subsidiary ledger account assigned to each job is a document called a job-cost record. Job-Cost Record An example of a job-cost record is displayed in Exhibit 3–3 . At this juncture, just focus on the major sections and headings, which are printed in blue. (For now just ignore the detailed entries, printed in black, which will be explained in due course.) This job-cost record is for job F16 consisting of 80 deluxe aluminum fishing boats, which was produced during November 20x1. Three major sections on the job-cost record are used to accumulate the costs of direct material, direct labor, and manufacturing over- head assigned to the job. The other two sections are used to record the total cost and average unit cost for the job, and to keep track of units shipped to customers. A job-cost record may be a paper document upon which the entries for direct material, direct labor, and manufacturing overhead are written. Increasingly, it is a computer file where entries are made using a computer. Accumulating Costs in a Job-Order Costing System ADIRONDACK OUTFITTERS hiL25664_ch03_078-131.indd 84hiL25664_ch03_078-131.indd 84 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment 85 JOB-COST RECORD Job Number Date Started Description Date Completed Number of Units Completed Direct Material QuantityDate Requisition Number Unit Price Cost Direct Labor HoursDate Time Card Number Rate Cost Manufacturing Overhead QuantityDate Cost Driver (Activity Base) Application Rate Cost Cost Summary AmountCost Item Total direct material Total direct labor Total manufacturing overhead F16 Nov. 1, 20x1 11/1 803 7,200 sq ft $2.50 $18,000 11/30 60 20 $12,000 11/30 Machine hours 2,000 $9.00 $18,000 Various dates Various time cards 600 $20 $12,000 80 deluxe aluminum fishing boats Nov. 22, 20x1 80 Total cost Unit cost $18,000 12,000 18,000 $48,000 $600 Shipping Summary Date Units Shipped Cost Balance Units Remaining in Inventory Exhibit 3–3 Job-Cost Record: Adirondack Outfitters, Inc. ADIRONDACK OUTFITTERS The procedures used to accumulate the costs of direct material, direct labor, and manufacturing overhead for a job constitute the set of activities performed by the job- order costing system. These procedures are discussed next. Direct-Material Costs As raw materials are needed for the production process, they are transferred from the warehouse to the production department. To authorize the release of materials, the pro- duction department supervisor completes a material requisition form and presents it to the warehouse supervisor. A copy of the material requisition form goes to the cost accounting department. There it is used as the basis for transferring the cost of the req- uisitioned material from the Raw-Material Inventory account to the Work-in-Process hiL25664_ch03_078-131.indd 85hiL25664_ch03_078-131.indd 85 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer 86 Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment Inventory account, and for entering the direct-material cost on the job-cost record for the production job in process. A document such as the material requisition form, which is used as the basis for an accounting entry, is called a source document. Exhibit 3–4 shows an example of a material requisition form. In many production facilities, material requisitions are entered directly into a com- puter by the production department supervisor. The requisition is automatically trans- mitted to computers in the warehouse and in the cost accounting department. Such automation reduces the flow of paperwork, minimizes clerical errors, and speeds up the product-costing process. Supply Chain Management An organization’s supply chain refers to the flow of all goods, services, and information into and out of the organization. Thus, Adirondack Out- fitters’ supply chain looks like this: A supply chain often includes many companies and other organizations. Supply chain management means proactively working with some or all of the organizations in a com- pany’s supply chain to improve service and to manage or reduce costs. For example, Adirondack Outfitters’ managers might work with the vendor supplying aluminum sheet metal to improve delivery schedules or reduce material costs. Adirondack Outfitters’ managers also might consult with retailers about more effective displays for the com- pany’s products or more timely information about the retailers’ restocking needs. Material-Requirements Planning For products and product components that are produced routinely, the required materials are known in advance. For these products and components, material requisitions are based on a bill of materials that lists all of the materials needed. In complex manufacturing operations, in which production takes place in several stages, material-requirements planning (or MRP ) may be used. MRP is an operations- management tool that assists managers in scheduling production in each stage of the manufacturing process. Such careful planning ensures that, at each stage in the produc- tion process, the required subassemblies, components, or partially processed materials will be ready for the next stage. MRP systems, which are generally computerized, include files that list all of the component parts and materials in inventory and all of the parts and materials needed in each stage of the production process. Adirondack Outfitters’ operations are too limited to need an MRP system. Companies supplying goods, services, and information to Adirondack Outfitters Adirondack Outfitters Adirondack Outfitters’ customers (i.e., retailers that sell the company’s canoes and boats) Material-Requisition Number Job Number to Be Charged Department Supervisor Date Department QuantityItem Unit Cost Amount 352 J621 Timothy Williams 1/28/x1 Painting White enamel paint Clear lacquer 8 gallons 2 gallons $14.00 11.00 $112 22 Exhibit 3–4 Material Requisition Form ADIRONDACK OUTFITTERS hiL25664_ch03_078-131.indd 86hiL25664_ch03_078-131.indd 86 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment 87 Direct-Labor Costs The assignment of direct-labor costs to jobs is based on time records filled out by employ- ees. A time record is a form that records the amount of time an employee spends on each production job. The time record is the source document used in the cost-accounting department as the basis for adding direct-labor costs to Work-in-Process Inventory and to the job-cost records for the various jobs in process. In some factories, a computerized time-clock system may be used. Employees enter the time they begin and stop work on each job into the time clock. The time clock is connected to a computer, which records the time spent on various jobs and transmits the information to the accounting department. Exhibit 3–5 displays an example of a time record. As the example shows, most of the employee’s time was spent working on two different production jobs. In the account- ing department, the time spent on each job will be multiplied by the employee’s wage rate, and the cost will be recorded in Work-in-Process Inventory and on the appropriate job-cost records. The employee also spent one-half hour on shop cleanup duties. This time will be classified by the accounting department as indirect labor, and its cost will be included in manufacturing overhead. Manufacturing-Overhead Costs It is relatively simple to trace direct-material and direct-labor costs to production jobs, but manufacturing overhead is not easily traced to jobs. By definition, manufacturing overhead is a heterogeneous pool of indirect production costs, such as indirect material, indirect labor, utility costs, and depreciation. These costs often bear no obvious relation- ship to individual jobs or units of product, but they must be incurred for production to take place. Therefore, it is necessary to assign manufacturing-overhead costs to jobs in order to have a complete picture of product costs. This process of assigning manufac- turing-overhead costs to production jobs is called overhead application (or sometimes overhead absorption ). Overhead Application For product-costing information to be useful, it must be pro- vided to managers on a timely basis. Suppose the cost-accounting department waited until the end of an accounting period so that the actual costs of manufacturing overhead could be determined before applying overhead costs to the firm’s products. The result would be very accurate overhead application. However, the information might be useless because it was not available to managers for planning, control, and decision making dur- ing the period. Predetermined Overhead Rate The solution to this problem is to apply overhead to products on the basis of estimates made at the beginning of the accounting period. The accounting department chooses some measure of productive activity to use as the basis for overhead application. In traditional product-costing systems, this measure is usually Employee Name Employee Number Date Department Time Started Time Stopped Job Number Ron Bradley 12 12/19/x1 Painting A267 Shop cleanup J122 8:00 11:30 1:00 11:30 12:00 5:00 Exhibit 3–5 Time Record ADIRONDACK OUTFITTERS Learning Objective 3-4 Compute a predetermined overhead rate and explain its use in job-order costing for job-shop and batch-production environments. hiL25664_ch03_078-131.indd 87hiL25664_ch03_078-131.indd 87 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer 88 Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment 1Timothy Aeppel, The Wall Street Journal, January 27, 2010, p. A1. For more on Caterpillar, see D. DeFreitas, J. Gillette, R. Fink, and W. Cox, “Getting Lean and Mean at Caterpillar,” Strategic Finance, January, 2013, pp. 24–33. 2For up-to-date information on the Marine Corps logistic Command’s supply chain management mission, see www.logcom.usmc.mil. The information above is based on Faith Keenan, “The Marines Learn New Tactics—From Walmart,” BusinessWeek, December 24, 2001, p. 74. SUPPLY CHAIN MANAGEMENT Supply chain management has become a critically important issue in many companies and other organizations. Here are several examples of how organizations are managing their supply chains to get or provide better service at lower costs. Caterpillar, Inc.—The Inventory “Bullwhip Effect” Managing the supply chain is particularly critical for management during an economic slump and as the economy starts to emerge from a downturn. “Caterpillar, Inc., recently told its steel suppliers that it will more than double its purchases of the metal” within a year, even if there is no increase in sales of Caterpillar’s own products. “In fact, the heavy equipment manufacturer has been boosting orders to suppliers for everything from big tires and hydraulic tubes to shatterproof glass.” Why would Caterpillar be making such a large inventory resupply effort even in the face of nearly flat sales? “Chalk it up to the ‘bullwhip effect,’ which is reverberating” throughout the global economy. “This phenomenon occurs when companies significantly cut or add inventories. Economists call it a bullwhip because even small increases in demand can cause a big snap in the need for parts and materials further down the supply chain. The bullwhip has broad implications” for the economy as “companies rush to fill orders while also restock- ing warehouse shelves. It touches everyone from retailers to the industrial companies that supply” the many resources needed to manufacture more products. “The manner in which companies, large and small, respond to market shifts determines which ones emerge first” from an economic downturn and start to grow again.1 U.S. Marine Corps The U.S. Marine Corps “knew they had problems. When a soldier at Camp Pendleton would put in an order for a spare part, it took him a week to get it—from the other side of the base. Private companies, meanwhile, were greasing their supply chains to provide just-in-time delivery, and the Marines knew they could do better. So the Corps sketched a 10-year tech strategy in logistics, to ensure that 173,000 Marines have what they need when they need it. To execute, the Corps hired consultants and studied companies like Walmart and United Parcel Service.” The Corps “aims to reduce inventory by half, saving up to $200 million. Taking a page from Unilever and Swissair, the Corps is developing better relations with suppliers to make sure they have access to hard-to-get items like tank parts. And with advice from Caterpillar, the Marines have been upgrading warehouses, adding gadgets like hand-held wireless scanners for real-time inventory placement and tracking.”2 Caterpillar, Inc. and the U.S. Marine Corps M A P anagement ccounting ractice some volume-based cost driver (or activity base ), such as direct-labor hours, direct- labor cost, or machine hours. An estimate is made of (1) the amount of manufacturing overhead that will be incurred during a specified period of time and (2) the amount of the cost driver (or activity base) that will be used or incurred during the same time period. Then a predetermined overhead rate is computed as follows: Predetermined overhead rate 5 Budgeted manufacturing-overhead cost ________________________________________ Budgeted amount of cost driver (or activity base) For example, Adirondack Outfitters has chosen machine hours as its cost driver (or activ- ity base). For the year 20x1, the firm estimates that overhead cost will amount to $360,000 hiL25664_ch03_078-131.indd 88hiL25664_ch03_078-131.indd 88 7/11/13 10:24 PM7/11/13 10:24 PM Final PDF to printer Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment 89 and that total machine hours used will be 40,000 hours. The 40,000 budgeted machine hours represent the company’s practical capacity for production. This means that 40,000 machine hours are expected to be available for production under normal operating condi- tions. Recall from the discussion in Chapter 1 (p. 20) that normal operating conditions allow for such issues as routine machine maintenance, employee fatigue, and so forth. Adirondack Outfitters’ predetermined overhead rate is computed as follows: Predetermined overhead rate 5 $360,000 ___________ 40,000 hours 5 $9.00 per machine hour In our discussion of the predetermined overhead rate, we have emphasized the term cost driver, because increasingly this term is replacing the more traditional term activity base. Furthermore, we have emphasized that traditional product-costing systems tend to rely on a single, volume-based cost driver. We will discuss more elaborate product- costing systems based on multiple cost drivers later in this chapter. This topic is exam- ined in even greater detail in Chapter 5. Applying Overhead Costs The predetermined overhead rate is used to apply manu- facturing overhead costs to production jobs. The quantity of the cost driver (or activity base) required by a particular job is multiplied by the predetermined overhead rate to determine the amount of overhead cost applied to the job. For example, suppose Adiron- dack Outfitters’ job number D22 requires 30 machine hours. The overhead applied to the job is computed as follows: Predetermined overhead rate .......................................................................................................................... $ 9 Machine hours required by job D22 ................................................................................................................. 3 30 Overhead applied to job D22 ........................................................................................................................... $270 The $270 of applied overhead will be added to Work-in-Process Inventory and recorded on the job-cost record for job D22. The accounting entries made to add manu- facturing overhead to Work-in-Process Inventory may be made daily, weekly, or monthly, depending on the time required to process production jobs. Before the end of an account- ing period, entries should be made to record all manufacturing costs incurred to date in Work-in-Process Inventory. This is necessary to properly value Work-in-Process Inven- tory on the balance sheet. Summary of Event Sequence in Job-Order Costing The flowchart in Exhibit 3–6 summarizes the sequence of activities performed by the job- order costing system. The role of the various documents used in job-order costing also is emphasized in the flowchart. Illustration of Job-Order Costing Now let’s examine the accounting entries made by Adirondack Outfitters, Inc. during November of 20x1. The company worked on two production jobs: Job number C12, 80 deluxe wooden canoes Job number F16, 80 deluxe aluminum fishing boats The job numbers designate these as the 12th canoe production job and the 16th fish- ing boat production job undertaken during the year. The events of November are described below along with the associated accounting entries. Illustration of Job-Order Costing Learning Objective 3-5 Prepare journal entries to record the costs of direct material, direct labor, and manufacturing overhead in a job-order costing system. ADIRONDACK OUTFITTERS hiL25664_ch03_078-131.indd 89hiL25664_ch03_078-131.indd 89 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer Transfers costs from Finished-Goods Inventory to Cost of Goods Sold Ledger Cost of Goods Sold Sale of goods Transfers job costs from Work-in-Process Inventory to Finished-Goods Inventory Ledger Finished-Goods Inventory Production of job is finished Accumulates cost for job Ledger Work-in-Process Inventory Direct material Direct labor Manufacturing overhead Subsidiary LedgerSubsidiary Ledger Job-Cost Record Predetermined Overhead Rate Cost Driver (or Activity Base) Direct-Labor Time Records X Material Requisition Production takes place Provide basis for assigning costs to jobs Authorizes release of material to production Production Order for Job Authorizes production Production Process Documents Cost Accounting Activities Exhibit 3–6 Summary of Event Sequence in a Job-Order Costing System hiL25664_ch03_078-131.indd 90 hiL25664_ch03_078-131.indd 90 6/22/13 8:06 P M 6/22/13 8:06 P M Final PD F to printer Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment 91 Purchase of Material Four thousand square feet of rolled aluminum sheet metal were purchased on account for $10,000. The purchase is recorded with the following journal entry. (1) Raw-Material Inventory ..................................................................................... 10,000 Accounts Payable ......................................................................................... 10,000 The postings of this and all subsequent journal entries to the ledger are shown in Exhibit 3–11 , which appears on page 100. Use of Direct Material On November 1, the following material requisitions were submitted. Requisition number 802: (for job number C12) 8,000 board feet of lumber, at $2 per board foot, for a total of $16,000 Requisition number 803: (for job number F16) 7,200 square feet of aluminum sheet metal, at $2.50 per square foot, for a total of $18,000 The following journal entry records the release of these raw materials to production. (2) Work-in-Process Inventory ................................................................................. 34,000 Raw-Material Inventory ................................................................................. 34,000 The associated ledger posting is shown in Exhibit 3–11 . These direct-material costs are also recorded on the job-cost record for each job. The job-cost record for job number F16 is displayed in Exhibit 3–3 on page 85. Since the job-cost record for job number C12 is similar, it is not shown. Use of Indirect Material On November 15, the following material requisition was submitted. Requisition number 804: 5 gallons of bonding glue, at $10 per gallon, for a total cost of $50 Small amounts of bonding glue are used in the production of all classes of boats manufactured by Adirondack Outfitters. Since the cost incurred is small, no attempt is made to trace the cost of glue to specific jobs. Instead, glue is considered an indirect material, and its cost is included in manufacturing overhead. The company accumulates all manufacturing-overhead costs in the Manufacturing Overhead account. All actual overhead costs are recorded by debiting this account. The account is debited when indi- rect materials are requisitioned, when indirect-labor costs are incurred, when utility bills are paid, when depreciation is recorded on manufacturing equipment, and so forth. The journal entry made to record the usage of glue is as follows: (3) Manufacturing Overhead ................................................................................... 50 Manufacturing Supplies Inventory .................................................................. 50 The posting of this journal entry to the ledger is shown in Exhibit 3–11 . No entry is made on any job-cost record for the usage of glue, since its cost is not traced to individual production jobs. hiL25664_ch03_078-131.indd 91hiL25664_ch03_078-131.indd 91 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer 92 Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment Use of Direct Labor At the end of November, the cost accounting department uses the labor time records filed during the month to determine the following direct-labor costs of each job. Direct labor: job number C12 .................................................................................... $ 9,000 Direct labor: job number F16 .................................................................................... 12,000 Total direct labor ...................................................................................................... $21,000 The journal entry made to record these costs is as follows: (4) Work-in-Process Inventory ................................................. 21,000 Wages Payable ............................................................. 21,000 The associated ledger posting is shown in Exhibit 3–11 . These direct-labor costs also are recorded on the job-cost record for each job. The job-cost record for job number F16 is displayed in Exhibit 3–3 on page 85. Only one direct-labor entry is shown on the job-cost record. In practice, there would be numerous entries made on different dates at a variety of wage rates for different employees. Use of Indirect Labor The analysis of labor time records undertaken on November 30 also revealed the following use of indirect labor: Indirect labor: not charged to any particular job, $14,000 This cost comprises the production supervisor’s salary and the wages of various employees who spent some of their time on maintenance and general cleanup duties during November. The following journal entry is made to add indirect-labor costs to manufacturing overhead: (5) Manufacturing Overhead .................................................................................... 14,000 Wages Payable .............................................................................................. 14,000 No entry is made on any job-cost record, since indirect-labor costs are not traceable to any particular job. In practice, journal entries (4) and (5) are usually combined into one compound entry as follows: Work-in-Process Inventory ......................................................................................... 21,000 Manufacturing Overhead ............................................................................................ 14,000 Wages Payable .................................................................................................. 35,000 Incurrence of Manufacturing-Overhead Costs The following manufacturing-overhead costs were incurred during November: Manufacturing overhead: Rent on factory building ...................................................................................................................... $ 3,000 Depreciation on equipment .................................................................................................................. 5,000 Utilities (electricity and natural gas) ...................................................................................................... 4,000 Property taxes .................................................................................................................................... 2,000 Insurance ........................................................................................................................................... 1,000 Total ...................................................................................................................................................... $15,000 This small production facility records the cost of manufacturing small boats and canoes, which are manufactured in small batches. Direct material, direct labor, and manufacturing- overhead costs are tracked. hiL25664_ch03_078-131.indd 92hiL25664_ch03_078-131.indd 92 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment 93 The following compound journal entry is made on November 30 to record these costs: (6) Manufacturing Overhead ................................................................................... 15,000 Prepaid Rent ................................................................................................ 3,000 Accumulated Depreciation—Equipment ......................................................... 5,000 Accounts Payable (utilities and property taxes) ................................................ 6,000 Prepaid Insurance ........................................................................................ 1,000 The entry is posted in Exhibit 3–11 . No entry is made on any job-cost record, because manufacturing-overhead costs are not traceable to any particular job. Application of Manufacturing Overhead Various manufacturing-overhead costs were incurred during November, and these costs were accumulated by debiting the Manufacturing Overhead account. However, no manu- facturing-overhead costs have yet been added to Work-in-Process Inventory or recorded on the job-cost records. The application of overhead to the firm’s products is based on a predetermined overhead rate. This rate was computed by the accounting department at the beginning of 20x1 as follows: Predetermined overhead rate 5 Budgeted total manufacturing overhead for 20x1 ________________________________________ Budgeted total machine hours for 20x1 5 $360,000 ________ 40,000 5 $9.00 per machine hour As explained previously, the 40,000 budgeted machine hours represent the company’s annual practical capacity for production. Factory machine-usage records indicate the following actual usage of machine hours during November: Machine hours used: job number C12 ................................................................................................ 1,200 hours Machine hours used: job number F16 ................................................................................................ 2,000 hours Total machine hours .......................................................................................................................... 3,200 hours The total manufacturing overhead applied to Work-in-Process Inventory during November is calculated as follows: Machine Hours Predetermined Overhead Rate Manufacturing Overhead Applied Job number C12 ...................................... 1,200 3 $9.00 5 $10,800 Job number F16 ...................................... 2,000 3 $9.00 5 18,000 Total manufacturing overhead applied ............................................................................................ $28,800 The following journal entry is made to add applied manufacturing overhead to Work-in-Process Inventory. (7) Work-in-Process Inventory .................................................................................... 28,800 Manufacturing Overhead .................................................................................. 28,800 The entry is posted in Exhibit 3–11 , and the manufacturing overhead applied to job number F16 is entered on the job-cost record in Exhibit 3–3 on page 85. hiL25664_ch03_078-131.indd 93hiL25664_ch03_078-131.indd 93 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer 94 Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment Summary of Overhead Accounting As the following time line shows, three concepts are used in accounting for overhead. Overhead is budgeted at the beginning of the accounting period, it is applied during the period, and actual overhead is measured at the end of the period. Beginning of accounting period End of accounting period Applied overhead Actual overhead Budgeted overhead (and calculation of predetermined overhead rate) Time Exhibit 3–7 summarizes the accounting procedures used for manufacturing over- head. The left side of the Manufacturing Overhead account is used to accumulate actual manufacturing-overhead costs as they are incurred throughout the accounting period. The actual costs incurred for indirect material, indirect labor, factory rental, equipment depreciation, utilities, property taxes, and insurance are recorded as debits to the account. The right side of the Manufacturing Overhead account is used to record overhead applied to Work-in-Process Inventory. While the left side of the Manufacturing Overhead account accumulates actual over- head costs, the right side applies overhead costs using the predetermined overhead rate, based on estimated overhead costs. The estimates used to calculate the predetermined over- head rate will generally prove to be incorrect to some degree. Consequently, there will usu- ally be a nonzero balance left in the Manufacturing Overhead account at the end of the year. This balance is usually relatively small, and its disposition is covered later in this illustration. Selling and Administrative Costs During November, Adirondack Outfitters incurred selling and administrative costs as follows: Rental of sales and administrative offices ................................................................................................ $ 1,500 Salaries of sales personnel ..................................................................................................................... 4,000 Salaries of management ......................................................................................................................... 8,000 Advertising ............................................................................................................................................ 1,000 Office supplies used ............................................................................................................................... 300 Total ..................................................................................................................................................... $14,800 Since these are not manufacturing costs, they are not added to Work-in-Process Inven- tory. Selling and administrative costs are period costs, not product costs. They are “As production processes are becoming more automated, manufacturing overhead is becoming a greater and greater portion of total manufacturing costs. This is true of almost all manufacturing firms.” (3d) Chrysler Exhibit 3–7 Manufacturing Overhead Account Manufacturing Overhead Actual manufacturing- Manufacturing overhead overhead costs are is applied to production accumulated as they jobs. are incurred. Various Accounts The associated credits are to various accounts related to manufacturing- overhead costs. Work-in-Process Inventor y Manufacturing overhead is added to Work-in- Process Inventory. hiL25664_ch03_078-131.indd 94hiL25664_ch03_078-131.indd 94 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment 95 treated as expenses of the accounting period in which they are incurred. The following journal entry is made. (8) Selling and Administrative Expenses .................................................................... 14,800 Wages Payable .............................................................................................. 12,000 Accounts Payable .......................................................................................... 1,000 Prepaid Rent ................................................................................................. 1,500 Office Supplies Inventory ................................................................................ 300 The entry is posted in Exhibit 3–11 . Completion of a Production Job Job number F16 was completed during November, whereas job number C12 remained in process. As the job-cost record in Exhibit 3–3 (page 85) indicates, the total cost of job number F16 was $48,000. The following journal entry records the transfer of these job costs from Work-in-Process Inventory to Finished-Goods Inventory. (9) Finished-Goods Inventory ................................................................................... 48,000 Work-in-Process Inventory ............................................................................. 48,000 The entry is posted in Exhibit 3–11 . Sale of Goods Sixty deluxe aluminum fishing boats manufactured in job number F16 were sold for $900 each during November. The cost of each unit sold was $600, as shown on the job-cost record in Exhibit 3–3 (page 85). The following journal entries are made. (10) Accounts Receivable ........................................................................................ 54,000 Sales Revenue .............................................................................................. 54,000 (11) Cost of Goods Sold .......................................................................................... 36,000 Finished-Goods Inventory ............................................................................... 36,000 These entries are posted in Exhibit 3–11 . The remainder of the manufacturing costs for job number F16 remain in Finished- Goods Inventory until some subsequent accounting period when the units are sold. Therefore, the cost balance for job number F16 remaining in inventory is $12,000 (20 units remaining times $600 per unit). This balance is shown on the job-cost record in Exhibit 3–3 (page 85). Underapplied and Overapplied Overhead During November, Adirondack Outfitters incurred total actual manufacturing-overhead costs of $29,050, but only $28,800 of overhead was applied to Work-in-Process Inventory. The amount by which actual overhead exceeds applied overhead, called underapplied overhead, is calculated below. Actual manufacturing overhead * ................................................................................................................. $29,050 Applied manufacturing overhead † ............................................................................................................... 28,800 Underapplied overhead .............................................................................................................................. $ 250 *Sum of debit entries in the Manufacturing-Overhead account: $50 1 $14,000 1 $15,000 5 $29,050. See Exhibit 3–11 . †Applied overhead: $9.00 per machine hour 3 3,200 machine hours. hiL25664_ch03_078-131.indd 95hiL25664_ch03_078-131.indd 95 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer 96 Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment If actual overhead had been less than applied overhead, the difference would have been called overapplied overhead. Underapplied or overapplied overhead is caused by errors in the estimates of overhead and activity used to compute the predetermined over- head rate. In this illustration, Adirondack Outfitters’ predetermined rate was underesti- mated by a small amount. Disposition of Underapplied or Overapplied Overhead At the end of an account- ing period, the managerial accountant has two alternatives for the disposition of under- applied or overapplied overhead. Under the most common alternative, the underapplied or overapplied overhead is closed into Cost of Goods Sold. This is the method used by Adirondack Outfitters, and the required journal entry is shown below. (12) Cost of Goods Sold .......................................................................................... 250 Manufacturing Overhead ................................................................................ 250 This entry, which is posted in Exhibit 3–11 , brings the balance in the Manufactur- ing Overhead account to zero. The account is then clear to accumulate manufacturing- overhead costs incurred in the next accounting period. Journal entry (12) has the effect of increasing cost-of-goods-sold expense. This reflects the fact that the cost of the units sold had been underestimated due to the slightly underestimated predetermined overhead rate. Most companies use this approach because it is simple and the amount of underapplied or overapplied overhead is usually small. Moreover, most firms wait until the end of the year to close underapplied or overapplied overhead into Cost of Goods Sold, rather than making the entry monthly as in this illustration. Proration of Underapplied or Overapplied Overhead Some companies use a more accurate procedure to dispose of underapplied or overapplied overhead. This approach recognizes that underestimation or overestimation of the predetermined over- head rate affects not only Cost of Goods Sold, but also Work-in-Process Inventory and Finished-Goods Inventory. As the following diagram shows, applied overhead passes through all three of these accounts. Therefore, all three accounts are affected by any inaccuracy in the predetermined overhead rate. Work-In-Process Inventory Finished-Goods Inventory Cost of Goods Sold Applied Overhead is added to work in process Applied overhead is included in cost of goods completed Applied overhead is included in cost of goods sold When underapplied or overapplied overhead is allocated among the three accounts shown above, the process is called proration. The amount of the current period’s applied overhead remaining in each account is the basis for the proration procedure. In the Adirondack Outfitters illustration, the amounts of applied overhead remaining in the three accounts on November 30 are determined as follows: Work-In-Process Inventory Finished-Goods Inventory Cost of Goods Sold Overhead applied to job C12 10,800 Overhead applied to job F16 18,000 18,000 Applied overhead transfered to Finished Goods when job F16 was completed 18,000 13,500 Applied overhead transferred to Cost of Goods Sold when 60 out of 80 units were sold 13,500 hiL25664_ch03_078-131.indd 96hiL25664_ch03_078-131.indd 96 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment 97 Applied Overhead Remaining in Each Account on November 30 Account Explanation Amount Percentage Calculation of Percentages Work in Process ................ Job C12 only .................... $10,800 ............ 37.5% ............ 10,800 4 28,800 Finished Goods ................. ¼ of units in job F16 ......... 4,500 ............ 15.6% * .......... 4,500 4 28,800 Cost of Goods Sold ........... ¾ of units in job F16 ......... 13,500 ........... 46.9% * .......... 13,500 4 28,800 Total overhead applied in November ................................... $28,800 ........... 100.0% *Rounded Using the percentages calculated above, the proration of Adirondack Outfitters’ underapplied overhead is determined as follows: Account Underapplied Overhead 3 Percentage 5 Amount Added to Account Work in Process ....................................................... $250 3 37.5% 5 $ 93.75 Finished Goods ........................................................ 250 3 15.6% 5 39.00 Cost of Goods Sold .................................................. 250 3 46.9% 5 117.25 Total underapplied overhead prorated ....................................................................................................... $250.00 If Adirondack Outfitters had chosen to prorate underapplied overhead, the following journal entry would have been made. Work-in-Process Inventory ......................................................................................... 93.75 Finished-Goods Inventory ........................................................................................... 39.00 Cost of Goods Sold .................................................................................................... 117.25 Manufacturing Overhead .................................................................................... 250.00 Since this is not the method used by Adirondack Outfitters in our continuing illustration, this entry is not posted to the ledger in Exhibit 3–11 . Proration of underapplied and overapplied overhead is used by a small number of firms that are required to do so under the rules specified by the Cost Accounting Stan- dards Board (CASB). This federal agency was chartered by Congress in 1970 to develop cost-accounting standards for large government contractors. The agency was discontin- ued by Congress in 1980, but it was re-created in 1988. The standards set forth by the agency apply to significant government contracts and have the force of federal law. Schedule of Cost of Goods Manufactured The Excel spreadsheet in Exhibit 3–8 displays the November schedule of cost of goods manufactured for Adirondack Outfitters. The schedule details the costs of direct material, direct labor, and manufacturing overhead applied to work in process during November and shows the change in Work-in-Process Inventory. The cost of goods manufactured, shown in the last line of the schedule, is $48,000. This is the amount transferred from Work-in-Process Inventory to Finished-Goods Inventory during November, as recorded in journal entry number (9). Schedule of Cost of Goods Sold A schedule of cost of goods sold for Adirondack Outfitters is displayed as an Excel spreadsheet in Exhibit 3–9 . This schedule shows the November cost of goods sold and details the changes in Finished-Goods Inventory during the month. The Excel spread- sheet in Exhibit 3–10 displays the company’s November income statement. As the income statement shows, income before taxes is $2,950, from which income tax expense of $1,420 is subtracted, yielding net income of $1,530. Learning Objective 3-6 Prepare a schedule of cost of goods manufactured, a schedule of cost of goods sold, and an income statement for a manufacturer. hiL25664_ch03_078-131.indd 97hiL25664_ch03_078-131.indd 97 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer 98 Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment Exhibit 3–8 Schedule of Cost of Goods Manufactured ADIRONDACK OUTFITTERS Posting Journal Entries to the Ledger All of the journal entries in the Adirondack Outfitters illustration are posted to the ledger in Exhibit 3–11 . An examination of these T-accounts provides a summary of the cost flows discussed throughout the illustration. Further Aspects of Overhead Application Actual and Normal Costing Most firms use a predetermined overhead rate, based on overhead and activity estimates for a relatively long time period. When direct material and direct labor are added to Work-in-Process Inventory at their actual amounts, but overhead is applied to Work- in-Process Inventory using a predetermined overhead rate, the product-costing system is referred to as normal costing. This approach, which takes its name from the use of an overhead rate that is normalized over a fairly long period, is used in the Adirondack Outfitters illustration. Further Aspects of Overhead Application “We use an actual costing system for the costs incurred in producing a feature film.” (3e) The Walt Disney Company hiL25664_ch03_078-131.indd 98hiL25664_ch03_078-131.indd 98 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment 99 Exhibit 3–9 Schedule of Cost of Goods Sold ADIRONDACK OUTFITTERS Exhibit 3–10 Income Statement ADIRONDACK OUTFITTERS hiL25664_ch03_078-131.indd 99hiL25664_ch03_078-131.indd 99 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer 100 Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment A few companies use actual costing, a system in which direct material and direct labor are added to work in process at their actual amounts, and actual overhead is allo- cated to work in process using an actual overhead rate computed at the end of each accounting period. Note that even though an actual overhead rate is used, the amount of overhead assigned to each production job is still an allocated amount. Overhead costs, which are by definition indirect costs, cannot be traced easily to individual production Accounts Receivable Accounts Payable Bal. 11,000 3,000 Bal. (10) 54,000 10,000 (1) 6,000 (6) 1,000 (8) Prepaid Insurance Wages Payable Bal. 2,000 1,000 (6) 10,000 Bal. 21,000 (4) 14,000 (5) 12,000 (8) Prepaid Rent Office Supplies Inventory Bal. 5,000 Bal. 900 300 (8) 3,000 (6) 1,500 (8) Manufacturing Supplies Inventory Accumulated Depreciation: Equipment Bal. 750 50 (3) 105,000 Bal. 5,000 (6) Raw-Material Inventory Manufacturing Overhead Bal. 30,000 34,000 (2) (3) 50 28,800 (7) (1) 10,000 (5) 14,000 250 (12) (6) 15,000 Work-in-Process Inventory Cost of Goods Sold Bal. 4,000 48,000 (9) (11) 36,000 (2) 34,000 (12) 250 (4) 21,000 (7) 28,800 Finished-Goods Inventory Selling and Administrative Expenses Bal. 12,000 36,000 (11) (8) 14,800 (9) 48,000 Sales Revenue 54,000 (10) * The numbers in parentheses relate T-account entries to the associated journal entries. The numbers in color are the November 1 account balances. Exhibit 3–11 Ledger Accounts for Adirondack Outfitters Illustration * ADIRONDACK OUTFITTERS hiL25664_ch03_078-131.indd 100hiL25664_ch03_078-131.indd 100 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment 101 jobs. A significant drawback of actual costing is that product-cost information is not available until the end of the accounting period, when the actual overhead rate is com- puted. Actual and normal costing may be summarized as follows: ACTUAL COSTING Work-in-Process Inventory NORMAL COSTING Work-in-Process Inventory Actual direct- material costs Actual direct- material costs Actual direct- labor costs Actual direct- labor costs Overhead allocated: Overhead applied: Choosing the Cost Driver for Overhead Application Manufacturing overhead includes various indirect manufacturing costs that vary greatly in their relationship to the production process. If a single, volume-based cost driver (or activity base) is used in calculating the predetermined overhead rate, it should be some productive input that is common across all of the firm’s products. If, for example, all of the firm’s products require direct labor, but only some products require machine time, direct-labor hours would be a preferable activity base. If machine time were used as the base, products not requiring machine time would not be assigned any overhead cost. In selecting a volume-based cost driver (or activity base), the goal is to choose an input that varies in a pattern that is most similar to the pattern with which overhead costs vary. Products that indirectly cause large amounts of overhead costs also should require large amounts of the cost driver, and vice versa. During periods when the cost driver is at a low level, the overhead costs incurred should be low. Thus, there should be a correlation between the incurrence of overhead costs and use of the cost driver. Limitation of Direct Labor as a Cost Driver In traditional product-costing systems, the most common volume-based cost drivers are direct-labor hours and direct-labor cost. However, there is a trend away from using direct labor as the overhead application base. Many production processes are becoming increasingly automated, through the use of robotics and computer-integrated manufacturing systems. Increased automation brings two results. First, manufacturing-overhead costs represent a larger proportion of total production costs. Second, direct labor decreases in importance as a factor of production. As direct labor declines in importance as a productive input, it becomes less appropriate as a cost driver. For this reason, some firms have switched to machine hours, process time, or throughput time as cost drivers that better reflect the pattern of overhead cost incurrence. Throughput time (or cycle time ) is the average amount of time required to convert raw materials into finished goods ready to be shipped to customers. Throughput time includes the time required for material handling, production processing, inspection, and packaging. Departmental Overhead Rates In the Adirondack Outfitters illustration presented earlier in this chapter, all of the firm’s manufacturing overhead was combined into a single cost pool. Then the overhead was applied to products using a single predetermined overhead rate based on machine hours. Actual overhead rate (computed at end of period) 3 Actual amount of cost driver used (e.g., direct-labor hours) Predetermined overhead rate (computed at beginning of period) 3 Actual amount of cost driver used (e.g., direct-labor hours) “Direct labor is becoming less and less appropriate as a basis for the application of manufacturing overhead.” (3f) Chrysler hiL25664_ch03_078-131.indd 101hiL25664_ch03_078-131.indd 101 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer 102 Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment Since only one overhead rate is used in Adirondack Outfitters’ entire factory, it is known as a plantwide overhead rate. In some production processes, the relationship between overhead costs and the firm’s products differs substantially across production depart- ments. In such cases, the firm may use departmental overhead rates, which differ across production departments. This usually results in a more accurate assignment of overhead costs to the firm’s products. An even more accurate assignment of overhead costs can be achieved with activity-based costing (ABC), which is covered extensively in Chapter 5. Two-Stage Cost Allocation When a company uses departmental overhead rates, the assignment of manufacturing- overhead costs to production jobs is accomplished in two stages, comprising what is called two-stage cost allocation. In the first stage, all manufacturing-overhead costs are assigned to the production departments, such as machining and assembly. In the sec- ond stage, the overhead costs that have been assigned to each production department are applied to the production jobs that pass through the department. Let’s examine this two- stage process in more detail. Stage One In the first stage, all manufacturing-overhead costs are assigned to the firm’s production departments. However, stage one often involves two different types of allocation processes. First, all manufacturing-overhead costs are assigned to departmental overhead centers. This step is called cost distribution (or sometimes cost allocation ). For example, the costs of heating a factory with natural gas would be distributed among all of the departments in the factory, possibly in proportion to the cubic feet of space in each department. In the cost distribution step, manufacturing- overhead costs are assigned to both production departments and service departments. Service departments, such as equipment-maintenance and material-handling depart- ments, are departments that do not work directly on the firm’s products but are neces- sary for production to take place. Second, all service department costs are reassigned to the production departments through a process called service department cost allocation. In this step, an attempt is made to allocate service department costs on the basis of the relative proportion of each service department’s output that is used by the various production departments. For example, production departments with more equipment would be allocated a larger share of the maintenance department’s costs. At the conclusion of stage one, all manufacturing-overhead costs have been assigned to the production departments. Stage Two In the second stage, all of the manufacturing-overhead costs accumulated in each production department are assigned to the production jobs on which the depart- ment has worked. This process is called overhead application (or sometimes overhead absorption). In stage two, each production department has its own predetermined over- head rate. These rates often are based on different cost drivers. The two-stage process of assigning overhead costs to production jobs is portrayed in Exhibit 3–12 . Notice the roles of cost distribution, service department cost allocation, and overhead application in the exhibit. The techniques of overhead distribution and ser- vice department cost allocation will be covered later in the text. In this chapter, we are focusing primarily on the process of overhead application. 3 Two-Stage Cost Allocation “We’re going to need much more general knowledge of how the business works.” (3g) Boeing Learning Objective 3-7 Describe the two-stage allocation process used to assign manufacturing overhead costs to production jobs. 3 One might legitimately ask why this is called two-stage cost allocation when there are three types of alloca- tion involved. The term two-stage allocation is entrenched in the literature and in practice. It stems from the fact that there are two cost objects, or entities, to which costs are assigned: production departments in stage one and production jobs in stage two. hiL25664_ch03_078-131.indd 102hiL25664_ch03_078-131.indd 102 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment 103 Project Costing: Job-Order Costing in Nonmanufacturing Organizations Job-order costing also is used in service industry companies and other nonmanufacturing organizations. However, rather than referring to production “jobs,” such organizations use terminology that reflects their operations. For example, hospitals such as the Philadelphia Children’s Hospital assign costs to “cases,” and consulting firms like McKinsey track “contract” costs. Law firms assign costs to cases, while government agencies typically refer to “programs” or “missions.” The need for cost accumulation exists in these and similar organizations for the same reasons found in manufacturing firms. For example, a mission to launch a commercial satellite by NASA or Arianespace is assigned a cost for the purposes of planning, cost control, and pricing of the launch service. Project Costing: Job-Order Costing in Nonmanufacturing Organizations STAGE ONE Overhead costs are assigned to production departments. Manufacturing-Overhead Distribution (General manufacturing-overhead costs are distributed to all departments.) Service Department Cost Allocation (Service department costs are allocated to the production departments.) Production Departments STAGE TWO Overhead costs are assigned to production jobs. Overhead Application (All costs accumulated in the production departments are applied to products.)* Production jobs pass through production departments. * The Machining Department manufactures bicycle components, such as the bicycle frame pictured. In the Assembly Department, the components are put together. The Machining Department and the Assembly Department each has its own predetermined overhead rate. Factory Custodial Services Department Machinery Repair Department Service Departments Machining Department Assembly Department Exhibit 3–12 Developing Departmental Overhead Rates Using Two-Stage Allocation Learning Objective 3-8 Describe the process of project costing used in service industry firms and nonprofit organizations. hiL25664_ch03_078-131.indd 103hiL25664_ch03_078-131.indd 103 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer 104 Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment To illustrate the cost-accumulation system used in a service industry firm, let’s turn our attention to Midtown Advertising Agency in Cincinnati, Ohio. This small ad agency has two managing partners who pay themselves annual salaries of $100,000 each, and an artistic staff of six people who each earn $50,000 per year. Fringe benefits for these pro- fessionals average 40 percent of their compensation. So Midtown Advertising Agency’s direct professional labor budget is as follows: Partner salaries .................................................................................................................................... $200,000 Partner benefits (40%) .......................................................................................................................... 80,000 Total partner compensation ................................................................................................................... $280,000 Artistic staff salaries .............................................................................................................................. $300,000 Artistic staff benefits (40%) ................................................................................................................... 120,000 Total artistic staff compensation ............................................................................................................. $420,000 The ad agency’s annual overhead budget, which totals $756,000, appears in Exhibit 3–13 . The overhead budget includes the costs of the support staff, artistic and Exhibit 3–13 Midtown Advertising Agency: Annual Overhead Budget hiL25664_ch03_078-131.indd 104hiL25664_ch03_078-131.indd 104 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment 105 photographic supplies, office operation, utilities, rent, insurance, advertising, vehicle main- tenance, and depreciation. Midtown’s accountant has estimated that one-third of the bud- geted overhead cost is incurred to support the ad agency’s two partners, and two-thirds of it goes to support the artistic staff. Thus, the following two overhead rates are calculated. Budgeted annual partner support overhead ___________________________________ Budgeted annual partner compensation 5 $756,000 3 1∕3 ____________ $280,000 5 90% Budgeted annual artistic staff support overhead ______________________________________ Budgeted annual artistic staff compensation 5 $756,000 3 2∕3 ____________ $420,000 5 120% Overhead is assigned to each ad contract at the rate of 90 percent of partner direct professional labor plus 120 percent of artistic staff direct professional labor. During May, Midtown Advertising Agency completed an advertising project for Super Scoop Ice Cream Company. The contract required $1,800 in direct material, $1,200 of partner direct professional labor, and $2,000 of artistic staff direct professional labor. The total cost of the contract is computed as follows: Contract MJH0207: Advertising Program for Super Scoop Ice Cream Company Direct material .......................................................................................................................... $1,800 Direct professional labor (partner) .............................................................................................. 1,200 Direct professional labor (artistic staff) ........................................................................................ 2,000 Applied overhead: ..................................................................................................................... Partner support ($1,200 3 90%) ........................................................................................... 1,080 Artistic staff support ($2,000 3 120%) .................................................................................. 2,400 Total cost .................................................................................................................................. $8,480 The total contract cost of $8,480 includes actual direct material and direct professional labor costs, and applied overhead based on the predetermined overhead rates for partner support costs and artistic staff support costs. The contract cost can be used by the firm in controlling costs, for planning cash flows and operations, and as one informational input in its contract-pricing decisions. In addition to the contract cost, the firm also should con- sider the demand for its advertising services and the prices charged by its competitors. The discussion above provides only a brief overview of cost-accumulation proce- dures in service industry and nonprofit organizations. The main point is that job-order costing systems are used in a wide variety of organizations, and these systems provide important information to managers for planning, decision making, and control. Changing Technology in Manufacturing Operations The technology of manufacturing is changing rapidly. These technological changes often affect the managerial accounting procedures used to collect data and transmit information to the intended users. Among such technological changes are electronic data interchange (EDI), Extensible Markup Language (XML), bar code tracking, and radio frequency identification systems (RFID). EDI and XML Electronic data interchange (or EDI ) is the direct exchange of data between organizations via a computer-to-computer interface. EDI is used to transmit such documents as pur- chase orders, shipping notices, receiving notices, invoices, and a host of other production- related data. This eliminates the need for paperwork, speeding up the flow of information and substantially reducing errors. EDI is now in widespread use. For example, Walmart places most of its merchandise orders to its suppliers using this information technology. Changing Technology in Manufacturing Operations “Every research contract negotiated between Cornell and the federal government includes an overhead com- ponent to cover the univer- sity’s indirect costs.” (3h) Cornell University hiL25664_ch03_078-131.indd 105hiL25664_ch03_078-131.indd 105 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer 106 Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment A recently developed alternative to EDI is Extensible Markup Language (or XML ), which is Web-based and less expensive to implement than EDI. Its purpose is to allow users to share structured data (e.g., product order lists or price data) via the Internet. XML allows its users to define “tags,” which the computer then interprets as a particu- lar type of information. For example, a tag might indicate a product’s in-stock date or price. See www.XML.com for a primer on this rapidly growing Web-based data- sharing tool. Use of Bar Codes and RFID Systems We all have seen bar codes used to record inventory and sales information in retail stores. This efficient means of recording data also is widely used in recording important events in manufacturing processes. Production employees can record the time they begin work- ing on a particular job order by scanning the bar code on their employee ID badge and a bar code assigned to the production job order. When raw materials arrive at the produc- tion facility, their bar code is scanned and the event is recorded. Inventory records are updated automatically. Raw materials and partially completed components are assigned bar codes, and their movement throughout the production process is efficiently recorded. For example, raw materials may be requisitioned by a production employee simply by scanning the bar code assigned to the needed raw materials. When the materials are sent from the warehouse to the requisitioning production department, the bar code is scanned again. Inventory records are updated instantly. Bar codes represent one more instance where technology has changed both the production environment and the procedures used in accounting for production operations. Bar codes are increasingly being replaced by radio frequency identification systems (RFID). Unlike bar codes, which can be read by a scanner only when visible, the RFID system allows the information to be read from longer distances and without visibility. For example, a raw-material shipment that embeds the RFID system could be identified while still unpacked or in a delivery truck. “Each production job, from beginning to end, can take several weeks. Bar code technology is used exten- sively. The container that carries the work in process is bar-coded, and we use that to track each job.” (3i) Micrus (joint venture of IBM and Cirrus Logic, now part of NXP Semiconductor) RADIO FREQUENCY IDENTIFICATION SYSTEMS (RFID) Among the benefits attributed to RFID systems are reduced labor costs, fewer supply delays, and a reduction of waste in the supply chain. Leading the move toward RFID sys- tems are Walmart and the U.S. Department of Defense . “Both organizations have mandated that their suppliers comply with their RFID guidelines.” GlaxoSmithKline is putting RFID tags on its medications. Honeywell uses RFID technology to tag parts used in aircraft such as the Airbus . The RFID system enables a part to be tracked “from birth, through the air- lines, and repair by Honeywell.” Thomasville uses RFID technology to tag its self-assembly furniture shipped to Target and Walmart . “The RFID tags enable Thomasville to confirm the delivery of the products to the retailers. Because of the size of its products, the company is tagging at the item level, with an RFID tag inside each product box.” 4 Walmart, GlaxoSmithKline, U.S. Department of Defense , Honeywell, Airbus, Thomasville, and Target M A P anagement ccounting ractice 4 Jennifer Zaino, “Car Makers Steer Toward RFID,” RFID Journal, February 2013, p. 1; Claire Swedberg, “Honeywell Aerospace Tags Parts for Airbus,” RFID Journal, February 2013, p. 1; Jonathan Collins, “Unisys Manages RFIO for Thomasville,” RFID Journal, June 2005, p. 2; and C.T. Stambaugh and F.W. Carpenter, “RFID: Wireless Innovations in Inventory Monitoring and Accounting,” Strategic Finance, December 2009, pp. 35–40. hiL25664_ch03_078-131.indd 106hiL25664_ch03_078-131.indd 106 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment 107 Focus on Ethics DID BOEING EXPLOIT ACCOUNTING RULES TO CONCEAL COST OVERRUNS AND PRODUCTION SNAFUS? Aircraft manufacturers use job-order costing to determine the cost of an airplane. As this chapter discusses, sup- ply chain management and production controls are also important tools used by manufacturers to manage pro- duction costs. As BusinessWeek reports, however, things don’t always go according to plan. For three years, Boeing ’s top management had been seeking a merger with McDonnell-Douglas Corpora- tion , whose board of directors was reluctant to approve the deal. Finally, the deal went through, and the world’s largest aerospace company was born—“the first manufacturer ever with the ability to build everything that flies, from helicopters and fighter jets to space stations.” Unfortunately, “a disaster was quietly unfolding inside Boeing’s sprawling factories—one that would ultimately wind up costing billions of dollars, cause several execu- tives to lose their jobs, and lead to claims of accounting fraud. Facing an unprecedented surge in orders because of a booming economy, workers were toiling around the clock, pushing the assembly line to the breaking point. At the same time, the company was struggling to over- haul outdated production methods. These pressures were building up to what was, in essence, a manufacturing ner- vous breakdown. In the weeks after the merger announce- ment, parts shortages and overtime approached all-time highs. As costs went through the roof, the profitability of airliners such as the 777 swooned. A special team formed to study the crisis issued a report with a blunt conclusion: ‘Our production system is broken.’” Had investors “understood the scope of the prob- lems, the stock would probably have tumbled and the McDonnell deal—a stock swap that hinged on Boeing’s ability to maintain a lofty share price—would have been jeopardized.” In May of 2002, BusinessWeek reported the results of its three-month investigation, which “reconstructed this hidden chapter in the company’s history—and analyzed its current implications.” The BusinessWeek article alleges that “new details supplied by several inside witnesses indi- cate that Boeing did more than simply fail to tell investors about its production disaster. It also engaged in a wide variety of aggressive accounting techniques that papered over the mess. Critics say the company should have taken charges for the assembly-line disaster in the first half of 1997, even if it meant jeopardizing the McDonnell merger. They also claim that Boeing took advantage of the unusual flexibility provided by program accounting —a system that allows the huge upfront expense of building a plane to be spread out over several years—to cover up cost over- runs and to book savings from efficiency initiatives that never panned out. ‘Boeing managed its earnings to the point where it got caught,’ says Debra A. Smith, a part- ner at Constraints Management, a Seattle-area manufac- turing consultancy, and a former senior auditor at Deloitte & Touche who worked on the company’s account during the early 1980s. ‘Boeing basically decided in the short run that [managing earnings] was a lesser evil than losing the merger,’ adds Smith. At a time when investors are asking themselves how far Corporate America can be trusted, the Boeing saga provides rich new evidence that companies have much greater leeway to manipulate their numbers than most people suspect.” 5 Boeing allegedly used a system they called program accounting to spread their huge cost overruns across several years, thereby propping up earnings and the company’s share price. After the merger with McDonnell- Douglas, however, the truth came out in the form of much lower earnings. What is your view of how Boeing handled its cost overruns, its production problems, and the merger with McDonnell-Douglas? Did the company’s top executives act ethically? How about their accountants? 5 Stanley Holmes and Mike France, “Boeing’s Secret: Did the Aircraft Giant Exploit Accounting Rules to Conceal a Huge Factory Snafu?” Businessweek, May 20, 2002, pp. 110–120. Also see Andy Pasztor and Anne Soueo, “Boeing Could Pay Large Penalty to Settle Probes, Avoid Prosecution,” The Wall Street Journal, September 17, 2005, pp. A1, A8. Unrelated to the ethical issues described above, Boeing has experienced more recent setbacks relating to the grounding of its 787 Dreamliner, due to problems with the aircraft’s lithium-ion batteries. As this book goes to press, the problem had aparently been solved, and several airlines had resumed their flights of the Dreamliner. See Christopher Drew, “United Joins in Grounded Dreamliners’ Return to the Skies,” The New York Times (on line), May 20, 2013, p. 1 hiL25664_ch03_078-131.indd 107hiL25664_ch03_078-131.indd 107 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer 108 Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment LO3-1 Discuss the role of product and service costing in manufacturing and nonmanufacturing firms. Product costing is the process of accumulating the costs of a production process and assigning them to the firm’s products. Product costs are needed for three major purposes: (1) to value inventory and cost of goods sold in financial accounting; (2) to provide managerial accounting information to managers for planning, cost control, and decision making; and (3) to provide cost data to various organizations outside the firm. LO3-2 Diagram and explain the flow of costs through the manufacturing accounts used in prod- uct costing. The costs of direct material, direct labor, and manufacturing overhead are first entered into the Work-in-Process Inventory account. When goods are completed, the accumulated manufacturing costs are transferred from Work-in-Process Inventory to Finished-Goods Inventory. Finally, these prod- uct costs are transferred from Finished-Goods Inventory to Cost of Goods Sold when sales occur. LO3-3 Distinguish between job-order costing and process costing. Job-order costing is used by firms that engage in either job-shop or batch-production operations. Such firms produce relatively small numbers of dissimilar products. Process costing is used by companies that produce relatively large num- bers of nearly identical products. LO3-4 Compute a predetermined overhead rate and explain its use in job-order costing for job- shop and batch-production environments. Overhead is applied to production jobs using a predeter- mined overhead rate, which is based on estimates of manufacturing overhead (in the numerator) and the level of some cost driver or activity base (in the denominator). LO3-5 Prepare journal entries to record the costs of direct material, direct labor, and manufac- turing overhead in a job-order costing system. Journal entries, as illustrated in the chapter, are used to track the flow of manufacturing costs through the various accounts, such as Raw-Material Inventory, Work-in-Process Inventory, Finished-Goods Inventory, and Cost of Goods Sold. LO3-6 Prepare a schedule of cost of goods manufactured, a schedule of cost of goods sold, and an income statement for a manufacturer. These accounting schedules, which are illustrated in the chap- ter, provide information to management about the costs incurred in a production operation. LO3-7 Describe the two-stage allocation process used to assign manufacturing overhead costs to pro- duction jobs. In stage one, cost distribution and service-department cost allocation are used to assign all manufacturing overhead costs to production departments. In stage two, cost application is used to assign overhead costs from production departments to production jobs using a predetermined overhead rate. LO3-8 Describe the process of project costing used in service industry firms and nonprofit orga- nizations. Job-order costing methods are used in a variety of service industry firms and nonprofit orga- nizations. Accumulating costs of projects, contracts, cases, programs, or missions provides important information to managers in such organizations as hospitals, law firms, and government agencies. Chapter Summary Review Problem on Job-Order Costing Piedmont Paint Company uses a job-order costing system, and the company had two jobs in process at the beginning of the current year. Job JY65 currently has a cost of $134,400 assigned to it, and job DC66 currently has a cost of $85,600 assigned to it. The following additional information is available. • The company applies manufacturing overhead on the basis of machine hours. Budgeted overhead and machine activity (based on practical capacity) for the year were $1,344,000 and 16,000 hours, respectively. • The company worked on four jobs during the first quarter. Direct materials used, direct labor incurred, and machine hours consumed were as follows: Job No. Direct Material Direct Labor Machine Hours JY65 ................................... $33,600 ......................... $ 56,000 ............................ 1,200 DC66 .................................. — ......................... 35,200 ............................ 700 SG78 .................................. 70,400 ......................... 104,000 ............................ 2,000 RG82 .................................. 24,000 ......................... 14,080 ............................ 500 • Manufacturing overhead during the first quarter included charges for depreciation ($54,400), indi- rect labor ($96,000), indirect materials used ($8,000), and other factory costs ($223,200). • Piedmont Paint Company completed job JY65 and job DC66. Job DC66 was sold on account, pro- ducing a profit of $55,520 for the firm. hiL25664_ch03_078-131.indd 108hiL25664_ch03_078-131.indd 108 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment 109 Required: 1. Determine Piedmont Paint Company’s predetermined overhead application rate. 2. Prepare journal entries as of March 31 to record the following. ( Note: Use summary entries where appropriate by combining individual job data.) a. The issuance of direct material to production and the direct labor incurred. b. The manufacturing overhead incurred during the quarter. c. The application of manufacturing overhead to production. d. The completion of jobs JY65 and DC66. e. The sale of job DC66. 3. Determine the cost of the jobs still in production as of March 31. 4. Did the finished-goods inventory increase or decrease during the first quarter? By how much? 5. Was manufacturing overhead under- or overapplied for the first quarter of the year? By how much? Solution to Review Problem 1. Predetermined overhead rate 5 budgeted overhead 4 budgeted machine hours 5 $1,344,000 4 16,000 5 $84 per machine hour 2. (a) Work-in-Process Inventory .......................................................... 128,000 * Raw-Material Inventory ................................................... 128,000 Work-in-Process Inventory .......................................................... 209,280 † Wages Payable ................................................................. 209,280 *$33,600 1 $70,400 1 $24,000 5 $128,000 †$56,000 1 $35,200 1 $104,000 1 $14,080 5 $209,280 (b) Manufacturing Overhead ............................................................. 381,600 Accumulated Depreciation .............................................. 54,400 Wages Payable ................................................................. 96,000 Manufacturing Supplies Inventory .................................. 8,000 Miscellaneous Accounts .................................................. 223,200 (c) Work-in-Process Inventory .......................................................... 369,600 * Manufacturing Overhead ................................................. 369,600 *(1,200 1 700 1 2,000 1 500) 3 $84 5 $369,600 (d) Finished-Goods Inventory ........................................................... 504,400 * Work-in-Process Inventory .............................................. 504,400 *Job JY65: $134,400 1 $33,600 1 $56,000 1 (1,200 3 $84) 5 $324,800 Job DC66: $85,600 1 $35,200 1 (700 3 $84) 5 $179,600 $504,400 5 $324,800 1 $179,600 (e) Accounts Receivable ................................................................... 235,120 * Sales Revenue .................................................................. 235,120 *$179,600 1 $55,520 5 $235,120 Cost of Goods Sold ..................................................................... 179,600 Finished-Goods Inventory ............................................... 179,600 3. Job SG78 and RG82 are in production as of March 31: Job SG78: $70,400 1 $104,000 1 (2,000 3 $84) ..................... $342,400 Job RG82: $24,000 1 $14,080 1 (500 3 $84) .......................... 80,080 Total ................................................................................. $422,480 4. Finished-goods inventory increased by $324,800 ($504,400 2 $179,600). 5. The company’s actual overhead amounted to $381,600, whereas applied overhead totaled $369,600. Thus, overhead was underapplied by $12,000. hiL25664_ch03_078-131.indd 109hiL25664_ch03_078-131.indd 109 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer 110 Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment Review Questions Key Terms For each term’s definition refer to the indicated page, or turn to the glossary at the end of the text. activity base, 88 actual costing, 100 actual manufacturing overhead, 94 applied manufacturing overhead, 93 bill of materials, 86 cost distribution (sometimes called cost allocation), 102 cost of goods manufactured, 97 cycle time, 101 departmental overhead centers, 102 departmental overhead rate, 102 job-cost record, 84 job-order costing, 83 material requisition form, 85 normal costing, 98 overapplied overhead, 96 overhead application (or absorption), 87 plantwide overhead rate, 102 predetermined overhead rate, 88 process-costing system, 84 product-costing system, 80 proration, 96 schedule of cost of goods manufactured, 97 schedule of cost of goods sold, 97 service department cost allocation, 102 service departments, 102 source document, 86 supply chain, 86 throughput time, 101 time record, 87 two-stage cost allocation, 102 underapplied overhead, 95 volume-based cost driver, 88 Exercises For each of the following companies, indicate whether job-order or process costing is more appropriate. 1. Manufacturer of household cleaning solutions. 2. Manufacturer of custom hot tubs and spas. 3. Architectural firm. All applicable Exercises are available with McGraw-Hill’s Connect Accounting ® . ■ Exercise 3–23 Job-Order versus Process Costing (LO 3-1, 3-3) 3–1. List and explain four purposes of product costing. 3–2. Explain the difference between job-order and process costing. 3–3. How is the concept of product costing applied in ser- vice industry firms? 3–4. What are the purposes of the following documents: ( a ) material requisition form, ( b ) labor time record, and ( c ) job-cost record. 3–5. Why is manufacturing overhead applied to prod- ucts when product costs are used in making pricing decisions? 3–6. Explain the benefits of using a predetermined overhead rate instead of an actual overhead rate. 3–7. Describe one advantage and one disadvantage of prorat- ing overapplied or underapplied overhead. 3–8. Describe an important cost-benefit issue involving accuracy versus timeliness in accounting for overhead. 3–9. Explain the difference between actual and normal costing. 3–10. When a single, volume-based cost driver (or activity base) is used to apply manufacturing overhead, what is the managerial accountant’s primary objective in select- ing the cost driver? 3–11. Describe some costs and benefits of using multiple overhead rates instead of a plantwide overhead rate. 3–12. Describe the process of two-stage cost allocation in the development of departmental overhead rates. 3–13. Define each of the following terms, and explain the relationship among them: ( a ) overhead cost distribu- tion, ( b ) service department cost allocation, and ( c ) overhead application. 3–14. Describe how job-order costing concepts are used in professional service firms, such as law practices and consulting firms. 3–15. What is meant by the term cost driver? What is a volume-based cost driver? 3–16. Describe the flow of costs through a product-costing system. What special accounts are involved, and how are they used? 3–17. Give an example of how a hospital, such as the Mayo Clinic , might use job-order costing concepts. 3–18. Why are some manufacturing firms switching from direct-labor hours to machine hours or throughput time as the basis for overhead application? 3–19. What is the cause of overapplied or underapplied overhead? 3–20. Briefly describe two ways of closing out overapplied or underapplied overhead at the end of an accounting period. 3–21. Describe how a large retailer such as Lowes could use EDI. 3–22. Explain how a Texas Instruments engineer might use bar code technology to record the time she spends on various activities. hiL25664_ch03_078-131.indd 110hiL25664_ch03_078-131.indd 110 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment 111 4. Manufacturer of ceramic tile. 5. Producer of yogurt. 6. Manufacturer of custom backyard tool sheds. 7. Manufacturer of paper clips. 8. Engineering consulting firm. 9. Manufacturer of balloons. 10. Manufacturer of custom sailboats. Rexford Company manufactures finger splints for kids who get tendonitis from playing video games. The firm had the following inventories at the beginning and end of the month of January. January 1 January 31 Finished goods ................................................. $162,500 $152,100 Work in process ................................................ 305,500 326,300 Raw material .................................................... 174,200 161,200 The following additional manufacturing data pertains to January operations. Raw material purchased ....................................................................... $248,300 Direct labor ......................................................................................... 390,000 Actual manufacturing overhead ............................................................ 227,500 Actual selling and administrative expenses ............................................ 230,000 Rexford Company applies manufacturing overhead at the rate of 70 percent of direct-labor cost. Any overapplied or underapplied manufacturing overhead is accumulated until the end of the year. Required: Compute the following amounts. 1. The company’s prime cost for January. 2. The total manufacturing cost for January. 3. The cost of goods manufactured for January. 4. The cost of goods sold for January. 5. The balance in the Manufacturing Overhead account on January 31. Debit or credit? (CMA, adapted) Shawn Toy Company incurred the following costs to produce job number TB78, which consisted of 1,000 teddy bears that can walk, talk, and play cards. Direct material: 8/11/x0 Requisition number 201: 500 yards of fabric at $.90 per yard 8/12/x0 Requisition number 208: 600 cubic feet of stuffing at $.40 per cubic foot Direct labor: 8/15/x0 Time card number 82: 550 hours at $14 per hour Manufacturing overhead: Applied on the basis of direct-labor hours at $3.00 per hour. Job number TB78 was finished on August 20. On August 30, 800 of the bears were shipped to a local toy store. Required: Prepare a job-cost record using the information given above. (Use Exhibit 3–3 as a guide.) Cherry Hill Glass Company employs a normal-costing system. The following information pertains to the year just ended. • Total manufacturing costs were $1,250,000. • Cost of goods manufactured was $1,212,500. • Applied manufacturing overhead was 30 percent of total manufacturing costs. • Manufacturing overhead was applied to production at a rate of 80 percent of direct-labor cost. • Work-in-process inventory on January 1 was 75 percent of work-in-process inventory on December 31. ■ Exercise 3–24 Job-Order Costing Basics (LO 3-2, 3-4, 3-5, 3-6) ■ Exercise 3–25 Job-Cost Record (LO 3-2, 3-3, 3-4) ■ Exercise 3–26 Cost Relationships; Normal Costing System (LO 3-2, 3-4, 3-6) hiL25664_ch03_078-131.indd 111hiL25664_ch03_078-131.indd 111 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer 112 Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment Required: 1. Compute Cherry Hill’s total direct-labor cost for the year. 2. Calculate the total cost of direct material used during the year. 3. Compute the value of the company’s work-in-process inventory on December 31. (CMA, adapted) Dewitt Educational Products started and finished job number RM67 during June. The job required $5,100 of direct material and 40 hours of direct labor at $18 per hour. The predetermined overhead rate is $6 per direct-labor hour. Required: Prepare journal entries to record the incurrence of production costs and the completion of job number RM67. The controller for Tender Bird Poultry, Inc. estimates that the company’s fixed overhead is $150,000 per year. She also has determined that the variable overhead is approximately $.15 per chicken raised and sold. Since the firm has a single product, overhead is applied on the basis of output units, chickens raised and sold. Required: 1. Calculate the predetermined overhead rate under each of the following output predictions: 100,000 chickens, 200,000 chickens, and 300,000 chickens. 2. Does the predetermined overhead rate change in proportion to the change in predicted production? Why? Visit the website of a film producer, such as Disney, MGM, or Warner Brothers. Walt Disney Studios www.disney.com MGM www.mgm.com Warner Brothers www.warnerbros.com Required: Read about one of the company’s recent (or upcoming) film releases. Then discuss why or why not job-order costing would be an appropriate costing method for feature film production. Would your answer be any different depending on the type of film being produced (e.g., animation in a studio versus filming on location in the Swiss Alps)? Jay Sports Equipment Company, Inc. incurred the following costs during 20x2. Direct material used ............................................................................................................................... $226,200 Direct labor ............................................................................................................................................ 421,200 Manufacturing overhead applied .............................................................................................................. 234,000 During 20x2, products costing $156,000 were finished, and products costing $171,600 were sold on account for $253,500. There were no purchases of raw material during the year. The beginning balances in the firm’s inventory accounts are as follows: Raw material .......................................................................................................................................... $295,100 Work in process ...................................................................................................................................... 23,400 Finished goods ....................................................................................................................................... 39,000 Required: 1. Prepare T-accounts to show the flow of costs through the company’s manufacturing accounts during 20x2. 2. Prepare a partial balance sheet and a partial income statement to reflect the information given above. ( Hint: See Exhibit 3–2 .) ■ Exercise 3–27 Basic Journal Entries in Job-Order Costing (LO 3-5) ■ Exercise 3–28 Fixed and Variable Costs; Overhead Rate; Agribusiness (LO 3-1, 3-4) ■ Exercise 3–29 Job-Order Costing; Feature Film Production; Use of Internet (LO 3-1, 3-3) ■ Exercise 3–30 Manufacturing Cost Flows (LO 3-2, 3-5, 3-6) hiL25664_ch03_078-131.indd 112hiL25664_ch03_078-131.indd 112 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment 113 Selected data concerning the past year’s operations of the Lone Star Leather Company are as follows: Inventories Beginning Ending Raw material ...................................................................................................... $142,000 $ 162,000 Work in process .................................................................................................. 160,000 60,000 Finished goods ................................................................................................... 180,000 220,000 Other data: Direct material used ........................................................................................ $ 652,000 Total manufacturing costs charged to production during the year (includes direct material, direct labor, and manufacturing overhead applied at a rate of 60% of direct-labor cost ................................................. 1,372,000 Cost of goods available for sale ....................................................................... 1,652,000 Selling and administrative expenses ................................................................. 63,000 Required: 1. What was the cost of raw materials purchased during the year? 2. What was the direct-labor cost charged to production during the year? 3. What was the cost of goods manufactured during the year? 4. What was the cost of goods sold during the year? (CMA, adapted) Crunchem Cereal Company incurred the following actual costs during 20x4. Direct material used ............................................................................................................................ $412,500 Direct labor ........................................................................................................................................ 180,000 Manufacturing overhead ...................................................................................................................... 378,000 The firm’s predetermined overhead rate is 210 percent of direct-labor cost. The January 1 inventory balances were as follows: Raw material ...................................................................................................................................... $45,000 Work in process .................................................................................................................................. 58,500 Finished goods ................................................................................................................................... 63,000 Each of these inventory balances was 10 percent higher at the end of the year. Required: 1. Prepare a schedule of cost of goods manufactured for 20x4. 2. What was the cost of goods sold for the year? 3. Build a spreadsheet: Construct an Excel spreadsheet to solve all of the preceding requirements. Show how the solution will change if the following data change: direct material used amounted to $409,000 and raw-material inventory on January 1 was $43,000. The following data pertain to the Aquarius Hotel Supply Company for the year just ended. Budgeted sales revenue ........................................................................................................................ $945,000 Budgeted manufacturing overhead ........................................................................................................ 650,000 Budgeted machine hours (based on practical capacity) ............................................................................ 20,000 Budgeted direct-labor hours (based on practical capacity) ....................................................................... 25,000 Budgeted direct-labor rate per hour ....................................................................................................... 13 Actual manufacturing overhead ............................................................................................................. 690,000 Actual machine hours ........................................................................................................................... 22,000 Actual direct-labor hours ....................................................................................................................... 26,000 Actual direct-labor rate per hour ............................................................................................................ 14 ■ Exercise 3–32 Schedule of Cost of Goods Manufactured (LO 3-2, 3-6) ■ Exercise 3–33 Predetermined Overhead Rate; Various Cost Drivers (LO 3-4, 3-5) ■ Exercise 3–31 Basic Manufacturing Cost Flows (LO 3-2, 3-6) hiL25664_ch03_078-131.indd 113hiL25664_ch03_078-131.indd 113 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer 114 Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment Required: 1. Compute the firm’s predetermined overhead rate for the year using each of the following common cost drivers: ( a ) machine hours, ( b ) direct-labor hours, and ( c ) direct-labor dollars. 2. Calculate the overapplied or underapplied overhead for the year using each of the cost drivers listed above. Refer to the data for the preceding exercise for Aquarius Hotel Supply Company. Prepare a journal entry to add to work-in-process inventory the total manufacturing overhead cost for the year, assuming: 1. The firm uses actual costing. 2. The firm uses normal costing, with a predetermined overhead rate based on machine hours. The following information pertains to Paramus Metal Works for the year just ended. Budgeted direct-labor cost: 77,000 hours (practical capacity) at $17 per hour Actual direct-labor cost: 79,000 hours at $18 per hour Budgeted manufacturing overhead: $993,300 Budgeted selling and administrative expenses: $417,000 Actual manufacturing overhead: Depreciation ........................................................................................................................................ $225,000 Property taxes ..................................................................................................................................... 19,000 Indirect labor ....................................................................................................................................... 79,000 Supervisory salaries ............................................................................................................................. 210,000 Utilities ................................................................................................................................................ 58,000 Insurance ............................................................................................................................................ 32,000 Rental of space ................................................................................................................................... 295,000 Indirect material (see data below .......................................................................................................... 79,000 Indirect material: Beginning inventory, January 1 ............................................................................................................. 46,000 Purchases during the year .................................................................................................................... 95,000 Ending inventory, December 31 ............................................................................................................ 62,000 Required: 1. Compute the firm’s predetermined overhead rate, which is based on direct-labor hours. 2. Calculate the overapplied or underapplied overhead for the year. 3. Prepare a journal entry to close out the Manufacturing Overhead account into Cost of Goods Sold. 4. Build a spreadsheet: Construct an Excel spreadsheet to solve requirements (1) and (2) above. Show how the solution will change if the following data change: budgeted manufacturing overhead was $990,000, property taxes were $25,000, and purchases of indirect material amounted to $97,000. Happy Days Balloon Company incurred $167,000 of manufacturing overhead costs during the year just ended. However, only $145,000 of overhead was applied to production. At the conclusion of the year, the following amounts of the year’s applied overhead remained in the various manufacturing accounts. Applied Overhead Remaining in Account on December 31 Work-in-Process Inventory ..................................................................................... $29,000 Finished-Goods Inventory ....................................................................................... 50,750 Cost of Goods Sold .............................................................................................. 65,250 Required: Prepare a journal entry to close out the balance in the Manufacturing Overhead account and prorate the balance to the three manufacturing accounts. ■ Exercise 3–34 Actual versus Normal Costing (LO 3-4, 3-5) ■ Exercise 3–35 Overapplied or Underapplied Overhead (LO 3-4, 3-5) ■ Exercise 3–36 Proration of Underapplied Overhead (LO 3-5) hiL25664_ch03_078-131.indd 114hiL25664_ch03_078-131.indd 114 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment 115 Contemporary Trends is an interior decorating firm in Munich. The following costs were incurred in the firm’s contract to redecorate the mayor’s offices. Direct material used ...................................................................................................................................... € 4,100 Direct professional labor ................................................................................................................................ € 7,000 The firm’s budget for the year included the following estimates: Budgeted overhead .................................................................................................................................... € 510,000 Budgeted direct professional labor .............................................................................................................. € 300,000 Overhead is applied to contracts using a predetermined overhead rate calculated annually. The rate is based on direct professional labor cost. Required: Calculate the total cost of the firm’s contract to redecorate the mayor’s offices. (Remember to express your answer in terms of euros. On the day this exercise was written the euro was valued at 1.2905 U.S. dollars.) Rocky Mountain Leatherworks, which manufactures saddles and other leather goods, has three depart- ments. The Assembly Department manufactures various leather products, such as belts, purses, and sad- dlebags, using an automated production process. The Saddle Department produces handmade saddles and uses very little machinery. The Tanning Department produces leather. The tanning process requires little in the way of labor or machinery, but it does require space and process time. Due to the different production processes in the three departments, the company uses three different cost drivers for the application of manufacturing overhead. The cost drivers and overhead rates are as follows: Department Cost Driver Predetermined Overhead Rate Tanning Department Square feet of leather $4 per square foot Assembly Department Machine time $11 per machine hour Saddle Department Direct-labor time $5 per direct-labor hour The company’s deluxe saddle and accessory set consists of a handmade saddle, two saddlebags, a belt, and a vest, all coordinated to match. The entire set uses 110 square feet of leather from the Tan- ning Department, 4 machine hours in the Assembly Department, and 45 direct-labor hours in the Saddle Department. Required: Job number DS-25 consisted of 25 deluxe saddle and accessory sets. Prepare journal entries to record applied manufacturing overhead in the Work-in-Process Inventory account for each department. Suppose you are the controller for a company that produces handmade glassware. 1. Choose a volume-based cost driver upon which to base the application of overhead. Write a memo to the company president explaining your choice. 2. Now you have changed jobs. You are the controller of a microchip manufacturer that uses a highly automated production process. Repeat the same requirements stated above. Refer to Exhibit 3–12 , which portrays the three types of allocation procedures used in two-stage allo- cation. Give an example of each of these allocation procedures in a hospital setting. The ultimate cost object is a patient-day of hospital care. This is one day of care for one patient. ( Hint: First think about the various departments in a hospital. Which departments deal directly with patients; which ones are service departments and do not deal directly with patients? What kinds of costs does a hospital incur that should be distributed among all of the hospital’s departments? Correct hospital terminology is not important here. Focus on the concepts of cost allocation portrayed in Exhibit 3–12 .) Refer to the illustration of overhead application in the Midtown Advertising Agency on pp. 104–105. Suppose the firm used a single cost driver, total staff compensation, to apply overhead costs to each ad contract. ■ Exercise 3–38 Cost Drivers; Different Production Methods (LO 3-4, 3-5) ■ Exercise 3–39 Choice of a Cost Driver for Overhead Application (LO 3-1, 3-4) ■ Exercise 3–40 Two-Stage Allocation (LO 3-1, 3-7) ■ Exercise 3–41 Overhead Application in a Service Industry Firm (LO 3-8) ■ Exercise 3–37 Project Costing; Interior Decorating (LO 3-1, 3-8) Ex hiL25664_ch03_078-131.indd 115hiL25664_ch03_078-131.indd 115 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer 116 Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment Required: 1. Compute the total budgeted staff compensation: both partner and artistic staff compensation. 2. Compute Midtown’s overhead rate on the basis of this single cost driver. 3. Recalculate the applied overhead for the Super Scoop Ice Cream Company contract. 4. Compare the applied overhead using the single cost driver with the applied overhead computed using the two cost drivers used in the text illustration. Problems Vermont Clock Works manufactures fine, handcrafted clocks. The firm uses a job-order costing sys- tem, and manufacturing overhead is applied on the basis of direct-labor hours. Estimated manufacturing overhead for the year is $260,000. The firm employs 10 master clockmakers, who constitute the direct- labor force. Each of these employees is expected to work 2,000 hours during the year, which represents each employee’s practical capacity. The following events occurred during October. a. The firm purchased 2,900 board feet of mahogany veneer at $12 per board foot. b. Twenty brass counterweights were requisitioned for production. Each weight cost $27. c. Five gallons of glue were requisitioned for production. The glue cost $25 per gallon. Glue is treated as an indirect material. d. Depreciation on the clockworks building for October was $7,000. e. A $300 utility bill was paid in cash. f. Time cards showed the following usage of labor: Job number G60: 12 grandfather’s clocks, 950 hours of direct labor Job number C81: 15 cuckoo clocks, 500 hours of direct labor The master clockmakers (direct-labor personnel) earn $22 per hour. g. The October property tax bill for $890 was received but not yet paid in cash. h. The firm employs laborers who perform various tasks such as material handling and shop cleanup. Their wages for October amounted to $3,100. i. Job number G60, which was started in July, was finished in October. The total cost of the job was $15,100. j. Nine of the grandfather’s clocks from job number G60 were sold in October for $1,600 each. Required: 1. Calculate the firm’s predetermined overhead rate for the year. 2. Prepare journal entries to record the events described above. Birmingham Bowling Ball Company (BBBC) uses a job-order costing system to accumulate manufactur- ing costs. The company’s work-in-process on December 31, 20x3, consisted of one job (no. 3088), which was carried on the year-end balance sheet at $78,400. There was no finished-goods inventory on this date. BBBC applies manufacturing overhead to production on the basis of direct-labor cost. (The bud- geted direct-labor cost is the company’s practical capacity, in terms of direct-labor hours, multiplied by the budgeted direct-labor rate.) Budgeted totals for 20x4 for direct labor and manufacturing overhead are $2,100,000 and $2,730,000, respectively. Actual results for the year follow. Direct material used .......................................................................................................................... $2,800,000 Direct labor ...................................................................................................................................... 2,175,000 Indirect material used ....................................................................................................................... 32,500 Indirect labor .................................................................................................................................... 1,430,000 Factory depreciation ......................................................................................................................... 870,000 Factory insurance ............................................................................................................................. 29,500 Factory utilities ................................................................................................................................. 415,000 Selling and administrative expenses ................................................................................................... 1,080,000 Total ............................................................................................................................................ $8,832,000 Job no. 3088 was completed in January 20x4; there was no work in process at year-end. All jobs pro- duced during 20x4 were sold with the exception of job no. 3154, which contained direct-material costs of $78,000 and direct-labor charges of $42,500. BBBC charges any under- or overapplied overhead to Cost of Goods Sold. ■ Problem 3–42 Basic Job-Order Costing; Journal Entries (LO 3-4, 3-5) 1. Predetermined overhead rate: $13 per hour ■ Problem 3–43 Job-Order Costing; Focus on Manufacturing Overhead (LO 3-2, 3-4, 3-5) 5. BBBC’s applied overhead: $2,827,500 6. Overapplied overhead: $50,500 All applicable Problems are available with McGraw-Hill’s Connect Accounting ®. hiL25664_ch03_078-131.indd 116hiL25664_ch03_078-131.indd 116 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment 117 Required: 1. Determine the company’s predetermined overhead application rate. 2. Determine the additions to the Work-in-Process Inventory account for direct material used, direct labor, and manufacturing overhead. 3. Compute the amount BBBC would disclose as finished-goods inventory on the December 31, 20x4, balance sheet. 4. Prepare the journal entry needed to record the year’s completed production. 5. Compute the amount of under- or overapplied overhead at year-end, and prepare the necessary journal entry to record its disposition. 6. Determine BBBC’s 20x4 cost of goods sold. 7. Would it be appropriate to include selling and administrative expenses in either manufacturing overhead or cost of goods sold? Briefly explain. The following data refer to Mister Munchie, Inc. for the year 20x4. Work-in-process inventory, 12/31/x3 ................. $ 24,300 Utilities for sales and administrative offices .............. 7,500 Selling and administrative salaries ...................... 41,400 Other selling and administrative expenses ............... 12,000 Insurance on factory and equipment ................... 10,800 Indirect-labor cost incurred ..................................... 87,000 Work-in-process inventory, 12/31/x4 ................. 24,900 Depreciation on factory building .............................. 11,400 Finished-goods inventory, 12/31/x3 ................... 42,000 Depreciation on cars used by sales personnel .......... 3,600 Indirect material used ........................................ 14,700 Direct-labor cost incurred ....................................... 237,000 Depreciation on factory equipment ..................... 6,300 Raw-material inventory, 12/31/x4 ........................... 33,000 Raw-material inventory, 12/31/x3 ...................... 30,300 Rental for warehouse space to store raw material .... 9,300 Property taxes on factory ................................... 7,200 Rental of space for company president’s office ........ 5,100 Finished-goods inventory, 12/31/x4 ................... 46,200 Applied manufacturing overhead ............................. 174,000 Purchases of raw material in 20x4 ..................... 117,000 Sales revenue ........................................................ 617,400 Utilities for factory ............................................. 18,000 Income tax expense ............................................... 15,300 Cash, 12/31/x4 ................................................ 7,500 Accounts receivable, 12/31/x4 ............................... 5,100 Required: 1. Prepare Mister Munchie’s schedule of cost of goods manufactured for 20x4. 2. Prepare the company’s schedule of cost of goods sold for 20x4. The company closes overapplied or underapplied overhead into Cost of Goods Sold. 3. Prepare the company’s income statement for 20x4. Dessert Delite Company produces frozen microwavable desserts. The following accounts appeared in the ledger as of December 31. ■ Problem 3–44 Schedules of Cost of Goods Manufactured and Sold; Income Statement (LO 3-6) 1. Cost of goods manufactured: $524,700 3. Selling and administrative expenses: $69,600 Ex Raw-Material Inventory Bal. 1/1 29,400 ? ? Bal. 12/31 50,400 Accounts Payable 3,500 Bal. 1/1 191,100 ? 1,400 Bal. 12/31 Work-in-Process Inventory Bal. 1/1 23,800 Direct material ? ? Direct labor ? Manufacturing overhead ? Bal. 12/31 26,600 Finished-Goods Inventory Bal. 1/1 16,800 ? ? Bal. 12/31 28,000 ■ Problem 3–45 Manufacturing Cost Flows; Analysis of T-Accounts (LO 3-2, 3-5) hiL25664_ch03_078-131.indd 117hiL25664_ch03_078-131.indd 117 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer 118 Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment Additional information: a. Accounts payable is used only for direct-material purchases. b. Underapplied overhead of $3,500 for the year has not yet been closed into cost of goods sold. Required: Complete the T-accounts by computing the amounts indicated by a question mark. Southwestern Fashions, Inc. which uses a job-order costing system, had two jobs in process at the start of the year: job no. 101 ($168,000) and job no. 102 ($107,000). The following information is available: a. The company applies manufacturing overhead on the basis of machine hours (based on practical capacity). Budgeted overhead and machine activity for the year were anticipated to be $1,680,000 and 32,000 hours, respectively. b. The company worked on four jobs during the first quarter. Direct materials used, direct labor incurred, and machine hours consumed were as follows: Job No. Direct Material Direct Labor Machine Hours 101 ....................................................................... $42,000 $ 70,000 2,400 102 ....................................................................... — 44,000 1,400 103 ....................................................................... 88,000 130,000 4,000 104 ....................................................................... 30,000 17,600 1,000 c. Manufacturing overhead during the first quarter included charges for depreciation ($68,000), indi- rect labor ($120,000), indirect materials used ($10,000), and other factory costs ($279,000). d. Southwestern Fashions completed job no. 101 and job no. 102. Job no. 102 was sold on account, producing a profit of $69,400 for the firm. Required: 1. Determine the company’s predetermined overhead application rate. 2. Prepare journal entries for the first quarter to record the following. ( Note: Use summary entries where appropriate by combining individual job data.) a. The issuance of direct material to production and the direct labor incurred. b. The manufacturing overhead incurred during the quarter. c. The application of manufacturing overhead to production. d. The completion of jobs no. 101 and no. 102. e. The sale of job no. 102. 3. Determine the cost of the jobs still in production as of March 31. 4. Did the finished-goods inventory increase or decrease during the first quarter? By how much? 5. Was manufacturing overhead under- or overapplied for the first quarter of the year? By how much? ■ Problem 3–46 Job-Order Costing; Journal Entries (LO 3-2, 3-4, 3-5) 1. Predetermined overhead rate: $52.50 per machine hour 4. Finished-goods inventory increase: $406,000 Manufacturing Overhead ? ? Cost of Goods Sold 994,000 Wages Payable 2,800 Bal. 1/1 205,800 ? 7,000 Bal. 12/31 Sales Revenue ? ? Accounts Receivable Bal. 1/1 15,400 ? 1,128,400 Bal. 12/31 21,000 hiL25664_ch03_078-131.indd 118hiL25664_ch03_078-131.indd 118 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment 119 Juarez, Inc. uses a job-order costing system for its products, which pass from the Machining Depart- ment, to the Assembly Department, to finished-goods inventory. The Machining Department is heavily automated; in contrast, the Assembly Department performs a number of manual-assembly activities. The company applies manufacturing overhead using machine hours in the Machining Department and direct-labor cost in the Assembly Department. The following information relates to the year just ended: Machining Department Assembly Department Budgeted manufacturing overhead ..................................... $2,000,000 $1,540,000 Actual manufacturing overhead .......................................... 2,130,000 1,525,000 Budgeted direct-labor cost (based on practical capacity) ...... 750,000 2,800,000 Actual direct-labor cost ...................................................... 725,000 2,890,000 Budgeted machine hours (based on practical capacity) ......... 200,000 50,000 Actual machine hours ........................................................ 212,500 55,000 The data that follow pertain to job no. DC66, the only job in production at year-end. Machining Department Assembly Department Direct material ................................................................ $12,250 $ 3,350 Direct labor .................................................................... $13,950 $29,300 Machine hours ............................................................... 180 75 Selling and administrative expense amounted to $2,325,000. Required: 1. Assuming the use of normal costing, determine the predetermined overhead rates used in the Machining Department and the Assembly Department. 2. Compute the cost of the company’s year-end work-in-process inventory. 3. Determine whether overhead was under- or overapplied during the year in the Machining Department. 4. Repeat requirement (3) for the Assembly Department. 5. If Juarez disposes of under- or overapplied overhead as an adjustment to Cost of Goods Sold, would the company’s Cost of Goods Sold account increase or decrease? Explain. 6. How much overhead would have been charged to the company’s Work-in-Process account during the year? 7. Comment on the appropriateness of the company’s cost drivers (i.e., the use of machine hours in Machining and direct-labor cost in Assembly). Golden State Enterprises provides consulting services throughout California and uses a job-order cost- ing system to accumulate the cost of client projects. Traceable costs are charged directly to individ- ual clients; in contrast, other costs incurred by Golden State, but not identifiable with specific clients, are charged to jobs by using a predetermined overhead application rate. Clients are billed for directly chargeable costs, overhead, and a markup. Golden State’s director of cost management, Brent Dean, anticipates the following costs for the upcoming year: Cost Percentage of Cost Directly Traceable to Clients Professional staff salaries .................. $3,750,000 .................................... 80% Administrative support staff ............... 450,000 .................................... 60% Photocopying .................................... 75,000 .................................... 90% Travel ............................................... 375,000 .................................... 90% Other operating costs ........................ 150,000 .................................... 50% Total ............................................ $4,800,000 The firm’s partners desire to make a $960,000 profit for the firm and plan to add a percentage markup on total cost to achieve that figure. ■ Problem 3–48 Job-Order Costing in a Consulting Firm (LO 3-1, 3-2, 3-4, 3-8) 2. Predetermined overhead rate: 28% of traceable costs 4. Overhead: $21,000 ■ Problem 3–47 Job-Order Costing; Focus on Overhead and Cost Drivers (LO 3-2, 3-4, 3-5, 3-6, 3-7) 4. Overapplied overhead: $64,500 hiL25664_ch03_078-131.indd 119hiL25664_ch03_078-131.indd 119 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer 120 Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment On March 10, Golden State completed work on a project for Davis Manufacturing. The following costs were incurred: professional staff salaries, $61,500; administrative support staff, $3,900; photo- copying, $750; travel, $6,750; and other operating costs, $2,100. Required: 1. Determine Golden State Enterprises’ total traceable costs for the upcoming year and the firm’s total anticipated overhead. 2. Calculate the predetermined overhead rate. The rate is based on total costs traceable to client jobs. 3. What percentage of cost will the firm add to each job to achieve its profit target? 4. Determine the total cost of the Davis Manufacturing project. How much would Davis be billed for services performed? 5. Notice that only 50 percent of Golden State’s other operating cost is directly traceable to specific cli- ent projects. Cite several costs that would be included in this category and difficult to trace to clients. 6. Notice that 80 percent of the professional staff cost is directly traceable to specific client projects. Cite several reasons that would explain why this figure isn’t 100 percent. The following data refer to Superior Metals Corporation for the year 20x4. Raw-material inventory, 12/31/x3 ....................... $ 66,750 Depreciation on factory equipment ................... 45,000 Purchases of raw material in 20x4 ...................... 548,250 Insurance on factory and equipment ................. 30,000 Raw-material inventory, 12/31/x4 ....................... 44,250 Utilities for factory ........................................... 52,500 Direct-labor cost incurred ................................... 355,500 Work-in-process inventory, 12/31/x3 ............... -0- Selling and administrative expenses .................... 201,750 Work-in-process inventory, 12/31/x4 ............... 30,000 Indirect labor cost incurred ................................. 112,500 Finished-goods inventory, 12/31/x3 ................. 26,250 Property taxes on factory .................................... 67,500 Finished-goods inventory, 12/31/x4 ................. 30,000 Depreciation on factory building .......................... 93,750 Applied manufacturing overhead ...................... 433,125 Income tax expense ........................................... 18,750 Sales revenue ................................................. 1,578,750 Indirect material used ......................................... 33,750 Required: 1. Prepare Superior Metals’ schedule of cost of goods manufactured for 20x4. 2. Prepare the company’s schedule of cost of goods sold for 20x4. The company closes overapplied or underapplied overhead into Cost of Goods Sold. 3. Prepare the company’s income statement for 20x4. 4. Build a spreadsheet: Construct an Excel spreadsheet to solve all of the preceding requirements. Show how the solution will change if the following data change: sales revenue was $1,580,000, applied manufacturing overhead was $430,000, and utilities amounted to $49,000. Refer to the schedule of cost of goods manufactured prepared for Superior Metals Corporation in the preceding problem. Required: 1. How much of the manufacturing costs incurred during 20x4 remained associated with work-in-process inventory on December 31, 20x4? 2. Suppose the company had increased its production in 20x4 by 30 percent. Would the direct-material cost shown on the schedule have been larger or the same? Why? 3. Answer the same question as in requirement (2) for depreciation on the factory building. 4. Suppose only half of the $45,000 in depreciation on equipment had been related to factory machinery, and the other half was related to selling and administrative equipment. How would this have changed the schedule of cost of goods manufactured? Seaway, Inc. manufactures outboard motors and an assortment of other marine equipment. The company uses a job-order costing system. Normal costing is used, and manufacturing overhead is applied on the basis of machine hours. Estimated manufacturing overhead for the year is $1,520,200, and management estimates the firm’s practical capacity at 69,100 machine hours. ■ Problem 3–49 Schedules of Cost of Goods Manufactured and Sold; Income Statement (LO 3-6) 1. Total actual manufacturing overhead: $435,000 2. Cost of goods available for sale: $1,355,625 ■ Problem 3–50 Interpreting the Schedule of Cost of Goods Manufactured (LO 3-2, 3-6) ■ Problem 3–51 Journal Entries in Job-Order Costing (LO 3-4, 3-5) 2. Applied manufacturing overhead: $143,000 hiL25664_ch03_078-131.indd 120hiL25664_ch03_078-131.indd 120 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment 121 Required: 1. Calculate the company’s predetermined overhead rate for the year. 2. Prepare journal entries to record the following events, which occurred during April. a. The firm purchased marine propellers from Peninsula Marine Corporation for $8,240 on account. b. A requisition was filed by the Gauge Department supervisor for 280 pounds of clear plastic. The material cost $.70 per pound when it was purchased. c. The Motor Testing Department supervisor requisitioned 320 feet of electrical wire, which is considered an indirect material. The wire cost $.10 per foot when it was purchased. d. An electric utility bill of $900 was paid in cash. e. Direct-labor costs incurred in April were $73,500. f. April’s insurance cost was $2,100 for insurance on the cars driven by sales personnel. The policy had been prepaid in March. g. Metal tubing costing $2,800 was purchased on account. h. A cash payment of $1,850 was made on outstanding accounts payable. i. Indirect-labor costs of $19,000 were incurred during April. j. Depreciation on equipment for April amounted to $8,500. k. Job number G22, consisting of 60 tachometers, was finished during April. The total cost of the job was $1,200. l. During April, 6,500 machine hours were used. m. Sales on account for April amounted to $181,000. The cost of goods sold in April was $142,500. Joey Dulwich has recently been hired as a cost management specialist by Offset Press Company, a privately held company that produces a line of offset printing presses and lithograph machines. During his first few months on the job, Dulwich discovered that Offset has been underapplying factory overhead to the Work-in-Process Inventory account, while overstating expenses through the General and Admin- istrative Expense account. This practice has been going on since the start of the company, which is in its sixth year of operation. The effect in each year has been favorable, having a material impact on the company’s tax position. No internal audit function exists at Offset, and the external auditors have not yet discovered the underapplied factory overhead. Prior to the sixth-year audit, Dulwich had pointed out the practice and its effect to Mary Brown, the corporate controller, and had asked her to let him make the necessary adjustments. Brown directed him not to make the adjustments, but to wait until the external auditors had completed their work and see what they uncovered. The sixth-year audit has now been completed, and the external auditors have once again failed to discover the underapplication of factory overhead. Dulwich again asked Brown if he could make the required adjustments and was again told not to make them. Dulwich, however, believes that the adjust- ments should be made and that the external auditors should be informed of the situation. Since there are no established policies at Offset Press Company for resolving ethical conflicts, Dulwich is considering one of the following three alternative courses of action: • Follow Brown’s directive and do nothing further. • Attempt to convince Brown to make the proper adjustments and to advise the external auditors of her actions. • Tell the Audit Committee of the Board of Directors about the problem and give them the appropri- ate accounting data. Required: 1. As a group, discuss the situation at Offset. For each of the three alternative courses of action that Dulwich is considering, discuss whether or not the action is appropriate. 2. Independent of your answer to requirement (1), assume that Dulwich again approaches Brown to make the necessary adjustments and is unsuccessful. Discuss the steps that Dulwich should take in proceeding to resolve this situation. (CMA, adapted) ■ Problem 3–52 Ethical Issues; Underapplication of Manufacturing Overhead (LO 3-1, 3-2, 3-4, 3-6) hiL25664_ch03_078-131.indd 121hiL25664_ch03_078-131.indd 121 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer 122 Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment Marvelous Marshmallow Company’s cost of goods sold for January was $690,000. January 31 work- in-process inventory was 90 percent of January 1 work-in-process inventory. Manufacturing overhead applied was 50 percent of direct-labor cost. Other information pertaining to the company’s inventories and production for the month of January is as follows: Beginning inventories, January 1: Raw material ....................................................................................................................................... $ 34,000 Work in process ................................................................................................................................... 80,000 Finished goods .................................................................................................................................... 204,000 Purchases of raw material during January ................................................................................................. 226,000 Ending inventories, January 31: Raw material ....................................................................................................................................... 52,000 Work in process ................................................................................................................................... ? Finished goods .................................................................................................................................... 210,000 Required: 1. Prepare a schedule of cost of goods manufactured for the month of January. 2. Prepare a schedule to compute the prime costs (direct material and direct labor) incurred during January. 3. Prepare a schedule to compute the conversion costs (direct labor and manufacturing overhead) charged to work in process during January. (CPA, adapted) Biloxi Billiards Company uses normal costing, and manufacturing overhead is applied to work in process on the basis of machine hours. On January 1 of the current year there were no balances in work-in-process or finished-goods inventories. The following estimates were included in the current year’s budget. Total budgeted manufacturing overhead .................................................................................................. $306,000 Total budgeted machine hours ................................................................................................................ 51,000 During January, the firm began the following production jobs: M07: 1,200 machine hours T28: 3,000 machine hours B19: 1,800 machine hours During January, job numbers M07 and T28 were completed, and job number M07 was sold. The actual manufacturing overhead incurred during January was $38,000. Required: 1. Compute the company’s predetermined overhead rate for the current year. 2. How much manufacturing overhead was applied to production during January? 3. Calculate the overapplied or underapplied overhead for January. 4. Prepare a journal entry to close the balance calculated in requirement (3) into Cost of Goods Sold. 5. Prepare a journal entry to prorate the balance calculated in requirement (3) among the Work-in- Process Inventory, Finished-Goods Inventory, and Cost of Goods Sold accounts. Tiana Shar, the controller for Caesar Glassware Company, is in the process of analyzing the overhead costs for the month of November. She has gathered the following data for the month. ■ Problem 3–54 Proration of Overapplied or Underapplied Overhead (LO 3-2, 3-4, 3-5, 3-6) 2. Applied manufacturing overhead: $36,000 5. Proration amount: Work-in-Process Inventory: $10,800 ■ Problem 3–55 Overhead Application Using a Predetermined Overhead Rate (LO 3-2, 3-4, 3-5, 3-6) 2. Job 57, applied manufacturing overhead: $35,000 6. November, applied manufacturing overhead: $85,000 ■ Problem 3–53 Cost of Goods Manufactured; Prime and Conversion Costs (LO 3-2, 3-6) 1. Manufacturing overhead applied: $160,000 2. Raw material available for use: $260,000 hiL25664_ch03_078-131.indd 122hiL25664_ch03_078-131.indd 122 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment 123 Labor Direct-labor hours: Job 57 ...................................................................................................................................... 7,000 Job 58 ...................................................................................................................................... 6,000 Job 59 ...................................................................................................................................... 4,000 Labor costs: Direct-labor wages .................................................................................................................... $408,000 Indirect-labor wages .................................................................................................................. 30,000 Supervisory salaries ................................................................................................................... 12,000 Material Inventories, November 1: Raw material and supplies ......................................................................................................... $ 21,000 Work in process (Job 57) ........................................................................................................... 108,000 Finished goods .......................................................................................................................... 125,000 Purchases of raw material and supplies: Raw material ............................................................................................................................. $270,000 Supplies (indirect material) ......................................................................................................... 30,000 Direct material and supplies requisitioned for production: Job 57 ...................................................................................................................................... $ 90,000 Job 58 ...................................................................................................................................... 75,000 Job 59 ...................................................................................................................................... 51,000 Supplies (indirect material) ............................................................................................................. 24,000 Total ............................................................................................................................................. $240,000 Other Building occupancy costs (heat, light, depreciation, etc.) Factory facilities ........................................................................................................................ $ 12,800 Sales offices .............................................................................................................................. 3,200 Administrative offices ................................................................................................................. 2,000 Total ......................................................................................................................................... $ 18,000 Production equipment costs: Power ....................................................................................................................................... $ 8,200 Repairs and maintenance ........................................................................................................... 3,000 Depreciation .............................................................................................................................. 3,000 Other ........................................................................................................................................ 2,000 Total ......................................................................................................................................... $ 16,200 The firm’s job-order costing system uses direct-labor hours (measured at practical capacity) as the cost driver for overhead application. In December of the preceding year, Shar had prepared the following budget for direct-labor and manufacturing-overhead costs for the current year. The plant is theoretically capable of operating at 140,000 direct-labor hours per year. However, Shar estimates that the practical capacity is 115,000 hours in a typical year. Manufacturing Overhead Direct-Labor Hours Variable Fixed 100,000 ........................................................................................................ $300,000 $230,000 115,000 ........................................................................................................ 345,000 230,000 130,000 ........................................................................................................ 390,000 230,000 During November the following jobs were completed: Job 57 ............................................................................................................. 10 oz. water glasses Job 58 ............................................................................................................. 5 oz. juice glasses Required Assist Shar by making the following calculations. 1. Calculate the predetermined overhead rate for the current year. 2. Calculate the total cost of Job 57. 3. Compute the amount of manufacturing overhead applied to Job 59 during November. hiL25664_ch03_078-131.indd 123hiL25664_ch03_078-131.indd 123 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer 124 Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment 4. What was the total amount of manufacturing overhead applied during November? 5. Compute the actual manufacturing overhead incurred during November. 6. Calculate the overapplied or underapplied overhead for November. (CMA, adapted) Rochester Heating Systems, Inc. calculates its predetermined overhead rate on a quarterly basis. The following estimates were made for the current year. Estimated Manufacturing Overhead Estimated Direct-Labor Hours Quarterly Predetermined Overhead Rate (per direct-labor hour) First quarter .................................................. $ 400,000 50,000 ? Second quarter ............................................. 320,000 32,000 ? Third quarter ................................................ 200,000 25,000 ? Fourth quarter .............................................. 280,000 28,000 ? Total $1,200,000 135,000 The firm’s main product, part number SC71, requires $600 of direct material and 20 hours of direct labor per unit. The labor rate is $17 per hour. Required: 1. Calculate the firm’s quarterly predetermined overhead rate for each quarter. 2. Determine the cost of one unit of part number SC71 if it is manufactured in February versus May. 3. Suppose the company’s pricing policy calls for a 10 percent markup over cost. Calculate the price to be charged for a unit of part number SC71 if it is produced in February versus May. 4. Calculate the company’s predetermined overhead rate for the year if the rate is calculated annually. 5. Based on your answer to requirement (4), what is the cost of a unit of part number SC71 if it is manufactured in February? In May? 6. What is the price of a unit of part SC71 if the predetermined overhead rate is calculated annually? Conundrum, Inc. manufactures puzzles. Due to a fire in the administrative offices, the accounting records for September of the current year were partially destroyed. You have been able to piece together the following information from the ledger. ■ Problem 3–56 Predetermined Overhead Rate; Different Time Periods; Pricing (LO 3-4) 2. May, total cost: $1,140 5. February, total cost: $1,117.80 ■ Problem 3–57 Flow of Manufacturing Costs; Incomplete Data (LO 3-2, 3-4, 3-5) 4. $114,000 Raw-Material Inventory 120,000 Bal. 9/30 135,000 Accounts Payable 36,000 Bal. 8/31 Work-in-Process Inventory Bal. 8/31 24,000 Finished-Goods Inventory Bal. 8/31 105,000 Manufacturing Overhead 180,000 Cost of Goods Sold Wages Payable 4,500 Bal. 9/30 Sales Revenue Accounts Receivable Bal. 8/31 24,000 hiL25664_ch03_078-131.indd 124hiL25664_ch03_078-131.indd 124 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment 125 Upon examining various source documents and interviewing several employees, you were able to gather the following additional information. a. Collections of accounts receivable during September amounted to $615,000. b. Sales revenue in September was 120 percent of cost of goods sold. All sales are on account. c. Overhead is applied using an annual predetermined overhead rate using direct-labor hours (based on practical capacity). d. The budgeted overhead for the current year is $2,160,000. e. Budgeted direct-labor cost for the current year is $2,880,000. The direct-labor rate is $20 per hour. f. The accounts payable balance on September 30 was $3,000. Only purchases of raw material are credited to accounts payable. A payment of $243,000 was made on September 15. g. September’s cost of goods sold amounted to $540,000. h. The September 30 balance in finished-goods inventory was $15,000. i. Payments of $238,500 were made to direct-labor employees during September. The August 31 balance in the Wages Payable account was $3,000. j. The actual manufacturing overhead for September was $180,000. k. An analysis of the puzzles still in process on September 30 revealed that so far these items have required 1,500 hours of direct labor and $61,500 of direct material. Required: Calculate the following amounts. Then complete the T-accounts given in the problem. 1. Sales revenue for September. 2. September 30 balance in accounts receivable. 3. Cost of raw material purchased during September. 4. September 30 balance in work-in-process inventory. 5. Direct labor added to work in process during September. 6. Applied overhead for September. 7. Cost of goods completed during September. 8. Raw material used during September. 9. August 31 balance in raw-material inventory. 10. Overapplied or underapplied overhead for September. Bandway Company manufactures brass musical instruments for use by high school students. The com- pany uses a normal-costing system, in which manufacturing overhead is applied on the basis of direct- labor hours. The company’s budget for the current year included the following predictions. Budgeted total manufacturing overhead ................................................................................................... $462,000 Budgeted total direct-labor hours (based on practical capacity) .................................................................. 21,000 During October, the firm worked on the following two production jobs: Job number T79, consisting of 76 trombones Job number C41, consisting of 110 cornets The events of October are described as follows: a. One thousand square feet of rolled brass sheet metal was purchased on account for $6,000. b. Four hundred pounds of brass tubing was purchased on account for $5,200. c. The following requisitions were submitted on October 5: Requisition number 112: 260 square feet of brass sheet metal at $5.50 per square foot (for Job number T79) Requisition number 113: 1,100 pounds of brass tubing, at $9.00 per pound (for Job number C41) Requisition number 114: 10 gallons of valve lubricant, at $12 per gallon All brass used in production is treated as direct material. Valve lubricant is an indirect material. d. An analysis of labor time cards revealed the following labor usage for October. Direct labor: Job number T79, 850 hours at $20 per hour Direct labor: Job number C41, 950 hours at $20 per hour ■ Problem 3–58 Comprehensive Job-Order Costing Problem (LO 3-2, 3-4, 3-5, 3-6) 4. Total actual overhead: $36,230 7. Gross margin: $12,165 hiL25664_ch03_078-131.indd 125hiL25664_ch03_078-131.indd 125 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer 126 Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment Indirect labor: General factory cleanup, $4,500 Indirect labor: Factory supervisory salaries, $9,600 e. Depreciation of the factory building and equipment during October amounted to $13,000. f. Rent paid in cash for warehouse space used during October was $1,340. g. Utility costs incurred during October amounted to $2,400. The invoices for these costs were received, but the bills were not paid in October. h. October property taxes on the factory were paid in cash, $2,370. i. The insurance cost covering factory operations for the month of October was $2,900. The insur- ance policy had been prepaid. j. The costs of salaries and fringe benefits for sales and administrative personnel paid in cash during October amounted to $7,500. k. Depreciation on administrative office equipment and space amounted to $4,500. l. Other selling and administrative expenses paid in cash during October amounted to $1,150. m. Job number T79 was completed on October 20. n. Half of the trombones in Job number T79 were sold on account during October for $720 each. The October 1 balances in selected accounts are as follows: Cash .................................................................................................................................................... $ 11,000 Accounts Receivable ............................................................................................................................. 20,000 Prepaid Insurance ................................................................................................................................. 6,000 Raw-Material Inventory ......................................................................................................................... 150,000 Manufacturing Supplies Inventory .......................................................................................................... 600 Work-in-Process Inventory .................................................................................................................... 89,000 Finished-Goods Inventory ...................................................................................................................... 223,000 Accumulated Depreciation: Buildings and Equipment .............................................................................. 99,000 Accounts Payable ................................................................................................................................. 14,500 Wages Payable ..................................................................................................................................... 8,500 Required: 1. Calculate the company’s predetermined overhead rate for the year. 2. Prepare journal entries to record the events of October. 3. Set up T-accounts, and post the journal entries made in requirement (2). 4. Calculate the overapplied or underapplied overhead for October. Prepare a journal entry to close this balance into Cost of Goods Sold. 5. Prepare a schedule of cost of goods manufactured for October. 6. Prepare a schedule of cost of goods sold for October. 7. Prepare an income statement for October. Refer to the preceding problem regarding Bandway Company. Complete the job-cost record for Job number T79, which appears at the top of the next page. (Assume that all of the labor hours for job T79 occurred during the week of 10/8 through 10/12.) ColorTech Corporation manufactures two different color printers for the business market. Cost estimates for the two models for the current year are as follows (bottom of next page): ■ Problem 3–59 Job-Cost Record; Continuation of Preceding Problem (LO 3-2, 3-3, 3-4) Unit cost: $488.55 (rounded) ■ Problem 3–60 Plantwide versus Departmental Overhead Rates; Product Pricing (LO 3-1, 3-7) 2. Advanced system, price: $1,804 5. Basic system, price: $1,243 hiL25664_ch03_078-131.indd 126hiL25664_ch03_078-131.indd 126 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment 127 Basic System Advanced System Direct material ............................................................................................. $ 450 $ 900 Direct labor (20 hours at $16 per hour) ......................................................... 320 320 Manufacturing overhead * ............................................................................ 420 420 Total ............................................................................................................ $1,190 $1,640 *The predetermined overhead rate is $21 per direct-labor hour. Each model of printer requires 20 hours of direct labor. The basic system requires 5 hours in department A and 15 hours in department B. The advanced system requires 15 hours in department A BANDWAY COMPANY JOB-COST RECORD Job Number Date Started Description Date Completed Number of Units Completed Direct Material QuantityDate Requisition Number Unit Price Cost Direct Labor HoursDate Time Card Number Rate Cost Manufacturing Overhead QuantityDate Cost Driver (Activity Base) Application Rate Cost Cost Summary AmountCost Item Total direct material Total direct labor Total manufacturing overhead Total cost Unit cost T79 10/8 to 10/12 10–08 through 10–12 10/8 to 10/12 Shipping Summary Date Units Remaining in Inventory Cost BalanceUnits Shipped (Continuation of Problem 3–60) hiL25664_ch03_078-131.indd 127hiL25664_ch03_078-131.indd 127 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer 128 Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment and 5 hours in department B. The overhead costs budgeted in these two production departments are as follows: Department A Department B Variable cost ........................................................................... $17 per direct-labor hour $5 per direct-labor hour Fixed cost ............................................................................... $210,000 $210,000 The firm’s management expects to operate at a level of 21,000 direct-labor hours in each pro- duction department during the current year. (This estimate is based on the practical capacity of each department.) Required: 1. Show how the company’s predetermined overhead rate was determined. 2. If the firm prices each model of printer at 10 percent over its cost, what will be the price of each model? 3. Suppose the company were to use departmental predetermined overhead rates. Calculate the rate for each of the two production departments. 4. Compute the product cost of each model using the departmental overhead rates calculated in requirement (3). 5. Compute the price to be charged for each model, assuming the company continues to price each product at 10 percent above cost. Use the revised product costs calculated in requirement (4). 6. Write a memo to the president of ColorTech Corporation making a recommendation as to whether the firm should use a plantwide overhead rate or departmental rates. Consider the potential impli- cations of the overhead rates and the firm’s pricing policy. How might these considerations affect the firm’s ability to compete in the marketplace? Cases Liliana Richmond started KidCo, Inc. in Albuquerque, New Mexico to produce affordable children’s furnishings. The company uses a job-order costing system. KidCo’s work-in-process inventory at the end of November consisted of the following jobs . Job No. Description Units Accumulated Cost CBS102 ............................ Cribs ................................. 20,000 ............................. $ 900,000 PLP086 ............................. Playpens ........................... 15,000 ............................. 420,000 DRS114 ............................ Dressers ........................... 25,000 ............................. 250,000 Total ............................................................................................................................... $1,570,000 The company’s November 30 finished-goods inventory, which is valued using the FIFO (first-in, first-out) method, consisted of five items. Item Quantity and Unit Cost Accumulated Cost Cribs ............................................... 7,500 units @ $64 each .................................... $ 480,000 Strollers .......................................... 13,000 units @ $23 each .................................. 299,000 Carriages ........................................ 11,200 units @ $102 each ................................ 1,142,400 Dressers ......................................... 21,000 units @ $55 each .................................. 1,155,000 Playpens ......................................... 19,400 units @ $35 each .................................. 679,000 Total ............................................................................................................................... $3,755,400 KidCo applies manufacturing overhead on the basis of direct-labor hours. The company’s overhead budget for the year totals $4,500,000. The company plans to use 600,000 direct-labor hours during this period, which is the firm’s estimated practical capacity. Through the first 11 months of the year, a total of 555,000 direct-labor hours were worked, and total overhead amounted to $4,273,500. At the end of November, the balance in KidCo’s Raw-Material Inventory account, which includes both raw material and purchased parts, was $668,000. Additions to inventory and requisitions from inventory during December included the following. ■ Case 3–61 Interpreting Information from a Job-Order Costing System (LO 3-1, 3-2, 3-3, 3-4, 3-5, 3-6) 2. Manufacturing overhead rate: $7.50 per hour 3. Value of finished-goods inventory on 12/31: $455,600 hiL25664_ch03_078-131.indd 128hiL25664_ch03_078-131.indd 128 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment 129 Raw Material Purchased Parts Purchases ............................................................ $242,000 .................................. $396,000 Requisitions: Job CBS102 ..................................................... 51,000 ................................... 104,000 Job PLP086 ..................................................... 3,000 .................................. 10,800 Job DRS114 .................................................... 124,000 ................................... 87,000 Job STR077 (10,000 strollers) .......................... 62,000 .................................. 81,000 Job CRG098 (5,000 carriages) .......................... 65,000 .................................. 187,000 During December, KidCo’s factory payroll consisted of the following: CBS102 ............................................................... 12,000 hr. .............................. $122,400 PLP086 ................................................................ 4,400 hr. .............................. 43,200 DRS114 ............................................................... 19,500 hr. .............................. 200,500 STR077 ............................................................... 3,500 hr. .............................. 30,000 CRG098 ............................................................... 14,000 hr. .............................. 138,000 Indirect labor ........................................................ 3,000 hr. .............................. 29,400 Supervision ........................................................................................................................ 57,600 Total .............................................................................................................................. $621,100 The following list shows the jobs that were completed and the unit sales for December. Production Job No. Items Quantity Completed CBS102 ............ Cribs .................. 20,000 PLP086 ............. Playpens ............ 15,000 STR077 ............ Strollers ............. 10,000 CRG098 ............ Carriages ........... 5,000 Sales Items Quantity Shipped Cribs ................ 17,500 Playpens .......... 21,000 Strollers ........... 14,000 Dressers .......... 18,000 Carriages ......... 6,000 Required: 1. Explain when it is appropriate for a company to use a job-order costing system. 2. Calculate the dollar balance in KidCo’s Work-in-Process Inventory account as of December 31. 3. Calculate the dollar amount related to the playpens in KidCo’s Finished-Goods Inventory account as of December 31. (CMA, adapted) Opticom, Inc. a manufacturer of fiber optic communications equipment, uses a j ob-order costing sys- tem. Since the production process is heavily automated, manufacturing overhead is applied on the basis of machine hours using a predetermined overhead rate. The current annual rate of $30 per machine hour is based on budgeted manufacturing overhead costs of $2,400,000 and a budgeted activity level of 80,000 machine hours (the company’s estimated practical capacity). Operations for the year have been completed, and all of the accounting entries have been made for the year except the application of manu- facturing overhead to the jobs worked on during December, the transfer of costs from Work in Process to Finished Goods for the jobs completed in December, and the transfer of costs from Finished Goods to Cost of Goods Sold for the jobs that have been sold during December. Summarized data as of November 30 and for the month of December are presented in the following table. Jobs T11-007, N11-013, and N11-015 were completed during December. All completed jobs except Job N11-013 had been turned over to customers by the close of business on December 31. ■ Case 3–62 Cost Flows in a Job-Order Costing System; Schedule of Cost of Goods Manufactured; Automation (LO 3-2, 3-4, 3-5, 3-6) 3. Manufacturing overhead applied in December: $180,000 6. Total actual manufacturing overhead: $2,392,000 Ex hiL25664_ch03_078-131.indd 129hiL25664_ch03_078-131.indd 129 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer 130 Chapter 3 Product Costing and Cost Accumulation in a Batch Production Environment Work-in-Process December Activity Job No. Balance November 30 Direct Material Direct Labor Machine Hours T11-007 ..................... $174,000 $ 3,000 ................... $ 9,000 .................... 300 N11-013 ..................... 110,000 8,000 ................... 24,000 .................... 1,000 N11-015 ..................... -0- 51,200 ................... 53,400 .................... 1,400 D12-002 ..................... -0- 75,800 ................... 40,000 .................... 2,500 D12-003 ..................... -0- 52,000 ................... 33,600 .................... 800 Total ........................ $284,000 $190,000 ................... $160,000 .................... 6,000 Operating Activity Activity through November 30 December Activity Actual manufacturing overhead incurred: Indirect material ....................................................... $ 250,000 ...................................... $ 18,000 Indirect labor ........................................................... 690,000 ...................................... 60,000 Utilities .................................................................... 490,000 44,000 Depreciation ............................................................ 770,000 ...................................... 70,000 Total overhead ......................................................... $2,200,000 ..................................... $192,000 Other data: Raw-material purchases* .......................................... $1,930,000 ..................................... $196,000 Direct-labor costs .................................................... $1,690,000 ..................................... $160,000 Machine hours ........................................................ 73,000 ..................................... 6,000 Account Balances at Beginning of Year January 1 Raw-material inventory * ................................................................... $210,000 Work-in-process inventory ................................................................. 120,000 Finished-goods inventory ................................................................... 250,000 *Raw material purchases and raw-material inventory consist of both direct and indirect materials. The balance of the Raw-Material Inventory account as of December 31 of the year just completed is $170,000. Required: 1. Explain why manufacturers use a predetermined overhead rate to apply manufacturing overhead to their jobs. 2. How much manufacturing overhead would Opticom have applied to jobs through November 30 of the year just completed? 3. How much manufacturing overhead would have been applied to jobs during December of the year just completed? 4. Determine the amount by which manufacturing overhead is overapplied or underapplied as of December 31 of the year just completed. 5. Determine the balance in the Finished-Goods Inventory account on December 31 of the year just completed. 6. Prepare a Schedule of Cost of Goods Manufactured for Opticom, Inc. for the year just completed. ( Hint: In computing the cost of direct material used, remember that Opticom includes both direct and indirect material in its Raw-Material Inventory account.) (CMA, adapted) hiL25664_ch03_078-131.indd 130hiL25664_ch03_078-131.indd 130 6/22/13 8:06 PM6/22/13 8:06 PM Final PDF to printer This page intentionally left blank 4 FOCUS COMPANY >>>
Process Costing and Hybrid
Product-Costing Systems
MVP
Sports Equipment Company
THIS CHAPTER’S FOCUS COMPANY is the MVP
Sports Equipment Company. The company’s Wisconsin
Division manufactures baseball gloves in its Milwaukee
plant. MVP’s Wisconsin Division uses a product-
costing method called process costing. Under process costing, direct
material and conversion costs (direct labor and manufacturing over-
head) are first assigned to each of the processes (or departments)
used in the manufacturing operation. Then, the costs of each process (or department) are
assigned to the units worked on in the department. Process costing is used by manufacturing
companies that produce relatively large numbers of similar products.
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In contrast to the process-costing system used in MVP’s Wisconsin Division,
we explore a different product-costing system in the company’s Minnesota
Division. This MVP division manufactures two types of basketballs in its
Minneapolis plant. The professional basketballs are covered with genuine
leather, whereas the scholastic basketballs are covered with imitation leather. Except for
the different exterior material, though, each basketball requires the same production steps.
MVP’s Minnesota Division uses a product-costing system called operation costing, which is
well suited to its production environment.
<<< IN CONTRAST MVP Sports Equipment Company hiL25664_ch04_132-163.indd 133hiL25664_ch04_132-163.indd 133 7/4/13 2:51 AM7/4/13 2:51 AM Final PDF to printer 134 After completing this chapter, you should be able to: We have seen that a product-costing system performs two primary functions: 1. Accumulating production costs. 2. Assigning those production costs to the firm's products. Product costs are needed for the purposes of planning, cost management, decision mak- ing, and reporting to various outside organizations, such as governmental regulatory agencies. Job-order costing was described in Chapter 3. This type of product-costing system is used when relatively small numbers of products are produced in distinct batches or job orders and these products differ significantly from each other. This chapter covers process-costing systems. Process costing is used in repetitive production environments, where large numbers of identical or very similar products are manufactured in a continu- ous flow. Industries using process costing include paper, petroleum, chemicals, textiles, food processing, lumber, and electronics. Comparison of Job-Order Costing and Process Costing In many ways, job-order costing and process costing are similar. Both product-costing systems have the same ultimate purpose—assignment of production costs to units of out- put. Moreover, the flow of costs through the manufacturing accounts is the same in the two systems. Flow of Costs Exhibit 4–1 displays the flow of costs in two process-costing situations: one with a sin- gle production department and one with two production departments used in sequence. The same accounts are used in this process-costing illustration as were used in job-order costing in the preceding chapter. As the illustration shows, direct-material, direct-labor, Comparison of Job-Order Costing and Process Costing 4-1 List and explain the similarities and important differences between job-order and process costing. 4-2 Prepare journal entries to record the flow of costs in a process-costing system with sequential production departments. 4-3 Prepare a table of equivalent units under weighted-average process costing. 4-4 Compute the cost per equivalent unit under the weighted-average method of process costing. 4-5 Analyze the total production costs for a department under the weighted-average method of process costing. 4-6 Prepare a departmental production report under weighted-average process costing. 4-7 Describe how an operation costing system accumulates and assigns the costs of direct-material and conversion activity in a batch manufacturing process. Learning Objective 4-1 List and explain the similarities and important differences between job-order and process costing. hiL25664_ch04_132-163.indd 134hiL25664_ch04_132-163.indd 134 7/4/13 2:51 AM7/4/13 2:51 AM Final PDF to printer Chapter 4 Process Costing and Hybrid Product-Costing Systems 135 and manufacturing-overhead costs are added to a Work-in-Process Inventory account. As goods are finished, costs are transferred to Finished-Goods Inventory. During the period when goods are sold, the product costs are transferred to Cost of Goods Sold. In the two-department case, when goods are finished in the first production department, costs accumulated in the Work-in-Process Inventory account for production department A are transferred to the Work-in-Process Inventory account for production department B. The journal entries for the case of two sequential production departments, as illus- trated in Exhibit 4–1 , are as follows. (The numbers used in the journal entries are assumed for the purpose of showing the form of the entries.) 1. As direct material and direct labor are used in production department A, these costs are added to the Work-in-Process Inventory account for department A. Overhead is applied using a predetermined overhead rate. The predetermined overhead rate is computed in the same way in job-order and process costing. Work-in-Process Inventory: Production Department A ............................. 100,000 Raw-Material Inventory ....................................................... 50,000 Wages Payable ............................................................... 20,000 Manufacturing Overhead ..................................................... 30,000 2. When production department A completes its work on some units of product, these units are transferred to production department B. The costs assigned to these goods are transferred from the Work-in-Process Inventory account for department A to the Work-in-Process Inventory account for department B. In department B, the costs assigned to these partially completed products are called transferred-in costs. Learning Objective 4-2 Prepare journal entries to record the flow of costs in a process-costing system with sequential production departments. Exhibit 4–1 Flow of Costs in Process- Costing Systems Work-in-Process Inventory Finished-Goods Inventory Cost of Goods Sold Direct material Direct labor Applied manufacturing overhead Cost of goods completed and transferred to finished goods Cost of goods sold during current period One Production Department Work-in-Process Inventory: Production Department A Work-in-Process Inventory: Production Department B Direct material Direct labor Applied manufacturing overhead Cost of goods completed in department A and transferred to department B Cost of goods completed and transferred to finished goods Finished-Goods Inventory Cost of Goods Sold Direct material Direct labor Applied manufacturing overhead Cost of goods sold during current period Two Sequential Production Departments hiL25664_ch04_132-163.indd 135hiL25664_ch04_132-163.indd 135 7/4/13 2:51 AM7/4/13 2:51 AM Final PDF to printer 136 Chapter 4 Process Costing and Hybrid Product-Costing Systems Work-in-Process Inventory: Production Department B ...................................... 80,000 Work-in-Process Inventory: Production Department A .............................. 80,000 3. Direct material and direct labor are used in production department B, and man- ufacturing overhead is applied using a predetermined overhead rate. Work-in-Process Inventory: Production Department B ..................................... 75,000 Raw-Material Inventory ........................................................................ 40,000 Wages Payable .................................................................................... 15,000 Manufacturing Overhead ...................................................................... 20,000 4. Goods are completed in production department B and transferred to the fin- ished-goods warehouse. Finished-Goods Inventory ............................................................................. 130,000 Work-in-Process Inventory: Production Department B ............................ 130,000 5. Goods are sold. Cost of Goods Sold ...................................................................................... 125,000 Finished-Goods Inventory ..................................................................... 125,000 Differences Between Job-Order and Process Costing In job-order costing, costs are accumulated by job order and recorded on job-cost records. The cost of each unit in a particular job order is found by dividing the total cost of the job order by the number of units in the job. In process costing, costs are accumulated by department, rather than by job order or batch. The cost per unit is found by averaging the total costs incurred over the units produced. Exhibit 4–2 summarizes this key difference between job-order and process costing. Equivalent Units: A Key Concept Material, labor, and overhead costs often are incurred at different rates in a production process. Direct material is usually placed into production at one or more discrete points in the process. In contrast, direct labor and manufacturing overhead, called conversion costs, usually are incurred continuously throughout the process. When an accounting period ends, the partially completed goods that remain in process generally are at differ- ent stages of completion with respect to material and conversion activity. For example, the in-process units may be 75 percent complete with respect to conversion, but they may already include all of their direct materials. This situation is portrayed in Exhibit 4–3 . Equivalent Units The graphical illustration in Exhibit 4–3 supposes there are 1,000 physical units in pro- cess at the end of an accounting period. Each of the physical units is 75 percent complete with respect to conversion (direct labor and manufacturing overhead). How much con- version activity has been applied to these partially completed units? Conversion activity occurs uniformly throughout the production process. Therefore, the amount of conver- sion activity required to do 75 percent of the conversion on 1,000 units is equivalent to the amount of conversion activity required to do all of the conversion on 750 units. This number is computed as follows: 1,000 partially completed physical units in process 3 75% complete with respect to conversion 5 750 equivalent units Equivalent Units: A Key Concept “Process-based costing pro- vided our first opportunity to convert the functional budget into process costing. It allowed us to look at what drives the costs of the indi- vidual processes.” (4a) John Deere Health Care, Inc. Learning Objective 4-1 List and explain the similari- ties and important differences between job-order and process costing. Learning Objective 4-3 Prepare a table of equivalent units under weighted-average process costing. hiL25664_ch04_132-163.indd 136hiL25664_ch04_132-163.indd 136 7/4/13 2:51 AM7/4/13 2:51 AM Final PDF to printer Chapter 4 Process Costing and Hybrid Product-Costing Systems 137 The term equivalent units is used in process costing to refer to the amount of manufac- turing activity that has been applied to a batch of physical units. The 1,000 physical units in process represent 750 equivalent units of conversion activity. The term equivalent units also is used to measure the amount of direct materials rep- resented by the partially completed goods. Since direct materials are incorporated at the beginning of the production process, the 1,000 physical units represent 1,000 equivalent units of direct material (1,000 physical units 3 100% complete with respect to direct materials). The most important feature of process costing is that the costs of direct material and conversion are assigned to equivalent units rather than to physical units. Refer again to Exhibit 4–3 . For simplicity, suppose that the only production activity of the current accounting period was to start work on the 1,000 physical units and complete 75 percent of the required conversion activity. Assume that the costs incurred were $1,500 for con- version (direct labor and manufacturing overhead) and $5,000 for direct material. These costs would then be assigned as follows: $1,500 conversion cost ____________________________ 750 equivalent units of conversion 5 $2.00 per equivalent unit for conversion $5,000 direct-material cost _________________________________ 1,000 equivalent units of direct material 5 $5.00 per equivalent unit for direct material This is a highly simplified example because there is no work-in-process inventory at the beginning of the accounting period and no goods were completed during the period. Nevertheless, it illustrates the important concept that under process costing, costs are assigned to equivalent units rather than physical units. Exhibit 4–2 Comparison of Job-Order and Process Costing A. Job-Order Costing: Accumulates Costs by Job Order Work-in-Process Inventory Finished- Goods Inventory Cost of Goods Sold B. Process Costing: Accumulates Costs by Production Department Direct material Direct labor Manufacturing overhead Cost of Goods Sold Finished-Goods Inventory Work-in-Process Inventory: Production Department B Direct material Direct labor Manufacturing overhead Job 1 Job 3 Job 2 Work-in-Process Inventory: Production Department A “Operations [managers] have a keen interest in cost management. To truly man- age costs, you must look at the processes involved.” (4b) John Deere Health Care, Inc. hiL25664_ch04_132-163.indd 137hiL25664_ch04_132-163.indd 137 7/4/13 2:51 AM7/4/13 2:51 AM Final PDF to printer 138 Chapter 4 Process Costing and Hybrid Product-Costing Systems Illustration of Process Costing The key document in a typical process-costing system is the departmental production report, prepared for each production department at the end of every accounting period. This report replaces the job-cost record, which is used to accumulate costs by job in a job-order costing system. The departmental production report summarizes the flow of production quantities through the department, and it shows the amount of production cost transferred out of the department's Work-in-Process Inventory account during the period. The following four steps are used in preparing a departmental production report. 1. Analysis of physical flow of units. 2. Calculation of equivalent units (for direct material and conversion activity). 3. Computation of unit costs (i.e., the cost per equivalent unit for direct material and conversion). 4. Analysis of total costs (determine the cost to be removed from work in process and transferred either to the next production department or to finished goods). The method of process costing that we will focus on in this chapter is called the weighted-average method. This method is almost always used in practice by companies Illustration of Process Costing Exhibit 4–3 Direct Material and Conver- sion Activity in a Typical Pro- duction Process When the accounting period ends, the partially completed goods are 75% complete with respect to conversion. The goods are 100% complete with respect to direct material. Conversion activity (direct labor and manufacturing overhead) applied uniformly throughout the process Direct material is placed into production at the beginning of the production process. Production Process (e.g., chemical refining process) Process costing is used in the wine industry. First, raw material (in this case, grapes) is harvested and entered into production. Then conversion costs are incurred in the production process. At the end of the accounting period, partially completed units of wine remain in process as the wine ages. hiL25664_ch04_132-163.indd 138hiL25664_ch04_132-163.indd 138 7/4/13 2:51 AM7/4/13 2:51 AM Final PDF to printer Chapter 4 Process Costing and Hybrid Product-Costing Systems 139 using process costing. There is another process-costing method called the first-in, first- out, or FIFO, method. This method is covered in some cost accounting courses, but it is rarely used in practice. 1 Basic Data for Illustration The Wisconsin Division of MVP Sports Equipment Company manufactures baseball gloves in its Milwaukee plant. In the Cutting Department, direct material consisting of imitation leather is placed into production at the beginning of the process. Direct-labor and manufacturing overhead costs are incurred uniformly throughout the process. The material is rolled to make it softer and then cut into the pieces needed to produce baseball gloves. The predetermined overhead rate used in the Cutting Department is 125 percent of direct-labor cost. The Excel spreadsheet in Exhibit 4–4 presents a summary of the activity and costs in the Cutting Department during March. The direct-material and conversion costs listed in Exhibit 4–4 for the March 1 work in process consist of costs that were incurred during Feb- ruary. These costs were assigned to the units remaining in process at the end of February. Based on the data in Exhibit 4–4 , the Cutting Department's Work-in-Process Inven- tory account has the following balance on March 1: Work-in-Process Inventory: Cutting Department March 1 balance 57,200 1 The FIFO method of process costing is also covered in a supplement to this text titled Process Costing: The First-In, First-Out Method. This supplement is available to students and instructors on the text website: http://www.mhhe.com/hilton10e. MVP Sports Equipment Company Exhibit 4–4 Basic Data for Illustration— Cutting Department MVP Sports Equipment Company hiL25664_ch04_132-163.indd 139hiL25664_ch04_132-163.indd 139 7/4/13 2:51 AM7/4/13 2:51 AM Final PDF to printer 140 Chapter 4 Process Costing and Hybrid Product-Costing Systems NEW YORK WINE INDUSTRY The New York State wine industry, the second largest in the United States after California, contributes nearly $4 billion to the state’s economy annually. The Empire State’s 30 thou- sand acres of vineyards and 212 wineries produce over 200 million bottles of wine each year. New York wineries in the Finger Lakes region, in the Hudson Valley, along the Lake Erie shoreline, in the Niagara escarpment area, and on Long Island constitute the fastest- growing segment of New York’s two largest industries: agriculture and tourism. Wine production provides an excellent example of process costing. The processes used in a typical Finger Lakes area vineyard are as follows: 2 • Trimming: At the end of a growing season, the vines are trimmed, which helps prepare them for the next harvest. • Tying: The vines are tied onto wires to help protect them from the weather. (This also occurs at the end of the season.) • Hilling: Dirt is piled up around the roots to further protect them. • Conditioning: In the spring, dirt is leveled back from the roots. • Untying: The vines are untied from the wires to allow them freedom to grow dur- ing the spring and summer months. • Chemical spraying: The vines are sprayed in the spring to protect them from disease and insects. • Harvesting: The highest-quality grapes are picked by hand to minimize damage. • Stemming and crushing: Batches of grapes are loaded into a machine, which gently removes the stems and mildly crushes them. • Pressing: After removal from the stemmer/crusher, the juice runs freely from the grapes. • Filtering: The grapes are crushed mechanically to render more juice from them. • Fermentation: This process varies, depending on the type of wine. For example, riesling grape juice is placed in stainless-steel tanks for fermentation. Chardon- nay grape juice undergoes a two-stage fermentation process in oak barrels. • Aging: Again, this process varies. Riesling wines are aged in the stainless-steel tanks for approximately a year. Chardonnays are aged in the oak barrels for about two years. • Bottling: A machine bottles the wine and corks the bottles. • Labeling: Each bottle is labeled with the name of the vintner, vintage, and variety. • Packing: The bottles are packed in 12-bottle cases. • Case labeling: The cases are stamped with the same information as is on the bottles. • Shipping: The wine is shipped to wine distributors and retailers. M A P anagement ccounting ractice 2 Based on the author’s research, and D.J. Groom, “Wine Industry Important to New York State,” Syracuse Post- Standard, January 10, 2010. The following journal entry is made during March to add the costs of direct material, direct labor, and manufacturing overhead to Work-in-Process Inventory. Work-in-Process Inventory: Cutting Department ..................................... 283,500 Raw-Material Inventory ................................................................ 90,000 Wages Payable ............................................................................ 86,000 Manufacturing Overhead .............................................................. 107,500 hiL25664_ch04_132-163.indd 140hiL25664_ch04_132-163.indd 140 7/4/13 2:51 AM7/4/13 2:51 AM Final PDF to printer Chapter 4 Process Costing and Hybrid Product-Costing Systems 141 Weighted-Average Method of Process Costing We now present the four steps used to prepare a departmental production report using weighted-average process costing. Step 1: Analysis of Physical Flow of Units The first step is to prepare a table sum- marizing the physical flow of production units during March. The table is shown in Exhibit 4–5 and reflects the following inventory formula. ( Physical units in beginning work in process ) 1 ( Physical units started ) 2 ( Physical units completed and transferred out ) 5 ( Physical units in ending work in process ) Step 2: Calculation of Equivalent Units The second step in the process-costing procedure is to calculate the equivalent units of direct material and conversion activity. A table of equivalent units, displayed in Exhibit 4–6 , is based on the table of physical flows prepared in step 1 ( Exhibit 4–5 ). The 40,000 physical units that were completed and transferred out of the Cutting Department were 100 percent complete. Thus, they represent 40,000 equivalent units for both direct material and conversion. The 10,000 units in the ending work-in-process inventory are complete with respect to direct mate- rial, and they represent 10,000 equivalent units of direct material. However, they are only 50 percent complete with respect to conversion. Therefore, the ending work-in-process inventory represents 5,000 equivalent units of conversion activity (10,000 physical units 3 50% complete). As Exhibit 4–6 indicates, the total number of equivalent units is calculated: ( Equivalent units of activity in units completed and transferred out ) 1 ( Equivalent units of activity in ending work in process ) 5 ( Total equivalent units of activity ) Learning Objective 4-3 Prepare a table of equivalent units under weighted-average process costing. Physical Units Work in process, March 1 .............................................................................. 20,000 Units started during March ............................................................................ 30,000 Total units to account for ............................................................................... 50,000 Units completed and transferred out during March .......................................... 40,000 Work in process, March 31 ............................................................................ 10,000 Total units accounted for ............................................................................... 50,000 MVP Sports Equipment Company Exhibit 4–5 Step 1: Analysis of Physi- cal Flow of Units—Cutting Department Physical Units Percentage of Completion with Respect to Conversion Equivalent Units Direct Material Conversion Work in process, March 1 ........................................ 20,000 10% Units started during March ...................................... 30,000 Total units to account for ......................................... 50,000 Units completed and transferred out during March .... 40,000 100% 40,000 40,000 Work in process, March 31 ...................................... 10,000 50% 10,000 5,000 Total units accounted for ......................................... 50,000 _____ _____ Total equivalent units .............................................. 50,000 45,000 MVP Sports Equipment Company Exhibit 4–6 Step 2: Calculation of Equiva- lent Units—Cutting Depart- ment (weighted-average method) hiL25664_ch04_132-163.indd 141hiL25664_ch04_132-163.indd 141 7/4/13 2:51 AM7/4/13 2:51 AM Final PDF to printer 142 Chapter 4 Process Costing and Hybrid Product-Costing Systems Note that the total equivalent units of activity, for both direct material and conversion, exceeds the activity accomplished in the current period alone. Since only 30,000 physi- cal product units were started during March and direct material is added at the beginning of the process, only 30,000 equivalent units of direct material were actually placed into production during March. However, the total number of equivalent units of direct mate- rial used for weighted-average process costing is 50,000 (see Exhibit 4–6 ). The other 20,000 equivalent units of direct material were actually entered into production during the preceding month. This is the key feature of the weighted-average method. The number of equivalent units of activity is calculated without making a distinction as to whether the activity occurred in the current accounting period or the preceding period. Step 3: Computation of Unit Costs The third step in the process-costing procedure, calculating the cost per equivalent unit for both direct material and conversion activity, is presented in Exhibit 4–7 . The cost per equivalent unit for direct material is computed by dividing the total direct-material cost, including the cost of the beginning work in process and the cost incurred during March, by the total equivalent units (from step 2, Exhibit 4–6 ). An analogous procedure is used for conversion costs. Step 4: Analysis of Total Costs Now we can complete the process-costing pro- cedure by determining the total cost to be transferred out of the Cutting Department's Work-in-Process Inventory account and into the Stitching Department's Work-in-Process Inventory account. Exhibit 4–8 provides the required calculations. For convenience, the computations in step 3 are repeated in Exhibit 4–8 . At the bottom of Exhibit 4–8 , a check is made to be sure that the total costs of $340,700 have been fully accounted for in the cost of goods completed and transferred out and the balance remaining in work-in-pro- cess inventory. The calculations in Exhibit 4–8 are used as the basis for the following journal entry to transfer the cost of goods completed and transferred out of the Cutting Department. Work-in-Process Inventory: Stitching Department .............................................................. 290,400 Work-in-Process Inventory: Cutting Department ......................................................... 290,400 On March 31, the Cutting Department's Work-in-Process Inventory account appears as follows. The March 31 balance in the account agrees with that calculated in Exhibit 4–8 . Learning Objective 4-4 Compute the cost per equiva- lent unit under the weighted- average method of process costing. Learning Objective 4-5 Analyze the total production costs for a department under the weighted-average method of process costing. Exhibit 4–7 Step 3: Computation of Unit Costs—Cutting Department (weighted-average method) MVP Sports Equipment Company Direct Material Conversion Total Work in process, March 1 (from Exhibit 4–4) ................................. $ 50,000 $ 7,200 $ 57,200 Costs incurred during March (from Exhibit 4–4) ............................. 90,000 193,500 283,500 Total costs to account for ............................................................. $140,000 $200,700 $340,700 Equivalent units (from step 2, Exhibit 4–6) ..................................... 50,000 45,000 Costs per equivalent unit .............................................................. $2.80 $4.46 $7.26 $ , , 140 000 50 000 $ , , 200 700 45 000 $2.80 1 $4.46 Work-in-Process Inventory: Cutting Department March 1 balance 57,200 March cost of direct material, direct labor, and applied manufacturing overhead 283,500 290,400 Cost of goods completed and transferred out of Cutting Department March 31 balance 50,300 hiL25664_ch04_132-163.indd 142hiL25664_ch04_132-163.indd 142 7/4/13 2:51 AM7/4/13 2:51 AM Final PDF to printer Chapter 4 Process Costing and Hybrid Product-Costing Systems 143 Direct Material Conversion Total Work in process, March 1 (from Exhibit 4–4) ............................... $ 50,000 $ 7,200 $ 57,200 Costs incurred during March (from Exhibit 4–4) ........................... 90,000 193,500 283,500 Total costs to account for ........................................................... $140,000 $200,700 $340,700 Equivalent units (from step 2, Exhibit 4–6) ................................... 50,000 45,000 Costs per equivalent unit ............................................................ $2.80 $4.46 $7.26 $140,000 ________ 50,000 $200,700 ________ 45,000 $2.80 1 $4.46 Cost of goods completed and transferred out of the Cutting Department during March: ( Number of units transferred out ) 3 ( Total cost per equivalent unit ) .............................. 40,000 3 $7.26 .......................................... $290,400 Cost remaining in March 31 work-in-process inventory in the Cutting Department: Direct material: ( Number of equivalent units of direct material ) 3 ( Cost per equivalent unit of direct material ) .......... 10,000 3 $2.80 ........................................... $ 28,000 Conversion: ( Number of equivalent units of conversion ) 3 ( Cost per equivalent unit of conversion ) ............... 5,000 3 $4.46 ............................................ 22,300 Total cost of March 31 work in process .......................................................................................................... $ 50,300 Check: Cost of goods completed and transferred out ....................................................................................... $290,400 Cost of March 31 work-in-process inventory ....................................................................................... 50,300 Total costs accounted for ................................................................................................................... $340,700 Exhibit 4–8 Step 4: Analysis of Total Costs—Cutting Department (weighted-average method) MVP Sports Equipment Company Departmental Production Report We have now completed all four steps necessary to prepare the March production report for the Cutting Department. The report, which is displayed in Exhibit 4–9 , simply combines the tables presented in Exhibits 4–6 and 4–8 . The report provides a convenient summary of all of the process-costing calculations made under the weighted-average method. Why is this process-costing method called the weighted-average method? Be- cause the cost per equivalent unit for March, for both direct material and conversion activity, is computed as a weighted average of the costs incurred during two different accounting periods, February and March. To demonstrate this fact, we will focus on direct material. Since direct material is placed into production at the beginning of the process, the 20,000 physical units in the March 1 work in process already have their direct material. The direct-material cost per equivalent unit in the March 1 work in pro- cess is $2.50 ($50,000 4 20,000, from Exhibit 4–4 ). This cost was actually incurred in February. In March, 30,000 physical units were entered into work in process and received their direct material. The direct-material cost incurred in March was $90,000. Thus, the direct-material cost per equivalent unit experienced in March was $3.00 ($90,000 4 30,000). Under the weighted-average method of process costing, the cost per equivalent unit for direct material was calculated in Exhibit 4–7 to be $2.80. This $2.80 unit-cost figure is a weighted average, as the calculation at the top of page 144 shows. The point of this demonstration is that under weighted-average process costing, unit-cost figures are weighted averages of costs incurred over two or more accounting periods. Learning Objective 4-6 Prepare a departmental pro- duction report under weighted- average process costing. “The goal is for manage- ment to use the [cost] infor- mation daily. We want to . . . make sure that people have the information they need to make more informed deci- sions.” (4c) John Deere Health Care, Inc. hiL25664_ch04_132-163.indd 143hiL25664_ch04_132-163.indd 143 7/4/13 2:51 AM7/4/13 2:51 AM Final PDF to printer 144 Chapter 4 Process Costing and Hybrid Product-Costing Systems Weights Direct-material Proportion of total equiv- Direct- Proportion of total Weighted- cost per alent units of direct material cost equivalent units average cost equivalent unit material in the beginning per equivalent of direct material per equivalent in February work-in-process unit in March added during March unit of direct inventory material $2.50 20,000 20,000 30,000 $3.00 30,000 20,000 30,000 $2.80 Exhibit 4–9 March Production Report: Cutting Department (weighted-average method) MVP Sports Equipment Company MVP SPORTS EQUIPMENT COMPANY March Production Report: Cutting Department Physical Units Percentage of Completion with Respect to Conversion Equivalent Units Direct Material Conversion Work in process, March 1 ........................................ 20,000 10% Units started during March ...................................... 30,000 Total units to account for ......................................... 50,000 Units completed and transferred out during March .... 40,000 100% 40,000 40,000 Work in process, March 31 ...................................... 10,000 50% 10,000 5,000 Total units accounted for ......................................... 50,000 _____ _____ Total equivalent units ............................................... 50,000 45,000 Direct Material Conversion Total Work in process, March 1 (from Exhibit 4–4) ............... $ 50,000 $ 7,200 $ 57,200 Costs incurred during March (from Exhibit 4–4) ........... 90,000 193,500 283,500 Total costs to account for ........................................... $140,000 $200,700 $340,700 Equivalent units (from step 2, Exhibit 4–6) ................... 50,000 45,000 Costs per equivalent unit ............................................ $2.80 $4.46 $7.26 $140,000 ________ 50,000 $200,700 ________ 45,000 $2.80 1 $4.46 Cost of goods completed and transferred out of the Cutting Department during March: ( Number of units transferred out ) 3 ( Total cost per equivalent unit ) ......................... 40,000 3 $7.26 ............................................... $290,400 Cost remaining in March 31 work-in-process inventory in the Cutting Department: Direct material: ( Number of equivalent units of direct material ) 3 ( Cost per equivalent unit of direct material ) ...... 10,000 3 $2.80 ............................................... $ 28,000 Conversion: ( Number of equivalent units of conversion ) 3 ( Cost per equivalent unit of conversion ) .......... 5,000 3 $4.46 ................................................. 22,300 Total cost of March 31 work in process .......................................................................................................... $ 50,300 Check: Cost of goods completed and transferred out ....................................................................................... $290,400 Cost of March 31 work-in-process inventory .......................................................................................... 50,300 Total costs accounted for ...................................................................................................................... $340,700 hiL25664_ch04_132-163.indd 144hiL25664_ch04_132-163.indd 144 7/4/13 2:51 AM7/4/13 2:51 AM Final PDF to printer Chapter 4 Process Costing and Hybrid Product-Costing Systems 145 Other Issues in Process Costing Several other issues related to process costing are worth discussion. Actual versus Normal Costing Our illustration of process costing assumed that normal costing was used. As explained in Chapter 3, in a normal-costing system, direct material and direct labor are applied to Work-in-Process Inventory at their actual amounts, but manufacturing overhead is applied to Work-in-Process Inventory using a predetermined overhead rate. In contrast, under an actual-costing system, the actual costs of direct material, direct labor, and man- ufacturing overhead are entered into Work-in-Process Inventory. Either actual or normal costing may be used in conjunction with a process-costing system. Our illustration used normal costing since a predetermined overhead rate was used to compute applied manufacturing overhead in Exhibit 4–4 . This resulted in applied overhead for March of $107,500 (125% 3 $86,000). If actual costing had been used, the manufacturing overhead cost for March would have been the actual overhead cost incurred instead of the applied overhead amount given in Exhibit 4–4 . In all other ways, the process-costing procedures used under actual and normal costing are identical. When normal costing is used, there may be overapplied or underapplied overhead at the end of the period. This amount is either closed into Cost of Goods Sold or prorated, as explained in Chapter 3. Other Cost Drivers for Overhead Application Our illustration used a predetermined overhead rate based on direct-labor cost. Since the application of manufacturing overhead was based on direct-labor cost, direct labor and manufacturing overhead were combined into the single cost element conversion costs. This procedure is quite common in practice. If some cost driver (or activity base) other than direct labor had been used to apply manufacturing overhead, then overhead costs would be accounted for separately from direct-labor costs in the process-costing calculations. Suppose, for example, that manufacturing overhead is applied on the basis of machine hours. A group of 100 physical units is 100 percent complete as to direct mate- rial, 60 percent complete as to direct labor, and 40 percent complete as to machine time. This situation could arise in a production process that is labor-intensive in its early stages but more automated in its later stages. In this case, the 100 physical units represent the following quantities of equivalent units: Other Issues in Process Costing Physical Units 100 Equivalent Units Direct Material 100 Direct Labor 60 Manufacturing Overhead 40 100 3 100% 100 3 60% 100 3 40% Throughout the entire process-costing procedure, there will now be three cost elements (direct material, direct labor, and manufacturing overhead) instead of only two (direct material and conversion). In all other respects, the process-costing calculations will be identical to those illustrated earlier in the chapter. Subsequent Production Departments In our illustration, production requires two sequential production operations: cutting and stitching. Although the process-costing procedures for the second department are similar to those illustrated for the first, there is one additional consideration. The cost of hiL25664_ch04_132-163.indd 145hiL25664_ch04_132-163.indd 145 7/4/13 2:51 AM7/4/13 2:51 AM Final PDF to printer 146 Chapter 4 Process Costing and Hybrid Product-Costing Systems goods completed and transferred out of the Cutting Department must remain assigned to the partially completed product units as they undergo further processing in the Stitching Department. Process-costing procedures for subsequent production departments are cov- ered in cost accounting texts. 3 Hybrid Product-Costing Systems Job-order and process costing represent the polar extremes of product-costing systems. However, some production processes exhibit characteristics of both job-order and process- costing environments. Examples of such production processes include some clothing and food-processing operations. In these production processes, the conversion activities may be very similar or identical across all of the firm's product lines, even though the direct materials may differ significantly. Different clothing lines require significantly different direct materials, such as cotton, silk, or wool. However, the conversion of these materials, involving direct labor and manufacturing overhead, may not differ much across product types. In the food industry, production of economy-grade or premium applesauce differs with regard to the quality and cost of the direct-material input, apples. However, the cook- ing, straining, and canning operations for these two product lines are nearly identical. Operation Costing for Batch Manufacturing Processes The production processes described above often are referred to as batch manufacturing processes. Such processes are characterized by high-volume production of several product lines that differ in some important ways but are nearly identical in others. Since batch man- ufacturing operations have characteristics of both job-order costing and process-costing environments, a hybrid product-costing system is required. One common approach is called operation costing. This product-costing system is used when conversion activities are very similar across product lines, but the direct materials differ significantly. Con- version costs are accumulated by department, and process-costing methods are used to assign these costs to products. In contrast, direct-material costs are accumulated by job order or batch, and job-order costing is used to assign material costs to products. The main features of operation costing are illustrated in Exhibit 4–10 . Notice in the exhibit that products pass sequentially through production departments A and B. Direct- material costs are traced directly to each batch of goods, but conversion costs are applied on a departmental basis. Direct labor and manufacturing overhead are combined in a single cost category called conversion costs, rather than separately identifying direct labor. Moreover, under operation costing, conversion costs are applied to products using a predetermined application rate. This predetermined rate is based on budgeted conver- sion costs, as follows: 4 Predetermined application rate for conversion costs 5 Budgeted conversion costs (direct labor and manufacturing overhead) __________________________________ Budgeted cost driver (or activity base) As an illustration of operation costing, we will focus on the Minnesota Division of MVP Sports Equipment Company. This division manufactures two different grades of basketballs: professional balls, which have genuine leather exteriors, and scholastic balls, which use imitation leather. The cutting and stitching operations for the two different products are identical. Scholastic balls are sold without special packaging, but profes- sional balls are packaged in an attractive cardboard box. Hybrid Product-Costing Systems 3 Sequential production operations are also covered in a supplement to this textbook titled Process Costing in Sequential Production Departments. This supplement is available to students and instructors on the text website: http://www.mhhe.com/hilton10e . 4The budgeted amount for the cost driver is based on the company’s practical capacity for production. Learning Objective 4-7 Describe how an operation costing system accumulates and assigns the costs of direct material and conversion activ- ity in a batch manufacturing process. MVP Sports Equipment Company hiL25664_ch04_132-163.indd 146hiL25664_ch04_132-163.indd 146 7/4/13 2:51 AM7/4/13 2:51 AM Final PDF to printer Chapter 4 Process Costing and Hybrid Product-Costing Systems 147 During October two batches were entered into production and finished. There was no beginning or ending inventory of work in process for October. Cost and production data are given in Exhibit 4–11 . Notice in Exhibit 4–11 that the direct-material costs are identified by batch. The conversion costs, however, are associated with the two produc- tion departments and the Packaging Department. The product cost for each of the basketballs is computed as follows: Professional Scholastic Direct material: Batch P19 ($20,000 4 1,000) ........................................................................... $20.00 Batch S28 ($30,000 4 3,000) ........................................................................... $10.00 Conversion: Preparation Department (conversion costs of $30,000 4 4,000 units produced)* ...................................... 7.50 7.50 Conversion: Finishing Department (conversion costs of $24,000 4 4,000 units produced)* ...................................... 6.00 6.00 Conversion: Packaging Department (conversion costs of $500 4 1,000 units packaged)* ........................................... .50 –0– Total product cost ..................................................................................................... $34.00 $23.50 *The two production departments each worked on a total of 4,000 balls, but the Packaging Department handled only the 1,000 professional balls. Notice in the preceding display that each ball receives the same conversion costs in the Preparation Department and the Finishing Department, since these operations are identical for the two products. Direct-material costs and packaging costs, though, dif- fer for the products. The total costs of $104,500 ( Exhibit 4–11 ) are accounted for in the product costs, as shown below. Professional balls: 1,000 3 $34.00 ........................................................................................................... $ 34,000 Scholastic balls: 3,000 3 $23.50 .............................................................................................................. 70,500 Total ......................................................................................................................................................... $104,500 The following journal entries are made to record the Minnesota Division's flow of costs. The first entry is made to record the requisition of raw material by the Preparation Exhibit 4–10 Operation Costing Accumulated by department Accumulated by batch Work-in-Process Inventory: Production Department A Batch 1 Batch 2 Work-in-Process Inventory: Production Department B Batch 3 Batch 4 Conversion costs Direct labor Manufacturing overhead Direct-material costs Finished-Goods Inventory hiL25664_ch04_132-163.indd 147hiL25664_ch04_132-163.indd 147 7/4/13 2:51 AM7/4/13 2:51 AM Final PDF to printer 148 Chapter 4 Process Costing and Hybrid Product-Costing Systems Operation Costing Data Direct-material costs: Batch P19 (1,000 professional balls) ...................................................... $20,000 (includes $1,000 for packaging material) Batch S28 (3,000 scholastic balls) ......................................................... 30,000 Total direct-material costs $50,000 Conversion costs (budgeted): Preparation Department ............................................................................................................................ $ 30,000 Finishing Department ................................................................................................................................ 24,000 Packaging Department .............................................................................................................................. 500 Total ......................................................................................................................................................... $ 54,500 Total costs: Direct material ............................................................................................................................................ 50,000 Conversion: Preparation ......................................................................... $ 30,000 Finishing ............................................................................ 24,000 Packaging .......................................................................... 500 Total conversion costs ............................................................................................................. 54,500 Total ........................................................................................................................................................... $104,500 Predetermined application rates for conversion costs: * Preparation Department: Budgeted conversion costs ____________________ Budgeted production 5 $30,000 _________ 4,000 units 5 $7.50 per unit Finishing Department: Budgeted conversion costs ____________________ Budgeted production 5 $24,000 _________ 4,000 units 5 $6.00 per unit Packaging Department: Budgeted conversion costs ____________________ Budgeted units packaged 5 $500 _________ 1,000 units 5 $.50 per unit *The cost driver (or activity base) is the number of units processed. MVP Sports Equipment Company Exhibit 4–11 Basic Data for Illustration of Operation Costing Department, when batch P19 is entered into production. (This amount excludes the $1,000 in packaging costs to be incurred subsequently for batch P19.) Work-in-Process Inventory: Preparation Department ................................................................ 19,000 Raw-Material Inventory .................................................................................................. 19,000 The following entry is made to record the requisition of raw material by the Prepara- tion Department, when batch S28 is entered into production. Work-in-Process Inventory: Preparation Department ................................................................ 30,000 Raw-Material Inventory .................................................................................................. 30,000 Conversion costs are applied in the Preparation Department with the following jour- nal entry. Work-in-Process Inventory: Preparation Department ................................................................ 30,000 Applied Conversion Costs .............................................................................................. 30,000 The following entry records the transfer of the partially completed professional and scholastic basketballs to the Finishing Department. Work-in-Process Inventory: Finishing Department ................................................................... 79,000 Work-in-Process Inventory: Preparation Department ....................................................... 79,000 hiL25664_ch04_132-163.indd 148hiL25664_ch04_132-163.indd 148 7/4/13 2:51 AM7/4/13 2:51 AM Final PDF to printer Chapter 4 Process Costing and Hybrid Product-Costing Systems 149 The conversion costs applied in the Finishing Department are recorded as follows: Work-in-Process Inventory: Finishing Department ................................................................... 24,000 Applied Conversion Costs .............................................................................................. 24,000 Next, the professional balls are transferred to the Packaging Department, and the scholastic balls are transferred to finished goods. Work-in-Process Inventory: Packaging Department ................................................................. 32,500 Finished-Goods Inventory ....................................................................................................... 70,500 Work-in-Process Inventory: Finishing Department ....................................................... 103,000 Raw-material (packaging) costs and conversion costs are recorded in the Packaging Department as follows: Work-in-Process Inventory: Packaging Department ................................................................. 1,500 Raw-Material Inventory ................................................................................................. 1,000 Applied Conversion Costs .............................................................................................. 500 Finally, the professional basketballs are transferred to finished goods. Finished-Goods Inventory ...................................................................................................... 34,000 Work-in-Process Inventory: Packaging Department ....................................................... 34,000 Suppose that at the end of an accounting period, applied conversion costs differ from the actual conversion costs incurred. Then the difference, called overapplied or under- applied conversion costs, would be closed into Cost of Goods Sold. This accounting treat- ment is similar to that described in Chapter 3 for overapplied or underapplied overhead. Chapter Summary LO4-1 List and explain the similarities and important differences between job-order and process costing. Process costing is used in production processes where relatively large numbers of nearly iden- tical products are manufactured. The purpose of a process-costing system is the same as that of a job- order costing system—to accumulate costs and assign these costs to units of product. Job-order costing is used by firms that produce relatively small numbers of dissimilar products. LO4-2 Prepare journal entries to record the flow of costs in a process-costing system with sequen- tial production departments. Costs of direct material, direct labor, and manufacturing overhead are added to a Work-in-Process Inventory account. Direct labor and manufacturing overhead often are combined into a single cost category termed conversion costs. When products are completed, the costs assigned to them are transferred either to Finished-Goods Inventory or to the next production depart- ment's Work-in-Process Inventory account. Finally, when goods are sold, their costs are transferred to the expense account called Cost of Goods Sold. LO4-3 Prepare a table of equivalent units under weighted-average process costing. The table of equivalent units, illustrated in the chapter, computes the equivalent units of activity for the period for both direct material and conversion costs. LO4-4 Compute the cost per equivalent unit under the weighted-average method of process costing. The cost per equivalent unit, for both direct material and conversion, is calculated as shown in the chap- ter. For each factor input, direct material and conversion, the cost of that input is divided by the number of equivalent units for that input. LO4-5 Analyze the total production costs for a department under the weighted-average method of process costing. The total production costs incurred during the period, for both direct material and conversion, are assigned to either ending work-in-process inventory or to the cost of goods completed and transferred out. LO4-6 Prepare a departmental production report under weighted-average process costing. As illustrated in the chapter, there are four steps in preparing a departmental production report: (1) analyze hiL25664_ch04_132-163.indd 149hiL25664_ch04_132-163.indd 149 7/4/13 2:51 AM7/4/13 2:51 AM Final PDF to printer 150 Chapter 4 Process Costing and Hybrid Product-Costing Systems the physical flow of units, (2) calculate the equivalent units, (3) compute the cost per equivalent unit, and (4) analyze the total costs of the department. In the weighted-average method of process costing, the cost per equivalent unit, for each cost category, is a weighted average of (1) the costs assigned to the beginning work-in-process inventory and (2) the costs incurred during the current period. LO4-7 Describe how an operation costing system accumulates and assigns the costs of direct mate- rial and conversion activity in a batch manufacturing process. Operation costing is a hybrid of job- order and process costing. It is designed for production processes in which the direct material differs significantly among product lines, but the conversion activities are essentially the same. Direct-material costs are accumulated by batches of products using job-order costing methods. Conversion costs are accumulated by production departments and are assigned to product units using process-costing methods. Review Problem on Process Costing The following data have been compiled for MVP's Cutting Department for the month of June. Conver- sion activity occurs uniformly throughout the production process. Work in process, June 1—25,000 units: Direct material: 100% complete, cost of ..................................................................................................... $ 73,750 Conversion: 40% complete, cost of ........................................................................................................ 46,000 Balance in work in process, June 1 ........................................................................................................ $119,750 Units started during June ............................................................................................................................... 40,000 Units completed during June and transferred out ............................................................................................. 60,000 Work in process, June 30: Direct material: 100% complete Conversion: 60% complete Costs incurred during June: Direct material .......................................................................................................................................... $121,250 Conversion costs: direct labor and applied manufacturing overhead ............................................................. 237,500 Required: Prepare the Cutting Department's June production report using weighted- average process costing. ( Hint: Follow the format of Exhibit 4–9 .) Solution to Review Problem The Cutting Department's June production report is displayed in Exhibit 4–12 . Exhibit 4–12 June Production Report:Cutting Department (weighted-average method) MVP Sports Equipment Company MVP SPORTS EQUIPMENT COMPANY June Production Report: Cutting Department Physical Units Percentage of Completion with Respect to Conversion Equivalent Units Direct Material Conversion Work in process, June 1 ........................................ 25,000 40% Units started during June ...................................... 40,000 Total units to account for ....................................... 65,000 Units completed and transferred out during June .... 60,000 100% 60,000 60,000 Work in process, June 30 ...................................... 5,000 60% 5,000 3,000 Total units accounted for ....................................... 65,000 _____ _____ Total equivalent units ............................................ 65,000 63,000 Direct Material Conversion Total Work in process, June 1 ............................................................... $ 73,750 $ 46,000 $119,750 Costs incurred during June ........................................................... 121,250 237,500 358,750 Total costs to account for .............................................................. $195,000 $283,500 $478,500 Equivalent units ........................................................................... 65,000 63,000 Costs per equivalent unit .............................................................. $3.00 $4.50 $7.50 $195,000 ________ 65,000 $283,500 ________ 63,000 $3.00 1 $4.50 (continues) hiL25664_ch04_132-163.indd 150hiL25664_ch04_132-163.indd 150 7/4/13 2:51 AM7/4/13 2:51 AM Final PDF to printer Chapter 4 Process Costing and Hybrid Product-Costing Systems 151 Cost of goods completed and transferred out of the Cutting Department during June: ( Number of units transferred out ) 3 ( Total cost per equlvalent unit ) .............................. 60,000 3 $7.50 .................................... $450,000 Cost remaining in June 30 work-in-process inventory in the Cutting Department: Direct material: ( Number of equivalent units of direct material ) 3 ( Cost per equivalent unit of direct material ) .............. 5,000 3 $3.00 ..................................... $ 15,000 Conversion: ( Number of equivalent units of conversion ) 3 ( Cost per equivalent unit of conversion ) ............. 3,000 3 $4.50 ..................................... 13,500 Total cost of June 30 work in process ......................................................................................................... $ 28,500 Check: Cost of goods completed and transferred out ................................................................................... $450,000 Cost of June 30 work-in-process inventory ..................................................................................... 28,500 Total costs accounted for ............................................................................................................... $478,500 Key Terms For each term's definition refer to the indicated page, or turn to the glossary at the end of the text. batch manufacturing, 146 departmental production report, 138 equivalent units, 137 hybrid product-costing system, 146 operation costing, 146 process-costing system, 134 transferred-in costs, 135 weighted-average method, 138 Review Questions 4–1. Explain the primary differences between job-order and process costing. 4–2. List five types of manufacturing in which process cost- ing would be an appropriate product-costing system. What is the key characteristic of these products that makes process costing a good choice? 4–3. List three nonmanufacturing businesses in which process costing could be used. For example, a public accounting firm could use process costing to accumu- late the costs of processing clients' tax returns. 4–4. What are the purposes of a product-costing system? 4–5. Define the term equivalent unit and explain how the concept is used in process costing. 4–6. List and briefly describe the purpose of each of the four process-costing steps. 4–7. Show how to prepare a journal entry to enter direct- material costs into the Work-in-Process Inventory account for the first department in a sequential produc- tion process. Show how to prepare the journal entry recording the transfer of goods from the first to the sec- ond department in the sequence. 4–8. What are transferred-in costs? 4–9. A food processing company has two sequential produc- tion departments: mixing and cooking. The cost of the January 1 work in process in the cooking department is detailed as follows: Direct material ............................................................... $ 79,000 Conversion .................................................................... 30,000 Transferred-in costs ....................................................... 182,000 During what time period and in what department were the $182,000 of costs listed above incurred? Explain your answer. 4–10. Explain the reasoning underlying the name of the weighted-average method. 4–11. How does process costing differ under normal or actual costing? 4–12. How would the process-costing computations differ from those illustrated in the chapter if overhead were applied on some activity base other than direct labor? 4–13. Explain the concept of operation costing. How does it dif- fer from process or job-order costing? Why is operation costing well suited for batch manufacturing processes? 4–14. What is the purpose of a departmental production report prepared using process costing? Exercises All applicable Exercises are available with McGraw-Hill’s Connect Accounting ®. ■ Exercise 4–15 Physical Flow of Units (LO 4-1, 4-3) In each case below, fill in the missing amount. 1. Work in Process, June 1 .................................................................................................................. 10,000 pounds Units started during June ................................................................................................................. ? Units completed during June ............................................................................................................ 16,000 pounds Work in process, June 30 ................................................................................................................ 3,000 pounds hiL25664_ch04_132-163.indd 151hiL25664_ch04_132-163.indd 151 7/4/13 2:51 AM7/4/13 2:51 AM Final PDF to printer 152 Chapter 4 Process Costing and Hybrid Product-Costing Systems 2. Work in process, April 1 ................................................................................................................... 12,000 yards Units started during April .................................................................................................................. 22,000 yards Units completed during April ............................................................................................................. 21,500 yards Work in process, April 30 ................................................................................................................. ? 3. Work in process, January 1 .............................................................................................................. 50,000 liters Units started during the year ............................................................................................................ 67,000 liters Units completed during the year ....................................................................................................... ? Work in process, December 31 ........................................................................................................ 45,000 liters ■ Exercise 4–16 Physical Flow and Equivalent Units; Weighted-Average (LO 4-1, 4-3) The Milwaukee plant of Healthy Life Styles, Inc. produces low-fat salad dressing. The following data pertain to the year just ended. Percentage of Completion Units Direct Material Conversion Work in process, January 1 ................................................................... 30,000 gal. 70% 50% Work in process, December 31 .............................................................. 25,000 gal. 75% 20% During the year the company started 140,000 gallons of material in production. Required: Prepare a schedule analyzing the physical flow of units and computing the equivalent units of both direct material and conversion for the year. Use weighted-average process costing. ■ Exercise 4–17 Equivalent Units; Weighted-Average (LO 4-1, 4-3) PetroTech Company refines a variety of petrochemical products. The following data are from the firm's Amarillo plant. Work in process, July 1 ............................................................................................................... 1,900,000 liters Direct material ....................................................................................................................... 100% complete Conversion ............................................................................................................................ 30% complete Units started in process during July ............................................................................................. 750,000 liters Work in process, July 31 ............................................................................................................. 250,000 liters Direct material ....................................................................................................................... 100% complete Conversion ............................................................................................................................ 70% complete Required: Compute the equivalent units of direct material and conversion for the month of July. Use the weighted-average method of process costing. ■ Exercise 4–18 Equivalent Units; Weighted-Average (LO 4-1, 4-3) Andromeda Glass Company manufactures decorative glass products. The firm employs a process- costing system for its manufacturing operations. All direct materials are added at the beginning of the process, and conversion costs are incurred uniformly throughout the process. The company's production schedule for August follows. Units Work in process on August 1 (60% complete as to conversion) ............................................................................... 2,000 Units started during August ................................................................................................................................... 3,500 Total units to account for .............................................................................................................................. 5,500 Units from beginning work in process, which were completed and transferred out during August .............................. 2,000 Units started and completed during August ............................................................................................................ 1,800 Work in process on August 31 (20% complete as to conversion) ............................................................................. 1,700 Total units accounted for .............................................................................................................................. 5,500 Required: Calculate each of the following amounts using weighted-average process costing. 1. Equivalent units of direct material during August. 2. Equivalent units of conversion activity during August. (CMA, adapted) hiL25664_ch04_132-163.indd 152hiL25664_ch04_132-163.indd 152 7/4/13 2:51 AM7/4/13 2:51 AM Final PDF to printer Chapter 4 Process Costing and Hybrid Product-Costing Systems 153 Use the Internet to access the website for Weyerhaeuser ( www.weyerhaeuser.com ), International Paper ( www.internationalpaper.com ), or Boise Cascade ( www.boisecascade.com ). Required: Skim over the information presented on the website about the company's products and operations. Then discuss why process costing is an appropriate product-costing method for this company. ■ Exercise 4–19 Process Costing; Use of Internet (LO 4-1) ■ Exercise 4–20 Cost per Equivalent Unit; Weighted-Average (LO 4-1, 4-4) Duluth Glass Company manufactures window glass for automobiles. The following data pertain to the Plate Glass Department. Work in process, February 1 Direct material ........................................................................................................................................ $ 43,200 Conversion ............................................................................................................................................. 40,300 Costs incurred during February Direct material ........................................................................................................................................ $135,000 Conversion ............................................................................................................................................. 190,000 The equivalent units of activity for February were as follows: 16,500 equivalent units of direct material, and 47,000 equivalent units of conversion activity. Required: Calculate the cost per equivalent unit, for both direct material and conversion, during Feb- ruary. Use weighted-average process costing. ■ Exercise 4–21 Cost per Equivalent Unit; Weighted-Average (LO 4-1, 4-4) Montana Lumber Company grows, harvests, and processes timber for use in construction. The following data pertain to the firm's sawmill during June. Work in process, June 1 Direct material ................................................................................................................................ $ 74,900 Conversion ..................................................................................................................................... 167,000 Costs incurred during June Direct material ................................................................................................................................ $380,700 Conversion ..................................................................................................................................... 625,000 The equivalent units of activity for June were as follows: 6,700 equivalent units of direct material, and 1,600 equivalent units of conversion activity. Required: Calculate the cost per equivalent unit, for both direct material and conversion, during June. Use weighted-average process costing. ■ Exercise 4–22 Analysis of Total Costs; Weighted-Average (LO 4-4, 4-5) The following data pertain to Tuscaloosa Paperboard Company, a manufacturer of cardboard boxes. Work in process, March 1 10,000 units* Direct material .............................................................................................................................. $ 10,900 Conversion ................................................................................................................................... 28,950 Costs incurred during March Direct material .............................................................................................................................. $112,700 Conversion ................................................................................................................................... 160,200 *Complete as to direct material; 35% complete as to conversion. The equivalent units of activity for March were as follows: Direct material (weighted-average method) .................................................................................................. 103,000 Conversion (weighted-average method) ........................................................................................................ 97,000 Completed and transferred out .................................................................................................................... 89,000 Required: Compute the following amounts using weighted-average process costing. 1. Cost of goods completed and transferred out during March. 2. Cost of the March 31 work-in-process inventory. hiL25664_ch04_132-163.indd 153hiL25664_ch04_132-163.indd 153 7/4/13 2:51 AM7/4/13 2:51 AM Final PDF to printer 154 Chapter 4 Process Costing and Hybrid Product-Costing Systems Raleigh Textiles Company manufactures a variety of natural fabrics for the clothing industry. The fol- lowing data pertain to the Weaving Department for the month of November. Equivalent units of direct material (weighted-average method) .................................................................... 62,500 Equivalent units of conversion (weighted-average method) ......................................................................... 49,000 Units completed and transferred out during November ............................................................................... 47,000 The cost data for November are as follows: Work in process, November 1 Direct material ................................................................................................................................... $ 85,750 Conversion ........................................................................................................................................ 16,900 Costs incurred during November Direct material ................................................................................................................................... $158,000 Conversion ........................................................................................................................................ 267,300 There were 19,000 units in process in the Weaving Department on November 1 (100% complete as to direct material, and 38% complete as to conversion). Required: Compute each of the following amounts using weighted-average process costing. 1. Cost of goods completed and transferred out of the Weaving Department. 2. Cost of the November 30 work-in-process inventory in the Weaving Department. 3. Build a spreadsheet: Construct an Excel spreadsheet to solve all of the preceding requirements. Show how the solution will change if the following data change: the costs incurred in November were $160,000 for direct material and $270,000 for conversion. ■ Exercise 4–23 Analysis of Total Costs; Weighted-Average (LO 4-4, 4-5) ■ Exercise 4–24 Operation Costing (LO 4-7) The November production of MVP's Minnesota Division consisted of batch P25 (2,000 professional basketballs) and batch S33 (4,000 scholastic basketballs). Each batch was started and finished during November, and there was no beginning or ending work in process. Costs incurred were as follows: Direct material: Batch P25, $42,000, including $2,500 for packaging material; batch S33, $45,000. Conversion costs: Preparation Department, predetermined rate of $7.50 per unit; Finishing Department, predetermined rate of $6.00 per unit; Packaging Department, predetermined rate of $.50 per unit. (Only the professional balls are packaged.) Required: 1. Draw a diagram depicting the division's batch manufacturing process. Refer to Exhibit 4–10 for guidance. 2. Compute the November product cost for each type of basketball. 3. Prepare journal entries to record the cost flows during November. ■ Problem 4–25 Straightforward Weighted- Average Process Costing, Step-by-Step Approach (LO 4-3, 4-4, 4-5) 2. Equivalent units: conversion: 207,500 3. Cost per equivalent unit, direct material: $2.35 Toronto Titanium Corporation manufactures a highly specialized titanium sheathing material that is used extensively in the aircraft industry. The following data have been compiled for the month of June. Conversion activity occurs uniformly throughout the production process. Work in process, June 1—40,000 units: Direct material: 100% complete, cost of ............................................................................................... $110,500 Conversion: 38% complete, cost of ...................................................................................................... 22,375 Balance in work in process, June 1 ............................................................................................... $132,875 Units started during June ........................................................................................................................ 190,000 Units completed during June and transferred out to finished-goods inventory ............................................. 180,000 Work in process, June 30: Direct material: 100% complete Conversion: 55% complete Costs incurred during June: Direct material .................................................................................................................................... $430,000 Problems All applicable Problems are available with McGraw-Hill’s Connect Accounting ®. hiL25664_ch04_132-163.indd 154hiL25664_ch04_132-163.indd 154 7/4/13 2:51 AM7/4/13 2:51 AM Final PDF to printer Chapter 4 Process Costing and Hybrid Product-Costing Systems 155 Conversion costs: Direct labor .................................................................................................................................... $128,000 Applied manufacturing overhead ..................................................................................................... 192,000 Total conversion costs ..................................................................................................................... $320,000 Required: Prepare schedules to accomplish each of the following process-costing steps for the month of June. Use the weighted-average method of process costing. 1. Analysis of physical flow of units. 2. Calculation of equivalent units. 3. Computation of unit costs. 4. Analysis of total costs. ■ Problem 4–26 * Straightforward Weighted- Average Process Costing; Step-by-Step Approach (LO 4-3, 4-4, 4-5) 2. Equivalent units, direct material: 110,000 3. Conversion, cost per equivalent unit: $1.81 Moravia Company processes and packages cream cheese. The following data have been compiled for the month of April. Conversion activity occurs uniformly throughout the production process. Work in process, April 1—10,000 units: Direct material: 100% complete, cost of ........................................................................................ $ 22,000 Conversion: 20% complete, cost of ............................................................................................... 4,500 Balance in work in process, April 1 ................................................................................................ $ 26,500 Units started during April .................................................................................................................. 100,000 Units completed during April and transferred out to finished-goods inventory ....................................... 80,000 Work in process, April 30: Direct material: 100% complete Conversion: 331∕3% complete Costs incurred during April: Direct material .............................................................................................................................. $198,000 Conversion costs: Direct labor ............................................................................................................................. $ 52,800 Applied manufacturing overhead .............................................................................................. 105,600 Total conversion costs .............................................................................................................. $158,400 Required: Prepare schedules to accomplish each of the following process-costing steps for the month of April. Use the weighted-average method of process costing. 1. Analysis of physical flow of units. 2. Calculation of equivalent units. 3. Computation of unit costs. 4. Analysis of total costs. 5. Build a spreadsheet: Construct an Excel spreadsheet to solve all of the preceding requirements. Show how the solution will change if the following data change: the April 1 work-in-process costs were $27,000 for direct material and $5,000 for conversion. ■ Problem 4–27 Step-by-Step Weighted- -Average Process Costing (LO 4-3, 4-4, 4-5) 2. Conversion, total equivalent units: 1,148,800 3. Direct material: cost per equivalent unit: $1.30 Jupiter Corporation manufactures home security devices. During 20x4, 1,000,000 units were completed and transferred to finished-goods inventory. On December 31, 20x4, there were 310,000 units in work in process. These units were 48 percent complete as to conversion and 100 percent complete as to direct material. Finished-goods inventory consisted of 250,000 units. Materials are added to production at the beginning of the manufacturing process, and overhead is applied to each product at the rate of 100 percent of direct-labor costs. There was no finished-goods inventory on January 1, 20x4. A review of the inventory cost records disclosed the following information: Costs Units Direct Material Labor Work in process, January 1, 20x4 (83% complete as to conversion) .............................................................. 210,000 $ 300,000 $ 310,400 Units started in production ........................................................................ 1,100,000 Direct-material costs ....................................................................................................... 1,403,000 Direct-labor costs ......................................................................................................................................... 1,700,000 Ex *Note to instructors: This problem relates to problem 12 in the supplement, Process Costing: The First-in, First-Out Method. Assigning these two problems together facilitates a comparison of the weighted-average and FIFO methods. hiL25664_ch04_132-163.indd 155hiL25664_ch04_132-163.indd 155 7/4/13 2:51 AM7/4/13 2:51 AM Final PDF to printer 156 Chapter 4 Process Costing and Hybrid Product-Costing Systems Required: Prepare schedules as of December 31, 20x4, to compute the following: 1. Physical flow of units. 2. Equivalent units of production using the weighted-average method. 3. Costs per equivalent unit for material and conversion. 4. Cost of the December 31, 20x4, finished-goods inventory and work-in-process inventory. (CPA, adapted) ■ Problem 4–28 * Partial Production Report; Journal Entries; Weighted- Average Method (LO 4-2, 4-3, 4-4, 4-5) 1. Equivalent units, direct material: 120,000 2. Conversion, cost per equivalent unit: $10.28 Atlantic City Taffy Company produces various kinds of candy, but salt-water taffy is by far its most important product. The company accumulates costs for its product using process costing. Direct mate- rial is added at the beginning of the production process, and conversion activity occurs uniformly throughout the process. Production Report For August 20x1 Physical Units Percentage of Completion with Respect to Conversion Equivalent Units Direct Material Conversion Work in process, August 1 ............................................. 40,000 80% Units started during August ............................................ 80,000 Total units to account for ............................................... 120,000 Units completed and transferred out during August ......... 100,000 100,000 100,000 Work in process, August 31 ........................................... 20,000 30% 20,000 6,000 Total units accounted for ................................................ 120,000 Direct Material Conversion Total Work in process, August 1 .................................................................... $ 42,000 $ 305,280 $ 347,280 Costs incurred during August ................................................................ 96,000 784,400 880,400 Total costs to account for ..................................................................... $138,000 $1,089,680 $1,227,680 Required: Use weighted-average process costing in completing the following requirements. 1. Prepare a schedule of equivalent units. 2. Compute the costs per equivalent unit. 3. Compute the cost of goods completed and transferred out during August. 4. Compute the cost remaining in the work-in-process inventory on August 31. 5. Prepare a journal entry to record the transfer of the cost of goods completed and transferred out. ■ Problem 4–29 Partial Production Report; Journal Entries; Weighted- Average Method (LO 4-2, 4-3, 4-4, 4-5) 1(a). Conversion, total equiva- lent units: 58,000 1(b). Total cost per equivalent unit: $54.50 CircleD Fastener Corporation accumulates costs for its single product using process costing. Direct material is added at the beginning of the production process, and conversion activity occurs uniformly throughout the process. A partially completed production report for the month of June follows. Production Report For the Month of June Physical Units Percentage of Completion with Respect to Conversion Equivalent Units Direct Material Conversion Work in process, June 1 ................................................. 30,000 35% Units started during June ............................................... 34,000 Total units to account for ................................................ 64,000 Units completed and transferred out during June ............. 40,000 40,000 40,000 Work in process, June 30 ............................................... 24,000 75% 24,000 18,000 Total units accounted for ............................................... 64,000 *Note to instructors: This problem relates to problem 14 in the supplement, Process Costing: The First-In, First-Out Method. Assigning these two problems together facilitates a comparison of the weighted-average and FIFO methods. (continues) hiL25664_ch04_132-163.indd 156hiL25664_ch04_132-163.indd 156 7/4/13 2:51 AM7/4/13 2:51 AM Final PDF to printer Chapter 4 Process Costing and Hybrid Product-Costing Systems 157 Direct Material Conversion Total Work in process, June 1 ...................................................................... $147,600 $ 623,400 $ 771,000 Costs incurred during June .................................................................. 201,200 2,221,500 2,422,700 Total costs to account for .................................................................... $348,800 $2,844,900 $3,193,700 Required: 1. Complete each of the following process-costing steps using the weighted-average method: a. Calculation of equivalent units. b. Computation of unit costs. c. Analysis of total costs. 2. Prepare a journal entry to record the transfer of the cost of goods completed and transferred out during June. ■ Problem 4–30 Determination of Production Costs; Analysis of Equivalent Units (LO 4-3, 4-4, 4-5) 1. Overhead applied: $441,186 2. Equivalent units, conver- sion: 27,800 Texarkana Corporation assembles various components used in the computer industry. The company's major product, a disk drive, is the result of assembling three parts: JR1163, JY1065, and DC0766. The following information relates to activities of April: • Beginning work-in-process inventory: 3,000 units, 80 percent complete as to conversion; cost, $293,940 (direct material, $230,000; conversion, $63,940). • Production started: 27,000 units. • Production completed: 26,000 units. • Ending work-in-process inventory: 4,000 units, 45 percent complete as to conversion. • Direct material used: JR1163, $225,000; JY1065, $710,000; DC0766, $455,000. • Hourly wage of direct laborers, $21; total direct-labor payroll, $134,274. • Overhead application rate: $69 per direct-labor hour. All parts are introduced at the beginning of the manufacturing process; conversion cost is incurred uniformly throughout production. Required: 1. Calculate the total cost of direct material and conversion during April. 2. Determine the cost of goods completed during the month. 3. Determine the cost of the work-in-process inventory on April 30. 4. With regard to the ending work-in-process inventory: a. How much direct-material cost would be added to these units in May? b. What percentage of conversion would be performed on these units in May? 5. Assume that the disk drive required the addition of another part (TH55) at the 75 percent stage of completion. How many equivalent units with respect to part TH55 would be represented in April's ending work-in-process inventory? ■ Problem 4–31 Missing Data; Production Report; Weighted-Average (LO 4-3, 4-4, 4-5, 4-6) Costs incurred during Octo- ber, direct material: $600,000 Cost per equivalent unit, con- version: $11.85 The following data pertain to the Fantasia Flour Milling Company for the month of October. Work in process, October 1 (in units) ....................................................................................................... ? Units started during October ................................................................................................................... 70,000 Total units to account for ........................................................................................................................ 80,000 Units completed and transferred out during October ................................................................................. ? Work in process, October 31 (in units) ..................................................................................................... 5,000 Total equivalent units: direct material ...................................................................................................... 80,000 Total equivalent units: conversion ............................................................................................................ ? hiL25664_ch04_132-163.indd 157hiL25664_ch04_132-163.indd 157 7/4/13 2:51 AM7/4/13 2:51 AM Final PDF to printer 158 Chapter 4 Process Costing and Hybrid Product-Costing Systems Work in process, October 1: direct material ............................................................................................. $112,000 Work in process, October 1: conversion ................................................................................................... ? Costs incurred during October: direct material ......................................................................................... ? Costs incurred during October: conversion .............................................................................................. 900,000 Work in process, October 1: total cost ..................................................................................................... 142,225 Total costs incurred during October ......................................................................................................... 1,500,000 Total costs to account for ....................................................................................................................... 1,642,225 Cost per equivalent unit: direct material ................................................................................................... 8.90 Cost per equivalent unit: conversion ........................................................................................................ ? Total cost per equivalent unit .................................................................................................................. 20.75 Cost of goods completed and transferred out during October .................................................................... ? Cost remaining in ending work-in-process inventory: direct material ......................................................... ? Cost remaining in ending work-in-process inventory: conversion ............................................................... 41,475 Total cost of October 31 work in process ................................................................................................. 85,975 Additional Information: a. Direct material is added at the beginning of the production process, and conversion activity occurs uniformly throughout the process. b. Fantasia uses weighted-average process costing. c. The October 1 work in process was 15 percent complete as to conversion. d. The October 31 work in process was 70 percent complete as to conversion. Required: Compute the missing amounts, and prepare the firm's October production report. ■ Problem 4–32 Analysis of Work-in-Process Inventory Account (LO 4-2, 4-3, 4-4, 4-5) 2. Conversion, total equivalent units: 900 2. Direct material, cost per equivalent unit: $55 Lawncraft, Inc. manufactures wooden lawn furniture using an assembly-line process. All direct materi- als are introduced at the start of the process, and conversion cost is incurred evenly throughout manu- facturing. An examination of the company's Work-in-Process Inventory account for June revealed the following selected information: Debit side: June 1 balance: 200 units, 25% complete as to conversion, cost $18,000 * Production started: 800 units Direct material used during June: $43,000 June conversion cost: $30,000 Credit side: Production completed: 600 units *Supplementary records revealed direct-material cost of $12,000 and conversion cost of $6,000. Conversations with manufacturing personnel revealed that the ending work-in-process inventory was 75 percent complete as to conversion. Required: 1. Determine the number of units in the June 30 work-in-process inventory. 2. Calculate the cost of goods completed during June and prepare the appropriate journal entry to record completed production. 3. Determine the cost of the June 30 work-in-process inventory. 4. Briefly explain the meaning of equivalent units. Why are equivalent units needed to properly allo- cate costs between completed production and production in process? ■ Problem 4–33 Process Costing in a Public Accounting Firm (LO 4-3, 4-4, 4-5) 1(a). Equivalent units, over- head: 1,100 1(b). Overhead, cost per equivalent unit: £50 Beowulf and Grendel, a public accounting firm in London, is engaged in the preparation of income tax returns for individuals. The firm uses the weighted-average method of process costing for internal reporting. The following information pertains to February. (£ denotes the British monetary unit, pounds sterling.) * hiL25664_ch04_132-163.indd 158hiL25664_ch04_132-163.indd 158 7/4/13 2:51 AM7/4/13 2:51 AM Final PDF to printer Chapter 4 Process Costing and Hybrid Product-Costing Systems 159 Returns in process, February 1: (20% complete) ..................................................................................................................................... 300 Returns started in February ........................................................................................................................ 900 Returns in process, February 28: (75% complete) ..................................................................................................................................... 400 Returns in process, February 1: Labor .................................................................................................................................................... £ 3,500 Overhead .............................................................................................................................................. 4,000 Labor, February (4,500 hours) .................................................................................................................... 90,000 Overhead, February ................................................................................................................................... 51,000 *Although the Euro is generally used throughout Europe, day-to-day business in the United Kingdom continues to be conducted in pounds sterling. Required: 1. Compute the following amounts for labor and for overhead: a. Equivalent units of activity. b. Cost per equivalent unit. (Remember to express your answer in terms of the British pound sterling, denoted by £.) 2. Compute the cost of returns in process as of February 28. (CMA, adapted) ■ Problem 4–34 Missing Data; Production Report; Weighted-Average (LO 4-3, 4-4, 4-5, 4-6) Total equivalent units, conversion: 66,000 Costs incurred during January, direct material: $400,000 The following data pertain to the Canandaigua Carpet Company for January. Work in process, January 1 (in units) ........................................................................................................ 25,000 Units started during January .................................................................................................................... ? Total units to account for ......................................................................................................................... 80,000 Units completed and transferred out during January ................................................................................. ? Work in process, January 31 (in units) ...................................................................................................... 20,000 Total equivalent units: direct material ....................................................................................................... 80,000 Total equivalent units: conversion ............................................................................................................. ? Work in process, January 1: direct material .............................................................................................. $232,000 Work in process, January 1: conversion ................................................................................................... ? Costs incurred during January: direct material .......................................................................................... ? Costs incurred during January: conversion ............................................................................................... 820,000 Work in process, January 1: total cost ...................................................................................................... 342,600 Total costs incurred during January .......................................................................................................... 1,220,000 Total costs to account for ........................................................................................................................ 1,562,600 Cost per equivalent unit: direct material .................................................................................................... 7.90 Cost per equivalent unit: conversion ......................................................................................................... ? Total cost per equivalent unit ................................................................................................................... 22.00 Cost of goods completed and transferred out during January .................................................................... ? Cost remaining in ending work-in-process inventory: direct material .......................................................... ? Cost remaining in ending work-in-process inventory: conversion ................................................................ 84,600 Total cost of January 31 work in process .................................................................................................. 242,600 Additional Information: a. Direct material is added at the beginning of the production process, and conversion activity occurs uniformly throughout the process. b. The company uses weighted-average process costing. c. The January 1 work in process was 25 percent complete as to conversion. d. The January 31 work in process was 30 percent complete as to conversion. Required: Compute the missing amounts, and prepare the firm's January production report. hiL25664_ch04_132-163.indd 159hiL25664_ch04_132-163.indd 159 7/4/13 2:51 AM7/4/13 2:51 AM Final PDF to printer 160 Chapter 4 Process Costing and Hybrid Product-Costing Systems SolarTech Company manufactures a special lacquer, which is used in the aeronautical and space indus- tries. Two departments are involved in the production process. In the Mixing Department, various chem- icals are entered into production. After processing, the Mixing Department transfers a chemical called CXX to the Finishing Department. There the product is completed, packaged, and shipped under the brand name Solarfast. Mixing Dept. Various chemicals CXX Solarfast Finishing Dept. In the Mixing Department, the raw material is added at the beginning of the process. Labor and overhead are applied continuously throughout the process. All direct departmental overhead is traced to the departments, and plant overhead is allocated to the departments on the basis of direct labor. The plant overhead rate for 20x5 is $1.50 per direct-labor dollar. The following information relates to production during November 20x5 in the Mixing Department. a. Work in process, November 1 (5,000 pounds, 70 percent complete as to conversion): Raw material ........................................................................................................................................... $31,600 Direct labor ............................................................................................................................................. 18,000 Departmental overhead ............................................................................................................................ 10,220 Allocated plant overhead .......................................................................................................................... 27,000 b. Raw material: Inventory, November 1, 3,000 pounds ......................................................................................................... 16,000 Purchases, November 3, 9,000 pounds ...................................................................................................... 44,000 Purchases, November 18, 12,000 pounds .................................................................................................. 60,000 Released to production during November, 17,000 pounds c. Direct-labor cost during November, $70,000 d. Direct departmental overhead costs, $35,000 e. Transferred to Finishing Department, 16,000 pounds f. Work in process, November 30, 6,000 pounds, 30 percent complete as to conversion The company uses weighted-average process costing to accumulate product costs. However, for raw-material inventories the firm uses the FIFO inventory method. Required: 1. Prepare a production report for the Mixing Department for November 20x5. The report should show: a. Equivalent units of production by cost factor (i.e., direct material and conversion). b. Cost per equivalent unit for each cost factor. c. Cost of CXX transferred to the Finishing Department. d. Cost of the work-in-process inventory on November 30, 20x5, in the Mixing Department. 2. Prepare journal entries to record the following events: a. Release of direct material to production during November. b. Incurrence of direct-labor costs in November. c. Application of overhead costs for the Mixing Department (direct departmental and allocated plant overhead costs). d. Transfer of CXX out of the Mixing Department. (CMA, adapted) ■ Problem 4–35 Process Costing; Produc- tion Report; Journal Entries; Weighted-Average Method (LO 4-2, 4-3, 4-4, 4-5, 4-6) 1. Direct material, total equivalent units: 22,000 1. Conversion, cost per equivalent unit: $14.90 ■ Problem 4–36 Operation Costing; Unit Costs (LO 4-7) 2. Conversion cost per unit in dept. II: $40.00 4. $215.60 per sheet (Based on a problem contributed by Roland Minch.) Celestial Glass Company manufactures a variety of glass windows in its Charleston plant. In department I clear glass sheets are produced, and some of these sheets are sold as finished goods. Other sheets made in department I have metallic oxides added in department II to form colored glass sheets. Some of these colored sheets are sold; others are moved to department III for etching and then are sold. The company uses operation costing. hiL25664_ch04_132-163.indd 160hiL25664_ch04_132-163.indd 160 7/4/13 2:51 AM7/4/13 2:51 AM Final PDF to printer Chapter 4 Process Costing and Hybrid Product-Costing Systems 161 Celestial Glass Company's production costs applied to products in August are given in the follow- ing table. There was no beginning or ending inventory of work in process for August. Cost Category Dept. I Dept. II Dept. III Direct material ........................................................................ $900,000 $144,000 –0– Direct labor ............................................................................ 76,000 44,000 $ 76,000 Manufacturing overhead .......................................................... 460,000 136,000 147,500 Products Units Dept. I Dir. Mat. Dept. II Dir. Mat. Clear glass, sold after dept. I .................................................... 5,500 $495,000 –0– Unetched colored glass, sold after dept. II .................................. 2,000 180,000 $64,000 Etched colored glass, sold after dept. III ..................................... 2,500 225,000 80,000 Each sheet of glass requires the same steps within each operation. Required: Compute each of the following amounts. 1. The conversion cost per unit in department I. 2. The conversion cost per unit in department II. 3. The cost of a clear glass sheet. 4. The cost of an unetched colored glass sheet. 5. The cost of an etched colored glass sheet. ■ Problem 4–37 Operation Costing; Unit Costs; Journal Entries (LO 4-7) Trim, unit conversion cost: $10.35 Executive model line, total product cost: $288,900 Plattsburg Plastics Corporation manufactures a variety of plastic products, including a series of molded chairs. The three models of molded chairs, which are all variations of the same design, are Standard (can be stacked), Deluxe (with arms), and Executive (with arms and padding). The company uses batch manufacturing and has an operation-costing system. The production process includes an extrusion oper- ation and subsequent operations to form, trim, and finish the chairs. Plastic sheets are produced by the extrusion operation, some of which are sold directly to other manufacturers. During the forming opera- tion, the remaining plastic sheets are molded into chair seats and the legs are added; the Standard model is sold after this operation. During the trim operation, the arms are added to the Deluxe and Executive models and the chair edges are smoothed. Only the Executive model enters the finish operation where the padding is added. All of the units produced receive the same steps within each operation. The March production run had a total manufacturing cost of $1,347,000. The units of production and direct-material costs incurred were as follows: Units Produced Extrusion Materials Form Materials Trim Materials Finish Materials Plastic sheets ....................................................... 10,000 $ 90,000 Standard model .................................................... 12,000 108,000 $36,000 Deluxe model ....................................................... 6,000 54,000 18,000 $13,500 Executive model ................................................... 4,000 36,000 12,000 9,000 $18,000 Total .................................................................... 32,000 $288,000 $66,000 $22,500 $18,000 Manufacturing costs applied during the month of March were as follows: Extrusion Operation Form Operation Trim Operation Finish Operation Direct labor .............................................................................. $228,000 $ 90,000 $45,000 $27,000 Manufacturing overhead ............................................................ 360,000 108,000 58,500 36,000 Required: 1. For each product produced by Plattsburg Plastics Corporation during the month of March, deter- mine the ( a ) unit cost and ( b ) total cost. Be sure to account for all costs incurred during the month. (Carry out unit costs to three decimal places, i.e., a tenth of a cent.) 2. Prepare journal entries to record the flow of production costs during March. (CMA, adapted) hiL25664_ch04_132-163.indd 161hiL25664_ch04_132-163.indd 161 7/4/13 2:51 AM7/4/13 2:51 AM Final PDF to printer 162 Chapter 4 Process Costing and Hybrid Product-Costing Systems Orbital Industries of Canada, Ltd. manufactures a variety of materials and equipment for the aerospace industry. A team of R&D engineers in the firm's Winnipeg plant has developed a new material that will be useful for a variety of purposes in orbiting satellites and spacecraft. Tradenamed Ceralam, the material combines some of the best properties of both ceramics and laminated plastics. Ceralam is already being used for a variety of housings in satellites produced in three different countries. Ceralam sheets are produced in an operation called rolling, in which the various materials are rolled together to form a multilayer laminate. Orbital Industries sells many of these Ceralam sheets just after the rolling operation to aerospace firms worldwide. However, Orbital also processes many of the Ceralam sheets further in the Winnipeg plant. After rolling, the sheets are sent to the molding operation, where they are formed into various shapes used to house a variety of instruments. After molding, the sheets are sent to the punching operation, where holes are punched in the molded sheets to accommodate protruding instruments, electrical conduits, and so forth. Some of the molded and punched sheets are then sold. The remaining units are sent to the dipping operation, in which the molded sheets are dipped in a special chemical mixture to give them a reflective surface. During the month of November, the following products were manufactured at the Winnipeg plant. The direct-material costs are also shown. Units Direct Materials Used in Ceralam Sheets Direct Materials Used in Dipping Ceralam sheets (sold after the rolling operation) ............................ 6,000 $ 960,000 Nonreflective housings (sold after the punching operation) ............. 2,500 400,000 Reflective housings (sold after the dipping operation) ..................... 1,500 240,000 $60,000 Total ........................................................................................... 10,000 $1,600,000 $60,000 The costs incurred in producing the various Ceralam products in the Winnipeg plant during Novem- ber are shown in the following table. Manufacturing overhead is applied on the basis of direct-labor dol- lars at the rate of 150 percent. Rolling Molding Punching Dipping Direct material ...................................................................... $1,600,000 –0– –0– $ 60,000 Direct labor ........................................................................... 600,000 $224,000 $256,000 90,000 Manufacturing overhead ........................................................ 900,000 336,000 384,000 135,000 Total ..................................................................................... $3,100,000 $560,000 $640,000 $285,000 Orbital Industries of Canada uses operation costing for its Ceralam operations in the Winnipeg plant. (There were no inventories of work in process or finished goods on November 1 or November 30.) Required: 1. Prepare a table that includes the following information for each of the four operations. • Total conversion costs. • Units manufactured. • Conversion cost per unit. 2. Prepare a second table that includes the following information for each product (i.e., rolled Cera- lam sheets, nonreflective Ceralam housings, and reflective Ceralam housings). • Total manufacturing costs. • Units manufactured. • Total cost per unit. 3. Prepare journal entries to record the flow of all manufacturing costs through the Winnipeg plant's Ceralam operations during November. (Ignore the journal entries to record sales revenue.) 4. Build a spreadsheet: Construct an Excel spreadsheet to solve requirements 1 and 2 above. Show how the solution will change if the following data change: the cost of direct material used in dip- ping was $66,000 and the overhead application rate is 200% of direct-labor cost. ■ Problem 4–38 Operation Costing; Unit Costs; Cost Flow; Journal Entries (LO 4-7) 1. Molding, conversion cost per unit: $140 2. Product costs, total cost: $4,585,000 hiL25664_ch04_132-163.indd 162hiL25664_ch04_132-163.indd 162 7/4/13 2:51 AM7/4/13 2:51 AM Final PDF to printer Chapter 4 Process Costing and Hybrid Product-Costing Systems 163 Lycoming Leather Company manufactures leather goods in central Pennsylvania. The company's profits have declined during the past nine months. In an attempt to isolate the causes of poor profit perfor- mance, management is investigating the manufacturing operations of each of its products. One of the company's main products is leather belts. The belts are produced in a single, continu- ous process in the Harrisburg Plant. During the process, leather strips are sewn, punched, and dyed. The belts then enter a final finishing stage to conclude the process. Labor and overhead are applied continu- ously during the manufacturing process. All materials, leather strips, and buckles are introduced at the beginning of the process. The firm uses the weighted-average method to calculate its unit costs. The leather belts produced at the Harrisburg Plant are sold wholesale for $22.95 each. Manage- ment wants to compare the current manufacturing costs per unit with the market prices for leather belts. Top management has asked the plant controller to submit data on the cost of manufacturing the leather belts for the month of October. These cost data will be used to determine whether modifications in the production process should be initiated or whether an increase in the selling price of the belts is justified. The cost per belt used for planning and control is $11.50. The work-in-process inventory consisted of 500 partially completed units on October 1. The belts were 30 percent complete as to conversion. The costs included in the inventory on October 1 were as follows: Leather strips ............................................................................................................................................... $1,650 Buckles ....................................................................................................................................................... 350 Conversion costs .......................................................................................................................................... 2,500 Total ............................................................................................................................................................ $4,500 During October 8,000 leather strips and buckles were placed into production. A total of 8,100 leather belts were completed. The work-in-process inventory on October 31 consisted of 400 belts, which were 40 percent complete as to conversion. The costs charged to production during October were as follows: Leather strips ........................................................................................................................................... $ 41,000 Buckles ................................................................................................................................................... 8,000 Conversion costs ...................................................................................................................................... 55,320 Total ........................................................................................................................................................ $104,320 Required: In order to provide cost data regarding the manufacture of leather belts in the Harrisburg Plant to the top management of Lycoming Leather Company, compute the following amounts for the month of October. 1. The equivalent units for material and conversion. 2. The cost per equivalent unit of material and conversion. 3. The assignment of production costs to the October 31 work-in-process inventory and to goods transferred out. 4. The weighted-average unit cost of leather belts completed and transferred to finished goods. Com- ment on the company's cost per belt used for planning and control. 5. Lycoming Leather Company's production manager, Jack Murray, has been under pressure from the company president to reduce the cost of conversion. In spite of several attempts to reduce conversion costs, they have remained more or less constant. Now Murray is faced with an upcoming meeting with the company president, at which he will have to explain why he has failed to reduce conversion costs. Murray has approached his friend, Jeff Daley, who is the corporate controller, with the follow- ing request: “Jeff, I'm under pressure to reduce costs in the production process. There is no way to reduce material cost, so I've got to get the conversion costs down. If I can show just a little progress in next week's meeting with the president, then I can buy a little time to try some other cost-cutting measures I've been considering. I want you to do me a favor. If we raise the estimate of the percent- age of completion of October's inventory to 50 percent, that will increase the number of equivalent units. Then the unit conversion cost will be a little lower.” By how much would Murray's suggested manipulation lower the unit conversion cost? What should Daley do? Discuss this situation, citing specific ethical standards for managerial accountants. (These standards are listed in Chapter 1.) (CMA, adapted) Case ■ Case 4–39 Weighted-Average Process Costing; Ethics (LO 4-3, 4-4, 4-5, 4-6) Equivalent units, direct material: 8,500 Total cost per equivalent unit: $13.00 hiL25664_ch04_132-163.indd 163hiL25664_ch04_132-163.indd 163 7/4/13 2:51 AM7/4/13 2:51 AM Final PDF to printer 5 THIS CHAPTER’S FOCUS COMPANY is the Patio Grill Company, which manufactures high-end gas barbeque grills in its Denver plant. The company has recently experienced intense competition in its two high-volume product lines, forcing management to drop these products’ prices below their target levels. A careful study of this situation revealed that Patio Grill Company’s traditional product-costing system distorted product costs by assigning too much cost to the high-volume gas-grill lines and not enough cost to the low-volume, complex line of grills. Management then implemented a new costing system, called activity- based costing, or ABC, which assigns product costs more accurately than traditional product- costing systems. Armed with the cost insights from the ABC system, management was able to change its pricing structure to compete more effectively in the gas-grill market. FOCUS COMPANY >>>
Activity-Based Costing
and Management
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<<< IN CONTRAST In contrast to the manufacturing setting of the Patio Grill Company, we explore the use of activity-based costing by the Delaware Medical Center’s Primary Care Unit. ABC is used in this health care services setting to assign treatment costs to categories of patient visits, such as routine, extended, and complex visits, as well as new and continuing patients. With a good understanding of how much it costs the Primary Care Unit to provide various types of patient appointments, the clinic’s administration is in a much better position to make decisions. Delaware Medical Center D M C hiL25664_ch05_164-223.indd 165hiL25664_ch05_164-223.indd 165 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer 166 A revolution is transforming the world of business. Not since the mid-19th century have we seen changes as sweeping and dramatic. The growth of international competition, the breakneck pace of technological innovation, and startling advances in computer- ized systems have created a new playing field for manufacturers around the globe. Some manufacturers have emerged as world-class producers, while others have fallen by the wayside. World-class companies such as Caterpillar, Coca-Cola, Johnson & Johnson, and Pfizer are among the many manufacturers that have changed key business processes to compete effectively in the 21st century. The service industry also is undergoing dramatic transformation. The growth of the Internet, the trend toward a service economy, and the willingness of businesses to out- source many critical service functions have caused many service organizations to rein- vent the way they do business. Among the many service-industry firms that have adapted most successfully to the changing business environment are American Express, Bank of America, FedEx, Google, and Southwest Airlines. What is the role of managerial accounting in this rapidly changing environment? To explore this issue, we will review recent events in the life of Patio Grill Company, a manufacturer of barbeque grills and accessories. The company’s Denver plant manufac- tures three product lines, all high-end gas barbeque grills. The plant’s three gas grill lines are the Patio Standard (STD), the Deluxe (DEL), and the Ultimate (ULT). 5-1 Compute product costs under a traditional, volume-based product-costing system. 5-2 Explain how an activity-based costing system operates, including the use of a two-stage procedure for cost assignment, the identification of activity cost pools, and the selection of cost drivers. 5-3 Explain the concept of cost levels, including unit-level, batch-level, product-sustaining-level, and facility-level costs. 5-4 Compute product costs under an activity-based costing system. 5-5 Explain why traditional, volume-based costing systems tend to distort product costs. 5-6 Explain three criteria for selecting cost drivers. 5-7 Discuss several key issues in activity-based costing, including data collection and storyboarding. 5-8 Explain the concepts of activity-based management and two-dimensional ABC. 5-9 Explain and execute a customer-profitability analysis. 5-10 Understand and discuss how activity-based costing is used in service-industry organizations. After completing this chapter, you should be able to: hiL25664_ch05_164-223.indd 166hiL25664_ch05_164-223.indd 166 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer Chapter 5 Activity-Based Costing and Management 167 Traditional, Volume-Based Product-Costing System Until recently, Patio Grill Company’s Denver plant used a job-order product-costing sys- tem similar to the one described in Chapter 3 for Adirondack Outfitters. The cost of each product was the sum of its actual direct-material cost, actual direct-labor cost, and applied manufacturing overhead. Overhead was applied using a predetermined overhead rate based on direct-labor hours. Exhibit 5–1 provides the basic data upon which the tra- ditional costing system was based. The Excel spreadsheet in Exhibit 5–2 shows the calculation of the product cost for each of three gas-grill lines (STD, DEL, and ULT). Overhead is applied to the products at the rate of $24 per direct-labor hour. Notice that all of the Denver plant’s budgeted manu- facturing overhead costs are lumped together in a single cost pool. This total budgeted overhead amount ($4,896,000) then is divided by the plant’s total budgeted direct-labor hours (204,000 hours). The 204,000 direct labor hours is also equal to the plant’s practi- cal capacity for production, as expressed in terms of direct-labor hours. Patio Grill Company’s labor-hour-based product-costing system is typical of many manufacturing companies. Labor hours are related closely to the volume of activity in the factory, which sometimes is referred to as throughput. Consequently, these traditional product-costing systems often are said to be volume-based (or throughput-based ) cost- ing systems. Trouble in Denver The profitability of Patio Grill Company’s Denver operation has been faltering in recent years. The company’s pricing policy has been to set a target price for each grill equal to 120 percent of the full product cost. Thus, the prices were determined as shown in Exhibit 5–3 . Also shown are the actual prices that Patio Grill Company has been obtain- ing for its products. Due to price competition from other grill manufacturers, Patio Standard (STD) grills were selling at $585, approximately $10 below their target price of $595.20. Moreover, Patio Grill Company’s competition had forced management to reduce the price of the Deluxe grill (DEL) to $705, almost $20 below its target price of $724.80. Even at this lower price, the sales team was having difficulty getting orders for its planned volume of Deluxe grill production. Fortunately, the disappointing profitability of the Patio Standard and Deluxe model grills was partially offset by greater-than expected profits on the Ulti- mate (ULT) line of grills. Patio Grill Company’s sales personnel had discovered that the company was swamped with orders when the Ultimate grill’s target price of $902.40 was charged. Consequently, management had raised the price on the Ultimate grills several times, and eventually the product was selling for $940. Even at this price, Patio Grill Company’s customers did not seem to hesitate to place orders. Moreover, the company’s competitors did not mount a challenge in the market for the Ultimate line of grills. Patio’s management was pleased to have a niche for the Ultimate grill market, which appeared to Traditional, Volume-Based Product-Costing System Learning Objective 5-1 Compute product costs under a traditional, volume-based product-costing system. Patio Standard Grill STD Deluxe Grill DEL Ultimate Grill ULT Planned annual production: Volume in units ............................. 10,000 8,000 2,000 Production runs ............................ 80 runs of 125 units each 80 runs of 100 units each 40 runs of 50 units each Direct material .................................. $100 $120 $180 Direct labor (not including setup time) .............. $180 (9 hours @ $20 per hour) $220 (11 hours @ $20 per hour) $260 (13 hours @ $20 per hour) Machine hours (MH) per product unit ............................ 10 MH 12 MH 17 MH Total machine hours consumed by product line ............ 100,000 (10 MH 3 10,000 units) 96,000 (12 MH 3 8,000 units) 34,000 (17 MH 3 2,000 units) Exhibit 5–1 Basic Production and Cost Data: Patio Grill Company hiL25664_ch05_164-223.indd 167hiL25664_ch05_164-223.indd 167 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer 168 Chapter 5 Activity-Based Costing and Management Exhibit 5–2 Product Costs from Traditional, Volume-Based Product-Costing System: Patio Grill Company be a highly profitable, low-volume specialty product. Nevertheless, concern continued to mount in Denver about the difficulty in the Patio Standard and Deluxe grill markets. After all, these were the Denver plant’s bread-and-butter products, with projected annual sales of 10,000 Patio Standard grills and 8,000 Deluxe grills. Activity-Based Costing System Patio Grill Company’s director of cost management, Hamilton Burger, had been thinking for some time about a refinement in the Denver plant’s product-costing system. He won- dered if the traditional, volume-based system was providing management with accurate data about product costs. Burger had read about activity-based costing (ABC) systems, which follow a two-stage procedure to assign overhead costs to products. The first stage identifies significant activities in the production of the three products and assigns over- head costs to each activity in accordance with the cost of the organization’s resources used by the activity. The overhead costs assigned to each activity comprise an activity cost pool. After assigning overhead costs to activity cost pools in stage one, cost drivers appro- priate for each cost pool are identified in stage two. Then the overhead costs are allocated from each activity cost pool to each product line in proportion to the amount of the cost driver consumed by the product line. Activity-Based Costing System Learning Objective 5-2 Explain how an activity-based costing system operates, including the use of a two-stage procedure for cost assignment, the identification of activity cost pools, and the selection of cost drivers. Patio Standard Grill STD Deluxe Grill DEL Ultimate Grill ULT Production cost under traditional, volume-based system (Exhibit 5–2) .................................... $496.00 $604.00 $752.00 Target selling price (cost 3 120%) ........................................... 595.20 724.80 902.40 Actual current selling price ....................................................... 585.00 705.00 940.00 Exhibit 5–3 Target and Actual Selling Prices: Patio Grill Company hiL25664_ch05_164-223.indd 168hiL25664_ch05_164-223.indd 168 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer Chapter 5 Activity-Based Costing and Management 169 Facility Flow of production: products consume production-related activities. Overhead costs are assigned to activity cost pools associated with significant activities. Overhead costs are allocated from each activity cost pool to each product in proportion to its consumption of the activity. Each activity has its own cost driver. Setup Machine Related Purchasing Material Handling Quality Assurance Packing/ Shipping STAGE ONE Overhead costs are assigned to activity cost pools. STAGE TWO Overhead costs are assigned to products. Engineering Design Exhibit 5–4 Activity-Based Costing System The two-stage cost-assignment process of activity-based costing is depicted in Exhibit 5–4 . Burger discussed activity-based costing with Patty Cook, the assistant director of cost management. Together they met with all of Patio Grill Company’s department super- visors to discuss development of an ABC system. After initial discussion, an ABC pro- posal was made to the company’s top management. Approval was obtained, and an ABC project team was formed, which included Burger, Cook, and representatives of various functional departments. Through several months of painstaking data collection and anal- ysis, the project team was able to gather the data necessary to implement an ABC system. ABC Stage One Patio Grill Company’s ABC project team identified eight activity cost pools, which fall into four broad categories. 1. Unit level. This type of activity must be done for each unit of production. The machine-related activity cost pool represents a unit-level activity since every product unit requires machine time. 2. Batch level. These activities must be performed for each batch of products, rather than each unit. Patio Grill Company’s batch-level activities include the setup, purchasing, material handling, quality assurance, and packing/shipping activity cost pools. 3. Product-sustaining level. This category includes activities that are needed to support an entire product line but are not performed every time a new unit or batch of products is produced. Patio Grill Company’s project team identified engineering design costs as a product-sustaining-level activity cost pool. 4. Facility (or general operations) level. Facility-level activities are required in order for the entire production process to occur. Examples of such activity costs include plant management salaries, plant depreciation, property taxes, plant maintenance, and insurance. This classification of activities into unit-level, batch-level, product-sustaining-level, and facility-level activities is called a cost hierarchy. Learning Objective 5-3 Explain the concept of cost levels, including unit-level, batch-level, product-sustaining- level, and facility-level costs. hiL25664_ch05_164-223.indd 169hiL25664_ch05_164-223.indd 169 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer 170 Chapter 5 Activity-Based Costing and Management Activity Cost Pools Product-Sustaining Level Unit Level Batch Level Facility Level Engineering Design cost pool $130,000 Purchasing cost pool $300,000 Material-Handling cost pool $340,000 Quality-Assurance cost pool $110,000 Packing/Shipping cost pool $264,000 Machine-Related cost pool $1,242,000 Facility cost pool $2,300,000 Setup cost pool $210,000 Overhead Costs Total budgeted cost = $4,896,000 Exhibit 5–5 Stage One of Activity-Based Costing: Identification of Activity Cost Pools Patio Grill Company’s eight activity cost pools are depicted in Exhibit 5–5 . Notice that the total overhead cost for all eight activity cost pools, $4,896,000, is shown at the top of Exhibit 5–5 . This amount is the same as the total overhead cost shown in Exhibit 5–2 , which shows the details of the product costs calculated under Patio Grill Company’s tra- ditional product-costing system. ABC Stage Two In stage two of the activity-based costing project, Burger and Cook identified cost drivers for each activity cost pool. Then they used a three-step process to compute unit activity costs for each of Patio Grill Company’s three product lines, and for each of the eight activity cost pools. In the following sections, we will discuss in detail how stage two of the ABC project was carried out for the various activity cost pools identified in stage one. Then we will complete the ABC project by developing new product costs for each of the company’s gas-grill product lines. Machine-Related Cost Pool Let’s begin by focusing on only one of the eight activ- ity cost pools. The machine-related cost pool, a unit-level activity, totals $1,242,000 and includes the costs of machine maintenance, depreciation, computer support, lubrication, Learning Objective 5-4 Compute product costs under an activity-based costing system. hiL25664_ch05_164-223.indd 170hiL25664_ch05_164-223.indd 170 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer Chapter 5 Activity-Based Costing and Management 171 electricity, and calibration. Burger and Cook selected machine hours for the cost driver, since a product that uses more machine hours should bear a larger share of machine- related costs. Exhibit 5–6 shows how machinery costs are assigned to products in stage two of the ABC analysis. Notice that Exhibit 5–6 includes just a portion of a larger spread- sheet that we will examine in due course. The spreadsheet rows shown in Exhibit 5–6 focus just on the machine-related activity cost pool. Most of the columns in Exhibit 5–6 contain ABC data that were collected by the ABC project team. We will learn more later in this chapter about how that information is collected. For now, though, let’s just take this ABC information as a given. As noted in Exhibit 5–6 , the following columns contain data collected by the ABC project team. Data Collected by ABC Project Team (Exhibit 5–6) Column A Activity: machine related Column B Activity cost pool: $1,242,000 (from Exhibit 5–5) Column C Cost driver: machine hours Column D Cost driver quantity: 230,000 machine hours (total of machine hours for the three product lines in column G)1 Column F Product lines: STD, DEL, ULT Column G Cost driver quantity for each product line: STD, 100,000 machine hours (from Exhibit 5–1) DEL, 96,000 machine hours (from Exhibit 5–1) ULT, 34,000 machine hours (from Exhibit 5–1) Column I Product line production volume: STD, 10,000 units (from Exhibit 5–1) DEL, 8,000 units (from Exhibit 5–1) ULT, 2,000 units (from Exhibit 5–1) Notice that only three columns in Exhibit 5–6 remain: columns E, H, and J. These columns contain the amounts that are computed during the ABC calculations, and they appear in red in Exhibit 5–6 . Amounts Computed During ABC Calculations (Exhibit 5–6) Column E Pool rate Column H Activity cost for each product line Column J Activity cost per unit of product for each product line Exhibit 5–6 , below the spreadsheet excerpt, shows in detail how each of these amounts (shown in red) is computed. Take time now to examine Exhibit 5–6 carefully, in order to understand how these amounts are computed in the ABC calculations. A key number computed in Exhibit 5–6 (column E) is the pool rate, which is defined as the cost per unit of the cost driver for a particular activity cost pool. The pool rate for the machine-related cost pool is $5.40, which means that Patio Grill Company’s machine- related cost is $5.40 per machine hour. Each activity cost pool will have its own pool rate. Now we have seen the type of data that the ABC project team must supply for the machine-related cost pool. In addition, we have studied how the ABC calculations are carried out in order to determine the machine-related activity cost per unit of each type of product (STD, DEL, and ULT). The final conclusion of the ABC analysis for the machine-related cost pool only is given in column J of Exhibit 5–6 . Thus, under activity- based costing, the following machine-related costs per product unit should be assigned to each of the three product lines. STD: $54.00 of machine-related cost per grill DEL: $64.80 of machine-related cost per grill ULT: $91.80 of machine-related cost per grill 1The 230,000 machine hours used to compute the pool rate for the machine-related cost pool is also equal to man- agement’s estimate of the company’s practical capacity of production, as expressed in terms of machine hours. hiL25664_ch05_164-223.indd 171hiL25664_ch05_164-223.indd 171 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer 172 Chapter 5 Activity-Based Costing and Management INFORMATION SUPPLIED BY ABC PROJECT TEAM ABC CALCULATIONS Activity cost pools Cost drivers Cost driver quantity for each product line; add column G to get total in column D Product line production volume 1 Compute pool rate for machine-related activity 3 Compute product cost per unit for each product line Activity cost pool Activity cost pool Cost driver quantity Cost driver quantity Pool rate 44 5 $1,242,000 4 230,000 5 $5.40 Activity cost per unit of product $54.00 64.80 91.80 Product line STD DEL ULT Activity cost for each product line $540,000 518,400 183,600 Product line production volume 10,000 8,000 2,000 5 5 5 4 4 4 2 Compute total activity cost for each product line Product line STD DEL ULT Pool rate $5.40 5.40 5.40 Pool rate $5.40 5.40 5.40 Cost driver quantity for each product line 100,000 96,000 34,000 Activity cost for each product line $540,000 518,400 183,600 3 3 3 3 5 5 5 5 54 Exhibit 5–6 ABC Data and Calculations for the Machine-Related Cost Pool: Patio Grill Company Completing the ABC Calculations Now that we have studied the ABC data require- ments and calculations for the machine-related cost pool ( Exhibit 5–6 ), we can complete the ABC calculations by including all eight of the activity cost pools. These eight cost pools were given in Exhibit 5–5 . The entire Excel spreadsheet for Patio Grill Company’s activity-based costing project is displayed in Exhibit 5–7 . As the cliché goes, there is good news and bad news. The bad news is that the spreadsheet in Exhibit 5–7 contains eight times as many rows as the one we just examined in detail for the machine-related cost pool. The good news, though, is that the ABC data requirements and calculations are con- ceptually identical for each of the eight activity cost pools. In other words, the same type of ABC data is supplied for each activity cost pool, and the three steps of ABC computa- tions are performed for each activity cost pool in exactly the same manner as they were for the machine-related cost pool. So if we understand the computations in Exhibit 5–6 (for the machine-related costs), then we will understand the computations in Exhibit 5–7 for all eight activity cost pools. (The amounts that are computed in Exhibit 5–7 are shown in red.) Pause here and take a few moments to examine Exhibit 5–7 . Select an activity other than the machine-related activity we studied earlier. Try to verify the computations of the Learning Objective 5-4 Compute product costs under an activity-based costing system. hiL25664_ch05_164-223.indd 172hiL25664_ch05_164-223.indd 172 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer Chapter 5 Activity-Based Costing and Management 173 Exhibit 5–7 Activity-Based Costing Data and Calculations: Patio Grill Company pool rate in column E, the activity cost for each product line in column H, and the ABC overhead cost per unit of product in column J. Now that we have the activity cost per unit of product for each activity cost pool and each product line, it is straightforward to compute the total unit product cost for each type of grill. To do so, we need only add the direct-material and direct-labor costs for each grill type (given in Exhibit 5–1 ) to the ABC activity costs calculated in Exhibit 5–7 . We do this in the Excel spreadsheet displayed as Exhibit 5–8 . Interpreting the ABC Product Costs Hamilton Burger was amazed to see the product costs reported under the activity-based costing system. Both the STD and DEL grills exhibited lower product costs under the ABC system than under the traditional system. This could explain the price competition Patio Grill Company faced on its STD and DEL grills. Patio Grill Company’s competi- tors could sell their comparable standard and deluxe grills at a lower price because they hiL25664_ch05_164-223.indd 173hiL25664_ch05_164-223.indd 173 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer 174 Chapter 5 Activity-Based Costing and Management Exhibit 5–8 Product Costs from Activity-Based Costing System: Patio Grill Company realized it cost less to produce these grills than Patio Grill Company’s traditional cost- ing system had indicated. However, as Burger scanned the new product costs shown in Exhibit 5–8 , he was alarmed by the substantial increase in the reported cost of an ULT grill. The cost of an ULT grill had risen by more than $100 above the company’s original estimate. The complexity of the ULT grills, and its impact on costs, was hidden by the traditional, volume-based costing system. To compare the results of the two alternative costing systems, Burger prepared Exhibit 5–9 . As shown in Exhibit 5–9 , the STD grills emerged as a profitable product, selling for approximately 120 percent of their reported cost under the activity-based costing system ($585 4 $487). The DEL grills also were selling at approximately 120 percent of their new reported product cost ($705 4 $586.30). “No wonder we couldn’t sell the deluxe grills at the old target price of $724.80,” said Burger to Cook, as they looked over the data. “Our competitors probably knew their deluxe grills cost around $586, and they priced them accordingly.” When he got to the ULT column in Exhibit 5–9 , Burger was appalled. “We thought those ultimate grills were a winner,” lamented Burger, “but we’ve been selling them at a price that is just about 8 percent over their cost!” (Burger had made this calculation: actual current selling price of $940 4 ABC product cost of $867.80.) “And worse yet,” Burger continued, “we’ve been selling the ultimate grills for $940, which is more than a hundred dollars below the new target price of $1,041.36.” After looking over the data, Burger made a beeline for the president’s office. “We’ve got to get this operation straightened out,” he thought. This forklift operator is engaged in material handling, which is usually a batch-level activity in an ABC system. These engi- neering students are using a computer-aided-design (CAD) system, which is used in the product-sustaining-level activity of product design. hiL25664_ch05_164-223.indd 174hiL25664_ch05_164-223.indd 174 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer Chapter 5 Activity-Based Costing and Management 175 STD DEL ULT Reported unit overhead cost: Traditional, volume-based costing system (Exhibit 5–2) ........................................ $216.00 $264.00 $ 312.00 Activity-based costing system (Exhibit 5–8) ......................................................... 207.00 246.30 427.80 Reported unit product cost (direct material, direct labor, and overhead): Traditional, volume-based costing system (Exhibit 5–2) ........................................ 496.00 604.00 752.00 Activity-based costing system (Exhibit 5–8) ......................................................... 487.00 586.30 867.80 Sales price data: Original target price (120% of product cost based on traditional, volume-based costing system (Exhibit 5–3) ..................................................... 595.20 724.80 902.40 New target price (120% of product cost based on activity-based costing system .............................................................................................. 584.40 703.56 1,041.36 Actual current selling price (Exhibit 5–3) .................................................................. 585.00 705.00 940.00 Exhibit 5–9 Comparison of Product Costs and Target Prices from Alternative Product-Costing Systems: Patio Grill Company Burger also realized that the comparison of the two product-costing systems was even more striking when he focused on just the reported overhead costs. He commented to Cook, “The direct-material and direct-labor costs for each product line don’t change under ABC. They’re the same under both costing systems. Since these are direct costs, it’s straightforward to trace these costs to each product with considerable accuracy. It’s the overhead costs that cause the problem.” To see what Burger was getting at, look again at Exhibit 5–9 and focus on the top two rows. The overhead cost of a STD grill dropped from the old reported cost of $216 to $207 under ABC. Similarly, the over- head cost of a DEL grill dropped from the old reported cost of $264 to $246.30 under ABC. Now look at the ULT column, though. Here the overhead cost rose from the old reported cost of $312 to $427.80 under ABC! This represents an increase of more than a third. ($427.80 4 $312.00 is a little over 137 percent, which yields an increase of over 37 percent.) The Punch Line What has happened at Patio Grill Company’s Denver plant? The essence of the problem is that the traditional, volume-based costing system was overcosting the high-volume product lines (STD and DEL) and undercosting the complex, relatively low-volume prod- uct line (ULT). The high-volume products basically subsidized the low-volume line. The activity-based costing system revealed this problem by more accurately assigning over- head costs to the three product lines. Exhibit 5–10 summarizes the effects of the cost distortion under the traditional prod- uct-costing system. Patio Grill Company’s traditional system overcosted each STD grill by $9.00, for a total of $90,000 for the STD product line on a volume of 10,000 units. Each DEL grill was overcosted by $17.70, for a total of $141,600 on a volume of 8,000 units for the DEL product line. These excess costs had to come from somewhere, and that place was the ULT product line. Each ULT grill was undercosted by $115.80, for a total of $231,600 for the ULT product line on a volume of 2,000 units. Notice that the total amount by which the STD and DEL grill lines were overcosted equals the total amount by which the ULT grill line was undercosted. Why Traditional, Volume-Based Systems Distort Product Costs Why did Patio Grill Company’s traditional product-costing system distort its product costs? The answer lies in the use of a single, volume-based cost driver. The company’s old costing system assigned overhead to products on the basis of their relative usage of direct labor. Since the STD and DEL grill lines use substantially more direct labor than the ULT grill line, in total, the traditional system assigned them more overhead costs. Learning Objective 5-5 Explain why traditional, volume-based costing systems tend to distort product costs. hiL25664_ch05_164-223.indd 175hiL25664_ch05_164-223.indd 175 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer 176 Chapter 5 Activity-Based Costing and Management Traditional system overcosts STD grills by $9.00 per unit. Traditional system overcosts DEL grills by $17.70 per unit. Traditional system undercosts ULT grills by $(115.80) per unit. Sum of these three amounts is zero. Traditional system shifts costs from ULT product line to STD and DEL product lines. STD DEL ULT STD DEL ULT Traditional, volume based-costing system: reported product cost ................................. $496.00 $604.00 $ 752.00 Activity based-costing system: reported product cost .................................................. 487.00 586.30 867.80 Amount of cost distortion per unit .............................................................................. $ 9.00 $ 17.70 $ (115.80) 3 Production volume ............................................................................................... 3 10,000 3 8,000 3 2,000 Total amount of cost distortion for entire product line ................................................. $90,000 $141,600 $(231,600) Exhibit 5–10 Cost Distortion under Patio Grill Company’s Traditional Product-Costing System The problem with this result is that for every one of Patio Grill Company’s over- head activities, the proportion of the activity actually consumed by the ULT grill line is far greater than its low volume would suggest. The ULT grill line has a budgeted production volume of just 2,000 units, which is only 10 percent of Patio Grill Com- pany’s total budgeted production volume of 20,000 units. (20,000 units 5 10,000 STD units 1 8,000 DEL units 1 2,000 ULT units.) Now examine the ABC calculations in Exhibit 5–7 . Focus on column G, which details the consumption of the cost driver by each product line for each activity cost pool. Notice that for every one of the overhead activities, the ULT grill line consumes much more than a 10 percent share of the activity, even though the ULT line accounts for only 10 percent of budgeted production volume. The relatively heavy consumption of overhead activities by the ULT product line is due to its greater complexity and small production runs. We must conclude, therefore, that direct labor is not a suitable cost driver for Patio Grill Company’s overhead costs. Usage of direct labor does not drive most overhead costs in this company. There are actually two factors working against Patio Grill Company’s old product- costing system. First, many of the activities that result in the company’s overhead costs are not unit-level activities. Second, the company manufactures a diverse set of products. Non-Unit-Level Overhead Costs When Patio Grill Company’s ABC project team designed the activity-based costing system, only the machine-related overhead cost pool hiL25664_ch05_164-223.indd 176hiL25664_ch05_164-223.indd 176 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer Chapter 5 Activity-Based Costing and Management 177 was classified as a unit-level activity. All of the other activities were classified as batch- level, product-sustaining-level, or facility-level activities. This means that many of the company’s overhead costs are not incurred every time a unit is produced. Instead, many of these overhead costs are related to starting new production batches, supporting an entire product line, or running the entire operation. Since direct labor is a unit-level cost driver, it fails to capture the forces that drive these other types of costs. In Patio Grill Company’s new ABC system, cost drivers were chosen that were appropriate for each activity cost pool. For example, since setting up machinery for a new production run is a batch-level activity, the number of production runs is an appropriate batch-level cost driver. Product Diversity Patio Grill Company manufactures three different products. Although all three are gas barbeque grills, the three grills are quite different. The STD and DEL grills are high-volume, relatively simple products. The ULT grills constitute a considerably more complex, and relatively low-volume, product line. As a result of this product line diversity, Patio Grill Company’s three product lines consume overhead activ- ities in different proportions. For example, compare the consumption ratios for the pur- chasing and material-handling activity cost pools shown below. The consumption ratio is the proportion of an activity consumed by a particular product. These widely varying consumption ratios result from Patio Grill Company’s product line diversity. A single cost driver will not capture the widely differing usage of these activities by the three products. The activity-based costing system uses two different cost drivers to assign these costs to the company’s diverse products. Two Key Points To summarize, each of the following characteristics will undermine the ability of a volume-based product-costing system to assign overhead costs accurately. Consumption Ratios* Activity Cost Pool STD DEL ULT Purchasing activity (cost driver is purchase orders, or POs) ........................................................... 200 POs (33%) 192 POs (32%) 208 POs (35%) Material-handling activity (cost driver is production runs) ........................................................................ 80 runs (40%) 80 runs (40%) 40 runs (20%) *The purchase order and production run data come from Exhibit 5–7. Rockwell International (now part of Meritor) anagement ccounting ractice M A P COST DISTORTION AT ROCKWELL INTERNATIONAL When managers at Rockwell International noticed erratic sales in one of the company’s lines of truck axles, they investigated. One of the company’s best axle products was losing market share. A special cost study revealed that the firm’s costing system, which applied costs to products in proportion to direct-labor costs, had resulted in major distor- tions. The reported product costs for high-volume axles were approximately 20 percent too high, and the low-volume axles were being undercosted by roughly 40 percent. The firm’s practice of basing prices on reported product costs resulted in the overpricing of the high-volume axles. As a consequence, Rockwell’s competitors entered the market for the high-volume axle business.2 2For up to date 2013 information about Meritor, see The New York Times (Business Day Section), March 1, 2013. The information about Meritor’s Rockwell axles is from Ford S. Worthy, “Accounting Bores You? Wake Up,” Fortune 116, no. 8, pp. 43–53. For another example of cost distortion, see S. L. Mintz, “Compaq’s Secret Weapon,” CFO 10, no. 10, pp. 93–97. hiL25664_ch05_164-223.indd 177hiL25664_ch05_164-223.indd 177 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer 178 Chapter 5 Activity-Based Costing and Management • A large proportion of non-unit-level activities. A unit-level cost driver, such as direct labor, machine hours, or throughput, will not be able to assign the costs of non-unit-level activities accurately. • Product diversity. When the consumption ratios differ widely between activities, no single cost driver will accurately assign the resulting overhead costs. When either of these characteristics is present, a volume-based product-costing sys- tem is likely to distort product costs. Does the sort of product-cost distortion experienced by Patio Grill Company occur in other companies? The answer is yes, as illustrated by examples from Rockwell and DHL Express transport service. (See pages 177 and 179.) Activity-Based Costing: Some Key Issues Patio Grill Company’s movement toward activity-based costing is typical of changes cur- rently underway in many companies. Added domestic and foreign competition is forcing manufacturers to strive for a better understanding of their cost structures. Moreover, the cost structures of many manufacturers have changed significantly over the past decade. Years ago, a typical manufacturer produced a relatively small number of products that did not differ much in the amount and types of manufacturing support they required. Labor was the dominant element in such a firm’s cost structure. Nowadays, it’s a different ball game. Products are more numerous, are more complicated, and vary more in their production requirements. Perhaps most important, labor is becoming an ever-smaller component of total production costs. All these factors mean manufacturers must take a close look at their traditional, volume-based costing systems and consider a move toward activity-based costing. Among the many well-known manufacturers that have benefited from ABC are Boise Cascade, Caterpillar, Coca-Cola, Chrysler, Hewlett-Packard, John Deere, Johnson & Johnson, Pennzoil, and Pfizer to name only a few. The service sector also has undergone dynamic change in recent years. Increas- ing competition, outsourcing of key business processes, and the growth of the Internet have changed many service companies’ business models. As their business environment changes, many service-industry firms have made use of activity-based costing. Service companies benefiting from ABC include American Airlines, American Express, AT&T, Blue Cross/Blue Shield, DHL Express, FedEx, Genworth, and Toronto Dominion Bank, among many others. Governmental units also have implemented activity-based costing. Among the governmental units that have benefited from ABC are such diverse organiza- tions as the British Navy, the California Department of Taxation, the City of Indianapolis, and several agencies of the U.S. government, including the Immigration and Naturaliza- tion Service, the Internal Revenue Service, the Veterans Affairs Department, and the U.S. Postal Service. An important factor in the move toward ABC systems is related to the information requirements of such systems. The data required for activity-based costing are more read- ily available than in the past. Increasing automation, coupled with sophisticated real-time information systems, provides the kind of data necessary to implement highly accurate product-costing systems. Some key issues related to activity-based costing systems are discussed in the following sections. Cost Drivers A cost driver is a characteristic of an event or activity that results in the incurrence of costs. In activity-based costing systems, the most significant cost drivers are identified. Then a database is created, which shows how these cost drivers are distributed across products. Three factors are important in selecting appropriate cost drivers. Activity-Based Costing: Some Key Issues Learning Objective 5-6 Explain three criteria for selecting cost drivers. “Before the industry really became wide open in long- distance competition [as the result of deregulation], you could get by with knowing less. You could get by with having price structures that were not based on the underlying activities and the costs associated with those activities, but were instead based on broad averages. It was okay. It worked. it’s not good enough anymore. We have to get more precise in our costs. We have to deliver the kinds of prices to our customers that they’re willing to pay.” (5a) TELUS hiL25664_ch05_164-223.indd 178hiL25664_ch05_164-223.indd 178 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer Chapter 5 Activity-Based Costing and Management 179 1. Degree of correlation. The central concept of an activity-based costing system is to assign the costs of each activity to product lines on the basis of how each product line consumes the cost driver identified for that activity. The idea is to infer how each product line consumes the activity by observing how each prod- uct line consumes the cost driver. Therefore, the accuracy of the resulting cost assignments depends on the degree of correlation between consumption of the activity and consumption of the cost driver. Say that inspection cost is selected as an activity cost pool. The objective of the ABC system is to assign inspection costs to product lines on the basis of their consumption of the inspection activity. Two potential cost drivers come to mind: number of inspections and hours of inspection time. If every inspec- tion requires the same amount of time for all products, then the number of inspections on a product line will be highly correlated with the consumption of inspection activity by that product line. On the other hand, if inspections vary significantly in the time required, then simply recording the number of inspec- tions will not adequately portray the consumption of inspection activity. In this case, hours of inspection time would be more highly correlated with the actual consumption of the inspection activity. 2. Cost of measurement. Designing any information system entails cost-benefit trade-offs. The more activity cost pools there are in an activity-based costing system, the greater will be the accuracy of the cost assignments. However, more activity cost pools also entail more cost drivers, which results in greater costs of implementing and maintaining the system. Similarly, the higher the correlation between a cost driver and the actual consumption of the associated activity, the greater the accuracy of the cost assignments. However, it also may be more costly to measure the more highly correlated cost driver. Returning to our example of the inspection activity, it may be that inspection hours make a more accurate cost driver than the number of inspections. It is likely, however, that inspection hours also will be more costly to measure and track over time. “ABC is not a magic bullet, but it is a tool to help you understand your business better.” (5b) Braas Company DHL Express (now a division of Deutsche Post AE) anagement ccounting ractice M A P 3See Joanne Chiu, “DHL to Expand Asia Operations,” The Wall Street Journal Asia Business, June 21, 2012, p. 1; S. Player and C. Cobble, Cornerstones of Decision Making: Profiles of Enterprise ABM (Greensboro, NC: Oakhill Press, 1999), pp. 131–44. COST DISTORTION AT DHL EXPRESS DHL Express, a division of the German logistics company Deutsche Post AE, provides interna- tional express mail services. DHL ships packages to 220 countries and territories through- out the world. Management at DHL found that its cost accounting system had distorted costs between the various types of express transport services the firm provided. Before implementation of a full activity-based costing system at DHL, express transport services provided to banks appeared to be unprofitable, whereas transport services provided to heavy manufacturers appeared to be highly profitable. “This was bad news because we (DHL) had a lot more banking customers than heavy manufacturing customers.” After fully implementing ABC, however, management found that the previous costing sys- tem had used cost drivers that failed to account for package weights, thereby distorting costs between services to banks and services to heavy manufacturers. The ABC analysis revealed that express transport services to banks were actually quite profitable after all.3 hiL25664_ch05_164-223.indd 179hiL25664_ch05_164-223.indd 179 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer 180 Chapter 5 Activity-Based Costing and Management 3. Behavioral effects. Information systems have the potential not only to facilitate decisions but also to influence the behavior of decision makers. This can be good or bad, depending on the behavioral effects. In identifying cost drivers, an ABC analyst should consider the possible behavioral consequences. For example, in a just-in-time (JIT) production environment, a key goal is to reduce inventories and material-handling activities to the absolute minimum level pos- sible. The number of material moves may be the most accurate measure of the consumption of the material-handling activity for cost assignment purposes. It also may have a desirable behavioral effect of inducing managers to reduce the number of times materials are moved, thereby reducing material-handling costs. Dysfunctional behavioral effects are also possible. For example, the number of vendor contacts may be a cost driver for the purchasing activity of vendor selection. This could induce purchasing managers to contact fewer vendors, which could result in the failure to identify the lowest-cost or highest- quality vendor. Collecting ABC Data The output of an organization’s various departments consists of the activities performed by personnel or machines in those departments. Activities usually result in paperwork or the generation of computer documents. For example, engineering departments typi- cally deal with documents such as specification sheets and engineering change orders. Purchasing departments handle requisitions and orders, which may be either hard-copy or computer documents. In an ABC system, analysis of documents such as these can be used to assign the costs of activities to product lines on the basis of the amount of activity generated by each product. Interviews and Paper Trails The information used in Patio Grill Company’s ABC system came initially from extensive interviews with key employees in each of the orga- nization’s support departments and a careful review of each department’s records. In the engineering area, for example, ABC project team members interviewed each engineer to determine the breakdown of time spent on each of the three products. They also examined every engineering change order completed in the past two years. The team concluded that engineering costs were driven largely by engineering hours and that the breakdown was 500 hours for the STD grill line, 400 hours for the DEL grill line, and 400 hours for the ULT grill line. Storyboarding As Patio Grill Company’s project team delved further into the ABC analysis, they made considerable use of another technique for collecting activity data. Storyboarding is a procedure used to develop a detailed process flowchart, which visu- ally represents activities and the relationships among the activities. A storyboarding ses- sion involves all or most of the employees who participate in the activities oriented toward achieving a specific objective. A facilitator helps the employees identify the key activities involved in their jobs. These activities are written on small cards and placed on a large board in the order they are accomplished. Relationships among the activities are shown by the order and proximity of the cards. Other information about the activities is recorded on the cards, such as the amount of time and other resources that are expended on each activity and the events that trigger the activity. After several storyboarding sessions, a completed storyboard emerges, recording key activity information vital to the ABC proj- ect. Historically, storyboards have been used by Walt Disney and other film producers in the development of plots for animated films. More recently, storyboarding has been used by advertising agencies in developing event sequences for TV commercials. Learning Objective 5-7 Discuss several key issues in activity-based costing including data collection and storyboarding. “After the initial run-through, we completed a separate analysis detailing how many times a [cost] driver was used. We performed a sort of cost-benefit analysis. We gave each [cost] driver a grade, such as how easy would the driver be to collect.” (5c) JohnDeere Health Care, Inc. “We were negotiating fees, and the customer was under the impression that they were paying more than they should . . . . To make this customer comfortable with the pricing, we needed a [more accurate] costing system.” (5d) Dana Commercial Credit Corporation hiL25664_ch05_164-223.indd 180hiL25664_ch05_164-223.indd 180 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer Chapter 5 Activity-Based Costing and Management 181 Storyboarding provides a powerful tool for collecting and organizing the data needed in an ABC project. Patio Grill Company’s ABC project team used storyboarding very effectively to study each of the firm’s activity cost pools. The team concluded that pur- chasing costs were driven by the number of purchase orders. Material-handling costs were driven by the number of production runs. Quality-assurance costs were driven by the number of inspection hours devoted to each product line. Packaging and shipping costs were driven by the number of shipments made. In summary, the ABC project team conducted a painstaking and lengthy analysis involving many employee interviews, the examination of hundreds of documents, and storyboarding sessions. The final result was the data used in the ABC calculations dis- played in Exhibits 5–7 and 5–8 . Multidisciplinary ABC Project Teams In order to gather information from all facets of an organization’s operations, it is essential to involve personnel from a variety of func- tional areas. A typical ABC project team includes accounting and finance people as well as engineers, marketing personnel, production and operations managers, and so forth. A multidisciplinary project team not only designs a better ABC system but also helps in gaining credibility for the new system throughout the organization. Activity Dictionary and Bill of Activities Many organizations’ ABC teams compile an activity dictionary, which is a complete listing of the activities identified and used in the ABC analysis. An activity dictionary helps in the implementation of activity-based costing across several divisions of an orga- nization, because it provides for consistency in the ABC system terminology and the complexity of the ABC analyses in the various divisions. A bill of activities is another commonly used element in an ABC analysis. A bill of activities for a product or service is a complete listing of the activities required for the product or service to be produced. As a familiar analogy, think about a recipe for choco- late chip cookies. The bill of materials for the cookies is the list of ingredients provided in the recipe. The bill of activities is the list of steps given in the recipe for making the cookies (e.g., combine ingredients in a bowl, stir in chocolate chips, place spoon-size globs of dough on greased cookie sheet, bake at 375 8 for 10 minutes or until done). “Having a plant-level activity dictionary allows the plant to manage its activities locally and serves as a standard reference that employees can use to see which activities roll up into which processes.” (5e) Navistar International Corporation Interviews with department personnel and storyboarding sessions are often used by activity-based costing project teams to accumulate the data needed for an ABC study. In the interview sessions, an ABC project team member asks departmental employees to detail their activities, as well as the time and other resources consumed by the activities. Storyboards, like the one depicted here, visually show the relationships between the activities performed in an organization. hiL25664_ch05_164-223.indd 181hiL25664_ch05_164-223.indd 181 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer 182 Chapter 5 Activity-Based Costing and Management Activity-Based Management Using activity-based costing (ABC) information to support organizational strategy, improve operations, and manage costs is called activity-based management or ABM. We have already caught a glimpse of activity-based management earlier in this chapter, where the management of Patio Grill Company used ABC information to better under- stand its product-pricing decisions. The company’s management discovered through the ABC analysis that some products were overcosted and some products were undercosted by their traditional product-costing system. This important insight presented manage- ment with the opportunity to revise its product pricing in order to reflect the more accu- rate product costs provided by the ABC analysis. When management followed up on this product-pricing opportunity, it was engaging in activity-based management. However, ABM is a much broader concept than this. Activity-based management involves any use of ABC information to support the organization’s strategy, improve operations, or man- age activities and their resulting costs. Two-Dimensional ABC One way of picturing the relationship between ABC and ABM is in terms of the two-dimensional ABC model depicted in Exhibit 5–11 . 4 The vertical dimension of the model depicts the cost assignment view of an ABC system. From the cost assignment viewpoint, the ABC system uses two-stage cost allocation to assign the costs of resources to the firm’s cost objects. These cost objects could be products manufactured, services produced, or customers served. Now focus on the horizontal dimension of the model. Depicted here is the process view of an ABC system. The emphasis now is on the activities themselves, the various processes by which work is accomplished in the organization. The left-hand side of Exhibit 5–11 depicts activity analysis, which is the detailed identification and descrip- tion of the activities conducted in the enterprise. Activity analysis entails identification not only of the activities but also of their root causes, the events that trigger activities, and the linkages among activities. The right-hand side of Exhibit 5–11 depicts the evalu- ation of activities through performance measures. It is these processes of activity analy- sis and evaluation that comprise activity-based management. Notice that the activities, which appear in the center of both dimensions in Exhibit 5–11 , are the focal point of ABC and ABM. Using ABM to Identify Non-Value-Added Activities and Costs An important goal of activity-based management is to identify and eliminate non- value-added activities and costs. Non-value-added activities are operations that are either (1) unnecessary and dispensable or (2) necessary, but inefficient and improvable. 5 Non-value-added costs, which result from such activities, are the costs of activities that can be eliminated without deterioration of product quality, performance, or perceived value. The following five steps provide a strategy for eliminating non-value-added costs in both manufacturing and service industry firms. Activity-Based Management Learning Objective 5-8 Explain the concepts of activity- based management and two-dimensional ABC. 4This section draws on Lewis J. Soloway, “Using Activity-Based Management in Aerospace and Defense Compa- nies,” Journal of Cost Management 6, no. 4 (Winter 1993), pp. 56–66; and Peter B. B. Turney, “What an Activity- Based Cost Model Looks Like,” Journal of Cost Management 5, no. 4 (Winter 1992), pp. 54–60. 5This definition, as well as other material in this section, is drawn from James A. Brimson, “Improvement and Elim- ination of Non-Value-Added Costs,” Journal of Cost Management 2, no. 2 (Summer 1988), pp. 62–65. hiL25664_ch05_164-223.indd 182hiL25664_ch05_164-223.indd 182 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer Chapter 5 Activity-Based Costing and Management 183 Identifying Activities The first step is activity analysis, which identifies all of the organization’s significant activities. The resulting activity list should be broken down to the most fundamental level practical. For example, rather than listing purchasing as an activity, the list should break down the purchasing operation into its component activities, such as obtaining part specifications, compiling vendor lists, selecting vendors, negotiat- ing prices, ordering, and expediting. Identifying Non-Value-Added Activities Three criteria for determining whether an activity adds value are as follows: • Is the activity necessary? If it’s a duplicate or nonessential operation, it is non-value-added. • Is the activity efficiently performed? In answering this question, it is helpful to compare the actual performance of the activity to a value-added baseline estab- lished using budgets, targets, or external benchmarks. • Is an activity sometimes value-added and sometimes non-value-added? For example, it may be necessary to move work-in-process units between production operations, but unnecessary to move raw materials around while in storage. “Putting a spotlight on non- value-added activities, such as [correcting] errors in procurement, provided the focus for ultimately imple- menting process improve- ments.” (5f) GTE Supply (currently a part of Verizon) Activity analysis Activity evaluation Process View Cost Assignment View Assignment of resource costs to activity cost pools associated with significant activities. Resource Costs Root Causes Activity Triggers Performance Measures Assignment of activity costs to cost objects using second-stage cost drivers. Activities Cost Objects (products or services produced, customers) Exhibit 5–11 Two-Dimensional ABC Model hiL25664_ch05_164-223.indd 183hiL25664_ch05_164-223.indd 183 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer 184 Chapter 5 Activity-Based Costing and Management Understanding Activity Linkages, Root Causes, and Triggers In identifying non-value-added activities, it is critical to understand the ways in which activities are linked together. The following chain of activities provides an example: The rework of defective units is a non-value-added activity. The rework is trig- gered by the identification of defective products during inspection. The root cause of the rework, however, could lie in any one of a number of preceding activities. Perhaps the part specifications were in error. Possibly an unreliable vendor was selected. Maybe the wrong parts were received. Perhaps the production activity is to blame. A set of linked activities (such as that depicted above) is called a process. Sometimes activity analysis is referred to as process value analysis (PVA). Reporting Non-Value-Added Costs Non-value-added costs should be highlighted in activity center cost reports. By identifying non-value-added activities, and reporting their costs, management can strive toward the ongoing goals of process improvement and elimination of non-value-added costs. One approach that cost-management analysts find helpful in identifying non-value- added activities is to categorize the ways in which time is spent in a production process. Let’s return to our illustration of Patio Grill Company’s Denver plant, where gas barbeque grills are manufactured. How is time spent in the plant from the time raw material arrives until a finished gas grill is shipped to a customer? As in most manufacturing operations, time is spent in the following five ways. 1. Process time. The time during which a product is undergoing conversion activity. 2. Inspection time. The amount of time spent ensuring that the product is of high quality. 3. Move time. The time spent moving raw materials, work in process, or finished goods between operations. 4. Waiting time. The amount of time that raw materials or work in process spend waiting for the next operation. 5. Storage time. The time during which materials, partially completed products, or finished goods are held in stock before further processing or shipment to customers. Thinking about the production operation in these terms allows management to ask the questions, “Does the time spent in all of these activities add value to the product? Will the customer pay for it? Can the time spent on inspection be reduced without diminishing product quality? Can production efficiency be improved by reducing the number of times materials, work-in-process, or finished goods are moved from one place to another? Can production be scheduled so that partially completed products spend less time just waiting for the next operation? Can storage time be reduced by ordering raw material and produc- ing products only as they are needed?” Many companies have implemented just-in-time (JIT) inventory and production management systems to reduce move, waiting, and stor- age time. JIT systems are covered in Appendix III at the end of this text (pp. 774–780). If reductions can be made in any of these time-consuming activities, without dimin- ishing product quality or functionality, management has a real opportunity to reduce non-value-added costs. Some companies have begun making a distinction between customer-value-added activities and business-value-added activities. For example, the addition of a 24/7 Specification of parts Vendor selection Receipt of parts Production Inspection of finished goods Rework of defective products hiL25664_ch05_164-223.indd 184hiL25664_ch05_164-223.indd 184 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer Chapter 5 Activity-Based Costing and Management 185 customer-service hotline to assist customers in maximizing their benefits from the prod- ucts or services they have purchased would likely be an activity that customers would value. In contrast, most customers would not value a company’s expenditures on infor- mation technology (IT) or accounting, whereas these activities are likely to be critical to the success of the company’s business model. One widely used approach to cost reduction during a production process is kaizen costing. This Japanese word refers to continual and gradual cost reduction, rather than radical improvement through major innovation or investments in technology. The idea is simple. Improvement is the goal and responsibility of every worker, from the CEO to manual laborers, in every activity, every day, all the time! Customer-Profitability Analysis It is quite possible for a company to have profitable products and, at the same time, incur customer-related costs that make certain customer relationships unprofitable. Customer- profitability analysis uses activity-based costing to determine the activities, costs, and profit associated with serving particular customers. Suppose, for example, that customer X frequently changes its orders after they are placed, but customer Y typically does not. Then the costs incurred in updating sales orders for changes should be recorded in a manner that reflects the fact that customer X is more responsible for those activities and costs than is customer Y. An effective cost management system should allow managers to derive such cost details. Many factors can result in some customers being more profitable than others. Cus- tomers that order in small quantities, order frequently, often change their orders, require special packaging or handling, demand faster delivery, or need special parts or engi- neering design generally are less profitable than customers who demand less in terms of customized services. If managers have a good understanding of which customers are generating the greatest profit, they can make more-informed decisions about customer service. Moreover, this allows customers to be educated as to the costs they are causing when demanding special services. In many cases, customers’ behavior can be changed in a way that reduces costs to the supplier. Then these cost savings can be shared by the supplier and the customer. The task of assigning costs to customers is a challenge. A system must be in place that enables the company to identify which customers are using customer support ser- vices and how frequently they do so. How much time must the company spend on a customer to make the sale and to provide ongoing support services? These costs are in addition to the cost of manufacturing the product or initially providing a service for the customer. Illustration of Customer-Profitability Analysis To illustrate customer-profitability analysis, let’s focus again on Patio Grill Company. Two more years have passed, and the company has successfully implemented its activity- based costing system in its Denver plant. At a recent strategy meeting with her senior management team, Patio Grill Company’s president and CEO expressed interest in assessing the profitability of the entire company’s various customer relationships. She found support for the idea from the director of cost management, who had been reading about customer-profitability analysis in some of his professional journals. The company’s marketing manager also expressed interest in customer-profitability analysis, since he was concerned about the profitability of a couple of Patio Grill Company’s customers in particular. “We have a few customers who seem to want the moon and the stars when it comes to customer service,” he complained. “I know the customer is always right and all, but you really have to wonder if we’re making any money from a couple of these custom- ers, what with all the extra design and packaging they demand. And some of our other Customer-Profitability Analysis Learning Objective 5-9 Explain and execute a customer-profitability analysis. hiL25664_ch05_164-223.indd 185hiL25664_ch05_164-223.indd 185 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer 186 Chapter 5 Activity-Based Costing and Management customers seem to require an awful lot of extra attention in sales calls, order processing, and billing. If we had a better idea of each customer’s profitability, it would help our mar- keting and sales staffs to focus their efforts.” The controller soon had his cost management staff attacking the customer-profitability analysis that the president had requested. The first step required an activity-based cost- ing analysis of certain customer-related costs that could seriously affect a customer’s profitability. Recall that ABC analysis relies on a cost hierarchy with cost levels, such as unit-level, batch-level, product-line-level, customer-level, and facility- or general- operations-level costs. In this use of activity-based costing, the cost management team is focusing on the customer-related costs. After an extensive analysis and several interviews with personnel throughout Patio Grill Company, the cost management team came up with the ABC analysis in Exhibit 5–12 . 6 Based on the activity-based costing information, the cost management team assessed the profitability of each of Patio Grill Company’s customer relationships. Detailed infor- mation from that analysis for five of these customers appears in the Excel spreadsheet in Exhibit 5–13 Customer-Profitability Analysis for Five Designated Customers: Patio Grill Company Customer-Related Activities Cost Driver Base Cost Driver Rate Order processing .............................................................. Purchase orders ................................ $ 150 Sales contacts (phone calls, faxes, etc.) .............................. Contacts ............................................ 100 Sales visits ....................................................................... Visits ................................................. 1,000 Shipment processing ......................................................... Shipments ......................................... 200 Billing and collection ......................................................... Invoices ............................................. 160 Design/engineering change orders ..................................... Engineering/design changes ............... 4,000 Special packaging ............................................................. Units packaged .................................. 40 Special handling ............................................................... Units handled ..................................... 60 Exhibit 5–12 ABC Analysis for Customer-Related Costs: Patio Grill Company 6An important point that could be overlooked here is that activity-based costing analysis can be used in a very specific, targeted manner to address a particular management problem. In this case, the ABC focus is customer- profitability analysis. This is the essence of activity-based management, using the results of an ABC analysis to manage an enterprise more effectively. “When we saw what some of our customers were costing us, we were quite surprised. We shared this information with them, and they were also surprised to see how much work went into servicing them. At this point, we negotiated with them to eliminate certain discounts they were receiv- ing.” (5g) Pfizer (formerly Warner Lambert) hiL25664_ch05_164-223.indd 186hiL25664_ch05_164-223.indd 186 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer Chapter 5 Activity-Based Costing and Management 187 Exhibit 5–13 . These five customers were singled out because three of them are key cus- tomers (i.e., customers 106, 112, and 113), and two of them (107 and 119) were suspected by the marketing manager to be at best marginally profitable. As it turned out, suspi- cions about customers 107 and 119 were well founded. Both customers were found to be unprofitable; in fact, customer 119 had caused a loss of almost $120,000 during the year. A complete customer-profitability analysis for all of Patio Grill Company’s custom- ers appears in the spreadsheet in Exhibit 5–14 . This exhibit reveals several interesting aspects of the customer-profitability scenario. Seventeen of 20 customers are profitable. Bank One Corp. (now part of JPMorgan Chase) anagement ccounting ractice M A P 7“Alienating Customers Isn’t Always a Bad Idea Many Firms Discover,” The Wall Street Journal, January 7, 1999. Exhibit 5–14 Customer-Profitability Analysis with Customers Ranked by Operating Income: Patio Grill Company CUSTOMER PROFITABILITY ANALYSIS AT BANK ONE CORP. The Wall Street Journal described how Bank One Corp. (now part of JPMorgan Chase Bank) has used customer-profitability analysis to guide decisions about customer service. At Bank One Corp., at the time one of the largest banks, “the line in the sand between preferred and nonpreferred customers has become strikingly obvious.” The bank is redesigning its 218 branches in Louisiana so its “Premier One” customers can be whisked away to a special teller window with no wait or to the desk of an appropriate bank officer. “Customers qualify by keeping at least $2,500 in a checking account or a total of $25,000 in a combination of certain bank accounts,” or by paying a $17 monthly fee. “Management estimates that the extra attention will go only to the top 20 percent of its customers.”7 hiL25664_ch05_164-223.indd 187hiL25664_ch05_164-223.indd 187 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer 188 Chapter 5 Activity-Based Costing and Management The three unprofitable customers (107, 134, and 119) resulted in losses of over $240,000 in operating income for Patio Grill Company in a single year! Notice that over 25 percent of the company’s profit is generated by its top three customers. Almost half the compa- ny’s profit comes from its top six customers, and fully three-quarters of its profit is gener- ated by half its customers. This sort of customer-profitability scenario is quite typical for manufacturers. The lion’s share of most companies’ profits comes from a handful of their customers. Such an insight is important for management as it determines where to devote the company’s resources in serving customers. 8 A graphical portrayal of Patio Grill Company’s complete customer-profitability analysis is given in Exhibit 5–15 . This graph is called a customer-profitability profile, and it is a common and useful way of presenting a customer-profitability analysis to management. Activity-Based Costing in the Service Industry We conclude this chapter with the important point that activity-based costing has found widespread usage in the service industry as well as in manufacturing. There have been many ABC success stories in such diverse organizations as airlines, insurance compa- nies, banks, hospitals, financial services firms, hotels, railroads, and government agen- cies. Among the service organizations that used activity-based costing are Air France, American Airlines, American Express, Bank of America, Cambridge Hospital Commu- nity Health Care Network, City of Indianapolis, FedEx, Owens & Minor, Telus, Union Pacific, U.S. Naval Supply Center, and the U.S. Postal Service. The overall objectives of ABC in service firms are no different than they are in manu- facturing companies. Managers want more accurate information about the cost of produc- ing the services they are selling. Moreover, they want to use this information to improve operations and to better meet the needs of their customers in a more cost-effective manner. “Almost any person in any organization that imple- ments ABM has some real surprises when they start seeing the data about customer profitability and product profitability.” (5h) Shiloh Industries, Inc. Activity-Based Costing in the Service Industry 11 2 10 8 11 4 11 6 11 0 12 1 12 4 12 7 12 8 12 5 13 5 13 3 11 3 11 1 10 6 13 6 13 7 10 7 13 4 11 9 110 100 90 80 70 60 50 40 30 20 10 0 Cumulative Operating Income as a Percentage of Total Operating Income *Customers ranked by operating income. 75% of actual operating income 50% of actual operating income 25% of actual operating income Customers* Exhibit 5–15 Customer-Profitability Profile in Terms of Cumulative Operating Income as a Percentage of Total Operating Income: Patio Grill Company 8In a conversation with a vice president from a large consumer-products manufacturer, the author was struck by the executive’s statement that, “You can bet we pay a lot of attention to the needs and desires of the ‘Mart Brothers,’ K and Wal.” “As bankers become more familiar with the [ABC] num- bers and start to embrace them, their decision making improves, their profitability increases, and the growth of the business improves.” (5i) Summit Bancorp (now part of Bank of America) Learning Objective 5-10 Understand and discuss how activity-based costing is used in service-industry organizations. hiL25664_ch05_164-223.indd 188hiL25664_ch05_164-223.indd 188 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer Chapter 5 Activity-Based Costing and Management 189 The general approach of identifying activities, activity cost pools, and cost drivers is used in the service industry as well as in manufacturing. The classification of activities into unit-level, batch-level, product-sustaining-level, and facility-level activities also applies in service industry settings. For example, Pennsylvania Blue Shield used these activity classifications in its ABC system. 9 Examples from the Blue Shield system are as follows: • Unit level: Entering initial claim data into the computer (for each claim received). • Batch level: Moving a batch of claims from one processing step to the next. • Product-sustaining level: Maintenance of the medical-services provider network (i.e., maintaining relationships with physicians and hospitals providing medical care to claimants). • Facility (general operations) level: General administration of the claims busi- ness unit. Activity-Based Costing at Delaware Medical Center To see how management can use activity-based costing in a service-industry setting, let’s explore how ABC is used at Delaware Medical Center’s Primary Care Unit. 10 Delaware Medical Center serves patients in Wilmington, Delaware, and several surrounding coun- ties. The Primary Care Unit is the medical center’s outpatient clinic and provides nearly 25,000 patient appointments in a typical year. The Primary Care Unit’s administration implemented activity-based costing in order to determine how much it costs to serve patients in various categories. The Primary Care Unit classifies patient appointments as routine, extended, or complex, depending on the appointment length and complexity. In addition, each appointment is classified as either a new-patient appointment or a continu- ing-patient appointment. Thus, every patient appointment is one of the following six types. Every patient appointment involves a registered nurse (or RN), who takes vital signs and prepares the patient for the primary health care professional. Then, every patient is seen by one primary health care professional, which can be a physician, a nurse practi- tioner, an intern, or a resident. No appointment involves more than one of these types of primary health care professionals. The Primary Care Unit’s ABC project team designated the following activities and cost drivers. Activity Cost Driver Physician time Physician minutes with patient Nurse practitioner time Nurse practitioner minutes with patient Intern or resident time Intern or resident minutes with patient Registered nurse time Registered nurse minutes with patient Clerical time: new patients New patient visits Clerical time: continuing patients Continuing patient visits Billing Billing lines (i.e., number of line items on bill) Facility Patient visits (both new and continuing) Delaware Medical Center D M C Routine Extended Complex New patient New patient; routine appointment New patient; extended appointment New patient; complex appointment Continuing patient Continuing patient; routine appointment Continuing patient; extended appointment Continuing patient; complex appointment 9Angela Norkiewicz, “Nine Steps to Implementing ABC,” Management Accounting 75, no. 10 (April 1994), pp. 28–33. 10For a more elaborate example of activity-based costing in a hospital’s primary care unit, see V. G. Narayanan, R. Moore, and L. Brem, “Cambridge Hospital Community Health Care Network—The Primary Care Unit” (Boston: The President and Fellows of Harvard College, 2000). In this case, minutes of time with a health care professional is a key cost driver. hiL25664_ch05_164-223.indd 189hiL25664_ch05_164-223.indd 189 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer 190 Chapter 5 Activity-Based Costing and Management The activity-based costing analysis is displayed in the Excel spreadsheet in Exhibit 5–16 . Notice that this ABC spreadsheet for Delaware Medical Center’s Primary Care Unit has a format that is identical to the ABC spreadsheet prepared for Patio Grill Company ( Exhibit 5–7 on page 173). The column headings are different, because the Primary Care Unit provides medical services to patients, whereas Patio Grill Company manufactures barbeque grills. Conceptually and computationally, however, the two Excel spreadsheets are identical. The information supplied by the primary care unit’s ABC project team is located in the following columns. Column A: Activity Column B: Activity cost pool Column C: Cost driver Column D: Cost driver quantity Column F: Patient visit type (routine, extended, or complex) Column G: Cost driver quantity for each type of patient visit Column I: Patient volume for each type of visit The ABC computations are in columns E, H, and J and are shown in red. Column E: Pool rate Pool rate 5 Activity cost pool 4 Cost driver quantity (column E) (column B) (column D) For example, the pool rate for physician time (cell E6) is calculated as follows: $4.00 per physician minute 5 $960,000 4 240,000 minutes of physician time Column H: Activity cost for patient type Activity cost for patient type 5 Pool rate 3 Cost driver quantity for patient type (column H) (column E) (column G) For example, the physician activity cost for a routine visit (cell H6) is calculated as follows: $320,000 5 $4.00 per physician minute 3 80,000 physician minutes on routine visits Column J: Activity cost per patient of each type For example, the physician activity cost per routine patient visit (cell J6) is calculated as follows: $40 per routine visit attended by a physician 5 $320,000 4 8,000 routine visits attended by a physician Interpreting the Primary Care Unit’s ABC Information The Primary Care Unit’s administration can use the ABC information in Exhibit 5–16 to determine the cost of each of the six types of patient appointments discussed earlier. Notice, though, that there is an important conceptual difference in the interpretation of the Primary Care Unit’s ABC data ( Exhibit 5–16 ) versus the interpretation of Patio Grill Company’s ABC data ( Exhibit 5–7 on page 173). In the Patio Grill Company manufac- turing illustration, all eight of the activities identified in the ABC analysis were required by each line of barbeque grills manufactured. However, that is not true in the Primary Care Unit example. In this health care services setting, each patient sees either a physi- cian, or a nurse practitioner, or an intern, or a resident—not all four. Moreover, each patient is either a new patient or a continuing patient—not both. Therefore, to compute Activity cost per patient of each type 5 Activity cost for patient type 4 Patient type volume (column J) (column H) (column I) hiL25664_ch05_164-223.indd 190hiL25664_ch05_164-223.indd 190 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer Chapter 5 Activity-Based Costing and Management 191 Exhibit 5–16 Activity-Based Costing Analy- sis: Delaware Medical Center Delaware Medical Center D M C the cost of a particular type of appointment, we must select only one of the primary health care professionals, which are highlighted by the red bar on the right-hand side of Exhibit 5–16 . Moreover, we select just one of the two categories for clerical time, new patient or continuing patient, which are highlighted by the green bar on the right- hand side of Exhibit 5–16 . Finally, since every patient appointment involves a registered nurse, and billing, and use of the primary care unit facility, all of these activities must be included in the cost calculation. (These activities are highlighted by the yellow bars on the right-hand side of Exhibit 5–16 .) Let’s compute the cost of an extended appointment in which a new patient sees a nurse practitioner. Activity Cost (spreadsheet cell) Nurse practitioner time ........................................................................... $60.00 (cell J11 in Exhibit 5–16) Registered nurse time ............................................................................ 11.50 (cell J19 in Exhibit 5–16) Clerical time: new patients ...................................................................... 11.00 (cell J23 in Exhibit 5–16) Billing .................................................................................................... 1.50 (cell J31 in Exhibit 5–16) Facility .................................................................................................. 10.00 (cell J35 in Exhibit 5–16) Total ...................................................................................................... $94.00 Now let’s compute the cost of a routine appointment in which a continuing patient sees a physician. hiL25664_ch05_164-223.indd 191hiL25664_ch05_164-223.indd 191 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer 192 Chapter 5 Activity-Based Costing and Management With a good understanding of how much it costs the Primary Care Unit to provide various types of patient appointments, the clinic’s administration is in a much better posi- tion to make decisions. Determining appropriate charges for appointments, justifying third-party reimbursements from insurance companies and government agencies, and adding or discontinuing services are among the types of decisions that will be enhanced by the ABC information. Activity Cost (spreadsheet cell) Physician time ...................................................................................... $40.00 (cell J6 in Exhibit 5–16) Registered nurse time ........................................................................... 11.50 (cell J18 in Exhibit 5–16) Clerical time: continuing patients ............................................................ 5.00 (cell J26 in Exhibit 5–16) Billing ................................................................................................... 1.00 (cell J30 in Exhibit 5–16) Facility .................................................................................................. 10.00 (cell J34 in Exhibit 5–16) Total ..................................................................................................... $67.50 Focus on Ethics ETHICAL ISSUES SURROUNDING ACTIVITY-BASED COSTING Xavier Auto Parts, Inc. manufactures a wide range of auto parts, which it sells to auto manufacturers, primarily in the United States and Canada.* The company’s Engine Parts Division operated three plants in South Carolina and specialized in engine parts. The division’s Charlotte plant manufactured some 6,500 different parts. Trouble Brewing Both the Engine Parts Division, as well as the Charlotte plant in particular, had shown satisfactory profitability for the past 20 years. In 2013, however, the Charlotte plant’s profitability took a sharp downward turn, in spite of ris- ing sales. The trend continued through the next several years. Management at both the division and plant levels took note of the plant’s declining profits and held several strategy meetings as a result. Division Strategy The Engine Parts Division had always positioned itself as the industry’s full-line producer. If a customer wanted a product, the division would make it. Although occasionally very-low-volume products were discontinued due to lack of consistent orders, the division’s product line remained a full line of engine parts. As part of its strategy review, divi- sion management did two things. First, an activity-based costing study was initiated in the Charlotte plant in order to give management a better picture of each product line’s profitability. Second, a high-level review was undertaken to determine whether the full-line-producer strategy con- tinued to make sense. Activity-based Costing An ABC project team was formed, and a successful pilot study was conducted on two of the Charlotte plant’s prod- uct lines. Then the ABC project was extended to the entire Charlotte operation. Management was astonished to find that fully a quarter of the plant’s products were selling at a loss. Moreover, the ABC project highlighted the extent of the product-line proliferation at the Charlotte plant. It turned out that in many instances, unprofitable products had been dropped only to creep back into the product line-up after a customer requested it and a salesperson acquiesced. It became a joke around the plant that the only way to be sure a dropped product was really gone was to burn the engineering drawings and destroy the special tools required to make it. ABC Team Recommendations The ABC project team made sweeping recommenda- tions to division management, which suggested that the Charlotte plant’s product lines be pruned and that roughly 20 percent of its products be dropped. New emphasis would then be devoted to increasing the profitability of the remaining 80 percent of the Charlotte plant’s products. hiL25664_ch05_164-223.indd 192hiL25664_ch05_164-223.indd 192 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer 193 Attention would be given to identifying inefficient pro- cesses, and process improvements would be evaluated. Top Management Response Top management balked at the recommendations of the ABC project team. Some top managers did not believe the ABC results. It just seemed impossible to them that so many of the Charlotte plant’s products were losers. Other members of the management team largely accepted the validity of the ABC study, but they, too, hesitated to drop so many products. To do so would most likely have meant massive layoffs and even the possibility of closing the Charlotte plant altogether, while shifting its remaining pro- duction to the division’s other two plants. Some members of the ABC project team quietly speculated that some of the division’s managers were more concerned about their own pay and perks than they were about the well-being of the division. In the final analysis, only a handful of prod- ucts were dropped, and then only if they were suspected to be unprofitable before the ABC study was undertaken. Aftermath The Charlotte plant’s profits continued to deteriorate, as did the Engine Parts Division’s profitability. Eventually, Xavier’s corporate management cut its losses by selling off the Engine Parts Division to a competitor at bargain- basement prices. The division’s new owners closed the Charlotte plant and changed the division’s focus to be a boutique producer of high-quality engine parts, which was more in line with its own corporate strategy. Ethical Issues What ethical issues do you see in this scenario? How would you resolve them? *The scenario described here, while fictitious, is based on several real-world events described in the ABC literature. Anecdotes in vari- ous ABC cases and other sources, as well as the author’s research, form the basis for the events described. A key source is the well- known “Schrader-Bellows” case, by R. Cooper (Boston: President and Fellows of Harvard College), which remains a classic case describing issues surrounding activity-based costing. Chapter Summary LO5-1 Compute product costs under a traditional, volume-based product-costing system. Tradi- tional product-costing systems are structured on single, volume-based cost drivers, such as direct labor or machine hours. Overhead is applied to production jobs using a predetermined overhead rate, which is based on estimates of manufacturing overhead (in the numerator) and the level of some cost driver (in the denominator). LO5-2 Explain how an activity-based costing system operates, including the use of a two-stage procedure for cost assignment, the identification of activity cost pools, and the selection of cost drivers. In the first stage of ABC, resource costs are identified and divided into activity cost pools. In the second stage, a cost driver is selected for each activity cost pool, and the costs in each pool are assigned to cost objects, such as products, services, product lines, customers, and so forth. LO5-3 Explain the concept of cost levels, including unit-level, batch-level, product-sustaining- level, and facility-level costs. Unit-level costs are incurred for each unit produced. Batch-level costs are incurred once for each batch of products (i.e., one production run). Product-sustaining-level costs are incurred once for each product line. Facility-level costs are incurred to keep the overall facility in operation. LO5-4 Compute product costs under an activity-based costing system. A product’s cost is the sum of its direct-material cost, its direct-labor cost, and its overhead cost, which is the accumulation of all the resource costs driven to the product by the various cost drivers selected for the ABC system. LO5-5 Explain why traditional, volume-based costing systems tend to distort product costs. Tra- ditional, volume-based costing systems tend to distort product costs because of two factors: (1) prod- uct-line diversity and (2) non-unit-level overhead costs. No single cost driver can capture the complex relationships between products and the myriad activities necessary to produce and sell them. hiL25664_ch05_164-223.indd 193hiL25664_ch05_164-223.indd 193 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer 194 Chapter 5 Activity-Based Costing and Management Review Problem on Cost Drivers and Product-Cost Distortion LO5-6 Explain three criteria for selecting cost drivers. Three criteria for selecting cost drivers are: (1) the degree of correlation between the cost driver and the incurrence of costs in the activity cost pool associated with the cost driver; (2) the cost of measurement of the cost driver; and (3) the behavioral effects that might result from the selection of a cost driver. LO5-7 Discuss several key issues in activity-based costing, including data collection and story- boarding. Collecting ABC data is difficult and costly. Techniques for data collection include inter- views, examination of work product and other documentation, and sometimes storyboarding, which is a detailed map of the processes used in the organization. LO5-8 Explain the concepts of activity-based management and two-dimensional ABC. Activity- based management (ABM) is the use of activity-based costing information to improve operations and eliminate non-value-added costs. One way of depicting ABM is the two-dimensional ABC model. This model combines the cost assignment role of ABC with the process and activity evaluation view of an ABC system. LO5-9 Explain and execute a customer-profitability analysis. Customer profitability analysis is an application of ABM in which management determines the cost drivers for customer-related costs. The resulting ABC information is then used to assess the profitability of key customer relationships. LO5-10 Understand and discuss how activity-based costing is used in service-industry organiza- tions. Activity-based costing has found widespread successful implementation in the service industry. The application of ABC in the service industry is similar to that in manufacturing, wherein a two-stage costing model is used that first assigns resource costs to activity cost pools and then uses cost drivers to assign the costs in these pools to the various services provided and customers served. Many service- industry firms are implementing ABC and ABM systems to better meet the needs of management. Edgeworth Box Corporation manufactures a variety of special packaging boxes used in the pharmaceu- tical industry. The company’s Dallas plant is semiautomated, but the special nature of the boxes requires some manual labor. The controller has chosen the following activity cost pools, cost drivers, and pool rates for the Dallas plant’s product-costing system. Two recent production orders had the following requirements. Activity Cost Pool Overhead Cost Cost Driver Budgeted Level for Cost Driver Pool Rate Purchasing, storage, and material handling ................ $ 200,000 Raw-material costs $ 1,000,000 20% of material cost Engineering and product design ...................................... 100,000 Hours in design department 5,000 hrs. $20 per hour Machine setup costs ..................... 70,000 Production runs 1,000 runs $70 per run Machine depreciation and maintenance ...................... 300,000 Machine hours 100,000 hrs. $3 per hour Factory depreciation, taxes, insurance, and utilities .............. 200,000 Machine hours 100,000 hrs. $2 per hour Other manufacturing-overhead costs ........................................ 150,000 Machine hours 100,000 hrs. $1.50 per hour Total $1,020,000 20,000 Units of Box C52 10,000 Units of Box W29 Direct-labor hours .................................................................................... 42 hr. 21 hr. Raw-material cost .................................................................................... $40,000 $35,000 Hours in design department ..................................................................... 10 25 Production runs ....................................................................................... 2 4 Machine hours ......................................................................................... 24 20 hiL25664_ch05_164-223.indd 194hiL25664_ch05_164-223.indd 194 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer Chapter 5 Activity-Based Costing and Management 195 Required: 1. Compute the total overhead that should be assigned to each of the two production orders, C52 and W29. 2. Compute the overhead cost per box in each order. 3. Suppose the Dallas plant were to use a single predetermined overhead rate based on direct-labor hours. The direct-labor budget calls for 4,000 hours. a. Compute the predetermined overhead rate per direct-labor hour. b. Compute the total overhead cost that would be assigned to the order for box C52 and the order for box W29. c. Compute the overhead cost per box in each order. 4. Why do the two product-costing systems yield such widely differing overhead costs per box? Solution to Review Problem 1. 2. Overhead cost per box: $.4248 per box $8,496 ______ 20,000 $.79 per box $7,910 ______ 10,000 3. Computations based on a single predetermined overhead rate based on direct-labor hours: a. Total budgeted overhead ___________________________ Total budgeted direct-labor hours 5 $1,020,000 __________ 4,000 5 $255/hr. b. Total overhead assigned to each order: Box C52 order: 42 direct-labor hours 3 $255/hr. 5 $10,710 Box W29 order: 21 direct-labor hours 3 $255/hr. 5 $5,355 c. Overhead cost per box: Box C52: $10,710 4 20,000 5 $.5355 per box Box W29: $5,355 4 10,000 5 $.5355 per box 4. The widely differing overhead costs are assigned as a result of the inherent inaccuracy of the sin- gle, volume-based overhead rate. The relative usage of direct labor by the two production orders does not reflect their relative usage of other manufacturing support services. Box C52 Box W29 Purchasing, storage, and material handling ............................. $8,000 (20% 3 $40,000) $7,000 (20% 3 $35,000) Engineering and product design ............................................. 200 (10 3 $20/hr.) 500 (25 3 $20/hr.) Machine setup costs ............................................................. 140 (2 3 $70/run) 280 (4 3 $70/run) Machine depreciation and maintenance ................................. 72 (24 3 $3/hr.) 60 (20 3 $3/hr.) Factory depreciation, taxes, insurance, and utilities ................. 48 (24 3 $2/hr.) 40 (20 3 $2/hr.) Other manufacturing overhead costs ...................................... 36 (24 3 $1.50/hr.) 30 (20 3 $1.50/hr.) Total overhead assigned to production order ........................... $8,496 $7,910 Key Terms For each term’s definition refer to the indicated page, or turn to the glossary at the end of the text. activity analysis, 182 activity-based costing (ABC) system, 168 activity-based management (ABM), 182 activity cost pool, 168 activity dictionary, 181 batch-level activity, 169 bill of activities, 181 consumption ratio, 177 cost driver, 178 cost hierarchy, 169 customer-profitability analysis, 185 customer profitability profile, 188 facility-(or general-opera- tions) level activity, 169 kaizen costing, 185 non-value-added activities, 182 non-value-added costs, 182 pool rate, 171 process, 184 process value analysis (PVA), 184 product-sustaining-level activity, 169 storyboarding, 180 two-dimensional ABC model, 182 unit-level activity, 169 volume-based (or throughput-based) costing system, 167 ⎛ ⎜ ⎝⎛ ⎜ ⎝⎛ ⎜ ⎝⎛ ⎜ ⎝ hiL25664_ch05_164-223.indd 195hiL25664_ch05_164-223.indd 195 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer 196 Chapter 5 Activity-Based Costing and Management Exercises All applicable Exercises are available with McGraw-Hill’s Connect Accounting ®. Review Questions 5–1. Briefly explain how a traditional, volume-based product-costing system operates. 5–2. Why was Patio Grill Company’s management being misled by the traditional product-costing system? What mistakes were being made? 5–3. Explain how an activity-based costing system operates. 5–4. What are cost drivers? What is their role in an activity- based costing system? 5–5. List and briefly describe the four broad categories of activities identified in stage one of an activity-based costing system. 5–6. How can an activity-based costing system alleviate the problems Patio Grill Company’s management was hav- ing under its traditional, volume-based product-costing system? 5–7. Why do product-costing systems based on a single, volume-based cost driver tend to overcost high-volume products? What undesirable strategic effects can such distortion of product costs have? 5–8. How is the distinction between direct and indirect costs handled differently under volume-based versus activity- based costing systems? 5–9. Explain the concept of a pool rate in activity-based costing. (Refer to Exhibit 5–6 .) 5–10. Briefly explain two factors that tend to result in product cost distortion under traditional, volume-based product- costing systems. 5–11. List three factors that are important in selecting cost drivers for an ABC system. 5–12. What is the role of activity dictionary in an ABC project? 5–13. Explain why a new product-costing system may be needed when line managers suggest that an apparently p rofitable product be dropped. 5–14. Explain why a manufacturer with diverse product lines may benefit from an ABC system. 5–15. Are activity-based costing systems appropriate for the service industry? Explain. 5–16. Explain why the maintenance of the medical-services provider network is treated as a product-sustaining- level activity by Pennsylvania Blue Shield. 5–17. How could the administration at Delaware Medical Center’s Primary Care Unit use the activity-based cost- ing information developed by the ABC project team? 5–18. Explain a key difference in the interpretation of the ABC data in Exhibit 5–7 (Patio Grill Company) and Exhibit 5–16 (Delaware Medical Center). 5–19. Explain the concept of two-dimensional ABC. Support your explanation with a diagram. 5–20. What is meant by the term activity analysis? Give three criteria for determining whether an activity adds value. 5–21. Distinguish between an activity’s trigger and its root cause. Give an example of each. 5–22. What is meant by customer-profitability analysis? Give an example of an activity that might be performed more commonly for one customer than for another. 5–23. Explain the relationship between customer profitability analysis and activity-based costing. 5–24. What is a customer profitability profile? 5–25. Give an example of a customer-value-added activity and a business-value-added activity in a hotel. Precision Lens Company manufactures sophisticated lenses and mirrors used in large optical telescopes. The company is now preparing its annual profit plan. As part of its analysis of the profitability of indi- vidual products, the controller estimates the amount of overhead that should be allocated to the individ- ual product lines from the following information. The total budgeted material-handling cost is $90,000. Required: 1. Under a costing system that allocates overhead on the basis of direct-labor hours, the material- handling costs allocated to one mirror would be what amount? 2. Answer the same question as in requirement (1), but for lenses. 3. Under activity-based costing (ABC), the material-handling costs allocated to one mirror would be what amount? The cost driver for the material-handling activity is the number of material moves. 4. Answer the same question as in requirement (3), but for lenses. (CMA, adapted) ■ Exercise 5–26 Volume-Based Cost Driver versus ABC (LO 5-1, 5-2, 5-4) Mirrors Lenses Units produced .......................................................... 30 30 Material moves per product line .................................. 4 16 Direct-labor hours per unit .......................................... 250 250 hiL25664_ch05_164-223.indd 196hiL25664_ch05_164-223.indd 196 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer Chapter 5 Activity-Based Costing and Management 197 Digitech, Ltd. manufactures various computer components in its Tokyo plant. The following costs are budgeted for January. (Yen is the Japanese monetary unit.) Required: Divide these costs into activity cost pools, and identify a cost driver for assigning each pool of costs to products. Calculate the total cost in each activity cost pool. Refer to the information given in the preceding exercise. For each of the activity cost pools identified, indicate whether it represents a unit-level, batch-level, product-sustaining-level, or facility-level activity. Rainbow Spray Paints, Inc. has used a traditional cost accounting system to apply quality-control costs uniformly to all products at a rate of 16 percent of direct-labor cost. Monthly direct-labor cost for the enamel paint line is $98,000. In an attempt to more equitably distribute quality-control costs, Rainbow is considering activity-based costing. The monthly data shown in the following chart have been gathered for the enamel paint line. Required: 1. Calculate the monthly quality-control cost to be assigned to the enamel paint line under each of the following product-costing systems. a. Traditional system which assigns overhead on the basis of direct-labor cost. b. Activity-based costing. 2. Does the traditional product-costing system overcost or undercost the enamel paint line with respect to quality-control costs? By what amount? (CMA, adapted) Wheelco, Inc. manufactures automobile and truck wheels. The company produces four basic, h igh- volume wheels used by each of the large automobile and pickup truck manufacturers. Wheelco also has two specialty wheel lines. These are fancy, complicated wheels used in expensive sports cars. Lately, Wheelco’s profits have been declining. Foreign competitors have been undercutting Wheel- co’s prices in three of its bread-and-butter product lines, and Wheelco’s sales volume and market share have declined. In contrast, Wheelco’s specialty wheels have been selling steadily, although in relatively small numbers, in spite of three recent price increases. At a recent staff meeting, Wheelco’s president made the following remarks: “Our profits are going down the tubes, folks. It costs us 31 dollars to manufacture our DC16 wheel. That’s our best seller, with a volume last year of 19,000 units. But our chief competitor is selling basically the same wheel for 28 bucks. I don’t see how they can do it. I think ■ Exercise 5–27 Cost Drivers; Activity Cost Pools (LO 5-2, 5-3)Insurance, plant ............................................................................................................................. 780,000 yen Electricity, machinery ..................................................................................................................... 156,000 Electricity, light ............................................................................................................................... 78,000 Engineering design ........................................................................................................................ 793,000 Depreciation, plant ......................................................................................................................... 910,000 Depreciation, machinery ................................................................................................................. 1,820,000 Custodial wages, plant ................................................................................................................... 52,000 Equipment maintenance, wages ..................................................................................................... 195,000 Equipment maintenance, parts ........................................................................................................ 39,000 Setup wages ................................................................................................................................. 52,000 Inspection of finished goods ........................................................................................................... 39,000 Property taxes ............................................................................................................................... 156,000 Natural gas, heating ....................................................................................................................... 39,000 Raw materials and components ...................................................................................................... 3,835,000 ■ Exercise 5–28 Categorizing Activity Cost Pools (LO 5-2, 5-3) ■ Exercise 5–29 Activity-Based Costing; Quality Control Costs (LO 5-1, 5-2, 5-4, 5-5) Activity Cost Pool Cost Driver Pool Rates Quantity of Driver for Enamel Paint Incoming material inspection ................. Type of material .................. $ 23.00 per type ............ 24 types In-process inspection ............................ Number of units .................. .28 per unit ............. 35,000 units Product certification .............................. Per order ............................ 144.00 per order ........... 50 orders ■ Exercise 5–30 Distortion of Product Costs (LO 5-2, 5-5) hiL25664_ch05_164-223.indd 197hiL25664_ch05_164-223.indd 197 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer 198 Chapter 5 Activity-Based Costing and Management it’s just one more example of foreign dumping. I’m going to write my senator about it! Thank goodness for our specialty wheels. I think we’ve got to get our sales people to push those wheels more and more. Take the JY16 model, for example. It’s a complicated thing to make, and we don’t sell many. But look at the profit margin. Those wheels cost us 52 dollars to make, and we’re selling them for 110 bucks each.” Required: What do you think is behind the problems faced by Wheelco? Comment on the president’s remarks. Do you think his strategy is a good one? What do you recommend, and why? Refer to the description given for Wheelco, Inc., in the preceding exercise. Suppose the firm’s president has decided to implement an activity-based costing system. Required: 1. List and briefly describe the key features that Wheelco’s new product-costing system should have. 2. What impact will the new system be likely to have on the company’s situation? 3. What strategic options would you expect to be suggested by the product-costing results from the new system? Seneca Falls Winery is a small, family-run operation in upstate New York. The winery produces two vari- eties of wine: riesling and chardonnay. Among the activities engaged in by the winery are the following: 1. Trimming: At the end of a growing season, the vines are trimmed, which helps prepare them for the next harvest. 2. Tying: The vines are tied onto wires to help protect them from the cold. (This also occurs at the end of the season.) 3. Hilling: Dirt is piled up around the roots to help protect them from frost. 4. Conditioning: After the snow melts in the spring, dirt is leveled back from the roots. 5. Untying: The vines are untied from the wires to allow them freedom to grow during the spring and summer months. 6. Chemical spraying: The vines are sprayed in the spring to protect them from disease and insects. 7. Harvesting: All of the grapes of both varieties are picked by hand to mini- mize damage. 8. Stemming and crushing: Batches of grapes are hand-loaded into a machine, which gently removes the stems and mildly crushes them. 9. Pressing: After removal from the stemmer/crusher, the juice runs freely from the grapes. 10. Filtering: The grapes are crushed mechanically to render more juice from them. 11. Fermentation: The riesling grape juice is placed in stainless steel tanks for fer- mentation. The chardonnay grape juice undergoes a two-stage fermentation process in oak barrels. 12. Aging: The riesling wines are aged in the stainless steel tanks for approximately a year. The chardonnays are aged in the oak bar- rels for about two years. 13. Bottling: A machine bottles the wine and corks the bottles. 14. Labeling: Each bottle is manually labeled with the name of the vintner, vintage, and variety. 15. Packing: The bottles are manually packed in 12-bottle cases. 16. Case labeling: The cases are hand-stamped with the same information that the bottles received. 17. Shipping: The wine is shipped to wine distributors and retailers, mainly in central New York. Generally, about 100 cases are shipped at a time. 18. Maintenance on buildings: This is done during the slow winter months. 19. Maintenance on equipment: This is done when needed, and on a routine basis for preventive maintenance. Required: Classify each of the activities listed as a unit, batch, product-sustaining, or facility-level activity. ■ Exercise 5–31 Key Features of Activity-Based Costing (LO 5-2, 5-5, 5-8) ■ Exercise 5–32 Winery; Classification of Activities (LO 5-2, 5-3, 5-6, 5-7) hiL25664_ch05_164-223.indd 198hiL25664_ch05_164-223.indd 198 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer Chapter 5 Activity-Based Costing and Management 199 Zodiac Model Rocketry Company sells model rocketry kits and supplies to retail outlets and through its catalog. Some of the items are manufactured by Zodiac, while others are purchased for resale. For the products it manufactures, the company currently bases its selling prices on a product-costing system that accounts for direct material, direct labor, and the associated overhead costs. In addition to these product costs, Zodiac incurs substantial selling costs, and Jack Maxey, controller, has suggested that these sell- ing costs should be included in the product pricing structure. After studying the costs incurred over the past two years for one of its products, rocket motors, Maxey has selected four categories of selling costs and chosen cost drivers for each of these costs. The selling costs actually incurred during the past year and the cost drivers are as follows: The rocket motors are sold to retail outlets in boxes, each containing 12 motors. The sale of partial boxes is not permitted. Commissions are paid on sales to retail outlets but not on catalog sales. The cost of catalog sales includes telephone costs and the wages of personnel who take the catalog orders. Maxey believes that the selling costs vary significantly with the size of the order. Order sizes are divided into three categories as follows: An analysis of the previous year’s records produced the following statistics. Required: 1. Prepare a schedule showing Zodiac Model Rocketry Company’s total selling cost for each order size and the per-rocket motor selling cost within each order size. 2. Explain how the analysis of the selling costs for rocket motors is likely to impact future pricing and product decisions at Zodiac Model Rocketry Company. (CMA, adapted) United Technologies Corporation is using activity-based costing in two of its subsidiaries: Otis Elevator Company and Carrier Corporation. The following table shows 27 activities and eight accounts identified at Carrier, along with the classification determined by the ABC project team. 11 ■ Exercise 5–33 ABC; Selling Costs (LO 5-2, 5-4, 5-6) Cost Category Amount Cost Driver Sales commissions ....................................... $ 675,000 Boxes of rocket motors sold to retail stores Catalogs ....................................................... 295,400 Catalogs distributed Costs of catalog sales ................................... 105,000 Rocket motors sold through catalogs Credit and collection ..................................... 60,000 Number of retail orders Total selling costs .......................................... $1,135,400 Order Size Catalog Sales Retail Sales Small ........................................................... 1–10 rocket motors 1–10 boxes of motors Medium ....................................................... 11–20 rocket motors 11–20 boxes of motors Large ........................................................... Over 20 rocket motors Over 20 boxes of motors Order Size Small Medium Large Total Retail sales in boxes (12 motors per box) .............................. 2,000 45,000 178,000 225,000 Catalog sales in units (i.e., motors) ....................................... 79,000 52,000 44,000 175,000 Number of retail orders ....................................................... 485 2,415 3,100 6,000 Catalogs distributed ............................................................ 254,300 211,300 125,200 590,800 ■ Exercise 5–34 United Technologies; Classification of Activities (LO 5-2, 5-3, 5-6, 5-7) 11Robert Adams and Ray Carter, “United Technologies’ Activity-Based Accounting Is a Catalyst for Success,” As Easy as ABC 18 (1995), p. 4. United Technologies uses the term “structural-level activity,” instead of “facility-level activity” as we have done in the chapter and in the table presented here. Name of Activity or Account Classification by Activity Level Acquiring material ........................... Batch Inspecting incoming materials ......... Batch Moving materials ............................ Batch Planning production ........................ Batch Name of Activity or Account Classification by Activity Level Processing special orders ................ Batch Processing supplier invoices ............ Batch Receiving material .......................... Batch Scheduling production ..................... Batch (continues ) hiL25664_ch05_164-223.indd 199hiL25664_ch05_164-223.indd 199 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer 200 Chapter 5 Activity-Based Costing and Management Required: Choose two activities or accounts from each of the four classifications and explain why you agree or disagree with the ABC project team’s classification. As a group, discuss the activities of your college or university admission, registration, etc.). List as many activities as you can. Required: Make a presentation to your class that includes the following: 1. Your list of activities. 2. The classification of each activity (e.g., unit level). 3. An appropriate cost driver for each activity. Visit the website of a city, state, or Canadian province of your choosing (e.g., the City of Charlotte, www.charmeck.org ). Required: Read about the services offered to the public by this governmental unit. Then discuss how activity-based costing could be used effectively by the governmental unit to determine the cost of pro- viding these services. Non-value-added costs occur in nonmanufacturing organizations, just as they do in manufacturing firms. Required: Identify four potential non-value-added costs in (1) an airline, (2) a bank, and (3) a hotel. Since you have always wanted to be an industrial baron, invent your own product and describe at least five steps used in its production. Required: Explain how you would go about identifying non-value-added costs in the production process. List five activities performed by the employees of an airline on the ground. Required: For each of these activities, suggest a performance measure that could be used in activity- based management. ■ Exercise 5–35 Classification of Activities in a University; Cost Drivers (LO 5-2, 5-3, 5-6, 5-7, 5-10) ■ Exercise 5–36 Activity-Based Costing in a Government Agency; Use of Internet (LO 5-2, 5-8, 5-10) ■ Exercise 5–37 Non-Value-Added Costs (LO 5-8) ■ Exercise 5–38 Design Your Own Production Process; Non-Value-Added Costs (LO 5-8) ■ Exercise 5–39 Performance Measures in Two-Dimensional ABC; ABM (LO 5-8, 5-10) Name of Activity or Account Classification by Activity Level Inspecting production processes .................................. Batch Processing purchase orders ........................................ Batch Building occupancy ......................... Facility Depreciation ................................... Facility General management ...................... Facility Maintaining facilities ....................... Facility Managing the environment ............................... Facility Assuring quality .............................. Sustaining Expediting ...................................... Sustaining Maintaining tools and dies ..................................... Sustaining Maintaining/improving production processes ................... Sustaining Managing human resources ............. Sustaining Name of Activity or Account Classification by Activity Level Managing waste disposal ................. Sustaining Processing payroll ............................ Sustaining Processing production information .................................. Sustaining Providing product cost ...................... Sustaining Setting manufacturing methods ...................................... Sustaining Supervising production ..................... Sustaining Sustaining accounting ...................... Sustaining Maintaining production equipment .... Sustaining Direct-labor allowances .................... Unit Direct-labor fringes .......................... Unit Utilities (equipment) ......................... Unit Overtime (hourly) ............................. Unit Rework ........................................... Unit Shift differential ............................... Unit Spoilage .......................................... Unit hiL25664_ch05_164-223.indd 200hiL25664_ch05_164-223.indd 200 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer Chapter 5 Activity-Based Costing and Management 201 Visit a restaurant for a meal or think carefully about a recent visit to a restaurant. List as many a ctivities as you can think of that would be performed by the restaurant’s employees for its customers. Required: For each activity on your list, indicate the following: 1. Value-added or non-value-added. 2. The trigger of the activity. 3. The possible root causes of the activity. As a group, think carefully about the various activities and steps involved in the course registration pro- cess at your college or university. Required: 1. List the steps in the registration process in the sequence in which they occur. 2. Prepare an activity analysis of the registration process. Discuss the activity linkages, triggers, and root causes. 3. Redesign your institution’s course registration process with these goals in mind: a. Improve the convenience and effectiveness of the process for a student registering. b. Improve the effectiveness and cost efficiency of the process from the standpoint of the institution. The customer-profitability analysis for Patio Grill Company, which is displayed in Exhibit 5–14 , ranks customers by operating income. An alternative, often-used approach is to rank customers by sales revenue. Required: 1. List the customer numbers in the left-hand column of Exhibit 5–14 by sales revenue, from highest to lowest. Is the ranking different from that in Exhibit 5–14 ? 2. Patio Grill Company’s smallest customers, in terms of sales revenue, are last in the listing prepared for requirement (1). Are these customers the company’s least profitable? 3. Would the customer-profitability profile in Exhibit 5–15 be different if the customers were ranked by sales revenue instead of operating income? Explain. 4. What factors could cause a larger customer (in terms of sales revenue) to be less profitable than a smaller customer? Windy City Design Company specializes in designing commercial office space in Chicago. The firm’s president recently reviewed the following income statement and noticed that operating profits were below her expectations. She had a hunch that certain customers were not profitable for the company and asked the controller to perform a customer-profitability analysis showing profitability by customer for the month of October. The controller provided the following customer-profitability graph: ■ Exercise 5–40 Activity Analysis; Non-Value-Added Activities (LO 5-8, 5-10) ■ Exercise 5–41 College Registration; Activity Analysis (LO 5-8, 5-10) ■ Exercise 5–42 Customer Profitability Analysis; Customers Ranked by Sales Revenue (LO 5-9) ■ Exercise 5–43 Customer-Profitability Graph (LO 5-9) WINDY CITY DESIGN COMPANY Income Statement For the Month Ended October 31 Sales revenue ..................................................................................................................... $300,000 Cost of services billed ......................................................................................................... 255,000 Gross margin ...................................................................................................................... $ 45,000 Marketing and administrative costs ...................................................................................... 30,000 Operating income ............................................................................................................... $ 15,000 hiL25664_ch05_164-223.indd 201hiL25664_ch05_164-223.indd 201 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer 202 Chapter 5 Activity-Based Costing and Management Required: Put yourself in the position of Windy City’s controller and write a memo to the president to accompany the customer-profitability graph. Comment on the implications of the customer-profitability analysis and raise four or more questions that should be addressed by the firm’s management team. Service-industry firms can make effective use of ABC systems as well as manufacturers. For each of the following businesses, list five key activities that are important in the provision of the firm’s service. For each activity cost pool, suggest an appropriate cost driver to use in assigning costs from the activity cost pool to the services provided to customers. 1. Delta Airlines 2. Kentucky Fried Chicken 3. Island Health & Fitness Club 4. Bank of America branch bank 5. Sheraton Hotel 6. Cook County Hospital ■ Exercise 5–44 Activity-based Costing (LO 5-2, 5-3, 5-10) O p er at in g in co m e $8,000 WINDY CITY DESIGN COMPANY Customer-Profitability Graph For the Month Ended October 31 1 $5,500 2 $4,500 3 $4,000 4 Customer number $ –5,000 –4,000 –3,000 –2,000 –1,000 0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 5 –$2,000 6 – $5,000 Clark and Shiffer LLP perform activities related to e-commerce consulting and information systems in Vancouver, British Columbia. The firm, which bills $140 per hour for services performed, is in a very tight local labor market and is having difficulty finding quality help for its overworked professional staff. The cost per hour for professional staff time is $50. Selected information follows. • Billable hours to clients for the year totaled 6,000, consisting of: information systems services, 3,600; e-commerce consulting, 2,400. • Administrative cost of $381,760 was (and continues to be) allocated to both services based on bill- able hours. These costs consist of staff support, $207,000; in-house computing, $145,000; and mis- cellaneous office charges, $29,760. A recent analysis of staff support costs found a correlation with the number of clients served. In- house computing and miscellaneous office charges varied directly with the number of computer hours logged and number of client transactions, respectively. A tabulation revealed the following data: ■ Problem 5–45 Activity-Based Costing; Analysis of Operations (LO 5-1, 5-2, 5-3, 5-4, 5-8) 2. E-commerce consulting, billings, $336,000 3. Application rate, staff support: $690 per client E-Commerce Consulting Information Systems Services Total Number of clients ...................................................................................... 60 240 300 Number of computer hours ......................................................................... 2,100 2,900 5,000 Number of client transactions ..................................................................... 720 480 1,200 Problems All applicable Problems are available with McGraw-Hill’s Connect Accounting ®. hiL25664_ch05_164-223.indd 202hiL25664_ch05_164-223.indd 202 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer Chapter 5 Activity-Based Costing and Management 203 Required: 1. Activity-based costing (ABC) is said to result in improved costing accuracy when compared with traditional costing procedures. Briefly explain how this improved accuracy is attained. 2. Assume that the firm uses traditional costing procedures, allocating total costs on the basis of bill- able hours. Determine the profitability of the firm’s e-commerce and information systems activi- ties, expressing your answer both in dollars and as a percentage of activity revenue. 3. Repeat requirement (2), using activity-based costing. 4. Stephen Shiffer, one of the firm’s partners, doesn’t care where his professionals spend their time because, as he notes, “many clients have come to expect both services and we need both to stay in business. Also, information systems and e-commerce professionals are paid the same hourly rate.” Should Shiffer’s attitude change? Explain. 5. Is an aggressive expansion of either service currently desirable? Briefly discuss. Kitchen King’s Toledo plant manufactures three product lines, all multi-burner, ceramic cook tops. The plant’s three product models are the Regular (REG), the Advanced (ADV), and the Gourmet (GMT). Until recently, the plant used a job-order product-costing system, with manufacturing overhead applied on the basis of direct-labor hours. The following table displays the basic data upon which the traditional costing system was based. The annual budgeted overhead is $1,224,000, and the company’s predetermined overhead rate is $12 per direct-labor hour. The product costs for the three product models, as reported under the plant’s traditional costing system, are shown in the following table. Kitchen King’s pricing policy is to set a target price for each product equal to 130 percent of the full product cost. Due to price competition from other appliance manufacturers, REG units were selling at $525, and ADV units were selling for $628. These prices were somewhat below the firm’s target prices. However, these results were partially offset by greater-than-expected profits on the GMT product line. Management had raised the price on the GMT model to $800, which was higher than the original target price. Even at this price, Kitchen King’s customers did not seem to hesitate to place orders, Moreover, the company’s competitors did not mount a challenge in the market for the GMT product line. Neverthe- less, concern continued to mount in Toledo about the difficulty in the REG and ADV markets. After all, these were the plant’s bread-and-butter products, with projected annual sales of 5,000 REG units and 4,000 ADV units. Kitchen King’s director of cost management, Angela Ramirez, had been thinking for some time about a refinement in the Toledo plant’s product-costing system. Ramirez wondered if the traditional, volume-based system was providing management with accurate data about product costs. She had read about activity-based costing, and wondered if ABC would be an improvement to the plant’s ■ Problem 5–46 Straightforward ABC calculations (LO 5-1, 5-2, 5-3, 5-4, 5-5) 2. Machine-related costs for REG line: $135,000 3. Total cost per unit, under ABC, for GMT line: $663.90 5. Cost distortion per unit for ADV line: overcosted by $8.85 REG ADV GMT Planned annual production: Volume in units ...................... 5,000 4,000 1,000 Production runs ..................... 40 runs of 125 units 40 runs of 100 units 20 runs of 50 units Direct material $129 $151 $203 Direct labor: (not including setup) .............. $171 (9 hrs. @ $19 per hr.) $209 (11 hrs. @ $19 per hr.) $247 (13 hrs. @ $19 per hr.) Machine hours (MH) per product unit ..................... 10 MH 12 MH 17 MH Total machine hours consumed by product line in a year ......... 50,000 (10 MH 3 5,000) 48,000 (12 MH 3 4,000) 17,000 (17 MH 3 1,000) REG ADV GMT Direct material ............................................ $129.00 $151.00 $203.00 Direct labor (not including set-up time) ....................... 171.00 (9 hr. @ $19) 209.00 (11 hr. @ $19) 247.00 (13 hr. @ $19) Manufacturing overhead ............................... 108.00 (9 hr. @ $12) 132.00 (11 hr. @ $12) 156.00 (13 hr. @ $12) Total cost per unit ........................................ $408.00 $492.00 $606.00 hiL25664_ch05_164-223.indd 203hiL25664_ch05_164-223.indd 203 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer 204 Chapter 5 Activity-Based Costing and Management product-costing system. After some discussion, an ABC proposal was made to the company’s top man- agement, and approval was obtained. The data collected for the new ABC system is displayed in the following table. Required: 1. Show how the company’s overhead rate of $12 per direct-labor hour was calculated. 2. Complete an activity-based costing analysis for Kitchen King’s three product lines. Display the results of your ABC analysis in a table similar to Exhibit 5–7 in the text. 3. Prepare a table similar to Exhibit 5–8 , which computes the new product cost for each product line under ABC. 4. Prepare a table similar to Exhibit 5–9 , which compares the overhead cost, total product cost, and target price for each product line under the two alternative costing systems. 5. Was each of Kitchen King’s three product lines overcosted or undercosted? By how much per unit? 6. Build a spreadsheet: Construct an Excel spreadsheet to solve requirement (2). Show how the solu- tion would change if the machine-related cost pool was $621,000, and the facility cost pool was $1,150,000. Activity Activity Cost Pool Cost Driver Product Line Cost Driver Quantity for Product Line Machine related ............................................ $310,500 Machine REG 50,000 Hours ADV 48,000 GMT 17,000 Total 115,000 Material handling .......................................... 52,500 Production REG 40 Runs ADV 40 GMT 20 Total 100 Purchasing ................................................... $ 75,000 Purchase REG 100 Orders ADV 96 GMT 104 Total 300 Setup ............................................................ 85,000 Production REG 40 Runs ADV 40 GMT 20 Total 100 Inspection .................................................... 27,500 Inspection REG 400 Hours ADV 400 GMT 300 Total 1,100 Shipping ....................................................... 66,000 Shipments REG 500 ADV 400 GMT 200 Total 1,100 Engineering .................................................. 32,500 Engineering REG 250 Hours ADV 200 GMT 200 Total 650 Facility ......................................................... 575,000 Machine REG 50,000 Hours ADV 48,000 GMT 17,000 Total 115,000 hiL25664_ch05_164-223.indd 204hiL25664_ch05_164-223.indd 204 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer Chapter 5 Activity-Based Costing and Management 205 Refer to your solution to requirement (2) of the preceding problem. Required: Prepare an exhibit similar to Exhibit 5–6 in the text to explain the ABC calculations for the material-handling activity. Use your exhibit to explain ABC to a friend who is not a business major. Wilmington Office Equipment Corporation manufactures two types of filing cabinets—Deluxe and Executive—and applies manufacturing overhead to all units at the rate of $80 per machine hour. Produc- tion information follows. The controller, who is studying the use of activity-based costing, has determined that the firm’s over- head can be identified with three activities: manufacturing setups, machine processing, and product shipping. Data on the number of setups, machine hours, and outgoing shipments, which are the activi- ties’ three respective cost drivers, follow. The firm’s total overhead of $6,160,000 is subdivided as follows: manufacturing setups, $1,344,000; machine processing, $3,696,000; and product shipping, $1,120,000. Required: 1. Compute the unit manufacturing cost of Deluxe and Executive filing cabinets by using the com- pany’s current overhead costing procedures. 2. Compute the unit manufacturing cost of Deluxe and Executive filing cabinets by using activity- based costing. 3. Is the cost of the Deluxe filing cabinet overstated or understated (i.e., distorted) by the use of machine hours to allocate total manufacturing overhead to production? By how much? 4. Calculate the aggregate amount by which the Deluxe cabinet line is undercosted by the company’s current traditional overhead costing procedures. Then calculate the aggregate amount by which the traditional system overcosts the Executive cabinet line. 5. Assume that the current selling price of a Deluxe filing cabinet is $270 and the marketing manager is contemplating a $30 discount to stimulate volume. Is this discount advisable? Briefly discuss. Digital Light Corporation has just completed a major change in its quality control (QC) process. Previ- ously, products had been reviewed by QC inspectors at the end of each major process, and the com- pany’s 10 QC inspectors were charged as direct labor to the operation or job. In an effort to improve efficiency and quality, a computerized video QC system was purchased for $500,000. The system con- sists of a minicomputer, 15 video cameras, other peripheral hardware, and software. The new system uses cameras stationed by QC engineers at key points in the production process. Each time an operation changes or there is a new operation, the cameras are moved, and a new master picture is loaded into the computer by a QC engineer. The camera takes pictures of the units in process, and the computer com- pares them to the picture of a “good” unit. Any differences are sent to a QC engineer who removes the bad units and discusses the flaws with the production supervisors. The new system has replaced the 10 QC inspectors with two QC engineers. The operating costs of the new QC system, including the salaries of the QC engineers, have been included as factory overhead in calculating the company’s plantwide manufacturing-overhead rate, which is based on direct-labor dollars. The company’s president is confused. His vice president of ■ Problem 5–47 Continuation of Preceding Problem; Explaining ABC (LO 5-2, 5-3, 5-4) Pool rate for material- handling activity: $525 per production run ■ Problem 5–48 Activity-Based Costing; Cost Distortion; Product Promotion (LO 5-1, 5-2, 5-3, 5-4, 5-5) 2. Application rate, product shipping: $3,200 per OS 2. Deluxe, total cost per unit: $253.50 Deluxe Executive Direct-material cost ................................................................................................ $40 $65 Direct-labor cost ..................................................................................................... 25 25 Budgeted volume (units) .......................................................................................... 16,000 30,000 Deluxe Executive Total Setups ............................................................................................ 100 60 160 Machine hours ................................................................................. 32,000 45,000 77,000 Outgoing shipments ......................................................................... 200 150 350 ■ Problem 5–49 Overhead Application; Activity-Based Costing (LO 5-1, 5-2, 5-3, 5-4, 5-5) hiL25664_ch05_164-223.indd 205hiL25664_ch05_164-223.indd 205 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer 206 Chapter 5 Activity-Based Costing and Management production has told him how efficient the new system is. Yet there is a large increase in the overhead rate. The computation of the rate before and after automation is as follows: “Three hundred percent,” lamented the president. “How can we compete with such a high overhead rate?” Required: 1. a. Define “manufacturing overhead,” and cite three examples of typical costs that would be included in manufacturing overhead. b. Explain why companies develop predetermined overhead rates. 2. Explain why the increase in the overhead rate should not have a negative financial impact on the company. 3. Explain how management could change its overhead application system to eliminate confusion over product costs. 4. Discuss how an activity-based costing system might benefit Digital Light Corporation. (CMA, adapted) Meditech, Inc. manufactures two types of medical devices, Medform and Procel, and applies over- head on the basis of direct-labor hours. Anticipated overhead and direct-labor time for the upcoming accounting period are $710,000 and 20,000 hours, respectively. Information about the company’s prod- ucts follows. Medform: Estimated production volume, 2,500 units Direct-material cost, $30 per unit Direct labor per unit, 3 hours at $15 per hour Procel: Estimated production volume, 3,125 units Direct-material cost, $45 per unit Direct labor per unit, 4 hours at $15 per hour Meditech’s overhead of $710,000 can be identified with three major activities: order processing ($120,000), machine processing ($500,000), and product inspection ($90,000). These activities are driven by number of orders processed, machine hours worked, and inspection hours, respectively. Data relevant to these activities follow. Management is very concerned about declining profitability despite a healthy increase in sales volume. The decrease in income is especially puzzling because the company recently undertook a massive plant renovation during which new, highly automated machinery was installed—machinery that was expected to produce significant operating efficiencies. Required: 1. Assuming use of direct-labor hours to apply overhead to production, compute the unit manufactur- ing costs of the Medform and Procel products if the expected manufacturing volume is attained. 2. Assuming use of activity-based costing, compute the unit manufacturing costs of the Medform and Procel products if the expected manufacturing volume is attained. Before After Budgeted manufacturing overhead ............................................................... $3,800,000 $4,200,000 Budgeted direct-labor cost .......................................................................... 2,000,000 1,400,000 Budgeted overhead rate .............................................................................. 190% 300% ■ Problem 5–50 Activity-Based Costing; Cost Analysis (LO 5-1, 5-2, 5-3, 5-4, 5-5) 1. Predetermined overhead rate: $35.50 per direct-labor hour 2. Application rate, product inspection: $6 per IH Orders Processed Machine Hours Worked Inspection Hours Medform .................................................... 350 23,000 4,000 Procel ........................................................ 250 27,000 11,000 Total ...................................................... 600 50,000 15,000 hiL25664_ch05_164-223.indd 206hiL25664_ch05_164-223.indd 206 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer Chapter 5 Activity-Based Costing and Management 207 3. Meditech’s selling prices are based heavily on cost. a. By using direct-labor hours as an application base, which product is overcosted and which product is undercosted? Calculate the amount of the cost distortion for each product. b. Is it possible that overcosting and undercosting (i.e., cost distortion) and the subsequent deter- mination of selling prices are contributing to the company’s profit woes? Explain. 4. Build a spreadsheet: Construct an Excel spreadsheet to solve requirements 1, 2, and 3( a ) above. Show how the solution will change if the following data change: the overhead associated with order processing is $125,000 and the overhead associated with product inspection is $95,000. John Patrick has recently been hired as controller of Valdosta Vinyl Company (VVC), a manufacturer of vinyl siding used in residential construction. VVC has been in the vinyl siding business for many years and is currently investigating ways to modernize its manufacturing process. At the first staff meet- ing Patrick attended, Jack Kielshesky, chief engineer, presented a proposal for automating the Mold- ing Department. Kielshesky recommended that the company purchase two robots that would have the capability of replacing the eight direct-labor employees in the department. The cost savings outlined in the proposal include the elimination of direct-labor cost in the Molding Department plus a reduction of manufacturing overhead cost in the department to zero, because VVC charges manufacturing overhead on the basis of direct-labor dollars using a plantwide rate. The president of VVC was puzzled by Kielsh- esky’s explanation: “This just doesn’t make any sense. How can a department’s overhead rate drop to zero by adding expensive, high-tech manufacturing equipment? If anything, it seems like the rate ought to go up.” Kielshesky responded by saying “I’m an engineer, not an accountant. But if we’re charging over- head on the basis of direct labor, and we eliminate the labor, then we eliminate the overhead.” Patrick agreed with the president. He explained that as firms become more automated, they should rethink their product-costing systems. The president then asked Patrick to look into the matter and pre- pare a report for the next staff meeting. Patrick gathered the following data on the manufacturing- overhead rates experienced by VVC over the years. Patrick also wanted to have some departmental data to present at the meeting and, by using VVC’s accounting records, he was able to estimate the following annual averages for each manufacturing department over the five decades since VVC’s formation. Required: 1. Disregarding the proposed use of robots in the Molding Department, describe the shortcomings of the system for applying overhead that is currently used by Valdosta Vinyl Company. 2. Explain the misconceptions underlying Kielshesky’s statement that the manufacturing-overhead cost in the Molding Department will be reduced to zero if the automation proposal is implemented. 3. Recommend ways to improve VVC’s method for applying overhead by describing how it should revise its product-costing system for each of the following departments: a. In the Cutting and Finishing Departments. b. To accommodate automation in the Molding Department. (CMA, adapted) ■ Problem 5–51 Automation; Robotics; Overhead Application; Activity-Based Costing (LO 5-1, 5-2, 5-5, 5-8) Historical Plantwide Data Decade Average Annual Manufacturing- Overhead Cost Average Annual Direct-Labor Cost Average Manufacturing- Overhead Application Rate 1st ............................................... $ 2,200,000 $2,000,000 110% 2nd .............................................. 6,240,000 2,400,000 260 3rd .............................................. 13,600,000 4,000,000 340 4th ............................................... 24,600,000 6,000,000 410 5th ............................................... 38,710,000 7,900,000 490 Annual Averages during Recent Years Cutting Department Finishing Department Molding Department Manufacturing overhead ................ $22,000,000 $14,000,000 $4,000,000 Direct labor .................................. 4,000,000 3,500,000 500,000 hiL25664_ch05_164-223.indd 207hiL25664_ch05_164-223.indd 207 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer 208 Chapter 5 Activity-Based Costing and Management Rapid City Technology, Inc. manufactures chemicals used in agricultural pest control. The controller has established the following activity cost pools and cost drivers. Activity Cost Pool Budgeted Overhead Cost Cost Driver Budgeted Level for Cost Driver Pool Rate Machine setups ................. $1,000,000 Number of setups 250 $4,000 per setup Material handling ............... 300,000 Weight of raw material 75,000 lb. $4 per pound Hazardous waste control .......................... 100,000 Weight of hazardous chemicals used 10,000 lb. $10 per pound Quality control ................... 300,000 Number of inspections 2,000 $150 per inspection Other overhead costs ......... 800,000 Machine hours 40,000 $20 per machine hour Total .................................. $2,500,000 An order for 1,000 boxes of a chemical product designated JLRP has the following production requirements. Machine setups ........................................................................................................................ 6 setups Raw material ............................................................................................................................ 9,000 pounds Hazardous materials ................................................................................................................. 2,100 pounds Inspections ............................................................................................................................... 8 inspections Machine hours ......................................................................................................................... 550 machine hours Required: 1. Compute the total overhead that should be assigned to the JLRP order. 2. What is the overhead cost per box of JLRP chemicals? 3. Suppose the company were to use a single predetermined overhead rate based on machine hours. Compute the rate per hour. 4. Under the approach in requirement (3), how much overhead would be assigned to the JLRP chemical order? a. In total. b. Per box of JLRP chemical. 5. Explain why these two product-costing systems result in such widely differing costs. Which system do you recommend? Why? 6. Build a spreadsheet: Construct an Excel spreadsheet to solve requirements (1), (2), (3), and (4) above. Show how the solution will change if the following data change. The overhead associated with machine setups is $500,000, and there are 1,000 inspections budgeted. Refer to the original data given in the preceding problem for Rapid City Technology, Inc. Required: 1. Calculate the unit cost of a production order for 100 specially coated containers used in transporting chemicals. In addition to direct material costing $210 per container and direct labor costing $60 per container, the order requires: Machine setups .................................................................................................................................. 4 Raw material ...................................................................................................................................... 800 pounds Hazardous materials ........................................................................................................................... 400 pounds Inspections ......................................................................................................................................... 4 Machine hours ................................................................................................................................... 60 2. Build a spreadsheet: Construct an Excel spreadsheet to solve the preceding requirement. (This will be an extension of the spreadsheet constructed for requirement (6) in the preceding problem.) Show how the solution will change if the data given in the preceding problem change as fol- lows: the overhead associated with machine setups is $500,000, and there are 1,000 inspections budgeted. ■ Problem 5–52 Activity Cost Pools; Cost Drivers; Pool Rates (LO 5-1, 5-2, 5-5) 1. Assigned overhead cost, machine setups: $24,000 3. Predetermined overhead rate: $62.50 per machine hr. ■ Problem 5–53 Overhead Cost Drivers (LO 5-4, 5-5) hiL25664_ch05_164-223.indd 208hiL25664_ch05_164-223.indd 208 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer Budgeted manufacturing overhead Budgeted direect-labor hours $ , , ( , )( ) ( , 3 264 000 1 000 4 5 0000 6 96 )( ) $ per direct-labor hour Chapter 5 Activity-Based Costing and Management 209 Knickknack, Inc., manufactures two products: odds and ends. The firm uses a single, plantwide over- head rate based on direct-labor hours. Production and product-costing data are as follows: Odds Ends Production quantity ............................................................................ 1,000 units 5,000 units Direct material ................................................................................... $160 $240 Direct labor (not including setup time) ................................................. 120 (4 hr. at $30) 180 (6 hr. at $30) Manufacturing overhead* ................................................................... 384 (4 hr. at $96) 576 (6 hr. at $96) Total cost per unit .............................................................................. $664 $996 *Calculation of predetermined overhead rate: Manufacturing overhead budget: Machine-related costs ....................................................................................................................... $1,800,000 Setup and inspection ......................................................................................................................... 720,000 Engineering ....................................................................................................................................... 360,000 Plant-related costs ............................................................................................................................. 384,000 Total ................................................................................................................................................. $3,264,000 Predetermined overhead rate: Knickknack, Inc., prices its products at 120 percent of cost, which yields target prices of $796.80 for odds and $1,195.20 for ends. Recently, however, Knickknack has been challenged in the market for ends by a European competitor, Bricabrac Corporation. A new entrant in this market, Bricabrac has been sell- ing ends for $880 each. Knickknack’s president is puzzled by Bricabrac’s ability to sell ends at such a low cost. She has asked you (the controller) to look into the matter. You have decided that Knickknack’s traditional, volume-based product-costing system may be causing cost distortion between the firm’s two products. Ends are a high-volume, relatively simple product. Odds, on the other hand, are quite complex and exhibit a much lower volume. As a result, you have begun work on an activity-based costing system. Required: 1. Let each of the overhead categories in the budget represent an activity cost pool. Categorize each in terms of the type of activity (e.g., unit-level activity). 2. The following cost drivers have been identified for the four activity cost pools. Activity Cost Pool Cost Driver Budgeted Level of Cost Driver Machine-related costs Machine hours 18,000 hr. Setup and inspection Number of production runs 80 runs Engineering Engineering change orders 200 change orders Plant-related costs Square footage of space 3,840 sq. ft. You have gathered the following additional information: • Each odd requires 8 machine hours, whereas each end requires 2 machine hours. • Odds are manufactured in production runs of 25 units each. Ends are manufactured in 125 unit batches. • Three-quarters of the engineering activity, as measured in terms of change orders, is related to odds. • The plant has 3,840 square feet of space, 80 percent of which is used in the production of odds. For each activity cost pool, compute a pool rate. 3. Determine the unit cost, for each activity cost pool, for odds and ends. 4. Compute the new product cost per unit for odds and ends, using the ABC system. 5. Using the same pricing policy as in the past, compute prices for odds and ends. Use the product costs determined by the ABC system. 6. Show that the ABC system fully assigns the total budgeted manufacturing overhead costs of $3,264,000. 7. Show how Knickknack’s traditional, volume-based costing system distorted its product costs. (Use Exhibit 5–10 for guidance.) ■ Problem 5–54 Activity-Based Costing; Activity Cost Pools; Pool Rates; Calculation of Product Costs; Cost Distortion (LO 5-1, 5-2, 5-3, 5-4, 5-5) 2. II. Setup and inspection: $9,000 per run 5. Odds, new target price: $2,420.64 hiL25664_ch05_164-223.indd 209hiL25664_ch05_164-223.indd 209 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer 210 Chapter 5 Activity-Based Costing and Management Gourmet Specialty Coffee Company (GSCC) is a distributor and processor of different blends of cof- fee. The company buys coffee beans from around the world and roasts, blends, and packages them for resale. GSCC currently has 12 different coffees that it offers to gourmet shops in one-pound bags. The major cost is raw materials; however, there is a substantial amount of manufacturing overhead in the predominantly automated roasting and packing process. The company uses relatively little direct labor. Some of the coffees are very popular and sell in large volumes, while a few of the newer blends have very low volumes. GSCC prices its coffee at full product cost, including allocated overhead, plus a markup of 30 percent. If prices for certain coffees are significantly higher than market, adjustments are made. The company competes primarily on the quality of its products, but customers are price- conscious as well. Data for the 20x5 budget include manufacturing overhead of $12,000,000, which has been allo- cated on the basis of each product’s direct-labor cost. The budgeted direct-labor cost for 20x5 totals $1,200,000. Based on the sales budget and raw-material budget, purchases and use of raw materials (mostly coffee beans) will total $5,800,000. The expected prime costs for one-pound bags of two of the company’s products are as follows: Jamaican Colombian Direct material ........................................................................................................ $2.90 $3.90 Direct labor ............................................................................................................ .40 .40 GSCC’s controller believes the traditional product-costing system may be providing misleading cost information. She has developed an analysis of the 20x5 budgeted manufacturing-overhead costs shown in the following chart. Activity Cost Driver Budgeted Activity Budgeted Cost Purchasing .............................. Purchase orders ...................... 2,316 .......................... $ 2,316,000 Material handling ..................... Setups .................................... 3,600 .......................... 2,880,000 Quality control ......................... Batches ................................... 1,440 .......................... 576,000 Roasting .................................. Roasting hours ........................ 192,200 .......................... 3,844,000 Blending .................................. Blending hours ........................ 67,200 .......................... 1,344,000 Packaging ............................... Packaging hours ...................... 52,000 .......................... 1,040,000 Total manufacturing-overhead cost ...................................................................................................... $12,000,000 Data regarding the 20x5 production of Jamaican and Colombian coffee are shown in the following table. There will be no raw-material inventory for either of these coffees at the beginning of the year. Jamaican Colombian Budgeted sales ............................................................................................... 2,000 lb. 100,000 lb. Batch size ...................................................................................................... 500 lb. 20,000 lb. Setups ........................................................................................................... 3 per batch 3 per batch Purchase order size ........................................................................................ 500 lb. 50,000 lb. Roasting time ................................................................................................. 1 hr. per 200 lb. 1 hr. per 200 lb. Blending time ................................................................................................. .5 hr. per 200 lb. .5 hr. per 200 lb. Packaging time ............................................................................................... .1 hr. per 200 lb. .1 hr. per 200 lb. Required: 1. Using GSCC’s current product-costing system: a. Determine the company’s predetermined overhead rate using direct-labor cost as the single cost driver. b. Determine the full product costs and selling prices of one pound of Jamaican coffee and one pound of Colombian coffee. 2. Develop a new product cost, using an activity-based costing approach, for one pound of Jamaican coffee and one pound of Colombian coffee. 3. What are the implications of the activity-based costing system with respect to: a. The use of direct labor as a basis for applying overhead to products? b. The use of the existing product-costing system as the basis for pricing? (CMA, adapted) ■ Problem 5–55 Activity-Based Costing (LO 5-1, 5-2, 5-3, 5-4, 5-5) 1(a). Overhead rate: $10 per direct-labor dollar 2. New product cost: $11.06 per pound of Jamaican coffee Ex hiL25664_ch05_164-223.indd 210hiL25664_ch05_164-223.indd 210 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer Chapter 5 Activity-Based Costing and Management 211 Pensacola Air Industries (PAI) manufactures aircraft parts for small aircraft. Over the past decade, PAI’s management has met its goal of reducing its reliance on government contract work to 50 percent of total sales. Thus, PAI’s sales are now roughly evenly split between government and commercial sales. Traditionally, the costs of the Material-Handling Department have been allocated to direct material as a percentage of direct-material dollar value. This was adequate when the majority of the manufactur- ing was homogeneous and related to government contracts. Recently, however, government auditors have rejected some proposals, stating that “the amount of Material-Handling Department costs allocated to these proposals is disproportionate to the total effort involved.” Kara Lindley, the newly hired cost-accounting manager, was asked by the manager of the Govern- ment Contracts Unit, Paul Anderson, to find a more equitable method of allocating Material-Handling Department costs to the user departments. Her review has revealed the following information. • The majority of the direct-material purchases for government contracts are high-dollar, low-volume purchases, while commercial materials represent low-dollar, high-volume purchases. • Administrative departments such as marketing, finance and administration, human resources, and maintenance also use the services of the Material-Handling Department on a limited basis but have never been charged in the past for material-handling costs. • One purchasing manager with a direct phone line is assigned exclusively to purchasing high-dollar, low-volume material for government contracts at an annual salary of $54,000. Employee benefits are estimated to be 20 percent of the annual salary. The annual dedicated phone line costs are $4,200. The components of the Material-Handling Department’s budget for 20x4, as proposed by Lindley’s predecessor, are as follows: Payroll ...................................................................................................... $ 270,000 Employee benefits .................................................................................... 54,000 Telephone ................................................................................................ 57,000 Other utilities ............................................................................................ 33,000 Materials and supplies .............................................................................. 9,000 Depreciation ............................................................................................. 9,000 Direct-material budget: Government contracts ........................................................................... 3,009,000 Commercial products ............................................................................ 1,311,000 Lindley has estimated the number of purchase orders to be processed in 20x4 to be as follows: Government contracts* .............................................................................. 120,000 Commercial products ................................................................................ 234,000 Marketing ................................................................................................. 2,700 Finance and administration ........................................................................ 4,050 Human resources ..................................................................................... 750 Maintenance ............................................................................................ 1,500 Total ........................................................................................................ 363,000 *Exclusive of high-dollar, low-volume materials. Lindley recommended to Anderson that material-handling costs be allocated on a per purchase order basis. Anderson realizes that the company has been allocating to government contracts more material-handling costs than can be justified. However, the implication of Lindley’s analysis could be a decrease in his unit’s earnings and, consequently, a cut in his annual bonus. Anderson told Lindley to “adjust” her numbers and modify her recommendation so that the results will be more favorable to the Government Contracts Unit. Being new in her position, Lindley is not sure how to proceed. She feels ambivalent about Ander- son’s instructions and suspects his motivation. To complicate matters for Lindley, the company’s new president has asked her to prepare a three-year forecast of the Government Contracts Unit’s results, and she believes that the newly recommended allocation method would provide the most accurate data. However, this would put her in direct opposition to Anderson’s directives. Lindley has assembled the following data to project the material-handling costs. • The number of purchase orders increases 5 percent per year. • The ratio of government purchase orders to total purchase orders remains at 33 percent. • Total direct-material costs increase 2.5 percent per year. ■ Problem 5–56 Activity-Based Costing; Forecasting; Ethics (LO 5-1, 5-2, 5-5, 5-8) 1. Material-handling rate: 10% 2(a). Material-handling cost per purchase order: $1.00 hiL25664_ch05_164-223.indd 211hiL25664_ch05_164-223.indd 211 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer 212 Chapter 5 Activity-Based Costing and Management • Material-handling costs remain the same percentage of direct-material costs. • Direct government costs (payroll, employee benefits, and direct phone line) remain constant. • In addition, she has assumed that government material in the future will be 70 percent of total material. Required: 1. Calculate the material-handling rate that would have been used by Kara Lindley’s predecessor at Pensacola Air Industries. 2. a. Calculate the revised material-handling costs to be allocated on a per purchase order basis. b. Discuss why purchase orders might be a more reliable cost driver than the dollar amount of direct material. 3. Calculate the difference due to the change to the new method of allocating material-handling costs to government contracts. 4. Prepare a forecast of the cumulative dollar impact over a three-year period from 20x4 through 20x6 of Kara Lindley’s recommended change for allocating Material-Handling Department costs to the Government Contracts Unit. Round all calculations to the nearest whole number. 5. Referring to the standards of ethical conduct for management accountants: a. Discuss why Kara Lindley has an ethical conflict. b. Identify several steps that Lindley could take to resolve the ethical conflict. (CMA, adapted) Queensland Electronics Company manufactures two large-screen television models, the Novelle, which has been produced for 10 years and sells for $910, and the Zodiac, a new model introduced in early 20x3, which sells for $1,160. Based on the following income statement for 20x4, a decision has been made to concentrate Queensland’s marketing resources on the Zodiac model and to begin to phase out the Novelle model. QUEENSLAND ELECTRONICS COMPANY Income Statement For The Year Ended December 31, 20x4 Zodiac Novelle Total Sales ................................................................................ $4,640,000 $20,020,000 $24,660,000 Cost of goods sold ............................................................. 3,232,000 13,024,000 16,256,000 Gross margin ................................................................. $1,408,000 $ 6,996,000 $ 8,404,000 Selling and administrative expenses .................................... 980,000 5,700,000 6,680,000 Net income ................................................................... $ 428,000 $ 1,296,000 $ 1,724,000 Units produced and sold ..................................................... 4,000 22,000 Net income per unit sold ................................................ $ 107.00 $ 58.91* *Rounded. The standard unit costs for the Zodiac and Novelle models are as follows: Zodiac Novelle Direct material ............................................................................................................. $579 $211 Direct labor: Zodiac (3.5 hr. 3 $14) ............................................................................................ 49 Novelle (1.5 hr. 3 $14) ............................................................................................ 21 Machine usage: Zodiac (4 hr. 3 $19) ............................................................................................... 76 Novelle (8 hr. 3 $19) ............................................................................................... 152 Manufacturing overhead* ............................................................................................. 104 208 Standard cost .......................................................................................................... $808 $592 *Manufacturing overhead was applied on the basis of machine hours at a predetermined rate of $26 per hour. ■ Problem 5–57 Activity-Based Costing; Activity-Based Management (LO 5-1, 5-2, 5-3, 5-4, 5-5) 2. Quality control, $15.00 per inspection 2. Novelle, total cost: $11,650,400 hiL25664_ch05_164-223.indd 212hiL25664_ch05_164-223.indd 212 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer Chapter 5 Activity-Based Costing and Management 213 Queensland Electronics Company’s controller is advocating the use of activity-based cost- ing and activity-based management and has gathered the following information about the company’s manufacturing-overhead costs for 20x4. Number of Events Activity Center (cost driver) Traceable Costs Zodiac Novelle Total Soldering (number of solder joints) $ 880,000 400,000 1,200,000 1,600,000 Shipments (number of shipments) 836,000 3,800 15,200 19,000 Quality control (number of inspections) 1,170,000 21,060 56,940 78,000 Purchase orders (number of orders) 1,110,000 105,450 79,550 185,000 Machine power (machine hours) 47,500 15,200 174,800 190,000 Machine setups (number of setups) 948,500 4,500 4,985 9,485 Total traceable costs $4,992,000 Required: 1. Briefly explain how an activity-based costing system operates. 2. Using activity-based costing, determine if Queensland Electronics should continue to emphasize the Zodiac model and phase out the Novelle model. (CMA, adapted) Ultratech, Inc., manufactures several different types of printed circuit boards; however, two of the boards account for the majority of the company’s sales. The first of these boards, a television circuit board, has been a standard in the industry for several years. The market for this type of board is competitive and price-sensitive. Ultratech plans to sell 65,000 of the TV boards in 20x4 at a price of $300 per unit. The second high-volume product, a personal computer circuit board, is a recent addition to Ultratech’s prod- uct line. Because the PC board incorporates the latest technology, it can be sold at a premium price. The 20x4 plans include the sale of 40,000 PC boards at $600 per unit. Ultratech’s management group is meeting to discuss how to spend the sales and promotion dol- lars for 20x4. The sales manager believes that the market share for the TV board could be expanded by concentrating Ultratech’s promotional efforts in this area. In response to this suggestion, the production manager said, “Why don’t you go after a bigger market for the PC board? The cost sheets that I get show that the contribution from the PC board is more than double the contribution from the TV board. I know we get a premium price for the PC board. Selling it should help overall profitability.” The cost-accounting system shows that the following costs apply to the PC and TV boards. PC Board TV Board Direct material ............................................................................................................ $280 $160 Direct labor ................................................................................................................ 4 hr. 1.5 hr. Machine time ............................................................................................................. 1.5 hr. .5 hr. Variable manufacturing overhead is applied on the basis of direct-labor hours. For 20x4, vari- able overhead is budgeted at $2,240,000, and direct-labor hours are estimated at 280,000. The hourly rates for machine time and direct labor are $20 and $28, respectively. The company applies a material-handling charge at 10 percent of material cost. This material-handling charge is not included in variable manufacturing overhead. Total 20x4 expenditures for direct material are bud- geted at $21,600,000. Andrew Fulton, Ultratech’s controller, believes that before the management group proceeds with the discussion about allocating sales and promotional dollars to individual products, it might be worth- while to look at these products on the basis of the activities involved in their production. Fulton has prepared the following schedule to help the management group understand this concept. “Using this information,” Fulton explained, “we can calculate an activity-based cost for each TV board and each PC board and then compare it to the standard cost we have been using. The only cost that remains the same for both cost methods is the cost of direct material. The cost drivers will replace the direct labor, machine time, and overhead costs in the old standard cost figures.” ■ Problem 5–58 Activity-Based Costing (LO 5-1, 5-2, 5-4, 5-5, 5-8) 2. Total contribution margin for PC boards: $4,720,000 2. Variable overhead rate: $8 per hr. 3. Machine setup: $3.20 per setup 3. Total for 40,000 units (PC boards), procurement: $440,000 Ex hiL25664_ch05_164-223.indd 213hiL25664_ch05_164-223.indd 213 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer 214 Chapter 5 Activity-Based Costing and Management Budgeted Cost Cost Driver Budgeted Annual Activity for Cost Driver Procurement ..................................... $ 800,000 Number of parts ......................... 4,000,000 parts Production scheduling ....................... 440,000 Number of boards ...................... 110,000 boards Packaging and shipping .................... 880,000 Number of boards ...................... 110,000 boards Total ................................................. $ 2,120,000 Machine setup .................................. $ 892,000 Number of setups ...................... 278,750 setups Hazardous waste disposal ................. 96,000 Pounds of waste ........................ 16,000 pounds Quality control .................................. 1,120,000 Number of inspections ............... 160,000 inspections General supplies ............................... 132,000 Number of boards ...................... 110,000 boards Total ................................................. $ 2,240,000 Machine insertion ............................. $ 2,400,000 Number of parts ......................... 3,000,000 parts Manual insertion ............................... 8,000,000 Number of parts ......................... 1,000,000 parts Wave-soldering ................................. 264,000 Number of boards ...................... 110,000 boards Total ................................................. $10,664,000 Required per Unit PC Board TV Board Parts: .................................................................................................................. 55 26 Machine insertions ........................................................................................... 36 25 Manual insertions ............................................................................................ 19 1 Machine setups ................................................................................................... 3 2 Hazardous waste disposal .................................................................................... .40 lb. .03 lb. Inspections .......................................................................................................... 2 1 Required: 1. Identify at least four general advantages associated with activity-based costing. 2. On the basis of Ultratech’s unit cost data given in the problem, calculate the total amount that each of the two product lines will contribute toward covering fixed costs and profit in 20x4. (In other words, for each product line calculate the total sales revenue minus the total variable costs. This amount is often referred to as a product’s total contribution margin. ) 3. Repeat requirement (2) but now use the cost data from the activity-based costing system. 4. Explain how a comparison of the results of the two costing methods may impact the decisions made by Ultratech’s management group. (CMA, adapted) Scott Manufacturing produces two items in its Virginia Beach plant: Tuff Stuff and Ruff Stuff. Since inception, Scott has used only one manufacturing-overhead cost pool to accumulate costs. Overhead has been allocated to products based on direct-labor hours. Until recently, Scott was the sole producer of Ruff Stuff and was able to dictate the selling price. However, last year Marvella Products began market- ing a comparable product at a price below the cost assigned by Scott. Market share has declined rapidly, and management must now decide whether to meet the competitive price or to discontinue the product line. Recognizing that discontinuing the product line would place an additional burden on its remaining product, Tuff Stuff, management is using activity-based costing to determine if it would show a different cost structure for the two products. The two major indirect costs for manufacturing the products are power usage and setup costs. Most of the power is used in fabricating, while most of the setup costs are required in assembly. The setup costs are predominantly related to the Tuff Stuff product line. The plant manager, Kati Scott, has decided to separate the Manufacturing Department costs into two activity cost pools as follows: Fabricating: machine hours will be the cost driver. Assembly: number of setups will be the cost driver. Jack Riley, the controller, has gathered the following information. ■ Problem 5–59 Activity-Based Costing; Production and Pricing Decisions (LO 5-1, 5-2, 5-3, 5-4, 5-5, 5-8) 1(a). Total overhead: $1,050,000 1(b). Total budgeted direct- labor hours: 100,000 Ex hiL25664_ch05_164-223.indd 214hiL25664_ch05_164-223.indd 214 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer Chapter 5 Activity-Based Costing and Management 215 MANUFACTURING DEPARTMENT Annual Budget before Separation of Overhead Product Line Total Tuff Stuff Ruff Stuff Number of units ............................................ 20,000 20,000 Direct-labor hours* ....................................... 2 hours per unit 3 hours per unit Total direct-labor cost .................................... $2,400,000 Direct material .............................................. $15.00 per unit $9.00 per unit Budgeted overhead: Indirect labor ............................................ 72,000 Fringe benefits ......................................... 15,000 Indirect material ........................................ 93,000 Power ...................................................... 540,000 Setup ....................................................... 225,000 Quality assurance ..................................... 30,000 Other utilities ............................................ 30,000 Depreciation ............................................. 45,000 *Direct-labor hourly rate is the same in both departments. MANUFACTURING DEPARTMENT Cost Structure after Separation of Costs into Activity Cost Pools Fabricating Assembly Direct-labor cost .............................................................................. 74% 26% Direct material (no change) ............................................................... 100% 0% Indirect labor ................................................................................... 76% 24% Fringe benefits ................................................................................. 80% 20% Indirect material ............................................................................... $60,000 $33,000 Power ............................................................................................. $480,000 $60,000 Setup .............................................................................................. $15,000 $210,000 Quality assurance ............................................................................ 80% 20% Other utilities ................................................................................... 50% 50% Depreciation .................................................................................... 78% 22% Cost driver: Product Line Tuff Stuff Ruff Stuff Machine-hours per unit .................................................................... 4.4 6.0 Setups ............................................................................................ 1,000 272 Required: 1. Assigning overhead based on direct-labor hours, calculate the following: a. Total budgeted cost of the Manufacturing Department. b. Unit cost of Tuff Stuff and Ruff Stuff. 2. After separation of overhead into activity cost pools, compute the total budgeted cost of each department: fabricating and assembly. 3. Using activity-based costing, calculate the unit costs for each product. (In computing the pool rates for the fabricating and assembly activity cost pools, round to the nearest cent. Then, in computing unit product costs, round to the nearest cent.) 4. Discuss how a decision regarding the production and pricing of Ruff Stuff will be affected by the results of your calculations in the preceding requirements. (CMA, adapted) hiL25664_ch05_164-223.indd 215hiL25664_ch05_164-223.indd 215 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer Predetermined overhead rate � Budgeted overheaad Budgeted direct labor � 875% 216 Chapter 5 Activity-Based Costing and Management Gigabyte, Inc., manufactures three products for the computer industry: Gismos (product G): annual sales, 8,000 units Thingamajigs (product T): annual sales, 15,000 units Whatchamacallits (product W): annual sales, 4,000 units The company uses a traditional, volume-based product-costing system with manufacturing overhead applied on the basis of direct-labor dollars. The product costs have been computed as follows: The calculation of the predetermined overhead rate is as follows: Manufacturing overhead budget: Machinery ............................................................................................................................................. $3,675,000 Machine setup ....................................................................................................................................... 15,750 Inspection ............................................................................................................................................. 1,575,000 Material handling ................................................................................................................................... 2,625,000 Engineering ........................................................................................................................................... 1,034,250 Total ...................................................................................................................................................... $8,925,000 Direct-labor budget (based on budgeted annual sales): Product G: 8,000 3 $48.00 5 $ 384,000 Product T: 15,000 3 $36.00 5 540,000 Product W: 4,000 3 $24.00 5 96,000 Total $1,020,000 Gigabyte’s pricing method has been to set a target price equal to 150 percent of full product cost. However, only the thingamajigs have been selling at their target price. The target and actual current prices for all three products are the following: Product G Product T Product W Product cost ........................................................................................... $573.00 $508.50 $286.50 Target price ............................................................................................ 859.50 762.75 429.75 Actual current selling price ...................................................................... 639.00 762.75 600.00 Gigabyte has been forced to lower the price of gismos in order to get orders. In contrast, Gigabyte has raised the price of whatchamacallits several times, but there has been no apparent loss of sales. Gigabyte, Inc., has been under increasing pressure to reduce the price even further on gismos. In con- trast, Gigabyte’s competitors do not seem to be interested in the market for whatchamacallits. Gigabyte apparently has this market to itself. Required: 1. Is product G the company’s least profitable product? 2. Is product W a profitable product for Gigabyte, Inc.? 3. Comment on the reactions of Gigabyte’s competitors to the firm’s pricing strategy. What dangers does Gigabyte, Inc. face? 4. Gigabyte’s controller, Nan O’Second, recently attended a conference at which activity-based cost- ing systems were discussed. She became convinced that such a system would help Gigabyte’s management to understand its product costs better. She got top management’s approval to design an activity-based costing system, and an ABC project team was formed. In stage one of the ABC project, each of the overhead items listed in the overhead budget was placed into its own activity ■ Problem 5–60 Traditional versus Activity- Based Costing Systems (LO 5-1, 5-2, 5-3, 5-4, 5-5, 5-8) 4. Product G, annual raw- material cost: $840,000 5. Product T, engineering: $6.90 per unit Product G Product T Product W Raw material ...................... $105.00 $157.50 $ 52.50 Direct labor ........................ 48.00 (2.4 hr. at $20) 36.00 (1.8 hr. at $20) 24.00 (1.2 hr. at $20) Manufacturing overhead* .... 420.00 ($48 3 875%) 315.00 ($36 3 875%) 210.00 ($24 3 875%) Total product cost ............... $573.00 $508.50 $286.50 hiL25664_ch05_164-223.indd 216hiL25664_ch05_164-223.indd 216 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer Chapter 5 Activity-Based Costing and Management 217 cost pool. Then a cost driver was identified for each activity cost pool. Finally, the ABC project team compiled data showing the percentage of each cost driver that was consumed by each of Gigabyte’s product lines. These data are summarized as follows: Activity Cost Pool Cost Driver Product G Product T Product W Machinery Machine hours 24% 50% 26% Machine setup Number of setups 22% 30% 48% Inspection Number of inspections 16% 44% 40% Material handling Raw-material costs 25% 69% 6% Engineering Number of change orders 35% 10% 55% Show how the controller determined the percentages given above for raw-material costs. (Round to the nearest whole percent.) 5. Develop product costs for the three products on the basis of an activity-based costing system. (Round to the nearest cent.) 6. Calculate a target price for each product, using Gigabyte’s pricing formula. Compare the new tar- get prices with the current actual selling prices and previously reported product costs. 7. Build a spreadsheet: Construct an Excel spreadsheet to solve requirements (5) and (6) above. Show how the solution will change if the inspection activity was divided among the three products in the following manner: product G, 20%; product T, 40%, and product W, 40%. Refer to the new target prices calculated in the preceding problem for Gigabyte’s three products, based on the new activity-based costing system. Required: Write a memo to the company president commenting on the situation Gigabyte, Inc., has been facing regarding the market for its products and the actions of its competitors. Discuss the strategic options available to management. What do you recommend, and why? Refer to the product costs developed in requirement (5) of Problem 5–60. Prepare a table showing how Gigabyte’s traditional, volume-based product-costing system distorts the product costs of gismos, thingamajigs, and whatchamacallits. (You may wish to refer to Exhibit 5–10 for guidance. Because of rounding in the calculation of the product costs, there will be a small rounding error in this cost distor- tion analysis as well.) Bodacious Bagels, Inc., manufactures a variety of bagels, which are frozen and sold in grocery stores. The production process consists of the following steps. 1. Ingredients, such as flour and raisins, are received and inspected. Then they are stored until needed. 2. Ingredients are carried on hand carts to the mixing room. 3. Dough is mixed in 40-pound batches in four heavy-duty mixers. 4. Dough is stored on large boards in the mixing room until a bagel machine is free. 5. A board of dough is carried into the bagel room. The board is tipped, and the dough slides into the hopper of a bagel machine. This machine pulls off a small piece of dough, rolls it into a cylindrical shape, and then squeezes it into a doughnut shape. The bagel machines can be adjusted in a setup procedure to accommodate different sizes and styles of bagels. Workers remove the uncooked bagels and place them on a tray, where they are kept until a boiling vat is free. 6. Next the trays of uncooked bagels are carried into an adjoining room, which houses three 50-gal- lon vats of boiling water. The bagels are boiled for approximately one minute. 7. Bagels are removed from the vats with a long-handled strainer and placed on a wooden board. The boards full of bagels are carried to the oven room, where they are kept until an oven rack is free. The two ovens contain eight racks which rotate but remain upright, much like the seats on a Ferris wheel. A rack full of bagels is finished baking after one complete revolution in the oven. When a rack full of bagels is removed from the oven, a fresh rack replaces it. The oven door is opened and closed as each rack completes a revolution in the oven. ■ Problem 5–61 Strategic Cost Analysis; Continuation of Preceding Problem (LO 5-2, 5-8) ■ Problem 5–62 Cost Distortion; Continuation of Problem 5–60 (LO 5-2, 5-5) ■ Problem 5–63 Basic Elements of a Production Process; Non-Value-Added Costs (LO 5-8, 5-10) hiL25664_ch05_164-223.indd 217hiL25664_ch05_164-223.indd 217 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer 218 Chapter 5 Activity-Based Costing and Management 8. After the bagels are removed from the oven, they are placed in baskets for cooling. 9. While the bagels are cooling, they are inspected. Misshapen bagels are removed and set aside. (Most are eaten by the staff.) 10. After the bagels are cool, the wire baskets are carried to the packaging department. Here the bagels are dumped into the hopper on a bagging machine. This machine packages a half-dozen bagels in each bag and seals the bag with a twist tie. 11. Then the packaged bagels are placed in cardboard boxes, each holding 24 bags. The boxes are placed on a forklift and are driven to the freezer, where the bagels are frozen and stored for shipment. Required: 1. Identify the steps in the bagel-production process that fall into each of the following categories: process time, inspection time, move time, waiting time, storage time. 2. List the steps in the production process that could be candidates for non-value-added activities. Refer to the information given in the preceding problem for Bodacious Bagels, Inc. Required: Redesign the bagel production process after eliminating the non-value-added costs. What new equip- ment could the company purchase to make the production process more efficient? Contemporary Kitchen Furnishings, Inc. (CKF) manufactures a variety of housewares for the consumer market in the midwest. The company’s three major product lines are cooking utensils, tableware, and flatware. CKF implemented activity-based costing four years ago and now has a well-developed ABC system in place for determining product costs. Only recently, however, has the ABC system been sys- tematically used for the purposes of activity-based management. As a pilot project, CKF’s controller asked the ABC project team to do a detailed activity analysis of the purchasing activity. The following specific activities were identified. 1. Receipt of parts specifications from the Design Engineering Department. 2. Follow-up with design engineers to answer any questions. 3. Vendor (supplier) identification. 4. Vendor consultations (by phone or in person). 5. Price negotiation. 6. Vendor selection. 7. Ordering (by phone or mail). 8. Order follow-up. 9. Expediting (attempting to speed up delivery). 10. Order receiving. 11. Inspection of parts. 12. Return of parts not meeting specifications. 13. Consultation with design engineers and production personnel if parts do not satisfy intended purpose. 14. Further consultation and/or negotiation with vendor if necessary. 15. Ship parts back to vendor if necessary. 16. If satisfactory, move parts to storage. Required: 1. Draw a diagram to depict CKF’s two-dimensional activity-based costing efforts. The diagram should include the following: a. The cost assignment role of ABC, with the cost pools, activities, and product lines represented. b. The process view of ABC, with the purchasing activities displayed. Also indicated here will be the linkages amo0ng the activities. (To save space, indicate the activities by their numbers.) c. The activity evaluation phase of two-dimensional ABC. ■ Problem 5–64 Elimination of Non-Value- Added Costs; Production System Redesign (LO 5-8) ■ Problem 5–65 Two-Dimensional Activity-Based Costing; Activity Analysis; ABM (LO 5-8) hiL25664_ch05_164-223.indd 218hiL25664_ch05_164-223.indd 218 8/8/13 5:19 PM8/8/13 5:19 PM Final PDF to printer Chapter 5 Activity-Based Costing and Management 219 2. Identify the triggers for each of the following activities in CKF’s purchasing activity analysis: Follow-up with design engineers (activity 2) Expediting (activity 9) Inspection of parts (activity 11) Return of parts (activity 12) Consultation with design engineers and production personnel (activity 13) 3. For each of the activities listed in requirement (2), identify the possible root causes. 4. Choose four activities in CKF’s purchasing function, and suggest a performance measure for each of these activities. FiberCom, Inc., manufactures fiber optic cables for the computer and telecommunications industries. At the request of the company vice president of marketing, the cost management staff has recently com- pleted a customer-profitability study. The following activity-based costing information was the basis for the analysis. Customer-Related Activities Cost Driver Base Cost Driver Rate Sales activity ....................................... Sales visits .......................................... $2,000 Order taking ........................................ Purchase orders .................................. 400 Special handling .................................. Units handled ...................................... 100 Special shipping .................................. Shipments ........................................... 1,000 Cost-driver data for two of FiberCom’s customers for the most recent year are: Customer-Related Activities Caltex Computer Trace Telecom Sales activity ....................................... 8 visits ............................................ 6 visits Order taking ........................................ 15 orders .......................................... 20 orders Special handling .................................. 800 units handled ................................ 600 units handled Special shipping .................................. 18 shipments .................................... 20 shipments The following additional information has been compiled for FiberCom for two of its customers, Caltex Computer and Trace Telecom, for the most recent year: Caltex Computer Trace Telecom Sales revenue ...................................... $380,000 ..................................... $247,600 Cost of goods sold ............................... 160,000 ..................................... 124,000 General selling costs ............................ 48,000 ..................................... 36,000 General administrative costs ................. 38,000 ..................................... 32,000 Required: 1. Prepare a customer-profitability analysis for Caltex Computer and Trace Telecom. (Hint: Refer to Exhibit 5–13 for guidance.) 2. Build a spreadsheet: Construct an Excel spreadsheet to solve requirement (1) above. Show how the solution will change if the following information changes: Trace Telecom’s sales revenue was $250,000 and Caltex Computer’s cost of goods sold was $155,000. Refer to the information given in the preceding problem for FiberCom, Inc., and two of its customers, Caltex Computer and Trace Telecom. Additional information for six of FiberCom’s other customers for the most recent year follows: Customer Operating Income Network-All, Inc ............................................................................................................................. $186,000 The California Group ...................................................................................................................... 12,000 Golden Gate Service Associates ...................................................................................................... 142,000 Tele-Install, Inc . ............................................................................................................................. (36,000) Graydon Computer Company .......................................................................................................... 120,000 Mid-State Computing Company ...................................................................................................... 84,000 Required: 1. Prepare FiberCom’s customer-profitability profile for the most recent year. ■ Problem 5–66 Customer-Profitability Analysis; Activity-Based Costing (LO 5-9) 1. Caltex computer, operating income: $14,000 ■ Problem 5–67 Customer-Profitability Profile; Continuation of Preceding Problem (LO 5-9) hiL25664_ch05_164-223.indd 219hiL25664_ch05_164-223.indd 219 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer 220 Chapter 5 Activity-Based Costing and Management Cases 2. As FiberCom’s director of cost management, write a memo to the company’s vice president of marketing which will accompany the customer-profitability profile. Include a brief explanation of the methodology used and comment on the results. Cincinnati Cycle Company produces two subassemblies, JY-63 and RX-67, used in manufacturing motorcycles. The company is currently using an absorption costing system that applies overhead based on direct-labor hours. The budget for the current year ending December 31, 20x4 is as follows: Jay Rexford, Cincinnati Cycle’s president, has been reading about a new type of costing method called activity-based costing. Rexford is convinced that activity-based costing will cast a new light on future profits. As a result, Jack Canfield, the company’s director of cost management, has accumulated cost pool information for this year shown on the following chart. This information is based on a product mix of 5,000 units of JY-63 and 5,000 units of RX-67. In addition, the following information is projected for the next calendar year, 20x5. JY-63 RX-67 Sales (in units) ...................................................................................................... 5,100 4,900 Beginning inventory, finished goods (in units) .......................................................... 800 600 Ending inventory, finished goods (in units) ............................................................... 700 700 On January 1, 20x5, Rexford is planning to increase the prices of JY-63 to $710 and RX-67 to $910. Material costs are not expected to increase in 20x5, but direct labor will increase by 8 percent, and all manufacturing overhead costs will increase by 6 percent. Due to the nature of the manufacturing process, the company does not have any beginning or ending work-in-process inventories. ■ Case 5–68 Activity-Based Costing; Budgeted Operating Margin (LO 5-1, 5-2, 5-3, 5-4, 5-5, 5-8) 2. Assembly: $40 per assem- bly hour 4. RX-67, gross margin: $(226,000) Ex CINCINNATI CYCLE COMPANY Budgeted statement of gross margin for 20x4 JY-63 RX-67 Total Sales in units .......................................... 5,000 5,000 10,000 Sales revenue ......................................... $ 3,400,000 $ 4,400,000 $ 7,800,000 Cost of goods manufactured and sold: Beginning finished-goods inventory .......... $ 480,000 $ 600,000 $ 1,080,000 Add: Direct material ................................ 2,000,000 3,500,000 5,500,000 Direct labor .................................... 370,370 185,186 555,556 Applied manufacturing overhead* .... 1,088,050 544,026 1,632,076 Cost of goods available for sale ................ $ 3,938,420 $ 4,829,212 $ 8,767,632 Less: Ending finished-goods inventory ...... 480,000 600,000 1,080,000 Cost of goods sold .................................. $ 3,458,420 $ 4,229,212 $ 7,687,632 Gross margin .......................................... $ (58,420) $ 170,788 $ 112,368 *Applied on the basis of direct-labor hours: Machining ....................................... $ 849,056 Assembly ........................................ 433,962 Material handling ............................. 113,208 Inspection ....................................... 235,850 Total ............................................ $1,632,076 Cost Pool Information for 20x4 Cost Pool Activity JY-63 RX-67 Direct labor ...................... Direct-labor hours (per product line) ..................... 10,000 5,000 Material handling .............. Number of parts (per unit) ................................... 5 10 Inspection ........................ Inspection hours (per product line) ....................... 5,000 7,500 Machining ........................ Machine hours (per product line) .......................... 15,000 30,000 Assembly ......................... Assembly hours (per product line) ........................ 6,000 5,500 hiL25664_ch05_164-223.indd 220hiL25664_ch05_164-223.indd 220 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer Predetermined overhead rate: Budgeted overheead Budgeted direct-labor hours $ , ,7 140 000 422 000 170 , $ hours per hour Chapter 5 Activity-Based Costing and Management 221 Cincinnati Cycle Company uses a just-in-time inventory system and has materials delivered to the production facility directly from the vendors. The raw-material inventory both at the beginning and the end of the month is immaterial and can be ignored for the purposes of a budgeted income statement. The company uses the first-in, first-out (FIFO) inventory method. Required: 1. Explain how activity-based costing differs from traditional product-costing methods. 2. Using activity-based costing, calculate the total cost for 20x5 for the following activity cost pools: material handling, inspection, machining, and assembly. (For the total costs, round to the nearest dollar.) Then, calculate the pool rate per unit of the appropriate cost driver for each of the four activities. 3. Prepare a table showing for each product line the estimated 20x5 cost for each of the following cost elements: direct material, direct labor, machining, assembly, material handling, and inspec- tion. (Round to the nearest dollar.) 4. Prepare a budgeted statement showing the gross margin for Cincinnati Cycle Company for 20x5, using activity-based costing. The statement should show each product and a total for the company. Be sure to include detailed calculations for the cost of goods manufactured and sold. (Round each amount in the statement to the nearest dollar.) (CMA, adapted) Madison Electric Pump Corporation manufactures electric pumps for commercial use. The company produces three models, designated as regular, advanced, and deluxe. The company uses a job-order cost accounting system with manufacturing overhead applied on the basis of direct-labor hours. The system has been in place with little change for 25 years. Product costs and annual sales data are as follows: For the past 10 years, the company’s pricing formula has been to set each product’s target price at 110 percent of its full product cost. Recently, however, the regular-model pump has come under increas- ing price pressure from offshore competitors. The result was that the price on the regular model has been lowered to $220. ■ Case 5–69 Traditional versus Activity- Based Costing Systems (LO 5-1, 5-2, 5-3, 5-4, 5-5) 1. Regular model, target price: $231.00 2. Advanced model, total unit cost: $875.50 Regular Model Advanced Model Deluxe Model Annual sales (units) .............................. 20,000 1,000 10,000 Product costs: Direct material ................................. $ 20 $ 50 $ 84 Direct labor ..................................... 20 (1 hr. at $20) 40 (2 hr. at $20) 40 (2 hr. at $20) Manufacturing overhead* ............... . 170 (1 hr. at $170) 340 (2 hr. at $170) 340 (2 hr. at $170) Total product cost ................................ $210 $430 $464 * The calculation of the predetermined overhead rate is as follows: Manufacturing-overhead budget: Depreciation, machinery ................................................................................................................... $2,960,000 Maintenance, machinery .................................................................................................................. 240,000 Depreciation, taxes, and insurance for factory .................................................................................... 600,000 Engineering ..................................................................................................................................... 700,000 Purchasing, receiving and shipping ................................................................................................... 500,000 Inspection and repair of defects ........................................................................................................ 750,000 Material handling ............................................................................................................................. 800,000 Miscellaneous manufacturing overhead costs .................................................................................... 590,000 Total ................................................................................................................................................ $7,140,000 Direct-labor budget: Regular model: 20,000 hours Advanced model: 2,000 hours Deluxe model: 20,000 hours Total 42,000 hours hiL25664_ch05_164-223.indd 221hiL25664_ch05_164-223.indd 221 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer 222 Chapter 5 Activity-Based Costing and Management The company president recently asked the controller, “Why can’t we compete with these other companies? They’re selling pumps just like our regular model for $212. That’s only two bucks more than our production cost. Are we really that inefficient? What gives?” The controller responded by saying, “I think this is due to an outmoded product-costing system. As you may remember, I raised a red flag about our system when I came on board last year. But the decision was to keep our current system in place. In my judgment, our product-costing system is distorting our product costs. Let me run a few numbers to demonstrate what I mean.” Getting the president’s go-ahead, the controller compiled the basic data needed to implement an activity-based costing system. These data are displayed in the following table. The percentages are the proportion of each cost driver consumed by each product line. Required: 1. Compute the target prices for the three pump models, based on the traditional, volume-based product-costing system. 2. Compute new product costs for the three products, based on the new data collected by the control- ler. Round to the nearest cent. 3. Calculate a new target price for the three products, based on the activity-based costing system. Compare the new target price with the current actual selling price for the regular model pump. 4. Write a memo to the company president explaining what has been happening as a result of the firm’s traditional volume-based product-costing system. 5. What strategic options does management have? What do you recommend, and why? Refer to the product costs developed in requirement (2) of the preceding problem. Prepare a table show- ing how Madison Electric Pump Corporation’s traditional, volume-based product-costing system dis- torts the product costs of the three pump models. (You may wish to refer to Exhibit 5–10 for guidance. Because of rounding in the calculation of the product costs, there will be a small rounding error in this cost distortion analysis as well.) Madison Electric Pump Corporation’s controller, Erin Jackson, developed new product costs for the three pump models using activity-based costing. It was apparent that the firm’s traditional product- costing system had been undercosting the advanced model electric pump by a significant amount. This was due largely to the low volume of the advanced model. Before she could report back to the presi- dent, Jackson received a phone call from her friend, Alan Tyler. He was the production manager for the advanced model electric pump. Tyler was upset, and he let Jackson know it. “Erin, I’ve gotten wind of your new product cost analysis. There’s no way the advanced model costs anywhere near what your numbers say. For years and years this line has been highly profitable, and its reported product cost was low. Now you’re telling us it costs more than twice what we thought. I just don’t buy it.” Jackson briefly explained to her friend about the principles of activity-based costing and why it resulted in more accurate product costs. “Alan, the advanced model really is losing money. It simply has too low a volume to be manufactured efficiently.” Tyler was even more upset now. “Erin, if you report these new product costs to the president, he’s going to discontinue the advanced model. My job’s on the line, Erin! How about massaging those num- bers a little bit. Who’s going to know?” Product Lines Activity Cost Pool Cost Driver Regular Model Advanced Model Deluxe Model I: Depreciation, machinery Machine time 39% 13% 48% Maintenance, machinery II: Engineering Engineering hours 47% 6% 47% Inspection and repair of defects III: Purchasing, receiving, and shipping Number of material orders 47% 8% 45% Material handling IV: Depreciation, taxes, and insurance for factory Factory space usage 42% 15% 43% Miscellaneous manufacturing overhead ■ Case 5–70 Cost Distortion; Continuation of Preceding Case (LO 5-8) ■ Case 5–71 Ethical Issues Related to Product-Cost Distortion; Activity-Based Costing; Continuation of Cases 5–69 and 5–70 (LO 5-5, 5-8) hiL25664_ch05_164-223.indd 222hiL25664_ch05_164-223.indd 222 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer Chapter 5 Activity-Based Costing and Management 223 “I’ll know, Alan. And you’ll know,” responded Jackson. “Look, I’ll go over my analysis again, just to make sure I haven’t made an error.” Required: Discuss the ethical issues involved in this scenario. 1. Is the controller, Erin Jackson, acting ethically? 2. Is the production manager, Alan Tyler, acting ethically? 3. What are Jackson’s ethical obligations? To the president? To her friend? hiL25664_ch05_164-223.indd 223hiL25664_ch05_164-223.indd 223 7/4/13 1:23 AM7/4/13 1:23 AM Final PDF to printer 6 THIS CHAPTER’S FOCUS COMPANY is Tasty Donuts, Inc., a Canadian chain of 10 donut shops in Toronto, Ontario. Using the Tasty Donuts illustration, we explore cost behavior, cost estimation, and cost prediction. Cost behavior refers to the relationship between cost and activity. Variable and fixed costs, which we studied in Chapter 2, are two examples of the many types of cost behavior. Cost estimation is the process of determining how a particular cost behaves, often relying on historical cost data. Cost prediction means using our knowledge of cost behavior to fore- cast the cost to be incurred at a particular level of activity. Cost analysis helps Tasty Donuts’ management plan for the costs to be incurred at various levels of donut sales activity. FOCUS COMPANY >>>
Activity Analysis, Cost
Behavior, and Cost
Estimation
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<<< IN CONTRAST In contrast to the service-industry setting of Tasty Donuts, we turn to a manufacturing environment to explore the effect of the learning curve on cost behavior. In many production processes, production effi- ciency increases with experience. As cumulative production output increases, the average labor time required per unit declines. As the labor time declines, labor cost declines as well. This phenomenon is called the learning curve. To illustrate the learning-curve concept, we explore its use by Cosmos Communications Technology (CCT), a Canadian manufacturer of sophisticated communications satellites in Vancouver, British Columbia. CCT’s management has found that the learning curve applies to the labor-intensive assembly operation for each new satellite design. hiL25664_ch06_224-265.indd 225hiL25664_ch06_224-265.indd 225 7/4/13 1:32 AM7/4/13 1:32 AM Final PDF to printer 226 After completing this chapter, you should be able to : Managers in almost any organization want to know how costs will be affected by changes in the organization’s activity. The relationship between cost and activity, called cost behavior, is relevant to the management functions of planning, control, and decision making. In order to plan operations and prepare a budget, managers at Nabisco need to predict the costs that will be incurred at different levels of production and sales. To con- trol the costs of providing commercial-loan services at Wells Fargo , executives need to have a feel for the costs that the bank should incur at various levels of commercial-loan activity. In deciding whether to add a new intensive care unit, a hospital’s administrators need to predict the cost of operating the new unit at various levels of patient demand. In each of these situations, knowledge of cost behavior will help the manager to make the desired cost prediction. A cost prediction is a forecast of cost at a particular level of activity. In the first half of this chapter, we will study cost behavior patterns and their use in making cost predictions. How does a managerial accountant determine the cost behavior pattern for a particu- lar cost item? The determination of cost behavior, which is often called cost estimation, can be accomplished in a number of ways. One way is to analyze historical data concern- ing costs and activity levels. Cost estimation is covered in the second half of this chapter. The following diagram summarizes the key points in the preceding discussion. 6-1 Explain the relationships between cost estimation, cost behavior, and cost prediction. 6-2 Define and describe the behavior of the following types of costs: variable, step-variable, fixed, step-fixed, semivariable (or mixed), and curvilinear. 6-3 Explain the importance of the relevant range in using a cost behavior pattern for cost prediction. 6-4 Define and give examples of engineered costs, committed costs, and discretionary costs. 6-5 Describe and use the following cost estimation methods: account classification, visual fit, high-low, and least-squares regression. 6-6 Describe the multiple regression, engineering, and learning-curve approaches to cost estimation. 6-7 Describe some problems often encountered in collecting data for cost estimation. 6-8 Perform and interpret a least-squares regression analysis with a single independent variable (appendix). Learning Objective 6-1 Explain the relationships between cost estimation, cost behavior, and cost prediction. Cost estimation Cost behavior Cost prediction The process of determining cost behavior. Often focuses on historical data. The relationship between cost and activity. Using knowledge of cost behavior to forecast the level of cost at a particular level of activity. Focus is on the future. hiL25664_ch06_224-265.indd 226hiL25664_ch06_224-265.indd 226 7/4/13 1:32 AM7/4/13 1:32 AM Final PDF to printer Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation 227 Cost Behavior Patterns Our discussion of cost behavior patterns, also called cost functions, will be set in the con- text of a donut shop business. Tasty Donuts, Inc., operates a chain of 10 donut shops in the city of Toronto, Ontario. Each shop sells a variety of donuts, muffins, and sweet rolls as well as various beverages. Beverages, such as coffee and fruit juices, are prepared in each donut shop, but all of the company’s donuts and baked products are made in a centrally located bakery. The company leases several small delivery trucks to transport the bakery items to its donut shops. Use of a central bakery is more cost-efficient. Moreover, this approach allows the firm to smooth out fluctuations in demand for each type of product. For example, the demand for glazed donuts may change from day to day in each donut shop, but these fluctuations tend to cancel each other out when the total demand is aggre- gated across all 10 shops. The corporate controller for Tasty Donuts has recently completed a study of the com- pany’s cost behavior to use in preparing the firm’s budget for the coming year. The con- troller studied the following costs. Direct material: ingredients for donuts, muffins, and sweet rolls; beverages; paper products, such as napkins and disposable cups. Direct labor: wages and fringe benefits of bakers, donut shop sales personnel, and delivery-truck drivers. Overhead: Facilities costs: property taxes; depreciation on bakery building, donut shops, and equipment; salaries and fringe benefits of maintenance personnel. Indirect labor: salaries and fringe benefits of managers and assistant managers for bakery and donut shops. Delivery trucks: rental payments under lease contract; costs of gasoline, oil, tires, and maintenance. Utilities: electricity, telephone, and trash collection. In studying the behavior of each of these costs, the controller measured company activity in terms of dozens of bakery items sold. Thus, dozens of bakery items sold is the cost driver for each of the costs studied. A bakery item is one donut, muffin, or sweet roll. The costs to make each of these products are nearly identical. The number of bakery items sold each day is roughly the same as the number produced, since bakery goods are produced to keep pace with demand as reported by the company’s donut shop managers. Variable Costs Variable costs were discussed briefly in Chapter 2. We will summarize that discussion here in the context of the Tasty Donuts illustration. A variable cost changes in total in direct proportion to a change in the activity level (or cost driver). Tasty Donuts’ direct- material cost is a variable cost. As the company sells more donuts, muffins, and sweet rolls, the total cost of the ingredients for these goods increases in direct proportion to the number of items sold. Moreover, the quantities of beverages sold and paper products used by customers also increase in direct proportion to the number of bakery items sold. As a result, the costs of beverages and paper products are also variable costs. Panel A of Exhibit 6–1 displays a graph of Tasty Donuts’ direct-material cost. As the graph shows, total variable cost increases in proportion to the activity level (or cost driver). When activity triples, for example, from 50,000 dozen items to 150,000 dozen items, total direct-material costs triple, from $55,000 to $165,000. However, the variable cost per unit remains the same as activity changes. The total direct-material cost incurred per dozen items sold is constant at $1.10 per dozen. The table in panel B of Exhibit 6–1 illustrates this point. The variable cost per unit also is represented in the graph in panel A of Exhibit 6–1 as the slope of the cost line. Cost Behavior Patterns D NUTS TA STY “Failure to understand costs would have left Portugal Telecom vulnerable to com- petition. Understanding the company’s costs became essential to cost reduction efforts and to the company’s long-term viability.” (6a) Accenture, (regarding its client, Portugal Telecom) Learning Objective 6-2 Define and describe the behavior of the following types of costs: variable, step-variable, fixed, step-fixed, semivariable (or mixed), and curvilinear. hiL25664_ch06_224-265.indd 227hiL25664_ch06_224-265.indd 227 7/24/13 2:35 AM7/24/13 2:35 AM Final PDF to printer 228 Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation To summarize, as activity changes, total variable cost increases in direct proportion to the change in activity level, but the variable cost per unit remains constant. Step-Variable Costs Some costs are nearly variable, but they increase in small steps instead of continuously. Such costs, called step-variable costs, usually include inputs that are purchased and used in relatively small increments. At Tasty Donuts, Inc., the direct-labor cost of bak- ers, counter-service personnel, and delivery-truck drivers is a step-variable cost. Many of these employees are part-time workers, called upon for relatively small increments of time, such as a few hours. On a typical day, for example, Tasty Donuts may have 35 employees at work in the bakery and the donut shops. If activity increases slightly, these employees can handle the extra work. However, if activity increases substantially, the bakery manager or various restaurant managers may call on additional help. Exhibit 6–2 , a graph of Tasty Donuts’ monthly direct-labor cost, shows that this cost remains constant within an activity range of about 5,000 dozen bakery items per month. When monthly activity increases beyond this narrow range, direct-labor costs increase. Approximating a Step-Variable Cost If the steps in a step-variable cost behavior pattern are small, the step-variable cost function may be approximated by a variable cost function without much loss in accuracy. Exhibit 6–3 shows such an approximation for Tasty Donuts’ direct-labor cost. Total direct-material cost (food ingredients, beverages, paper products) $165,000 $110,000 $ 55,000 50,000 100,000 150,000 Activity, or cost driver (dozens of bakery items sold) Slope is variable cost per unit of activity, $1.10 per dozen bakery items A. Graph of Total Direct-Material Cost Exhibit 6–1 Variable Cost: Direct-Material Cost, Tasty Donuts, Inc. D NUTS TA STY B. Tabulation of Direct-Material Cost Activity (or cost driver) Direct-Material Cost per Dozen Bakery Items Sold Total Direct- Material Cost 50,000 $1.10 $ 55,000 100,000 1.10 110,000 150,000 1.10 165,000 hiL25664_ch06_224-265.indd 228hiL25664_ch06_224-265.indd 228 7/4/13 1:32 AM7/4/13 1:32 AM Final PDF to printer Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation 229 Fixed Costs Fixed costs were covered briefly in Chapter 2. We will summarize that discussion here, using the Tasty Donuts illustration. A fixed cost remains unchanged in total as the activ- ity level (or cost driver) varies. Facilities costs, which include property taxes, deprecia- tion on buildings and equipment, and the salaries of maintenance personnel, are fixed costs for Tasty Donuts, Inc. These fixed costs are graphed in panel A of Exhibit 6–4 . This graph shows that the total monthly cost of property taxes, depreciation, and maintenance personnel is $200,000 regardless of how many dozen bakery items are produced and sold during the month. The fixed cost per unit does change as activity varies. Exhibit 6–4 (panel B) shows that the company’s facilities cost per dozen bakery items is $4.00 when 50,000 dozen items are produced and sold. However, this unit cost declines to $2.00 when 100,000 dozen items are produced and sold. If activity increases to 150,000 dozen items, unit fixed cost will decline further, to about $1.33. A graph provides another way of viewing the change in unit fixed cost as activity changes. Panel C of Exhibit 6–4 displays a graph of Tasty Donuts’ cost of property taxes, depreciation, and maintenance personnel per dozen bakery items. As the graph shows, the fixed cost per dozen bakery items declines steadily as activity increases. To summarize, as the activity level increases, total fixed cost does not change, but unit fixed cost declines. For this reason, it is preferable in any cost analysis to work with total fixed cost rather than fixed cost per unit. Step-Fixed Costs Some costs remain fixed over a wide range of activity but jump to a different amount for activity levels outside that range. Such costs are called step-fixed costs. Tasty Donuts’ cost of indirect labor is a step-fixed cost. Indirect-labor cost consists of the salaries and fringe benefits for the managers and assistant managers of the company’s bakery and donut shops. Tasty Donuts’ monthly indirect-labor cost is graphed in Exhibit 6–5 . “By understanding the costs and workload associ- ated with the real business activities we undertake . . . we are better positioned to understand where value is created. . . . From this infor- mation, we can then make better decisions as to the management and direction of the business.” (6b) Transco Total direct-labor cost (wages and fringe benefits of bakers, sales personnel, and delivery-truck drivers) $45,000 $30,000 $15,000 50,000 100,000 150,000 Activity, or cost driver (dozens of bakery items sold) Difference between the two lines is small, resulting in little loss of accuracy Step-variable cost behavior pattern Variable cost behavior pattern used as an approximation $45,000 $30,000 $15,000 50,000 100,000 150,000 Activity, or cost driver (dozens of bakery items sold) Size of cost increment in one step is $1,500 of direct-labor cost per month Size of activity range in one step is 5,000 dozen bakery items per month Total direct-labor cost (wages and fringe benefits of bakers, sales personnel, and delivery-truck drivers) Exhibit 6–2 Step-Variable Cost: Direct- Labor Cost, Tasty Donuts D NUTS TA STY Exhibit 6–3 Approximating a Step- Variable Cost, Tasty Donuts D NUTS TA STY hiL25664_ch06_224-265.indd 229hiL25664_ch06_224-265.indd 229 7/4/13 1:32 AM7/4/13 1:32 AM Final PDF to printer 230 Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation Total monthly fixed costs: facilities costs A. Graph of Total Monthly Fixed Costs: Facilities Costs $200,000 50,000 100,000 150,000 Activity, or cost driver (dozens of bakery items sold per month) Exhibit 6–4 Fixed Cost: Facilities Costs, Tasty Donuts, Inc. D NUTS TA STY B. Tabulation of Monthly Fixed Costs: Facilities Costs Activity (or cost driver) Cost of Facilities per Dozen Bakery Items Sold Total Monthly Cost of Facilities 50,000 ................................................. $4.00 ...................................... $200,000 100,000 ................................................. 2.00 ...................................... 200,000 150,000 ................................................. 1.33 * ..................................... 200,000 *Rounded. Unit fixed cost: facilities costs $4.00 50,000 100,000 150,000 Activity, or cost driver (dozens of bakery items sold per month) $1.33 $2.00 C. Graph of Unit Fixed Costs: Cost of Facilities per Dozen Bakery Items Sold As Exhibit 6–5 shows, for activity in the range of 50,000 to 100,000 dozen bakery items per month, Tasty Donuts’ monthly indirect-labor cost is $35,000. For this range of activity, the company employs a full-time manager and a full-time assistant manager in the bakery and in each donut shop. When monthly activity exceeds this range during the summer tourist season, the company employs additional part-time assistant managers in the bakery and in its busiest donut shops. The company hires college students who are majoring in restaurant management for these summer positions. Their salaries boost the monthly indirect-labor cost to $45,000. Tasty Donuts has not experienced demand of less than 50,000 dozen bakery items per month. However, the controller anticipates that if hiL25664_ch06_224-265.indd 230hiL25664_ch06_224-265.indd 230 7/4/13 1:32 AM7/4/13 1:32 AM Final PDF to printer Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation 231 such a decrease in demand were to occur, the company would reduce the daily operating hours for its donut shops. This would allow the firm to operate each donut shop with only a full-time manager and no assistant manager. As the graph in Exhibit 6–5 indicates, such a decrease in managerial personnel would reduce monthly indirect-labor cost to $25,000. Semivariable Cost A semivariable (or mixed ) cost has both a fixed and a variable component. The cost of operating delivery trucks is a semivariable cost for Tasty Donuts, Inc. These costs are graphed in Exhibit 6–6 . As the graph shows, the company’s delivery-truck costs have two components. The fixed-cost component is $3,000 per month, which is the monthly rental payment paid under the lease contract for the delivery trucks. The monthly rental payment is constant, regardless of the level of activity (or cost driver). The variable-cost 50,000 100,000 150,000 Total indirect-labor cost (salaries and fringe benefits of bakery and donut shop management personnel) $45,000 $35,000 $25,000 Activity, or cost driver (dozens of bakery items sold per month) $10,000 $20,000 $3,000 Slope is variable cost per unit of activity, $.10 per dozen bakery items Total cost of operating delivery trucks Variable cost component Total cost line Fixed cost component 50,000 100,000 150,000 Activity, or cost driver (dozens of bakery items sold per month) Exhibit 6–5 Step-Fixed Cost: Indirect- Labor Cost, Tasty Donuts, Inc. D NUTS TA STY Exhibit 6–6 Semivariable Cost: Cost of Operating Delivery Trucks, Tasty Donuts, Inc. D NUTS TA STY hiL25664_ch06_224-265.indd 231hiL25664_ch06_224-265.indd 231 7/4/13 1:32 AM7/4/13 1:32 AM Final PDF to printer 232 Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation component consists of the costs of gasoline, oil, routine maintenance, and tires. These costs vary with activity, since greater activity levels result in more deliveries. The dis- tance between the fixed-cost line (dashed line) and the total-cost line in Exhibit 6–6 is the amount of variable cost. For example, at an activity level of 100,000 dozen bakery items, the total variable-cost component is $10,000. The slope of the total-cost line is the variable cost per unit of activity. For Tasty Donuts, the variable cost of operating its delivery trucks is $.10 per dozen bakery items sold. Curvilinear Cost The graphs of all of the cost behavior patterns examined so far consist of either straight lines or several straight-line sections. A curvilinear cost behavior pattern has a curved graph. Tasty Donuts’ utilities cost, depicted as the solid curve in Exhibit 6–7 , is a curvi- linear cost. For low levels of activity, this cost exhibits decreasing marginal costs. As the discussion in Chapter 2 indicated, a marginal cost is the cost of producing the next unit, in this case the next dozen bakery items. As the graph in Exhibit 6–7 shows, the marginal utilities cost of producing the next dozen bakery items declines as activity increases in the range zero to 100,000 dozen items per month. For activity greater than 100,000 dozen bakery items per month, the graph in Exhibit 6–7 exhibits increasing marginal costs. Tasty Donuts’ utilities cost includes electricity, telephone, and trash-collection costs. The utilities cost is curvilinear as a result of the company’s pattern of electricity usage in the bakery. If the demand in a particular month is less than 100,000 dozen bakery items, the goods can be produced entirely in the modernized section of the bakery. This section Total monthly cost of utilities $1,500 $2,500 $5,000 $6,500 $7,500 75,00050,00025,000 100,000 125,000 150,000 Activity, or cost driver (dozens of bakery items sold per month)Relevant range Exhibit 6–7 Curvilinear Cost: Utilities Cost, Tasty Donuts, Inc. D NUTS TA STY hiL25664_ch06_224-265.indd 232hiL25664_ch06_224-265.indd 232 7/4/13 1:32 AM7/4/13 1:32 AM Final PDF to printer Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation 233 uses recently purchased deep-fat fryers and ovens that are very energy-efficient. As long as the bakery operates only the modernized section, the utilities cost per dozen items declines as production increases. During the summer tourist months, when Tasty Donuts’ sales exceed 100,000 dozen items per month, the older section of the bakery also must be used. This section uses much older cooking equipment that is less energy-efficient. As a result, the marginal utili- ties cost per dozen bakery items rises as monthly activity increases in the range above 100,000 dozen items per month. Relevant Range The cost behavior graphed in Exhibit 6–7 is very different at low activity levels (below 50,000) than it is at high activity levels (above 125,000). However, management need not concern itself with these extreme levels of activity if it is unlikely that Tasty Donuts, Inc., will operate at those activity levels. Management is interested in cost behavior within the company’s relevant range, the range of activity within which management expects the company to operate. Tasty Donuts’ management believes the firm’s relevant range to be 75,000 to 120,000 dozen bakery items per month. Based on past experience and sales projections, management does not expect the firm to operate outside that range of monthly activity. Tasty Donuts’ relevant range is shown in Exhibit 6–7 as the section of the graph between the dashed lines. Approximating a Curvilinear Cost within the Relevant Range The straight, dashed line in Exhibit 6–7 may be used to approximate Tasty Donuts’ utilities cost. Notice that the approximation is quite accurate for activity levels within the relevant range. How- ever, as the activity level gets further away from the boundary of the relevant range, the approximation declines in accuracy. For monthly activity levels of 25,000 or 150,000, for example, the approximation is very poor. The straight, dashed line used to approximate Tasty Donuts’ utilities cost within the relevant range represents a semivariable cost behavior pattern. This straight-line graph has a slope of $.05, which represents a unit variable-cost component of $.05 per dozen bakery items. The line intersects the vertical axis of the graph at $1,500, which represents a fixed-cost component of $1,500 per month. Managerial accountants often use a semi- variable-cost behavior pattern to approximate a curvilinear cost. However, it is important to limit this approximation to the range of activity in which its accuracy is acceptable. Using Cost Behavior Patterns to Predict Costs How can Tasty Donuts’ corporate controller use the cost behavior patterns identified in the cost study to help in the budgeting process? First, a sales forecast is made for each month during the budget year. Suppose management expects Tasty Donuts’ activity level to be 110,000 dozen bakery items during the month of June. Second, a cost prediction is made for each of the firm’s cost items. The following cost predictions are based on the cost behavior patterns discussed earlier. (Try to verify these cost predictions by referring to the graphs in Exhibits 6–1 through 6–7 .) Cost Item Cost Prediction for June (110,000 dozen bakery items per month) Direct material ............................................................................................................... $121,000 Direct labor .................................................................................................................... 33,000 Overhead: Facilities costs ........................................................................................................... 200,000 Indirect labor ............................................................................................................. 45,000 Delivery trucks ........................................................................................................... 14,000 Utilities ...................................................................................................................... 7,000 “Cost estimation is a critical part of our job.” (6c) Ford Motor Company Learning Objective 6-3 Explain the importance of the relevant range in using a cost behavior pattern for cost prediction. hiL25664_ch06_224-265.indd 233hiL25664_ch06_224-265.indd 233 7/4/13 1:32 AM7/4/13 1:32 AM Final PDF to printer 234 Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation IS DIRECT LABOR A VARIABLE OR A FIXED COST? A BusinessWeek article titled “The Disposable Worker,” explained “how companies are making the era of the ‘temp’ more than temporary.” This raises the question: Are direct- labor costs variable or fixed? The answer, as with many questions, is “it depends.” What it depends on is the ability and willingness of a company’s management to continually fine-tune the size of its workforce. If labor contracts make it difficult to lay off workers during an economic downturn, or if top management adopts a policy of maintaining a stable workforce, direct-labor costs will tend to be largely fixed (or step-fixed). However, if management can and is willing to reduce the labor force when activity declines, then labor cost will be a variable (or step-variable) cost. The current trend in many companies seems to be toward adjusting the workforce to conform to current needs. Here are several cases in point. Nestlé “Nestlé’s prepared foods unit has built an in-house roster of part-time workers in Chero- kee County, South Carolina, who stick by the telephone to hear if they should report on a given day to assemble frozen chicken dinners. The county job-placement office sends Nestlé lists of ‘call-ins’: people available to work when Nestlé phones them. The workers usually get a day’s notice. Some agree to stay by the phone in the morning, in case the company is short for the afternoon shift. They typically work two to six days a week and earn slightly more than $11 an hour, which is considered good part-time pay in the area.” The head of human resources for the prepared-foods division says demand for its Lean Cuisine glazed-chicken entrees and Stouffers creamed-spinach side dishes is fairly steady. The company still hires some people full time. But the Nestlé executive says it is still hard to predict labor needs, because schedules for producing certain meals vary, and each product requires a different number of people to make. “‘We don’t need the same number of people every day,’ he says. ‘They work as we need them.’”1 Lincoln Electric “In Cleveland, Lincoln Electric Co. shifts salaried workers to hourly clerical jobs, pay- ing them a different wage for each assignment. The Cleveland-based manufacturer of welding and cutting parts says that, for nearly 60 years, it has guaranteed long-term employment for all of its workers who have worked steadily for three years in its U.S. operations. The flip side is that employees have to be willing to change their job assign- ments, depending on the type and volume of orders Lincoln receives.2 Hilton Hotels “Many employers, wary of losing valued workers altogether, are reducing the workweek rather than the workforce. Officials of Hilton Hotels Corp. in Beverly Hills, California, boast that they have laid off relatively few workers. However, Hilton says workweek reductions are widespread among its 77,000 workers.”3 By relying more on part-time workers and daily call-ins, cross-training and frequently moving employees to new jobs, and shortening the workweek, Nestlé, Lincoln Electric, and Hilton Hotels are moving toward direct-labor costs that are much more variable than in the past. Other companies trending toward a “just-in-time workforce” are Walmart, Taco Bell, Starbucks, and U-Haul, among others. This is “all part of the larger development in corporate America of transforming labor from a fixed to a more flexible cost.”4 1P. Coy, M. Conlin, and M. Herbst, “The Disposable Worker,” BusinessWeek, January 18, 2010, pp. 33–45; and C. Ansberry, “In the New Workplace, Jobs Morph to Suit Rapid Change of Pace,” The Wall Street Journal, March 3, 2002, pp. A1, A7. See also J. Jargon, L. Radnofsky, and A. Berzon, “Health-Care Law Spurs a Shift to Part-Time Workers,” The Wall Street Journal (online), November 4, 2012, p. 1. 2Ibid., pp. A1, A7. 3J. Eig, “Do Part-Time Workers Hold Key to When the Recession Breaks?” The Wall Street Journal, January 3, 2002, p. A1. 4M. Conlin, “The Big Squeeze on Workers,” BusinessWeek, May 13, 2002, pp. 96–98; and M. Conlin, “The Software Says You’re Just Average,” BusinessWeek, February 25, 2002, p. 126. Nestlé, Lincoln Elec- tric, and Hilton Hotels M A P anagement ccounting ractice hiL25664_ch06_224-265.indd 234hiL25664_ch06_224-265.indd 234 7/4/13 1:32 AM7/4/13 1:32 AM Final PDF to printer Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation 235 The preparation of a complete budget involves much more analysis and detailed planning than is shown here. 5 The point is that cost prediction is an important part of the planning process. The cost behavior patterns discussed in this chapter make those cost predictions possible. Engineered, Committed, and Discretionary Costs In the process of budgeting costs, it is often useful for management to make a distinc- tion between engineered, committed, and discretionary costs. An engineered cost bears a definitive physical relationship to the activity measure. Tasty Donuts’ direct-material cost is an engineered cost. It is impossible to produce more donuts without incurring greater material cost for food ingredients. A committed cost results from an organization’s ownership or use of facilities and its basic organization structure. Property taxes, depreciation on buildings and equipment, costs of renting facilities or equipment, and the salaries of management personnel are examples of committed fixed costs. Tasty Donuts’ facilities cost is a committed fixed cost. A discretionary cost arises as a result of a management decision to spend a particular amount of money for some purpose. Examples of discretionary costs include amounts spent on research and development, advertising and promotion, management develop- ment programs, and contributions to charitable organizations. For example, suppose Tasty Donuts’ management decided to spend $12,400 each month on promotion and advertising. The distinction between committed and discretionary costs is an important one. Man- agement can change committed costs only through relatively major decisions that have long- term implications. Decisions to build a new production facility, lease a fleet of vehicles, or add more management personnel to oversee a new division are examples of such deci- sions. These decisions will generally influence costs incurred over a long period of time. In contrast, discretionary costs can be changed in the short run much more easily. Manage- ment can be flexible about expenditures for advertising, promotion, employee training, or research and development. This does not imply that such programs are unimportant, but simply that management can alter them over time. For example, the management of a man- ufacturing firm may decide to spend $100,000 on research and development in the current year, but cut back to $60,000 in the next year because of an anticipated economic downturn. “Cost information about activities provides a bench- mark to assess how we are doing against best-in-class and competitors.” (6d) BlueCross BlueShield of North Carolina 5The budgeting process is covered in Chapter 9. The raw material in these luxury shoes represents an engineered cost. The depre- ciation on the production equipment is a committed cost. Expenditures on adver- tising and promotion are discretionary costs. Pictured here is luxury shoe production by J. M. Weston in Limoges, France Learning Objective 6-4 Define and give examples of engineered costs, committed costs, and discretionary costs. hiL25664_ch06_224-265.indd 235hiL25664_ch06_224-265.indd 235 7/4/13 1:32 AM7/4/13 1:32 AM Final PDF to printer 236 Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation Cost Behavior in Other Industries We have illustrated a variety of cost behavior patterns for Tasty Donuts’ restaurant busi- ness. The same cost behavior patterns are used in other industries. The cost behavior pattern appropriate for a particular cost item depends on the organization and the activ- ity base (or cost driver). In manufacturing firms, production quantity, direct-labor hours, and machine hours are common cost drivers. Direct-material and direct-labor costs are usually considered variable costs. Other variable costs include some manufacturing-over- head costs, such as indirect material and indirect labor. Fixed manufacturing costs are generally the costs of creating production capacity. Examples include depreciation on plant and equipment, property taxes, and the plant manager’s salary. Such overhead costs as utilities and equipment maintenance are usually semivariable or curvilinear costs. A semivariable-cost behavior pattern is generally used to approximate a curvilinear cost within the relevant range. Supervisory salaries are usually step-fixed costs, since one person can supervise production over a range of activity. When activity increases beyond that range, such as when a new shift is added, an additional supervisor is added. In merchandising firms, such as Home Depot , the activity base (or cost driver) usu- ally is sales revenue. The cost of merchandise sold is a variable cost. Most labor costs are fixed or step-fixed costs, since a particular number of sales and stock personnel can generally handle sales activity over a fairly wide range of sales. Store facility costs, such as rent, depreciation on buildings and furnishings, and property taxes, are fixed costs. In some industries, the choice of the cost driver is not obvious, and the cost behavior pattern can depend on the cost driver selected. At Southwest Airlines , for instance, the cost driver could be air miles flown, passengers flown, or passenger miles flown. A pas- senger mile is the transportation of one passenger for one mile. Fuel costs are variable with respect to air miles traveled, but are not necessarily variable with respect to passen- ger miles flown. An airplane uses more fuel in flying from New York to Los Angeles than from New York to Chicago. However, a plane does not require significantly more fuel to fly 200 people from one city to another than to fly 190 people the same distance. In contrast, an airport landing fee is a fixed cost for a particular number of aircraft arrivals, regardless of how far the planes have flown or how many people were transported. The point of this discussion is that both the organization and the cost driver are crucial deter- minants of the cost behavior for each cost item. Conclusions drawn about cost behavior in one industry are not necessarily transferable to another industry. Cost Estimation As the preceding discussion indicates, different costs exhibit a variety of cost behavior patterns. Cost estimation is the process of determining how a particular cost behaves. Sev- eral methods are commonly used to estimate the relationship between cost and activity. Some of these methods are simple, while some are quite sophisticated. In some firms, managers use more than one method of cost estimation. The results of the different methods are then combined by the cost analyst on the basis of experience and judgment. We will examine several methods of cost estimation in the context of the Tasty Donuts illustration. Account-Classification Method The account-classification method of cost estimation, also called account analysis, involves a careful examination of the organization’s ledger accounts. The cost analyst classifies each cost item in the ledger as a variable, fixed, or semivariable cost. The classification is based on the analyst’s knowledge of the organization’s activities and “In the management of a university, just like any other organization, you have to know your cost structure. We think very carefully about how student enroll- ment will affect faculty sal- ary costs, computing costs, and lots of other costs stu- dents don’t necessarily tend to think about.” (6e) Cornell University Cost Estimation Learning Objective 6-5 Describe and use the follow- ing cost estimation methods: account classification, visual fit, high-low, and least-squares regression. hiL25664_ch06_224-265.indd 236hiL25664_ch06_224-265.indd 236 7/4/13 1:32 AM7/4/13 1:32 AM Final PDF to printer Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation 237 experience with the organization’s costs. For example, it may be obvious to the analyst going through the ledger that direct-material cost is variable, building depreciation is fixed, and utility costs are semivariable. Once the costs have been classified, the cost analyst estimates cost amounts by examining job-cost records, paid bills, labor time cards, or other source documents. A property-tax bill, for example, will provide the cost analyst with the information needed to estimate this fixed cost. This examination of historical source documents is combined with other knowledge that may affect costs in the future. For example, the municipal government may have recently enacted a 10 percent property-tax increase, which takes effect the following year. For some costs, particularly those classified as semivariable, the cost analyst may use one of several more systematic methods of incorporating historical data in the cost estimate. These methods are discussed next. Visual-Fit Method When a cost has been classified as semivariable, or when the analyst has no clear idea about the behavior of a cost item, it is helpful to use the visual-fit method to plot recent observations of the cost at various activity levels. The resulting scatter diagram helps the analyst visualize the relationship between cost and the level of activity (or cost driver). To illustrate, suppose Tasty Donuts’ controller has compiled the following historical data for the company’s utility costs. Month Utility Cost for Month Activity or Cost Driver (dozens of bakery items sold per month) January ..................................................... $5,100 ..................................................... 75,000 February ................................................... 5,300 ..................................................... 78,000 March ....................................................... 5,650 ..................................................... 80,000 April .......................................................... 6,300 ..................................................... 92,000 May .......................................................... 6,400 ..................................................... 98,000 June ......................................................... 6,700 ..................................................... 108,000 July ........................................................... 7,035 ..................................................... 118,000 August ...................................................... 7,000 ..................................................... 112,000 September ................................................ 6,200 ..................................................... 95,000 October ..................................................... 6,100 ..................................................... 90,000 November ................................................. 5,600 ..................................................... 85,000 December ................................................. 5,900 ..................................................... 90,000 The scatter diagram of these data is shown in Exhibit 6–8 . The cost analyst can visu- ally fit a line to these data by laying a ruler on the plotted points. The line is positioned so that roughly equal numbers of plotted points lie above and below the line. Using this method, Tasty Donuts’ controller visually fit the line shown in Exhibit 6–8 . Just a glance at the visually fit cost line reveals that Tasty Donuts’ utilities cost is a semivariable cost within the relevant range. The scatter diagram provides little or no information about the cost relationship outside the relevant range. Recall from the discus- sion of Tasty Donuts’ utilities cost (see Exhibit 6–7 ) that the controller believes the cost behavior pattern to be curvilinear over the entire range of activity. This judgment is based on the controller’s knowledge of the firm’s facilities and an understanding of electricity usage by the modern bakery equipment and the older bakery equipment. As Exhibit 6–7 shows, however, the curvilinear utilities cost can be approximated closely by a semivari- able cost within the relevant range. The data plotted in the scatter diagram lie within the relevant range. Consequently, the data provide a sound basis for the semivariable approximation that the controller has chosen to use. hiL25664_ch06_224-265.indd 237hiL25664_ch06_224-265.indd 237 7/4/13 1:32 AM7/4/13 1:32 AM Final PDF to printer 238 Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation The visually fit cost line in Exhibit 6–8 intercepts the vertical axis at $1,500. Thus, $1,500 is the estimate of the fixed-cost component in the semivariable-cost approxima- tion. To determine the variable cost per unit, subtract the fixed cost from the total cost at any activity level. The remainder is the total variable cost for that activity level. For example, the total variable cost for an activity level of 50,000 dozen items is $2,500 (total cost of $4,000 minus fixed cost of $1,500). This yields a variable cost of $.05 per dozen bakery items ($.05 5 $2,500 4 50,000). These variable and fixed cost estimates were used for the semivariable-cost approx- imation discussed earlier in the chapter ( Exhibit 6–7 ). These estimates are valid only within the relevant range Evaluation of Visual-Fit Method The scatter diagram and visually fit cost line pro- vide a valuable first step in the analysis of any cost item suspected to be semivariable or curvilinear. The method is easy to use and to explain to others, and it provides a useful view of the overall cost behavior pattern. The visual-fit method also enables an experienced cost analyst to spot outliers in the data. An outlier is a data point that falls far away from the other points in the scatter dia- gram and is not representative of the data. Suppose, for example, that the data point for January had been $6,000 for 75,000 units of activity. Exhibit 6–8 reveals that such a data point would be way out of line with the rest of the data. The cost analyst would follow up on such a cost observation to discover the reasons behind it. It could be that the data point is in error. Perhaps a utility bill was misread when the data were compiled, or pos- sibly the billing itself was in error. Another possibility is that the cost observation is cor- rect but due to unusual circumstances. Perhaps Toronto experienced a record cold wave during January that required the company’s donut shops to use unusually high amounts of electric heat. Perhaps an oven in the bakery had a broken thermostat during January that caused the oven to overheat consistently until discovered and repaired. An outlier can result from many causes. If the outlier is due to an error or very unusual circumstances, the data point should be ignored in the cost analysis. A significant drawback of the visual-fit method is its lack of objectivity. Two cost ana- lysts may draw two different visually fit cost lines. This is not usually a serious problem, how- ever, particularly if the visual-fit method is combined with other, more objective methods. Utilities cost (for one month) $1,000 $2,000 $3,000 $4,000 $5,000 $6,000 $7,000 $8,000 50,000 100,000 150,000 Activity, or cost driver (dozens of bakery items sold per month) Relevant range (75,000 to 120,000) Visually fit cost line January data point: $5,100 for 75,000 units of activity Exhibit 6–8 Scatter Diagram of Cost Data with Visually Fit Cost Line, Tasty Donuts, Inc. D NUTS TA STY hiL25664_ch06_224-265.indd 238hiL25664_ch06_224-265.indd 238 7/4/13 1:32 AM7/4/13 1:32 AM Final PDF to printer Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation 239 High-Low Method In the high-low method, the semivariable-cost approximation is computed using exactly two data points. The high and low activity levels are chosen from the available data set. These activity levels, together with their associated cost levels, are used to compute the variable and fixed cost components as follows: Variable cost per dozen bakery items 5 Difference between the costs corresponding to the highest and lowest activity levels ____________________________________ Difference between the highest and lowest activity levels 5 $7,035 2 $5,100 _______________ 118,000 2 75,000 5 $1,935 ______ 43,000 5 $.045 per dozen items Now we can compute the total variable cost at either the high or low activity level. At the low activity of 75,000 dozen items, the total variable cost is $3,375 ($.045 3 75,000). Subtracting the total variable cost from the total cost at the 75,000 dozen activity level, we obtain the fixed-cost estimate of $1,725 ($5,100 2 $3,375). Notice that the high and low activity levels are used to choose the two data points. In general, these two points need not necessarily coincide with the high and low cost levels in the data set. Exhibit 6–9 presents a graph of Tasty Donuts’ utilities cost, which is based on the high-low method of cost estimation. As in any cost estimation method, this estimate of the cost behavior pattern should be restricted to the relevant range. Evaluation of High-Low Method The high-low method is more objective than the visual-fit method, since it leaves no room for the cost analyst’s judgment. However, the high-low method suffers from a major weakness. Only two data points are used to esti- mate the cost behavior pattern; the remainder of the data points are ignored. In this regard, the visual-fit method is superior to the high-low method, since the former approach uses all of the available data. Utilities cost (for one month) $1,725 $4,000 $3,000 $5,000 $6,000 $7,000 $8,000 50,000 100,000 150,000 Activity, or cost driver (dozens of bakery items sold per month) Relevant range (75,000 to 120,000) Low activity level Cost line based on high-low method Only two data points are used; the remainder of the data are ignored High activity level Exhibit 6–9 Graph of Utilities Cost Using High-Low Method, Tasty Donuts, Inc. D NUTS TA STY hiL25664_ch06_224-265.indd 239hiL25664_ch06_224-265.indd 239 7/4/13 1:32 AM7/4/13 1:32 AM Final PDF to printer 240 Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation Least-Squares Regression Method Statistical techniques may be used to estimate objectively a cost behavior pattern using all of the available data. The most common of these methods is called least-squares regression. To understand this method, examine Exhibit 6–10 , which repeats the scat- ter diagram of Tasty Donuts’ utilities cost data. The exhibit also includes a cost line that has been drawn through the plotted data points. Since the data points do not lie along a perfectly straight line, any cost line drawn through this scatter diagram will miss some or most of the data points. The objective is to draw the cost line so as to make the deviations between the cost line and the data points as small as possible. In the least-squares regression method, the cost line is positioned so as to minimize the sum of the squared deviations between the cost line and the data points. The inset to Exhibit 6–10 depicts this technique graphically. Note that the deviations between the cost line and the data points are measured vertically on the graph rather than perpendicular to the line. The cost line fit to the data using least-squares regression is called a least- squares regression line (or simply a regression line ). Why is the regression method based on minimizing the squares of the deviations between the cost line and the data points? A complete answer to this question lies in the theory of statistics. In short, statistical theorists have proved that a least-squares regression line possesses some very desirable properties for making cost predictions and drawing infer- ences about the estimated relationship between cost and activity. As always, the least-squares regression estimate of the cost behavior pattern should be restricted to the relevant range. Utilities cost (for one month) $1,000 75,00050,00025,000 100,000 125,000 150,000 Activity, or cost driver (dozens of bakery items sold per month) Relevant range (75,000 to 120,000) $2,000 $3,000 $4,000 $5,000 $6,000 $7,000 $8,000 $9,000 $10,000 Least-squares regression line Inset: Close-up of least-squares regression line and data points The sum of the squares of these deviations is minimized Exhibit 6–10 Graph of Utilities Cost Using Least-Squares Regression Method, Tasty Donuts, Inc. D NUTS TA STY hiL25664_ch06_224-265.indd 240hiL25664_ch06_224-265.indd 240 7/4/13 1:32 AM7/4/13 1:32 AM Final PDF to printer Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation 241 Equation Form of Least-Squares Regression Line The least-squares regression line shown in Exhibit 6–10 may be represented by the equation of a straight line. In the following equation, X denotes Tasty Donuts’ activity level for a month, and Y denotes the estimated utilities cost for that level of activity. The intercept of the line on the vertical axis is denoted by a, and the slope of the line is denoted by b. Within the relevant range, a is interpreted as an estimate of the fixed-cost component, and b is interpreted as an esti- mate of the variable cost per unit of activity. Y 5 a 1 bX (1) In regression analysis, X is referred to as the independent variable, since it is the vari- able upon which the estimate is based. Y is called the dependent variable, since its esti- mate depends on the independent variable. The least-squares regression line for Tasty Donuts’ utilities cost is shown below in equation form. Y 5 1,920 1 .0448X Estimated utilities cost for one month Activity level for one month Within the relevant range of activity, the regression estimate of the fixed-cost compo- nent is $1,920 per month, and the regression estimate of the variable-cost component is $.0448 per dozen bakery items. There are several statistical software packages available that do regression analysis. However, a common method of computing the least-squares regression estimates is to use a spreadsheet application such as Microsoft® Excel. This approach is covered in this chapter’s appendix, which you may want to read now. Evaluation of Least-Squares Regression Method We have seen that least-squares regression is an objective method of cost estimation that makes use of all available data. Moreover, the regression line has desirable statistical properties for making cost pre- dictions and drawing inferences about the relationship between cost and activity. The method does require considerably more computation than either the visual-fit or high- low method. However, computer programs are readily available to perform least-squares regression. Evaluating a Particular Least-Squares Regression Line We have seen the ben- efits of least-squares regression in general. How does a cost analyst evaluate a particular regression line based on a specific set of data? A number of criteria may be used, includ- ing economic plausibility and goodness of fit. The cost analyst should always evaluate a regression line from the perspective of economic plausibility. Does the regression line make economic sense? Is it intuitively plausible to the cost analyst? If not, the analyst should reconsider using the regression line to make cost predictions. It may be that the chosen independent variable is not a good predictor of the cost behavior being analyzed. Perhaps another independent vari- able should be considered. Alternatively, there may be errors in the data upon which the regression is based. Rechecking the data will resolve this issue. It could be that funda- mental assumptions that underlie the regression method have been violated. In this case, the analyst may have to resort to some other method of cost estimation. Another criterion commonly used to evaluate a particular regression line is to assess its goodness of fit. Statistical methods can be used to determine objectively how well a regression line fits the data upon which it is based. If a regression line fits the data well, a large proportion of the variation in the dependent variable will be explained by the hiL25664_ch06_224-265.indd 241hiL25664_ch06_224-265.indd 241 7/4/13 1:32 AM7/4/13 1:32 AM Final PDF to printer 242 Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation variation in the independent variable. One frequently used measure of goodness of fit is described in the appendix at the end of this chapter. 6 Multiple Regression In each of the cost estimation methods discussed so far, we have based the estimate on a single independent variable. Moreover, all of Tasty Donuts’ cost behavior patterns were specified with respect to a single activity (or cost driver), dozens of bakery items produced and sold. However, there may be two or more independent variables that are important predictors of cost behavior. To illustrate, we will continue our analysis of Tasty Donuts’ utilities costs. The com- pany uses electricity for two primary purposes: operating cooking equipment, such as deep-fat fryers and ovens, and heating the bakery and donut shops. The cost of electricity for food production is a function of the firm’s activity, as measured in dozens of bakery items produced and sold. However, the cost of electricity for donut shop heating is related more closely to the number of customers than to the number of bakery items sold. A donut shop’s heating costs go up each time the shop’s door is opened, resulting in loss of heat. Two customers purchasing half a dozen donuts each result in greater heating cost than one customer buying a dozen donuts. Suppose Tasty Donuts’ controller wants to estimate a cost behavior pattern for utili- ties cost that is based on both units of sales and number of customers. The method of multiple regression may be used for this purpose. Multiple regression is a statistical method that estimates a linear (straight-line) relationship between one dependent variable and two or more independent variables. In Tasty Donuts’ case, the following regression equation would be estimated. Y 5 a 1 b 1 X 1 1 b 2 X 2 (2) where Y denotes the dependent variable, utilities cost X 1 denotes the first independent variable, dozens of bakery items sold X 2 denotes the second independent variable, number of customers served In regression equation (2), a denotes the regression estimate of the fixed-cost com- ponent, b 1 denotes the regression estimate of the variable utilities cost per dozen bakery items, and b 2 denotes the regression estimate of the variable utilities cost per customer served. The multiple-regression equation will likely enable Tasty Donuts’ controller to make more accurate cost predictions than could be made with the simple regression dis- cussed previously. A simple regression is based on a single independent variable. Mul- tiple regression is covered more extensively in cost accounting and statistics texts. Data Collection Problems Regardless of the method used, the resulting cost estimation will be only as good as the data upon which it is based. The collection of data appropriate for cost estimation requires a skilled and experienced cost analyst. Six problems frequently complicate the process of data collection: 1. Missing data. Misplaced source documents or failure to record a transaction can result in missing data. 2. Outliers. We have discussed these extreme observations of cost-activity rela- tionships. If outliers are determined to represent errors or highly unusual cir- cumstances, they should be eliminated from the data set. 3. Mismatched time periods. The units of time for which the dependent and independent variables are measured may not match. For example, production Learning Objective 6-6 Describe the multiple regression, engineering, and learning-curve approaches to cost estimation. Learning Objective 6-7 Describe some problems often encountered in collecting data for cost estimation. 6 We have only scratched the surface of regression analysis as a tool for cost estimation. For an expanded discussion of the least-squares regression method, see any statistics text. hiL25664_ch06_224-265.indd 242hiL25664_ch06_224-265.indd 242 7/4/13 1:32 AM7/4/13 1:32 AM Final PDF to printer Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation 243 activity may be recorded daily, but costs may be recorded monthly. A common solution is to aggregate the production data to get monthly totals. 4. Trade-offs in choosing the time period. In choosing the length of the time period for which data are collected, there are conflicting objectives. One objec- tive is to obtain as many data points as possible, which implies a short time period. Another objective is to choose a long enough time period to ensure that the accounting system has accurately associated costs with time periods. If, for example, a cost that resulted from production activity in one period is recorded in a later period, the cost and activity data will not be matched properly. Longer time periods result in fewer recording lags in the data. 5. Allocated and discretionary costs. Fixed costs are often allocated on a per-unit- of-activity basis. For example, fixed manufacturing-overhead costs such as depreciation are allocated to units of production. As a result, such costs may appear to be variable in the cost records. Discretionary costs often are budgeted in a manner that makes them appear variable. A cost such as advertising, for example, may be fixed once management decides on the level of advertising. If management’s policy is to budget advertising on the basis of sales dollars, however, the cost will appear to be variable to the cost analyst. An experienced analyst will be wary of such costs and take steps to learn how their amounts are determined. 6. Inflation. During periods of inflation, historical cost data may not reflect future cost behavior. One solution is to choose historical data from a period of low inflation and then factor in the current inflation rate. Other, more sophisticated approaches are also available, and they are covered in cost accounting texts. Engineering Method of Cost Estimation All of the methods of cost estimation examined so far are based on historical data. Each method estimates the relationship between cost and activity by studying the relation- ship observed in the past. A completely different method of cost estimation is to study the process that results in cost incurrence. This approach is called the engineering method of cost estimation. In a manufacturing firm, for example, a detailed study is made of the production technology, materials, and labor used in the manufacturing process. Rather than asking what the cost of material was last period, the engineering approach is to ask how much material should be needed and how much it should cost. Industrial engineers sometimes perform time and motion studies, which determine the steps required for people to perform the manual tasks that are part of the production process. Cost behavior patterns for various types of costs are then estimated on the basis of the engineering analysis. Engineering cost studies are time-consuming and expensive, but they often provide highly accurate estimates of cost behavior. Moreover, in rapidly evolving, high-technology industries, there may not be any historical data on which to base cost estimates. Such industries as genetic engineering, superconductivity, and electronics are evolving so rapidly that historical data are often irrelevant in esti- mating costs. Effect of Learning on Cost Behavior In many production processes, production efficiency increases with experience. As cumulative production output increases, the average labor time required per unit declines. As the labor time declines, labor cost declines as well. This phenomenon is called the learning curve. First documented by aeronautical engineer P. T. Wright in the 1930s, the learning curve concept was popularized by the Boston Consulting Group (BCG) in the 1970s. BCG broadened the learning curve idea to include costs other than direct labor and named this phenomenon the experience curve. The learning-curve and Effect of Learning on Cost Behavior Learning Objective 6-6 Describe the multiple regression, engineering, and learning-curve approaches to cost estimation. hiL25664_ch06_224-265.indd 243hiL25664_ch06_224-265.indd 243 7/4/13 1:32 AM7/4/13 1:32 AM Final PDF to printer 244 Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation experience-curve concepts have been applied primarily to complex, labor-intensive man- ufacturing operations, such as aircraft assembly and shipbuilding. Boeing and Airbus , for example, make extensive use of the learning and experience curve concepts when budget- ing the cost for a new aircraft design. However, the learning curve also has seen limited application in the health care services industry, mainly focusing on complex surgical procedures. To illustrate the learning curve concept, let’s explore its use by Cosmos Communi- cations Technology (CCT), a Canadian manufacturer of sophisticated communications satellites in Vancouver, British Columbia. The company’s satellites transmit voice and data communications around the world. CCT’s management has found that the learning curve applies to the labor-intensive assembly operation for each new satellite design. A graphical portrayal of CCT’s learning curve is shown in panel A of Exhibit 6–11 . On this learning curve, when cumulative output doubles, the average labor time per unit declines by 20 percent. Panel B of Exhibit 6–11 displays the total labor time and average labor time per unit for various levels of cumulative output. As cumulative output doubles from 5 to 10 units, for example, the average labor time per unit declines by 20 percent, from 100 hours per unit to 80 hours per unit. As CCT gains experience with a new satellite design, estimates of the cost of direct labor should be adjusted downward to take this learning effect into account. When the learning-curve concept is applied to a broader set of costs than just labor costs, it is referred to as an experience curve. Suppose, for example, that all labor and variable overhead costs are observed to decline by 20 percent every time cumulative out- put doubles. Then we would change the vertical axis of Exhibit 6–11 to labor and vari- able overhead costs. The graph would then be called an experience curve. Average labor time per unit (hours) 20 40 60 80 100 10 20 30 40 50 60 70 80 Cumulative production output (units) A. Graphical Presentation of Learning Curve Exhibit 6–11 Learning Curve B. Tabular Presentation of Learning Curve Cumulative Output (In units) Average Labor Time per Unit (hours) Total Labor Time (hours) 5 .................................................... 100.0 ................................................ 500.0 10 .................................................... 80.0 ................................................ 800.0 20 .................................................... 64.0 ................................................ 1,280.0 40 .................................................... 51.2 ................................................ 2,048.0 hiL25664_ch06_224-265.indd 244hiL25664_ch06_224-265.indd 244 7/4/13 1:32 AM7/4/13 1:32 AM Final PDF to printer Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation 245 Learning curves have been used extensively in such industries as aircraft production, shipbuilding, and electronics to assist cost analysts in predicting labor costs. These cost predictions are then used in scheduling production, budgeting, setting product prices, and other managerial decisions. Focus on Ethics CISCO SYSTEMS, WALMART, TACO BELL, STARBUCKS, U-HAUL, GENERAL DYNAM- ICS, AND FARMER’S INSURANCE: IS DIRECT LABOR A VARIABLE COST? The question as to whether direct labor is a variable cost is interesting from a cost estimation perspective, but it also presents an interesting ethical issue. Direct material is always a variable cost. At the other extreme, depreciation on fixed facilities and infrastructure typically is not. What about direct labor? Here it depends on the ability and willingness of management to adjust the labor force to current needs. If management is able and willing to hire workers as needed and lay them off when activity declines, direct labor would be a variable cost. The contemporary trend at many companies seems to be in this direction. “Companies are looking first to bring in con- tract workers that they can quickly tap and zap without paying any benefits or severance.” * In fact, the temps have recently been the fastest-growing sector of employment. “And they aren’t accounted for as regular employees. This helps companies that use a lot of them, like Cisco Systems Inc. , to drive up revenue per employee.” “The growing use of the just-in-time workforce is not the only means by which companies are priming the pro- ductivity pump. Workers complain that many employers are taking advantage of outdated labor laws by misclas- sifying them as salaried-exempt so they can skirt overtime pay. Walmart , Taco Bell , Starbucks , and U-Haul , among oth- ers, have been slapped with class actions. In the case of General Dynamics Corp. , this resulted in a $100 million award that is now on appeal. At Farmer’s Insurance , employees got $90 million. Some employers are so worried about the issue that they are now doing wage-and-hour audits.” Is it ethical to “tap and zap” employees? What do you think? (For more on this issue, see the Management Accounting Practice inset on page 234.) *The information and quotations in this box are from Michelle Conlin, “The Big Squeeze on Workers,” BusinessWeek, May 13, 2002, pp. 96, 97. See also P. Coy, M. Conlin, and M. Herbst, “The Disposable Worker,” BusinessWeek, January 18, 2010, pp. 33–39. Chapter Summary LO6-1 Explain the relationships between cost estimation, cost behavior, and cost prediction. Cost behavior is the relationship between cost and activity. Cost estimation refers to the determination of a cost’s behavior. A cost prediction is a forecast of a cost at a particular level of activity. LO6-2 Define and describe the behavior of the following types of costs: variable, step-variable, fixed, step-fixed, semivariable (or mixed), and curvilinear. A variable cost changes in total in direct proportion to a change in the activity level (or cost driver). A step-variable cost is nearly variable, but increases in small steps instead of continuously. A fixed cost remains unchanged in total as the activity level (or cost driver) varies. A step-fixed cost remains constant over a wide range of activity but jumps to a different amount for activity levels outside that range. A semivariable (or mixed) cost has both a vari- able and a semivariable component. A curvilinear cost behavior pattern has a curved graph. LO6-3 Explain the importance of the relevant range in using a cost behavior pattern for cost prediction. Cost predictions should be confined to the relevant range, which is the range of activity expected for the organization. If the organization operates at an activity level outside the relevant range, any cost predictions based on data from the relevant range may not be very accurate. LO6-4 Define and give examples of engineered costs, committed costs, and discretionary costs. An engineered cost bears a definitive physical relationship to the activity measure. Direct material cost is an example. A committed cost results from an organization’s ownership or use of facilities and its hiL25664_ch06_224-265.indd 245hiL25664_ch06_224-265.indd 245 7/4/13 1:32 AM7/4/13 1:32 AM Final PDF to printer 246 Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation basic organization structure. Examples include property taxes and depreciation on buildings and equip- ment. A discretionary cost arises as a result of a management decision to spend a particular amount of money for some purpose. Examples include research and development, advertising, and promotion. LO6-5 Describe and use the following cost-estimation methods: account classification, visual fit, high-low, and least-squares regression. The account-classification, visual-fit, high-low, and least- squares regression methods of cost estimation are all based on an analysis of historical cost data observed at a variety of activity levels. The account-classification method involves a careful examination of an organization’s ledger accounts. In the visual-fit method, a cost analyst plots recent observations of cost at various activity levels. In the high-low method, a semivariable cost is estimated using only two data points: the high and the low activity levels. In the least-squares regression method, the cost line is esti- mated so as to minimize the sum of the squared deviations between the cost line and the data points. LO6-6 Describe the multiple regression, engineering, and learning-curve approaches to cost esti- mation. Multiple regression is a statistical method that estimates a linear (straight-line) relationship between one dependent variable and two or more independent variables. The engineering method of cost estimation is based on a detailed analysis of the process that results in cost incurrence. Under the learning-curve approach, the labor cost is estimated by studying the relationship between the cumulative production quantity and the average labor time required per unit. When this approach is applied to costs other than labor, it is referred to as the experience-curve approach. LO6-7 Describe some problems often encountered in collecting data for cost estimation. Some common data collection problems include missing data, outliers (highly unusual observations), mis- matched time periods, and cost inflation. Allocated and discretionary costs create other challenges in data collection and cost estimation. LO6-8 Perform and interpret a least-squares regression analysis with a single independent variable (Appendix). In the least-squares regression method, the cost line is estimated so as to minimize the sum of the squared deviations between the cost line and the data points. The resulting regression line has an intercept on the vertical (cost) axis and a slope, which measures how steeply the cost line rises as activity increases. Review Problems on Cost Behavior and Estimation Problem 1 Erie Hardware, Inc. operates a chain of four retail stores. Data on the company’s maintenance costs for its store buildings and furnishings are as follows: Month Maintenance Cost Sales January .................................................. $53,000 ...................................................... $600,000 February ................................................ 55,000 ...................................................... 700,000 March .................................................... 47,000 ...................................................... 550,000 April ....................................................... 51,000 ...................................................... 650,000 May ....................................................... 45,000 ...................................................... 500,000 June ...................................................... 49,000 ...................................................... 610,000 Using the high-low method, estimate and graph the cost behavior for the firm’s maintenance costs. Problem 2 The Keystone Sentinel is a weekly newspaper sold throughout Pennsylvania. The following costs were incurred by its publisher during a week when circulation was 100,000 newspapers: total variable costs, $40,000; total fixed costs, $66,000. Fill in your predictions for the following cost amounts. Circulation 110,000 Newspapers 120,000 Newspapers Total variable cost Variable cost per unit Total fixed cost Fixed cost per unit hiL25664_ch06_224-265.indd 246hiL25664_ch06_224-265.indd 246 7/4/13 1:32 AM7/4/13 1:32 AM Final PDF to printer Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation 247 Solutions to Review Problems Problem 1 Sales Cost At high activity level, February ......................................... $700,000 $55,000 At low activity level, May ................................................. 500,000 45,000 Difference ...................................................................... $200,000 $10,000 Variable cost per sales dollar 5 $10,000 _______ 200,000 5 $.05 per sales dollar Total cost at $700,000 of sales ...................................................................................................... $55,000 Total variable cost at $700,000 of sales (700,000 3 $.05) .............................................................. 35,000 Difference is total fixed cost ............................................................................................................ $20,000 The company’s maintenance cost may be expressed by the following equation. Total maintenance cost 5 $20,000 1 $.05 (sales dollars) Alternatively, the maintenance cost can be expressed in the following graph. Maintenance cost Fixed-cost component $60,000 $40,000 $20,000 Sales Slope of $.05 per sales dollar represents the variable-cost component $200,000 $400,000 $600,000 Problem 2 Circulation 110,000 Newspapers 120,000 Newspapers Total variable cost $40,000 3 110,000 _______ 100,000 5 $44,000 $40,000 3 120,000 _______ 100,000 5 $48,000 Variable cost per unit $44,000 4 110,000 5 $.40 $48,000 4 120,000 5 $.40 Total fixed cost $66,000 $66,000 Fixed cost per unit $66,000 4 110,000 5 $.60 $66,000 4 120,000 5 $.55 cost prediction, 226 curvilinear cost, 232 dependent variable, 241 discretionary cost, 235 engineered cost, 235 engineering method, 243 experience curve, 243 fixed cost, 229 goodness of fit, 241 high-low method, 239 independent variable, 241 learning curve, 243 least-squares regression method, 240 multiple regression, 242 outlier, 238 regression line, 240 relevant range, 233 scatter diagram, 237 semivariable ( or mixed) cost, 231 simple regression, 242 step-fixed costs, 229 step-variable costs, 228 variable cost, 227 visual-fit method, 237 account-classification method ( also called account analysis), 236 coefficient of determination, * 249 committed cost, 235 cost behavior, 226 cost estimation, 226 For each term’s definition refer to the indicated page, or turn to the glossary at the end of the text. Key Terms *Term appears in the appendix. ⎛ ⎜ ⎝⎛ ⎜ ⎝⎛ ⎜ ⎝⎛ ⎜ ⎝ hiL25664_ch06_224-265.indd 247hiL25664_ch06_224-265.indd 247 7/4/13 1:32 AM7/4/13 1:32 AM Final PDF to printer 248 Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation APPENDIX TO CHAPTER 6 Least-Squares Regression Using Microsoft® Excel The least-squares regression line, which is shown below in equation form, includes two estimates. These estimates, which are called parameters, are the intercept (denoted by a ) and the slope coefficient (denoted by b ). Y 5 a 1 bX (3) where X denotes the independent variable (activity level for one month) Y denotes the dependent variable (cost for one month) Statistical theorists have shown that these parameters are defined by the following two equations. 7 a 5 (SY )(S X 2 ) 2 (SX )(SXY ) _____________________ n(S X 2 ) 2 (SX )(SX ) (4) b 5 n(SXY ) 2 (SX )(SY ) __________________ n(S X 2 ) 2 (SX )(SX ) (5) where n denotes the number of data points S denotes summation; for example, S Y denotes the sum of the Y (cost) values in the data Calculating the intercept (a) and the slope coefficient (b) would be very laborious to do manually. Fortunately, there are many statistical software programs available to do the regression calculations. Alternatively, Microsoft® Excel can calculate the regression estimates, as the next section demonstrates. Using Microsoft® Excel to Calculate the Regression Parameters A cost analyst can use commands in Microsoft® Excel to easily calculate the regression estimate for the intercept ( a ) and the slope ( b ). All the analyst needs to do is input the data in a spreadsheet. The spread- sheet in Exhibit 6–12 displays the data used to compute Tasty Donuts’ utilities cost. The dependent variable (utilities cost) is in column B, and the independent variable (activity) is in column C. Then the Excel functions INTERCEPT and SLOPE are used to compute the parameters. To use each command, the analyst specifies the range of cells in the spreadsheet in which the values of the dependent variable reside and the range of cells in which the values of the independent variable reside. This is illustrated in the Excel worksheet in Exhibit 6–12 as follows: Cell B24 contains the following formula: 5 INTERCEPT(B7:B18,C7:C18) Cell B25 contains the following formula: 5 SLOPE(B7:B18,C7:C18) In these formulas, B7:B18 specifies the range of cells where the values of the dependent variable reside, and C7:C18 specifies the range of cells where the values of the independent variable reside. As the Excel calculations show in Exhibit 6–12 , the regression estimates are as follows: Intercept: a 5 1,920 Slope: b 5 .0448 So the regression equation is the following: Y 5 1,920 1 .0448X Estimated utilities cost for one month Activity level for one month D NUTS TA STY Learning Objective 6-8 Perform and interpret a least- squares regression analysis with a single independent variable. 7 The derivation of these equations, which requires calculus, is covered in any introductory statistics text. hiL25664_ch06_224-265.indd 248hiL25664_ch06_224-265.indd 248 7/4/13 1:32 AM7/4/13 1:32 AM Final PDF to printer Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation 249 Goodness of Fit The goodness of fit for Tasty Donuts’ regression line may be measured by the coefficient of deter- mination, commonly denoted by R 2 . This measure is defined as the percentage of the variability of the dependent variable about its mean that is explained by the variability of the independent variable about its mean. The higher the R 2 , the better the regression line fits the data. The interpretation for a high R 2 is that the independent variable is a good predictor of the behavior of the dependent variable. In cost estimation, a high R 2 means that the cost analyst can be relatively confident in the cost predictions based on the estimated cost behavior pattern. Statistical theorists have shown that R 2 can be computed using the following formula: R 2 5 1 2 S(Y 2 Y9 ) 2 _________ S(Y 2 __ Y ) 2 (6) where Y denotes the observed value of the dependent variable (cost) at a particular activity level Y 9 denotes the predicted value of the dependent variable (cost), based on the regression line, at a particular activity level _ Y denotes the mean (average) observation of the dependent variable (cost) Excel can be used once again to calculate the R 2 . The analyst simply uses the RSQ command in Excel. As shown in cell B26 of the Excel worksheet in Exhibit 6–12 , the R 2 is .949. Cell B26 contains the following formula: 5 RSQ(B7:B18,C7:C18) This is a high value for R 2 , and Tasty Donuts’ controller may be quite confident in the resulting cost predictions. As always, these predictions should be confined to the relevant range. Exhibit 6–12 Using Microsoft® Excel to Compute the Least-Squares Regression Estimates D NUTS TA STY hiL25664_ch06_224-265.indd 249hiL25664_ch06_224-265.indd 249 7/4/13 1:32 AM7/4/13 1:32 AM Final PDF to printer 250 Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation Review Questions 6–1. Describe the importance of cost behavior patterns in planning, control, and decision making. 6–2. Define the following terms, and explain the relationship between them: ( a ) cost estimation, ( b ) cost behavior, and ( c ) cost prediction. 6–3. Suggest an appropriate activity base (or cost driver) for each of the following organizations: ( a ) hotel, ( b ) hospital, ( c ) computer manufacturer, ( d ) computer sales store, ( e ) computer repair service, and ( f ) public accounting firm. 6–4. Draw a simple graph of each of the following types of cost behavior patterns: ( a ) variable, ( b ) step-variable, ( c ) fixed, ( d ) step-fixed, ( e ) semivariable, and ( f ) curvilinear. 6–5. Explain the impact of an increase in the level of activity (or cost driver) on ( a ) total fixed cost and ( b ) fixed cost per unit of activity. 6–6. Explain why a manufacturer’s cost of supervising pro- duction might be a step-fixed cost. 6–7. Explain the impact of an increase in the level of activity (or cost driver) on ( a ) total variable cost and ( b ) variable cost per unit. 6–8. Using graphs, show how a semivariable (or mixed) cost behavior pattern can be used to approximate ( a ) a step- variable cost and ( b ) a curvilinear cost. 6–9. Indicate which of the following descriptions is most likely to describe each cost listed below. Description Costs Engineered cost Annual cost of maintaining an interstate highway Committed cost Cost of ingredients in a breakfast cereal Discretionary cost Cost of advertising for a credit card company Depreciation on an insurance company’s computer Cost of charitable donations that are budgeted as 1 percent of sales revenue Research and development costs, which have been budgeted at $45,000 per year 6–10. A cost analyst showed the company president a graph that portrayed the firm’s utility cost as semivariable. The president criticized the graph by saying, “This fixed-cost component doesn’t look right to me. If we shut down the plant for six months, we wouldn’t incur half of these costs.” How should the cost analyst respond? 6–11. What is meant by a learning curve? Explain its role in cost estimation. 6–12. Suggest an appropriate independent variable to use in predicting the costs of the following tasks. a. Handling materials at a loading dock. b. Registering vehicles at a county motor vehicle office. c. Picking oranges. d. Inspecting computer components in an electronics firm. 6–13. What is an outlier? List some possible causes of outli- ers. How should outliers be handled in cost estimation? 6–14. Explain the cost estimation problem caused by allocated and discretionary costs. 6–15. Describe the visual-fit method of cost estimation. What are the main strengths and weaknesses of this method? 6–16. What is the chief drawback of the high-low method of cost estimation? What problem could an outlier cause if the high-low method were used? 6–17. Explain the meaning of the term least squares in the least-squares regression method of cost estimation. 6–18. Use an equation to express a least-squares regression line. Interpret each term in the equation. 6–19. Distinguish between simple regression and multiple regression. 6–20. List several possible cost drivers that could be used by a cruise line such as Carnival. 6–21. Briefly describe two methods that can be used to evalu- ate a particular least-squares regression line. Exercises All applicable Exercises are available with McGraw-Hill’s Connect Accounting ® . WMTB is an independent television station run by a major state university. The station’s broadcast hours vary during the year depending on whether the university is in session. The station’s production- crew and supervisory costs are as follows for August and October. Cost Item Cost Behavior Cost Amount Broadcast Hours during Month Production Crew ............................... Variable August ......................................... $5,330 410 October ........................................ 8,840 680 Supervisory employees ...................... Fixed August ......................................... 6,000 410 October ........................................ 6,000 680 ■ Exercise 6–22 Behavior of Fixed and Variable Costs; Television Station (LO 6-1, 6-2) hiL25664_ch06_224-265.indd 250hiL25664_ch06_224-265.indd 250 7/4/13 1:32 AM7/4/13 1:32 AM Final PDF to printer Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation 251 Required: 1. Compute the cost per broadcast hour during August and October for each of these cost items. 2. What will be the total amount incurred for each of these costs during December, when the station’s activity will be 440 broadcast hours? 3. What will be the cost per broadcast hour in December for each of the cost items? Draw a graph of the cost behavior for each of the following costs incurred by the Valley View Hospital. The hospital measures monthly activity in patient days. Label both axes and the cost line in each graph. 1. The cost of food varies in proportion to the number of patient days of activity. In January, the hospital provided 2,800 patient days of care, and food costs amounted to $22,400. 2. The cost of salaries and fringe benefits for the administrative staff totals $13,000 per month. 3. The hospital’s laboratory costs include two components: ( a ) $40,000 per month for compensation of personnel and depreciation on equipment, and ( b ) $10 per patient day for chemicals and other materials used in performing the tests. 4. The cost of utilities depends on how many wards the hospital needs to use during a particular month. During months with activity under 2,000 patient days of care, two wards are used, resulting in utility costs of $9,000. During months with greater than 2,000 patient days of care, three wards are used, and utility costs total $14,000. 5. Many of the hospital’s nurses are part-time employees. As a result, the hours of nursing care provided can be easily adjusted to the amount required at any particular time. The cost of wages and fringe benefits for nurses is approximately $2,500 for each block of 200 patient days of care provided during a month. For example, nursing costs total $2,500 for 1 to 200 patient days, $5,000 for 201 to 400 patient days, $7,500 for 401 to 600 patient days, and so forth. Lancaster Meat Company produces one of the best sausage products in southeastern Pennsylvania. The company’s controller used the account-classification method to compile the following information. a. Depreciation schedules revealed that monthly depreciation on buildings and equipment is $21,000. b. Inspection of several invoices from meat packers indicated that meat costs the company $1.20 per pound of sausage produced. c. Wage records showed that compensation for production employees costs $.85 per pound of sausage produced. d. Payroll records showed that supervisory salaries total $11,000 per month. e. Utility bills revealed that the company incurs utility costs of $5,000 per month plus $.25 per pound of sausage produced. Required: 1. Classify each cost item as variable, fixed, or semivariable. 2. Write a cost formula to express the cost behavior of the firm’s production costs. (Use the form Y 5 a 1 bX, where Y denotes production cost and X denotes quantity of sausage produced.) Brazilia Bus Tours has incurred the following bus maintenance costs during the recent tourist season. (The real is Brazil’s national monetary unit. On the day this exercise was written, the real was equivalent in value to .5092 U.S. dollar.) Month Miles Traveled by Tour Buses Maintenance Cost November ....................................................... 12,750 .................................................... 17,100 real December ....................................................... 15,900 . .................................................... 17,400 January ........................................................... 19,050 .................................................... 17,550 February ......................................................... 22,500 .................................................... 18,000 March ............................................................. 30,000 .................................................... 18,750 April ................................................................ 12,000 .................................................... 16,500 ■ Exercise 6–23 Graphing Cost Behavior Patterns; Hospital (LO 6-1, 6-2) ■ Exercise 6–24 Account-Classification Method; Food Processing (LO 6-1, 6-2, 6-5) ■ Exercise 6–25 High-Low Method; Tour Company (LO 6-1, 6-2, 6-5) hiL25664_ch06_224-265.indd 251hiL25664_ch06_224-265.indd 251 7/4/13 1:32 AM7/4/13 1:32 AM Final PDF to printer 252 Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation Required: 1. Use the high-low method to estimate the variable cost per tour mile traveled and the fixed cost per month. 2. Develop a formula to express the cost behavior exhibited by the company’s maintenance cost. 3. Predict the level of maintenance cost that would be incurred during a month when 34,000 tour miles are driven. (Remember to express your answer in terms of the real. ) 4. Build a spreadsheet: Construct an Excel spreadsheet to solve all of the preceding requirements. Show how the solution will change if the following information changes: in March there were 32,000 miles traveled and the cost was 20,000 real. The behavior of the annual maintenance and repair cost in the Grounds Department of the Allegheny Public School District is shown by the solid line in the following graph. The dashed line depicts a semivariable-cost approximation of the department’s repair and maintenance cost. Monthly repair and maintenance cost $3,000 $2,000 $4,000 $1,000 Thousands of miles driven Actual cost (curvilinear) Approximation (semivariable) 10 20 30 40 50 60 70 80 90 100 Required: 1. What is the actual (curvilinear) and estimated (semivariable) cost shown by the graph for each of the following activity levels? Actual Estimated a. 20,000 miles b. 40,000 miles c. 60,000 miles d. 90,000 miles 2. How good an approximation does the semivariable-cost pattern provide if the department’s relevant range is 40,000 to 60,000 miles per month? What if the relevant range is 20,000 to 90,000 miles per month? The Kansas City Veterinary Laboratory performs a variety of diagnostic tests on commercial and domes- tic animals. The lab has incurred the following costs over the past year. Month Diagnostic Tests Completed Cost January ........................................................... 1,525 ........................................................... $30,100 February ........................................................ 2,250 ........................................................... 36,500 March ............................................................ 3,550 ........................................................... 50,000 April ............................................................... 3,100 ........................................................... 47,800 May ............................................................... 2,350 ........................................................... 37,400 June .............................................................. 2,950 ........................................................... 44,000 July ................................................................ 3,000 ........................................................... 45,500 August ........................................................... 3,050 ........................................................... 45,000 September ..................................................... 2,650 ........................................................... 43,500 October .......................................................... 2,450 ........................................................... 38,300 November ...................................................... 2,400 ........................................................... 39,050 December ...................................................... 2,525 ........................................................... 40,100 ■ Exercise 6–26 Approximating a Curvilinear Cost; Public School District (LO 6-1, 6-2, 6-3) ■ Exercise 6–27 Visual-Fit Method; Veterinary Laboratory (LO 6-1, 6-2, 6-5) hiL25664_ch06_224-265.indd 252hiL25664_ch06_224-265.indd 252 7/4/13 1:32 AM7/4/13 1:32 AM Final PDF to printer Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation 253 Required: 1. Plot the data above in a scatter diagram. Assign cost to the vertical axis and the number of diag- nostic tests to the horizontal axis. Visually fit a line to the plotted data. 2. Using the visually fit line, estimate the monthly fixed cost and the variable cost per diagnostic test. Visit the website of one of the following companies, or a different company of your choosing. Levi Strauss www.levi.com Apple Computer www.apple.com General Electric www.ge.com Boeing www.boeing.com Ford www.ford.com/us Honeywell www.honeywell.com Required: Read about the company’s products and operations. Then list five manufacturing costs that the company would incur and explain what type of cost behavior you believe would be appropriate for each of these cost items. Jonathan Macintosh is a highly successful upstate New York orchardman who has formed his own com- pany to produce and package applesauce. Apples can be stored for several months in cold storage, so applesauce production is relatively uniform throughout the year. The recently hired controller for the firm is about to apply the high-low method in estimating the company’s energy cost behavior. The fol- lowing costs were incurred during the past 12 months: Month Pints of Applesauce Produced Energy Cost January ..................................................... 105,000 ...................................................... $70,200 February ................................................... 63,000 ...................................................... 66,300 March ....................................................... 66,000 ...................................................... 66,000 April .......................................................... 72,000 ...................................................... 67,350 May .......................................................... 90,000 ...................................................... 68,700 June ......................................................... 96,000 ...................................................... 70,050 July ........................................................... 120,000 ...................................................... 84,000 August ...................................................... 90,000 ...................................................... 68,400 September ................................................ 90,000 ...................................................... 69,000 October ..................................................... 84,000 ...................................................... 68,100 November ................................................. 123,000 ...................................................... 72,300 December .................................................. 117,000 ...................................................... 74,850 Required: 1. Use the high-low method to estimate the company’s energy cost behavior and express it in equation form. 2. Predict the energy cost for a month in which 78,000 pints of applesauce are produced. Refer to the data in the preceding exercise. Required: 1. Draw a scatter diagram and graph the company’s energy cost behavior using the visual-fit method. 2. Predict the energy cost for a month in which 78,000 pints of applesauce are produced. 3. What peculiarity is apparent from the scatter diagram? What should the cost analyst do? Weathereye, Inc. manufactures weather satellites. The final assembly and testing of the satellites is a largely manual operation involving dozens of highly trained electronics technicians. The follow- ing learning curve has been estimated for the firm’s newest satellite model, which is about to enter production. ■ Exercise 6–28 Cost Behavior: Use of Internet (LO 6-2) ■ Exercise 6–29 Estimating Cost Behavior; High-Low Method (LO 6-1, 6-2, 6-5) ■ Exercise 6–30 Estimating Cost Behavior; Visual-Fit Method (LO 6-1, 6-2, 6-5) ■ Exercise 6–31 Learning Curve; High Technology (LO 6-1, 6-6) hiL25664_ch06_224-265.indd 253hiL25664_ch06_224-265.indd 253 7/4/13 1:32 AM7/4/13 1:32 AM Final PDF to printer 254 Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation Average labor time per unit (hours) Assembly and Testing Cumulative production in units 300 150 1 4 8 12 Required: 1. What will be the average labor time required to assemble and test each satellite when the company has produced four satellites? Eight satellites? 2. What will be the total labor time required to assemble and test all satellites produced if the firm manufactures only four satellites? Eight satellites? 3. How can the learning curve be used in the company’s budgeting process? In setting cost standards? The State Department of Taxation processes and audits income-tax returns for state residents. The state tax commissioner has recently begun a program to estimate the costs of running the department. The independent variable used in the program is the number of returns processed. The analysis revealed that the following variable costs are incurred in auditing a typical tax return. Time spent by tax professional, 20 hours at $25 per hour Time spent by clerical employees, 10 hours at $12 per hour Telephone charges, $10 per audit Computer time, $50 per audit Postage, $2 per audit In addition, the department incurs $10,000 of fixed costs each month that are associated with the process of auditing returns. Required: Draw a graph depicting the monthly costs of auditing state tax returns. Label the horizontal axis “Tax returns audited.” Gator Beach Marts, a chain of convenience grocery stores in the Fort Lauderdale area, has store hours that fluctuate from month to month as the tourist trade in the community varies. The utility costs for one of the company’s stores are listed below for the past six months. Month Total Hours of Operation Total Utility Cost January ........................................................... 550 ...................................................... $3,240 February ......................................................... 600 ...................................................... 3,400 March ............................................................. 700 ...................................................... 3,800 April ................................................................ 500 ...................................................... 3,200 May ................................................................ 450 ...................................................... 2,700 June ............................................................... 400 ...................................................... 2,600 Required: 1. Use the high-low method to estimate the cost behavior for the store’s utility costs. Express the cost behavior in formula form ( Y 5 a 1 bX ). What is the variable utility cost per hour of operation? 2. Draw a scatter diagram of the store’s utility costs. Visually fit a cost line to the plotted data. Estimate the variable utility cost per hour of operation. 3. Build a spreadsheet: Construct an Excel spreadsheet and use the Excel commands to perform a least-squares regression. Estimate the cost behavior for the store’s utility cost. Express the cost behavior in formula form. What is the variable utility cost per hour of operation? ■ Exercise 6–32 Cost Estimation; Government Agency (LO 6-2, 6-6) ■ Exercise 6–33 Estimating Cost Behavior by Multiple Methods (Appendix) (LO 6-1, 6-2, 6-5, 6-8) hiL25664_ch06_224-265.indd 254hiL25664_ch06_224-265.indd 254 7/4/13 1:32 AM7/4/13 1:32 AM Final PDF to printer Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation 255 4. During July, the store will be open 300 hours. Predict the store’s total utility cost for July using each of the cost-estimation methods employed in requirements (1), (2), and (3). 5. Use your Excel sheet from requirement (3) to calculate and interpret the R 2 value for the regression. Recent monthly costs of providing on-board flight service incurred by New England Airlines are shown in the following table. Month Number of Passengers Cost of On-Board Flight Service July ............................................................ 16,000 ..................................................... $54,000 August ....................................................... 17,000 ..................................................... 54,000 September ................................................. 16,000 ..................................................... 57,000 October ...................................................... 18,000 ..................................................... 60,000 November .................................................. 15,000 ..................................................... 54,000 December ................................................... 17,000 ..................................................... 57,000 Required: 1. Build a spreadsheet: Construct an Excel spreadsheet and use the Excel commands to perform a least-squares regression. Estimate the cost behavior of the airline’s on-board flight service. Express the cost behavior in equation form. 2. Use Excel to calculate and interpret the R 2 value for the regression. ■ Exercise 6–34 Airline; Least-Squares Regression (Appendix) (LO 6-1, 6-2, 6-5, 6-8) Problems All applicable Problems are available with McGraw-Hill’s Connect Accounting ® . For each of the following cost items (1 through 11), choose the graph (a through l) that best represents it. 1. The cost of utilities at a university. For low student enrollments, utility costs increase with enroll- ment, but at a decreasing rate. For large student enrollments, utility costs increase at an increasing rate. 2. The cost of on-line back-up storage at a rate of $2.50 per gigabyte, up to 50 gigabytes, beyond which storage is unlimited. 3. The cost of outsourcing diagnostic blood testing by a hospital. The hospital pays an independent lab a fee of $1,000 per month plus $3 for each test done. 4. The salary costs of the shift supervisors at a truck depot. Each shift is eight hours. The depot oper- ates with one, two, or three shifts at various times of the year. 5. The salaries of the security personnel at a factory. The security guards are on duty around the clock. 6. The wages of table-service personnel in a restaurant. The employees are part-time workers, who can be called upon for as little as two hours at a time. 7. The cost of electricity during peak-demand periods is based on the following schedule. Up to 10,000 kilowatt-hours (kWh) ......................................... $.09 per kWh Above 10,000 kilowatt-hours ................................................. $.12 per kWh The price schedule is designed to discourage overuse of electricity during periods of peak demand. 8. The cost of sheet metal used to manufacture automobiles. 9. The cost of chartering a private airplane. The cost is $410 per hour for the first three hours of a flight. Then the charge drops to $305 per hour. 10. Under a licensing agreement with a South American import/export company, your firm has begun shipping machine tools to several countries. The terms of the agreement call for an annual licensing fee of $95,000 to be paid to the South American import company if total exports are under $4,500,000. For sales in excess of $4,500,000, an additional licensing fee of 9 percent of sales is due. ■ Problem 6–35 Cost Behavior Patterns in a Variety of Settings; International Issues. (LO 6-1, 6-2) hiL25664_ch06_224-265.indd 255hiL25664_ch06_224-265.indd 255 7/4/13 1:32 AM7/4/13 1:32 AM Final PDF to printer 256 Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation 11. Your winery exports wine to several Pacific Rim countries. In one nation, you must pay a tariff for every case of wine brought into the country. The tariff schedule is the following: 0 to 6,000 cases per year ............................................................ $11 per case 6,001 to 12,000 cases per year ................................................... $14 per case Above 12,000 cases per year ....................................................... $19 per case (b)(a) (c) (d) (e) (f ) (g) (h) ( i ) (k )( j ) ( l ) The Piedmont School of Music has hired you as a consultant to help in analyzing the behavior of the school’s costs. Use the account-classification method of cost estimation to classify each of the following costs as variable, fixed, or semivariable. Before classifying the costs, choose an appropriate measure for the school’s activity. 1. Cost of buying books, sheet music, and other academic materials that are supplied to the students by the school. 2. Repairs on musical instruments. The school employs a full-time repair technician. Repair jobs that are beyond the technician’s capability are taken to a local musical-instrument dealer for repairs. 3. Fee charged by a local public accounting firm to audit the school’s accounting records. 4. Salaries and fringe benefits of the school’s full-time teachers. 5. Salaries and fringe benefits of the school’s full-time administrative staff. 6. Wages of the school’s part-time assistant recital instructors. These employees are hired on a tem- porary basis. For each student enrolled in the school’s music programs, four hours of assistant instructor time are needed per week. 7. Depreciation on the school’s musical instruments. 8. Rent for the building in which the school operates. 9. Electricity for the school. The school pays a fixed monthly charge plus $.10 per kilowatt-hour of electricity. ■ Problem 6–36 Account-Classification Method; Private School (LO 6-1, 6-2, 6-5) hiL25664_ch06_224-265.indd 256hiL25664_ch06_224-265.indd 256 7/4/13 1:32 AM7/4/13 1:32 AM Final PDF to printer Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation 257 Liberty Bell Fitness, Inc. operates a chain of fitness centers in Philadelphia. The firm’s controller is accumulating data to be used in preparing its annual profit plan for the coming year. The cost behavior pattern of the firm’s equipment maintenance costs must be determined. The accounting staff has sug- gested the use of an equation, in the form of Y 5 a 1 bX, for maintenance costs. Data regarding the maintenance hours and costs for last year are as follows: Month Hours of Maintenance Service Maintenance Costs January ................................................... 525 .......................................................... $ 4,710 February ................................................. 505 .......................................................... 4,310 March ..................................................... 310 .......................................................... 2,990 April ........................................................ 495 .......................................................... 4,200 May ........................................................ 315 .......................................................... 3,000 June ....................................................... 485 .......................................................... 4,215 July ......................................................... 315 .......................................................... 2,950 August .................................................... 405 .......................................................... 3,680 September .............................................. 475 .......................................................... 4,100 October ................................................... 345 .......................................................... 3,250 November ............................................... 350 .......................................................... 3,260 December ............................................... 335 ......................................................... 3,015 Total ........................................................ 4,860 ....................................................... $43,680 Average ................................................... 405 .......................................................... $ 3,640 Required: 1. Using the high-low method of cost estimation, estimate the behavior of the maintenance costs incurred by Liberty Bell Fitness, Inc. Express the cost behavior pattern in equation form. 2. Using your answer to requirement (1), what is the variable component of the maintenance cost? 3. Compute the predicted maintenance cost at 600 hours of activity. 4. Compute the variable cost per hour and the fixed cost per hour at 610 hours of activity. Explain why the fixed cost per hour could be misleading. (CMA, adapted) Lone Mountain Extraction, which mines ore in Idaho, uses a calendar year for both financial-reporting and tax purposes. The following selected costs were incurred in December, the low point of activity, when 1,400 tons of ore were extracted: Straight-line depreciation ....................... $30,000 Royalties ................................... $140,000 Charitable contributions * ........................ 12,000 Trucking and hauling .................. 280,000 Mining labor/fringe benefits .................... 315,000 *Incurred only in December. Peak activity of 2,700 tons occurred in June, resulting in mining labor/fringe benefit costs of $607,500, royalties of $224,500, and trucking and hauling outlays of $360,000. The trucking and hauling outlays exhibit the following behavior: Less than 1,400 tons ........................................................................................................................... $240,000 From 1,400–1,899 tons ....................................................................................................................... 280,000 From 1,900–2,399 tons ....................................................................................................................... 320,000 From 2,400–2,899 tons ....................................................................................................................... 360,000 Lone Mountain Extraction uses the high-low method to analyze costs. Required: 1. Classify the five costs listed in terms of their behavior: variable, step-variable, committed fixed, discretionary fixed, step-fixed, or semivariable. Show calculations to support your answers for mining labor/fringe benefits and royalties. 2. Calculate the total cost for next February when 1,700 tons are expected to be extracted. 3. Comment on the cost-effectiveness of hauling 1,400 tons with respect to Lone Mountain’s trucking/hauling cost behavior. Can the company’s effectiveness be improved? How? ■ Problem 6–37 High-Low Method; Fitness Centers (LO 6-1, 6-2, 6-5) 1. Fixed maintenance cost per month: $510 ■ Problem 6–38 Cost Behavior and Analysis; High-Low Method (LO 6-2, 6-4, 6-5) 2. Total cost for 1,700 tons: $852,000 hiL25664_ch06_224-265.indd 257hiL25664_ch06_224-265.indd 257 7/4/13 1:32 AM7/4/13 1:32 AM Final PDF to printer 258 Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation 4. Distinguish between committed and discretionary fixed costs. If the company were to experience severe economic difficulties, which of the two types of fixed costs should management try to cut? Why? 5. Speculate as to why the company’s charitable contribution cost arises only in December. The following selected data were taken from the accounting records of Manitoba Manufacturing Com- pany. The company uses direct-labor hours as its cost driver for overhead costs. Month Direct-Labor Hours Manufacturing Overhead January ............................................................. 26,000 ............................................ $749,250 February ........................................................... 25,000 ............................................ 720,000 March ............................................................... 28,000 ............................................ 772,500 April .................................................................. 23,000 ............................................ 681,000 May .................................................................. 30,000 ............................................ 775,500 June ................................................................. 34,000 ............................................ 879,000 June’s costs consisted of machine supplies ($153,000), depreciation ($22,500), and plant maintenance ($703,500). These costs Exhibit the following respective behavior: variable, fixed, and semivariable. The manufacturing overhead figures presented in the preceding table do not include supervisory labor cost, which is step-fixed in nature. For volume levels of less than 15,000 hours, supervisory labor amounts to $67,500. The cost is $135,000 from 15,000–29,999 hours and $202,500 when activity reaches 30,000 hours or more. Required: 1. Determine the machine supplies cost and depreciation for April. 2. Using the high-low method, analyze Manitoba Manufacturing Company’s plant maintenance cost and calculate the monthly fixed portion and the variable cost per direct-labor hour. 3. Assume that present cost behavior patterns continue into the latter half of the year. Estimate the total amount of manufacturing overhead the company can expect in October if 29,500 direct-labor hours are worked. 4. Briefly explain the difference between a fixed cost and a step-fixed cost. 5. Assume that a company has a step-fixed cost. Generally speaking, where on a step should the firm attempt to operate if it desires to achieve a maximum return on its investment? ( Note: Instructors who wish to cover all three cost-estimation methods with the same data set may assign this problem in conjunction with the next one.) Nantucket Marine Supply is a wholesaler for a large variety of boating and fishing equipment. The company’s controller, Alan Denney, has recently completed a cost study of the firm’s material-handling department. The activity measure (independent variable) used in the study was hundreds of pounds of equipment loaded or unloaded at the company’s loading dock. Denney compiled the following data. Month Units of Activity (hundreds of pounds of equipment loaded or unloaded) Material-Handling Department Costs January .......................................... 1,800 ................................................ $11,700 February ........................................ 1,600 ................................................ 11,300 March ............................................ 1,300 ................................................ 11,250 April ............................................... 1,000 ................................................ 10,200 May ............................................... 2,200 ................................................ 11,100 June .............................................. 2,400 ................................................ 12,550 July ................................................ 2,000 ................................................ 12,000 August ........................................... 1,800 ................................................ 11,400 September ...................................... 2,600 ................................................ 12,120 October .......................................... 1,100 . ................................................ 11,050 November ...................................... 1,200 ................................................ 11,350 December ...................................... 1,400 ................................................ 11,350 ■ Problem 6–39 Cost Behavior and Analysis; High-Low Method (LO 6-2, 6-5) 2. Plant maintenance cost, April: $555,000 ■ Problem 6–40 Cost Estimation with Different Methods; Wholesaler (LO 6-1, 6-2, 6-5, 6-6) 3. Variable cost per unit of activity: $1.00 hiL25664_ch06_224-265.indd 258hiL25664_ch06_224-265.indd 258 7/4/13 1:32 AM7/4/13 1:32 AM Final PDF to printer Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation 259 Required: 1. Draw a scatter diagram of the cost data for the material-handling department. 2. Visually fit a cost line to the scatter diagram. 3. Estimate the variable and fixed components of the department’s cost behavior pattern using the visually fit cost line. 4. Using your estimate from requirement (3), specify an equation to express the department’s cost behavior. 5. Estimate the material-handling department’s cost behavior using the high-low method. Use an equation to express the results of this estimation method. 6. Write a brief memo to the company’s president explaining why the cost estimates developed in requirements (4) and (5) differ. 7. Predict the company’s material-handling costs for a month when 2,250 units of activity are recorded. Use each of your cost equations to make the prediction. Which prediction would you prefer to use? Why? Refer to the data in the preceding problem for Nantucket Marine Supply. Required: 1. Build a spreadsheet: Construct an Excel spreadsheet and use the Excel commands to perform a least-squares regression. Estimate of the variable- and fixed-cost components in the company’s material-handling department costs. 2. Write the least-squares regression equation for the department’s costs. 3. Predict the firm’s material-handling department’s costs for a month when 2,250 units of activity are recorded. 4. Why do the three cost predictions computed in this and the preceding problem differ? Which method do you recommend? Why? 5. Use your Excel spreadsheet from requirement (1) to compute the R 2 value for the regression. Interpret the R 2 value. Shenandoah Valley Golf Association is a nonprofit, private organization that operates three 18-hole golf courses in Virginia. The organization’s financial director has just analyzed the course maintenance costs incurred by the golf association during recent summers. The courses are maintained by a full-time crew of four people, who are assisted by part-time employees. These employees are typically college students on their summer vacations. The course maintenance costs vary with the number of people using the course. Since a large part of the maintenance work is done by part-time employees, the maintenance crew size can easily be adjusted to reflect current needs. The financial director’s analysis revealed that the course maintenance cost includes two components: • A fixed component of $13,000 per month (when the courses are open). • A step-variable cost component. For each additional 1 to 10 people teeing off in one day, $10 in costs are incurred. Thus, if 101 to 110 people tee off, $110 of additional cost will be incurred. If 111 to 120 people tee off, $120 of additional cost will be incurred. Required: 1. Draw a graph of Shenandoah Valley Golf Association’s course maintenance costs. Show on the graph the fixed-cost component and the step-variable cost component. Label each clearly. 2. Use a semivariable-cost behavior pattern to approximate the golf association’s course maintenance cost behavior. Visually fit the semivariable cost line to your graph. 3. Using your graph, estimate the variable- and fixed-cost component included in your semivariable approximation. Express this approximate cost behavior pattern in equation form. 4. Fill in the following table of cost predictions. ■ Problem 6–41 Continuation of Preceding Problem; Computing Least- Squares Regression Esti- mates; Comparing Multiple Methods (Appendix) (LO 6-1, 6-2, 6-5, 6-6, 6-8) 1(c). Monthly fixed cost: $9,943 ■ Problem 6–42 Approximating a Step- Variable Cost; Visual-Fit Method; Golf Course (LO 6-1, 6-2, 6-5) hiL25664_ch06_224-265.indd 259hiL25664_ch06_224-265.indd 259 7/4/13 1:32 AM7/4/13 1:32 AM Final PDF to printer 260 Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation Predicted Course Maintenance Costs Using Fixed Cost Coupled with Step-Variable Cost Behavior Pattern Using Semivariable Cost Approximation 150 people tee off ? ? 158 people tee off ? ? The controller of Saratoga Auto Cylinder Company believes that the identification of the variable and fixed components of the firm’s costs will enable the firm to make better planning and control deci- sions. Among the costs the controller is concerned about is the behavior of indirect-materials cost. She believes there is a correlation between machine hours and the amount of indirect materials used. A member of the controller’s staff has suggested that least-squares regression be used to determine the cost behavior of indirect materials. The regression equation shown below was developed from 40 pairs of observations. S 5 $190 1 $5H where S 5 total monthly cost of indirect materials H 5 machine hours per month Required: 1. Explain the meaning of 190 and 5 in the regression equation S 5 $190 1 $5 H. 2. Calculate the estimated cost of indirect materials if 850 machine hours are to be used during a month. (Assume that 850 falls within the relevant range for this cost equation.) 3. To determine the validity of the cost estimate computed in requirement (2), what question would you ask the controller about the data used for the regression? 4. The high and low activity levels during the past four years, as measured by machine hours, occurred during April and August, respectively. Data concerning machine hours and indirect- material usage follow. April August Machine hours .................................................... 1,000 700 Indirect supplies: Beginning inventory ........................................ $1,300 $1,000 Ending inventory ............................................. 1,350 3,000 Purchases ...................................................... 5,900 6,200 Determine the cost of indirect materials used during April and August. 5. Use the high-low method to estimate the behavior of the company’s indirect-material cost. Express the cost behavior pattern in equation form. 6. Which cost estimate would you recommend to the controller, the regression estimate or the high- low estimate? Why? (CMA, adapted) Shortly after being hired as a cost analyst with Florida International Airlines, Kim Williams was asked to prepare a report that focused on passenger ticketing cost. The airline writes most of its own tickets, makes little use of travel agents, and has seen an increased passenger interest in e-ticketing. After some discussion, Williams thought it would be beneficial to begin her report with an over- view of three different cost estimation tools: scatter diagrams, least-squares regression, and the high-low method. She would then present the results of her analysis of the past year’s monthly ticketing cost, which was driven largely by the number of tickets written. These results would be presented in the form of algebraic equations that were derived by the three tools just cited. The equations follow. (C denotes ticketing cost, and PT denotes number of passenger tickets written.) Least-squares regression: C 5 $300,000 1 $2.25 PT Scatter diagram: C 5 $295,000 1 $2.20 PT High-low method: C 5 $301,000 1 $2.40 PT ■ Problem 6–43 Comparing Regression and High-Low Estimates; Manufacturer (LO 6-1, 6-2, 6-5) 2. Estimated cost of indirect material at 850 machine hours: $4,440 5. Fixed cost: $350 ■ Problem 6–44 Cost Estimation Methods; Cost Analysis; E-Commerce (LO 6-2, 6-5) 4. C: $1,549,000 hiL25664_ch06_224-265.indd 260hiL25664_ch06_224-265.indd 260 7/4/13 1:32 AM7/4/13 1:32 AM Final PDF to printer Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation 261 Williams had analyzed data over the past 12 months and built equations on these data, purposely includ- ing the slowest month of the year (February) and the busiest month (November) so that things would tend to average out. She observed that November was especially busy because of Thanksgiving, pas- sengers purchasing tickets for upcoming holiday travel in December, and the effects of a strike by Southeastern Airlines, Florida International’s chief competitor. The lengthy strike resulted in many of Southeastern’s passengers being rerouted on Florida International flights. Required: 1. Prepare a bullet-point list suitable for use in Williams’s report that describes the features of scatter diagrams, least-squares regression, and the high-low method. Determine which of the three tools will typically produce the most accurate results. 2. Will the three cost estimation tools normally result in different equations? Why? 3. Assuming the use of least-squares regression, explain what the $300,000 and $2.25 figures represent. 4. Assuming the use of a scatter diagram, predict the cost of an upcoming month when Florida Inter- national expects to write 570,000 tickets. 5. Did Williams err in constructing the equations on data of the past 12 months? Briefly explain. 6. Assume that over the next few years, more of Florida International’s passengers will take advan- tage of e-ticketing over the Internet. What will likely happen to the airline’s cost structure in terms of variable and fixed cost incurred? Randolph Dana owns a catering company that prepares banquets and parties for business functions throughout the year. Dana’s business is seasonal, with a heavy schedule during the summer months and the year-end holidays. During peak periods there are extra costs; however, even during nonpeak periods Dana must work more to cover his expenses. One of the major events Dana’s customers request is a cocktail party. He offers a standard cocktail party and has developed the following cost structure on a per-person basis. Food and beverages ................................................................... $14.00 Labor (.6 hr. @ $11 per hour) ..................................................... 6.60 Overhead (.6 hr. @ $14 per hour) ............................................... 8.40 Total cost per person .................................................................. $29.00 When bidding on cocktail parties, Dana adds a 15 percent markup to this cost structure as a profit margin. Dana is quite certain about his estimates of the prime costs but is not as comfortable with the overhead estimate. This estimate was based on the actual data for the past 12 months presented in the following table. These data indicate that overhead expenses vary with the direct-labor hours expended. The $14 per hour overhead estimate was determined by dividing total overhead expended for the 12 months ($805,000) by total labor hours (57,600) and rounding to the nearest dollar. Month Labor Hours Overhead Expenses January .................................................... 2,800 ................................................... $59,000 February .................................................. 2,500 ................................................... 55,000 March ...................................................... 3,000 ................................................... 60,000 April ......................................................... 4,500 ................................................... 67,000 May ......................................................... 4,200 ................................................... 64,000 June ........................................................ 6,500 ................................................... 74,000 July .......................................................... 5,500 ................................................... 71,000 August ..................................................... 7,000 ................................................... 75,000 September ............................................... 7,500 ................................................... 77,000 October .................................................... 4,500 ................................................... 68,000 November ................................................ 3,100 ................................................... 62,000 December ................................................ 6,500 .................................................... 73,000 Dana recently attended a meeting of the local chamber of commerce and heard a business consul- tant discuss regression analysis and its business applications. After the meeting, Dana decided to do a regression analysis of the overhead data he had collected. The following results were obtained. Intercept ( a ) ....................................................................... 48,000 Coefficient ( b ) .................................................................... 4 ■ Problem 6–45 Interpreting Regression Analysis in Cost Estimation (LO 6-2, 6-5) 2(b). Absorption cost per person: $29 hiL25664_ch06_224-265.indd 261hiL25664_ch06_224-265.indd 261 7/4/13 1:32 AM7/4/13 1:32 AM Final PDF to printer 262 Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation Required: 1. Explain the difference between the overhead rate originally estimated by Dana and the overhead rate developed from the regression method. 2. Using data from the regression analysis, develop the following cost estimates per person for a cocktail party. a. Variable cost per person b. Absorption (full) cost per person (includes both variable and fixed cost per person) Assume that the level of activity remains within the relevant range. 3. Dana has been asked to prepare a bid for a 250-person cocktail party to be given next month. Determine the minimum bid price that Dana should be willing to submit. 4. What other factors should Dana consider in developing the bid price for the cocktail party? (CMA adapted) Jefferson County Airport handles several daily commuter flights and many private flights. The county budget officer has compiled the following data regarding airport costs and activity over the past year. Month Airport Costs Flights Originating at Jefferson County Airport January .................................................. $20,000 ................................................... 1,200 February ................................................ 19,000 ................................................... 1,000 March .................................................... 18,000 ................................................... 900 April ....................................................... 19,000 ................................................... 1,400 May ....................................................... 17,000 ................................................... 800 June ...................................................... 20,000 ................................................... 1,100 July ........................................................ 21,000 ................................................... 1,500 August ................................................... 17,000 ................................................... 900 September ............................................. 21,000 ................................................... 1,200 October .................................................. 19,000 ................................................... 1,000 November .............................................. 24,000 ................................................... 1,400 December .............................................. 18,000 ................................................... 1,100 Required: 1. Draw a scatter diagram of the airport costs shown above. 2. Build a spreadsheet: Construct an Excel spreadsheet and use the Excel commands to perform a least-squares regression. Estimate the variable- and fixed-cost components in the airport’s cost behavior pattern. 3. Write the least-squares regression equation for the airport’s costs. 4. Predict the airport’s costs during a month when 1,500 flights originate at the airport. 5. Using the Excel spreadsheet prepared for requirement (2), compute the coefficient of determina- tion ( R 2 ) for the regression equation. Briefly interpret R 2 . ■ Problem 6–46 Computing Least-Squares Regression Estimates; Airport Costs (Appendix) (LO 6-1, 6-2, 6-5, 6-8) 2(c). Monthly fixed cost: $11,796 5(c). R 2 : .58 (rounded) Ex Cases Outside Environment, Inc. provides commercial landscaping services in San Diego. Sasha Cairns, the firm’s owner, wants to develop cost estimates that she can use to prepare bids on jobs. After analyzing the firm’s costs, Cairns has developed the following preliminary cost estimates for each 1,000 square feet of landscaping. Direct material ........................................................................................................................................ $390 Direct labor (5 direct-labor hours at $11 per hour) .................................................................................... 55 Overhead (at $18 per direct-labor hour) ................................................................................................... 90 Total cost per 1,000 square feet .......................................................................................................... $535 ■ Case 6–47 Interpreting Least-Squares Regression; Landscaping Service; Activity-Based Costing (LO 6-1, 6-2, 6-5) 2. Total variable cost per 1,000 square feet: $491.25 3. Overtime premium: $412.50 hiL25664_ch06_224-265.indd 262hiL25664_ch06_224-265.indd 262 7/4/13 1:32 AM7/4/13 1:32 AM Final PDF to printer Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation 263 Cairns is quite certain about the estimates for direct material and direct labor. However, she is not as comfortable with the overhead estimate. The estimate for overhead is based on the overhead costs that were incurred during the past 12 months as presented in the following schedule. The estimate of $18 per direct-labor hour was determined by dividing the total overhead costs for the 12-month period ($1,296,000) by the total direct-labor hours (72,000). Total Overhead Regular Direct- Labor Hours Overtime Direct- Labor Hours * Total Direct- Labor Hours January ............. $ 108,000 5,820 380 6,200 February ........... 94,000 4,760 40 4,800 March ............... 96,000 4,420 80 4,500 April .................. 112,000 5,180 420 5,600 May .................. 114,000 6,060 940 7,000 June ................. 130,000 6,480 1,520 8,000 July ................... 128,000 6,760 1,240 8,000 August .............. 112,000 6,100 700 6,800 September ........ 106,000 5,520 80 5,600 October ............. 94,000 5,540 60 5,600 November ......... 94,000 4,240 60 4,300 December ......... 108,000 5,120 480 5,600 Total .............. $1,296,000 66,000 6,000 72,000 *The overtime premium is 50 percent of the direct-labor wage rate. Cairns believes that overhead is affected by total monthly direct-labor hours. Cairns decided to perform a least-squares regression of overhead (OH) on total direct-labor hours (DLH). The following regression formula was obtained. OH 5 $52,400 1 $9.25 DLH Required: 1. The overhead rate developed from the least-squares regression is different from Cairns’ prelimi- nary estimate of $18 per direct-labor hour. Explain the difference in the two overhead rates. 2. Using the overhead formula that was derived from the least-squares regression, determine a total variable-cost estimate for each 1,000 square feet of landscaping. 3. Cairns has been asked to submit a bid on a landscaping project for the city government consisting of 50,000 square feet. Cairns estimates that 30 percent of the direct-labor hours required for the project will be on overtime. Calculate the incremental costs that should be included in any bid that Cairns would submit on this project. Use the overhead formula derived from the least-squares regression. 4. Should management rely on the overhead formula derived from the least-squares regression as the basis for the variable overhead component of its cost estimate? Explain your answer. 5. After attending a seminar on activity-based costing, Cairns decided to further analyze the company’s activities and costs. She discovered that a more accurate portrayal of the firm’s cost behavior could be achieved by dividing overhead into three separate pools, each with its own cost driver. Separate regression equations were estimated for each of the cost pools, with the following results. OH 1 5 $20,000 1 $4.15 DLH, where DLH denotes direct-labor hours OH 2 5 $18,200 4 $13.60 SFS, where SFS denotes the number of square feet of turf seeded (in thousands) OH 3 5 $16,000 1 $5.90 PL, where PL denotes the number of individual plantings (e.g., trees and shrubs) Assume that five direct-labor hours will be needed to landscape each 1,000 square feet, regardless of the specific planting material used. a. Suppose the landscaping project for the city will involve seeding all 50,000 square feet of turf and planting 70 trees and shrubs. Calculate the incremental variable overhead cost that Cairns should include in the bid. hiL25664_ch06_224-265.indd 263hiL25664_ch06_224-265.indd 263 7/4/13 1:32 AM7/4/13 1:32 AM Final PDF to printer 264 Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation b. Recompute the incremental variable overhead cost for the city’s landscaping project assuming half of the 50,000 square-foot landscaping area will be seeded and there will be 230 individual plantings. The plantings will cover the entire 50,000 square-foot area. c. Briefly explain, using concepts from activity-based costing, why the incremental costs differ in requirements ( a ) and ( b ). (CMA, adapted) ( Note: Instructors who wish to cover all three cost estimation methods with the same data set may assign this case in conjunction with the following case.) “I don’t understand this cost report at all,” exclaimed Jeff Mahoney, the newly appointed administrator of Valley General Hospital. “Our administrative costs in the new pediatrics clinic are all over the map. One month the report shows $7,000, and the next month it’s $13,900. What’s going on?” Mahoney’s question was posed to Megan McDonough, the hospital’s director of cost management. “The main problem is that the clinic has experienced some widely varying patient loads in its first year of operation. There seems to be some confusion in the public’s mind about what services we offer in the clinic. When do they come to the clinic? When do they go to the emergency room? That sort of thing. As the patient load has varied, we’ve frequently changed our clinic administrative staffing.” Mahoney continued to puzzle over the report. “Could you pull some data together, Megan, so we can see how this cost behaves over a range of patient loads?” “You’ll have it this afternoon,” McDonough responded. Later that morning, she gathered the following data: Month Patient Load Administrative Cost January ................................................... 400 .................................................. $ 6,000 February ................................................. 500 .................................................. 7,000 March ..................................................... 1,400 .................................................. 13,900 April ........................................................ 900 .................................................. 9,200 May ........................................................ 1,300 .................................................. 11,900 June ....................................................... 1,000 .................................................. 10,000 July ......................................................... 700 .................................................. 9,400 August .................................................... 300 .................................................. 4,100 September .............................................. 1,100 .................................................. 10,200 October ................................................... 1,500 .................................................. 16,100 November ............................................... 600 .................................................. 8,300 December ............................................... 1,200 .................................................. 11,100 McDonough does not believe the first year’s widely fluctuating patient load will be experienced again in the future. She has estimated that the clinic’s relevant range of monthly activity in the future will be 600 to 1,200 patients. Required: 1. Draw a scatter diagram of the clinic’s administrative costs during its first year of operation. 2. Visually fit a curvilinear cost line to the plotted data. 3. Mark the clinic’s relevant range of activity on the scatter diagram. 4. Visually fit a semivariable-cost line to approximate the curvilinear cost behavior pattern within the clinic’s relevant range. 5. Estimate the fixed- and variable-cost components of the visually fit semivariable-cost line. 6. Use an equation to express the semivariable-cost approximation of the clinic’s administrative costs. 7. What is your prediction of the clinic’s administrative cost during a month when 750 patients visit the clinic? When 350 patients visit? Which one of your visually fit cost lines did you use to make each of these predictions? Why? ■ Case 6–48 Approximating a Curvilinear Cost; Visual-Fit Method; Pedi- atrics Clinic (LO 6-1, 6-2, 6-5) hiL25664_ch06_224-265.indd 264hiL25664_ch06_224-265.indd 264 7/4/13 1:32 AM7/4/13 1:32 AM Final PDF to printer Chapter 6 Activity Analysis, Cost Behavior, and Cost Estimation 265 Refer to the data and accompanying information in the preceding case. Required: 1. Use the high-low method to estimate the cost behavior for the clinic’s administrative costs. Express the cost behavior in formula form ( Y 5 a 1 bX ). What is the variable cost per patient? 2. Build a spreadsheet: Construct an Excel spreadsheet and use the Excel commands to perform a least-squares regression and estimate the administrative cost behavior. Express the cost behavior in formula form. What is the variable cost per patient? Compute and interpret the R 2 value for the regression. 3. Write a memo to the hospital administrator comparing the cost estimates using ( a ) least-squares regression, ( b ) the high-low method, and ( c ) the scatter diagram and visually fit semivariable-cost line from the preceding case [requirements (4) and (5)]. Make a recommendation as to which esti- mate should be used, and support your recommendation. Make any other suggestions you feel are appropriate. 4. After receiving the memo comparing the three cost estimates, Mahoney called McDonough to dis- cuss the matter. The following exchange occurred. Mahoney: “As you know, Megan, I was never in favor of this clinic. It’s going to be a drag on our administrative staff, and we’d have been far better off keeping the pediatrics operation here in the hospital.” McDonough: “I was aware that you felt the clinic was a mistake. Of course, the board of trustees had other issues to consider. I believe the board felt the clinic should be built to make pediat- ric care more accessible to the economically depressed area on the other side of the city.” Mahoney: “That’s true, but the board doesn’t realize how difficult it’s going to make life for us here in the hospital. In any case, I called to tell you that when you and I report to the board next week, I’m going to recommend that the clinic be shut down. I want you to support my recommendation with one of your cost estimates showing that administrative costs will soar at high activity levels.” McDonough: “But that estimate was based on the high-low method. It’s not an appropriate method for this situation.” Mahoney: “It is an estimate, Megan, and it’s based on a well-known estimation method. This is just the ammunition I need to make the board see things my way.” McDonough: “I don’t know, Jeff. I just don’t think I can go along with that.” Mahoney: “Be a team player, Megan. I’ve got a meeting now. Got to run.” That night McDonough called to discuss the matter with her best friend, you. What would you advise her? ■ Case 6–49 Comparing Multiple Cost Estimation Methods; Ethics (Appendix) (LO 6-1, 6-2, 6-5, 6-8) 1. Variable administrative cost per patient: $10 hiL25664_ch06_224-265.indd 265hiL25664_ch06_224-265.indd 265 7/4/13 1:32 AM7/4/13 1:32 AM Final PDF to printer 7 THIS CHAPTER’S FOCUS is on the Seattle Contemporary Theater. This nonprofit enterprise was formed to bring con- temporary drama to the Seattle area. The theater operates in a historic theater building owned by the city, for which Seattle Contemporary Theater pays the city a fixed monthly rental charge and a portion of the price of each ticket sold. The theater must cover its operating expenses with ticket revenue in order to break even. Using the Seattle Contemporary Theater as an illustra- tion, we will explore a technique called cost-volume-profit (or CVP) analysis, which the theater’s managing director and business manager use to bet- ter understand the relationships between the theater’s costs, ticket sales volume, and revenue. FOCUS COMPANY >>>
Cost-Volume-Profit Analysis

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<<< IN CONTRAST In contrast to the nonprofit, entertainment-service setting of the Seattle Contemporary Theater, we explore the use of cost-volume-profit analysis by AccuTime Company. The management of this manufacturer of digital clocks uses CVP analysis to better understand the relationships between the company’s costs, sales volume, and profit. The company’s management also analyzes the firm’s cost structure, which refers to the relative proportion of fixed and variable costs. hiL25664_ch07_266-315.indd 267hiL25664_ch07_266-315.indd 267 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer 268 What effect on profit can United Airlines expect if it adds a flight on the Chicago to New York route? How will NBC ’s profit change if the ratings increase for its evening news program? How many patient days of care must Massachusetts General Hospital provide to break even for the year? What happens to this break-even patient load if the hospital leases a new computerized system for patient records? Each of these questions concerns the effects on costs and revenues when the orga- nization’s activity changes. The analytical technique used by managerial accountants to address these questions is called cost-volume-profit analysis. Often called CVP analysis for short, this technique summarizes the effects of changes in an organization’s volume of activity on its costs, revenue, and profit. Cost-volume-profit analysis can be extended to cover the effects on profit of changes in selling prices, service fees, costs, income-tax rates, and the organization’s mix of products or services. What will happen to profit, for example, if the New York Yankees raise ticket prices for stadium seats? In short, CVP analysis provides management with a comprehensive overview of the effects on revenue and costs of all kinds of short-run financial changes. Although the word profit appears in the term, cost-volume-profit analysis is not con- fined to profit-seeking enterprises. Managers in nonprofit organizations also routinely use CVP analysis to examine the effects of activity and other short-run changes on rev- enue and costs. For example, as the State of Florida gains approximately 1,000 people a day in population, the state’s political leaders must analyze the effects of this change on sales-tax revenues and the cost of providing services, such as education, transportation, After completing this chapter, you should be able to: 7-1 Compute a break-even point using the contribution-margin approach and the equation approach. 7-2 Compute the contribution-margin ratio and use it to find the break-even point in sales dollars. 7-3 Prepare a cost-volume-profit (CVP) graph and explain how it is used. 7-4 Apply CVP analysis to determine the effect on profit of changes in fixed expenses, variable expenses, sales prices, and sales volume. 7-5 Compute the break-even point and prepare a profit-volume graph for a multiproduct enterprise. 7-6 List and discuss the key assumptions of CVP analysis. 7-7 Prepare and interpret a contribution income statement. 7-8 Explain the role of cost structure and operating leverage in CVP relationships. 7-9 Understand the implications of activity-based costing for CVP analysis. 7-10 Be aware of the effects of advanced manufacturing technology on CVP relationships. 7-11 Understand the effect of income taxes on CVP analysis (appendix). hiL25664_ch07_266-315.indd 268hiL25664_ch07_266-315.indd 268 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer Chapter 7 Cost-Volume-Profit Analysis 269 and police protection. Managers at such diverse nonprofit institutions as Massachusetts General Hospital, Stanford University, and the United Way all use CVP analysis as a routine operational tool. Illustration of Cost-Volume-Profit Analysis To illustrate the various analytical techniques used in cost-volume-profit analysis, we will focus on a performing arts organization. The Seattle Contemporary Theater was recently formed as a nonprofit enterprise to bring contemporary drama to the Seattle area. The organization has a part-time, unpaid board of trustees comprising local professional people who are avid theater fans. The board has hired the following full-time employees. Managing director: Responsibilities include overall management of the organization; direction of six plays per year. Artistic director: Responsibilities include hiring of actors and production crews for each play; direction of six plays per year. Business manager and producer: Responsibilities include managing the organization’s business functions and ticket sales; direction of the production crews, who handle staging, lighting, costuming, and makeup. The board of trustees has negotiated an agreement with the city of Seattle to hold performances in a historic theater owned by the city. The theater has not been used for 30 years, but the city has agreed to refurbish it and to provide lighting and sound equip- ment. In return, the city will receive a rental charge of $10,000 per month plus $8 for each theater ticket sold. Projected Expenses and Revenue The theater’s business manager and producer, Andrew Lloyd, has made the following projections for the first few years of operation. Fixed expenses per month: Theater rental ..................................................................................................................................... $10,000 Employees’ salaries and fringe benefits ................................................................................................ 8,000 Actors’ wages .................................................................................................................................... 15,000 (to be supplemented with local volunteer talent) Production crew’s wages .................................................................................................................... 5,600 (to be supplemented with local volunteers) Playwrights’ royalties for use of plays ................................................................................................... 5,000 Insurance ........................................................................................................................................... 1,000 Utilities—fixed portion ........................................................................................................................ 1,400 Advertising and promotion ................................................................................................................... 800 Administrative expenses ...................................................................................................................... 1,200 Total fixed expenses per month ............................................................................................................ $48,000 Variable expenses per ticket sold: City’s charge per ticket for use of theater ............................................................................................. $ 8 Other miscellaneous expenses (for example, printing of playbills and tickets, variable portion of utilities) .............................................................................................................. 2 Total variable cost per ticket sold ......................................................................................................... $10 Revenue: Price per ticket ................................................................................................................................... $16 Importance of Cost Behavior Notice that the theater’s expenses have been cate- gorized according to their cost behavior: fixed or variable. Analyzing an organization’s cost behavior, the topic of Chapter 6, is a necessary first step in any cost-volume-profit analysis. As we proceed through this chapter, the data pertaining to Seattle Contemporary Theater will be an important part of our cost-volume-profit analysis. Illustration of Cost-Volume-Profit Analysis “Accounting is changing. You’re no longer sitting behind a desk just working on a computer, just crunch- ing the numbers. You’re actually getting to be a part of the day-to-day functions of the business.” (7a) Abbott Laboratories hiL25664_ch07_266-315.indd 269hiL25664_ch07_266-315.indd 269 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer 270 Chapter 7 Cost-Volume-Profit Analysis The Break-Even Point As the first step in the CVP analysis for Seattle Contemporary Theater, we will find the break-even point . The break-even point is the volume of activity where the organiza- tion’s revenues and expenses are equal. At this amount of sales, the organization has no profit or loss; it breaks even. Suppose Seattle Contemporary Theater sells 8,000 tickets during a play’s one-month run. The following income statement shows that the profit for the month will be zero; thus, the theater will break even. Sales revenue (8,000 3 $16) ................................................................................................................ $128,000 Less variable expenses (8,000 3 $10) ................................................................................................... 80,000 Total contribution margin ........................................................................................................................ $ 48,000 Less fixed expenses ............................................................................................................................... 48,000 Profit ..................................................................................................................................................... $ 0 Notice that this income statement highlights the distinction between variable and fixed expenses. The statement also shows the total contribution margin , which is defined as total sales revenue minus total variable expenses. This is the amount of rev- enue that is available to contribute to covering fixed expenses after all variable expenses have been covered. The contribution income statement will be covered in more depth later in the chapter. At this juncture, it provides a useful way to think about the meaning of breaking even. How could we compute Seattle Contemporary Theater’s break-even point if we did not already know it is 8,000 tickets per month? This is the question to which we turn our attention next. Contribution-Margin Approach Seattle Contemporary Theater will break even when the organization’s revenue from ticket sales is equal to its expenses. How many tickets must be sold during one month (one play’s run) for the organization to break even? The Break-Even Point “Break-even analyses figure prominently in any discussion of new programs. Although we have programs that operate at a loss because of their importance educationally, overall our cash inflows have to be sufficient to support our total program.” (7b) Cornell University Learning Objective 7-1 Compute a break-even point using the contribution-margin approach and the equation approach. Whether running a small business or a worldwide enterprise, understanding cost-volume-profit relationships is crucial in managing any organization. hiL25664_ch07_266-315.indd 270hiL25664_ch07_266-315.indd 270 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer Chapter 7 Cost-Volume-Profit Analysis 271 Each ticket sells for $16, but $10 of this is used to cover the variable expense per ticket. This leaves $6 per ticket to contribute to covering the fixed expenses of $48,000. When enough tickets have been sold in one month so that these $6 contributions per ticket add up to $48,000, the organization will break even for the month. Thus, we may compute the break-even volume of tickets as follows: Fixed expenses ____________________________ Contribution of each ticket toward covering fixed expenses 5 $48,000 _______ $6 5 8,000 Seattle Contemporary Theater must sell 8,000 tickets during a play’s one-month run to break even for the month. The $6 amount that remains of each ticket’s price, after the variable expenses are covered, is called the unit contribution margin . The general formula for computing the break-even sales volume in units is given below. Fixed expenses _____________________ Unit contribution margin 5 Break-even point (in units) (1) Contribution-Margin Ratio Sometimes management prefers that the break-even point be expressed in sales dollars rather than units. Seattle Contemporary Theater’s break-even point in sales dollars is computed as follows. Break-even point in units (tickets) ......................................................................................................... 8,000 Sales price per unit .............................................................................................................................. 3 $16 Break-even point in sales dollars .......................................................................................................... $128,000 The following computation provides an alternative way to determine the break-even point in sales dollars. Fixed expenses ______________________ Unit contribution margin _____________________ Unit sales price 5 $48,000 _______ $6 ____ $16 5 $48,000 _______ .375 5 $128,000 The unit contribution margin divided by the unit sales price is called the contribution- margin ratio . This ratio also can be expressed as a percentage, in which case it is called the contribution-margin percentage. Seattle Contemporary Theater’s contribution- margin ratio is .375 (in percentage form, 37.5%). Thus, the organization’s break-even point in sales dollars may be found by dividing its fixed expenses by its contribution- margin ratio. The logic behind this approach is that 37.5 percent of each sales dollar is available to make a contribution toward covering fixed expenses. The general formula is given below. Fixed expenses _____________________ Contribution-margin ratio 5 Break-even point in sales dollars (2) Equation Approach An alternative approach to finding the break-even point is based on the profit equation. Income (or profit) is equal to sales revenue minus expenses. If expenses are separated into variable and fixed expenses, the essence of the income (profit) statement is captured by the following equation. Sales revenue 2 Variable expenses 2 Fixed expenses 5 Profit Learning Objective 7-2 Compute the contribution- margin ratio and use it to find the break-even point in sales dollars. Learning Objective 7-1 Compute a break-even point using the contribution-margin approach and the equation approach. “Delta Air Lines computes a break-even load fac- tor, which is the average percentage of available passenger seats that need to be occupied on our flights in order for the company to break even.” (7c) Delta Air Lines hiL25664_ch07_266-315.indd 271hiL25664_ch07_266-315.indd 271 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer 272 Chapter 7 Cost-Volume-Profit Analysis This equation can be restated as follows: Unit sales price Sales volume in units Unit variable expense Sales volume in units Fixed expenses Profit (3) ( ( ( ( (( ( ( ( ( To find Seattle Contemporary Theater’s break-even volume of ticket sales per month, we define profit in equation (3) to be zero. ($ ) ($ ) $ , 0000840161 XX Unit sales price Sales volume in units Unit variablle expense Sales volume in units Fixed expenses Break-even profit (zero) (4) ( ( ( ( (( ( ( ( ( where X denotes the number of sales units (tickets) required to break even. Equation (4) can be solved for X as shown below. $16X 2 $10X 2 $48,000 5 0 $6X 5 $48,000 X 5 $48,000 _______ $6 5 8,000 Using the equation approach, we have arrived at the same general formula for computing the break-even sales volume (formula (1)). The contribution-margin and equation approaches are two equivalent techniques for finding the break-even point. Both methods reach the same conclusion, and so personal preference dictates which approach should be used. Graphing Cost-Volume-Profit Relationships While the break-even point conveys useful information to management, it does not show how profit changes as activity changes. To capture the relationship between profit and volume of activity, a cost-volume-profit (CVP) graph is commonly used. The follow- ing steps are used to prepare a CVP graph for Seattle Contemporary Theater. The graph is displayed in Exhibit 7–1 . Notice that the graph shows the relevant range, which is the range of activity within which management expects the theater to operate. Step 1: Draw the axes of the graph. Label the vertical axis in dollars and the horizontal axis in units of sales (tickets). Step 2: Draw the fixed-expense line. It is parallel to the horizontal axis, since fixed expenses do not change with activity. Step 3: Compute total expense at any convenient volume. For example, select a volume of 6,000 tickets. Variable expenses (6,000 3 $10 per ticket) ................................................................... $ 60,000 Fixed expenses ............................................................................................................. 48,000 Total expenses (at 6,000 tickets) .................................................................................... $108,000 Plot this point ($108,000 at 6,000 tickets) on the graph. See point A on the graph in Exhibit 7–1 . Graphing Cost-Volume-Profit Relationships Learning Objective 7-3 Prepare a cost-volume-profit (CVP) graph and explain how it is used. hiL25664_ch07_266-315.indd 272hiL25664_ch07_266-315.indd 272 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer Chapter 7 Cost-Volume-Profit Analysis 273 Step 4: Draw the total-expense line. This line passes through the point plotted in step 3 (point A ) and the intercept of the fixed-expense line on the vertical axis ($48,000). Step 5: Compute total sales revenue at any convenient volume. We will choose 6,000 tickets again. Total revenue is $96,000 (6,000 3 $16 per ticket). Plot this point ($96,000 at 6,000 tickets) on the graph. See point B on the graph in Exhibit 7–1 . Step 6: Draw the total revenue line. This line passes through the point plotted in step 5 (point B ) and the origin. Step 7: Label the graph as shown in Exhibit 7–1 . Interpreting the CVP Graph Several conclusions can be drawn from the CVP graph in Exhibit 7–1 . Break-Even Point The break-even point is determined by the intersection of the total- revenue line and the total-expense line. Seattle Contemporary Theater breaks even for the Exhibit 7–1 Cost-Volume-Profit Graph: Seattle Contemporary Theater $000 (per month) 10 2,000 Volume (tickets sold in one month) Relevant range 20 30 40 50 60 70 80 90 100 110 120 130 140 150 160 Total variable expenses for 8,000 tickets (at $10 per ticket), $80,000 4,000 6,000 8,000 10,000 12,000 Loss area Total fixed expenses per month, $48,000 Total fixed expenses Total expenses Profit area Total expenses for 8,000 tickets, $128,000 Break-even point: 8,000 tickets or $128,000 of sales A B Total revenue from ticket sales Learning Objective 7-3 Prepare a cost-volume-profit (CVP) graph and explain how it is used. hiL25664_ch07_266-315.indd 273hiL25664_ch07_266-315.indd 273 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer 274 Chapter 7 Cost-Volume-Profit Analysis month at 8,000 tickets, or $128,000 of ticket sales. This agrees with our calculations in the preceding section. Profit and Loss Areas The CVP graph discloses more information than the break- even calculation. From the graph, a manager can see the effects on profit of changes in volume. The vertical distance between the lines on the graph represents the profit or loss at a particular sales volume. If Seattle Contemporary Theater sells fewer than 8,000 tickets in a month, the organization will suffer a loss. The magnitude of the loss increases as ticket sales decline. The theater organization will have a profit if sales exceed 8,000 tickets in a month. Implications of the Break-Even Point The position of the break-even point within an organization’s relevant range of activity provides important information to man- agement. The Seattle Contemporary Theater building seats 450 people. The agree- ment with the city of Seattle calls for 20 performances during each play’s one-month Exhibit 7–2 Alternative Format for CVP Graph: Seattle Contemporary Theater $000 (per month) 10 2,000 Volume (tickets sold in one month) Relevant range 20 30 40 50 60 70 80 90 100 110 120 130 140 150 160 Total variable expenses for 8,000 tickets (at $10 per ticket), $80,000 4,000 6,000 8,000 10,000 12,000 Loss area Total fixed expenses per month, $48,000 Profit area Total expenses for 8,000 tickets, $128,000 Total expenses Break-even point: 8,000 tickets or $128,000 of sales A B Total revenue from ticket sales Total variable expenses hiL25664_ch07_266-315.indd 274hiL25664_ch07_266-315.indd 274 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer Chapter 7 Cost-Volume-Profit Analysis 275 run. Thus, the maximum number of tickets that can be sold each month is 9,000 (450 seats 3 20 performances). The organization’s break-even point is quite close to the maximum possible sales volume. This could be cause for concern in a nonprofit organiza- tion operating on limited resources. What could management do to improve this situation? One possibility is to rene- gotiate with the city to schedule additional performances. However, this might not be feasible, because the actors need some rest each week. Also, additional performances would likely entail additional costs, such as increased theater-rental expenses and increased compensation for the actors and production crew. Other possible solutions are to raise ticket prices or reduce costs. These kinds of issues will be explored later in the chapter. The CVP graph will not resolve this potential problem for the management of Seattle Contemporary Theater. However, the graph will direct management’s attention to the situation. Alternative Format for the CVP Graph An alternative format for the CVP graph, preferred by some managers, is displayed in Exhibit 7–2 (on preceding page) . The key difference is that fixed expenses are graphed above variable expenses, instead of the reverse as they were in Exhibit 7–1 . Profit-Volume Graph Yet another approach to graphing cost-volume-profit relationships is displayed in Exhibit 7–3 . This format is called a profit-volume graph , since it highlights the amount of profit or loss. Notice that the graph intercepts the vertical axis at the amount equal to fixed expenses at the zero activity level. The graph crosses the horizontal axis at the break-even point. The vertical distance between the horizontal axis and the profit line, at a particular level of sales volume, is the profit or loss at that volume. Exhibit 7–3 Profit-Volume Graph: Seattle Contemporary Theater $000 (per month) 50 2,000 Volume (tickets sold in one month) 40 30 20 10 0 10 20 30 40 50 4,000 6,000 8,000 10,000 Loss area Profit Total fixed expenses per month, $48,000 Break-even point: 8,000 tickets Total profit Loss Profit area hiL25664_ch07_266-315.indd 275hiL25664_ch07_266-315.indd 275 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer 276 Chapter 7 Cost-Volume-Profit Analysis 1 Remember that Seattle Contemporary Theater is a nonprofit enterprise. CVP analysis in a for-profit enterprise, including the effect of income taxes, is covered in the appendix to this chapter. Target Profit The board of trustees for Seattle Contemporary Theater would like to run free workshops and classes for young actors and aspiring playwrights. This program would cost $3,600 per month in fixed expenses, including teachers’ salaries and rental of space at a local college. No variable expenses would be incurred. If Seattle Contemporary Theater could make a profit of $3,600 per month on its performances, the Seattle Drama Workshop could be opened. The board has asked Andrew Lloyd, the organization’s business man- ager and producer, to determine how many theater tickets must be sold during each play’s one-month run to make a profit of $3,600. The desired profit level of $3,600 is called a target profit ( or income) . The problem of computing the volume of sales required to earn a particular target profit is very similar to the problem of finding the break-even point. After all, the break-even point is the num- ber of units of sales required to earn a target profit of zero. 1 Contribution-Margin Approach Each ticket sold by Seattle Contemporary Theater has a unit contribution margin of $6 (sales price of $16 minus unit variable expense of $10). Eight thousand of these $6 con- tributions will contribute just enough to cover fixed expenses of $48,000. Each additional ticket sold will contribute $6 toward profit. Thus, we can modify formula (1) given earlier in the chapter as follows: Fixed expenses 1 Target profit __________________________ Unit contribution margin 5 Number of sales units required to earn target profit (5) $48,000 1 $3,600 _______________ $6 5 8,600 tickets If Seattle Contemporary Theater sells 8,600 tickets during each play’s one-month run, the organization will make a monthly profit of $3,600 on its performances. This profit can be used to fund the Seattle Drama Workshop. The total dollar sales required to earn a target profit is found by modifying formula (2) given previously. Fixed expenses 1 Target profit __________________________ Contribution-margin ratio 5 Dollar sales required to earn target profit (6) $48,000 1 $3,600 _______________ .375 5 $137,600 where the contribution margin ratio 5 $6 ____ $16 5 .375 This dollar sales figure also can be found by multiplying the required sales of 8,600 tick- ets by the ticket price of $16 (8,600 3 $16 5 $137,600). Equation Approach The equation approach also can be used to find the units of sales required to earn a target profit. We can modify the profit equation given previously as follows: Unit sales price Sales volume required to earrn target profit Unit variaable expense Sales volume required to earn ttarget profit Fixed expensses Target profit ( (( (( (( ( ( ( Target Profit Learning Objective 7-4 Apply CVP analysis to deter- mine the effect on profit of changes in fixed expenses, variable expenses, sales prices, and sales volume. hiL25664_ch07_266-315.indd 276hiL25664_ch07_266-315.indd 276 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer Chapter 7 Cost-Volume-Profit Analysis 277 Filling in the values for Seattle Contemporary Theater, we have the following equation. ($16 3 X ) 2 ($10 3 X ) 2 $48,000 5 $3,600 (7) where X denotes the sales volume required to earn the target profit. Equation (7) can be solved for X as follows: $16X 2 $10X 2 $48,000 5 $3,600 $6X 5 $51,600 X 5 $51,600 _______ $6 5 8,600 Graphical Approach The profit-volume graph in Exhibit 7–3 also can be used to find the sales volume required to earn a target profit. First, locate Seattle Contemporary Theater’s target profit of $3,600 on the vertical axis. Then move horizontally until the profit line is reached. Finally, move down from the profit line to the horizontal axis to determine the required sales volume. Applying CVP Analysis The cost-volume-profit relationships that underlie break-even calculations and CVP graphs have wide-ranging applications in management. We will look at several common applications illustrated by Seattle Contemporary Theater. Safety Margin The safety margin of an enterprise is the difference between the budgeted sales rev- enue and the break-even sales revenue. Suppose Seattle Contemporary Theater’s busi- ness manager expects every performance of each play to be sold out. Then budgeted monthly sales revenue is $144,000 (450 seats 3 20 performances of each play 3 $16 per ticket). Since break-even sales revenue is $128,000, the organization’s safety margin is $16,000 ($144,000 2 $128,000). The safety margin gives management a feel for how close projected operations are to the organization’s break-even point. We will further discuss the safety margin concept later in the chapter. Changes in Fixed Expenses What would happen to Seattle Contemporary Theater’s break-even point if fixed expenses change? Suppose the business manager is concerned that the estimate for fixed utilities expenses, $1,400 per month, is too low. What would happen to the break-even point if fixed utilities expenses prove to be $2,600 instead? The break-even calculations for both the original and the new estimate of fixed utilities expenses are as follows: Original Estimate New Estimate Fixed utilities expenses ................................................................................. $ 1,400 $ 2,600 Total fixed expenses ..................................................................................... $48,000 $49,200 Break-even calculation ................................................................................. (Fixed expenses 4 unit contribution margin) $48,000 4 $6 $49,200 4 $6 Break-even point (units) ............................................................................... 8,000 tickets 8,200 tickets Break-even point (dollars) ............................................................................. $128,000 $131,200 Applying CVP Analysis “Basically the role of the [accountant] on the team [is] analyzing the financial impact of the business deci- sion and providing advice. Does this make sense finan- cially or not?” (7d) Abbott Laboratories Learning Objective 7-4 Apply CVP analysis to determine the effect on profit of changes in fixed expenses, variable expenses, sales prices, and sales volume. hiL25664_ch07_266-315.indd 277hiL25664_ch07_266-315.indd 277 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer 278 Chapter 7 Cost-Volume-Profit Analysis The estimate of fixed expenses has increased by 2.5 percent, since $1,200 is 2.5 percent of $48,000. Notice that the break-even point also increased by 2.5 percent (200 tickets is 2.5 percent of 8,000 tickets). This relationship will always exist. Fixed expenses _____________________ Unit contribution margin 5 Break-even point (in units) Fixed expenses 3 1.025 _____________________ Unit contribution margin 5 (Break-even point in units) 3 1.025 Donations to Offset Fixed Expenses Nonprofit organizations often receive cash donations from people or organizations desiring to support a worthy cause. A donation is equivalent to a reduction in fixed expenses, and it reduces the organization’s break- even point. In our original set of data, Seattle Contemporary Theater’s monthly fixed expenses total $48,000. Suppose that various people pledge donations amounting to $6,000 per month. The new break-even point is computed as follows: Fixed expenses 2 Donations ________________________ Unit contribution margin 5 Break-even point (in units) $48,000 2 $6,000 _______________ $6 5 7,000 tickets Changes in the Unit Contribution Margin What would happen to Seattle Contemporary Theater’s break-even point if miscellaneous variable expenses were $3 per ticket instead of $2? Alternatively, what would be the effect of raising the ticket price to $18? Change in Unit Variable Expenses If the theater organization’s miscellaneous vari- able expenses increase from $2 to $3 per ticket, the unit contribution margin will fall from $6 to $5. The original and new break-even points are computed as follows: Original Estimate New Estimate Miscellaneous variable expenses ...................................................................... $2 per ticket $3 per ticket Unit contribution margin ................................................................................... $6 $5 Break-even calculation ..................................................................................... (Fixed expenses 4 unit contribution margin) $48,000 4 $6 $48,000 4 $5 Break-even point (units) ................................................................................... 8,000 tickets 9,600 tickets Break-even point (dollars) ................................................................................. $128,000 $153,600 If this change in unit variable expenses actually occurs, it will no longer be possible for the organization to break even. Only 9,000 tickets are available for each play’s one- month run (450 seats 3 20 performances), but 9,600 tickets would have to be sold to break even. Once again, CVP analysis will not solve this problem for management, but it will direct management’s attention to potentially serious difficulties. Change in Sales Price Changing the unit sales price will also alter the unit contribu- tion margin. Suppose the ticket price is raised from $16 to $18. This change will raise the unit contribution margin from $6 to $8. The new break-even point will be 6,000 tickets ($48,000 4 $8). A $2 increase in the ticket price will lower the break-even point from 8,000 tickets to 6,000 tickets. Is this change desirable? A lower break-even point decreases the risk of operating with a loss if sales are sluggish. However, the organization may be more likely to at least break even with a $16 ticket price than with an $18 ticket price. The reason is that the lower ticket price encourages more people to attend the theater’s performances. hiL25664_ch07_266-315.indd 278hiL25664_ch07_266-315.indd 278 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer Chapter 7 Cost-Volume-Profit Analysis 279 It could be that break-even sales of 8,000 tickets at $16 are more likely than break-even sales of 6,000 tickets at $18. Ultimately, the desirability of the ticket-price increase depends on management’s assessment of the likely reaction by theater patrons. Management’s decision about the ticket price increase also will reflect the funda- mental goals of Seattle Contemporary Theater. This nonprofit drama organization was formed to bring contemporary drama to the people of Seattle. The lower the ticket price, the more accessible the theater’s productions will be to people of all income levels. The point of this discussion is that CVP analysis provides valuable information, but it is only one of several elements that influence management’s decisions. Predicting Profit Given Expected Volume So far, we have focused on finding the required sales volume to break even or achieve a particular target profit. Thus, we have asked the following question. Given: Fixed expenses Unit contribution margin Target profit , Find: {required sales volume} We also can use CVP analysis to turn this question around and make the following query. Given: Fixed expenses Unit contribution margin Expected sales volume , Find: {expected profit} Suppose the management of Seattle Contemporary Theater expects fixed monthly expenses of $48,000 and unit variable expenses of $10 per ticket. The organization’s board of trustees is considering two different ticket prices, and the business manager has forecast monthly demand at each price. Ticket Price Forecast Monthly Demand $16 ...................................................................................................................... 9,000 $20 ...................................................................................................................... 6,000 Expected profit may be calculated at each price as shown in the following table. In these profit calculations, the total contribution margin is the difference between total sales revenue and total variable expenses. This use of the term contribution margin is a “total” concept rather than the “per unit” concept used earlier in the chapter. The total contribution margin is the total amount left to contribute to covering fixed expenses after total variable expenses have been covered. Ticket Price $16 $20 Sales revenue: 9,000 3 $16 ................................................................................................... $144,000 6,000 3 $20 ................................................................................................... $120,000 Less variable expenses: 9,000 3 $10 ................................................................................................... 90,000 6,000 3 $10 ................................................................................................... 60,000 Total contribution margin ....................................................................................... $ 54,000 $ 60,000 Less fixed expenses .............................................................................................. 48,000 48,000 Profit $ 6,000 $ 12,000 The difference in expected profit at the two ticket prices is due to two factors: 1. A different unit contribution margin, defined previously as unit sales price minus unit variable expenses 2. A different sales volume ⎧ ⎨ ⎩ ⎧ ⎨ ⎩ ⎧ ⎨ ⎩ ⎧ ⎨ ⎩ hiL25664_ch07_266-315.indd 279hiL25664_ch07_266-315.indd 279 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer 280 Chapter 7 Cost-Volume-Profit Analysis Incremental Approach Rather than presenting the entire income statement under each ticket price alternative, we can use a simpler incremental approach. This analysis focuses only on the difference in the total contribution margin under the two prices. Thus, the combined effect of the change in unit contribution margin and the change in sales volume is as follows: Expected total contribution margin at $20 ticket price: 6,000 3 ($20 2 $10) ........................................................................................................................ $60,000 Expected total contribution margin at $16 ticket price: 9,000 3 ($16 2 $10) ........................................................................................................................ 54,000 Difference in total contribution margin ....................................................................................................... $ 6,000 The $6,000 difference in expected profit, at the two ticket prices, is due to a $6,000 difference in the total contribution margin. The board of trustees will consider these pro- jected profits as it decides which ticket price is best. Even though Seattle Contemporary Theater is a nonprofit organization, it may still have legitimate reasons for attempting to make a profit on its theater performances. For example, the board might use these profits to fund a free drama workshop, provide scholarships for local young people to study drama in college, or produce a free outdoor play for Seattle’s residents. Interdependent Changes in Key Variables Sometimes a change in one key variable will cause a change in another key variable. Suppose the board of trustees is choosing between ticket prices of $16 and $20, and the business manager has projected demand as shown in the preceding section. A famous retired actress who lives in Seattle has offered to donate $10,000 per month to Seattle Contemporary Theater if the board will set the ticket price at $16. The actress is inter- ested in making the theater’s performances affordable for as many people as possible. The facts are now as follows: Ticket Price Unit Contribution Margin Forecast Monthly Demand Net Fixed Expenses (after subtracting donation) $16 ............... $ 6 ............. 9,000 ............... $38,000 ($48,000 2 $10,000) 20 ................ 10 ............. 6,000 ............... 48,000 The organization’s expected profit at each price is computed as follows: Ticket Price $16 $20 Sales revenue: 9,000 3 $16 ................................................................................................ $144,000 6,000 3 $20 ................................................................................................ $120,000 Less variable expenses: 9,000 3 $10 ................................................................................................ 90,000 6,000 3 $10 ................................................................................................ 60,000 Total contribution margin .................................................................................... $ 54,000 $ 60,000 Less net fixed expenses (net of donation) 38,000 48,000 Profit ................................................................................................................. $16,000 $ 12,000 Now the difference in expected profit at the two ticket prices is due to three factors: 1. A different unit contribution margin. 2. A different sales volume. 3. A difference in the net fixed expenses, after deducting the donation. hiL25664_ch07_266-315.indd 280hiL25664_ch07_266-315.indd 280 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer Chapter 7 Cost-Volume-Profit Analysis 281 Incremental Approach The combined effect of these factors is shown in the following analysis, which focuses on the effects of the price alternatives on the total contribution margin and the net fixed expenses. Expected total contribution margin at $20 ticket price: 6,000 3 ($20 2 $10) ......................................................................................................................... $60,000 Expected total contribution margin at $16 ticket price: 9,000 3 ($16 2 $10) ......................................................................................................................... 54,000 Difference in total contribution margin ........................................................................................................ $ 6,000 (higher with $20 ticket price) Net fixed expenses at $20 ticket price ........................................................................................................ $48,000 Net fixed expenses at $16 ticket price ........................................................................................................ 38,000 Difference in net fixed expenses (higher with $20 ticket price) ..................................................................... $10,000 The expected total contribution margin is $6,000 higher with the $20 ticket price, but net fixed expenses are $10,000 higher. Thus, Seattle Contemporary Theater will make $4,000 more in profit at the $16 price ($10,000 2 $6,000). CVP Information in Published Annual Reports Cost-volume-profit relationships are so important to understanding an organization’s operations that some companies disclose CVP information in their published annual reports. The following illustration is from the airline industry. AIRLINES KEEP A CLOSE EYE ON BREAK-EVEN LOAD FACTORS An airline’s break-even load factor is the percentage of available seats that must be filled in order for the airline’s revenues to equal its expenses. This is the point where the airline breaks even on its flight operations. Airlines pay close attention to their system-wide break-even load factors and often disclose them in their annual reports. JetBlue, a successful discount airline founded in 1998, now serves over 70 cities in the USA in addition to a number of destinations in the Caribbean, Latin America, and South America. A recent airline industry analysis listed JetBlue’s break-even load factor as 81.79 percent. By comparison, the break-even load factors for a few other well-known airlines were reported as follows: American, 83.14 percent; United, 88.6 percent; and Southwest, 79.6 percent.2 It is not necessarily valid, however, to compare operating statistics, such as break- even load factors, across airlines. According to industry analysts, the definition of operat- ing expenses used in calculating the break-even load factor differs across airlines. For example, some airlines exclude fuel costs from the calculation of operating expenses, because oil prices fluctuate widely and are not under an airline management’s control. Given the disparity in the definition of the expenses used to calculate the break-even load factor, comparisons across airlines are suspect. However, it is worthwhile to track a particular airline’s break-even load factor across time periods.3 American Airlines, JetBlue Airways, Southwest Airlines, and United Airlines anagement ccounting ractice M A P 2“4Q 2012 Scorecard” www.theairlinewebsite.com. 3Based on the authors’ research. hiL25664_ch07_266-315.indd 281hiL25664_ch07_266-315.indd 281 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer 282 Chapter 7 Cost-Volume-Profit Analysis CVP Analysis with Multiple Products Our CVP illustration for Seattle Con- temporary Theater has assumed that the organization has only one product, a theater seat at a dramatic performance. Most firms have a sales mix consisting of more than one product, and this adds some complexity to their CVP analyses. As we have seen, Seattle Con- temporary Theater’s monthly fixed expenses total $48,000, and the unit variable expense per ticket is $10. Now suppose that the city of Seattle has agreed to refurbish 10 theater boxes in the historic theater building. Each box has five seats, which are more comfortable and afford a better view of the stage than the theater’s general seating. The board of trustees has decided to charge $16 per ticket for general seating and $20 per ticket for box seats. These facts are summarized as follows: Seat Type Ticket Price Unit Variable Expense Unit Contribution Margin Seats in Theater Seats Available per Month (20 performances) Regular $16 $10 $ 6 450 9,000 Box 20 10 10 50 1,000 Notice that 90 percent of the available seats are regular seats, and 10 percent are box seats. The business manager estimates that tickets for each type of seat will be sold in the same proportion as the number of seats available. If, for example, 5,000 tickets are sold during a month, sales will be as follows: Regular seats: 90% 3 5,000 .................................................................................................................. 4,500 Box seats: 10% 3 5,000 .................................................................................................................. 500 Total ........................................................................................................................................ 5,000 For any organization selling multiple products, the relative proportion of each type of product sold is called the sales mix . The business manager’s estimate of Seattle Contem- porary Theater’s sales mix is 90 percent regular seats and 10 percent box seats. The sales mix is an important assumption in multiproduct CVP analysis. The sales mix is used to compute a weighted-average unit contribution margin . This is the average of the several products’ unit contribution margins, weighted by the relative sales proportion of each product. Seattle Contemporary Theater’s weighted-average unit con- tribution margin is computed below. Weighted-average unit contribution margin 5 ($6 3 90%) 1 ($10 3 10%) 5 $6.40 The organization’s break-even point in units is computed using the following formula. Break-even point 5 Fixed expenses _____________________________ Weighted-average unit contribution margin (8) 5 $48,000 _______ $6.40 5 7,500 tickets CVP Analysis with Multiple Products Major airlines keep a close watch on the break-even passenger load factor. Learning Objective 7-5 Compute the break-even point and prepare a profit-volume graph for a multiproduct enterprise. hiL25664_ch07_266-315.indd 282hiL25664_ch07_266-315.indd 282 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer Chapter 7 Cost-Volume-Profit Analysis 283 The break-even point of 7,500 tickets must be interpreted in light of the sales mix. Seattle Contemporary Theater will break even for the month if it sells 7,500 tickets as follows: Break-even Regular seats: 7,500 3 90% ................................................................................... 6,750 tickets sales in Box seats: 7,500 3 10% ................................................................................... 750 tickets units Total ........................................................................................................................ 7,500 tickets The following income calculation verifies the break-even point. Sales revenue: Regular seats: 6,750 3 $16 ............................................................................................................. $108,000 Box seats: 750 3 $20 ............................................................................................................. 15,000 Total revenue: 7,500 seats in total ..................................................................................................... $123,000 Less variable expenses: 7,500 3 $10 ................................................................................................... 75,000 Total contribution margin ....................................................................................................................... $ 48,000 Less fixed expenses .............................................................................................................................. 48,000 Profit .................................................................................................................................................... $ 0 The break-even point of 7,500 tickets per month is valid only for the sales mix assumed in computing the weighted-average unit contribution margin. If 7,500 tickets are sold in any other mix of regular and box seats, the organization will not break even. Notice that break-even formula (8) is a modification of formula (1) given earlier in the chapter. The only difference is that formula (8) uses the weighted-average unit con- tribution margin. Seattle Contemporary Theater’s business manager has constructed the profit-volume graph in Exhibit 7–4 . The PV graph shows the organization’s profit at any level of total monthly sales, assuming the sales mix of 90 percent regular seats and 10 percent box seats. For example, if 9,000 tickets are sold in total, at the assumed sales mix, the PV graph indicates that profit will be $9,600. ⎧ ⎨ ⎩ Exhibit 7–4 Profit-Volume Graph with Multiple Products: Seattle Contemporary Theater $000 (per month) 50 2,000 Volume* (tickets sold in one month) 40 30 20 10 0 10 20 30 40 50 4,000 6,000 8,000 10,000 Loss area Profit Break-even point: 7,500 tickets in total Total profit Loss Profit area * Sales mix assumption: 90% regular seats 10% box seats hiL25664_ch07_266-315.indd 283hiL25664_ch07_266-315.indd 283 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer 284 Chapter 7 Cost-Volume-Profit Analysis With multiproduct CVP analysis, a managerial accountant can investigate the impact on profit of changes in sales volume, prices, variable costs, fixed costs, or the sales mix itself. For example, what would be the effect on Seattle Contemporary Theater’s break- even point if the sales mix were 95 percent regular seats and 5 percent box seats? With this sales mix, the weighted-average unit contribution margin is computed as follows: Weighted-average unit contribution margin 5 ($6 3 95%) 1 ($10 3 5%) 5 $6.20 The break-even point increases from 7,500 tickets to approximately 7,742 tickets as a result of the lower proportion of expensive seats in the sales mix. Break-even point 5 Fixed expenses _____________________________ Weighted-average unit contribution margin 5 $48,000 _______ $6.20 5 7,742 tickets* *Rounded Assumptions Underlying CVP Analysis For any cost-volume-profit analysis to be valid, the following important assumptions must be reasonably satisfied within the relevant range. 1. The behavior of total revenue is linear (straight-line). This implies that the price of the product or service will not change as sales volume varies within the rel- evant range. 2. The behavior of total expenses is linear (straight-line) over the relevant range. This implies the following more specific assumptions. a. Expenses can be categorized as fixed, variable, or semivariable. Total fixed expenses remain constant as activity changes, and the unit variable expense remains unchanged as activity varies. b. The efficiency and productivity of the production process and workers remain constant. 3. In multiproduct organizations, the sales mix remains constant over the relevant range. 4. In manufacturing firms, the inventory levels at the beginning and end of the period are the same. This implies that the number of units produced during the period equals the number of units sold. Role of Computerized Planning Models and Electronic Spreadsheets Cost-volume-profit analysis is based on the four general assumptions listed above as well as specific estimates of all the variables used in the analysis. Since these variables are rarely known with certainty, it is helpful to run a CVP analysis many times with differ- ent combinations of estimates. For example, Seattle Contemporary Theater’s business manager might do the CVP analysis using different estimates for the ticket prices, sales mix for regular and box seats, unit variable expenses, and fixed expenses. This approach is called sensitivity analysis , since it provides the analyst with a feel for how sensitive the analysis is to the estimates upon which it is based. The widespread availability of personal computers and electronic spreadsheet software has made sensitivity analysis relatively easy to do. Assumptions Underlying CVP Analysis Learning Objective 7-6 List and discuss the key assumptions of CVP analysis. hiL25664_ch07_266-315.indd 284hiL25664_ch07_266-315.indd 284 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer Chapter 7 Cost-Volume-Profit Analysis 285 CVP Relationships and the Income Statement The management functions of planning, control, and decision making all are facilitated by an understanding of cost-volume-profit relationships. These relationships are impor- tant enough to operating managers that some businesses prepare income statements in a way that highlights CVP issues. Before we examine this new income-statement format, we will review the more traditional income statement used in the preceding chapters. Traditional Income Statement An income statement for AccuTime Company, a manufacturer of digital clocks, is shown in Exhibit 7–5 (panel A). During 20x1 the firm manufactured and sold 20,000 clocks at a price of $25 each. This income statement is prepared in the traditional manner. Cost of goods sold includes both variable and fixed manufacturing costs, as measured by the firm’s product-costing system. The gross margin is computed by subtracting cost of goods sold from sales. Selling and administrative expenses are then subtracted; each expense includes both variable and fixed costs. The traditional income statement does not disclose the breakdown of each expense into its variable and fixed components. Contribution Income Statement Many operating managers find the traditional income-statement format difficult to use, because it does not separate variable and fixed expenses. Instead they prefer the contribution income statement . A contribution income statement for AccuTime CVP Relationships and the Income Statement A. Traditional Format ACCUTIME COMPANY Income Statement For the Year Ended December 31, 20x1 Sales .................................................................................................................. $500,000 Less: Cost of goods sold ....................................................................................... 380,000 Gross margin ....................................................................................................... $120,000 Less: Operating expenses: Selling expenses .......................................................................................... $ 35,000 Administrative expenses ............................................................................... 35,000 70,000 Net income .......................................................................................................... $ 50,000 B. Contribution Format ACCUTIME COMPANY Income Statement For the Year Ended December 31, 20x1 Sales .................................................................................................................. $500,000 Less: Variable expenses: Variable manufacturing ................................................................................ $280,000 Variable selling ............................................................................................ 15,000 Variable administrative ................................................................................. 5,000 300,000 Contribution margin ............................................................................................. $200,000 Less: Fixed expenses: Fixed manufacturing .................................................................................... $100,000 Fixed selling ................................................................................................ 20,000 Fixed administrative ..................................................................................... 30,000 150,000 Net income .......................................................................................................... $ 50,000 Exhibit 7–5 Income Statement: Traditional and Contribution Formats Learning Objective 7-7 Prepare and interpret a contribution income statement. hiL25664_ch07_266-315.indd 285hiL25664_ch07_266-315.indd 285 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer 286 Chapter 7 Cost-Volume-Profit Analysis is shown in Exhibit 7–5 (panel B). The contribution format highlights the distinc- tion between variable and fixed expenses. The variable manufacturing cost of each clock is $14, and the total fixed manufacturing cost is $100,000. On the contribution income statement, all variable expenses are subtracted from sales to obtain the con- tribution margin. For AccuTime, $200,000 remains from total sales revenue, after all variable costs have been covered, to contribute to covering fixed costs and making a profit. All fixed costs are then subtracted from the contribution margin to obtain net income. Comparison of Traditional and Contribution Income Statements Operating managers frequently prefer the contribution income statement, because its separation of fixed and variable expenses highlights cost-volume-profit relationships. It is readily apparent from the contribution format statement how income will be affected when sales volume changes by a given percentage. Suppose management projects that sales volume in 20x2 will be 20 percent greater than in 20x1. No changes are anticipated in the sales price, variable cost per unit, or fixed costs. Examination of the contribu- tion income statement shows that if sales volume increases by 20 percent, the follow- ing changes will occur. (Our discussion ignores income taxes, which are covered in the appendix at the end of this chapter.) Income Statement Item 20x1 Amount Change 20x2 Amount Sales .......................................... $500,000 ........................ $100,000 ......................... $600,000 (20% 3 $500,000) Total variable expenses ................ $300,000 ........................ $60,000 ........................... $360,000 (20% 3 $300,000) Contribution margin ..................... $200,000 ........................ $40,000 ........................... $240,000 (20% 3 $200,000) Total fixed expenses ..................... $150,000 ........................ —0— .............................. $150,000 (no change in fixed expenses when volume changes) Net income .................................. $ 50,000 ....................... $40,000 ........................... $ 90,000 (income changes by the amount of the contribution-margin change) Notice that net income increases by the same amount as the increase in the con- tribution margin. Moreover, the contribution margin changes in direct proportion to the change in sales volume. These two facts enable us to calculate the increase in net income using the following shortcut. Recall that the contribution-margin ratio is the per- centage of contribution margin to sales. Increase in sales revenue Contribution-marrgin ratio Increase in net income $ ,100 000 where Contribution-margin r . $ ,40 40 000 aatio Contribution margin Sales revenue .40 $$ , $ , 200 000 500 000 ( ( ( ( (((( hiL25664_ch07_266-315.indd 286hiL25664_ch07_266-315.indd 286 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer Chapter 7 Cost-Volume-Profit Analysis 287 The preceding analysis makes use of cost-volume-profit relationships that are dis- closed in the contribution income statement. Such an analysis cannot be made with the information presented in the traditional income statement. Cost Structure and Operating Leverage The cost structure of an organization is the relative proportion of its fixed and variable costs. Cost structures differ widely among industries and among firms within an industry. A company using a computer-integrated manufacturing system has a large investment in plant and equipment, which results in a cost structure dominated by fixed costs. In con- trast, a home building contractor’s cost structure has a much higher proportion of variable costs. The highly automated manufacturing firm is capital-intensive, whereas the home building contractor is labor-intensive. An organization’s cost structure has a significant effect on the sensitivity of its profit to changes in volume. A convenient way to portray a firm’s cost structure is shown in the Excel spreadsheet in Exhibit 7–6 . 4 The data for AccuTime Company (company A) comes from the firm’s 20x1 contribution income statement in Exhibit 7–5 . For com- parison purposes, two other firms’ cost structures also are shown. Although these three firms have the same sales revenue ($500,000) and net income ($50,000), they have very different cost structures. Company B’s production process is largely manual, and its cost structure is dominated by variable costs. It has a low contribution-margin ratio of only 20 percent. In contrast, company C employs a highly automated production process, and its cost structure is dominated by fixed costs. The firm’s contribution-margin ratio is 90 percent. Company A falls between these two extremes with a contribution-margin ratio of 40 percent. Suppose sales revenue increases by 10 percent, or $50,000, in each company. The resulting increase in each company’s profit is calculated in Exhibit 7–7 . Notice that company B, with its high variable expenses and low contribution- margin ratio, shows a relatively low percentage increase in profit. In contrast, the high fixed expenses and large contribution-margin ratio of company C result in a relatively high percentage increase in profit. Company A falls in between these two extremes. To summarize, the greater the proportion of fixed costs in a firm’s cost structure, the greater the impact on profit will be from a given percentage change in sales revenue. Cost Structure and Operating Leverage Exhibit 7–6 Comparison of Cost Structures Learning Objective 7-8 Explain the role of cost structure and operating leverage in CVP relationships. 4 This form of income statement, in which each item on the statement is expressed as a percentage of sales revenue, is often called a common-size income statement. hiL25664_ch07_266-315.indd 287hiL25664_ch07_266-315.indd 287 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer 288 Chapter 7 Cost-Volume-Profit Analysis Operating Leverage The extent to which an organization uses fixed costs in its cost structure is called operating leverage . The operating leverage is greatest in firms with a large proportion of fixed costs, low proportion of variable costs, and the resulting high contribution-margin ratio. Exhibit 7–6 shows that company B has low operating leverage, company C has high operating leverage, and company A falls in between. To a physical scientist, leverage refers to the ability of a small force to move a heavy weight. To the managerial accoun- tant, operating leverage refers to the ability of the firm to generate an increase in net income when sales revenue increases. Measuring Operating Leverage The managerial accountant can measure a firm’s operating leverage, at a particular sales volume, using the operating leverage factor : Operating leverage factor 5 Contribution margin _________________ Net income Using the data in Exhibit 7–6 , the operating leverage factors of companies A, B, and C are computed as follows: 4 5 Company A (AccuTime) ..................................... $200,000 4 $50,000 5 4 Company B (high variable expenses) .................. $100,000 4 $50,000 5 2 Company C (high fixed expenses) ....................... $450,000 4 $50,000 5 9 The operating leverage factor is a measure, at a particular level of sales, of the percentage impact on net income of a given percentage change in sales revenue. Multi- plying the percentage change in sales revenue by the operating leverage factor yields the percentage change in net income. 3 5 Company A (AccuTime) ..................................... 10% 3 4 5 40% Company B (high variable expenses) .................. 10% 3 2 5 20% Company C (high fixed expenses) ....................... 10% 3 9 5 90% The percentage change in net income shown above for each company may be verified by re-examining Exhibit 7–7 . Contribution Margin( ( NetIncome( ( Operating Leverage Factor( ( Percentage Increase in Sales Revenue( ( OperatingLeverageFactor( ( PercentageChange inNet Income( ( ( Increase In Sales Revenue ) 3 ( Contribution Margin Ratio ) 5 ( Increase In Net Income ) Percentage Increase in Net Income Company A (AccuTime) ........................... $50,000 3 40% 5 $20,000 40% ($20,000 4 $50,000) Company B (high variable expenses) ........ $50,000 3 20% 5 $10,000 20% ($10,000 4 $50,000) Company C (high fixed expenses) ............ $50,000 3 90% 5 $45,000 90% ($45,000 4 $50,000) Exhibit 7–7 Effect on Profit of Increase in Sales Revenue hiL25664_ch07_266-315.indd 288hiL25664_ch07_266-315.indd 288 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer Chapter 7 Cost-Volume-Profit Analysis 289 Break-Even Point and Safety Margin A firm’s operating leverage also affects its break-even point. Since a firm with relatively high operating leverage has proportionally high fixed expenses, the firm’s break-even point will be relatively high. This fact is illus- trated using the data from Exhibit 7–6 . 4 5 Company A (AccuTime) ..................................... $150,000 4 40% 5 $375,000 Company B (high variable expenses) .................. $ 50,000 4 20% 5 $250,000 Company C (high fixed expenses) ....................... $400,000 4 90% 5 $444,444 * *Rounded The safety margin also is affected by a firm’s operating leverage. Suppose the bud- geted sales revenue for each of the three companies is $500,000. Then the safety margin, defined as budgeted sales revenue minus break-even sales revenue, is calculated as shown on the next page. Fixed Expenses( ( ContributionMargin Ratio( ( Break-EvenSales Revenue( ( OPERATING LEVERAGE HELPS WEB COMPANIES TO BE PROFITABLE Some Web-based companies are demonstrating that “once they turn profitable, they can become big moneymak- ers. The reason is operating leverage. That’s accounting- speak for a simple concept: Once you invest enough to build a Web site and your basic operations, you don’t need to spend much money as sales rise. After you cover your fixed costs, the expense of processing each sale is so little that profits grow faster than revenues.” Expedia, the online travel agency, is an example of a successful Web-based company benefiting from the operating leverage concept. In one quarter alone, Expedia doubled its sales. Yet its overhead, including administrative and marketing costs, rose less than ten percent. “One big reason is that the company had already paid for the computer gear it needed to handle the higher volume of ticket sales.”5 Expedia’s high operating leverage factor enables it to have a high contribution- margin ratio and also a high gross margin percentage. In 2012, Expedia’s annual gross margin percentage was 81.8 percent. This means that over 81 cents of every sales dollar at Expedia went to the firm’s gross margin. In comparison, Amazon’s annual gross margin percentage for the same year was 28.3 percent. Expedia and Amazon anagement ccounting ractice M A P 5R. Crum, “Expedia Reports Ten Percent Earnings Increase,” www.marketwatch.com, by The Wall Street Journal, February 5, 2013; T. J. Mullaney and R. D. Hof, “Finally, the Pot of Gold,” Business Week, June 24, 2002, p. 106. hiL25664_ch07_266-315.indd 289hiL25664_ch07_266-315.indd 289 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer 290 Chapter 7 Cost-Volume-Profit Analysis Budgeted Sales Revenue Break-Even Sales Revenue Safety Margin Company A (AccuTime) ..................................................... $500,000 $375,000 $125,000 Company B (high variable expenses) .................................. 500,000 250,000 250,000 Company C (high fixed expenses) ....................................... 500,000 444,444 55,556 To summarize, company C’s high fixed expenses result in a high break-even point and low safety margin. Company B displays the opposite characteristics, and company A falls in between the two extremes. Labor-Intensive Production Processes versus Advanced Manufacturing Systems The effects of labor-intensive (manual) production processes and highly automated, advanced manufacturing systems illustrated by companies A, B, and C are typical. As Exhibit 7–8 shows, a movement toward an advanced manufacturing environment often results in a higher break-even point, lower safety margin, and higher operating lever- age. However, high-technology manufacturing systems generally have greater through- put, thus allowing greater potential for profitability. Along with the increased potential for profitability comes increased risk. In an economic recession, for example, a highly automated company with high fixed costs will be less able to adapt to lower consumer demand than will a firm with a more labor-intensive production process. Cost Structure and Operating Leverage: A Cost-Benefit Issue A firm’s cost structure plays an important role in determining its cost-volume-profit rela- tionships. A company with proportionately high fixed costs has relatively high operat- ing leverage. The result of high operating leverage is that the firm can generate a large percentage increase in net income from a relatively small percentage increase in sales revenue. On the other hand, a firm with high operating leverage has a relatively high break-even point. This entails some risk to the firm. The optimal cost structure for an organization involves a trade-off. Management must weigh the benefits of high operating leverage against the risks of large committed fixed costs and the associated high break-even point. Advanced manufacturing Proportion of fixed costs in cost structure Operating leverage Break-even point Throughput, profit potential, and risk Safety margin Labor-intensive Exhibit 7–8 Labor-Intensive Production Processes versus Advanced Manufacturing Systems hiL25664_ch07_266-315.indd 290hiL25664_ch07_266-315.indd 290 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer Chapter 7 Cost-Volume-Profit Analysis 291 CVP Analysis, Activity-Based Costing, and Advanced Manufacturing Systems Traditional cost-volume-profit analysis focuses on the number of units sold as the only cost and revenue driver. Sales revenue is assumed to be linear in units sold. Moreover, costs are categorized as fixed or variable, with respect to the number of units sold, within the relevant range. This approach is consistent with traditional product-costing systems, in which cost assignment is based on a single, volume-related cost driver. In CVP analy- sis, as in product costing, the traditional approach can be misleading or provide less than adequate information for various management purposes. An activity-based costing sys- tem can provide a much more complete picture of cost-volume-profit relationships and thus provide better information to managers. To illustrate the potential impact of activity-based costing on CVP analysis, we will continue our discussion of AccuTime Company. The basic data underlying the contribu- tion income statement shown in Exhibit 7–5 are as follows: Sales volume ................................................................................................................................ 20,000 units Sales price ................................................................................................................................... $25 Unit variable costs: Variable manufacturing ............................................................................................................. $14 Variable selling and administrative ............................................................................................. 1 Total unit variable cost .............................................................................................................. $15 Unit contribution margin ................................................................................................................ $10 Fixed costs: Fixed manufacturing ................................................................................................................. $ 100,000 Fixed selling and administrative ................................................................................................. 50,000 Total fixed costs ........................................................................................................................ $150,000 These data are adequate for a traditional CVP analysis of various questions manage- ment may ask. For example, the break-even point is easily calculated as 15,000 units, as the following analysis shows: Break-even point 5 Fixed costs _____________________ Unit contribution margin 5 $150,000 ________ $10 5 15,000 units CVP Analysis, Activity-Based Costing, and Advanced Manufacturing Systems “ABC was critical to the organization in helping us gain a better understanding of our costs. . . . It provided us with a foundation for managing expenses better.” (7e) BlueCross BlueShield of North Carolina HEALTH-CARE COSTS AND OPERATING LEVERAGE Kaiser Permanente was founded in 1945 to provide health care for workers at Henry F. Kaiser’s West Coast shipyards and steel mills. It led the U.S. HMOs by building its own hospitals, marketing its own health insurance, and working with doctors in the Perman- ente Medical Group, who practice exclusively for Kaiser. Such a vertical integration allows Kaiser to control costs better than HMOs that contract with independent doctors and hospitals. This strategy results in Kaiser’s cost structure being dominated by fixed costs. Kaiser has to focus on maintaining membership growth because of its high operating leverage. 6 As a result of the Affordable Care Act, Kaiser Permante expects its member- ship roles of individual subscribers to rise substantially in the next few years. Kaiser Permanente anagement ccounting ractice M A P 6 Based on the authors’ research; and Geoff Colvin, “Kaiser Permanente Prepares for Obamacare,” money.cnn.com, October 3, 2012. Learning Objective 7-9 Understand the implications of activity-based costing for CVP analysis. hiL25664_ch07_266-315.indd 291hiL25664_ch07_266-315.indd 291 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer 292 Chapter 7 Cost-Volume-Profit Analysis Alternatively, management may determine how many clocks must be sold to earn a target net profit of $200,000, as the following calculation demonstrates: Sales volume required to earn target net profit of $200,000 5 Fixed costs 1 Target net profit _________________________ Unit contribution margin 5 $150,000 1 $200,000 __________________ $10 5 35,000 units What do these questions have in common? They both focus on sales volume as the sole revenue and cost driver. The CVP analysis depends on a distinction between costs that are fixed and costs that are variable with respect to sales volume. A Move Toward JIT and Flexible Manufacturing Now let’s examine another question AccuTime’s management could face. Suppose man- agement is considering the installation of a flexible manufacturing system and a move toward just-in-time (JIT) production. A flexible manufacturing system uses highly auto- mated material-handling and production equipment to manufacture a variety of similar products. In the new production process, setups would be quicker and more frequent and production runs would be smaller. Fewer inspections would be required, due to the total quality control (TQC) philosophy that often accompanies JIT. Variable manufacturing costs would be lower, due to savings in direct labor. Finally, general factory overhead costs would increase, due to the greater depreciation charges on the new production equipment. Suppose management wants to answer the same two questions addressed previ- ously, under the assumption that the production process changes are adopted. To properly address this issue, we need a much more detailed understanding of the impact of other, non-volume-based cost drivers on AccuTime’s costs. This type of detail is the hallmark of an activity-based costing system. Suppose AccuTime’s controller completes an ABC analysis of the company’s 20x1 activity before the new equipment is installed. The results are shown in Exhibit 7–9 . There is a subtle but important point to realize about the cost behavior depicted in Exhibit 7–9 . Setup, inspection, and material handling are listed as fixed costs. They are Pictured here is a production cell in a flexible manufactur- ing system engaged in the production of disks for com- puter hard disk drives. In such a high-tech manufacturing environment, setups are quicker and more frequent, and production runs are smaller. An activity-based costing CVP analysis will give management a better under- standing of cost-volume-profit relationships. Learning Objective 7-10 Be aware of the effects of advanced manufacturing technology on CVP relationships. hiL25664_ch07_266-315.indd 292hiL25664_ch07_266-315.indd 292 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer Chapter 7 Cost-Volume-Profit Analysis 293 largely fixed with respect to sales volume. However, they are not fixed with respect to other cost drivers, such as the number of setups, inspections, and hours of material han- dling. This is the fundamental distinction between a traditional CVP analysis and an activity-based costing CVP analysis. The traditional CVP analysis recognizes a single, volume-based cost driver, namely, sales volume. The activity-based costing CVP analysis recognizes multiple cost drivers. As a result, some costs viewed as fixed under the tradi- tional analysis are considered variable (with respect to the appropriate cost drivers) under the ABC approach. Now let’s return to management’s decision regarding the installation of a flexible manufacturing system and the adoption of the JIT and TQC philosophies. The activity- based costing analysis of the proposed production technology is displayed in Exhibit 7–10 . Due to the decreased use of direct labor, the unit variable manufacturing cost has declined from $14 to $9, thus bringing the total unit variable cost down to $10. This results in an increase in the unit contribution margin to $15. The installation of sophisticated new manufacturing equipment has more than tripled general factory overhead, from $60,000 to $184,000. Under the proposed JIT approach, setups will be daily instead of weekly; each setup will be quicker and less expensive. As a result of the emphasis on total quality control, only one inspection per day will be necessary, instead of three as before. More- over, each inspection will be less expensive. Finally, the amount of material-handling activity will decline dramatically, although there will be a slight increase in the cost per hour. This is due to the higher skill grade of labor required to operate the new automated material-handling system. Using the ABC data in Exhibit 7–10 , we can answer the two CVP questions posed by management. If the new production technology is adopted, the following CVP computa- tions will be appropriate. Break-even point 5 Fixed costs _____________________ Unit contribution margin 5 $250,000 ________ $15 5 16,667 units (rounded) Sales volume required to earn target net profit of $200,000 5 Fixed costs 1 Target net profit _________________________ Unit contribution margin 5 $250,000 1 $200,000 __________________ $15 5 30,000 units Exhibit 7–9 Activity-Based Costing Data under Current Production Process (20x1) Sales price ................................................................................................................................................. $25 Unit variable costs: Variable manufacturing ........................................................................................................................... $14 Variable selling and administrative ........................................................................................................... 1 Total unit variable costs ........................................................................................................................... $15 Unit contribution margin .............................................................................................................................. $10 Fixed costs (fixed with respect to sales volume): General factory overhead (including depreciation on plant and equipment) ................................................. $ 60,000 Setup (52 setups at $100 per setup) * ...................................................................................................... 5,200 Inspection [(52)(21) inspections at $20 per inspection] † ............................................................................ 21,840 Material handling (1,080 hours at $12 per hour) ....................................................................................... 12,960 Total fixed manufacturing costs ................................................................................................................ $100,000 Fixed selling and administrative costs ...................................................................................................... 50,000 Total fixed costs .......................................................................................................................................... $150,000 *One setup per week. † Three inspections per day, seven days a week (52 weeks per year). hiL25664_ch07_266-315.indd 293hiL25664_ch07_266-315.indd 293 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer 294 Chapter 7 Cost-Volume-Profit Analysis Notice that AccuTime’s break-even point increased with the introduction of the advanced manufacturing system (from 15,000 to 16,667 units). However, the number of sales units required to earn a target net profit of $200,000 declined (from 35,000 to 30,000 units). These kinds of CVP changes are typical when firms install an advanced manufacturing system. Typically, the cost structure of an advanced manufacturing envi- ronment is characterized by a lower proportion of variable costs and a larger proportion of costs that are fixed (with respect to sales volume). ABC Provides a Richer Understanding of Cost Behavior and CVP Relationships The point of this section is that activity-based costing provides a richer description of a company’s cost behavior. AccuTime’s traditional costing system treated setup, inspec- tion, and material handling as fixed costs. However, the ABC analysis showed that while these costs are largely fixed with respect to sales volume, they are not fixed with respect to other appropriate cost drivers. In analyzing the cost-volume-profit implications of the proposed changes in manufacturing technology, it was crucial to have an understanding of how these costs would change with respect to such cost drivers as the number of set- ups, number of quality-assurance inspections, and amount of material-handling activity. Just as ABC can improve an organization’s product-costing system, it also can facili- tate a deeper understanding of cost behavior and CVP relationships. Sales price ................................................................................................................................................ $25 Unit variable costs: Variable manufacturing .......................................................................................................................... $ 9 Variable selling and administrative .......................................................................................................... 1 Total unit variable costs .......................................................................................................................... $10 Unit contribution margin ............................................................................................................................. $15 Fixed costs (fixed with respect to sales volume): General factory overhead (including depreciation on plant and equipment) ................................................ $184,000 Setup (365 setups at $30 per setup) ....................................................................................................... 10,950 Inspection (365 inspections at $10 per inspection) .................................................................................. 3,650 Material handling (100 hours at $14 per hour) ......................................................................................... 1,400 Total fixed manufacturing costs ............................................................................................................... $200,000 Fixed selling and administrative costs ..................................................................................................... 50,000 Total fixed costs ......................................................................................................................................... $250,000 Chapter Summary LO7-1 Compute a break-even point using the contribution-margin approach and the equation approach. These two approaches result in the same general formula for computing the break-even point (in units). Under the equation approach, the profit equation is specified as follows: Sales revenue 2 Variable expenses 2 Fixed expenses 5 Profit. When this equation is manipulated, the contribution-margin approach to the break-even point results, as follows: Break-even point (in units) 5 Fixed expenses 4 Unit contribution margin. LO7-2 Compute the contribution-margin ratio and use it to find the break-even point in sales dollars. The contribution-margin ratio is defined as follows: Unit contribution margin 4 Unit sales price. The break-even point (in sales dollars) can be computed as follows: Fixed expenses 4 Contribution- margin ratio. LO7-3 Prepare a cost-volume-profit (CVP) graph and explain how it is used. A cost-volume-profit graph shows the break-even point (in sales dollars) as the intersection of the total revenue line and the total expense line. The graph can be used to help management understand how changes in the volume of activity affect cost and profit. Exhibit 7–10 Activity-Based Costing Data under Proposed Production Technology hiL25664_ch07_266-315.indd 294hiL25664_ch07_266-315.indd 294 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer Chapter 7 Cost-Volume-Profit Analysis 295 LO7-4 Apply CVP analysis to determine the effect on profit of changes in fixed expenses, variable expenses, sales prices, and sales volume. Management can use the break-even equation to predict the effects on the break-even point of changes in any component of the equation, e.g., sales price, unit variable cost, fixed cost, and so forth. Such prediction can help management in making a variety of operational decisions. LO7-5 Compute the break-even point and prepare a profit-volume graph for a multiproduct enterprise. Break-even analysis in a multiproduct firm is accomplished by computing a weighted- average contribution margin, which is based on the expected sales mix. The same break-even formulas are used as in a single-product analysis, except that the unit contribution margin is replaced by the weighted-average contribution margin. This analysis is limited by the assumption of a constant sales mix across the range of total sales volume. LO7-6 List and discuss the key assumptions of CVP analysis. CVP analysis involves several key assumptions, which follow: (1) Total revenue is linear (i.e., a straight line) with respect to changes in the volume of activity. (2) Total expense is linear (i.e., a straight line) with respect to changes in the volume of activity. An implication of this assumption is that the efficiency and productivity of the production process remains constant. (3) The sales mix remains constant over the relevant range. (4) The beginning and ending inventory levels are the same in a manufacturing firm. LO7-7 Prepare and interpret a contribution income statement. Cost-volume-profit relationships are important enough to operating managers that some firms prepare a contribution income statement. This income-statement format separates fixed and variable expenses and computes the aggregate con- tribution margin. This statement format helps managers discern the effects on profit from changes in volume. The contribution income statement also discloses an organization’s cost structure, which is the relative proportion of its fixed and variable costs. LO7-8 Explain the role of cost structure and operating leverage in CVP relationships. An organi- zation’s cost structure is the relative proportions of its fixed and variable costs. The extent to which an organization uses fixed costs in its cost structure is called operating leverage. Firms with high operating leverage tend to have higher break-even points, other things being equal. LO7-9 Understand the implications of activity-based costing for CVP analysis. Activity-based costing (ABC) provides a richer description of an organization’s cost behavior and CVP relationships than is provided by a traditional costing system. An ABC cost-volume-profit analysis recognizes that some costs that are fixed with respect to sales volume may not be fixed with respect to other important cost drivers. In many cases, management can benefit substantially from such an improved understanding of cost behavior and CVP relationships. LO7-10 Be aware of the effects of advanced manufacturing technology on CVP relationships. Companies with advanced manufacturing technology tend to have higher fixed costs, lower variable costs, and higher break-even points. LO7-11 Understand the effect of income taxes on CVP analysis (Appendix). When a firm is required to pay taxes on income, it is important to distinguish between after-tax (AT) income and before- tax (BT) income. AT income is equal to BT income minus income tax expense. Therefore, BT income is equal to AT income 4 (1 2 tax rate). The number of units of sales required to earn a specified AT income is equal to (BT income 1 fixed expenses) 4 unit contribution margin. Review Problem on Cost-Volume-Profit Analysis Overlook Inn is a small bed-and-breakfast inn located in the Great Smoky Mountains of Tennessee. The charge is $50 per person for one night’s lodging and a full breakfast in the morning. The retired couple who own and manage the inn estimate that the variable expense per person is $20. This includes such expenses as food, maid service, and utilities. The inn’s fixed expenses total $42,000 per year. The inn can accommodate 10 guests each night. Required: Compute the following: 1. Contribution margin per unit of service. (A unit of service is one night’s lodging for one guest.) 2. Contribution-margin ratio. 3. Annual break-even point in units of service and in dollars of service revenue. 4. The number of units of service required to earn a target net profit of $60,000 for the year. (Ignore income taxes.) hiL25664_ch07_266-315.indd 295hiL25664_ch07_266-315.indd 295 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer 296 Chapter 7 Cost-Volume-Profit Analysis Solution to Review Problem 1. Contribution margin per unit of service 5 Nightly room charge 2 Variable expense per person $30 5 $50 2 $20 2. Contribution-margin ratio 5 Contribution margin per unit ________________________ Nightly room charge .60 5 $30 ____ $50 3. Break-even point in units of service 5 Fixed expenses ________________________ Contribution margin per unit 1,400 5 $42,000 _______ $30 Break-even point in dollars of revenue 5 Fixed expenses _____________________ Contribution-margin ratio $70,000 5 $42,000 _______ .60 4. Number of units of service required to earn target net profit 5 Fixed expenses 1 Target net profit ________________________________ Contribution margin per unit of service 3,400 5 $42,000 1 $60,000 ________________ $30 Key Terms For each term’s definition refer to the indicated page, or turn to the glossary at the end of the text. after-tax net income, * 296 before-tax income, * 296 break-even point, 270 contribution income statement, 285 contribution-margin ratio, 271 cost structure, 287 cost-volume-profit (CVP) analysis, 268 cost-volume-profit (CVP) graph, 272 gross margin, 285 operating leverage, 288 operating leverage factor, 288 profit-volume graph, 275 safety margin, 277 sales mix, 282 sensitivity analysis, 284 target profit ( or income), 276 total contribution margin, 279 unit contribution margin, 282 weighted-average unit contribution margin, 282 *Term appears in the appendix. APPENDIX TO CHAPTER 7 Effect of Income Taxes Profit-seeking enterprises must pay income taxes on their profits. A firm’s after-tax net income , the amount of income remaining after subtracting the firm’s income-tax expense, is less than its before-tax income . This fact is expressed in the following formula. (After-tax net income) 5 (Before-tax income) 2 t(Before-tax income) where t denotes the income-tax rate. Rearranging this equation yields the following formula. (After-tax net income) 5 (Before-tax income)(1 2 t) (9) To illustrate this formula, suppose AccuTime Company must pay income taxes of 40 percent of its before-tax income. The company’s contribution income statement for 20x1 follows. Learning Objective 7-11 Understand the effect of income taxes on CVP analysis. hiL25664_ch07_266-315.indd 296hiL25664_ch07_266-315.indd 296 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer Chapter 7 Cost-Volume-Profit Analysis 297 Sales, 20,000 units at $25 each ................................................................................................................ $500,000 Variable expenses, 20,000 units at $15 each * ............................................................................................ 300,000 Contribution margin .................................................................................................................................. $200,000 Fixed expenses ......................................................................................................................................... 150,000 Income before taxes .................................................................................................................................. $ 50,000 Income tax expense, .40 3 $50,000 ......................................................................................................... 20,000 Net income, $50,000 3 (1 2 .40) ............................................................................................................ $ 30,000 *Variable cost per unit is $15: variable manufacturing cost of $14 plus variable selling and administrative costs of $1. The requirement that companies pay income taxes affects their cost-volume-profit relationships. To earn a particular after-tax net income will require greater before-tax income than if there were no tax. For example, if AccuTime’s target after-tax net income were $30,000, the company would have to earn before-tax income of $50,000. AccuTime’s income statement shows this relationship. How much before-tax income must be earned in order to achieve a particular target after-tax net income? Rearranging equation (9) above yields the following formula. Target after-tax net income 5 ( Target before-tax income ) (1 2 t) Divide both sides by (1 2 t) Target after-tax net income __________ 1 2 t 5 ( Target before-tax income ) 1 2 t _____ 1 2 t Target after-tax net income _________ 1 2 t 5 Target before-tax income If AccuTime Company’s target after-tax net income is $30,000, its target before-tax income is calculated as follows: Target after-tax net income _____________ 1 2 t 5 $30,000 _______ 1 2 .40 5 $50,000 5 Target before-tax income Now we are in a position to compute the number of digital clocks that AccuTime must sell in order to achieve a particular after-tax net income. We begin with the following before-tax income equation. Sales 2 Variable expenses 2 Fixed expenses 5 Before-tax income Now we use our formula for before-tax income. Sales Variable expenses Fixed expenses Afterr-tax net income Unit sales price Sales 1 t vvolume in units Unit variable expeense Sales volume in units Fixeed expenses After-tax net income 1 t( (( ( ( (( ( ( ( Using the data for AccuTime Company, and assuming target after-tax net income of $30,000: ($25 3 X) 2 ($15 3 X) 2 $150,000 5 $30,000 _______ 1 2 .40 where X denotes the number of units that must be sold to achieve the target after-tax net income. Now we solve for X as follows: ($25 2 $15) 3 X 5 $150,000 1 $30,000 _______ 1 2 .40 $10 3 X 5 $150,000 1 $30,000 _______ 1 2 .40 X 5 $150,000 1 $30,000 _______ 1 2 .40 _________________ $10 5 20,000 units In terms of sales revenue, AccuTime must achieve a sales volume of $500,000 (20,000 units 3 $25 sales price). We can verify these calculations by examining AccuTime’s income statement given previously. ⎧ ⎨ ⎩ hiL25664_ch07_266-315.indd 297hiL25664_ch07_266-315.indd 297 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer 298 Chapter 7 Cost-Volume-Profit Analysis Notice in the preceding calculations that $10 is the unit contribution margin ($25 sales price minus $15 variable expense). Thus, the general formula illustrated for AccuTime is the following: Number of units of sales required to earn target after-tax net income 5 Fixed expenses 1 Target after-tax net income _____________ 1 2 t ____________________________ Unit contribution margin where t denotes the income tax rate. A cost-volume-profit graph for AccuTime Company is displayed in Exhibit 7–11 . As the graph shows, 20,000 units must be sold to achieve $30,000 in after-tax net income. The company’s break-even point is 15,000 units. The break-even point is not affected by income taxes, because at the break-even point, there is no income. Notice that AccuTime Company must sell 5,000 units beyond the break-even point in order to achieve after-tax net income of $30,000. Each unit sold beyond the break-even point contributes $10 toward before-tax income. However, of that $10 contribution margin, $4 will have to be paid in income taxes. This leaves an after-tax contribution of $6 toward after-tax net income. Thus, selling 5,000 units beyond the break-even point results in after-tax net income of $30,000 (5,000 units 3 $6 after-tax con- tribution per unit). $000 (per year) 5,000 10,000 15,000 20,000 25,000 30,000 Volume (digital clocks sold in one year) 50 100 150 200 250 300 350 400 450 500 Total variable expenses for 20,000 units (at $15 per unit), $300,000 Total revenue Total expenses Break-even point: 15,000 units or $375,000 of sales Total fixed expenses per year, $150,000 Before-tax income for 20,000 units of sales, $50,000* AccuTime Company Sales volume required to achieve after-tax net income of $30,000* (Before-tax income) 3 (1 2 Tax rate) 5 After-tax income* $50,000 3 (1 2 .40) 5 $30,000 Exhibit 7–11 Cost-Volume-Profit Graph (with income taxes) Review Questions 7–1. Briefly explain each of the following methods of com- puting a break-even point in units: ( a ) contribution- margin approach, ( b ) equation approach, and ( c ) graphical approach. 7–2. What is the meaning of the term unit contribution margin? Contribution to what? 7–3. What information is conveyed by a cost-volume-profit graph in addition to a company’s break-even point? hiL25664_ch07_266-315.indd 298hiL25664_ch07_266-315.indd 298 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer Chapter 7 Cost-Volume-Profit Analysis 299 7–4. What does the term safety margin mean? 7–5. Suppose the fixed expenses of a travel agency increase. What will happen to its break-even point, measured in number of clients served? Why? 7–6. Delmarva Oyster Company has been able to decrease its variable expenses per pound of oysters harvested. How will this affect the firm’s break-even sales volume? 7–7. In a strategy meeting, a manufacturing company’s president said, “If we raise the price of our product, the company’s break-even point will be lower.” The financial vice president responded by saying, “Then we should raise our price. The company will be less likely to incur a loss.” Do you agree with the president? Why? Do you agree with the financial vice president? Why? 7–8. What will happen to a company’s break-even point if the sales price and unit variable cost of its only product increase by the same dollar amount? 7–9. An art museum covers its operating expenses by charging a small admission fee. The objective of the nonprofit organization is to break even. A local arts enthusiast has just pledged an annual donation of $10,000 to the museum. How will the donation affect the museum’s break-even attendance level? 7–10. How can a profit-volume graph be used to predict a company’s profit for a particular sales volume? 7–11. List the most important assumptions of cost-volume- profit analysis. 7–12. Why do many operating managers prefer a contribu- tion income statement instead of a traditional income statement? 7–13. What is the difference between a manufacturing com- pany’s gross margin and its total contribution margin? 7–14. East Company manufactures VCRs using a completely automated production process. West Company also man- ufactures VCRs, but its products are assembled manually. How will these two firms’ cost structures differ? Which company will have a higher operating leverage factor? 7–15. When sales volume increases, which company will experience a larger percentage increase in profit: company X, which has mostly fixed expenses, or company Y, which has mostly variable expenses? 7–16. What does the term sales mix mean? How is a weighted-average unit contribution margin computed? 7–17. A car rental agency rents subcompact, compact, and full-size automobiles. What assumptions would be made about the agency’s sales mix for the purpose of a cost-volume-profit analysis? 7–18. How can a hotel’s management use cost-volume-profit analysis to help in deciding on room rates? 7–19. How could cost-volume-profit analysis be used in bud- geting? In making a decision about advertising? 7–20. Two companies have identical fixed expenses, unit vari- able expenses, and profits. Yet one company has set a much lower price for its product. Explain how this can happen. 7–21. A company with an advanced manufacturing environ- ment typically will have a higher break-even point, greater operating leverage, and larger safety margin than a labor-intensive firm. True or false? Explain. 7–22. Explain briefly how activity-based costing (ABC) affects cost-volume-profit analysis. Exercises All applicable Exercises are available with McGraw-Hill’s Connect Accounting ®. University Pizza delivers pizzas to the dormitories and apartments near a major state u niversity. The company’s annual fixed expenses are $54,000. The sales price of a pizza is $10, and it costs the company $6 to make and deliver each pizza. (In the following requirements, ignore income taxes.) Required: 1. Using the contribution-margin approach, compute the company’s break-even point in units (pizzas). 2. What is the contribution-margin ratio? 3. Compute the break-even sales revenue. Use the contribution-margin ratio in your calculation. 4. How many pizzas must the company sell to earn a target net profit of $60,000? Use the equation method. Fill in the missing data for each of the following independent cases. (Ignore income tax e s.) Sales Revenue Variable Expenses Total Contribution Margin Fixed Expenses Net Income Break-Even Sales Revenue 1. ? $120,000 $240,000 ? $150,000 ? 2. $ 55,000 11,000 ? ? 19,000 ? 3. ? 80,000 ? $60,000 ? $ 80,000 4. 160,000 ? 30,000 ? ? 160,000 ■ Exercise 7–23 Basic CVP Analysis; Pizza Delivery Business (LO 7-1, 7-2, 7-4) ■ Exercise 7–24 Fill in Blanks; Basic CVP Relationships (LO 7-1, 7-2) hiL25664_ch07_266-315.indd 299hiL25664_ch07_266-315.indd 299 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer 300 Chapter 7 Cost-Volume-Profit Analysis The Dallas Armadillos, a minor-league baseball team, play their weekly games in a small stadium just outside Dallas. The stadium holds 6,000 people, and tickets sell for $20 each. The franchise owner esti- mates that the team’s annual fixed expenses are $360,000, and the variable expense per ticket sold is $2. (In the following requirements, ignore income taxes.) Required: 1. Draw a cost-volume-profit graph for the sports franchise. Label the axes, break-even point, profit and loss areas, fixed expenses, variable expenses, total-expense line, and total-revenue line. 2. If the stadium is two-thirds full for each game, how many games must the team play to break even? Refe r to the data given in the preceding exercise. (Ignore income taxes.) Required: 1. Prepare a fully labeled profit-volume graph for the Dallas Armadillos. 2. What is the safety margin for the baseball franchise if the team plays a 10-game season and the team owner expects the stadium to be 45 percent full for each game? 3. If the team plays a 10-game season and the stadium is 40 percent full for each game, what ticket price would the team have to charge in order to break even? Rosario C ompany, which is located in Buenos Aires, Argentina, manufactures a component used in farm machinery. The firm’s fixed costs are 2,000,000 p per year. The variable cost of each component is 1,000 p, and the components are sold for 1,500 p each. The company sold 7,000 components during the prior year. ( p denotes the peso, Argentina’s national currency. Several countries use the peso as their monetary unit. On the day this exercise was written, Argentina’s peso was worth .192 U.S. dollars. In the following requirements, ignore income taxes.) Required: Answer requirements (1) through (4) independently. 1. Compute the break-even point in units. 2. What will the new break-even point be if fixed costs increase by 5 percent? 3. What was the company’s net income for the prior year? 4. The sales manager believes that a reduction in the sales price to 1,400 p will result in orders for 1,000 more components each year. What will the break-even point be if the price is changed? 5. Should the price change discussed in requirement (4) be made? Explain. Pacific R im Publications, Inc., specializes in reference books that keep abreast of political and economic issues in the Pacific Rim countries. The results of the company’s operations during the prior year are given in the following table. All units produced during the year were sold. (Ignore income taxes.) Sales revenue ..................................................................................................................................... $1,000,000 Manufacturing costs: Fixed .............................................................................................................................................. 250,000 Variable .......................................................................................................................................... 500,000 Selling costs: Fixed .............................................................................................................................................. 25,000 Variable .......................................................................................................................................... 50,000 Administrative costs: Fixed .............................................................................................................................................. 60,000 Variable .......................................................................................................................................... 15,000 Required: 1. Prepare a traditional income statement and a contribution income statement for the company. 2. What is the firm’s operating leverage for the sales volume generated during the prior year? 3. Suppose sales revenue increases by 12 percent. What will be the percentage increase in net income? 4. Which income statement would an operating manager use to answer requirement (3)? Why? ■ Exercise 7–25 CVP Graph; Sports Franchise (LO 7-3, 7-4) ■ Exercise 7–26 Continuation of Preced- ing Exercise; Profit-Volume Graph; Safety Margin (LO 7-3, 7-4) ■ Exercise 7–27 Using CVP Analysis; Manufacturing (LO 7-1, 7-4) ■ Exercise 7–28 Contribution Income State- ment; Publishing (LO 7-7, 7-8) hiL25664_ch07_266-315.indd 300hiL25664_ch07_266-315.indd 300 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer Chapter 7 Cost-Volume-Profit Analysis 301 Use the Internet to a ccess the website of one of these airlines, or a different airline of your choosing. American Airlines www.americanair.com British Airways www.british-airways.com Delta Air Lines www.delta-air.com Qantas Airways www.qantas.com Southwest Airlines www.southwestair.com Required: Find the company’s most recent annual report. Does the management discussion in the report disclose the airline’s break-even load factor? If so, what is it for the most recent year reported? Brad’s Bicycle Shop sells 21-speed bicycles. For purposes of a cost-volume-profit analysis, t he shop owner has divided sales into two categories, as follows: Product Type Sales Price Invoice Cost Sales Commission High-quality ...................................................................... $1,000 $550 $50 Medium-quality ................................................................. 600 270 30 Seventy percent of the shop’s sales are medium-quality bikes. The shop’s annual fixed expenses are $148,500. (In the following requirements, ignore income taxes.) Required: 1. Compute the unit contribution margin for each product type. 2. What is the shop’s sales mix? 3. Compute the weighted-average unit contribution margin, assuming a constant sales mix. 4. What is the shop’s break-even sales volume in dollars? Assume a constant sales mix. 5. How many bicycles of each type must be sold to earn a target net income of $99,000? Assume a constant sales mix. A contribution income statement for the La Jolla Inn is shown below. ( Ignore income taxes.) Revenue ............................................................................................................................................... $1,500,000 Less: Variable Expenses ........................................................................................................................ 900,000 Contribution margin .............................................................................................................................. $ 600,000 Less: Fixed expenses ............................................................................................................................ 450,000 Net Income ........................................................................................................................................... $ 150,000 Required: 1. Show the hotel’s cost structure by indicating the percentage of the hotel’s revenue represented by each item on the income statement. 2. Suppose the hotel’s revenue declines by 20 percent. Use the contribution-margin percentage to cal- culate the resulting decrease in net income. 3. What is the hotel’s operating leverage factor when revenue is $1,500,000? 4. Use the operating leverage factor to calculate the increase in net income resulting from a 25 percent increase in sales revenue. Refer to the income statement given in the preceding exercise. Prepare a new contribution i ncome state- ment for the La Jolla Inn in each of the following independent situations. (Ignore income taxes.) 1. The hotel’s volume of activity increases by 25 percent, and fixed expenses increase by 50 percent. 2. The ratio of variable expenses to revenue doubles. There is no change in the hotel’s volume of activity. Fixed expenses decline by $100,000. Power Grid Engineering Associates, Inc., provides consulting services to commercial e lectric utili- ties. The consulting firm’s contribution-margin ratio is 25 percent, and its annual fixed expenses are $200,000. The firm’s income-tax rate is 40 percent. ■ Exercise 7–29 Cost-Volume-Profit Analysis in an Airline; Use of Internet (LO 7-4) ■ Exercise 7–30 CVP Analysis with Multiple Products; Retail (LO 7-1, 7-5) ■ Exercise 7–31 Cost Structure and Operat- ing Leverage; Hotel and Restaurant (LO 7-2, 7-8) ■ Exercise 7–32 Continuation of Preceding Exercise (LO 7-7) ■ Exercise 7–33 CVP Analysis with Income Taxes; Consulting Firm (Appendix) (LO 7-1, 7-2, 7-4, 7-11) hiL25664_ch07_266-315.indd 301hiL25664_ch07_266-315.indd 301 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer 302 Chapter 7 Cost-Volume-Profit Analysis Required: 1. Calculate the firm’s break-even volume of service revenue. 2. How much before-tax income must the firm earn to make an after-tax net income of $120,000? 3. What level of revenue for consulting services must the firm generate to earn an after-tax net income of $120,000? 4. Suppose the firm’s income-tax rate declines to 35 percent. What will happen to the break-even level of consulting service revenue? Problems ScholarPak Company produced and sold 70,000 backpacks during the year just ended at an average price of $30 per unit. Variable manufacturing costs were $12 per unit, and variable marketing costs were $6 per unit sold. Fixed costs amounted to $540,000 for manufacturing and $216,000 for marketing. There was no year-end work-in-process inventory. (Ignore income taxes.) Required: 1. Compute ScholarPak’s break-even point in sales dollars for the year. 2. Compute the number of sales units required to earn a net income of $540,000 during the year. 3. ScholarPak’s variable manufacturing costs are expected to increase by 10 percent in the coming year. Compute the firm’s break-even point in sales dollars for the coming year. 4. If ScholarPak’s variable manufacturing costs do increase by 10 percent, compute the selling price that would yield the same contribution-margin ratio in the coming year. (CMA, adapted) Surreal S ound, Inc., manufactures and sells compact disks. Price and cost data are as follows: Selling price per unit (package of two CDs) ................................................................................................. $ 25.00 Variable costs per unit: Direct material ...................................................................................................................................... $ 8.20 Direct labor .......................................................................................................................................... 4.00 Manufacturing overhead ....................................................................................................................... 6.00 Selling expenses ................................................................................................................................... 1.60 Total variable costs per unit ............................................................................................................... $ 19.80 Annual fixed costs: Manufacturing overhead ....................................................................................................................... $ 288,000 Selling and administrative ..................................................................................................................... 414,000 Total fixed costs ................................................................................................................................ $ 702,000 Forecasted annual sales volume (140,000 units) ........................................................................................ $3,500,000 In the following requirements, ignore income taxes. Required: 1. What is Surreal Sound’s break-even point in units? 2. What is the company’s break-even point in sales dollars? 3. How many units would Surreal Sound have to sell in order to earn $390,000? 4. What is the firm’s margin of safety? 5. Management estimates that direct-labor costs will increase by 10 percent next year. How many units will the company have to sell next year to reach its break-even point? 6. If the company’s direct-labor costs do increase by 10 percent, what selling price per unit of prod- uct must it charge to maintain the same contribution-margin ratio? (CMA, adapted) ■ Problem 7–34 Basic CVP Computations (LO 7-1, 7-2, 7-4) 1. Break-even point: $1,890,000 4. Selling price: $32.00 ■ Problem 7–35 Basic CVP Relationships (LO 7-1, 7-2, 7-4) 2. Break-even point: $3,375,000 4. Margin of safety: $125,000 All applicable Problems are available with McGraw-Hill’s Connect Accounting ®. hiL25664_ch07_266-315.indd 302hiL25664_ch07_266-315.indd 302 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer Chapter 7 Cost-Volume-Profit Analysis 303 Detroit D isk, Inc. is a retailer for digital video disks. The projected net income for the current year is $600,000 based on a sales volume of 400,000 video disks. Detroit Disk has been selling the disks for $24 each. The variable costs consist of the $15 unit purchase price of the disks and a handling cost of $3 per disk. Detroit Disk’s annual fixed costs are $1,800,000. Management is planning for the coming year, when it expects that the unit purchase price of the video disks will increase 30 percent. (Ignore income taxes.) Required: 1. Calculate Detroit Disk’s break-even point for the current year in number of video disks. 2. What will be the company’s net income for the current year if there is a 10 percent increase in pro- jected unit sales volume? 3. What volume of sales (in dollars) must Detroit Disk achieve in the coming year to maintain the same net income as projected for the current year if the unit selling price remains at $24, but the unit purchase price of the disks increases by 30 percent as expected? 4. In order to cover a 30 percent increase in the disk’s purchase price for the coming year and still maintain the current contribution-margin ratio, what selling price per disk must Detroit Disk estab- lish for the coming year? 5. Build a spreadsheet: Construct an Excel spreadsheet to solve requirements (1), (2), and (3) above. Show how the solution will change if the following information changes: the selling price is $25, and the annual fixed costs are $1,700,000. (CMA, adapted) Dillon, Jones, and Kline, Ltd. is studying the acquisition of two electrical component i nsertion systems for producing its sole product, the universal gismo. Data relevant to the systems follow. Model A: Variable costs, $8.00 per unit Annual fixed costs, $1,971,200 Model B: Variable costs, $6.40 per unit Annual fixed costs, $2,227,200 The selling price is $32 per unit for the universal gismo, which is subject to a 5 percent sales commis- sion. (In the following requirements, ignore income taxes.) Required: 1. How many units must the company sell to break even if Model A is selected? 2. Which of the two systems would be more profitable if sales and production are expected to aver- age 184,000 units per year? 3. Assume Model B requires the purchase of additional equipment that is not reflected in the preceding figures. The equipment will cost $900,000 and will be depreciated over a five-year life by the straight- line method. How many units must the company sell to earn $1,912,800 of income if Model B is selected? As in requirement (2), sales and production are expected to average 184,000 units per year. 4. Ignoring the information presented in requirement (3), at what volume level will management be indifferent between the acquisition of Model A and Model B? In other words, at what volume level will the annual total cost of each system be equal? (Hint: At any given dollar sales volume, sales commissions will be the same amount regardless of which model is selected.) Boundaries, a chain of retail stores, sells books and music CDs. Condensed monthly i ncome data are presented in the following table for November 20x4. (Ignore income taxes.) Downtown Store Mall Store Total Sales ............................................................................................. $240,000 $360,000 $600,000 Less: Variable expenses .................................................................. 96,000 252,000 348,000 Contribution margin ........................................................................ $144,000 $108,000 $252,000 Less: Fixed expenses ...................................................................... 60,000 120,000 180,000 Operating income ........................................................................... $ 84,000 $(12,000) $ 72,000 ■ Problem 7–36 Basic CVP Relationships; Retailer (LO 7-1, 7-2, 7-4) 2. New projected sales volume: 440,000 units ■ Problem 7–37 CVP Relationships; Indiffer- ence Point (LO 7-1, 7-4) 1. Break-even point: 88,000 units ■ Problem 7–38 CVP Relationships; Retail (LO 7-1, 7-4) 1. Total decrease in operating income: $(32,400) hiL25664_ch07_266-315.indd 303hiL25664_ch07_266-315.indd 303 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer 304 Chapter 7 Cost-Volume-Profit Analysis Additional information: • Management estimates that closing the mall store would result in a 10 percent decrease in down- town store sales, while closing the downtown store would not affect mall store sales. • One-fourth of each store’s fixed expenses would continue through December 31, 20x5, if either store were closed. • The operating results for November 20x4 are representative of all months. Required: 1. Calculate the increase or decrease in Boundaries’ monthly operating income during 20x5 if the mall store is closed. 2. The management of Boundaries is considering a promotional campaign at the mall store that would not affect the downtown store. Annual promotional expenses at the mall store would be increased by $180,000 in order to increase mall store sales by 10 percent. What would be the effect of this promotional campaign on the company’s monthly operating income during 20x5? 3. One-half of the mall store’s dollar sales are from items sold at their variable cost to attract custom- ers to the store. Boundaries’ management is considering the deletion of these items, a move that would reduce the mall store’s direct fixed expenses by 15 percent and result in the loss of 20 percent of the remaining mall store’s sales volume. This change would not affect the downtown store. What would be the effect on Boundaries’ monthly operating income if the items sold at their variable cost are eliminated? 4. Build a spreadsheet: Construct an Excel spreadsheet to solve all of the preceding requirements. Show how the solution will change if the following information changes: the downtown store’s sales amounted to $235,000, and its variable expenses were $90,000. (CMA, adapted) Premier C orporation sells two models of home ice cream makers, Mister Ice Cream and Cold King. Cur- rent sales total 60,000 units, consisting of 21,000 Mister Ice Cream units and 39,000 Cold King units. Selling price and variable cost information follows. Mister Ice Cream Cold King Selling price ........................................................................................................... $37.00 $43.00 Variable cost ........................................................................................................... 20.50 32.50 Salespeople currently receive flat salaries that total $200,000. Management is contemplating a change to a compensation plan that is based on commissions in an effort to boost the company’s presence in the marketplace. Two plans are under consideration: Plan A: 10% commission computed on gross dollar sales. Mister Ice Cream sales are anticipated to be 19,500 units. Cold King sales are expected to total 45,500 units. Plan B: 30% commission computed on the basis of production contribution margins. Mister Ice Cream sales are expected to total 39,000 units. Cold King sales are anticipated to be 26,000 units. Required: 1. Define the term sales mix. 2. Comparing Plan A to the current compensation arrangement: a. Will Plan A achieve management’s objective of an increased presence in the marketplace? Briefly explain. b. From a sales-mix perspective, will the salespeople be promoting the product that one would logically expect? Briefly discuss. c. Will the sales force likely be satisfied with the results of Plan A? Why? d. Will Premier likely be satisfied with the resulting impact of Plan A on company profitability? Why? ■ Problem 7–39 Sales Mix and Employee Compensation; Operating Changes (LO 7-4, 7-5, 7-7) 2(c). Commissions: $267,800 3(b). Plan B, net income: $641,550 hiL25664_ch07_266-315.indd 304hiL25664_ch07_266-315.indd 304 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer Chapter 7 Cost-Volume-Profit Analysis 305 3. Assume that Plan B is under consideration. a. Compare Plan A and Plan B with respect to total units sold and the sales mix. Comment on the results. b. In comparison with flat salaries, is Plan B more attractive to the sales force? To the company? Show calculations to support your answers. Phoenix-based CompTronics manufactures audio speakers for desktop computers. T he following data relate to the period just ended when the company produced and sold 42,000 speaker sets: Sales .................................................................................................................................................. $4,032,000 Variable costs ...................................................................................................................................... 1,008,000 Fixed costs .......................................................................................................................................... 2,736,000 Management is considering relocating its manufacturing facilities to northern Mexico to reduce costs. Variable costs are expected to average $21.60 per set; annual fixed costs are anticipated to be $2,380,800. (In the following requirements, ignore income taxes.) Required: 1. Calculate the company’s current income and determine the level of dollar sales needed to double that figure, assuming that manufacturing operations remain in the United States. 2. Determine the break-even point in speaker sets if operations are shifted to Mexico. 3. Assume that management desires to achieve the Mexican break-even point; however, operations will remain in the United States. a. If variable costs remain constant, what must management do to fixed costs? By how much must fixed costs change? b. If fixed costs remain constant, what must management do to the variable cost per unit? By how much must unit variable cost change? 4. Determine the impact (increase, decrease, or no effect) of the following operating changes. a. Effect of an increase in direct material costs on the break-even point. b. Effect of an increase in fixed administrative costs on the unit contribution margin. c. Effect of an increase in the unit contribution margin on net income. d. Effect of a decrease in the number of units sold on the break-even point. Hollywood Stars, Inc., owns and operates a nationwide chain of movie theaters. T he chain’s 450 prop- erties vary from low-volume, small-town, single-screen theaters to high-volume, urban, multiscreen theaters. The firm’s management is considering installing popcorn machines, which would allow the theaters to sell freshly popped corn rather than prepopped corn. The fresh popcorn will be sold for $3.50 per tub. The annual rental costs and the operating costs vary with the size of the popcorn machines. The machine capacities and costs are shown below. (Ignore income taxes.) Popper Model Standard Super Giant Annual capacity ...................................................................... 40,000 tubs 80,000 tubs 120,000 tubs Costs: Annual machine rental ........................................................ $16,000.00 $22,000.00 $40,000.00 Popcorn cost per tub ........................................................... .26 .26 .26 Other costs per tub ............................................................. 2.44 2.28 2.10 Cost of each tub ................................................................. .16 .16 .16 Required: 1. Calculate a theater’s break-even sales volume (measured in tubs of popcorn) for each model of popcorn popper. 2. Prepare a profit-volume graph for one theater’s popcorn sales, assuming that the Giant Popper is purchased. 3. Calculate the volume (in tubs) at which the Standard Popper and the Super Popper earn the same profit or loss in each movie theater. (CMA, adapted) ■ Problem 7–40 CVP Analysis; Impact of Operating Changes (LO 7-1, 7-4) 2. Break-even point: 32,000 units ■ Problem 7–41 Break-Even Analysis; Profit-Volume Graph; Movie Theaters (LO 7-1, 7-3, 7-4) 1. Break-even sales volume, standard: 25,000 tubs hiL25664_ch07_266-315.indd 305hiL25664_ch07_266-315.indd 305 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer 306 Chapter 7 Cost-Volume-Profit Analysis SkiCo, Inc., manufactures ski boots. The company’s projected income for the coming year, based on sales of 160,000 units, is as follows: Sales ..................................................................................................................................................... $16,000,000 Operating expenses: Variable expenses ....................................................................................................... $4,000,000 Fixed expenses ........................................................................................................... 6,000,000 Total expenses .................................................................................................................................... 10,000,000 Net income ............................................................................................................................................. $ 6,000,000 Required: In completing the following requirements, ignore income taxes. 1. Prepare a CVP graph for SkiCo, Inc., for the coming year. 2. Calculate the firm’s break-even point for the year in sales dollars. 3. What is the company’s margin of safety for the year? 4. Compute SkiCo’s operating leverage factor, based on the budgeted sales volume for the year. 5. Compute SkiCo’s required sales in dollars in order to earn income of $9,000,000 in the coming year. 6. Describe the firm’s cost structure. Calculate the percentage relationships between variable and fixed expenses and sales revenue. (CMA, adapted) PneumoTech, I nc. is studying the addition of a new valve to its product line. The valve would be used by manufacturers of pneumatic equipment. The company anticipates starting with a relatively low sales volume and then boosting demand over the next several years. A new salesperson must be hired because PneumoTech’s current sales force is working at capacity. Two compensation plans are under consideration: Plan A: An annual salary of $33,000 plus a 10% commission based on gross dollar sales. Plan B: An annual salary of $99,000 and no commission. PneumoTech, Inc. will purchase the valve for $75 and sell it for $120. Anticipated demand during the first year is 6,000 units. (In the following requirements, ignore income taxes.) Required: 1. Compute PneumoTech’s break-even point for Plan A and Plan B. 2. What is meant by the term operating leverage? 3. Analyze the cost structures of both plans at the anticipated demand of 6,000 units. Which of the two plans is more highly leveraged? Why? 4. Assume that a general economic downturn occurred during year 2, with product demand falling from 6,000 to 5,000 units. Determine the percentage decrease in company net income if Pneumo- Tech had adopted Plan A. 5. Repeat requirement (4) for Plan B. Compare Plan A and Plan B, and explain a major factor that underlies any resulting differences. 6. Briefly discuss the likely profitability impact of an economic recession for highly automated man- ufacturers. What can you say about the risk associated with these firms? Zodiac C ompany has decided to introduce a new product, which can be manufactured by either a computer- assisted manufacturing system or a labor-intensive production system. The manufacturing method will not affect the quality of the product. The estimated manufacturing costs by the two methods are as follows: Labor-Intensive Production System Computer-Assisted Manufacturing System Direct material ............................................ $8.40 $7.50 Direct labor ................................................ .8DLH @ $13.50 10.80 .5DLH @ $18.00 9.00 Variable overhead ....................................... .8DLH @ $9.00 7.20 .5DLH @ $9.00 4.50 Fixed overhead * .......................................... $1,980,000 $3,660,000 *These costs are directly traceable to the new product line. They would not be incurred if the new product were not produced. ■ Problem 7–42 CVP Graph; Cost Structure; Operating Leverage (LO 7-2, 7-3, 7-4, 7-8) 2. Break-even point: $8,000,000 ■ Problem 7–43 Leverage; Analysis of Operating Change (LO 7-1, 7-4, 7-8) 1. Plan B break-even point: 2,200 units ■ Problem 7–44 Break-Even Analysis; Operating Leverage; New Manufacturing Environment (LO 7-1, 7-8, 7-10) 1. Computer-assisted, contribu- tion margin per unit: $21.00 hiL25664_ch07_266-315.indd 306hiL25664_ch07_266-315.indd 306 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer Chapter 7 Cost-Volume-Profit Analysis 307 The company’s marketing research department has recommended an introductory unit sales price of $45. Selling expenses are estimated to be $750,000 annually plus $3 for each unit sold. (Ignore income taxes.) Required: 1. Calculate Zodiac’s estimated break-even point in annual unit sales of the new product if the company uses the ( a ) labor-intensive production system; ( b ) computer-assisted manufacturing system. 2. Determine the annual unit sales volume at which the firm would be indifferent between the two manufacturing methods. 3. Management must decide which manufacturing method to employ. One factor it should consider is operating leverage. Explain the concept of operating leverage. How is this concept related to Zodiac’s decision? 4. Describe the circumstances under which the firm should employ each of the two manufacturing methods. 5. Identify some business factors other than operating leverage that management should consider before selecting the manufacturing method. (CMA, adapted) Steven Clark and two of his colleagues are considering opening a law office in a large m etropolitan area that would make inexpensive legal services available to those who could not otherwise afford ser- vices. The intent is to provide easy access for their clients by having the office open 360 days per year, 16 hours each day from 7:00 a.m. to 11:00 p.m. The office would be staffed by a lawyer, paralegal, legal secretary, and clerk-receptionist for each of the two eight-hour shifts. In order to determine the feasibility of the project, Clark hired a marketing consultant to assist with market projections. The results of this study show that if the firm spends $980,000 on advertising the first year, the number of new clients expected each day will be 50. Clark and his associates believe this number is reasonable and are prepared to spend the $980,000 on advertising. Other pertinent informa- tion about the operation of the office follows: • The only charge to each new client would be $60 for the initial consultation. All cases that warrant further legal work will be accepted on a contingency basis with the firm earning 30 percent of any favorable settlements or judgments. Clark estimates that 20 percent of new client consultations will result in favorable settlements or judgments averaging $4,000 each. It is not expected that there will be repeat clients during the first year of operations. • The hourly wages of the staff are projected to be $50 for the lawyer, $40 for the paralegal, $30 for the legal secretary, and $20 for the clerk-receptionist. Fringe benefit expense will be 40 percent of the wages paid. A total of 400 hours of overtime is expected for the year; this will be divided equally between the legal secretary and the clerk-receptionist positions. Overtime will be paid at one and one-half times the regular wage, and the fringe benefit expense will apply to the full wage. • Clark has located 6,000 square feet of suitable office space which rents for $56 per square foot annually. Associated expenses will be $54,000 for property insurance and $74,000 for utilities. • It will be necessary for the group to purchase malpractice insurance, which is expected to cost $360,000 annually. • The initial investment in the office equipment will be $120,000. This equipment has an estimated useful life of four years. • The cost of office supplies has been estimated to be $8 per expected new client consultation. Required: 1. Determine how many new clients must visit the law office being considered by Steven Clark and his colleagues in order for the venture to break even during its first year of operations. 2. Compute the law firm’s safety margin. (CMA, adapted) ■ Problem 7–45 Break-Even Point; Safety Margin; Law Firm (LO 7-1, 7-4) 1. Total fixed expenses: $2,983,960 2. Break-even number of clients: 10,220 (rounded) hiL25664_ch07_266-315.indd 307hiL25664_ch07_266-315.indd 307 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer 308 Chapter 7 Cost-Volume-Profit Analysis Saturn Game C ompany manufactures computer games. Last year Saturn sold 25,000 games at $50 each. Total costs amounted to $1,050,000 of which $300,000 were considered fixed. In an attempt to improve its product, the company is considering replacing a component part that has a cost of $5 with a new and better part costing $9 per unit in the coming year. A new machine would also be needed to increase plant capacity. The machine would cost $36,000 with a useful life of six years and no salvage value. The company uses straight-line depreciation on all plant assets. (Ignore income taxes.) Required: 1. What was Saturn Game Company’s break-even point in number of units last year? 2. How many units of product would the company have had to sell in the last year to earn $280,000? 3. If management holds the sales price constant and makes the suggested changes, how many units of product must be sold in the coming year to break even? 4. If the firm holds the sales price constant and makes the suggested changes, how many units of product will the company have to sell to make the same net income as last year? 5. If Saturn Game Company wishes to maintain the same contribution-margin ratio, what selling price per unit of product must it charge next year to cover the increased direct-material cost? (CMA, adapted) Refer to t he original data given for Saturn Game Company in the preceding problem. An activity-based costing study has revealed that Saturn’s $300,000 of fixed costs include the following components: Setup (40 setups at $800 per setup) ............................................................................................................. $ 32,000 Engineering (500 hours at $50 per hour) ....................................................................................................... 25,000 Inspection (1,000 inspections at $60 per inspection) ...................................................................................... 60,000 General factory overhead .............................................................................................................................. 123,000 Total ........................................................................................................................................................ $240,000 Fixed selling and administrative costs ............................................................................................................ 60,000 Total fixed costs ....................................................................................................................................... $300,000 Management is considering the installation of new, highly automated manufacturing equipment that would significantly alter the production process. In addition, management plans a move toward just- intime inventory and production management. If the new equipment is installed, setups will be quicker and less expensive. Under the proposed JIT approach, there would be 300 setups per year at $100 per setup. Since a total quality control program would accompany the move toward JIT, only 100 inspec- tions would be anticipated annually, at a cost of $90 each. After the installation of the new production system, 800 hours of engineering would be required at a cost of $56 per hour. General factory overhead would increase to $332,200. However, the automated equipment would allow Saturn to cut its unit vari- able cost by 20 percent. Moreover, the more consistent product quality anticipated would allow manage- ment to raise the price of computer games to $52 per unit. (Ignore income taxes.) Required: 1. Upon seeing the ABC analysis given in the problem, Saturn Game Company’s vice president for manufacturing exclaimed to the controller, “I thought you told me this $300,000 cost was fixed. These don’t look like fixed costs at all. What you’re telling me now is that setup costs us $800 every time we set up a production run. What gives?” As Saturn’s controller, write a short memo explaining to the vice president what is going on. 2. Compute Saturn’s new break-even point if the proposed automated equipment is installed. 3. Determine how many units Saturn will have to sell to show a profit of $280,000, assuming the new technology is adopted. 4. If Saturn adopts the new manufacturing technology, will its break-even point be higher or lower? Will the number of sales units required to earn a profit of $280,000 be higher or lower? (Refer to your answers for the first two requirements of the preceding problem.) Are the results in this case consistent with what you would typically expect to find? Explain. ■ Problem 7–46 CVP Analysis of Changes in Sales Prices and Costs (LO 7-1, 7-2, 7-4) 1. Unit contribution margin: $20 3. New break-even point: 19,125 units ■ Problem 7–47 Continuation of Preceding Problem; Activity-Based Costing; Advanced Manufac- turing Systems; Ethical Issues (LO 7-1, 7-4, 7-9, 7-10) 2. Unit contribution margin: $28 3. Number of sales units required to earn target net profit: 27,000 units hiL25664_ch07_266-315.indd 308hiL25664_ch07_266-315.indd 308 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer Chapter 7 Cost-Volume-Profit Analysis 309 5. The decision as to whether to purchase the automated manufacturing equipment will be made by Saturn’s board of directors. In order to support the proposed acquisition, the vice president for manu- facturing asked the controller to prepare a report on the financial implications of the decision. As part of the report, the vice president asked the controller to compute the new break-even point, assuming the installation of the equipment. The controller complied, as in requirement (2) of this problem. When the vice president for manufacturing saw that the break-even point would increase, he asked the controller to delete the break-even analysis from the report. What should the controller do? Which ethical standards for managerial accountants are involved here? Central Pennsylvania Limestone Company produces thin limestone sheets used for cosmetic facing o n buildings. The following income statement represents the operating results for the year just ended. The company had sales of 1,800 tons during the year. The manufacturing capacity of the firm’s facilities is 3,000 tons per year. (Ignore income taxes.) CENTRAL PENNSYLVANIA LIMESTONE COMPANY Income Statement For the Year Ended December 31, 20x4 Sales .............................................................................................................................................. $1,800,000 Variable costs: Manufacturing ............................................................................................................................. $ 630,000 Selling costs ................................................................................................................................ 360,000 Total variable costs .................................................................................................................. $ 990,000 Contribution margin ......................................................................................................................... $ 810,000 Fixed costs: Manufacturing ............................................................................................................................. $ 200,000 Selling ........................................................................................................................................ 215,000 Administrative .............................................................................................................................. 80,000 Total fixed costs ....................................................................................................................... $ 495,000 Net income ...................................................................................................................................... $ 315,000 Required: 1. Calculate the company’s break-even volume in tons for 20x4. 2. If the sales volume is estimated to be 2,100 tons in the next year, and if the prices and costs stay at the same levels and amounts, what is the net income that management can expect for 20x5? 3. Central Pennsylvania Limestone has been trying to get a foothold in the European market. The company has a potential German customer that has offered to buy 1,500 tons at $900 per ton. Assume that all of the firm’s costs would be at the same levels and rates as in 20x4. What net income would the firm earn if it took this order and rejected some business from regular customers so as not to exceed capacity? 4. Central Pennsylvania Limestone plans to market its product in a new territory. Management esti- mates that an advertising and promotion program costing $123,000 annually would be needed for the next two or three years. In addition, a $50 per ton sales commission to the sales force in the new territory, over and above the current commission, would be required. How many tons would have to be sold in the new territory to maintain the firm’s current net income? Assume that sales and costs will continue as in 20x4 in the firm’s established territories. 5. Management is considering replacing its labor-intensive process with an automated production system. This would result in an increase of $117,000 annually in fixed manufacturing costs. The variable manufacturing costs would decrease by $50 per ton. Compute the new break-even volume in tons and in sales dollars. 6. Ignore the facts presented in requirement (5). Assume that management estimates that the selling price per ton would decline by 10 percent next year. Variable costs would increase by $80 per ton, and fixed costs would not change. What sales volume in dollars would be required to earn a net income of $189,000 next year? (CMA, adapted) ■ Problem 7–48 CVP Relationships; Interna- tional Business; Automation (LO 7-1, 7-4, 7-10) 1. Break-even volume in tons: 1,100 5. Break-even point in tons: 1,224 hiL25664_ch07_266-315.indd 309hiL25664_ch07_266-315.indd 309 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer 310 Chapter 7 Cost-Volume-Profit Analysis Toledo Tool Company (TTC) manufactures a line of electric garden tools that are s old in general hard- ware stores. The company’s controller, Will Fulton, has just received the sales forecast for the coming year for TTC’s three products: hedge clippers, line trimmers, and leaf blowers. TTC has experienced considerable variations in sales volumes and variable costs over the past two years, and Fulton believes the forecast should be carefully evaluated from a cost-volume-profit viewpoint. The preliminary budget information for 20x4 follows: Hedge Clippers Line Trimmers Leaf Blowers Unit sales .............................................................................. 50,000 50,000 100,000 Unit selling price .................................................................... $84 $108 $144 Variable manufacturing cost per unit ....................................... 39 36 75 Variable selling cost per unit ................................................... 15 12 18 For 20x4, TTC’s fixed manufacturing overhead is budgeted at $6,000,000, and the company’s fixed selling and administrative expenses are forecasted to be $1,800,000. TTC has a tax rate of 40 percent. Required: 1. Determine TTC Company’s budgeted net income for 20x4. 2. Assuming the sales mix remains as budgeted, determine how many units of each product TTC must sell in order to break even in 20x4. 3. After preparing the original estimates, management determined that its variable manufacturing cost of leaf blowers would increase by 20 percent, and the variable selling cost of line trimmers could be expected to increase by $3 per unit. However, management has decided not to change the selling price of either product. In addition, management has learned that its leaf blower has been perceived as the best value on the market, and it can expect to sell three times as many leaf blow- ers as each of its other products. Under these circumstances, determine how many units of each product TTC would have to sell in order to break even in 20x4. (CMA, adapted) The Asian D ivision of Worldwide Reference Corporation produces a pocket dictionary containing popular phrases in six Asian languages. Annual budget data for the coming year follow. Projected sales are 100,000 books. Sales ....................................................................................................................................................... $2,000,000 Costs: Variable Fixed Direct material ........................................................................................ $ 600,000 $ –0– Direct labor ............................................................................................ 400,000 –0– Manufacturing overhead ......................................................................... 300,000 200,000 Selling and administrative ....................................................................... 100,000 220,000 Total costs .......................................................................................... $1,400,000 $420,000 1,820,000 Budgeted operating income ....................................................................................................................... $ 180,000 Required: 1. Calculate the break-even point in units and in sales dollars. 2. If the Asian Division is subject to an income-tax rate of 40 percent, compute the number of units the division would have to sell to earn an after-tax profit of $180,000. 3. If fixed costs increased $63,000 with no other cost or revenue factor changing, compute the divi- sion’s break-even sales in units. 4. Assuming the original data, prepare a profit-volume graph for the Asian Division. 5. Due to an unstable political situation in the country in which the Asian Division is located, man- agement believes the country may split into two independent nations. If this happens, the tax rate could rise to 50 percent. Assuming all other data as in the original problem, how many pocket dic- tionaries must be sold to earn $180,000 after taxes? 6. Build a spreadsheet: Construct an Excel spreadsheet to solve requirements (1), (2), (3), and (5) above. Show how the solution will change if the following information changes: sales amounted to $2,100,000, and fixed manufacturing overhead was $220,000. (CMA, adapted) ■ Problem 7–49 CVP; Multiple Products; Changes in Costs and Sales Mix (LO 7-4, 7-5) 2. Weighted-average unit contribution margin: $48.00 3. Total unit sales to break even: 200,000 units ■ Problem 7–50 Break-Even Point; After-Tax Net Income; Profit-Volume Graph; International Issues (Appendix) (LO 7-1, 7-2, 7-3, 7-4, 7-11) 1(b). Break-even point: $1,400,000 3. Break-even point: 80,500 units Ex hiL25664_ch07_266-315.indd 310hiL25664_ch07_266-315.indd 310 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer Chapter 7 Cost-Volume-Profit Analysis 311 Great Northern Ski Company r e cently expanded its manufacturing capacity. The firm will now be able to produce up to 15,000 pairs of cross-country skis of either the mountaineering model or the touring model. The sales department assures management that it can sell between 9,000 and 13,000 units of either product this year. Because the models are very similar, the company will produce only one of the two models. The following information was compiled by the accounting department. Model Touring Mountaineering Selling price per unit ................................................................................................... $132.00 $120.00 Variable costs per unit ................................................................................................. 79.20 79.20 Fixed costs will total $554,400 if the touring model is produced but will be only $475,200 if the mountaineering model is produced. Great Northern Ski Company is subject to a 40 percent income tax rate. (Round each answer to the nearest whole number.) Required: 1. Compute the contribution-margin ratio for the mountaineering model. 2. If Great Northern Ski Company desires an after-tax net income of $33,120, how many pairs of mountaineering skis will the company have to sell? 3. How much would the variable cost per unit of the mountaineering model have to change before it had the same break-even point in units as the touring model? 4. Suppose the variable cost per unit of mountaineering skis decreases by 10 percent, and the total fixed cost of mountaineering skis increases by 10 percent. Compute the new break-even point. 5. Suppose management decided to produce both products. If the two models are sold in equal pro- portions, and total fixed costs amount to $514,800, what is the firm’s break-even point in units? (CMA, adapted) Seattle Telecom, Inc. manufactures telecommunications equipment. The company has always b een pro- duction oriented and sells its products through agents. Agents are paid a commission of 15 percent of the selling price. Seattle Telecom’s budgeted income statement for 20x5 follows: SEATTLE TELECOM, INC. Budgeted Income Statement For the Year Ended December 31, 20x5 (in thousands) Sales ........................................................................................................................ $24,000 Manufacturing costs: Variable ................................................................................................................. $10,800 Fixed overhead ...................................................................................................... 3,510 14,310 Gross margin ............................................................................................................. $ 9,690 Selling and administrative expenses: Commissions ......................................................................................................... $ 3,600 Fixed marketing expenses ...................................................................................... 210 Fixed administrative expenses ................................................................................ 2,670 6,480 Net operating income ................................................................................................. $ 3,210 Less fixed interest expense ......................................................................................... 810 Income before income taxes ....................................................................................... $ 2,400 Less income taxes (30%) ........................................................................................... 720 Net income ................................................................................................................ $ 1,680 After the profit plan was completed for the coming year, Seattle Telecom’s sales agents demanded that the commissions be increased to 22½ percent of the selling price. This demand was the latest in a series of actions that Vinnie McGraw, the company’s president, believed had gone too far. He asked Dana Massa, the most sales-oriented officer in his production-oriented company, to estimate the cost to Seattle Telecom of employing its own sales force. Massa’s estimate of the additional annual cost of ■ Problem 7–51 Cost-Volume-Profit Analysis with Income Taxes and Multiple Products (Appendix) (LO 7-1, 7-2, 7-4, 7-5, 7-11) 1. Contribution margin ratio: .34 4. New break-even point: 10,729 units (rounded) ■ Problem 7–52 CVP Analysis; Marketing Decisions; Income Taxes (Appendix) (LO 7-1, 7-2, 7-4, 7-11) 1(a). Contribution margin ratio: .40 2. Required sales dollars to break even: $29,538,462 (rounded) hiL25664_ch07_266-315.indd 311hiL25664_ch07_266-315.indd 311 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer 312 Chapter 7 Cost-Volume-Profit Analysis employing its own sales force, exclusive of commissions, follows. Sales personnel would receive a com- mission of 10 percent of the selling price in addition to their salary. Estimated Annual Cost of Employing a Company Sales Force (in thousands) Salaries: Sales manager ........................................................................................................................................... $ 150 Sales personnel .......................................................................................................................................... 1,500 Travel and entertainment ................................................................................................................................. 600 Fixed marketing costs ..................................................................................................................................... 1,350 Total ............................................................................................................................................................... $3,600 Required: 1. Calculate Seattle Telecom’s estimated break-even point in sales dollars for 20x5. a. If the events that are represented in the budgeted income statement take place. b. If the company employs its own sales force. 2. If Seattle Telecom continues to sell through agents and pays the increased commission of 22½ percent of the selling price, determine the estimated volume in sales dollars for 20x5 that would be required to generate the same net income as projected in the budgeted income statement. 3. Determine the estimated volume in sales dollars that would result in equal net income for 20x5 regardless of whether the company continues to sell through agents and pays a commission of 22½ percent of the selling price or employs its own sales force. (CMA, adapted) Columbus C a nopy Company (CCC) manufactures and sells adjustable canopies that attach to motor homes and trailers. The market covers both new units as well as replacement canopies. CCC developed its 20x4 business plan based on the assumption that canopies would sell at a price of $800 each. The variable cost of each canopy is projected at $400, and the annual fixed costs are budgeted at $200,000. CCC’s after-tax profit objective is $480,000; the company’s tax rate is 40 percent. While CCC’s sales usually rise during the second quarter, the May financial statements reported that sales were not meeting expectations. For the first five months of the year, only 350 units had been sold at the established price, with variable costs as planned. It was clear the 20x4 after-tax profit projec- tion would not be reached unless some actions were taken. CCC’s president, Melanie Grand, assigned a management committee to analyze the situation and develop several alternative courses of action. The following mutually exclusive alternatives were presented to the president. • Reduce the sales price by $80. The sales organization forecasts that with the significantly reduced sales price, 2,700 units can be sold during the remainder of the year. Total fixed and variable unit costs will stay as budgeted. • Lower variable costs per unit by $50 through the use of less expensive raw materials and slightly modified manufacturing techniques. The sales price would also be reduced by $60, and sales of 2,200 units for the remainder of the year are forecast. • Cut fixed costs by $20,000 and lower the sales price by 5 percent. Variable costs per unit will be unchanged. Sales of 2,000 units are expected for the remainder of the year. Required: 1. If no changes are made to the selling price or cost structure, determine the number of units that Columbus Canopy Company must sell: a. In order to break even. b. To achieve its after-tax profit objective. 2. Determine which one of the alternatives management should select to achieve its annual after-tax profit objective. (CMA, adapted) ■ Problem 7–53 CVP Analysis with Production and Marketing Decisions; Taxes (Appendix) (LO 7-1, 7-4, 7-11) 1(a). Break-even point: 500 units hiL25664_ch07_266-315.indd 312hiL25664_ch07_266-315.indd 312 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer Chapter 7 Cost-Volume-Profit Analysis 313 Cases Susquehanna Medical Center operates a general hospital in northeastern Pennsylvania. The m edical center also rents space and beds to separately owned entities rendering specialized services, such as Pediatrics and Psychiatric Care. Susquehanna charges each separate entity for common services, such as patients’ meals and laundry, and for administrative services, such as billings and collections. Space and bed rentals are fixed charges for the year, based on bed capacity rented to each entity. Susquehanna Medical Center charged the following costs to Pediatrics for the year ended June 30, 20x5: Patient Days (variable) Bed Capacity (fixed) Dietary ....................................................................................... $ 720,000 — Janitorial .................................................................................... — $ 84,000 Laundry ...................................................................................... 360,000 — Laboratory .................................................................................. 540,000 — Pharmacy ................................................................................... 420,000 — Repairs and maintenance ............................................................ — 36,000 General and administrative .......................................................... — 1,560,000 Rent ........................................................................................... — 1,800,000 Billings and collections ................................................................ 360,000 — Total ....................................................................................... $2,400,000 $3,480,000 During the year ended June 30, 20x5, Pediatrics charged each patient an average of $360 per day, had a capacity of 60 beds, and had revenue of $7.2 million for 365 days. In addition, Pediatrics directly employed personnel with the following annual salary costs per employee: supervising nurses, $30,000; nurses, $24,000; and aides, $10,800. Susquehanna Medical Center has the following minimum departmental personnel requirements, based on total annual budgeted patient days: Annual Patient Days Supervising Nurses Nurses Aides Up to 22,000 .......................................................................................... 4 10 20 22,001 to 26,000 ................................................................................... 5 14 25 26,001 to 29,200 ................................................................................... 5 16 31 Pediatrics always employs only the minimum number of required personnel. Salaries of supervis- ing nurses, nurses, and aides are therefore fixed within ranges of annual patient days. Pediatrics operated at 100 percent capacity on 90 days during the year ended June 30, 20x5. Administrators estimate that on these 90 days, Pediatrics could have filled another 20 beds above capac- ity. Susquehanna Medical Center has an additional 20 beds available for rent for the year ending June 30, 20x6. Such additional rental would increase Pediatrics’ fixed charges based on bed capacity. (In the following requirements, ignore income taxes.) Required: 1. Calculate the minimum number of patient days required for Pediatrics to break even for the year ending June 30, 20x6, if the additional 20 beds are not rented. Patient demand is unknown, but assume that revenue per patient day, cost per patient day, cost per bed, and salary rates will remain the same as for the year ended June 30, 20x5. 2. Assume that patient demand, revenue per patient day, cost per patient day, cost per bed, and sal- ary rates for the year ending June 30, 20x6, remain the same as for the year ended June 30, 20x5. Prepare a schedule of Pediatrics’ increase in revenue and increase in costs for the year ending June 30, 20x6. Determine the net increase or decrease in Pediatrics’ earnings from the additional 20 beds if Pediatrics rents this extra capacity from Susquehanna Medical Center. (CPA, adapted) Lake Champlain Sporting Goods Company, a wholesale supply company, engages i ndependent sales agents to market the company’s products throughout New York and Ontario. These agents currently receive a commission of 20 percent of sales, but they are demanding an increase to 25 percent of sales made during the year ending December 31, 20x4. The controller already prepared the 20x4 budget before learning of the agents’ demand for an increase in commissions. The budgeted 20x4 income state- ment is shown below. Assume that cost of goods sold is 100 percent variable cost. ■ Case 7–54 Break-Even Analysis; Hospital CVP Relationships (LO 7-1, 7-4) 1. Contribution margin per patient-day: $240 2. Fixed charges by medical center: $1,160,000 ■ Case 7–55 Sales Commissions in a Wholesale Firm; Income Taxes (Appendix) (LO 7-1, 7-2, 7-4, 7-11) 1. Break-even point: $750,000 3. Contribution-margin ratio: .15 Ex hiL25664_ch07_266-315.indd 313hiL25664_ch07_266-315.indd 313 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer 314 Chapter 7 Cost-Volume-Profit Analysis LAKE CHAMPLAIN SPORTING GOODS COMPANY Budgeted Income Statement For the Year Ended December 31, 20x4 Sales ..................................................................................................................................................... $15,000,000 Cost of goods sold .................................................................................................................................. 9,000,000 Gross margin .......................................................................................................................................... $ 6,000,000 Selling and administrative expenses: Commissions .......................................................................................................... $3,000,000 All other expenses (fixed) ......................................................................................... 150,000 3,150,000 Income before taxes ........................................................................................................................... $ 2,850,000 Income tax (30%) ............................................................................................................................... 855,000 Net Income ......................................................................................................................................... $ 1,995,000 The company’s management is considering the possibility of employing full-time sales personnel. Three individuals would be required, at an estimated annual salary of $45,000 each, plus commissions of 5 percent of sales. In addition, two sales managers would be employed at fixed annual salaries of $120,000 each. All other fixed costs, as well as the variable cost percentages, would remain the same as the estimates in the 20x4 budgeted income statement. Required: 1. Compute Lake Champlain Sporting Goods’ estimated break-even point in sales dollars for the year ending December 31, 20x4, based on the budgeted income statement prepared by the controller. 2. Compute the estimated break-even point in sales dollars for the year ending December 31, 20x4, if the company employs its own sales personnel. 3. Compute the estimated volume in sales dollars that would be required for the year ending December 31, 20x4, to yield the same net income as projected in the budgeted income statement, if management continues to use the independent sales agents and agrees to their demand for a 25 percent sales commission. 4. Compute the estimated volume in sales dollars that would generate an identical net income for the year ending December 31, 20x4, regardless of whether Lake Champlain Sporting Goods Company employs its own sales personnel or continues to use the independent sales agents and pays them a 25 percent commission. (CPA, adapted) hiL25664_ch07_266-315.indd 314hiL25664_ch07_266-315.indd 314 7/4/13 3:15 AM7/4/13 3:15 AM Final PDF to printer This page intentionally left blank 8 THIS CHAPTER’S FOCUS COMPANY is FitDat.com , a designer and manufacturer of fitness monitors that operate by sending data to a smartphone during exer- cise. FitDat.com promotes its product in fitness magazines and online, and virtually all of its sales are Web-based. In the first half of this chapter, we explore two product-costing meth- ods, called absorption costing and variable costing. Under absorption costing, all manu- facturing costs, including fixed manufacturing overhead, are assigned as product costs and stored in inventory until the products are sold. Under variable costing, fixed manu- facturing overhead is not included in inventory as a product cost. Instead, fixed manufac- turing overhead is treated as a period cost, and it is expensed during the period in which it is incurred. The choice between absorption and variable costing arises only in manufacturing firms. FOCUS COMPANY >>>
Variable Costing and
the Costs of Quality
and Sustainability
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<<< IN CONTRAST In contrast to the absorption and variable costing systems discussed in the first part of the chapter, we turn our attention in the remainder of the chapter to two important topics related to costing and production. Again using the illustration of FitDat.com , we explore the measurement of quality costs in the production of products and services. The chapter concludes with a discussion of the costs of environmental sustain- ability. As a company that markets to health-conscious consumers, FitDat.com needs to be especially aware of the environmental impact of its operations and to incorporate the costs of sustainability in its decision making. hiL25664_ch08_316-349.indd 317hiL25664_ch08_316-349.indd 317 7/4/13 2:18 AM7/4/13 2:18 AM Final PDF to printer 318 Income is one of many important measures used by managers to make decisions and evaluate operational performance. In a manufacturing firm, two alternative account- ing treatments of fixed manufacturing overhead can result in different reported income amounts for the company. The difference in reported income can alter management’s view of the profitability of a particular decision or segment of the company. In Section 1 of this chapter, we will examine these alternative accounting methods, called absorption costing and variable costing. 1 In Sections 2 and 3 of the chapter, we will cover two additional costing issues that are taking on ever greater importance in managing any enterprise. Assessing and report- ing the costs of assuring quality in a company’s products or services is important as companies increasingly compete in a global market to sell their goods and services. And measuring and managing the costs of environmental sustainability has become one of the most important and challenging objectives for organizations of all types. 2 Section 1: Absorption and Variable Costing In the product-costing systems we have studied so far, manufacturing overhead is applied to Work-in-Process Inventory as a product cost along with direct material and direct labor. When the manufactured goods are finished, these product costs flow from Work-in- Process Section 1: Absorption and Variable Costing After completing this chapter, you should be able to: 8-1 Explain the accounting treatment of fixed manufacturing overhead under absorption and variable costing. 8-2 Prepare an income statement under absorption costing. 8-3 Prepare an income statement under variable costing. 8-4 Reconcile reported income under absorption and variable costing. 8-5 Explain the implications of absorption and variable costing for cost-volume-profit analysis. 8-6 Evaluate absorption and variable costing. 8-7 Prepare a quality-cost report. 8-8 Discuss two contrasting views of the optimal level of product quality. 8-9 Understand the different types of environmental costs, and discuss the management of these costs. 1 Section 1, which covers absorption and variable costing, is written as a module, and it can be studied separately from the rest of the chapter. This material may be studied after the completion of Chapter 3. 2 Sections 2 and 3, which cover the costs of quality assurance and environmental sustainability, respectively, are also written as modules, and each can be studied separately from the rest of the chapter. The material in these two sec- tions can be studied after the completion of Chapter 2. hiL25664_ch08_316-349.indd 318hiL25664_ch08_316-349.indd 318 7/4/13 2:18 AM7/4/13 2:18 AM Final PDF to printer Chapter 8 Variable Costing and the Costs of Quality and Sustainability 319 Since the costs of production are stored in inventory accounts until the goods are sold, these costs are said to be inventoried costs. Fixed Manufacturing Overhead: The Key In our study of product-costing systems, we have included both variable and fixed manu- facturing overhead in the product costs that flow through the manufacturing accounts. This approach to product costing is called absorption costing (or full costing ) , because all manufacturing-overhead costs are applied to (or absorbed by) manufactured goods. We now introduce an alternative approach to product costing called variable costing ( or direct costing ) , in which only variable manufacturing overhead is applied to Work- in-Process Inventory as a product cost. The distinction between absorption and variable costing is summarized in Exhibit 8–1 . Notice that the distinction involves the timing with which fixed manufacturing overhead becomes an expense. Under variable costing, fixed overhead is expensed immediately, as it is incurred. Under absorption costing, fixed overhead is inventoried until the account- ing period during which the manufactured goods are sold. But under both approaches, fixed overhead is eventually expensed. Work-in-Process Inventory Finished-Goods Inventory Cost of Goods Sold when goods are finished Direct material Direct labor Manufacturing overhead when goods are sold Inventory into Finished-Goods Inventory. Finally, during the accounting period when the goods are sold, the product costs flow from Finished-Goods Inventory into Cost of Goods Sold, an expense account. The following diagram summarizes this flow of costs. Learning Objective 8-1 Explain the accounting treatment of fixed manufacturing overhead under absorption and variable costing. Exhibit 8–1 Absorption versus Variable Costing Fixed manufacturing overhead Direct material Direct labor All manufacturing overhead when costs are incurred Work-in- Process Inventory on Balance Sheet when goods are finished Finished- Goods Inventory on Balance Sheet when goods are sold Expense on Income Statement Expense on Income Statement when costs are incurred when costs are incurred Work-in- Process Inventory on Balance Sheet when goods are finished Finished- Goods Inventory on Balance Sheet when goods are sold Expense on Income Statement B. Variable Costing A. Absorption Costing Direct material Direct labor Variable manufacturing overhead hiL25664_ch08_316-349.indd 319hiL25664_ch08_316-349.indd 319 7/4/13 2:18 AM7/4/13 2:18 AM Final PDF to printer 320 Chapter 8 Variable Costing and the Costs of Quality and Sustainability Illustration of Absorption and Variable Costing FitDat.com began operations on January 1, 20x0, to manufacture its electronic per- sonal fitness monitors. Cost, production, and sales data for the first three years of FitDat.com’s operations are given in Exhibit 8–2 . Comparative income statements for 20x0, 20x1, and 20x2 are presented in Exhibit 8–3 , using both absorption and variable costing. Absorption-Costing Income Statements Examine the absorption-costing income statements in the upper half of Exhibit 8–3 . Two fea- tures of these income statements are highlighted in the left-hand margin. First, notice that the Cost of Goods Sold expense for each year is determined by multiplying the year’s unit sales by the absorption manufacturing cost per unit, $36. Included in the $36 cost per unit is the predetermined fixed manufac- turing-overhead cost of $12 per unit. Second, notice that on FitDat.com’s absorption- costing income statements, the only period expenses are the selling and administrative expenses. There is no deduc- tion of fixed-overhead costs as a lump-sum period expense at the bottom of each income statement. As mentioned above, fixed manufacturing-overhead costs are included in Cost of Goods Sold on these absorption- costing income statements. Exhibit 8–2 Data for Illustration: FitDat.com 20x0 20x1 20x2 Production and inventory data: Planned production (in units) ........................................................ 50,000 50,000 50,000 Finished-goods inventory (in units), January 1 ............................... –0– –0– 15,000 Actual production (in units) ........................................................... 50,000 50,000 50,000 Sales (in units) ............................................................................. 50,000 35,000 65,000 Finished-goods inventory (in units), December 31 .......................... –0– 15,000 –0– Revenue and cost data, all three years: Sales price per unit ............................................................................................................................ $48 Manufacturing costs per unit: Direct material .............................................................................................................................. $12 Direct labor ................................................................................................................................... 8 Variable manufacturing overhead ................................................................................................. . . 4 Total variable cost per unit ............................................................................................................. $24 12 $36 Variable selling and administrative cost per unit ....................................................................................... $ 4 Fixed selling and administrative cost per year .......................................................................................... $100,000 *Planned annual production of 50,000 units is management’s estimate of the company’s practical capacity for production. .......................... ............................. Fixed manufacturing overhead: Budgeted annual fixed overhead _______________________ Planned annual production* Total absorption cost per unit Used only under absorption costing $600,000 ________ 50,000 ............................................................................... Pictured here is a Kawasaki machine that presses steel at a heavy-duty truck factory in Ma’anshan, China. The fixed costs of operating this manu- facturing plant include such costs as the depreciation on plant and equipment, prop- erty taxes, insurance, and the salary of the plant manager. Under absorption costing, these costs are treated as product costs and included in the cost of inventory. But under variable costing, these costs are expensed during the period incurred. Learning Objective 8-2 Prepare an income statement under absorption costing. ⎧ ⎨ ⎩ hiL25664_ch08_316-349.indd 320hiL25664_ch08_316-349.indd 320 7/4/13 2:18 AM7/4/13 2:18 AM Final PDF to printer Chapter 8 Variable Costing and the Costs of Quality and Sustainability 321 Variable-Costing Income Statements Now examine the income statements based on variable costing in the lower half of Exhibit 8–3 . Notice that the format of the statements is different from the format used in the absorption-costing statements. In the variable-costing statements, the contribu- tion format introduced in Chapter 7 is used to highlight the separation of variable and fixed costs. Let’s focus on the same two aspects of the variable-costing statements that we discussed for the absorption-costing statements. First, the manufacturing expenses subtracted from sales revenue each year include only the variable manu- facturing costs, which amount to $24 per unit. Second, fixed manufacturing over- head is subtracted as a lump-sum period expense at the bottom of each year’s income statement. Reconciling Income under Absorption and Variable Costing Examination of Exhibit 8–3 reveals that the income reported under absorption and vari- able costing is sometimes different. Although income is the same for the two product- costing methods in 20x0, it is different in 20x1 and 20x2. Let’s figure out why these results occur. No Change in Inventory In 20x0 there is no change in inventory over the course of the year. Beginning and ending inventory are the same, because actual production and sales are the same. Think about the implications of the stable inventory level for the treat- ment of fixed manufacturing overhead. On FitDat.com’s variable-costing statement, the Learning Objective 8-3 Prepare an income statement under variable costing FITDAT.COM Absorption-Costing Income Statement 20x0 20x1 20x2 Sales revenue (at $48 per unit) ..................................... $2,400,000 $1,680,000 $3,120,000 1 Less: Cost of goods sold (at absorption cost of $36 per unit) ................................ 1,800,000 1,260,000 2,340,000 Gross margin ............................................................... $ 600,000 $ 420,000 $ 780,000 Less: Selling and administrative expenses: 2 No fixed overhead Variable (at $4 per unit) ............................................ 200,000 140,000 260,000 Fixed ....................................................................... 100,000 100,000 100,000 Operating income ............................................................ $ 300,000 $ 180,000 $ 420,000 Exhibit 8–3 Income Statements under Absorption and Variable Costing Learning Objective 8-4 Reconcile reported income under absorption and variable costing. FITDAT.COM Variable-Costing Income Statement 20x0 20x1 20x2 Sales revenue (at $48 per unit) ..................................... $2,400,000 $1,680,000 $3,120,000 Less: Variable expenses: 1 Variable manufacturing costs (at variable cost of $24 per unit) ........................... 1,200,000 840,000 1,560,000 Variable selling and administrative costs (at $4 per unit) ........................................... 200,000 140,000 260,000 Contribution margin ..................................................... $1,000,000 $ 700,000 $1,300,000 Less: Fixed expenses: 2 Fixed manufacturing overhead ................................. 600,000 600,000 600,000 Fixed selling and administrative expenses 100,000 100,000 100,000 Operating income ........................................................ $ 300,000 $ 0 $ 600,000 hiL25664_ch08_316-349.indd 321hiL25664_ch08_316-349.indd 321 7/4/13 2:18 AM7/4/13 2:18 AM Final PDF to printer 322 Chapter 8 Variable Costing and the Costs of Quality and Sustainability $600,000 of fixed manufacturing overhead incurred during 20x0 is an expense in 20x0. Under absorption costing, however, fixed manufacturing overhead was applied to produc- tion at the predetermined rate of $12 per unit. Since all of the units produced in 20x0 also were sold in 20x0, all of the fixed manufacturing-overhead cost flowed through into Cost of Goods Sold. Thus, $600,000 of fixed manufacturing overhead was expensed in 20x0 under absorption costing also. The 20x0 column of Exhibit 8–4 reconciles the 20x0 operating income reported under absorption and variable costing. The reconciliation focuses on the two places in the income statements where differences occur between absorption and variable costing. The numbers in the left-hand margin of Exhibit 8–4 correspond to the numbers in the left-hand margin of the income statements in Exhibit 8–3 . Increase in Inventory In 20x1, inventory increased from zero on January 1 to 15,000 units on December 31. The increase in inventory was the result of production exceeding sales. Under variable costing, the $600,000 of fixed overhead cost incurred in 20x1 is expensed, just as it was in 20x0. Under absorption costing, however, only a portion of the 20x1 fixed manufacturing overhead is expensed in 20x1. Since the fixed overhead is inven- toried under absorption costing, some of this cost remains in inventory at the end of 20x1. The 20x1 column of Exhibit 8–4 reconciles the 20x1 operating income reported under absorption and variable costing. As before, the reconciliation focuses on the two places in the income statements where differences occur between absorption and variable costing. Decrease in Inventory In 20x2, inventory decreased from 15,000 units to zero. Sales during the year exceeded production. As in 20x0 and 20x1, under variable costing, the $600,000 of fixed manufacturing overhead incurred in 20x2 is expensed in 20x2. Under absorption costing, however, more than $600,000 of fixed overhead is expensed in 20x2. Why? Because some of the fixed overhead incurred during the prior year, which was inventoried then, is now expensed in 20x2 as the goods are sold. The 20x2 column of Exhibit 8–4 reconciles the 20x2 income under absorption and variable costing. Once again, the numbers on the left-hand side of Exhibit 8–4 corre- spond to those on the left-hand side of the income statements in Exhibit 8–3 . A Shortcut to Reconciling Income When inventory increases or decreases during the year, reported income differs under absorption and variable costing. This results from the fixed overhead that is inventoried under absorption costing but expensed immediately under variable costing. The following formula may be used to compute the difference in the amount of fixed overhead expensed in a given time period under the two product-costing methods. 3 3 This approach assumes that the predetermined fixed-overhead rate per unit does not change across time periods. 20x0 20x1 20x2 1 Cost of goods sold under absorption costing ............................ $1,800,000 $1,260,000 $2,340,000 1 Variable manufacturing costs under variable costing ................. 1,200,000 840,000 1,560,000 Subtotal ................................................................................. $ 600,000 $ 420,000 $ 780,000 2 Fixed manufacturing overhead as period expense under variable costing ........................................... 600,000 600,000 600,000 Total $ 0 $ (180,000) $ 180,000 Operating income under variable costing .................................. $ 300,000 $ 0 $ 600,000 Operating income under absorption costing .............................. 300,000 180,000 420,000 Difference in operating income ................................................ $ 0 $ (180,000) $ 180,000 Exhibit 8–4 Reconciliation of Income under Absorption and Variable Costing: FitDat.com “Another factor making inventory management more difficult has been growing globalization. . . . Corning Inc. last month said that it slashed production and cut wholesale prices on the big sheets of glass it makes for flat-panel televi- sions because of bloated inventories—not at Corning, but at companies further up the supply chain.” (8a) Corning Inc. hiL25664_ch08_316-349.indd 322hiL25664_ch08_316-349.indd 322 7/4/13 2:18 AM7/4/13 2:18 AM Final PDF to printer Chapter 8 Variable Costing and the Costs of Quality and Sustainability 323 Difference in fixed overhead expensed under absorption and variable costing 5 ( Change in inventory, in units ) 3 ( Predetermined fixed-overhead rate per unit ) As the following table shows, this difference in the amount of fixed overhead expensed explains the difference in reported income under absorption and variable costing. Year Change in Inventory (in units) Predetermined Fixed-Overhead Rate Difference in Fixed Overhead Expensed Absorption-Costing Income Minus Variable-Costing Income 20x0 ............. –0– 3 $12 5 –0– 5 –0– 20x1 ............. 15,000 increase 3 $12 5 $ 180,000 5 $ 180,000 20x2 ............. 15,000 decrease 3 $12 5 $(180,000) 5 $(180,000) Length of Time Period The discrepancies between absorption-costing and variable- costing income in Exhibit 8–3 occur because of the changes in inventory levels during 20x1 and 20x2. It is common for production and sales to differ over the course of a week, month, or year. Therefore, the income measured for those time periods often will differ between absorption and variable costing. This discrepancy is likely to be smaller over longer time periods. Over the course of a decade, for example, FitDat.com cannot sell much more or less than it produces. Thus, the income amounts under the two product- costing methods, when added together over a lengthy time period, will be approximately equal under absorption and variable costing. Notice in Exhibit 8–3 that FitDat.com total income over the three-year period is $900,000 under both absorption and variable costing. This results from the fact that the company produced and sold the same total amount over the three-year period. Cost-Volume-Profit Analysis One of the tools used by managers to plan and control business operations is cost- volume- profit analysis, which we studied in Chapter 7. FitDat.com’s break-even point in units can be computed as follows: Break-even point 5 Fixed costs _____________________ Unit contribution margin 5 $600,000 1 $100,000 _________________ $48 2 $24 2 $4 5 $700,000 ________ $20 5 35,000 units If FitDat.com sells 35,000 fitness monitors, income should be zero, as Exhibit 8–5 confirms. Notice that at the break-even point, $1,680,000 is both the total revenue (35,000 units 3 $48 price/unit) and total cost ($700,000 fixed cost plus variable cost of 35,000 units 3 $28 per unit). Now return to Exhibit 8–3 and examine the 20x1 income statements under absorption and variable costing. In 20x1, FitDat.com sold 35,000 units, the break-even volume. This fact is confirmed on the variable-costing income statement, since operating income is zero. On the absorption-costing income statement, however, the 20x1 operating income is $180,000. What has happened here? The answer to this inconsistency lies in the different treatment of fixed manufac- turing overhead under absorption and variable costing. Variable costing highlights the separation between fixed and variable costs, as do cost-volume-profit analysis and break- even calculations. Both of these techniques account for fixed manufacturing overhead as a lump sum. In contrast, absorption costing is inconsistent with CVP analysis, because fixed overhead is applied to goods as a product cost on a per-unit basis. Learning Objective 8-5 Explain the implications of absorption and variable costing for cost-volume-profit analysis. hiL25664_ch08_316-349.indd 323hiL25664_ch08_316-349.indd 323 7/4/13 2:18 AM7/4/13 2:18 AM Final PDF to printer 324 Chapter 8 Variable Costing and the Costs of Quality and Sustainability Exhibit 8–5 Break-Even Graph: FitDat.com Dollars Sales volume in units $700,000 $1,680,000 35,000 units Variable cost (at 35,000 units) Total cost Break-even point Sales revenue Fixed cost Evaluation of Absorption and Variable Costing Some managers find the inconsistency between absorption costing and CVP analysis troubling enough to warrant using variable costing for internal income reporting. Variable costing dovetails much more closely than absorption costing with any operational analy- ses that require a separation between fixed and variable costs. Pricing Decisions Many managers prefer to use absorption-costing data in cost-based pricing decisions. They argue that fixed manufacturing overhead is a necessary cost incurred in the production process. To exclude this fixed cost from the inventoried cost of a product, as is done under variable costing, is to understate the cost of the product. For this reason, most companies that use cost-based pricing base their prices on absorption-costing data. Proponents of variable costing argue that a product’s variable cost provides a better basis for the pricing decision. They point out that any price above a product’s variable cost makes a positive contribution to covering fixed cost and profit. Definition of an Asset Another controversy about absorption and variable costing hinges on the definition of an asset. An asset is a thing of value owned by the organiza- tion with future service potential. By accounting convention, assets are valued at their cost. Since fixed costs comprise part of the cost of production, advocates of absorption costing argue that inventory (an asset) should be valued at its full (absorption) cost of production. Moreover, they argue that these costs have future service potential since the inventory can be sold in the future to generate sales revenue. Proponents of variable costing argue that the fixed-cost component of a product’s absorption-costing value has no future service potential. Their reasoning is that the fixed manufacturing-overhead costs during the current period will not prevent these costs from having to be incurred again next period. Fixed-overhead costs will be incurred every period, regardless of production levels. In contrast, variable costs incurred to manufacture a product will not be repeated. To illustrate, FitDat.com produced 15,000 more fitness monitors in 20x1 than it sold. These units will be carried in inventory until they are sold in some future year. FitDat.com will never again have to incur the costs of direct material, direct labor, and variable overhead incurred in 20x1 to produce those fitness monitors. Yet FitDat.com will have to incur approximately $600,000 of fixed-overhead costs every year, even though the firm has the 15,000 units from 20x1 in inventory. External Reporting For external reporting purposes, generally accepted accounting principles require that income reporting be based on absorption costing. Federal tax laws also require the use of absorption costing in reporting income for tax purposes. Learning Objective 8-6 Evaluate absorption and variable costing. hiL25664_ch08_316-349.indd 324hiL25664_ch08_316-349.indd 324 7/4/13 2:18 AM7/4/13 2:18 AM Final PDF to printer Chapter 8 Variable Costing and the Costs of Quality and Sustainability 325 Why Not Both? Using computerized accounting systems, it is straightforward for a company to prepare income statements under both absorption and variable costing. Since absorption-costing statements are required for external reporting, managers will want to keep an eye on the effects of their decisions on financial reports to outsiders. Yet the supe- riority of variable-costing income reporting as a method for dovetailing with operational analyses cannot be denied. Preparation of both absorption-costing and variable-costing data is perhaps the best solution to the controversy. JIT Manufacturing Environment In a just-in-time inventory and production manage- ment system, all inventories are kept very low. Since finished-goods inventories are mini- mal, there is little change in inventory from period to period. Thus, in a JIT environment, the income differences under absorption and variable costing generally will be insignificant. Section 2: Costs of Assuring Quality In the manufacturing industry, product quality has become a key factor in determining a firm’s success or failure in the global marketplace. Advanced, highly reliable manufac- turing methods have made it possible to achieve very high standards of product quality. And in service firms, the quality of service can spell the difference between a profitable future and one of struggle and even failure. Hotel guests, for instance, are ever more dis- criminating as they assess the overall quality of service and then select their accommoda- tions accordingly. Similar comments apply to the airlines, cellphone service providers, banks, car rental firms, and financial investment firms. As a result, more and more firms are making product quality a keystone of their competitive strategy. Measuring and Reporting Quality Costs Recognizing the importance of maintaining high product quality, companies often mea- sure and report the costs of doing so. Before we examine the costs that companies incur to maintain high product quality, let’s consider what product quality means. Product Quality Be careful not to confuse a product’s grade with its quality. A prod- uct’s grade refers to the extent of its capabilities in performing an intended purpose, in Section 2: Costs of Assuring Quality IRS: UNIQUE PRODUCT PACKAGING IS AN INVENTORIABLE COST Most national tax authorities require the use of absorption costing for tax purposes. Thus, absorption costing must be used in valuing inventory and in determining cost-of-goods- sold expense, which in turn affects taxable income. In the United States, the Internal Revenue Service (IRS) defines inventoriable costs (i.e., product costs) that must be included in valuing inventory and cost-of-goods-sold expense to include the following: (1) direct material con- sumed in the production of the product and (2) direct labor, and (3) all indirect costs deemed to be necessary for the production of the company’s product. These necessary indirect costs include fixed-overhead costs. Thus, absorption costing is mandated by the IRS. One interesting nuance in the IRS interpretation of what constitutes inventoriable costs concerns a company’s expenditures on the design of the packaging for the com- pany’s products. Packaging design costs can run into hundreds of thousands of dollars for large consumer products companies. The IRS has specified that packaging design costs must be inventoried as product costs if the resulting design is successful—that is, it remains in use for several years. If, however, a package design fails in the marketplace, the company can deduct the package design costs early as an expense. Examples of unique and successful packaging designs that would be affected by this ruling include Pringles potato chip cans, Yoplait yogurt containers, and Perrier sparkling water bottles. IRS, Pringles, Yoplait, and Perrier anagement ccounting ractice M A P Learning Objective 8-7 Prepare a quality-cost report. hiL25664_ch08_316-349.indd 325hiL25664_ch08_316-349.indd 325 7/4/13 2:18 AM7/4/13 2:18 AM Final PDF to printer 326 Chapter 8 Variable Costing and the Costs of Quality and Sustainability relation to other products with the same functional use. For example, a laser printer that prints in color is of a higher grade than a laser printer that only prints in black-and-white. So what is meant by a high -quality product? There are two concepts of quality that determine a product’s degree of excellence or the product’s ultimate fitness for its intended use. A product’s quality of design refers to how well it is conceived or designed for its intended use. For example, a color laser printer intended for business use that has to be refilled three times a day because its paper tray is too small is a poorly designed color laser printer. The quality of conformance refers to the extent to which a product meets the specifications of its design. A color laser printer with an appropriately sized paper tray could be well designed, but if the paper jams due to shoddy manufacturing, it will be use- less. This printer fails to conform to its design specifications. Both quality of design and quality of conformance are required in order to achieve a high-quality finished product. Costs of Quality Due to the increasing importance of maintaining high product qual- ity, many companies routinely measure and report the costs of ensuring high quality. Four types of costs are monitored. First are prevention costs, the costs of preventing defects. Second are appraisal costs, the costs of determining whether defects exist. The third type of costs are internal failure costs, those costs of repairing defects found prior to product delivery. The last type of costs are external failure costs, those costs incurred after defective products have been delivered. Exhibit 8–6 shows a production quality-cost report prepared by FitDat.com for the month of May 20x2. As a manufacturer of smartphone-linked personal fitness monitors that are sold online, FitDat.com must identify quality costs in several different areas of operations, including production quality, service quality, and shipping quality. 4 As is always true in cost monitoring, quality-cost reporting is most useful when cost trends are examined over a period of time. Through trend analysis, management can see where improvement is occurring and where difficulties exist. Goals can be set to achieve a particular cost target in an area of concern. For example, FitDat.com management might strive to reduce annual external failure costs to less than 0.5% of sales by a certain date. If May 20x2 is a typical month for FitDat.com , then the external failure costs in 20x2 are about $45,600 ($3,800 from Exhibit 8–6 3 12 mo.). Sales in 20x2 are $3,120,000 ( Exhibit 8–3 ), so external failure costs are running at 1.46 percent of sales and reaching the 0.5 percent target will require a substantial effort. Observable versus Hidden Quality Costs The quality costs discussed in the pre- ceding section are observable. They can be measured and reported, often on the basis of information in the accounting records. In addition to these observable quality costs, how- ever, companies incur hidden quality costs. When products of inferior quality make it to market, customers are dissatisfied. Their dissatisfaction can result in decreased sales and a tarnished reputation for the company. Not only does the company experience lost sales for the inferior products but it will also likely experience lost sales in its other product lines. The opportunity cost of these lost sales and decreased market share can represent a significant hidden cost. Such hidden costs are difficult to estimate or report. Changing Views of Optimal Product Quality One way to express product quality is in the percentage of products that fail to conform to their specifications, that is, the percentage of defects. Given this perspective, what is the optimal level of product quality? 5 4 For further information on cost of quality, see Zafar U. Khan, “Cost of Quality,” in Barry J. Brinker, ed., Guide to Cost Management (New York: John Wiley & Sons, 2000), pp. 319–44; and Steve Ball, “Making the Cost of Quality Practical,” Strategic Finance (July 2006), pp. 34–41. 5 This discussion is based on the following sources: American Productivity and Quality Center, Using Enterprise Quality Measurement to Drive Business Value (Best Practices Report), 2012; Gary Cokins, “Measuring the Costs of Quality for Management,” Quality Progress, September 2006, pp. 45–51; and Jack Campanella, ed., Principles of Quality Costs, 3rd ed. (Milwaukee, WI: ASQC Quality Press, 1999). Learning Objective 8-8 Discuss two contrasting views of the optimal level of product quality. “The ‘cost of quality’ isn’t the price of creating a quality product or service. It’s the cost of NOT creat- ing a quality product or service.” (8b) ASQ hiL25664_ch08_316-349.indd 326hiL25664_ch08_316-349.indd 326 7/4/13 2:18 AM7/4/13 2:18 AM Final PDF to printer Chapter 8 Variable Costing and the Costs of Quality and Sustainability 327 Observable-Cost Perspective The traditional view of quality costs holds that find- ing the optimal level of product quality is a balancing act between incurring costs of prevention and appraisal on one hand and incurring costs of failure on the other. These are observable costs, as dis- cussed in the previous sec- tion. Panel A of Exhibit 8–7 depicts this trade-off. As the percentage of defective products decreases, the costs of prevention and appraisal increase. However, the costs of internal and external fail- ure decrease. Adding the costs of prevention, appraisal, and internal and external fail- ure yields total quality costs. The optimal product quality level is the point that mini- mizes total quality costs. Zero-Defect Perspective Due largely to the influence of Japanese product quality expert Genichi Taguchi, most companies now assess the May 20x2 Quality Costs Percent of Total Prevention costs Quality training ................................................................................ $ 200 1.3 Reliability engineering ...................................................................... 1,000 6.5 Pilot studies .................................................................................... 500 3.3 Systems development ...................................................................... 800 5.2 Total prevention costs .................................................................. $ 2,500 16.3 Appraisal costs Materials inspection ........................................................................ $ 600 3.9 Supplies inspection ......................................................................... 300 2.0 Reliability testing ............................................................................. 500 3.3 Testing laboratory ............................................................................ 2,500 16.3 Total appraisal costs .................................................................... $ 3,900 25.5 Internal failure costs Scrap .............................................................................................. $ 1,500 9.8 Repair ............................................................................................. 1,800 11.8 Rework ........................................................................................... 1,200 7.8 Downtime ....................................................................................... 600 3.9 Total internal failure costs ............................................................ $ 5,100 33.3 External failure costs Warranty costs ................................................................................ $ 1,400 9.2 Out-of-warranty repairs and replacement ......................................... 600 3.9 Customer complaints ...................................................................... 300 2.0 Product liability ............................................................................... 1,000 6.5 Transportation losses ...................................................................... 500 3.3 Total external failure costs ........................................................... $ 3,800 24.9 Total quality costs ................................................................................ $15,300 100.00 Exhibit 8–6 Quality-Cost Report: FitDat.com Costs of external failure are considered to be the most damaging for a company. In addition to the added costs of receiving and processing returned goods, external fail- ure causes hard-to-measure costs of customer dissatis- faction and possibly loss of future business. hiL25664_ch08_316-349.indd 327hiL25664_ch08_316-349.indd 327 7/4/13 2:18 AM7/4/13 2:18 AM Final PDF to printer 328 Chapter 8 Variable Costing and the Costs of Quality and Sustainability optimal cost of quality from a different perspective. The contemporary view is that if both observable and hidden costs of quality are considered, any deviation from a product’s tar- get specifications results in increased quality costs. Under this zero-defect viewpoint, as depicted in Panel B of Exhibit 8–7 , the optimal level of product quality occurs at the zero defect level. As Panel B shows, the observable and hidden costs of internal and external failure increase as the percentage of defective products increases. The observable and hidden costs of prevention and appraisal increase slightly and then decrease as the per- centage of defects increases. The most important point, though, is that the total costs of quality are minimized at the zero defect level. The relative merits of these two views of optimal product quality are still being debated by quality control experts. Moreover, the exact shape of the cost functions in Exhibit 8–7 probably differs among industries and product types. One thing is certain, though. To compete successfully in today’s global market, any company must pay very close attention to achieving a very high level of product quality. Total Quality Management Monitoring product quality coupled with measur- ing and reporting quality costs helps companies maintain programs of total quality management , or TQM. This refers to the broad set of management and control pro- cesses designed to focus the entire organization and all of its employees on providing products or services that do the best possible job of satisfying the customer. Among the tools used in total quality management is the Six Sigma program, an analytical method that aims at achieving near-perfect results in a production process. (See the Management Accounting Practice illustration on page 330 for details.) Identifying Quality Control Problems An effective TQM program includes meth- ods for identifying quality control problems. One method of identifying quality prob- lems is the cause-and-effect diagram (also called an Ishikawa diagram or a fishbone diagram). Exhibit 8–8 displays a cause-and-effect diagram used by Xerox Corporation to identify the causes of errors in its customer billing process. As the diagram shows, the quality improvement team has identified a wide range of possible causes for billing errors. After identifying possible causes for billing errors, the Xerox team, nicknamed the Billing Bloopers Team, could take systematic steps to eliminate the root causes of the errors. Another helpful tool in quality improvement programs is the Pareto diagram. Depicted in Exhibit 8–9 , the Pareto diagram shows graphically the frequency with which various quality control problems are observed for FitDat.com’s fitness monitors. The Pareto diagram helps the TQM team visualize and communicate to others what the most serious types of defects are. Steps can be taken then to attack the most serious and most frequent problems first. Exhibit 8–7 Quality Costs and the Optimal Level of Product Quality Total quality costs Failure costs Prevention and appraisal costs Minimum Minimum 0% 100% Costs A. Observable-Cost Perspective Total quality costs Failure costs Prevention and appraisal costs 0% 100% Costs B. Zero-Defect Perspective Percentage of defective products Percentage of defective products “Six Sigma might be the maturation of everything we’ve learned over the past 100 years about quality.” (8c) ASQ hiL25664_ch08_316-349.indd 328hiL25664_ch08_316-349.indd 328 7/4/13 2:18 AM7/4/13 2:18 AM Final PDF to printer Chapter 8 Variable Costing and the Costs of Quality and Sustainability 329 Exhibit 8–8 Cause-and-Effect Diagram: Bill- ing Quality at Xerox Corporation Billing system Cumbersome Multiple price plans System errors Programming Input requirements Opportunity for errors Pricing actions Frequency of change Employee driven Lack of knowledge External customers Communication Misinterpretation Reading an invoice Complexity Billing meters Training Current price information Wrong recipient Timeliness Billing quality does not meet objectives Delay in payment Delay in order process Ownership Lack of knowledge “Not my job” Awareness Focus Training/EducationLack of understanding Not knowing to whom to talk Communication Out-of-district personnel Ownership Lack of knowledge “Not my job” Awareness Focus Training/EducationLack of understanding Not knowing to whom to talk Communication District personnel Source: David M. Buehlman and Donald Stover, “How Xerox Solves Quality Problems,” Management Accounting 75, no. 3 (September 1993), pp. 33–36. Exhibit 8–9 Pareto Diagram: Frequency of Defect Types for FitDat.com’s Fitness Monitors Number of defective units 150 140 130 120 110 100 90 80 70 60 50 40 30 20 10 0 Loses communication with smartphone Display failure Power management problems Strap and casing defects Type of product defect hiL25664_ch08_316-349.indd 329hiL25664_ch08_316-349.indd 329 7/4/13 2:18 AM7/4/13 2:18 AM Final PDF to printer 330 Chapter 8 Variable Costing and the Costs of Quality and Sustainability SIX SIGMA FOR QUALITY MANAGEMENT AND COST REDUCTION “Originally conceived by Motorola Inc. as a quality-improvement device” two decades ago, “Six Sigma soon morphed into a cost-cutting utensil for manufacturers of all stripes. Now, it’s fast becoming the Swiss army knife of the business world.” Six Sigma is “an analytical method aimed at achieving near-perfect results in a production process. In statistics, the Greek letter sigma denotes variation in a standard bell curve. One sigma equals 690,000 defects per 1 million. Most companies do no bet- ter than three sigma, or 66,000 errors per million. Six Sigma reduces that count to 3.4 defects per million. That saves money by preventing waste.” Six Sigma “achieves results by reducing subjective errors in the assessment of prob- lems. First, auditors define a process where results are subpar. Then they measure the process to determine current performance, analyze this information to pinpoint where things are going wrong, and improve the process and eliminate the error. Last, controls are set up to prevent future bugs.” “In the world of manufacturing, Six Sigma has become something akin to a religion.” When General Electric ’s former chairman Jack Welch embraced Six Sigma, for example, “he quickly assembled an unprecedented army of employees to pinpoint and fix prob- lems throughout GE” using their Six Sigma training. “The results were awesome: In three years alone, these troops saved the company $8 billion, according to GE.” 6 More recently, Six Sigma has been applied well beyond manufacturing. At Caterpillar, “anywhere there was an outcome, there was a process. If there was a process, there was variation in performance. If there was variation in performance, the process was subject to Six Sigma. No area of the company was excluded, from production to revenue recogni- tion to client services.” 7 Examples of Six Sigma in a service setting include insurance, consulting and finan- cial services. National City Bank in Cleveland used Six Sigma to improve the quality of its new customer process. “The bank wanted to eliminate unnecessary steps that didn’t provide value to the customer and to reduce the number of defects that flowed from the process, [resulting in] a dramatic improvement in customer satisfaction [and] a significant decrease in cycle time and operational defects.” 8 Motorola, General Electric, Caterpillar, and National City Bank M A P anagement ccounting ractice 6 R. Crockett, C. Edwards, and S. Ante, “How Motorola Got Its Groove Back,” BusinessWeek, August 8, 2005, pp. 68–70; and M. Arndt, “Quality Isn’t Just for Widgets,” BusinessWeek, July 22, 2002, pp. 72, 73. 7 Keith T. Jones and Clement C. Chen, “The Pervasive Success of 6 Sigma at Caterpillar,” Strategic Finance, April 2010, pp. 29–33. 8 Peter Carlivati, “Six Sigma: A New Path to Perfection,” ABA Bank Marketing, April 2007, pp. 24–29. ISO 9000 Standards A key factor in determining the quality of a company’s products and services is its qual- ity control system. The organizational structure, personnel, procedures, and policies that are in place to monitor product quality will greatly affect a firm’s ability to achieve high- quality standards. In 1987, the International Organization for Standardization (ISO) , based in Geneva, Switzerland, issued a set of quality control standards for companies selling products in Europe. Now widely adopted in the United States and other coun- tries, the ISO 9000 standards, as they have come to be known, focus on the processes a hiL25664_ch08_316-349.indd 330hiL25664_ch08_316-349.indd 330 7/4/13 2:18 AM7/4/13 2:18 AM Final PDF to printer Chapter 8 Variable Costing and the Costs of Quality and Sustainability 331 company uses to match the quality of design and quality of conformance that its prod- ucts and services offer with the expectations of its customers. The ISO 9000 standards basically require that a company have a well-defined quality control system in place, and that the target level of product quality be maintained consistently. Moreover, the ISO 9000 standards require a company to prepare extensive documentation of all aspects of the quality control system. The first standard, ISO 9000, identifies the eight quality management principles shown in Exhibit 8–10 . The ISO 9000 standards consist of three major parts. ISO 9000 states the scope of the standard, defines and describes a quality management system, and establishes a quality-related vocabulary. ISO 9001 provides a model for quality assurance in design, development, production, installation, and servicing. And ISO 9004 provides guidelines for the design of a quality assurance system. 9 Implications for Managerial Accounting The ISO 9000 standards have several implications for managers and managerial accountants. First, the standards require extensive documentation of the quality control system. This task often falls to the controller’s office. In fact, several of the largest public accounting firms offer assurance services to help companies meet the ISO documentation requirements for certification. Second, the ISO standards require that the costs and benefits of the quality control sys- tem be measured and documented. Managerial accountants are responsible for measuring and reporting product life-cycle costs, quality costs, and the effectiveness of efforts at continuous improvement. To summarize, the ISO 9000 standards have a global impact on the way compa- nies approach their quality assurance objectives. The standards affect virtually every area within a firm subject to their guidelines. Managerial accountants are integrally involved in the informational and documentation aspects of the ISO 9000 program. 10 Exhibit 8–10 ISO 9000 Quality Management Principles 9 The standards originally issued as ISO 9002 and 9003 were subsequently absorbed into ISO 9001. 10 More information on the ISO 9000 standards can be found at www.iso.org/iso/iso_9000_selection_and_use- 2009 . Customer focus Organizations depend on their customers and therefore should understand current and future customer needs, should meet customer requirements and strive to exceed customer expectations. Leadership Leaders establish unity of purpose and direction of the organization. They should create and maintain the internal environment in which people can become fully involved in achieving the organization’s objectives. Involvement of people People at all levels are the essence of an organization and their full involvement enables their abilities to be used for the organization’s benefit. Process approach A desired result is achieved more efficiently when activities and related resources are managed as a process. System approach to management Identifying, understanding and managing interrelated processes as a system contributes to the organization’s effectiveness and efficiency in achieving its objectives. Continual improvement Continual improvement of the organization’s overall performance should be a permanent objective of the organization. Factual approach to decision making Effective decisions are based on the analysis of data and information. Mutually beneficial supplier relationships An organization and its suppliers are interdependent and a mutually beneficial relationship enhances the ability of both to create value. Source: ISO, Quality Management Principles, 2012, www.iso.org/iso/qmp_2012 . hiL25664_ch08_316-349.indd 331hiL25664_ch08_316-349.indd 331 7/4/13 2:18 AM7/4/13 2:18 AM Final PDF to printer 332 Chapter 8 Variable Costing and the Costs of Quality and Sustainability Section 3: Costs of Environmental Sustainability As the world’s population grows and business activity expands, concerned citizens the world over have become increasingly vocal about the critical need to preserve our envi- ronment for ourselves and for future generations. Issues like air and water quality, hidden carcinogens, global warming, and the overconsumption of nonrenewable energy sources are in the headlines every day. Business leaders have come to talk of the desirability of sustainable development, which means business activity that produces the goods and services needed in the present without limiting the ability of future generations to meet their needs. Many companies are striving for greater ecoefficiency, which means increas- ing their production of goods and services while at the same time decreasing the deleteri- ous effects on the environment of that production. Unfortunately, not all companies are striving equally hard toward these desirable goals. To force companies to pay attention to environmental issues, in the United States we have environmental laws, such as the Clean Air Act and the Comprehensive Environmen- tal Response, Compensation and Liability (“Superfund”) Act. These and other environ- mental laws are monitored and enforced by a federal watchdog agency, the Environmental Protection Agency ( EPA ). On a global scale, there are literally dozens of environmental agreements addressing the atmosphere, hazardous substances, the marine environment, nature conservation, and nuclear power issues. So, besides being a very important issue to all of us due to the clear health and quality-of-life implications, what does any of this have to do with managerial account- ing? The answer is that the costs of dealing with environmental issues in one way or another are enormous. These environmental costs take many forms, such as installing scrubbers on a smokestack to comply with EPA regulations, improving a production pro- cess to reduce or eliminate certain pollutants, or cleaning up a contaminated river. For many large companies, simply understanding the many environmental agreements and regulations that apply, or may apply, to their operations, is a complex and costly process. In this section, we will systematically explore these costs with the goal of having a better understanding of how to manage them. Classifying Environmental Costs There are many types of environmental costs. By organizing them into groups of similar costs, we can begin to organize our ideas about how to manage them. Private versus Social Environmental Costs One important distinction is between private costs and social (or public) costs. Private environmental costs are those borne by a company or individual. Examples would be costs incurred by a company to understand global environmental agreements, to comply with EPA regulations, or to clean up a polluted lake. Social environmental costs are those borne by the public at large. Examples of these include costs borne by the taxpayers to staff the EPA; costs borne by the taxpayers to clean up a polluted lake or river; costs borne by individuals, insurance companies, and Medicare due to health problems caused by pollutants; and the unquantifiable quality-of-life costs we all bear from a degraded environment. The tragic 2010 oil spill in the Gulf of Mexico stemming from an explosion on the Deep- water Horizon oil rig provides an unfortunate example of both social and private environ- mental costs. Huge private environmental costs were borne by the companies involved in the Deepwater Horizon’s drilling operations, such as BP and its partners. The social environmen- tal costs associated with this disaster included costs such as cleaning up fouled beaches and fragile wetlands, lost profits of the Gulf states’ recreational and fishing industries, and possi- ble human health hazards from the hydrocarbons contaminating the Gulf’s waters, marshes, and beaches. Through the legal process, some of the social environmental costs have been converted to private environmental costs as costs of cleanup or lost business are reimbursed by BP and the other companies involved in the disaster. But no one would dispute, despite billions of dollars paid by BP and others, that the social environmental costs are enormous. Section 3: Costs of Environmental Sustainability “When there’s heightened attention [to corporate responsibility] . . . we have a huge opportunity to effect meaningful change, given our size, scope, and number of customers.” (8d) Procter & Gamble Learning Objective 8-9 Understand the different types of environmental costs, and discuss the management of these costs. hiL25664_ch08_316-349.indd 332hiL25664_ch08_316-349.indd 332 7/4/13 2:18 AM7/4/13 2:18 AM Final PDF to printer Chapter 8 Variable Costing and the Costs of Quality and Sustainability 333 We will focus our attention here on envi- ronmental cost management, which is the strategic implementation of systems for identi- fying, measuring, controlling and reducing the private environmental costs borne by a com- pany or other organization. 11 Visible versus Hidden Environmental Costs Both social and private environmen- tal costs can be visible or hidden. Visible social environmental costs are those that are known and clearly identified as tied to environmental issues, such as the taxpayers’ costs of staffing the EPA or cleaning up a polluted lake. Hid- den social environmental costs include those that are caused by environmental issues but have not been so identified, such as the costs borne by individuals, insurance companies, or Medicare due to cancers caused by pollutants but not clearly identified as such. For example, is melanoma (a serious type of skin cancer) caused by an inherited genetic tendency, fail- ure to use sun block, or a thinning of the ozone layer resulting from industrial emissions of chlorofluorocarbons? All three are generally considered to play a role, but no one knows their relative importance so no one knows how to apportion the costs. The extent of costs with an industrial origin remains hidden. Managing Private Environmental Costs Let’s focus our attention now on environmental cost management, or the measuring and control or reduction of private environmental costs. Visible versus Hidden Private Environmental Costs Once again, we need to dis- tinguish between visible and hidden costs. Visible private environmental costs are those that are measurable and have been clearly identified as tied to environmental issues. Hidden private environmental costs are those that are caused by environmental issues but have not been so identified by the accounting system. 12 For example, a company engaged in the controversial practice of natural gas “fracking” (drilling oil and gas wells using a process that injects water, sand, and chemicals under high pressure to fracture the rock trapping the hydrocarbons) has visible private environmental costs including restoration of drilling sites after the well has been bored and extensive public relations efforts. But it also may have hidden private environmental costs associated with loss in market value due to added uncertainty over future environmental liabilities. Exhibit 8–11 provides examples of both visible and hidden private environmental costs. 13 Notice that the visible and the hidden costs listed in Exhibit 8–11 are further classified as follows: • Monitoring costs. Costs of monitoring the regulatory environment as well as monitoring the production process to determine if pollution is being generated (e.g., costs of testing wastewater for contaminants). 11 Based on the discussion in German Böer, Margaret Curtin, and Louis Hoyt, “Environmental Cost Management,” Management Accounting 80, no. 3 (September 1998), pp. 28–38. See also Ramona Dzinkowski, “Saving the Environment,” Strategic Finance 89, no. 1 (July 2007), pp. 51–53. 12 Based on Satish Joshi, Ranjani Krishnan, and Lester Lave, “Estimating the Hidden Costs of Environmental Regulation,” The Accounting Review 76, no. 2 (April 2001), pp. 171–98. See also Kathryn Kranhold, “GE’s Environmental Push Hits Business Realities,” The Wall Street Journal, September 14, 2007, p. A1. 13 Ibid. “Sustainability is essential to the health and future of our business. . . . [S]ince ecosystem services are vital to the performance of most companies, integrating the true cost for these services in the future could have significant impacts on cor- porate bottom lines.” (8e) Puma Many companies invest in significant private environ- mental costs to monitor and maintain the environment. In this photo, a company inspector tests wastewater for compliance with its own standards and government requirements. hiL25664_ch08_316-349.indd 333hiL25664_ch08_316-349.indd 333 7/4/13 2:18 AM7/4/13 2:18 AM Final PDF to printer 334 Chapter 8 Variable Costing and the Costs of Quality and Sustainability • Abatement costs. Costs incurred to reduce or eliminate pollution (e.g., changing a product’s design to use more expensive materials that do not result in environ- mental contamination). • Remediation costs (i.e., cleanup costs), including: On-site remediation. Costs of reducing or preventing the discharge into the environment of pollutants that have been generated in the production pro- cess (e.g., cost of installing scrubbers on a smokestack to remove certain air pollutants in the smoke). Off-site remediation. Costs of reducing or eliminating pollutants from the environment after they have been discharged (e.g., cost of cleaning up a river polluted by a company’s operations). The distinction between the visible and hidden costs listed in Exhibit 8–11 is an important but subtle one. Consider, for example, the incremental cost of using a more expensive material because it provides a smaller environmental impact. Is this a vis- ible or a hidden cost? The answer is it depends on whether the accounting system has measured this cost and identified it as an environmental cost. Studies show that many environmental costs are hidden, because the accounting system does not measure and identify them as environmental costs. “Most accounting systems accumulate visible costs into environmental cost pools, separate from other overhead cost pools . . . For example, many steel mills compile separate cost pools for wastewater treatment, remediation, hazardous waste disposal, pollution-abatement capital expenditures, and Exhibit 8–11 Private Environmental Costs Visible Costs Hidden Costs* Monitoring Inspecting products for contamination Measuring contamination of processes or machinery Verifying vendor compliance with environmental standards Inspection of products Incremental costs of procurement staff to ensure vendor compliance with environmental standards Abatement Qualifying vendors for environmental compliance Recycling materials, containers, or water Designing products and processes to reduce or eliminate negative environmental impacts Doing environmental impact analyses Incremental material costs incurred to use less-polluting materials Incremental direct-labor costs incurred to perform duties related to reducing pollution Incremental costs of more expensive processes installed all or in part to reduce pollution Incremental costs of purchasing hybrid (electric and gasoline powered) vehicles to reduce air pollution Remediation On-site Installing pollution reduction or elimination devices Disposing of toxic waste in an environmentally sound manner Treating toxic waste Incremental direct-labor costs incurred to maintain remediation equipment Incremental energy or other overhead costs incurred to operate remediation equipment Off-site Cleaning up polluted sites (e.g., water, soil, or buildings) Defending or settling environmental lawsuits Paying EPA fines Incremental direct-labor costs for workers used to perform environmental cleanup tasks Forgone contribution margins on lost sales due to an unfavorable environmental record or reputation *Each of the costs listed in the hidden costs column is included under the assumption that although these costs are caused by environmental concerns, the accounting system has not identified them as such. A study by Joshi et al. provides evidence for the plausibility of this assump- tion. See Satish Joshi, Ranjani Krishnan, and Lester Lave, “Estimating the Hidden Costs of Environmental Regulation,” The Accounting Review 76, no. 2 (April 2001), pp. 171–98. hiL25664_ch08_316-349.indd 334hiL25664_ch08_316-349.indd 334 7/4/13 2:18 AM7/4/13 2:18 AM Final PDF to printer Chapter 8 Variable Costing and the Costs of Quality and Sustainability 335 depreciation on pollution abatement equipment.” 14 However, a steel mill’s incremental material costs caused by changing from sinters to less-polluting pellets in response to more stringent environmental regulations is typically not separately reported by the accounting system as an environmental cost. 15 Hence, it remains a hidden environmen- tal cost. Why is this point about visible versus hidden costs so important? Because many observers believe that the visible costs reported by most accounting systems may be only a small proportion of the hidden costs. A steel-industry study, for example, concluded that the hidden costs were nearly 10 times the visible costs! ISO 14000 Standards and the GRI Sustainability Reporting Framework In 1996, the International Organization for Standardization (ISO) , based in Geneva, Switzerland, introduced standards on environmental sustainability and management. Although not as widely implemented as the ISO 9000 standards, 16 they have still enjoyed a large influence on the discussion of environmental reporting and management and the implementation of ISO 14000 is often cited proudly by companies whose efforts have been certified. ISO 14000 is a family of standards, of which ISO 14001 and 14004 include guide- lines for establishing and operating an Environmental Management System (EMS), and the other standards in the series further develop specific applications of the EMS con- cepts. The EMS defines the processes the company will follow in achieving its envi- ronmental objectives and targets. However, the standard does not specify the elements of environmental performance that are appropriate for a given company, nor does it address the costs of environmental sustainability. Rather, it relies on the EMS and related processes to help each company define and tailor performance metrics, outcomes, and investments that are appropriate for it. In this way, the ISO 14000 standards provide a structured approach to environmental management that is broadly applicable to many kinds of companies. For more specific guidance on environmental reporting and management, many companies turn to another source that is compatible with ISO 14000 but more prescrip- tive. The Global Reporting Initiative (GRI) , based in Boston, was founded to define and promote a concrete framework for environmental reporting. GRI’s Sustainability Report- ing Framework, which has evolved to address many aspects of social impact reporting, requires companies to define specific goals and measure performance relating to their environmental performance. Measurement categories include energy, water, and bio- diversity, and 30 specific Environmental Performance Indicators are prescribed. These include, for example, the following indicators: • Percentage of materials used that are recycled input materials. • Energy saved due to conservation and efficiency improvements. • Total direct and indirect greenhouse gas emissions by weight. • Percentage of products sold and their packaging materials that are reclaimed by category. • Total environmental protection expenditures by type. 17 14 Ibid. 15 Ibid 16 The ISO 9000 Standards are discussed in Chapter 8, “Section 2: Costs of Assuring Quality,” beginning on p. 325. 17 GRI, Sustainability Reporting Guidelines v.3.1, 2011, www.globalreporting.org/resourcelibrary/G3.1- Guidelines- Incl-Technical-Protocol . hiL25664_ch08_316-349.indd 335hiL25664_ch08_316-349.indd 335 7/4/13 2:18 AM7/4/13 2:18 AM Final PDF to printer 336 Chapter 8 Variable Costing and the Costs of Quality and Sustainability A recent report by the global accounting and consulting firm KPMG found that all forms of corporate responsibility reporting are gaining in importance. The findings conclude that, “Where [corporate responsibility] reporting was once seen as fulfilling a moral obligation to society, many companies are now recognizing it as a business imperative . . . [and] are increasingly demonstrating that [it] provides financial value and drives innovation.” 18 , 19 Implications for Managerial Accounting Programs such as the ones needed to track ISO 14000 and the GRI Sustainability Reporting Initiative require a substantial invest- ment in systems and people to document and track performance. This responsibility is usually trusted to those individuals in companies who are experienced in process design and in the challenges of measurement, individuals who are often found in the CFO’s and controller’s organizations. The skills needed for measurement and decision-making in an environmental context are no different from those needed in other operational contexts, and professionals trained in managerial accounting bring the ideal skills and perspectives to an area whose importance is on the rise. 20 18 KPMG, International Survey of Corporate Responsibility Reporting, 2011, www.kpmg.com/PT/pt/IssuesAnd Insights/Documents/corporate-responsibility2011 . 19 For some examples of how leading companies are responding to the challenges of sustainability, refer to the following articles published by the IMA: Susan C. Borkowski, Mary Jeanne Welsh, and Kristin Wentzel, “Johnson & Johnson: A Model for Sustainability Reporting,” Strategic Finance, September 2010, pp. 29–37; Cristiano Busco, Mark. L. Frigo, Emilia L. Leone, and Angelo Riccaboni, “Cleaning Up,” Strategic Finance, July 2010, pp. 29–37; and Jon Bartley et al., “Flexible Budgeting Meets Sustainability at Bacardi Limited,” Strategic Finance, December 2012, pp. 29–34. 20 A thorough discussion of sustainability reporting and its implications for managerial accounting can be found in the following resource: Institute of Management Accounting, Statements on Management Accounting 67: The Evo- lution of Accountability—Sustainability Reporting for Accountants, 2008, www.imanet.org/PDFs/Public/Research/ SMA/The Evolution of Accountability . Focus on Ethics INCENTIVE TO OVERPRODUCE INVENTORY The absorption of fixed overhead costs as part of the cost of inventory on the balance sheet presents ethical chal- lenges because it provides the opportunity to manipulate reported income. This classic case is based on an actual company’s experience. * Brandolino Company uses an actual-cost system to apply all production costs to units produced. The plant has a maximum production capacity of 40 million units but during year 1 it produced and sold only 10 million units. There were no beginning or ending inventories. The com- pany’s absorption-costing income statement for year 1 follows: BRANDOLINO COMPANY Income Statement For Year 1 Sales (10,000,000 units at $6) ............................. $ 60,000,000 Cost of goods sold: Direct costs (material and labor) (10,000,000 at $2) ................... $ 20,000,000 Manufacturing overhead ............ 48,000,000 68,000,000 Gross margin ....................................................... $ (8,000,000) Less: Selling and administrative expenses .............. 10,000,000 Operating income (loss) ........................................ $(18,000,000) *This scenario is based on the case “I Enjoy Challenges,” originally written by Michael W. Maher. It is used here with permission. The board of directors is upset about the $18 million loss. A consultant approached the board with the hiL25664_ch08_316-349.indd 336hiL25664_ch08_316-349.indd 336 7/4/13 2:18 AM7/4/13 2:18 AM Final PDF to printer 337 following offer: “I agree to become president for no fixed salary. But I insist on a year-end bonus of 10 percent of operating income (before considering the bonus).” The board of directors agreed to these terms and hired the consultant as Brandolino’s new president. The new president promptly stepped up production to an annual rate of 30 million units. Sales for year 2 remained at 10 million units. The resulting absorption-costing income statement for year 2 is displayed in the right- hand column. The day after the year 2 statement was verified, the president took his check for $1,400,000 and resigned to take a job with another corporation. He remarked, “I enjoy challenges. Now that Brandolino Company is in the black, I’d prefer tackling another challenging situation.” (His con- tract with his new employer is similar to the one he had with Brandolino Company.) What do you think is going on here? How would you evaluate the company’s year 2 performance? Using variable costing, what would operating income be for year 1? For year 2? (Assume that all selling and administrative costs are committed and unchanged.) Compare those results with the absorption-costing statements. Comment on the ethical issues in this scenario. BRANDOLINO COMPANY Income Statement For Year 2 Sales (10,000,000 units at $6) .................................. $60,000,000 Cost of goods sold: Costs of goods manufactured: Direct costs (material and labor) (30,000,000 at $2) ................. $ 60,000,000 Manufacturing overhead .......... 48,000,000 Total cost of goods manufactured ......................... $108,000,000 Less: Ending inventory: Direct costs (material and labor) (20,000,000 at $2) ................. $ 40,000,000 Manufacturing overhead (20/30 3 $48,000,000) ......... 32,000,000 Total ending inventory costs ...... $ 72,000,000 Cost of goods sold ..................................................... 36,000,000 Gross margin.............................................................. $24,000,000 Less: Selling and administrative expenses ................... 10,000,000 Operating income before bonus .................................. $14,000,000 Bonus ....................................................................... 1,400,000 Operating income after bonus ..................................... $12,600,000 Chapter Summary LO8-1 Explain the accounting treatment of fixed manufacturing overhead under absorption and variable costing. Under absorption (or full) costing, fixed overhead is applied to manufactured goods as a product cost. The fixed-overhead cost remains in inventory until the goods are sold. Under variable (or direct) costing, fixed overhead is a period cost expensed during the period when it is incurred. LO8-2 Prepare an income statement under absorption costing. On an absorption-costing income statement, the cost of goods sold is measured at absorption cost (i.e., includes direct material, direct labor, and both variable and fixed manufacturing overhead) and, therefore, fixed overhead is not a period cost. LO8-3 Prepare an income statement under variable costing. On a variable-costing income state- ment, the cost of goods sold is measured at variable cost (i.e., includes direct material, direct labor, and only variable manufacturing overhead), and fixed overhead is treated as a period cost. LO8-4 Reconcile reported income under absorption and variable costing. Income reported under absorption and variable costing can be reconciled by focusing on the effects of the two places where the two statements differ: (1) calculation of cost of goods sold and (2) period costs. LO8-5 Explain the implications of absorption and variable costing for cost-volume-profit analysis. Variable costing highlights the separation between fixed and variable costs, as do cost- volume-profit analysis and break-even calculations. Both of these techniques account for fixed manu- facturing overhead as a lump-sum period cost. In contrast, absorption costing is inconsistent with CVP analysis, because fixed overhead is applied to goods as a product cost on a per-unit basis. hiL25664_ch08_316-349.indd 337hiL25664_ch08_316-349.indd 337 7/4/13 2:18 AM7/4/13 2:18 AM Final PDF to printer 338 Chapter 8 Variable Costing and the Costs of Quality and Sustainability Review Problem on Absorption and Variable Costing ScholasticPak Company manufactures backpacks used by students. A typical backpack has the follow- ing price and variable costs. Sales price ........................................................................ $45 Direct material .................................................................. 15 Direct labor ....................................................................... 6 Variable overhead .............................................................. 9 Budgeted fixed overhead in the company’s first year of operations, was $900,000. Actual and planned production was 150,000 units, of which 125,000 were sold. ScholasticPak incurred the following selling and administrative expenses. Fixed ...................................................... $150,000 for the year Variable .................................................. $3 per unit sold Required: 1. Compute the product cost per backpack under ( a ) variable costing and ( b ) absorption costing. 2. Prepare income statements for the year using ( a ) variable costing and ( b ) absorption costing. 3. Reconcile the income reported under the two methods by analyzing the two key places where the income statements differ. Solution to Review Problem 1. Predetermined fixed overhead rate 5 Budgeted fixed overhead _____________________ Budgeted production 5 $900,000 ________ 150,000 5 $6 per unit LO8-6 Evaluate absorption and variable costing. There are pros and cons to both costing methods. Variable costing dovetails much more closely than absorption costing with any operational analysis that requires a separation between fixed and variable costs (e.g., CVP analysis). On the other hand, variable costing understates a product’s cost, because it excludes fixed manufacturing overhead from the unit cost calculation. In contrast, absorption costing alleviates that objection by including fixed overhead on a per-unit basis in a product’s cost. However, this distorts the cost behavior of fixed costs, which do not in fact vary with production activity. LO8-7 Prepare a quality-cost report. Most firms carefully monitor the costs of maintaining product quality. Quality costs often are categorized as follows: prevention costs, appraisal costs, internal failure costs, and external failure costs. These quality costs are periodically listed on a quality-cost report, which is used by management as it seeks to ensure quality products and services and manage the costs of providing them. LO8-8 Discuss two contrasting views of the optimal level of product quality. In addition to observ- able quality costs, companies experience hidden quality costs, such as the opportunity cost associated with lost market share. The predominant zero-defects perspective on product quality holds that if both observable and hidden costs of product quality are considered, the optimal level of product quality occurs at the zero-defect level. In contrast, the more traditional observable-cost perspective holds that the optimal level of product quality occurs at the minimum point on the total quality cost curve, which typically is above the zero-defect level. LO8-9 Understand the different types of environmental costs, and discuss the management of these costs. Companies incur a variety of environmental costs. These costs include private versus social environmental costs, and the private environmental costs include some visible and some hidden costs. These visible and hidden environmental costs include the costs of monitoring, abatement, and both on- site and off-site remediation. hiL25664_ch08_316-349.indd 338hiL25664_ch08_316-349.indd 338 7/4/13 2:18 AM7/4/13 2:18 AM Final PDF to printer Chapter 8 Variable Costing and the Costs of Quality and Sustainability 339 Product Cost per Unit Direct material .................................................................................................................................... $15 Direct labor ........................................................................................................................................ 6 Variable overhead ................................................................................................................................ 9 a. Cost per unit under variable costing .................................................................................................. $30 Fixed overhead per unit under absorption costing .............................................................................. 6 b. Cost per unit under absorption costing .............................................................................................. $36 2. a. Variable-Costing Income Statement Sales revenue (125,000 units sold at $45 per unit) ............................................................................... $5,625,000 Less: Variable expenses: Variable manufacturing costs (at variable cost of $30 per unit) ....................................................... 3,750,000 Variable selling and administrative costs (at $3 per unit 3 125,000 units sold) ............................... 375,000 Contribution margin ............................................................................................................................. $1,500,000 Less: Fixed expenses: Fixed manufacturing overhead ..................................................................................................... 900,000 Fixed selling and administrative expenses ..................................................................................... 150,000 Operating income ................................................................................................................................ $ 450,000 b. Absorption-Costing Income Statement Sales revenue (125,000 units sold at $45 per unit) ............................................................................... $5,625,000 Less: Cost of goods sold (at absorption cost of $36 per unit) .................................................................. 4,500,000 Gross margin ...................................................................................................................................... $1,125,000 Less: Selling and administrative expenses: Variable (at $3 per unit 3 125,000 units sold) .............................................................................. 375,000 Fixed .......................................................................................................................................... 150,000 Operating income ................................................................................................................................ $ 600,000 3. Cost of goods sold under absorption costing ......................................................................................... $4,500,000 Less: Variable manufacturing costs under variable costing ..................................................................... 3,750,000 Subtotal ............................................................................................................................................. $ 750,000 Less: Fixed manufacturing overhead as period expense under variable costing ....................................... 900,000 Total .................................................................................................................................................. $ (150,000) Operating income under variable costing .............................................................................................. $ 450,000 Less: Operating income under absorption costing ................................................................................. 600,000 Difference in operating income ............................................................................................................ $ (150,000) Key Terms For each term’s definition refer to the indicated page, or turn to the glossary at the end of the text. absorption (or full) costing, 319 appraisal costs, 326 environmental cost management, 333 environmental costs, 332 external failure costs, 326 grade, 325 internal failure costs, 326 prevention costs, 326 quality of conformance, 326 quality of design, 326 Six Sigma, 328 sustainable development, 332 total quality management (TQM), 328 variable (or direct) costing, 319 hiL25664_ch08_316-349.indd 339hiL25664_ch08_316-349.indd 339 7/4/13 2:18 AM7/4/13 2:18 AM Final PDF to printer 340 Chapter 8 Variable Costing and the Costs of Quality and Sustainability Review Questions 8–1. Briefly explain the difference between absorption cost- ing and variable costing. 8–2. Timing is the key in distinguishing between absorption and variable costing. Explain this statement. 8–3. The term direct costing is a misnomer. Variable costing is a better term for the product-costing method. Do you agree or disagree? Why? 8–4. When inventory increases, will absorption-costing or variable-costing income be greater? Why? 8–5. Why do many managers prefer variable costing over absorption costing? 8–6. Explain why some management accountants believe that absorption costing may provide an incentive for managers to overproduce inventory. 8–7. Will variable and absorption costing result in signifi- cantly different income measures in a JIT setting? Why? 8–8. Why do proponents of absorption costing argue that absorption costing is preferable as the basis for pricing decisions? 8–9. Why do proponents of variable costing prefer variable costing when making pricing decisions? 8–10. Which is more consistent with cost-volume-profit analysis, variable costing or absorption costing? Why? 8–11. Explain how the accounting definition of an asset is related to the choice between absorption and variable costing. 8–12. List and define four types of product quality costs. 8–13. Explain the difference between observable and hidden quality costs. 8–14. Distinguish between a product’s quality of design and its quality of conformance. 8–15. What is meant by a product’s grade, as a characteristic of quality? Give an example in the service industry. 8–16. “An ounce of prevention is worth a pound of cure.” Interpret this old adage in light of Exhibit 8–6 . 8–17. Briefly explain the purpose of a cause-and-effect (or fishbone) diagram. 8–18. Define the following types of environmental costs: private, social, visible, hidden, monitoring, abatement, and both on-site and off-site remediation. 8–19. Explain three strategies of environmental cost management. Exercises Dolphin Company manufactures two-person sailboats with a variable cost of $1,000. The sailboats sell for $1,750 each. Budgeted fixed manufacturing overhead for the most recent year was $11,000,000. Planned and actual production for the year were the same. Required: Under each of the following conditions, state ( a ) whether operating income is higher under variable or absorption costing and ( b ) the amount of the difference in reported operating income under the two methods. Treat each condition as an independent case. 1. Production ......................................... 22,000 units Sales ................................................. 25,000 units 2. Production ......................................... 10,600 units Sales ................................................. 10,600 units 3. Production ......................................... 11,000 units Sales ................................................. 9,800 units Refer to the data given in the preceding exercise for Dolphin Company. Required: 1. Prepare a cost-volume-profit graph for the company. (Scale the vertical axis in millions of dollars.) 2. Calculate Dolphin Company’s break-even point in units, and show the break-even point on the CVP graph. 3. Explain why variable costing is more compatible with your CVP graph than absorption costing would be. ■ Exercise 8–20 Difference in Income under Absorption and Variable Costing (LO 8-1, 8-4) ■ Exercise 8–21 Variable Costing and Cost- Volume-Profit Analysis. (LO 8-5) All applicable Exercises are available with McGraw-Hill’s Connect Accounting ®. hiL25664_ch08_316-349.indd 340hiL25664_ch08_316-349.indd 340 7/4/13 2:18 AM7/4/13 2:18 AM Final PDF to printer Chapter 8 Variable Costing and the Costs of Quality and Sustainability 341 Altoona Valve Company’s planned production for the year just ended was 20,000 units. This production level was achieved, and 21,000 units were sold. Other data follow: Direct material used ....................................................................................................... $300,000 Direct labor incurred ...................................................................................................... 150,000 Fixed manufacturing overhead ......................................................................................................... 210,000 Variable manufacturing overhead ..................................................................................................... 100,000 Fixed selling and administrative expenses ......................................................................................... 175,000 Variable selling and administrative expenses ..................................................................................... 52,500 Finished-goods inventory, January 1 ................................................................................................. 2,000 units The cost per unit remained the same in the current year as in the previous year. There were no work-in- process inventories at the beginning or end of the year. Required: 1. What would be Altoona Valve Company’s finished-goods inventory cost on December 31 under the variable-costing method? 2. Which costing method, absorption or variable costing, would show a higher operating income for the year? By what amount? (CMA, adapted) Sea Star Company manufactures diving masks with a variable cost of $12.50. The masks sell for $17.00. Budgeted fixed manufacturing overhead for the most recent year was $396,000. Actual production was equal to planned production. Required: Under each of the following conditions, state ( a ) whether operating income is higher under variable or absorption costing and ( b ) the amount of the difference in reported operating income under the two methods. Treat each condition as an independent case. 1. Production ......................................... 110,000 units Sales ................................................. 107,000 units 2. Production ......................................... 88,000 units Sales ................................................. 93,000 units 3. Production ......................................... 80,100 units Sales ................................................. 80,100 units Information taken from Collegiate Sporting Goods Company’s records for the most recent year is as follows: Direct material used .............................................................................................................................. $272,000 Direct labor ........................................................................................................................................... 128,000 Variable manufacturing overhead ........................................................................................................... 60,000 Fixed manufacturing overhead ............................................................................................................... 100,000 Variable selling and administrative costs ................................................................................................. 56,000 Fixed selling and administrative costs ..................................................................................................... 29,600 Required: 1. Assuming the company uses absorption costing, compute the inventoriable costs for the year. 2. Compute the year’s inventoriable costs using variable costing. (CMA, adapted) ■ Exercise 8–22 Absorption and Variable Costing (LO 8-1, 8-4) ■ Exercise 8–23 Difference in Income under Absorption and Variable Costing (LO 8-1, 8-4) ■ Exercise 8–24 Absorption versus Variable Costing (LO 8-1) hiL25664_ch08_316-349.indd 341hiL25664_ch08_316-349.indd 341 7/4/13 2:18 AM7/4/13 2:18 AM Final PDF to printer 342 Chapter 8 Variable Costing and the Costs of Quality and Sustainability Visit the website for one of the following companies, or a different company of your choosing. Coca-Cola www.cocacola.com Bridgestone www.bridgestonetire.com Motorola www.motorola.com/us/consumers/home Casio www.casio.com Toyota www.toyota.com Xerox Corporation www.xerox.com Required: Read about the company’s products and operations. Discuss the pros and cons of absorp- tion and variable costing as the basis for product costing if the firm uses cost-based pricing. Pinellas Pillow Company’s planned production for the year just ended was 10,000 units. This production level was achieved, but only 9,000 units were sold. Other data follows: Direct material used .............................................................................................................................. $80,000 Direct labor incurred ............................................................................................................................. 40,000 Fixed manufacturing overhead ............................................................................................................... 50,000 Variable manufacturing overhead ........................................................................................................... 24,000 Fixed selling and administrative expenses .............................................................................................. 60,000 Variable selling and administrative expenses .......................................................................................... 9,000 Finished-goods inventory, January 1 ...................................................................................................... None There were no work-in-process inventories at the beginning or end of the year. Required: 1. What would be Pinellas Pillow Company’s finished-goods inventory cost on December 31 under the variable-costing method? 2. Which costing method, absorption or variable costing, would show a higher operating income for the year? By what amount? (CPA, adapted) Information taken from Ticonderoga Paper Company’s records for the most recent year is as follows: Direct material used ............................................................................................................................... $203,000 Direct labor ........................................................................................................................................... 70,000 Variable manufacturing overhead ............................................................................................................ 35,000 Fixed manufacturing overhead ................................................................................................................ 56,000 Variable selling and administrative costs ................................................................................................. 28,000 Fixed selling and administrative costs ..................................................................................................... 14,000 Required: 1. Assuming Ticonderoga Paper Company uses variable costing, compute the inventoriable costs for the year. 2. Compute the year’s inventoriable costs using absorption costing. (CMA, adapted) List three observable and three hidden quality costs that could occur in the airline industry related to the quality of service provided. The following costs were incurred by Akasaka Metals Company to maintain the quality of its products. ( yen is the national currency of Japan.) 1. Operating an X-ray machine to detect faulty welds, 99,000 yen 2. Repairs of products sold last year, 103,000 yen 3. Cost of rewelding faulty joints, 19,000 yen 4. Cost of sending machine operators to a three-week training program so they could learn to use new production equipment with a lower defect rate, 17,900 yen ■ Exercise 8–25 Absorption and Variable Costing; Use of Internet (LO 8-1) ■ Exercise 8–26 Absorption and Variable Costing (LO 8-1, 8-4) ■ Exercise 8–27 Absorption and Variable Costing (LO 8-1) ■ Exercise 8–28 Costs of Quality; Airline (LO 8-7) ■ Exercise 8–29 Quality Costs (LO 8-7) hiL25664_ch08_316-349.indd 342hiL25664_ch08_316-349.indd 342 7/4/13 2:18 AM7/4/13 2:18 AM Final PDF to printer Chapter 8 Variable Costing and the Costs of Quality and Sustainability 343 Required: Classify each of these costs as a prevention, appraisal, internal failure, or external failure cost. Cerritos Circuitry manufactures electrical instruments for a variety of purposes. The following costs related to maintaining product quality were incurred in May. Training of quality-control inspectors ....................................................................................................... $31,500 Tests of instruments before sale ............................................................................................................. 45,000 Inspection of electrical components purchased from outside suppliers ...................................................... 18,000 Costs of rework on faulty instruments ..................................................................................................... 13,500 Replacement of instruments already sold, which were still covered by warranty ......................................... 24,750 Costs of defective parts that cannot be salvaged ...................................................................................... 9,150 Required: Prepare a quality-cost report similar to the report shown in Exhibit 8–6 . Visit the website of Interface, Inc., at http://www.interfaceglobal.com. Read about its efforts toward sustainable development by clicking on the “Sustainability” link. Required: What is Interface’s product? Describe the company’s efforts toward sustainable development. ■ Exercise 8–30 Quality-Cost Report (LO 8-7) ■ Exercise 8–31 Environmental Cost Management; Internet (LO 8-9) Problems Chenango Can Company manufactures metal cans used in the food-processing industry. A case of cans sells for $25. The variable costs of production for one case of cans are as follows: Direct material .......................................................................................................................................... $ 7.50 Direct labor .............................................................................................................................................. 2.50 Variable manufacturing overhead ............................................................................................................... 6.00 Total variable manufacturing cost per case ............................................................................................. $16.00 Variable selling and administrative costs amount to $.50 per case. Budgeted fixed manufacturing over- head is $400,000 per year, and fixed selling and administrative cost is $37,500 per year. The following data pertain to the company’s first three years of operation. (A unit refers to one case of cans.) Year 1 Year 2 Year 3 Planned production (in units) ...................................................... 80,000 80,000 80,000 Finished-goods inventory (in units), January 1 ............................. 0 0 20,000 Actual production (in units) ......................................................... 80,000 80,000 80,000 Sales (in units) ........................................................................... 80,000 60,000 90,000 Finished-goods inventory (in units), December 31 ........................ 0 20,000 10,000 Actual costs were the same as the budgeted costs. Required: 1. Prepare operating income statements for Chenango Can Company for its first three years of operations using: a. Absorption costing. b. Variable costing. 2. Reconcile Chenango Can Company’s operating income reported under absorption and variable costing for each of its first three years of operation. Use the shortcut method. 3. Suppose that during Chenango’s fourth year of operation actual production equals planned production, actual costs are equal to budgeted costs, and the company ends the year with no inventory on hand. a. What will be the difference between absorption-costing operating income and variable-costing operating income in year 4? b. What will be the relationship between total operating income for the four-year period as reported under absorption and variable costing? Explain. ■ Problem 8–32 Variable-Costing and Absorption-Costing Income Statements; Reconciling Operating Income (LO 8-2, 8-3, 8-4) 1. Absorption cost per case: $21 All applicable Problems are available with McGraw-Hill’s Connect Accounting ®. hiL25664_ch08_316-349.indd 343hiL25664_ch08_316-349.indd 343 7/4/13 2:18 AM7/4/13 2:18 AM Final PDF to printer 344 Chapter 8 Variable Costing and the Costs of Quality and Sustainability Cincinnati Cylinder Company began operations on January 1 to produce pneumatic cylinders used in a variety of machines. It used an absorption costing system with a planned production volume of 100,000 units. During its first year of operations, 100,000 units were produced and there were no fixed selling or administrative expenses. Inventory on December 31 was 20,000 units, and operating income for the year was $480,000. Required: 1. If Cincinnati Cylinder Company had used variable costing, its operating income would have been $440,000. Compute the break-even point in units under variable costing. 2. Draw a profit-volume graph for Cincinnati Cylinder Company. (Use variable costing.) Skinny Dippers, Inc., produces nonfat frozen yogurt which it sells to restaurants and ice cream shops. The product is sold in 10-gallon containers, which have the following price and variable costs. Sales price ........................................................................................................................................................ $30 Direct material ................................................................................................................................................... 10 Direct labor ....................................................................................................................................................... 4 Variable overhead .............................................................................................................................................. 6 Budgeted fixed overhead in 20x4, the company’s first year of operations, was $600,000. Actual produc- tion was 150,000 10-gallon containers, of which 125,000 were sold. Skinny Dippers, Inc. incurred the following selling and administrative expenses. Fixed ....................................................................................................................................... $100,000 for the year Variable ................................................................................................................................... $2 per container sold Required: 1. Compute the variable product cost per container of frozen yogurt under ( a ) variable costing and ( b ) absorption costing. 2. Prepare operating income statements for 20x4 using ( a ) absorption costing and ( b ) variable costing. 3. Reconcile the operating income reported under the two methods by analyzing the two key places where the income statements differ. 4. Reconcile the operating income reported under the two methods using the shortcut method. 5. Build a spreadsheet: Construct an Excel spreadsheet to solve all of the preceding requirements. Show how the solution will change if the following information changes: the selling price and direct-material cost per unit are $32 and $9, respectively. Outback, Ltd., manufactures tactical LED flashlights in Melbourne, Australia. The firm uses an absorp- tion-costing system for internal reporting purposes; however, the company is considering using variable costing. Data regarding planned and actual operations for 20x4 follow: Budgeted Costs Per Unit Total Actual Costs Direct material .................................................................. $ 6.00 $ 840,000 $ 780,000 Direct labor ....................................................................... 4.50 630,000 585,000 Variable manufacturing overhead ....................................... 2.00 280,000 260,000 Fixed manufacturing overhead ........................................... 2.50 350,000 357,500 Variable selling expenses ................................................... 4.00 560,000 500,000 Fixed selling expenses ....................................................... 3.50 490,000 490,000 Variable administrative expenses ........................................ 1.00 140,000 125,000 Fixed administrative expenses ............................................ 1.50 210,000 212,500 Total ........................................................................... $25.00 $3,500,000 $3,310,000 ■ Problem 8–33 Absorption and Variable Costing; CVP Analysis (LO 8-4, 8-5, 8-6) 1. Fixed overhead: $200,000 ■ Problem 8–34 Straightforward Problem on Absorption versus Variable Costing (LO 8-2, 8-3, 8-4, 8-6) 1. Predetermined fixed overhead rate: $4 per unit 2(a). Gross margin: $750,000 Ex ■ Problem 8–35 Variable versus Absorption Costing; JIT (LO 8-1, 8-4) 1. Total budgeted manufacturing costs, $2,100,000 2. Budgeted variable manufacturing costs: $12.50 per unit hiL25664_ch08_316-349.indd 344hiL25664_ch08_316-349.indd 344 7/4/13 2:18 AM7/4/13 2:18 AM Final PDF to printer Chapter 8 Variable Costing and the Costs of Quality and Sustainability 345 Planned Activity Actual Activity Sales in units ............................................................................................... 140,000 125,000 Production in units ....................................................................................... 140,000 130,000 Beginning finished-goods inventory in units ................................................... 35,000 35,000 The budgeted per-unit cost figures were based on the company producing and selling 140,000 units in 20x4. Outback uses a predetermined overhead rate for applying manufacturing overhead to its product. A total manufacturing overhead rate of $4.50 per unit was employed for absorption costing purposes in 20x4. Any overapplied or underapplied manufacturing overhead is closed to the Cost of Goods Sold account at the end of the year. The 20x4 beginning finished-goods inventory for absorption costing purposes was valued at the 20x3 budgeted unit manufacturing cost, which was the same as the 20x4 budgeted unit manufacturing cost. There are no work-in-process inventories at either the beginning or the end of the year. The planned and actual unit selling price for 20x4 was $35 per unit. Required: Was Outback’s 20x4 operating income higher under absorption costing or variable cost- ing? Why? Compute the following amounts. 1. The value of the 20x4 ending finished-goods inventory under absorption costing. 2. The value of the 20x4 ending finished-goods inventory under variable costing. 3. The difference between Outback’s 20x4 reported operating income calculated under absorption costing and calculated under variable costing. 4. Suppose Outback had introduced a JIT production and inventory management system at the beginning of 20x4. a. What would likely be different about the scenario as described in the problem? b. Would reported operating income under variable and absorption costing differ by the magni- tude you found in requirement (3)? Explain. (CMA, adapted) Adelphia Corporation, which uses absorption costing, just completed its first year of operations. Planned and actual production equaled 10,000 units, and sales totaled 9,600 units at $216 per unit. Cost data for the year are as follows: Direct material (per unit) .............................................................................................................................. $36 Conversion cost: Direct labor ............................................................................................................................................ 135,000 Variable manufacturing overhead ............................................................................................................. 195,000 Fixed manufacturing overhead ................................................................................................................. 660,000 Selling and administrative costs: Variable (per unit) .................................................................................................................................... 24 Fixed ..................................................................................................................................................... 354,000 Required: 1. Compute the company’s total cost for the year assuming that variable manufacturing costs are driven by the number of units produced, and variable selling and administrative costs are driven by the number of units sold. 2. How much of this cost would be held in year-end inventory under ( a ) absorption costing and ( b ) variable costing? 3. How much of the company’s total cost for the year would be included as an expense on the peri- od’s income statement under ( a ) absorption costing and ( b ) variable costing? 4. Build a spreadsheet: Construct an Excel spreadsheet to solve requirements (1) and (2) above. Show how the solution will change if the following information changes: the direct-material cost is $35 per unit, and the total direct-labor cost is $130,000. Ozarks Lighting Company had operating income for the first 10 months of the current year of $300,000. One hundred thousand units were manufactured during this period, and 100,000 units were sold. Fixed manufacturing overhead was $3,000,000 over the 10-month period (i.e., $300,000 per month). There are no selling and administrative expenses for Ozarks Lighting Company. Both variable and fixed costs are expected to continue at the same rates for the balance of the year (i.e., fixed costs at $300,000 per month and variable costs at the same variable cost per unit). There were 10,000 units in inventory on ■ Problem 8–36 Absorption Costing and Variable Costing (LO 8-1, 8-2, 8-3) 2. Year-end inventory: 400 units ■ Problem 8–37 Variable and Absorption Costing (LO 8-4) 2(a). Contribution margin per unit: $33 hiL25664_ch08_316-349.indd 345hiL25664_ch08_316-349.indd 345 7/4/13 2:18 AM7/4/13 2:18 AM Final PDF to printer 346 Chapter 8 Variable Costing and the Costs of Quality and Sustainability October 31. Twenty thousand units are to be produced and 19,000 units are to be sold in total over the last two months of the current year. Assume the unit variable cost is the same in the current year as in the previous year. ( Hint: You cannot calculate revenue or cost of goods sold; you must work directly with contribution margin or gross margin.) Required: 1. If operations proceed as described, will operating income be higher under variable or absorption costing for the current year in total? Why? 2. If operations proceed as described, what will operating income for the year in total be under ( a ) variable costing and ( b ) absorption costing? 3. Discuss the advantages and disadvantages of absorption and variable costing. Great Outdoze, Inc., manufactures high-quality sleeping bags, which sell for $130 each. The variable costs of production are as follows: Direct material .................................................................................................................................................... $40 Direct labor ........................................................................................................................................................ 22 Variable manufacturing overhead ......................................................................................................................... 16 Budgeted fixed overhead in 20x4 was $400,000 and budgeted production was 25,000 sleeping bags. The year’s actual production was 25,000 units, of which 22,000 were sold. Variable selling and administrative costs were $2 per unit sold; fixed selling and administrative costs were $60,000. Required: 1. Calculate the product cost per sleeping bag under ( a ) absorption costing and ( b ) variable costing. 2. Prepare operating income statements for the year using ( a ) absorption costing and ( b ) variable costing. 3. Reconcile reported operating income under the two methods using the shortcut method. Industrial Technologies, Inc. (ITI), produces two compression machines that are popular with manufac- turers of plastics: no. 165 and no. 172. Machine no. 165 has an average selling price of $30,000, whereas no. 172 typically sells for approximately $27,500. The company is very concerned about quality and has provided the following information: No. 165 No. 172 Number of machines produced and sold .............................................................. 160 200 Warranty costs: Average repair cost per unit ............................................................................. $900 $350 Percentage of units needing repair .................................................................. 70% 10% Reliability engineering at $150 per hour .............................................................. 1,600 hours 2,000 hours Rework at ITI’s manufacturing plant: Average rework cost per unit ......................................................................... $1,900 $1,600 Percentage of units needing rework ................................................................ 35% 25% Manufacturing inspection at $50 per hour ........................................................... 300 hours 500 hours Transportation costs to customer sites to fix problems .......................................... $29,500 $15,000 Quality training for employees ............................................................................. $35,000 $50,000 Required: 1. Classify the preceding costs as prevention, appraisal, internal failure, or external failure. 2. Using the classifications in requirement (1), compute ITI’s quality costs for machine no. 165 in dollars and as a percentage of sales revenues. Also calculate prevention, appraisal, internal failure, and external failure costs as a percentage of total quality costs. 3. Repeat requirement (2) for machine no. 172. ■ Problem 8–38 Variable-Costing and Absorption-Costing Income Statements (LO 8-2, 8-3, 8-4, 8-6) 1. Total variable cost: $78 per unit 2(a). Absorption costing, operating income: $688,000 ■ Problem 8–39 Quality Costs: Identification and Analysis (LO 8-7) 2. & 3. Total quality costs, No. 165: $526,700 hiL25664_ch08_316-349.indd 346hiL25664_ch08_316-349.indd 346 7/4/13 2:18 AM7/4/13 2:18 AM Final PDF to printer Chapter 8 Variable Costing and the Costs of Quality and Sustainability 347 4. Comment on your findings, noting whether the company is “investing” its quality expenditures differently for the two machines. 5. Quality costs can be classified as observable or hidden. What are hidden quality costs, and how do these costs differ from observable costs? News Technology, Inc., manufactures computerized laser printing equipment used by newspaper pub- lishers throughout North America. In recent years, the company’s market share has been eroded by stiff competition from Asian and European competitors. Price and product quality are the two key areas in which companies compete in this market. Ben McDonough, News Technology’s president, decided to devote more resources to the improve- ment of product quality after learning that his company’s products had been ranked fourth in product quality in a recent survey of newspaper publishers. He believed that the company could no longer afford to ignore the importance of product quality. McDonough set up a task force which he headed to imple- ment a formal quality-improvement program. Included on the task force were representatives from engi- neering, sales, customer service, production, and accounting, because McDonough believed this was a companywide program and all employees should share the responsibility for its success. After the first meeting of the task force, Sheila Hayes, manager of sales, asked Tony Reese, the pro- duction manager, what he thought of the proposed program. Reese replied, “I have reservations. Quality is too abstract to be attaching costs to it and then to be holding you and me responsible for cost improve- ments. I like to work with goals that I can see and count! I don’t like my annual income to be based on a decrease in quality costs; there are too many variables that we have no control over!” News Technology’s quality-improvement program has now been in operation for 18 months, and the following quality cost report has recently been issued. As they were reviewing the report, Hayes asked Reese what he thought of the quality program now. “The work is really moving through the Pro- duction Department,” replied Reese. “We used to spend time helping the Customer Service Department solve their problems, but they are leaving us alone these days. I have no complaints so far. I’ll be anxious to see how much the program increases our bonuses.” NEWS TECHNOLOGY, INC. Cost of Quality Report (in thousands) Quarter Ended 6/30/x3 9/30/x3 12/31/x3 3/31/x4 6/30/x4 9/30/x4 Prevention costs: Design review ................................... $ 19 $ 101 $ 110 $ 99 $ 103 $ 94 Machine maintenance ....................... 215 215 202 190 170 160 Training suppliers .............................. 6 46 26 21 21 16 Total ............................................. $ 240 $ 362 $ 338 $ 310 $ 294 $ 270 Appraisal costs: Incoming inspection ........................... $ 45 $ 53 $ 57 $ 36 $ 34 $ 22 Final testing ...................................... 160 160 154 140 115 94 Total ............................................. $ 205 $ 213 $ 211 $ 176 $ 149 $ 116 Internal failure costs: Rework ............................................ $ 120 $ 106 $ 114 $ 88 $ 78 $ 62 Scrap .............................................. 68 64 53 42 40 40 Total ............................................ $ 188 $ 170 $ 167 $ 130 $ 118 $ 102 External failure costs: Warranty repairs .............................. $ 69 $ 31 $ 24 $ 25 $ 23 $ 23 Customer returns ............................ 262 251 122 116 87 80 Total .......................................... $ 331 $ 282 $ 146 $ 141 $ 110 $ 103 Total quality cost ................................. $ 964 $1,027 $ 862 $ 757 $ 671 $ 591 Total production cost ........................... $4,120 $4,540 $4,380 $4,650 $4,580 $4,510 ■ Problem 8–40 Quality-Improvement Programs and Quality Costs (LO 8-7) hiL25664_ch08_316-349.indd 347hiL25664_ch08_316-349.indd 347 7/4/13 2:18 AM7/4/13 2:18 AM Final PDF to printer 348 Chapter 8 Variable Costing and the Costs of Quality and Sustainability Required: 1. Identify at least three factors that should be present for an organization to successfully implement a quality-improvement program. 2. By analyzing the cost of quality report presented, determine if News Technology’s quality- improvement program has been successful. List specific evidence to support your answer. 3. Discuss why Tony Reese’s current reaction to the quality-improvement program is more favorable than his initial reaction. 4. News Technology’s president believed that the quality-improvement program was essential and that the firm could no longer afford to ignore the importance of product quality. Discuss how the company could measure the opportunity cost of not implementing the quality-improvement program. (CMA, adapted) As a group, take a walking tour of your campus and the surrounding community. Make a list of all of the environmental costs of which you see evidence. Required: Make a presentation to the class about your findings. List and categorize the environmental costs you noted for either your college or for businesses in the community. (You might consider writing a letter to your campus newspaper regarding these environmental issues and their costs.) ■ Problem 8–41 Environmental Cost Management (LO 8-9) Huron Chalk Company manufactures sidewalk chalk which it sells online by the box at $25 per unit. Huron uses an actual costing system, which means that the actual costs of direct material, direct labor, and manufacturing overhead are entered into work-in-process inventory. The actual application rate for manufacturing overhead is computed each year; actual manufacturing overhead is divided by actual production (in units) to compute the application rate. Information for Huron’s first two years of opera- tions is as follows: Year 1 Year 2 Sales (in units) ................................................................................................................. 2,500 2,500 Production (in units) ......................................................................................................... 3,000 2,000 Production costs: Variable manufacturing costs ....................................................................................... $10,500 $ 7,000 Fixed manufacturing overhead ..................................................................................... 21,000 21,000 Selling and administrative expenses: Variable ...................................................................................................................... 12,500 12,500 Fixed .......................................................................................................................... 10,000 10,000 Required: Huron Chalk Company had no beginning or ending work-in-process inventories for either year. 1. Prepare operating income statements for both years based on absorption costing. 2. Prepare operating income statements for both years based on variable costing. 3. Prepare a numerical reconciliation of the difference in income reported under the two costing methods used in requirements (1) and (2). Refer to the information given in the preceding case for Huron Chalk Compan y . Required: 1. Reconcile Huron’s operating income reported under absorption and variable costing, during each year, by comparing the following two amounts on each income statement: • Cost of goods sold • Fixed cost (expensed as a period expense) 2. What was Huron’s total operating income across both years under absorption costing and under variable costing? ■ Case 8–42 Comparison of Absorption and Variable Costing (LO 8-2, 8-3, 8-4) 1. Operating income, year 1: $13,750 2. Contribution margin, year 2: $41,250 Ex ■ Case 8–43 Analysis of Differences in Absorption-Costing and Variable-Costing Income Statements; Continuation of Preceding Case (LO 8-1, 8-4) 1. Year 1, absorption costing operating income: $13,750 4. Total of all costs expensed across both years: $104,500 Cases hiL25664_ch08_316-349.indd 348hiL25664_ch08_316-349.indd 348 7/4/13 2:18 AM7/4/13 2:18 AM Final PDF to printer Chapter 8 Variable Costing and the Costs of Quality and Sustainability 349 3. What was the total sales revenue across both years under absorption costing and under variable costing? 4. What was the total of all costs expensed on the operating income statements across both years under absorption costing and under variable costing? 5. Subtract the total costs expensed across both years [requirement (4)] from the total sales revenue across both years [requirement (3)]: ( a ) under absorption costing and ( b ) under variable costing. 6. Comment on the results obtained in requirements (1), (2), (3), and (4) in light of the following assertion: Timing is the key in distinguishing between absorption and variable costing. Refer to the information given in Case 8-42 for Huron Chalk Company. Selected information from Huron’s year-end balance sheets for its first two years of operation is as follows: HURON CHALK COMPANY Selected Balance Sheet Information Based on absorption costing End of Year 1 End of Year 2 Finished-goods inventory .................................................................................... $5,250 $ 0 Retained earnings* ............................................................................................. 8,250 12,300 Based on variable costing End of Year 1 End of Year 2 Finished-goods inventory .................................................................................... $1,750 $ 0 Retained earnings* ............................................................................................. 4,750 12,300 *For convenience, assume that the company pays no taxes in Year 1 and Year 2, and operating income equals net income for computing of retained earnings. Required: 1. Why is the year 1 ending balance in finished-goods inventory higher if absorption costing is used than if variable costing is used? 2. Why is the year 2 ending balance in finished-goods inventory the same under absorption and vari- able costing? 3. Notice that the ending balance of finished-goods inventory under absorption costing is greater than or equal to the ending finished-goods inventory balance under variable costing for both years 1 and 2. Will this relationship always hold true at any balance sheet date? Explain. 4. Compute the amount by which the year-end balance in finished-goods inventory declined during year 2 (i.e., between December 31 of year 1 and December 31 of year 2): • Using the data from the balance sheet prepared under absorption costing. • Using the data from the balance sheet prepared under variable costing. 5. Refer to your calculations from requirement (4). Compute the difference in the amount by which the year-end balances in finished-goods inventory declined under absorption versus variable cost- ing. Then compare the amount of this difference with the difference in the company’s reported operating income for year 2 under absorption versus variable costing. (Refer to the operating income statements prepared in Case 8–42.) 6. Notice that the retained earnings balance at the end of both years 1 and 2 on the balance sheet prepared under absorption costing is greater than or equal to the corresponding retained earnings balance on the statement prepared under variable costing. Will this relationship hold true at any balance sheet date? Explain. ■ Case 8–44 Absorption and Variable Costing; Effect on the Balance Sheet; Continuation of Preceding Case (LO 8-1, 8-4) 4. Absorption costing, Finished-Goods Inventory, end of year 1: $5,250 5. Variable costing, reported operating income for year 2: $10,250 hiL25664_ch08_316-349.indd 349hiL25664_ch08_316-349.indd 349 7/11/13 10:36 PM7/11/13 10:36 PM Final PDF to printer 9 THIS CHAPTER’S FOCUS COMPANY is Snowcap Music Festivals, a pro- ducer and event manager of destination music events worldwide. Snow- cap Music Festivals prides itself on attracting leading musical talent to its events while also exposing festival guests to the “next big thing” by featuring new talent. The fun festival scene is made possible by a modern business organization that keeps operations running smoothly while ensuring that Snowcap Music Festivals stays profitable. One of the core elements of this business organization is a Financial Planning and Analysis (FP&A) system, and a key element of this system is the master budget. In this chapter, we will explore how Snowcap Music Festivals develops its master budget and uses it for planning individual events and overall company performance, communicat- ing within the company, allocating resources to different festivals, controlling opera- tions, evaluating performance, and providing incentives. How can one accounting process do all of that? Read on! FOCUS COMPANY >>>
Financial Planning
and Analysis:
The Master Budget
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<<< IN CONTRAST In contrast to the service and merchandising setting of Snowcap Music Festivals, we explore the manufacturing budgets for FestiChair.com , a manu- facturer of outdoor chairs based in Denver, Colorado. Manufacturing adds complexity to the budgeting process because of the variety of resources needed and because manufacturers hold inventory. The budget provides a means for planning and managing the various resources in manufacturing. And inventory presents some special challenges. As we explore how FestiChair.com goes about developing its annual budget, differences in the manufacturing setting will be emphasized. hiL25664_ch09_350-407.indd 351hiL25664_ch09_350-407.indd 351 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer 352 Financial Planning and Analysis (FP&A) Systems As a company grows and its founder can no longer keep all of the company details in her head, it will need to create systems to track that data and provide it when and where needed, in a format that managers find useful. One of those systems, the one that helps managers assess the company’s future and know if they are reaching their performance goals, is called a financial planning and analysis (FP&A) system . A complete FP&A system includes subsystems for (1) planning, (2) measuring and recording results, and (3) evaluating performance. If you were to design an FP&A sys- tem for an organization that you are part of, you might concentrate mostly on measuring and recording results. But if you did that, you would be missing out on one of the most important benefits of an FP&A system: forcing different parts of the organization to com- municate with one another to create performance targets and set expectations about the financial and nonfinancial results of operations. For example, suppose that the senior management of our focus company, Snowcap Music Festivals, decides to increase by 10 percent the number of tickets available for each of its three largest festivals but neglects to tell the merchandise (“merch”) depart- ment about the change. Unaware of the increased traffic that will be coming to the mer- chandise tent, the merch department orders the same number of T-shirts as the prior year. When T-shirts begin running out on the second day of the first big festival, it is too late to order more. Sales and profits are lost and there are a lot of unhappy guests. Then the merch group, now aware of the mistake, orders additional shirts for the next festival. But with the event only three weeks away, the T-shirt printer has already committed all of its production capacity. So now Snowcap has an unpleasant choice: either pay for costly overtime production by the T-shirt printer or try to find another printer of equal quality that has not already committed all of its capacity. Even if they succeed, it will have been a frustrating and costly way to start the festival season! Financial Planning and Analysis (FP&A) Systems 9-1 Explain the relationship between financial planning and analysis and the master budget. 9-2 List and explain five purposes of budgeting. 9-3 Describe the similarities and differences in the operational budgets prepared by manufacturers, service-industry firms, merchandisers, and nonprofit organizations. 9-4 Explain the concept of activity-based budgeting and the logic it brings to the budgeting process. 9-5 Prepare each of the budget schedules that make up the master budget in a nonmanufacturing firm, and that exist in manufacturing budgets as well. 9-6 Prepare the additional master budget schedules required by a manufacturing firm. 9-7 Discuss the role of assumptions and predictions in budgeting. 9-8 Describe a typical organization’s process of budget administration. 9-9 Discuss the behavioral issues in budgeting. After completing this chapter, you should be able to: Learning Objective 9-1 Explain the relationship between financial planning and analysis and the master budget. hiL25664_ch09_350-407.indd 352hiL25664_ch09_350-407.indd 352 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer Chapter 9 Financial Planning and Analysis: The Master Budget 353 The planning component of the FP&A system is called the master budget and it is intended to help prevent these kinds of problems. By formalizing the communication and coordination of operating and financial plans, the master budget makes sure that everyone’s plans are consistent and that the total output of all those plans yields a result that makes sense for the organization. The master budget collects all of the operating plans and trans- lates them into a financial picture of the results of the planned operations, along the way identifying the resources required to accomplish those plans and the costs of those resources. Developing a budget is a critical step in planning any economic activity. This is true for businesses, for governmental agencies, and for individuals. We all must budget our money to meet day-to-day expenses and to plan for major expenditures, such as buying a car or paying for college tuition. Similarly, businesses of all types and governmental units at every level must make financial plans to carry out routine operations, to plan for major expenditures, and to help in making financial decisions. Purposes of Budgeting A budget is a detailed plan, expressed in quantitative terms, that specifies how resources will be acquired and used during a specified period of time. As one of the key tools of an FP&A system, the budget has five primary purposes: planning; facilitating communica- tion and coordination; allocating resources; controlling profit and operations; and evalu- ating performance and providing incentives. Planning The most obvious purpose of a budget is to quantify a plan of action. The process of creating a budget forces the individuals who make up an organization to plan ahead. The development of a quarterly budget for a Sheraton Hotel, for example, forces the hotel manager, the reservation manager, and the food and beverage manager to plan for the staffing and supplies needed to meet anticipated demand for the hotel’s services. Facilitating Communication and Coordination For any organization to be effective, each manager throughout the organization must be aware of the plans made by other man- agers. In order to plan reservations and ticket sales effectively, the reservations manager for Delta Air Lines must know the flight schedules developed by the airline’s route man- ager. The budgeting process pulls together the plans of each manager in an organization. Allocating Resources As we discussed in earlier chapters, an organization’s resources have limited capacity, and budgets provide one means of allocating resources among competing uses. The city of Chicago, for example, must allocate its revenue among basic life services (such as police and fire protection), maintenance of property and equipment (such as city streets, parks, and vehicles), and other community services (such as child- care services and programs to prevent alcohol and drug abuse). Controlling Profit and Operations A budget is a plan, and plans are subject to change. Nevertheless, a budget serves as a useful benchmark with which actual results can be compared. For example, Prudential Insurance Company can compare its actual sales of insurance policies for a year against its budgeted sales. Such a comparison can help managers evaluate the firm’s effectiveness in selling insurance. The next two chap- ters examine the control purpose of budgets in more depth. Evaluating Performance and Providing Incentives Comparing actual results with budgeted results also helps managers evaluate the performance of individuals, departments, divisions, or entire companies. Since budgets are used to evaluate performance, they also can be used to provide incentives for people to perform well. For example, General Motors Company, like many other companies, provides incentives for managers to improve profits by awarding bonuses to managers who meet or exceed their budgeted profit goals. Learning Objective 9-2 List and explain five purposes of budgeting. “We view the role of finance as the trusted adviser to the business . . . providing a single version of data, but also business judgment and business insight. That requires a different set of skills like analytics and consultative abilities.” (9a) IBM “Budgeting is used exten- sively for cost control. Each plant manager develops a plant budget, and then each department supervisor is responsible for his or her own cost center. . . . There are budgets for every department in the company.” (9b) Best Foods (a subsidiary of Unilever) hiL25664_ch09_350-407.indd 353hiL25664_ch09_350-407.indd 353 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer 354 Chapter 9 Financial Planning and Analysis: The Master Budget Types of Budgets Different types of budgets serve different purposes. A master budget or profit plan , discussed below, is a comprehensive set of budgets covering all phases of an organization’s operations for a specified period of time. Budgeted financial statements , often called pro forma financial statements , show how the organiza- tion’s financial statements will appear at a specified time if operations proceed according to plan. Bud- geted financial statements include a budgeted income statement, a budgeted balance sheet, and a budgeted statement of cash flows. A capital budget is a plan for the acquisition of capital assets, such as buildings and equipment. Cap- ital budgeting is covered in depth later in the text. A financing budget is a plan that shows how the orga- nization will acquire its financial resources, such as through the issuance of stock or incurrence of debt. Budgets are developed for specific time periods. Short-range budgets cover a year, a quarter, or a month, whereas long-range budgets cover periods longer than a year. Rolling budgets are con- tinually updated by periodically adding a new incremental time period, such as a quarter, and dropping the period just completed. Rolling budgets are also called revolving bud- gets or continuous budgets. The Master Budget: A Planning Tool When developing a budget, it is helpful to think of the production process for goods or services as a big machine: certain inputs are fed into the machine, various resources are then applied to convert those inputs into something different, and the output from the machine is what people are willing to buy. These are exactly the things that a company needs to plan for in its budget: the quantity and cost of inputs, the quantity and cost of resources needed for conversion, and the units and revenues of outputs that can be sold. However, it is important to notice that in budgeting, the order of these plans is reversed. The sales planning process and sales budget are created first, because the need for products and services to fill sales orders is what drives the company’s production plans and the related production budget. The production budget, in turn, tells the company how much of each input and conversion resource is needed. Combining this information with the company’s input and resource cost estimates yields the appropriate budgets. This logic, and the budgets, are shown in Exhibit 9–1 . The master budget, the principal output of a budgeting system, is a comprehensive profit plan that ties together all phases of an organization’s operations. The master budget comprises many separate budgets, or sched- ules, that are interdependent. It is a complicated process, but if you will devote some time to understanding Exhibit 9–1 , you will be well on your way to understanding budgeting. Sales of Services or Goods Because the market demand for a service or product drives the production process, the starting point for any master budget is a sales revenue budget based on a sales forecast for services or goods. Airlines forecast the number of passengers on each of their routes. Banks forecast the number and dollar amount of consumer loans and home mortgages to be provided. E-commerce companies forecast the number of customers visiting their sites and the percentage that will make purchases. Manufacturing and merchandising compa- nies forecast sales of their goods. The Master Budget: A Planning Tool Diverse organizations use budgets for a variety of reasons. A resort hotel, such as this one on Mexico’s Caribbean cost, uses budgets to plan for meeting the payroll and operating expenses and to coordinate operations by matching staffing with projected seasonal demand. The resort also uses its budgeting process to allocate capital improvement funds among competing projects, such as expanding the resort by acquiring a neigh- boring property or improving existing facilities. hiL25664_ch09_350-407.indd 354hiL25664_ch09_350-407.indd 354 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer Chapter 9 Financial Planning and Analysis: The Master Budget 355 Some companies sell and forecast both goods and services. For example, IBM makes a significant portion of its revenues from the sale of computing equipment and software, but it makes even more from the sale of consulting and technology services. Its planning and budgeting process includes five different business segments: business services, tech- nology services, software, systems and technology, and financing. Sales Forecasting As we will demonstrate shortly, the accuracy of the entire budgeting process depends on first getting the sales budget right. Sales forecasting is a critical step in the budgeting process, and it is very difficult to do accurately. Various procedures are used in sales forecasting, and the final forecast usually com- bines information from many different sources. Many firms have a top-management-level market research staff whose job is to coordinate the company’s sales forecasting efforts. Typically, everyone from key executives to the firm’s sales personnel will be asked to contribute sales projections. Major factors considered when forecasting sales include the following: 1. Past sales levels and trends: a. For the firm developing the forecast (for example, Exxon ). b. For the entire industry (for example, the petroleum industry). 2. General economic trends. (Is the economy growing? How fast? Is a recession or economic slowdown expected?) 3. Economic trends in the company’s industry. (In the petroleum industry, for example, will sales of hybrid and electric vehicles continue to grow rapidly, thereby implying decreased demand for gasoline?) Production Budget Ending Inventory Budget: Work in Process and Finished Goods Operational Budgets Budgeted Financial Statements Ending Inventory Budget: Raw Material Direct- Material Budget Direct- Labor Budget Cash Disbursements Budget Cash Budget Budgeted Balance Sheet Budgeted Income Statement Budgeted Statement of Cash Flows Production Overhead* Budget Sales of Services or Goods Manufacturing Only Cash Receipts Budget Sales Budget Financing Budgets Selling and Administrative Expense Budget Exhibit 9–1 Components of a Master Budget *Production overhead was previously referred to as manufacturing overhead. However, we now employ the more general term to move beyond manufacturing and include service and merchandising operations. “I may be able to tell you how many toothbrushes we sold in Europe yesterday. But we want to get to the point where I can tell you today how many toothbrushes we will sell 45 to 60 days from now. If I figure that out, we can’t get beat.” (9c) Walmart hiL25664_ch09_350-407.indd 355hiL25664_ch09_350-407.indd 355 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer 356 Chapter 9 Financial Planning and Analysis: The Master Budget 4. Other factors expected to affect sales in the industry. (Is an unusually cold winter expected, which would result in increased demand for home heating oil in northern climates?) 5. Political and legal events. (For example, is any legislation pending in Congress that would affect the demand for petroleum, such as tax incentives to use alternative energy sources?) 6. The intended pricing policy of the company. 7. Planned advertising and product promotion. 8. Expected actions of competitors. 9. New products or processes contemplated by the company or other firms. (For example, will the use of new hydraulic fracturing techniques lead to greater availability of domestic natural gas supplies?) 10. Market research studies. The starting point in the sales forecasting process is generally the sales level of the prior year. Then the market research staff considers the information discussed above along with input from key executives and sales personnel. In many firms, elaborate econometric models are built to incorporate all the available information systematically. ( Econometric means economic measurement.) Statistical methods, such as regression analysis and probability distributions for sales, are often used. All in all, a great deal of effort generally goes into the sales forecast, since it is such a critical step in the budget- ing process. Making a sales forecast is like shooting an arrow. If the archer’s aim is off by only a fraction of an inch, the arrow will go further and further astray and miss the bull’s eye by a wide margin. Similarly, a slightly inaccurate sales forecast, coming at the very beginning of the budgeting process, will throw off all of the other schedules comprising the master budget. Operational Budgets Based on the sales budget, a company develops a set of operational budgets that specify how its operations will be carried out to meet the demand for its goods or services. The budgets constituting this operational por- tion of the master budget are depicted in the upper half of Exhibit 9–1 . Manufacturing Firms A manufacturing company develops a production budget, which shows the number of units of each product to be manufactured. Coupled with the production budget are ending-inventory budgets for raw material, work in process, and finished goods. Manufacturers plan to have some inventory on hand at all times to meet peak demand while keeping production at a stable level. From the production bud- get, a manufacturer develops budgets for the direct materials, direct labor, and overhead that will be required in the production process. A budget for selling and administrative expenses also is prepared. Merchandising Firms A merchandising firm does not manufacture products. Instead, it purchases products manufactured by others and sells them to the end users, adding value through a combination of distribution and retail operations. The operational por- tion of the master budget of a merchandising firm is similar to that of a manufacturing firm, but instead of a production budget for goods, a merchandiser develops a budget for merchandise purchases. A merchandising firm will not have a budget for direct material, “Historically, the personality types that drive sales and those that drive finance and operations are very different. They tend not to spend time with each other. And that’s a mistake. . . . The whole point of a forecast is that it’s supposed to give you guide- posts for what your actions are, how you allocate your resources, what you spend your time focusing on. At the very base of that, you need to involve the person who is out there actually driving the sale.” (9d) ePartners Inc. One advantage that “etailers,” such as Amazon.com , have in the sales- forecasting process is the large amount of information collected online about their customers’ buying patterns. This data, in theory at least, helps these firms in forecasting future sales. Pictured here is the Amazon.com distribution center in Fernley, Nevada. Learning Objective 9-3 Describe the similarities and differences in the operational budgets prepared by manufac- turers, service-industry firms, merchandisers, and nonprofit organizations. hiL25664_ch09_350-407.indd 356hiL25664_ch09_350-407.indd 356 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer Chapter 9 Financial Planning and Analysis: The Master Budget 357 because it does not engage in production. However, the merchandiser will develop bud- gets for labor (or personnel), overhead, and selling and administrative expenses. Service-Industry Firms Based on the sales budget for its services, a service-industry firm develops a set of budgets that show how the demand for those services will be met. A service firm prepares a production budget (for the production of its services) and the related operational budgets, but the precise nature of these budgets depends on the industry. An airline, for example, prepares the following operational budgets: a budget of planned air miles to be flown; material budgets for spare aircraft parts, aircraft fuel, and in-flight food; labor budgets for flight crews and maintenance personnel; and an overhead budget. Nonprofit Organizations The master budget for a nonprofit organization includes many of the components shown in Exhibit 9–1 . However, there are some important dif- ferences. The fundamental goal of a nonprofit organization is not to sell products or ser- vices (although some do that as a way of raising funds) but rather to complete programs in support of their mission. So instead of a sales budget, nonprofits generally begin the budgeting process with a programs budget that shows the level of services to be provided. From that beginning, operational budgets can be developed to identify the resources nec- essary for producing the programs. Consider Goodwill Industries International. Their mission is “helping people in need reach their fullest potential through the power of work.” They plan programs to support that mission. For each program planned, Goodwill must budget the level of service to be provided, such as number of people served and hours of operation. Each program requires resources to operate, and those resources are documented in the operational bud- gets of the organization. Nonprofit organizations also prepare budgets showing their anticipated funding. Goodwill budgets for revenues from thrift-store sales, government grants, and cash contributions. In summary, all organizations begin the budgeting process with plans for (1) the goods or services to be provided and (2) the revenue to be available, whether from sales or from other funding sources. Summary of Operational Budgets Operational budgets differ since they are adapted to the operations of individual companies in various industries. However, operational budgets are also similar in important ways. In each firm, they encompass a detailed plan for using the basic factors of production—material, labor, and overhead—to produce a product or provide a service. Financing Budgets After developing its sales and operational budgets, a company knows where its money will be coming from and where it will go. But several timing issues affect when they can collect the cash. To plan for this, companies develop a set of financing budgets, shown in the lower half of Exhibit 9–1, that project their cash flow and identify likely cash shortfalls and surpluses. Cash Receipts Budget Every business prepares a series of financing budgets. The cash receipts budget provides information about the cash flows into the company based on sales of its services or products (or from cash contributions and grants, in the case of non- profits). These inflows often will not precisely match budgeted sales. Reasons can include: • The timing of sales and collections can differ customer-to-customer. Between businesses, it is common to have payment terms specifying that cash will not change hands until 30 days or more after the sale date. • Different payment methods convert to cash at different speeds. Cash payments can usually be deposited to the bank the same day as the sale. Proceeds from hiL25664_ch09_350-407.indd 357hiL25664_ch09_350-407.indd 357 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer 358 Chapter 9 Financial Planning and Analysis: The Master Budget credit cards can take several days to be received, and check payments may take even longer. • Some sales are never collected. Uncollectible accounts receivable due to bounced checks, counterfeit money, and customers who default on their obliga- tions are all challenges that companies confront. Cash Disbursements Budget As shown in Exhibit 9–1 , the cash disbursements bud- get depends on the spending plans reflected in several operational budgets, making it quite a complex budget. To further complicate matters, the timing of cash flows out of the company does not precisely align with the expenditures reflected in the operational bud- gets. The company will not pay cash immediately for most of its expenditures. Rather, it will pay its suppliers according to standard commercial arrangements, often delaying payment 30 days or more past the delivery date. Cash Budget The cash budget summarizes the various cash inflows and outflows from operations. The cash budget plays a critical role in planning the firm’s cash needs. Frequently there is a mismatch in timing between when cash must be paid in order to produce the products or services and when cash can be collected from the customers who THE BUDGET: VALUABLE PLANNING TOOL OR COSTLY WASTE OF TIME? In Learning Objective 9-2, we discussed five very important purposes of budgeting. But as we will see in this chapter, budgeting is also an intricate process that is often time- consuming and costly. In the words of GE ’s legendary ex-CEO Jack Welch, “The budget- ing process at most companies has to be the most ineffective practice in management. It sucks the energy, time, fun, and big dreams out of an organization . . . [and] brings out the most unproductive behaviors.” 1 Strong words! Some argue that the purposes of budgeting can be achieved without the conventional budgeting process. These companies espouse an idea called “Beyond Budgeting” that proposes to replace annual budgets with rolling forecasts of key performance indicators. One convert is Statoil, a leading energy company based in Norway. Statoil split the bud- geting process into separate forecasting, goal setting, and resource allocation processes. It updates these plans often in order to maintain a long view of expected performance. “The goal is to set targets that motivate and inspire people without all the gaming and pay negotiations.” 2 Kitchen products company Elkay Manufacturing calls its implementation of this idea “Continuous Planning.” In Elkay’s case, their motivation is to make the planning process more responsive to strategic planning and to adapt to the changing business environ- ment. “There are no crystal balls. . . . [Our] process allows us to respond to changes in our business on a real-time basis, thereby negating the need for a budget.” 3 Others disagree, pointing out that the work of continuous planning is more costly than budgeting and that doing something continuously tends to make the process super- ficial. So the jury is still out. But so far, GE still prepares budgets! GE, Statoil, and Elkay M A P anagement ccounting ractice 1Jack Welch and Suzy Welch, Winning (HarperBusiness, 2005), p. 189. 2Russ Banham, “Freed from the Budget,” CFO Magazine, September 1, 2012, http://www3.cfo.com/article/2012/9/ budgeting_budgets-rolling-forecasts-continuous-planning-beyond-budgeting-round-table-statoil-elkay-group- health-holt-cat. 3Steve Player, “The Remodel: A Talk with Elkay’s VP of Finance,” BusinessFinance, January 27, 2010, http://businessfinancemag.com/article/total-remodel-0127. hiL25664_ch09_350-407.indd 358hiL25664_ch09_350-407.indd 358 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer Chapter 9 Financial Planning and Analysis: The Master Budget 359 buy the products or services. By predicting its net cash position at frequent points dur- ing the planning period, the firm can plan ahead. It can arrange sources of borrowing for times when cash outflows exceed inflows, and it can plan to pay off borrowings and make investments when the cash flow reverses. This ability to foresee and avoid cash emergen- cies makes the cash budget a very important and powerful tool. Budgeted Financial Statements The final portion of the master budget, depicted in Exhibit 9–1 , includes a budgeted income statement, a budgeted balance sheet, and a budgeted statement of cash flows. These budgeted financial statements show the overall financial results of the organiza- tion’s planned operations for the budget period. Activity-Based Budgeting The concepts that underlie activity-based costing (ABC) can be used to better understand the budgeting process. 4 Activity-based costing uses a two-stage cost-assignment process. In stage I, overhead costs are assigned to cost pools that represent the most significant activities constituting the production process. The activities identified vary across com- panies, but such activities as order processing, material handling, machine setup, labor scheduling, quality control, and purchasing provide examples. After assigning costs to the activity cost pools in stage I, cost drivers appropriate for each cost pool are identified. Then, in stage II, the overhead costs are allocated from each activity cost pool to cost objects (e.g., products, services, and customers) in proportion to the amount of activity consumed. Exhibit 9–2 portrays the two-stage allocation process used in activity-based costing systems. Activity-Based Budgeting 4Activity-based costing (ABC) is covered in Chapter 5. Learning Objective 9-4 Explain the concept of activity-based budgeting and the logic it brings to the budgeting process. Exhibit 9–2 Activity-Based Costing System Order Processing Quality Control Material Handling Machine Setup Labor Scheduling Purchasing STAGE I Resource costs are assigned to activities. STAGE II Overhead costs are assigned to cost objects. Resource costs are assigned to activity cost pools associated with significant activities. Costs are assigned from each activity cost pool to each cost object in proportion to its consumption of the activity. Each activity has its own cost driver. Cost objects (e.g., products or services produced, or customers served). hiL25664_ch09_350-407.indd 359hiL25664_ch09_350-407.indd 359 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer 360 Chapter 9 Financial Planning and Analysis: The Master Budget Exhibit 9–3 Activity-Based Budgeting Reverses Activity-Based Costing Resources Activity-Based Costing (ABC) Activity-Based Budgeting (ABB) Activities Cost objects: products and services produced, and customers served Resources Activities Forecast of products and services to be produced, and customers served Source: Robert S. Kaplan and Robin Cooper, Cost and Effect (Boston: Harvard Business School Press, 1998), p. 303. Applying ABC concepts to the budgeting process helps to explain the logic of bud- geting. Sometimes the process is even referred to as activity-based budgeting (ABB) . 5 Conceptually, ABB takes the ABC model and reverses the flow of the analysis, as depicted in Exhibit 9–3 . The first step is to specify the products or services to be pro- duced and the customers to be served. Then the activities that are necessary to produce these products and services are determined. Finally, the resources necessary to perform the specified activities are quantified. As portrayed in the diagram, ABC assigns resource costs to activities, and then it assigns activity costs to products and services produced and customers served. ABB, on the other hand, begins by forecasting the demand for prod- ucts and services as well as the customers to be served. These forecasts then are used to plan the activities for the budget period and budget the resources necessary to carry out the activities. In the next section of the chapter, we will illustrate the process of constructing a mas- ter budget. As we do so, notice how the conceptual activity-based budgeting model helps explain the steps in the budgeting process. Developing the Master Budget To illustrate the steps in developing a master budget, we consider the example of Snowcap Music Festivals. Snowcap is a producer and event manager of destination music events worldwide. The company prides itself on attracting leading musical talent to its events, known as SMurFests, while also exposing festival guests to the “next big thing” by iden- tifying and promoting new talent. The Snowcap brand enjoys exceptional consumer loyalty: frequent festivalgoers call themselves, naturally, SMurFs and SMurFettes. This translates into profits through repeat business, strong festival attendance, and significant Developing the Master Budget Learning Objective 9-5 Prepare each of the budget schedules that make up the master budget in a nonmanu- facturing firm, and that exist in manufacturing budgets as well. Commenting on how the company’s ABC and ABM initiatives led to activity- based budgeting: “We are using ABM as a means to execute our strategic management process.” (9e) AT&T Paradyne Corporation 5This section is based on the following references: James A. Brimson and John Antos, Driving Value Using Activity-Based Budgeting (New York: John Wiley & Sons, 1999); Sofia Börjesson, “A Case Study on Activity-Based Budgeting,” Journal of Cost Management 10, no. 4 (Winter 1997), pp. 7–18; and Robert S. Kaplan and Robin Cooper, Cost and Effect (Boston: Harvard Business School Press, 1998), pp. 301–15. hiL25664_ch09_350-407.indd 360hiL25664_ch09_350-407.indd 360 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer Chapter 9 Financial Planning and Analysis: The Master Budget 361 merchandise sales. The company works hard to create a stimulating and creative but safe environment. Snowcap Music Festivals is based in Boulder, Colorado, with European operations managed from a satellite office in Salzburg, Austria. The company is wholly owned by founder Wendee Redhawk and two partners. Redhawk started the company from her apartment in Boulder almost 20 years ago. Initially it wasn’t so much a company as a project to host a really big party for her college friends, their friends, and the community. But she managed to attract some talented bands to that first festival. After one of them subsequently became an international phenomenon, word of the festival spread quickly. Redhawk decided to make it a business venture and “We heard them first at Snowcap” became the company’s slogan. Unfortunately, Wendee Redhawk proved to be better at picking bands than she was at running a business. After three difficult years she brought in a partner with business training. The new partner, Doug Wing, realized that the fun festival scene would only be sustainable if supported by a modern business organization, keeping operations running smoothly while ensuring that Snowcap Music Festivals stayed profitable. Wing’s busi- ness skill and Redhawk’s ear for music were a winning combination: Snowcap became a big success and the SMurFest phenomenon was born. After expanding to multiple fes- tivals in the United States, Snowcap took on a European partner to expand the company into festivals abroad, beginning in Europe. As explained by Doug Wing, the core element of this business organization is the company’s Financial Planning and Analysis (FP&A) system. The FP&A system includes preparation of a master budget for each of the festivals. These festival budgets are com- bined with the headquarters budget to create an overall master budget for Snowcap Music Festivals. “When we run a festival, we have to commit to everything in advance: how many bands, what we’ll pay them, how many T-shirts to order, how much cash we’ll need to borrow or invest, and so on. The master budget is our formal plan for each event and the overall company. It helps us to achieve our FP&A goals.” When pressed for specific examples of these, Wing listed the following: 1. Documenting our plan for operations and financial results. Which festivals are most and least profitable? How profitable is the company overall? How will we manage cash flow? 2. Communicating our plans for, and assumptions about, the various festivals. Which festivals are planned for this year? When does each start and end? How many people should we plan for at each one? 3. Deciding how to share resources. How many people are needed for marketing? For operations? At each festival? At headquarters? 4. Controlling operations by developing benchmarks for the financial and opera- tional results of the festival. How much profit is each festival expected to generate? What is the goal for T-shirt sales? What is our carbon footprint goal? 5. Evaluating performance of festival managers against those benchmarks, providing a baseline for incentive compensation. Who is responsible for achieving attendance goals? What is the reward for meeting and exceeding attendance goals? In conclusion, Wing noted that, “Planning a festival without a master budget would be like driving to the festival without a map: you would have a rough idea of where you wanted to go but no idea of the best way to get there. And by the time you found your way the party might be over!” Wendee Redhawk added, “Is budgeting a pain? Sure it is. But so is practicing guitar: you can’t be any good without it, and at least in budgeting your fingers don’t bleed!” hiL25664_ch09_350-407.indd 361hiL25664_ch09_350-407.indd 361 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer 362 Chapter 9 Financial Planning and Analysis: The Master Budget We will trace Snowcap Music Festival’s 20x2 master budget for its three-day Rocky Mountain SMurFest, which will be held on the second weekend of July 20x2. The festi- val’s master budget contains the following schedules, which are displayed and explained in the following pages. Notice that this is a nonmanufacturing budget. It will demonstrate the basic opera- tions of a budget without all of the complexities added by the need to produce and main- tain inventories. Beginning on p. 371, we will look at the additional schedules needed in a manufacturing company’s budget to incorporate those complexities, so make sure you understand this basic budget first. Sales Budget As discussed earlier in the chapter, the first step in developing a master budget is always the creation of a sales budget. The sales budget for the 20x2 Rocky Mountain SMurFest is dis- played as Schedule 1. This budget shows the projected sales in units for the event and then multiplies the unit sales by the sales price to determine sales revenue. Tickets, which are sold only as a three-day pass for the entire festival, go on sale in January. Quarterly budgets show the timing of sales through the year, with significant ticket pre-sales in the first quarter but also significant sales of tickets during the event in July. Also, ticket prices are discounted for early purchasers. All T-shirt sales occur during the event and this is also reflected in the sales budget. Schedule 1 Schedule Sequence of Budgets Budget Category (from Exhibit 9–1 ) 1 Sales Budget Sales Budget 2 Purchases Budget Operational Budget 3 Direct Labor Budget Operational Budget 4 Production Overhead Budget Operational Budget 5 Selling, General and Administrative Expense Budget Operational Budget 6 Cash Receipts Budget Financing Budget 7 Cash Disbursements Budget Financing Budget 8 Cash Budget Financing Budget 9 Budgeted Income Statement Budgeted Financial Statement 10 Budgeted Statement of Cash Flows Budgeted Financial Statement SNOWCAP MUSIC FESTIVALS: Rocky Mountain SMurFest Sales Budget For the Year Ending December 31, 20x2 Quarter 1st 2nd 3rd 4th Year Ticket sales revenue: Ticket sales, in units* ................................ 10,000 10,000 5,000 0 25,000 Sales price per ticket ................................ 3 $100 3 $100 3 $150 Ticket sales revenue ............................. $1,000,000 $1,000,000 $750,000 $0 $2,750,000 T-shirt sales revenue: Festival attendance, based on total ticket sales .................... 25,000 Percent of guests buying T-shirt during festival ........................... 3 20% T-shirts sold, in units ................................ 0 0 5,000 0 Unit sales price ........................................ 3 $35 T-shirt sales revenue ............................ $ 0 $ 0 $175,000 $0 175,000 Total sales revenue ................................... $1,000,000 $1,000,000 $925,000 $0 $2,925,000 *Tickets are sold only as a three-day pass for the entire festival. One ticket 5 one three-day pass. Rocky Mountain SMurFest is held the second weekend in July. hiL25664_ch09_350-407.indd 362hiL25664_ch09_350-407.indd 362 7/24/13 2:53 AM7/24/13 2:53 AM Final PDF to printer Chapter 9 Financial Planning and Analysis: The Master Budget 363 Now that we know the sales forecast and the plan for revenues, we can begin to budget for the costs of the purchases needed to make the revenues possible. For Snowcap Music Festivals, there are two main inputs (music and T-shirts) and two main conversion resources (direct labor and production overhead). Purchases Budget A company like Snowcap Music Festivals buys a lot of goods and services from outside the organization in order to create its product (a music festival). It documents its plans for acquiring these goods and services in a purchases budget . The purchases budget, in turn, is based on the goods and services that Snowcap Music Festivals plans to sell, as documented in the sales budget discussed in the preceding section. For the 20x2 Rocky Mountain SMurFest, the purchases to be budgeted are the music that will be played and the merchandise that will be sold. The purchases budget is displayed in Schedule 2. Other common purchases budgets are for the direct materials needed in manufacturing and the goods needed for retail and distribution. Both of these bring added complexities relating to inventory planning and will be introduced later in the chapter. For the music festival, there are no inventory issues. All merchandise is assumed to be sold or returned. Notice that, as in the sales budget, this budget brings together operational assump- tions and financial data to create a plan. For example, the cost of two different types of performers is considered. Although the cost of groups may differ, use of an average cost per band within performer category simplifies planning. We also begin to see the effect of budget interactions. The number of T-shirts sold depends upon the number of festival attendees, so the purchases budget is constructed using the ticket sales information built into the sales budget. In this, and in subsequent budget schedules, we see the activity-based budgeting logic that was discussed earlier. Schedule 2 SNOWCAP MUSIC FESTIVALS: Rocky Mountain SMurFest Purchases Budget For the Year Ending December 31, 20x2 Quarter 1st 2nd 3rd 4th Year Music purchases: Number of headliner bands booked ................... 0 0 3 0 Average cost per headliner band ....................... 3 $250,000 Total cost for headliner bands ........................... $0 $0 $ 750,000 $0 $ 750,000 Number of undiscovered bands booked ............. 0 0 24 0 Average cost per undiscovered band ................. 3 $40,000 Total cost for undiscovered bands ...................... $0 $0 $ 960,000 $0 960,000 Total music cost ............................................... $0 $0 $ 1,710,000 $0 $1,710,000 T-shirt purchases: Number of attendees (from Schedule 1) ............ 0 0 25,000 0 Percent of guests buying T-shirt during festival .. 3 20% T-shirts needed, in units ................................... 0 0 5,000 0 Cost per T-shirt ................................................ 3 $15 Total T-shirt cost .............................................. $0 $0 $ 75,000 $0 75,000 Total music and merchandise costs ................... $0 $0 $ 1,785,000 $0 $1,785,000 Direct Labor Budget While the musicians are the critical element of a music festival, without a stage and a sound system it wouldn’t be much of a festival. Many other resources are needed to pull off an enjoyable, safe, and professional event, and many music festivals have failed because they didn’t pay attention to sound quality, security, or parking. hiL25664_ch09_350-407.indd 363hiL25664_ch09_350-407.indd 363 7/24/13 2:53 AM7/24/13 2:53 AM Final PDF to printer 364 Chapter 9 Financial Planning and Analysis: The Master Budget We introduced conversion costs in Chapter 2 as the direct labor and overhead needed to convert raw materials into a finished product, and here we put them in their broader context: conversion costs are the costs of the resources needed to convert purchased inputs into a mar- ketable product or service. These conversion resources are usually direct labor and various kinds of production overhead, and companies must plan for their availability, use, and cost. Recall that direct labor is labor that is traceable to a particular cost object and whose quantity varies systematically with some aspect of the production. In this case the cost object is the Rocky Mountain SMurFest, and the direct-labor budget captures the costs of labor that are directly traceable to the event. Ask yourself, “How would I create a labor budget for this event?” You might be tempted to just look at last year’s festival to see how many people were needed to work. However, last year’s employee numbers don’t include the effects of changes planned for this year’s Rocky Mountain SMurFest (different number of attendees, different number of bands, dif- ferent hours of operation) and may not be appropriate for the current plan. A better way to answer the question is to understand what drives the need for different kinds of labor and build the budget on that basis. Again, this reflects the activity-based budgeting logic. For a music festival, direct labor would comprise the operating personnel such as technicians (electricians and sound crew), guest-logistics staff (ticket takers, parking atten- dants, security), and musician-support staff (stage crew, backstage hosts). Festival hours, defined as the hours that musicians are performing, is the cost driver for technical labor. Attendee hours, based on the festival hours and the number of tickets sold, is the cost driver for guest-logistics labor. And the number of bands scheduled to perform is the cost driver for musician-support labor. These costs and relationships are budgeted in Schedule 3. Schedule 3 SNOWCAP MUSIC FESTIVALS: Rocky Mountain SMurFest Direct-Labor Budget For the Year Ending December 31, 20x2 Quarter 1st 2nd 3rd 4th Year Technician Labor: Festival hours* .......................................................... 0 0 48 0 Technician labor hours needed per festival hour .......... 3 17.5 Total technician labor hours needed .......................... 0 0 840 0 Average technician rate per hour ............................... 3 $45 Total cost for technician labor .................................... $0 $0 $ 37,800 $0 $37,800 Guest-Logistics Staff Labor: Number of attendees (from Schedule 1) .................... 0 0 25,000 0 Festival hours ........................................................... 3 48 Total attendee hours ................................................. 0 0 1,200,000 0 Staffing ratio (attendee hours per staff hour) ............... 4 1,000 Total guest-logistics staff hours needed ..................... 0 0 1,200 0 Average guest-logistics staff rate per hour .................. 3 $20 Total cost for guest-logistics staff labor ...................... $0 $0 $ 24,000 $0 24,000 Musician-Support Staff Labor: Number of bands ...................................................... 0 0 27 0 Musician-support staff hours per band ...................... 3 15 Total musician-support staff hours needed ................. 0 0 405 0 Average musician-support staff rate per hour ............. 3 $25 Total cost for musician-support staff labor .................. $0 $0 $ 10,125 $0 10,125 Total direct-labor costs ................................................. $0 $0 $ 71,925 $0 $71,925 *Musicians perform at the festival from 10:00 a.m. until 2:00 a.m., for three days. Although technicians and guest-support staff also work before and after the musicians perform, the average number of these staff needed is driven by the festival’s music hours and attendee hours, respectively. hiL25664_ch09_350-407.indd 364hiL25664_ch09_350-407.indd 364 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer Chapter 9 Financial Planning and Analysis: The Master Budget 365 A Note on Direct Labor and the Cost Hierarchy Where direct labor belongs in the cost hierarchy depends on management’s ability to adjust the organization’s labor force to match short-term requirements, as well as management’s attitude about making such adjustments. 6 Either for strategic business reasons or due to ethical concerns, many compa- nies strive to maintain a relatively stable labor force. If production employees are retained when production declines beyond the point where they have production work to do, then direct labor will not be a unit-level cost. In the extreme case, where employees are virtually never laid off, direct labor becomes a facility-level, or general-operations-level, cost. Production Overhead and SG&A Budgets In addition to direct labor, other resources required to put on the festival include supervi- sion, facilities costs, marketing, and costs incurred centrally by Snowcap Music Festivals in support of all of their festivals. These costs are divided into two different budgets. The production overhead budget includes conversion costs that relate to operating the festi- val. And the selling, general and administrative expense (SG&A) budget comprises costs relating to sales and marketing and to general company administration. In Schedule 4, the production overhead budget summarizes the costs of produc- tion other than purchases and direct labor. We can subdivide the production overhead costs into direct costs, which are traceable to the Rocky Mountain SMurFest, and indirect costs, which are incurred centrally within the Snowcap Music Festivals organization and then allocated among the various festivals. Each production overhead cost is budgeted according to the planned need for that resource. For example, the two guest-logistics supervisors begin work well in advance of the festival, working the entire months of May and June at a cost of $5,000 per month per supervisor. During July, the month of the festival, the guest-logistics supervisors continue to 6A typical cost hierarchy includes costs incurred at the unit level, batch level, product-sustaining level, customer level, and facility or general-operations level. Cost hierarchies are discussed in detail in Chapter 5. Schedule 4 SNOWCAP MUSIC FESTIVALS: Rocky Mountain SMurFest Production Overhead Budget For the Year Ending December 31, 20x2 Quarter 1st 2nd 3rd 4th Year Direct Production Overhead Costs: $ 0 $ 0 Supervisory labor * .................................................... 0 $20,000 $ 22,000 0 $ 42,000 Utilities (electricity, portable toilets) ............................. 0 5,000 80,000 0 85,000 Security, maintenance, and custodial ......................... 0 0 30,000 0 30,000 Catering ................................................................... 0 0 50,000 0 50,000 Rental: Audio equipment ........................................... 0 0 100,000 0 100,000 Rental: Festival grounds ............................................ 0 0 50,000 0 50,000 Rental: Other ............................................................ 0 1,000 40,000 0 41,000 Total direct production overhead costs ........................ $ 0 $26,000 $372,000 $ 0 $398,000 Allocated Production Overhead Costs: Tickets sold (from Schedule 1) ................................... 10,000 10,000 5,000 0 25,000 Cost per ticket sold (rate set by headquarters) ........... 3$2.50 3$2.50 3 $2.50 3 $2.50 3 $2.50 Allocated ticketing costs ........................................... $25,000 $25,000 $ 12,500 $ 0 $ 62,500 Purchasing and general supplies .............................. 10,000 25,000 35,000 10,000 80,000 Liability insurance ..................................................... 10,000 10,000 10,000 10,000 40,000 Total allocated production overhead costs ................... $45,000 $60,000 $ 57,500 $20,000 $182,500 Total production overhead costs ..................................... $45,000 $86,000 $429,500 $ 20,000 $580,500 *2nd Quarter: 4 supervisor-months of guest-services supervisors at $5,000 per supervisor-month. 3rd Quarter: 2 supervisor-months for guest-services at $5,000 per supervisor-month, plus 1supervisor-month of a technician supervisor at $8,000 per supervisor-month, plus 1 supervisor-month of a musician-support supervisor at $4,000 per supervisor-month. hiL25664_ch09_350-407.indd 365hiL25664_ch09_350-407.indd 365 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer 366 Chapter 9 Financial Planning and Analysis: The Master Budget work the entire month. In addition, one technician supervisor ($8,000 per month) and one musician-support supervisor ($4,000 per month) are added for the entire month of July. At the end of July, all supervisors move on to other festivals. Accordingly, $20,000 is budgeted for the second quarter of 20x2 (two guest-logistics supervisors in both May and June at $5,000 per month per supervisor) and $22,000 is budgeted for the third quarter ($10,000 for two guest-logistics supervisors in July plus the cost of the other two supervisors in July.). The method for allocating indirect production costs is determined by the central admin- istration of Snowcap Music Festivals. For example, ticketing for all festivals is handled at the company’s headquarters. The accountants there consider number of tickets sold to be the cost driver for ticketing, and they estimate the cost driver rate to be $2.50 per ticket han- dled. Each festival is therefore allocated an overhead cost related to ticketing of $2.50 per ticket. (Allocation of centralized costs will be discussed more extensively in Chapter 12.) The selling, general and administrative expense (SG&A) budget, shown in Sched- ule 5, includes the sales and marketing costs of the company. As in the previous budget, these overhead costs can be divided between direct costs, such as advertising that is spe- cifically for the Rocky Mountain SMurFest, and shared marketing costs that are allocated from headquarters to all of the festivals. Similarly, the general and administrative support provided by headquarters is allocated among the various festivals. The general and administrative costs allocated by Snowcap Music Festivals include depreciation costs of the headquarters building and various other fixed assets owned by Snowcap. The depreciation cost is included in the “Total SG&A expenses” line that will soon become part of the budgeted income statement. However, at the bottom of the SG&A budget, the depreciation is deducted as a noncash cost. This is done so that the cash portion of SG&A spending can be separated out for inclusion in the cash disbursements budget. A similar adjustment would be made for noncash costs included in any other budget schedule. Schedule 5 Financing Budgets The three financing budgets collectively show how a company manages the cash it needs to finance its operations. The cash receipts and cash disbursements budgets show the estimated inflows and outflows of cash relating to revenues and expenses, respectively. In these budgets, the revenue and expense numbers must be adjusted for any issues that affect the timing of cash flows. After the expected cash inflows and outflows have been determined, the overall cash budget combines this information to predict expected cash shortfalls and surpluses. Once they have been identified, plans can be made for financing the shortfalls and investing the surpluses. The cash receipts budget in Schedule 6 details Snowcap Music Festivals’ expected cash collections for the Rocky Mountain SMurFest during the budget period. Most ticket sales for the event are paid by debit or credit card, with funds available to the company in SNOWCAP MUSIC FESTIVALS: Rocky Mountain SMurFest Selling, General and Administrative Expense (SG&A) Budget For the Year Ending December 31, 20x2 Quarter 1st 2nd 3rd 4th Year Direct SG&A expenses: Event advertising ................................................... $25,000 $25,000 $15,000 $ 5,000 $ 70,000 Allocated SG&A expenses: Sales and marketing support .................................. 20,000 20,000 20,000 20,000 80,000 General and administrative support ......................... 25,000 25,000 25,000 25,000 100,000 Total SG&A expenses ................................................. $70,000 $70,000 $60,000 $50,000 $250,000 Less: Non-cash SG&A expenses (depreciation) ............ (7,500) (7,500) (7,500) (7,500) (30,000) Total cash disbursements for SG&A ............................. $62,500 $62,500 $52,500 $42,500 $220,000 hiL25664_ch09_350-407.indd 366hiL25664_ch09_350-407.indd 366 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer Chapter 9 Financial Planning and Analysis: The Master Budget 367 the same quarter as the sale. However, to promote early sales and cash inflow, Snowcap allows early ticket purchasers to pay 25 percent by credit card at the time of sale, with the other 75 percent automatically charged to the same card 90 days later. For the Rocky Mountain SMurFest, all tickets purchased during the first quarter of the year, between early January (when they go on sale) and the end of March, are sold this way. Beginning in April, all tickets must be paid for in full at the time of purchase. Festival T-shirts are very popular and are purchased by festival guests using credit cards, debit cards, and cash. Historically, a small number of purchases turn out to be fraudulent (using forged or stolen credit cards or counterfeit cash), and Snowcap Music Festival budgets this uncollectible portion at 2.5 percent of sales. Schedule 6 * 25% of 1st quarter ticket sales; 100% of ticket sales in all other quarters. †75% of 1st quarter ticket sales. ‡ 2.5% of T-shirt sales are expected to be uncollectible: $175,000 (T-shirt sales, from Schedule 1 ) 3 2.5% 5 $4,375. How to Budget Cash Flows To understand how the cash receipts and cash disburse- ments budgets are prepared, we focus on the timing of cash flows. Consider the second quarter column of Schedule 6. The ticket revenue estimate comes directly from Schedule 1, the sales budget. Since Snowcap Music Festival entices early purchasers by allowing them to pay in two installments if they buy during the first quarter (25 percent at time of purchase, 75 percent 90 days later), some of the first quarter’s revenue will be collected during the second quarter. Therefore, the cash that the firm will collect during the second quarter comprises two components, as depicted in the following diagram. SNOWCAP MUSIC FESTIVALS: Rocky Mountain SMurFest Cash Receipts Budget For the Year Ending December 31, 20x2 Quarter 1st 2nd 3rd 4th Year Ticket revenue (from Schedule 1): ................. $1,000,000 $1,000,000 $750,000 $0 $2,750,000 Collections in quarter of sale * ....................... $ 250,000 $1,000,000 $750,000 $2,000,000 Collections in quarter after sale † ................... 0 750,000 0 750,000 Total cash receipts from ticket sales .............. $ 250,000 $ 1,750,000 $ 750,000 $0 $2,750,000 T-shirt revenue (from Schedule 1): ................ $ 0 $ 0 $175,000 $0 $ 175,000 Less : Uncollectible accounts expense ‡ .......... ( 0) ( 0) ( 4,375) (0) (4,375) Total cash receipts from T-shirt sales ........... $ 0 $ 0 $ 170,625 $0 $ 170,625 Total cash receipts ........................................... $ 250,000 $1,750,000 $920,625 $0 $2,920,625 Total ticket revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Collections in quarter of sale . . . . . . . . . . . . . . . . . . . Collections in quarter following sale . . . . . . . . . . . . . $1,000,000 3 100% $1,000,000 $750,000 $1,750,000 Total cash receipts in second quarter from ticket sales . . . . . . . . . . . . . . . . . . . . . . 1st Quarter 2nd Quarter 3 75% $250,000 3 25% $1,000,000 hiL25664_ch09_350-407.indd 367hiL25664_ch09_350-407.indd 367 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer 368 Chapter 9 Financial Planning and Analysis: The Master Budget The second quarter’s total cash receipts from ticket sales are the sum of $1,000,000 (100 percent of second quarter ticket sales) and $750,000 (75 percent of first quarter ticket sales). One final point to notice is that 2.5 percent of T-shirt sales are not expected to be collected. Thus, the $4,375 of third quarter uncollectible accounts amounts to 2.5 percent of Rocky Mountain SMurFest T-shirt sales ($4,375 5 $175,000 3 2.5 percent), and cash receipts from T-shirt sales are only 97.5 percent of T-shirt sales revenue. In Schedule 7, the cash disbursements budget shows the timing of the cash flow- ing out of the company. Just as we saw that cash from sales does not always flow into the company exactly when the sale is made, cash for purchases does not necessarily flow out of the company at the exact time the purchase is made. Payment policies will differ between vendors and types of payments, and any significant differences need to be antici- pated in the budget. Often purchases are made on account, which means that payment is not made in cash at the time of the purchase. Instead, payment is made later under terms that are negotiated, often 30–60 days after delivery of the product or service. For band payments at Snowcap Music Festivals, the payment schedule for “head- liner” bands is typically 50 percent in advance and 50 percent after the show. However the “undiscovered” bands, which do not have the market power to demand advance pay- ment, are paid after they perform. In another type of arrangement, Snowcap’s contract with its T-shirt vendor for the Rocky Mountain SMurFest specifies that they will be paid 25 percent one month before the festival to help cover up-front costs for the unprinted shirts needed for this very large order, with the balance paid within 30 days after the festi- val ends. All other vendors for the Rocky Mountain SMurFest are paid in the same month that the expense is recorded. Schedule 7 Finally, in Schedule 8, the cash budget summarizes the company’s cash position. It shows that the Rocky Mountain SMurFest spends more cash than it takes in during the festival (which falls in the third quarter), but ticket presales are expected to have built a cash balance large enough to offset the shortfall. As a result, no outside sources of fund- ing are needed. However, the excess cash generated before the festival is not just hidden in a bass drum! It is invested until it is needed, and while invested it earns interest for the company. This interest earned is shown near the bottom of the cash budget. Snowcap Music Festi- vals earns an annual interest rate of 5 percent on its invested cash. For simplicity, we will assume that the net cash generated or used during a quarter occurs evenly throughout the SNOWCAP MUSIC FESTIVALS: Rocky Mountain SMurFest Cash Disbursements Budget For the Year Ending December 31, 20x2 Quarter 1st 2nd 3rd 4th Year Payments for purchases (from Schedule 2): Headliner bands (50% paid in prior quarter) ................ $ 0 $375,000 $ 375,000 $ 0 $ 750,000 Undiscovered bands ................................................... 0 0 960,000 0 960,000 T-shirts (25% paid in prior quarter) ............................ 0 18,750 56,250 0 75,000 Total cash disbursements for purchases ...................... $ 0 $393,750 $1,391,250 $ 0 $1,785,000 Other cash disbursements: Direct labor (from Schedule 3) .................................... $ 0 $ 0 $ 71,925 $ 0 $ 71,925 Production overhead costs (from Schedule 4) .............. 45,000 86,000 429,500 20,000 580,500 SG&A expenses (from Schedule 5, cash part only) ....... 62,500 62,500 52,500 42,500 220,000 Total other cash disbursements .................................. $107,500 $148,500 $ 553,925 $62,500 $ 872,425 Total cash disbursements ............................................... $107,500 $542,250 $1,945,175 $62,500 $2,657,425 hiL25664_ch09_350-407.indd 368hiL25664_ch09_350-407.indd 368 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer Chapter 9 Financial Planning and Analysis: The Master Budget 369 Schedule 8 SNOWCAP MUSIC FESTIVALS: Rocky Mountain SMurFest Cash Budget For the Year Ending December 31, 20x2 Quarter 1st 2nd 3rd 4th Year Beginning cash balance ................................................. $ 0 $ 143,391 $ 1,360,482 $ 346,535 $ 0 Cash receipts (from Schedule 6) ..................................... $250,000 $1,750,000 $ 920,625 $ 0 $2,920,625 Less : Cash disbursements (from Schedule 7) ................... (107,500) (542,250) (1,945,175) (62,500) (2,657,425) Change in cash balance due to operations ....................... $142,500 $1,207,750 $(1,024,550) $ (62,500) $ 263,200 Interest earned on investment of cash balance* ................ 891 9,341 10,603 3,941 24,776 Total change in cash balance ........................................... $143,391 $1,217,091 $(1,013,947) $ (58,559) $ 287,976 Ending cash balance ....................................................... $143,391 $1,360,482 $ 346,535 $ 287,976 $ 287,976 *The change in cash balance is assumed to occur evenly throughout the quarter and the 5% annual rate of return is applied to the average cash balance for the quarter. Example computation for the 2nd quarter: Average cash balance for the quarter 5 balance beginning of quarter 1 1/2 of the change in cash balance for quarter 5 $143,391 1 ($1,207,750 / 2) 5 $747,266 Rate of return for quarter 5 5% annual rate / 4 quarters 5 1.25% Quarterly interest earned 5 $747,266 3 1.25% 5 $9,341 (rounded). quarter being budgeted, and that the interest rate is applied to the average cash balance for the quarter. While not precisely accurate, this is close enough for a planning estimate. See the footnotes to Schedule 8 for an example of how interest income is calculated. Budgeted Financial Statements The budgeted income statement in Schedule 9, showing the expected revenues and expenses in 20x2 for the Rocky Mountain SMurFest, assumes that the built-in expectations about the festival are met. Arriving at net income requires an estimate of the appropriate tax rate, and Snowcap Music Festivals instructs its festivals to use their corporate rate of 35 percent in the festival budgets. Schedule 9 SNOWCAP MUSIC FESTIVALS: Rocky Mountain SMurFest Budgeted Income Statement For the Year Ending December 31, 20x2 Sales revenue (from Schedule 1) ............................................................................................ $2,925,000 Cost of goods sold: Cost of purchases (from Schedule 2) .................................................................................. $1,785,000 Direct labor costs (from Schedule 3) ................................................................................... 71,925 Production overhead costs (from Schedule 4) ...................................................................... 580,500 Total cost of goods sold ...................................................................................................... 2,437,425 Gross margin ........................................................................................................................ $ 487,575 Other income and expenses: SG&A expenses (from Schedule 5) ..................................................................................... (250,000) Uncollectible accounts expense (from Schedule 6) .............................................................. (4,375) Interest income (from Schedule 8) ...................................................................................... 24,776 Pre-tax income ..................................................................................................................... $ 257,976 Income tax (35%, rounded) .................................................................................................... (90,292) Net income ........................................................................................................................... $ 167,684 hiL25664_ch09_350-407.indd 369hiL25664_ch09_350-407.indd 369 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer 370 Chapter 9 Financial Planning and Analysis: The Master Budget Schedule 10 SNOWCAP MUSIC FESTIVALS: Rocky Mountain SMurFest Budgeted Statement of Cash Flows For the Year Ending December 31, 20x2 Cash flows from operating activities: Cash receipts: From customers (from Schedule 6) ................................................................................. $2,920,625 From interest (from Schedule 8) ..................................................................................... 24,776 Total cash receipts from operating activities .................................................................... $2,945,401 Cash disbursements (from Schedule 7): To suppliers of purchases .............................................................................................. $1,785,000 For direct labor .............................................................................................................. 71,925 For production overhead ................................................................................................ 580,500 For SG&A expenses ....................................................................................................... 220,000 Total cash disbursements for operating activities ............................................................. 2,657,425 Net cash flow from operating activities ............................................................................. $ 287,976 Cash flows from investing activities (none) .......................................................................... 0 Cash flows from financing activities (none) ......................................................................... 0 Net increase in cash and cash equivalents ......................................................................... $ 287,976 Balance in cash and cash equivalents, beginning of year ..................................................... 0 Balance in cash and cash equivalents, end of year .............................................................. $ 287,976 Lastly, Schedule 10 displays the budgeted statement of cash flows . Notice that the format used in the budgeted statement of cash flows follows that specified under the direct method of preparing the statement, which is recommended by the Financial Accounting Standards Board (FASB). 7 The format used in the statement of cash flows, which is a statement prepared by companies for external reporting purposes, generally differs from the format used in the financing budgets, which are prepared for internal use by management. Notice the differences in the format of Schedule 10 when compared with the financing budgets in Schedules 6, 7, and 8. The greater detail in the internal schedules provides information that is useful to management. 7The direct and indirect methods of preparing the statement of cash flows are covered in financial accounting texts. They also are covered in the supplement to this text entitled The Statement of Cash Flows and Financial Statement Analysis, which is available from the publisher. This supplement is not required in order to understand the prepara- tion of the budget, as explained in this chapter. Normally, the budgeted financial statements of an organization would include a budgeted balance sheet . However, this budget is only for the 20x2 Rocky Mountain SMurFest. Most of the assets and liabilities, and all of the equity, are found only on the consolidated (overall) Snowcap Music Festivals budget. For this reason, the balance sheet is omitted from this festival budget. The only asset of the festival is its cash position, which is presented in both the cash budget (Schedule 8) and the budgeted statement of cash flows (Schedule 10), and its primary contribution to the company is its generation of profits, as presented in the Budgeted Income Statement (Schedule 9). Summary: Key Features of a Master Budget The event budget for the 20x2 Rocky Mountain SMurFest includes many of the key features of a master budget. • It consists of a series of budget schedules. • Operational assumptions are specifically identified and incorporated into the budget. hiL25664_ch09_350-407.indd 370hiL25664_ch09_350-407.indd 370 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer Chapter 9 Financial Planning and Analysis: The Master Budget 371 • The budget schedules are heavily interdependent, with outputs of one schedule serving as inputs to another. • The budget schedules follow a logical sequence, beginning with the sales budget and building to the budgeted financial statements. • Activity-based budgeting logic is incorporated. • Most of the key types of master budget schedules are present: sales, purchases, direct labor, overhead (both production and SG&A), financing, and financial statements. Just as every company is different, every master budget will be different. But these elements are present in all master budgets and if you understand the logic and flow pre- sented above you will know how to approach budgeting in any context. 8 However, this is not the end of the budgeting story. Manufacturing products and maintaining inventories introduce complexities to the budgeting process that we address in the next section. Extending the Master Budget for a Manufacturing Firm Manufacturing firms have several characteristics that complicate the budgeting process. Foremost among these are inventories, which add several additional steps in order to adjust for planned changes in inventory levels. Both inventories of finished products and inventories of raw materials and components require additional budgeting steps. In many cases, manufacturing firms also have more complex cash flows because of the many transactions involved in their conversion processes and because of the many different ways they sell their products. Frequently, manufacturers also have large invest- ments in property, plant, and equipment that require periodic reinvestment. To help illustrate how these complexities are handled in budgeting, we will inves- tigate the master budget of FestiChair.com , a manufacturer of outdoor chairs based in Denver, Colorado. The company is wholly owned by Mary Edwards, who started the company in her basement 15 years ago. Success came quickly for the company, and Edwards eventually built a production facility outside Denver. The company’s manufac- turing process is highly automated, using several machines to cut out pieces of chair fab- ric and sew them together to form a variety of lightweight but durable seating products. Production of the metal chair frame is outsourced to a company in Monterrey, Mexico, and the frames are scheduled to arrive at FestiChair.com just before they are needed in production. Initially, Edwards called her firm FestiChair Company, and its chairs were sold whole- sale to event producers such as Snowcap Music Festivals using a traditional sales approach. Three years ago, however, Edwards changed the company’s name to FestiChair.com and made a major foray into the world of Internet sales, marketing its strong, light chairs to the active outdoor consumer segment. Now almost 75 percent of FestiChair.com’s sales are made through the company’s website. Although FestiChair.com retained several of its sales personnel to handle the traditional sales to event producers, new personnel had to be hired to handle the company’s Internet sales. Chairs are shipped to Internet customers via UPS, FedEx, and other express delivery services. In order to manufacture the appropriate quantity of chairs and get them to consumers when and where they are needed, FestiChair.com needs to predict seasonality, anticipate raw material needs, and plan production resources such as workers and machines. The company’s master budget is a crucial part of that process. Some of the budget schedules Extending the Master Budget for a Manufacturing Firm 8There are some structural differences in the budgets of nonprofit organizations. As discussed earlier in the chapter, the master budget of a nonprofit begins with the quantified program goals rather than a sales budget. And their financial statements are sometimes prepared according to different accounting standards. However, other than these structural differences, the logic and flow of the master budget is identical in the nonprofit and for-profit settings. Learning Objective 9-6 Prepare the additional master budget schedules required by a manufacturing firm. hiL25664_ch09_350-407.indd 371hiL25664_ch09_350-407.indd 371 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer 372 Chapter 9 Financial Planning and Analysis: The Master Budget listed below were discussed earlier in conjunction with the Snowcap Music Festivals master budget, but the ones that are highlighted were not. The first three new sched- ules are specific to the manufacturing setting, and a budgeted balance sheet is also included in this example. We will consider only these additional schedules in this section. (The schedules added for FestiChair.com are labelled A, B, C and D to distinguish them from the Snowcap Music Festival schedules.) Schedule Sequence of Budgets Budget Category (from Exhibit 9–1 ) Sales Budget A Production Budget Operational Budget B Direct-Material Budget Operational Budget Direct-Labor Budget Production Overhead Budget Selling, General, and Administrative Expense Budget Cash Receipts Budget Cash Disbursements Budget Cash Budget C Budgeted Schedule of Cost of Goods Manufactured and Sold Budgeted Financial Statements Budgeted Income Statement Budgeted Statement of Cash Flows D Budgeted Balance Sheet Budgeted Financial Statements Production Budget Resources for manufacturing, such as raw materials, production workers, and machines, are needed when the products are produced, not when they are sold. Why is there a differ- ence in timing between units sold and units produced? • Sales are sometimes hard to predict. • Often a logistical lag exists between when a product is made and when it can be sold. (Think of the China-to-U.S. supply chain.) • Companies build products for inventory as a way to smooth production levels so they don’t have to lay off workers or buy as many machines. The production budget shows the number of units that are to be produced during a bud- get period. As we saw in Exhibit 9–1 , it serves as the bridge between the sales budget and the operational budgets that plan for spending on production. FestiChair.com’s production budget, displayed as Schedule A, determines the num- ber of chairs to be produced each quarter based on the quarterly sales projections in the sales budget. Schedule A is based on the following formula. Sales in units 1 Desired ending inventory of finished goods 5 Total units required Total units required 2 Expected beginning inventory of finished goods 5 Units to be produced Focus on the second-quarter column in Schedule A, which is shaded. Expected second-quarter sales are 15,000 chairs. FestiChair.com also wants to have enough finished chairs on hand at the end of the second quarter to provide 10 percent of the expected sales for the third quarter. Since 1,500 chairs are expected to be in inventory at the beginning of the second quarter and (20,000 chairs 3 10%) 5 2,000 chairs are needed in inventory at the end of the second quarter, 500 additional chairs need to be produced for inventory. Therefore, in total, (15,000 1 500) 5 15,500 chairs need to be produced during the quarter. hiL25664_ch09_350-407.indd 372hiL25664_ch09_350-407.indd 372 7/24/13 2:53 AM7/24/13 2:53 AM Final PDF to printer Chapter 9 Financial Planning and Analysis: The Master Budget 373 Schedule A Direct-Material Budget In the master budget of a manufacturing company, the direct-material budget shows the number of units and the cost of material to be purchased and used during a budget period. FestiChair.com’s direct-material budget, which is displayed as Schedule B, has two sections: one for chair fabric and one for chair frames. As is true for almost all manu- facturers, FestiChair.com’s direct-material cost is a unit-level cost. 9 Each chair requires 12 sq. ft. of fabric and one chair frame. The frames required for chair production are prepackaged in small batches by the vendor in Monterrey and delivered to FestiChair .com on a just-in-time basis. 10 The top section of FestiChair.com’s direct-material budget shows the total amount of fabric needed to make chairs during each quarter. The darker- shaded portion of Schedule B computes the amount of fabric to be purchased each quarter. This part of the schedule is based on the following formula. Raw material required for production 1 Desired ending inventory of raw material 5 Total raw material required Total raw material required 2 Expected beginning inventory of raw material This section of Schedule B also computes the cost of each quarter’s chair fabric purchases. The lower, lighter-shaded portion of Schedule B calculates the quantity and cost of chair frames to be purchased each quarter. Finally, the last row of Schedule B totals the cost of chair fabric and chair frames to yield the total cost of raw material to be purchased each quarter. FESTICHAIR.COM Production Budget For the Year Ending December 31, 20x2 Quarter 1st 2nd 3rd 4th Year Sales in units (from sales budget - not shown) ..... 5,000 15,000 20,000 10,000 50,000 Add: Desired ending inventory of finished goods* ........................... 1,500 2,000 1,000 500† 500 Total units required ............................................ 6,500 17,000 21,000 10,500 50,500 Less: Expected beginning inventory of finished goods ............................. (500) (1,500) (2,000) (1,000) (500) Units to be produced .......................................... 6,000 15,500 19,000 9,500 50,000 * Ten percent of the next quarter’s expected sales. † Ten percent of the expected sales for the 1st quarter of the next year, 20x3, which is predicted to be 5,000 units. 9 A unit-level cost is one that must be incurred each time a unit is produced. 10 Just-in-time production and inventory control systems are covered in Appendix III at the end of the text (p. 774). 5 Raw material to be purchased hiL25664_ch09_350-407.indd 373hiL25664_ch09_350-407.indd 373 7/25/13 6:52 AM7/25/13 6:52 AM Final PDF to printer 374 Chapter 9 Financial Planning and Analysis: The Master Budget Schedule B FESTICHAIR.COM Direct-Material Budget For the Year Ending December 31, 20x2 Quarter 1st 2nd 3rd 4th Year Chair fabric: Chairs to be produced (from Schedule A) ..................................... 6,000 15,500 19,000 9,500 50,000 Raw material required per unit (sq. ft of fabric) ......................................... 3 12 3 12 3 12 3 12 3 12 Raw material required for production (sq. ft.) ..................................................... 72,000 186,000 228,000 114,000 600,000 Add: Desired ending inventory of raw material (sq. ft.) * ....................................... 18,600 22,800 11,400 7,200 † 7,200 Total raw material required ............................ 90,600 208,800 239,400 121,200 607,200 Less: Expected beginning inventory of raw material (sq. ft.) .............................. (7,200) (18,600) (22,800) (11,400) (7,200) Raw material to be purchased (sq. ft.) ............ 83,400 190,200 216,600 109,800 600,000 Cost per sq. ft. .............................................. 3 $9 3 $9 3 $9 3 $9 3 $9 Total cost of chair fabric purchases ................ $750,600 $1,711,800 $1,949,400 $ 988,200 $5,400,000 Chair frames: Chairs to be produced (from Schedule A) ........ 6,000 15,500 19,000 9,500 50,000 Chair frames required per chair ..................... 3 1 3 1 3 1 3 1 3 1 Chair frames to be purchased ‡ ...................... 6,000 15,500 19,000 9,500 50,000 Cost per chair frame ..................................... 3 $20 3 $20 3 $20 3 $20 3 $20 Total cost of chair frame purchases ................ $120,000 $ 310,000 $ 380,000 $ 190,000 $1,000,000 Total cost of raw material purchases (fabric and frames) ................................... $870,600 $2,021,800 $2,329,400 $1,178,200 $6,400,000 *Ten percent of the next quarter’s expected raw material requirements. †Ten percent of the expected raw material requirements for the 1st quarter of the next year, 20x3, which is assumed to be 72,000 sq. ft. (Sales, and therefore production, is predicted to be the same in each quarter of 20x3 as in the corresponding quarter of 20x2.) ‡Since the chair frames are delivered on a just-in-time basis, there is no need for buffer inventory stocks. Thus, the number of frames purchased each quarter is the same as the number needed each quarter. Production and Purchasing: An Important Link Notice the important link between planned production and purchases of raw material. This link is apparent in Schedule B, and it is also emphasized in the formula preceding the schedule. Let’s focus on the sec- ond quarter. Since 15,500 chairs are to be produced, 186,000 sq. ft. of material will be needed (15,500 chairs times 12 sq. ft. per unit). In addition, FestiChair.com wants to have 22,800 sq. ft. of material in inventory at the end of the quarter. 11 Thus, total needs are 208,800 sq. ft. Does FestiChair.com need to purchase this much raw material? No it does not, because 18,600 sq. ft. will be in inventory at the beginning of the quarter. Therefore, the firm needs to purchase only 190,200 sq. ft. of material during the quarter (208,800 sq. ft. less 18,600 sq. ft. in the beginning inventory). Inventory Management The linkage between planned production and raw material purchases is a particularly critical linkage in manufacturing firms. Thus, considerable effort is devoted to careful inventory planning and management. How did FestiChair.com decide how much raw material to have in inventory at the end of each quarter? Examina- tion of Schedule B reveals that each quarter’s desired ending inventory of raw material is 10 percent of the material needed for production in the next quarter. For example, 11 It often is desirable to have a buffer inventory just before a bottleneck manufacturing operation. hiL25664_ch09_350-407.indd 374hiL25664_ch09_350-407.indd 374 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer Chapter 9 Financial Planning and Analysis: The Master Budget 375 22,800 sq. ft. of raw material will be in inventory at the end of the second quarter, because 228,000 sq. ft. will be needed for production in the third quarter (22,800 5 10% 3 228,000). The effect of this approach is to have a larger ending inventory when the next quarter’s planned production is greater. Inventories are drawn down when the subsequent quarter’s planned production is lower. Further discussion of inventory management can be found in Appendix III on page 774. Budgeted Schedule of Cost of Goods Manufactured and Sold During our discussion of Snowcap Music Festivals, we introduced two of the budgeted financial statements: the budgeted income statement and the budgeted statement of cash flows. We now turn to the remaining budget schedule that is needed before manufacturer FestiChair.com can complete its budgeted financial statements . The budgeted schedule of cost of goods manufactured and sold shows the pro- duction costs that are expected to flow through the inventory accounts, and identifies the portion of production costs expected to be in work-in-process inventory, finished-goods inventory and cost of goods sold at the end of the period. • This budget schedule first summarizes the various costs of production from other budget schedules to compute the period’s total manufacturing costs. • It then adjusts for the beginning and ending cost of work-in-process inventory to compute the cost of goods manufactured. (Recall from Chapter 2 that cost of goods manufactured represents the total cost of products completed and trans- ferred to finished-goods inventory.) • Finally, the cost of goods manufactured is adjusted by the beginning and ending balances in finished-goods inventory to compute cost of goods sold. Schedule C shows FestiChair.com’s budgeted schedule of cost of goods manufac- tured and sold. Schedule C FESTICHAIR.COM Budgeted Schedule of Cost of Goods Manufactured and Sold For the Year Ending December 31, 20x2 Direct material (see Schedule B for details): Raw-material inventory, January 1 ............................................................................ $ 64,800 a Add: Purchases of raw material ................................................................................ 6,400,000 b Raw material available for use .................................................................................. $6,464,800 Deduct: Raw-material inventory, December 31 .......................................................... 64,800 a Direct material used ................................................................................................. $6,400,000 b Direct labor (from direct-labor budget*) ......................................................................... 375,000 Production overhead (from production overhead budget*) ............................................... 1,400,000 Total manufacturing costs ............................................................................................. $8,175,000 Add: Work-in-process inventory, January 1 .................................................................... 0 c Subtotal ...................................................................................................................... $8,175,000 Deduct: Work-in-process inventory, December 31 .......................................................... 0 c Cost of goods manufactured ......................................................................................... $8,175,000 Add: Finished-goods inventory, January 1 ...................................................................... 81,750 d Cost of goods available for sale ..................................................................................... $8,256,750 Deduct: Finished-goods inventory, December 31 ............................................................ 81,750 d Cost of goods sold ....................................................................................................... $8,175,000 a From Schedule B: 7,200 sq. ft. of chair fabric 3 $9 per sq. ft., and zero inventory of chair frames. b From Schedule B: $5,400,000 for chair fabric 1 $1,000,000 for chair frames. c The company’s production cycle is short enough that there is no work-in-process inventory at any time. d From Schedule A: 500 units 3 $163.50 per unit, which is the absorption manufacturing cost per unit ($8,175,000 cost of goods manufactured 4 50,000 units from Schedule A) . *This budget schedule was discussed earlier in this chapter and is not included in the FestiChair.com example. hiL25664_ch09_350-407.indd 375hiL25664_ch09_350-407.indd 375 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer 376 Chapter 9 Financial Planning and Analysis: The Master Budget Budgeted Balance Sheet After completing the budgeted income statement and budgeted statement of cash flows (discussed earlier in the chapter and so omitted from the FestiChair.com example), we turn last to the budgeted balance sheet. The budgeted balance sheet shows the expected end-of-period balances for the company’s assets, liabilities, and owner’s equity, assuming that planned operations are carried out. FestiChair.com’s budgeted balance sheet for December 31, 20x2, is displayed as Schedule D. To construct this bud- geted balance sheet, we start with the firm’s balance sheet projected for the beginning of the budget year ( Exhibit 9–4 ) and then adjust each account balance for the changes expected during 20x2. These expected changes are reflected in the various 20x2 budget schedules. Expected changes in account balances during 20x2 Balance sheet December 31, 20x1 (Exhibit 9–4) Balance sheet December 31, 20x2 (Schedule D) Explanations for the account balances on the budgeted balance sheet for December 31, 20x2, are given in the second half of Schedule D. Examine these explanations carefully. Notice how the budgeted balance sheet pulls together information from most of the schedules constituting the master budget. Exhibit 9–4 Prior-Year-End Balance Sheet hiL25664_ch09_350-407.indd 376hiL25664_ch09_350-407.indd 376 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer Chapter 9 Financial Planning and Analysis: The Master Budget 377 Schedule D FESTICHAIR.COM Budgeted Balance Sheet December 31, 20x2 Assets Current assets: Cash (from cash budget*) ..................................................................................... $ 831,000 Accounts receivable (net of allowance for uncollectible accounts) ............................ 405,000 a Inventory: Raw material (from Schedule C) ........................................................................ $ 64,800 Finished goods (from Schedule C) ..................................................................... 81,750 Supplies .......................................................................................................... 42,000 Total inventory ................................................................................................. 188,550 Total current assets .................................................................................................. $ 1,424,550 Long-lived assets: Building .......................................................................................................... $9,200,000 b Equipment ...................................................................................................... 2,280,000 Less accumulated depreciation on building and equipment ................................ (2,323,550 ) c Building and equipment, net of accumulated depreciation .................................. 9,156,450 Total assets ............................................................................................................. $10,581,000 Liabilities and Owner’s Equity Current liabilities: Accounts payable ................................................................................................. $ 471,280 d Total current liabilities .......................................................................................... $ 471,280 Long-term liabilities: Note payable (non-interest-bearing; due on December 31, 20X4) ........................... 4,100,000 Total liabilities .......................................................................................................... 4,571,280 Owner’s equity ......................................................................................................... 6,009,720 e Total liabilities and owner’s equity ............................................................................. $10,581,000 a From cash receipts budget*: uncollected portion of 4th quarter sales. b Balance in the Building account on the December 31, 20x1, balance sheet, plus a $1,000,000 building construction project in 20x2 (from capi- tal budget and cash budget*). c Balance in the Accumulated Depreciation account on the December 31, 20x1, balance sheet, plus $440,000 in depreciation during 20x2 (from production overhead budget*). d From cash disbursements budget*: unpaid portion of 4th quarter purchases. e Balance in Owner’s Equity on the December 31, 20x1, balance sheet, plus the 20x2 budgeted net income of $1,381,000 from budgeted income statement.* *This budget schedule was discussed earlier in this chapter and is not included in the FestiChair.com example. Assumptions and Predictions Underlying the Master Budget A master budget is based on many assumptions and estimates of unknown parameters. Some estimates tend to be quite accurate, while other predictions are much more difficult to make accurately. What are some of the assumptions and predictions that are reflected in FestiChair.com’s budget? Consider Schedules A and B. First, the company’s managers have assumed that peo- ple will continue to purchase more chairs in the spring and summer than in the cooler months of the year, as they have in the past. Second, they have assumed that production capacity is sufficient to meet the peak production requirement of 19,000 chairs in the third quarter. And third, the managers have assumed that the quantity of chair material needed for production will be available, when needed, at a price of $9 per sq. ft. for the entire year. Based on these assumptions, the managers have predicted direct-material costs for each quarter. FestiChair.com’s master budget reflects many other predictions, such as salaries, wage rates, electric and other utility rates, insurance and property tax rates, and so forth. Assumptions and Predictions Underlying the Master Budget Learning Objective 9-7 Discuss the role of assumptions and predictions in budgeting hiL25664_ch09_350-407.indd 377hiL25664_ch09_350-407.indd 377 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer 378 Chapter 9 Financial Planning and Analysis: The Master Budget Some of these predictions—property tax rates, for example—would likely be quite accu- rate. Other predictions would be more difficult, as, for example, the cost of natural gas for heating purposes due to its dependence on the weather. Making predictions and agreeing on assumptions are valuable parts of the budgeting process. Managers are forced to identify and agree on the assumptions that will be part of the year’s financial plan. And after making the predictions, the risk of being wrong can sometimes be mitigated by managers’ actions. For example, if the company is going to assume that chair fabric will be available all year at $9 per sq. ft., then the company will consider entering into purchasing contracts that will guarantee that availability. But these contracts also bring risk: if the sales volume predictions are too high, they could be stuck with a lot of extra fabric; and if market prices for fabric drop, their chair production costs might be higher than their competitors’ costs. Managers get paid to make decisions like these, and building them into the budgeting process helps. Financial Planning Models Managers must make assumptions and predictions in preparing budgets because orga- nizations operate in a world of uncertainty. That is why the master budget is just one part of the financial planning and analysis (FP&A) system. Another part of that system is the financial planning model. A financial planning model is a set of mathematical relationships that express the interactions among the various operational, financial, and environmental events that determine the overall results of an organization’s activities. A financial planning model is a mathematical expression of all the relationships expressed in the flowchart of Exhibit 9–1 . To illustrate this concept, focus on the following equation, which is used to budget FestiChair.com’s employee fringe benefits. (Employee fringe benefits) 5 .30 3 (Total salaries and wages) However, suppose the company’s managers are uncertain about this 30 percent esti- mate. A financial planning model might include the following equation instead. (Employee fringe benefits) 5 p 3 (Total salaries and wages) where 0 # p # 1.0. The budget staff can run the financial planning model as many times as desired on a computer, using a different value for p each time. Perhaps the following values would be tried: .29, .295, .30, .305, and .31. Now management can answer the question, What would be the effect on budgeted net income if employee fringe benefit costs increase to 30.5 percent of salaries and wages instead of 30 percent? In a fully developed financial planning model, all of the key estimates and assumptions are expressed as general math- ematical relationships. Then the model is run on a computer many times to determine the impact of different combinations of these unknown variables. “What if” questions can be answered about such unknown variables as inflation, interest rates, the value of the dollar, demand, competitors’ actions, union demands in forthcoming wage negotiations, and a host of other factors. The widespread availability of economical spreadsheet tools and cloud-based FP&A solutions has made financial planning models a more and more common management tool. Budget Administration In small organizations, the procedures used to gather information and construct a mas- ter budget are usually informal. In contrast, larger organizations use a formal process to collect data and prepare the master budget. Such organizations usually designate a budget director or chief budget officer . This is often the organization’s controller. The budget director specifies the process by which budget data will be gathered, collects the Budget Administration “Implementing a Web-based, enterprise-wide budgeting solution will help us develop business plans and allow our analysts to be proac- tive in monitoring quarterly results.” (9f ) Toronto Dominion Bank Learning Objective 9-8 Describe a typical organization’s process of budget administration. hiL25664_ch09_350-407.indd 378hiL25664_ch09_350-407.indd 378 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer Chapter 9 Financial Planning and Analysis: The Master Budget 379 information, and prepares the master budget. To communicate budget procedures and deadlines to employees throughout the organization, the budget director often develops and disseminates a budget manual . The budget manual states who is responsible for providing various types of information, when the information is required, and what form the information is to take. For example, the budget manual for a manufactur- ing firm might specify that each regional sales director is to send an estimate of the following year’s sales, by product line, to the budget director by September 1. The budget manual also states who should receive each schedule when the master budget is complete. A budget committee , consisting of key senior executives, often is appointed to advise the budget director during the preparation of the budget. The authority to give final approval to the master budget usually belongs to the board of directors, or a board of trustees in many nonprofit organizations. Usually the board has a subcommittee whose task is to examine the proposed budget carefully and recommend approval or any changes deemed necessary. By exercising its authority to make changes in the budget and grant final approval, the board of directors, or trustees, can wield considerable influence on the overall direction the organization takes. As more and more companies operate globally, the Internet is playing an ever- greater role in the budgeting process. E-budgeting is an increasingly popular, Internet- based budgeting tool that can help streamline and speed up an organization’s budgeting process. The e in e-budgeting stands for both electronic and enterprisewide; employees throughout an organization, at all levels and around the globe, can submit and retrieve budget information electronically via the Internet. Often part of a larger FP&A system, e-budgeting can occur in two different ways. In the first, a company runs a central FP&A application (software) on the company’s computers, and employees companywide use the Internet to access that centralized application (the enterprise-hosted model). In an increasingly popular alternative approach, an FP&A software provider hosts the application on its website and the company’s employees use the Internet to access the application and record data there. Unlike the enterprise-hosted model, this provider-hosted approach, often called a cloud or SaaS (software-as-a-service) solution, has the advantages of frequent, centralized updating of the e-budgeting software by the software vendor com- bined with the outsourcing of the technology issues associated with hosting and running “The rise of the cloud is more than just another platform shift that gets geeks excited. It will profoundly change the way people work and companies operate.” (9g) The Economist magazine BUDGET ADMINISTRATION AT CORNELL UNIVERSITY Cornell University ’s annual budget covers the period from July 1 through the following June 30. The budgeting process begins in October, when the deans and senior vice presi- dents have meetings to discuss the programs the university will conduct during the fol- lowing budget year. The university’s priorities in educational, research, and public service programs are established during these meetings. In early January, the university’s budget director, together with other members of the Operating Plans Committee, settles on a set of assumptions to be used during the remainder of the budgeting process. These assumptions include such key forecasts as the next year’s inflation rate, interest rates, and tuition levels. Based on these assumptions, the dean of each of Cornell’s colleges or professional schools must develop a detailed budget for salaries and general expenses. These detailed budgets are prepared during January and February by the financial staff in each college or professional school. In March, the university president and provost review these budgets with the deans. After any needed revisions have been made, the budgets for the various colleges and professional schools are consolidated by the university con- troller’s staff into a master budget. This budget is presented to the university’s board of trustees in May for final approval. Cornell University anagement ccounting ractice M A P hiL25664_ch09_350-407.indd 379hiL25664_ch09_350-407.indd 379 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer 380 Chapter 9 Financial Planning and Analysis: The Master Budget the software. However, it also has one very important disadvantage: the company’s propri- etary financial data resides outside of the company’s walls. This is a serious data security risk, but one that FP&A software providers are increasingly mitigating to the satisfaction of their clients via extensive security procedures. Managers in organizations using e-budgeting have found that it greatly streamlines the entire budgeting process. In the past, these organizations have compiled their mas- ter budgets on hundreds of spreadsheets, which had to be collected and integrated by the corporate controller’s office. One result of this cumbersome approach was that a disproportionate amount of time was spent compiling and verifying data from multiple sources. Under e-budgeting, both the submission of budget information and its compi- lation are accomplished electronically. Thus, e-budgeting is just one more area where the Internet has transformed how the workplace operates in the era of e-business. International Aspects of Budgeting As the economies and cultures of countries through- out the world become intertwined, more and more companies are becoming multinational in their operations. Firms with international operations face a variety of additional challenges in preparing their budgets. First, a multinational firm’s budget must reflect the translation of foreign currencies into the company’s official corporate currency, which is usu- ally determined by the location of the corporate head- quaters or the stock exchange on which the company has its primary listing. A U.S.-based company like McDonald’s converts the results of worldwide opera- tions into U.S. dollars. Since almost all the world’s currencies fluctuate in their values relative to the dol- lar, this makes budgeting for those translations dif- ficult. Although multinationals have sophisticated financial ways of hedging against such currency fluctuations, the budgeting task is still more challenging. Second, it is difficult to prepare budgets when inflation is high or unpredictable. Most countries occasionally experience periods of high inflation, and some coun- tries have experienced hyperinflation, sometimes with annual inflation rates well over 100 percent. Predicting such high inflation rates is difficult and further complicates a multinational’s budgeting process. Finally, the economies of all countries fluctuate in terms of consumer demand, availabil- ity of skilled labor, laws affecting commerce, and so forth. Companies with offshore opera- tions face the task of anticipating such changing conditions in their budgeting processes. Behavioral Impact of Budgets One of the underlying themes stressed in this text is the behavioral impact of managerial accounting practices. There is no other area where the behavioral implications are more important than in the budgeting area. A budget affects virtually everyone in an organiza- tion: those who prepare the budget, those who use the budget to facilitate decision mak- ing, and those who are evaluated using the budget. The human reactions to the budgeting process can have considerable influence on an organization’s overall effectiveness. A great deal of study has been devoted to the behavioral effects of budgets. Here we will barely scratch the surface by briefly considering two issues: budgetary slack and participative budgeting. International Aspects of Budgeting Behavioral Impact of Budgets As this photo from Thailand shows, McDonald’s operates throughout the world. Multinational companies face special challenges in preparing their budgets. Learning Objective 9-9 Discuss the behavioral issues in budgeting. hiL25664_ch09_350-407.indd 380hiL25664_ch09_350-407.indd 380 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer Chapter 9 Financial Planning and Analysis: The Master Budget 381 Budgetary Slack: Padding the Budget The information upon which a budget is based comes largely from people throughout an organization. For example, the sales forecast relies on market research and analysis by market research staff but also incorporates the projections of sales personnel. If a territo- rial sales manager’s performance is evaluated on the basis of whether the sales budget for the territory is exceeded, what is the incentive for the sales manager in projecting sales? The incentive is to give a conservative, or cautiously low, sales estimate. The sales manager’s performance will look much better in the eyes of top management when a conservative estimate is exceeded than when an ambitious estimate is not met. At least that is the perception of many sales managers, and, in the behavioral area, perceptions are what count most. When a supervisor provides a departmental cost projection for budgetary purposes, there is an incentive to overestimate costs. When the actual cost incurred in the depart- ment proves to be less than the inflated cost projection, the supervisor appears to have managed in a cost-effective way. These illustrations are examples of padding the budget . Budget padding means underestimating revenue or overestimating costs. The difference between the revenue or cost projection that a person provides and a realistic estimate of the revenue or cost is called budgetary slack . For example, if a manager believes the annual utilities cost will be $18,000, but gives a budgetary projection of $20,000, the manager has built $2,000 of slack into the budget. Why do people pad budgets with budgetary slack? There are three primary reasons. First, people often perceive that their performance will look better in their superiors’ eyes if they can “beat the budget.” Second, budgetary slack often is used to cope with uncer- tainty. A departmental supervisor may feel confident in the cost projections for 10 cost items. However, the supervisor also may feel that some unforeseen event during the bud- getary period could result in unanticipated costs. For example, an unexpected machine breakdown could occur. One way of dealing with that unforeseen event is to pad the bud- get. If nothing goes wrong, the supervisor can beat the cost budget. If some negative event does occur, the supervisor can use the budgetary slack to absorb the impact of the event and still meet the cost budget. The third reason why cost budgets are padded is that budgetary cost projections are often cut in the resource-allocation process. Thus, we have a vicious circle. Budgetary projections are padded because they will likely be cut, and they are cut because they are likely to have been padded. How does an organization solve the problem of budgetary slack? First, it can avoid relying on the budget as a negative evaluation tool. If a departmental supervisor is harassed by the budget director or some other top manager every time a budgetary cost projection is exceeded, the likely behavioral response will be to pad the budget. In con- trast, if the supervisor is allowed some managerial discretion to exceed the budget when necessary, there will be less tendency toward budgetary padding. Second, managers can be given incentives not only to achieve budgetary projections but also to provide accurate projections. This can be accomplished by asking managers to justify all or some of their projections and by rewarding managers who consistently provide accurate estimates. Participative Budgeting Most people will perform better and make greater attempts to achieve a goal if they have been consulted in setting the goal. The idea of participative budgeting is to involve employees throughout an organization in the budgetary process. Such participation can give employees the feeling that “this is our budget,” rather than the all-too-common feel- ing that “this is the budget you imposed on us.” While participative budgeting can be very effective, it also can have shortcomings. Too much participation and discussion can lead to vacillation and delay. Also, when those hiL25664_ch09_350-407.indd 381hiL25664_ch09_350-407.indd 381 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer 382 Chapter 9 Financial Planning and Analysis: The Master Budget involved in the budgeting process disagree in significant and irreconcilable ways, the process of participation can accentuate those differences. Finally, the problem of budget padding can be severe unless incentives for accurate projections are provided. Focus on Ethics IS PADDING THE BUDGET UNETHICAL? A departmental or divisional budget often is used as the basis for evaluating a manager’s performance. Actual results are compared with budgeted performance levels, and those who outperform the budget often are rewarded with promotions or salary increases. In many cases, bonuses are tied explicitly to performance relative to a budget. For example, the top-management personnel of a division may receive a bonus if divisional profit exceeds budgeted profit by a certain percentage. Serious ethical issues can arise in situations where a budget is the basis for rewarding managers. For exam- ple, suppose a division’s top-management personnel will split a bonus equal to 10 percent of the amount by which actual divisional profit exceeds the budget. This may cre- ate an incentive for the divisional budget officer, or other managers supplying data, to pad the divisional profit budget. Such padding would make the budget easier to achieve, thus increasing the chance of a bonus. Alterna- tively, there may be an incentive to manipulate the actual divisional results in order to maximize management’s bonus. For example, year-end sales could be shifted between years to increase reported revenue in a particu- lar year. Budget personnel could have such incentives for either of two reasons: (1) they might share in the bonus or (2) they might feel pressure from the managers who would share in the bonus. Put yourself in the position of the division controller. Your bonus, and that of your boss, the division vice presi- dent, will be determined in part by the division’s income in comparison to the budget. When your division has sub- mitted budgets in the past, the corporate management has usually cut your budgeted expenses, thereby increas- ing the division’s budgeted profit. This, of course, makes it more difficult for your division to achieve the budgeted profit. Moreover, it makes it less likely that you and your divisional colleagues will earn a bonus. Now your boss is pressuring you to pad the expense budget, because “the budgeted expenses will just be cut anyway at the corporate level.” Is padding the budget eth- ical under these circumstances? What do you think? And how could you resolve the situation? Chapter Summary LO9-1 Explain the relationship between financial planning and analysis and the master budget. The master budget is not created in isolation but is a key element of a larger system of financial plan- ning and analysis. Use of an integrated system forces communication of operational and financial goals across the organization. LO9-2 List and explain five purposes of budgeting. The budget is a key tool for planning, control, and decision making in virtually every organization. The five purposes of budgeting systems are: to force planning, to facilitate communication and coordination, to allocate resources, to control profit and operations, and to evaluate performance and provide incentives. LO9-3 Describe the similarities and differences in the operational budgets prepared by manu- facturers, service-industry firms, merchandisers, and nonprofit organizations. The key difference in the operational budgets of manufacturers and merchandisers versus service-industry and nonprofit organizations is that the operational budgets of manufacturers and merchandisers must account for the production or purchase and holding of inventory. In contrast, the budgets of service-industry and non- profit organizations generally do not have inventories of manufactured or purchased inventories. LO9-4 Explain the concept of activity-based budgeting and the logic it brings to the budgeting process. Activity-based budgeting (ABB) applies the concepts of activity-based costing (ABC) to the budgeting process. Utilizing ABC information in the budgeting process through ABB provides sound information for budgeting costs, because the underlying ABC information is based explicitly on the relationships among cost drivers, activities, and resources consumed. hiL25664_ch09_350-407.indd 382hiL25664_ch09_350-407.indd 382 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer Chapter 9 Financial Planning and Analysis: The Master Budget 383 LO9-5 Prepare each of the budget schedules that make up the master budget in a nonmanufac- turing firm, and that exist in manufacturing budgets as well. As shown in the chapter, the master budget of all firms includes the following key budget schedules: sales; purchases; direct-labor; produc- tion overhead; selling, general, and administrative expense; cash receipts; cash disbursements; and cash. Also included are the budgeted income statement and the budgeted statement of cash flows. LO9-6 Prepare the additional master budget schedules required by a manufacturing firm. Several additional budget schedules are needed in a manufacturing firm, primarily due to changing inventory levels. These include budget schedules for production; direct materials; and cost of goods manufactured and sold. Also included is the budgeted balance sheet, which is needed in a nonmanufacturing firm as well. LO9-7 Discuss the role of assumptions and predictions in budgeting. A master budget is based on many assumptions and predictions of unknown parameters. Some estimates tend to be quite accurate, while other predictions are much more difficult. Financial planning models provide insight into the impact of alternate predictions. LO9-8 Describe a typical organization’s process of budget administration. Most organizations have a well-defined process by which budget data is collected and the budget is prepared. This administrative pro- cess often includes a budget director or chief budget officer, a budget manual, and a budgeting committee. LO9-9 Discuss the behavioral issues in budgeting. A common problem in budgeting is the tendency of people to pad budgets. The resulting budgetary slack makes the budget less useful because the padded budget does not present an accurate picture of expected revenue and expenses. Participative budgeting is the process of allowing employees throughout the organization to have a significant role in developing the budget. Participative budgeting can result in greater commitment to meet the budget by those who participated in the process. Review Problem on Preparing Master Budget Schedules SolarTech, Inc., manufactures a special ceramic tile used as a component in residential solar energy systems. Sales are seasonal due to the seasonality in the home-building industry. • The expected pattern of sales for the next year (20x8) is as follows: Quarter 1st 2nd 3rd 4th Year Sales in units .................................... 2,000 6,000 8,000 4,000 20,000 • Each tile sells for $25. All sales are on account, and SolarTech’s experience with cash collections is that 60 percent of each quarter’s sales are collected during the same quarter as the sale. The remain- ing 40 percent of sales is collected in the quarter after the sale. SolarTech experiences negligible bad debts, and so this is ignored in the budgeting process. Sales in the fourth quarter of 20x7 are expected to be $100,000 (4,000 units). • SolarTech desires to have 10 percent of the following quarter’s sales needs in finished-goods inventory at the end of each quarter. (On December 31, 20x7, SolarTech expects to have 200 units in inventory.) • Each tile requires two pounds of raw material. SolarTech desires to have 10 percent of the next quarter’s raw material in inventory at the end of each quarter. (On December 31, 20x7, SolarTech expects to have 480 pounds of raw material in inventory.) • The raw material price is $5 per pound. The company buys its raw material on account and pays 70 percent of the resulting accounts payable during the quarter of the purchase. The remaining 30 percent is paid during the following quarter. (The raw-material purchases in the fourth quarter of 20x7 are expected to be $36,600.) Required: Prepare the following budget schedules for 20x8. Include a column for each quarter and for the year. 1. Sales budget (in units and dollars). 2. Cash receipts budget. 3. Production budget. 4. Direct material budget. ( Hint: The desired ending inventory in the fourth quarter is 480 pounds.) 5. Cash disbursements budget for raw material purchases. hiL25664_ch09_350-407.indd 383hiL25664_ch09_350-407.indd 383 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer 384 Chapter 9 Financial Planning and Analysis: The Master Budget Solution to Review Problem 1. Sales budget for 20x8: Quarter 1st 2nd 3rd 4th Year Sales in units .............................. 2,000 6,000 8,000 4,000 20,000 Unit sales price ........................... $ 25 $ 25 $ 25 $ 25 $ 25 Total sales revenue ................. $50,000 $150,000 $200,000 $100,000 $500,000 2. Cash receipts budget for 20x8: Quarter 1st 2nd 3rd 4th Year Sales revenue (from sales budget) ......... $50,000 $150,000 $200,000 $100,000 $500,000 Collections in quarter of sale (60% of revenue) ................................ $30,000 $ 90,000 $120,000 $ 60,000 $300,000 Collections in quarter after sale (40% of prior quarter’s revenue)* ......... 40,000* 20,000 60,000 80,000 200,000 Total cash receipts .............................. $70,000 $110,000 $180,000 $140,000 $500,000 *Forty percent of sales revenue from the 4th quarter of 20x7, which was given at $100,000. 3. Production budget for 20x8: Quarter 1st 2nd 3rd 4th Year Sales in units (from sales budget) ................ 2,000 6,000 8,000 4,000 20,000 Add desired ending inventory of finished goods* ......... 600 800 400 200† 200 Total units required .................................... 2,600 6,800 8,400 4,200 20,200 Less expected beginning inventory of finished goods ..................... 200 600 800 400 200 Units to be produced .................................. 2,400 6,200 7,600 3,800 20,000 *Ten percent of the next quarter’s expected sales. †Ten percent of the expected sales for the first quarter of the next year 20x9, which is predicted to be 2,000 units. 4. Direct-material budget for 20x8: Quarter 1st 2nd 3rd 4th Year Units to be produced (from production budget) ....... 2,400 6,200 7,600 3,800 20,000 Raw material required per unit (pounds) .......................................................... x 2 x 2 x 2 x 2 x 2 Raw material required for production (pounds) .......................................................... 4,800 12,400 15,200 7,600 40,000 Add desired ending inventory of raw material (pounds)* ................................. 1,240 1,520 760 480† 480 Total raw material required ................................... 6,040 13,920 15,960 8,080 40,480 Less expected beginning inventory of raw material (pounds) ................................... 480‡ 1,240 1,520 760 480 Raw material to be purchased (pounds) ................. 5,560 12,680 14,440 7,320 40,000 Cost per pound .................................................... x $5 x $5 x $5 x $5 x $5 Total cost of raw material purchases ..................... $27,800 $63,400 $72,200 $36,600 $200,000 *Ten percent of the next quarter’s raw material requirements. † The desired ending raw material inventory for the fourth quarter of 20x8 is given at 480 pounds. However, it can also be computed indepen- dently by noting that the expected sales pattern for 20x9 is the same as that for 20x8. Therefore, the first quarter budgets for 20x9 will be the same as those for the first quarter of 20x8. So the desired ending raw-material inventory for the fourth quarter of 20x8 is 480 pounds (10% 3 4,800 pounds required for production in the first quarter of 20x9.) ‡Given in problem. hiL25664_ch09_350-407.indd 384hiL25664_ch09_350-407.indd 384 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer Chapter 9 Financial Planning and Analysis: The Master Budget 385 5. Cash disbursements budget for raw material purchases for 20x8: Quarter 1st 2nd 3rd 4th Year Cost of raw material purchases (from direct-material budget) ...................... $27,800 $63,400 $72,200 $36,600 $200,000 Cash payments for purchases made during the quarter (70% of current quarter’s purchases) .................................. $19,460 $44,380 $50,540 $25,620 $140,000 Cash payments for prior quarter’s purchases (30% of prior quarter’s purchases) .................................. 10,980* 8,340 19,020 21,660 60,000 Total cash payments for raw material purchases .............................. $30,440 $52,720 $69,560 $47,280 $200,000 *Purchases in the fourth quarter of 20x7 were given at $36,600. Key Terms For each term’s definition refer to the indicated page, or turn to the glossary at the end of the text. activity-based budgeting (ABB), 360 budget, 353 budget committee, 379 budget director ( or chief budget officer), 378 budget manual, 379 budgetary slack, 381 budgeted balance sheet, 370 budgeted financial state- ments ( or pro forma financial statements), 354 budgeted income statement, 369 budgeted schedule of cost of goods manufactured and sold, 375 budgeted statement of cash flows, 370 capital budget, 354 cash budget, 368 cash disbursements budget, 368 cash receipts budget, 366 conversion costs, 364 direct-labor budget, 364 direct-material budget, 373 e-budgeting, 379 financial planning and analysis (FP&A) system, 352 financial planning model, 378 financing budget, 354 master budget ( or profit plan), 354 operational budgets, 356 padding the budget, 381 participative budgeting, 381 production budget, 372 production overhead budget, 365 profit plan ( or master budget), 354 purchases budget, 363 rolling budgets ( also revolving or continuous budgets), 354 sales budget, 362 sales forecasting, 355 selling, general, and administrative expense (SG&A) budget, 366 Review Questions 9–1. Explain how a budget facilitates communication and coordination. 9–2. Use an example to explain how a budget could be used to allocate resources in a university. 9–3. Explain what a master budget is, and list five of its parts. 9–4. Draw a flowchart similar to the one in Exhibit 9–1 for a service station. The service station provides automotive maintenance services in addition to selling gasoline and related products. 9–5. Give an example of how general economic trends would affect sales forecasting in the airline industry. 9–6. What is meant by the term operational budgets? List three operational budgets that would be prepared by Cook County Hospital in Chicago. 9–7. How does activity-based budgeting explain the logic of budgeting? 9–8. How does e-budgeting make use of the Internet? 9–9. Give three examples of how the city of Boston could use a budget for planning purposes. 9–10. Describe the role of a budget director. 9–11. What is the purpose of a budget manual? 9–12. How can a company’s board of directors use the budget to influence the future direction of the firm? 9–13. Discuss the importance of predictions and assumptions in the budgeting process. 9–14. Define the term budgetary slack, and briefly describe a problem it can cause. 9–15. How can an organization help to reduce the problems caused by budgetary slack? 9–16. Why is participative budgeting often an effective management tool? 9–17. Discuss this comment by a small-town bank president: “Budgeting is a waste of time. I’ve been running this business for 40 years. I don’t need to plan.” 9–18. List the steps you would go through in developing a budget to meet your college expenses. 9–19. Briefly describe three issues that create special chal- lenges for multinational firms in preparing their budgets. 9–20. What are the primary differences in budgeting between manufacturing and nonmanufacturing firms? hiL25664_ch09_350-407.indd 385hiL25664_ch09_350-407.indd 385 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer 386 Chapter 9 Financial Planning and Analysis: The Master Budget All applicable Exercises are available with McGraw-Hill’s Connect Accounting ® . Exercises San Fernando Fertilizer Company plans to sell 40,000 units of finished product in July and anticipates a growth rate in sales of 5 percent per month. The desired monthly ending inventory in units of finished product is 80 percent of the next month’s estimated sales. There are 32,000 finished units in inventory on June 30. Each unit of finished product requires four pounds of raw material at a cost of $1.40 per pound. There are 140,000 pounds of raw material in inventory on June 30. Required: 1. Compute the company’s total required production in units of finished product for the entire three- month period ending September 30. 2. Independent of your answer to requirement (1), assume the company plans to produce 120,000 units of finished product in the three-month period ending September 30, and to have raw-material inventory on hand at the end of the three-month period equal to 25 percent of the use in that period. Compute the total estimated cost of raw-material purchases for the entire three-month period ending September 30. (CMA, adapted) Coyote Loco, Inc., a distributor of salsa, has the following historical collection pattern for its credit sales. 70 percent collected in the month of sale. 15 percent collected in the first month after sale. 10 percent collected in the second month after sale. 4 percent collected in the third month after sale. 1 percent uncollectible. The sales on account have been budgeted for the last seven months as follows: June ........................................................................................................................................................ $122,500 July ......................................................................................................................................................... 150,000 August ..................................................................................................................................................... 175,000 September ............................................................................................................................................... 200,000 October .................................................................................................................................................... 225,000 November ................................................................................................................................................ 250,000 December ................................................................................................................................................ 212,500 Required: 1. Compute the estimated total cash collections during October from credit sales. 2. Compute the estimated total cash collections during the fourth quarter from sales made on account during the fourth quarter. 3. Build a spreadsheet: Construct an Excel spreadsheet to solve both of the preceding requirements. Show how the solution will change if the following information changes: sales in June and July were $100,000 and $130,000, respectively. (CMA, adapted) Fill in the missing amounts in the following schedules. July August September 1. Sales* ...................................................................... $240,000 $180,000 $ ? Cash receipts: From cash sales ................................................... $ ? $ ? $135,000 From sales on account † ........................................ ? 102,000 ? Total cash receipts ................................................ $ ? $ ? $ ? 2. Accounts payable, 12/31/x0 ...................................................................................... €600,000 ‡ Purchase of goods and services on account during 20x1 ............................................ 2,400,000 Payments of accounts payable during 20x1 ............................................................... ? Accounts payable, 12/31/x1 ...................................................................................... 800,000 ■ Exercise 9–21 Budgeting Production and Raw-Material Purchases (LO 9-3, 9-6) ■ Exercise 9–22 Cash Collections (LO 9-3, 9-5) ■ Exercise 9–23 Missing Amounts; Various Types of Budgets (LO 9-3, 9-5, 9-6) hiL25664_ch09_350-407.indd 386hiL25664_ch09_350-407.indd 386 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer Chapter 9 Financial Planning and Analysis: The Master Budget 387 3. Accounts receivable, 12/31/x0 .................................................................................. ¥1,700,000 § Sales on account during 20x1 ................................................................................... 4,500,000 Collections of accounts receivable during 20x1 .......................................................... 3,900,000 Accounts receivable, 12/31/x1 .................................................................................. ? 4. Accumulated depreciation, 12/31/x0 .......................................................................... $ 405,000 Depreciation expense during 20x1 ............................................................................. 75,000 Accumulated depreciation, 12/31/x1 ......................................................................... ? 5. Retained earnings, 12/31/x0 ..................................................................................... $1,537,500 Net income for 20x1 ................................................................................................. 300,000 Dividends paid in 20x1 ............................................................................................. –0– Retained earnings, 12/31/x1 ..................................................................................... ? *Half of each month’s sales are on account. June sales amounted to $180,000. † 60% of credit sales is collected in the month of sale; 40% is collected in the following month. ‡ The Euro (€) is used in most European markets. § The Yen (¥) is the Japanese national currency. The Chinese national currency is denominated in Yuan, which shares the same symbol. Alder Company budgets on an annual basis. The following beginning and ending inventory levels (in units) are planned for the next year. Two units of raw material are required to produce each unit of fin- ished product. January 1 December 31 Raw material ..................................... 245,000 ............................................ 315,000 Work in process ................................. 84,000 ............................................ 84,000 Finished goods .................................. 560,000 ........................................... 350,000 Required: 1. If Alder Company plans to sell 3,360,000 units during the year, compute the number of units the firm would have to manufacture during the year. 2. If 3,500,000 finished units were to be manufactured by Adler Company during the year, determine the amount of raw material to be purchased. (CMA, adapted) The following information is from White Mountain Furniture Showroom’s financial records. Month Sales Purchases July ............................................................. $180,000 ................................................... $105,000 August ........................................................ 165,000 ................................................... 120,000 September .................................................. 150,000 ................................................... 90,000 October ....................................................... 195,000 ................................................... 135,000 Collections from customers are normally 70 percent in the month of sale, 20 percent in the month following the sale, and 9 percent in the second month following the sale. The balance is expected to be uncollectible. All purchases are on account. Management takes full advantage of the 2 percent discount allowed on purchases paid for by the tenth of the following month. Purchases for November are bud- geted at $150,000, and sales for November are forecasted at $165,000. Cash disbursements for expenses are expected to be $36,000 for the month of November. The company’s cash balance on November 1 was $55,000. Required: Prepare the following schedules. 1. Expected cash collections during November. 2. Expected cash disbursements during November. 3. Expected cash balance on November 30. (CPA, adapted) ■ Exercise 9–24 Budgeting Production and Direct-Material Purchases (LO 9-3, 9-6) ■ Exercise 9–25 Cash Budgeting (LO 9-3, 9-5) hiL25664_ch09_350-407.indd 387hiL25664_ch09_350-407.indd 387 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer 388 Chapter 9 Financial Planning and Analysis: The Master Budget Choose a city or state in the United States (or a Canadian city or province), and use the Internet to explore the annual budget of the governmental unit you selected. For example, you could check out the budget for Los Angeles at www.losangeles.com . Alternatively, take a look at the U.S. federal budget at www.fms.treas.gov/annualreport/index.html . Required: List three items in the budget that you found surprising or particularly interesting, and explain why. Village Hardware is a retail hardware store. Information about the store’s operations follows. • November 20x4 sales amounted to $400,000. • Sales are budgeted at $440,000 for December 20x4 and $400,000 for January 20x5. • Collections are expected to be 60 percent in the month of sale and 38 percent in the month follow- ing the sale. Two percent of sales are expected to be uncollectible. Bad debts expense is recognized monthly. • The store’s gross margin is 25 percent of its sales revenue. • A total of 80 percent of the merchandise for resale is purchased in the month prior to the month of sale, and 20 percent is purchased in the month of sale. Payment for merchandise is made in the month following the purchase. • Other monthly expenses paid in cash amount to $45,200. • Annual depreciation is $432,000. The company’s balance sheet as of November 30, 20x4, is as follows: VILLAGE HARDWARE, INC. BALANCE SHEET NOVEMBER 30, 20x4 ASSETS Cash ...................................................................................................................................................... $ 44,000 Accounts receivable (net of $7,000 allowance for uncollectible accounts) ................................................... 152,000 Inventory ................................................................................................................................................ 280,000 Property, plant, and equipment (net of $1,180,000 accumulated depreciation) ........................................... 1,724,000 Total assets ............................................................................................................................................ $2,200,000 LIABILITIES AND OWNER’S EQUITY Accounts payable .................................................................................................................................... $ 324,000 Common stock ....................................................................................................................................... 1,590,000 Retained earnings ................................................................................................................................... 286,000 Total liabilities and owner’s equity ............................................................................................................ $2,200,000 Required: Compute the following amounts. 1. The budgeted cash collections for December 20x4. 2. The budgeted income (loss) before income taxes for December 20x4. 3. The projected balance in accounts payable on December 31, 20x4. (CMA, adapted) Tanya Williams is the new accounts manager at East Bank of Mississippi. She has just been asked to project how many new bank accounts she will generate during 20x5. The economy of the county in which the bank operates has been growing, and the bank has experienced a 10 percent increase in its number of bank accounts over each of the past five years. In 20x4, the bank had 10,000 accounts. The new accounts manager is paid a salary plus a bonus of $45 for every new account she gener- ates above the budgeted amount. Thus, if the annual budget calls for 500 new accounts, and 540 new accounts are obtained, Williams’s bonus will be $1,800 (40 3 $45). ■ Exercise 9–26 City or State Budget; Use of Internet (LO 9-2, 9-3) ■ Exercise 9–27 Budgeted Financial Statements; Retailer (LO 9-3, 9-5) ■ Exercise 9–28 Budgetary Slack; Bank (LO 9-9) hiL25664_ch09_350-407.indd 388hiL25664_ch09_350-407.indd 388 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer Chapter 9 Financial Planning and Analysis: The Master Budget 389 Williams believes the economy of the county will continue to grow at the same rate in 20x5 as it has in recent years. She has decided to submit a budgetary projection of 800 new accounts for 20x5. Required: Your consulting firm has been hired by the bank president to make recommendations for improving its operations. Write a memorandum to the president defining and explaining the negative consequences of budgetary slack. Also discuss the bank’s bonus system for the new accounts manager and how the bonus program tends to encourage budgetary slack. Splendid Stereo, Inc., is a large retailer of stereo equipment. The controller is about to prepare the bud- get for the first quarter of 20x5. Past experience has indicated that 75 percent of the store’s sales are cash sales. The collection experience for the sales on account is as follows: 80 percent during month of sale 15 percent during month following sale 5 percent uncollectible The total sales for December 20x4 are expected to be $380,000. The controller feels that sales in January 20x5 could range from $200,000 to $320,000. Required: 1. Demonstrate how financial planning can be used to project cash receipts in January of 20x5 for three different levels of January sales. Use the following columnar format. Total Sales in January, 20x5 $200,000 $260,000 $320,000 Cash receipts in January 20x5: From December sales on account ............................... $ $ $ From January cash sales ........................................... From January sales on account .................................. Total cash receipts ..................................................... $ $ $ 2. How could the controller of Splendid Stereo, Inc., use this financial planning approach to help in planning operations for January? Three Rivers Dental Associates (TRDA) is a large dental practice in Pittsburgh. The firm’s controller is preparing the budget for the next year. The controller projects a total of 48,000 office visits, to be evenly distributed throughout the year. Eighty percent of the visits will be half-hour appointments, and the remainder will be one-hour visits. The average rates for professional dental services are $60 for half-hour appointments and $105 for one-hour office visits. Ninety percent of each month’s profes- sional service revenue is collected during the month when services are rendered, and the remainder is collected the month following service. Uncollectible billings are negligible. TRDA’s dental associates earn $90 per hour. TRDA uses activity-based budgeting to budget office overhead and administrative expenses. Two cost drivers are used: office visits and direct professional labor. The cost-driver rates are as follows: Patient registration and records ......................................... $3.00 per office visit (of any length) All other overhead and administrative expenses .................. $7.50 per direct professional labor hour Required: Prepare the following budget schedules. 1. Direct-professional-labor budget for the month of June. 2. Cash collections during June for professional services rendered during May and June. 3. Overhead and administrative expense budget for the month of June. 4. Build a spreadsheet: Construct an Excel spreadsheet to solve all of the preceding requirements. Show how the solution will change if the following information changes: a total of 54,000 office visits are expected for the year and 70 percent of the office visits are half-hour appointments. ■ Exercise 9–29 Using Budgets for Financial Planning (LO 9-1, 9-2, 9-5, 9-7) ■ Exercise 9–30 Professional Services Budget; Dental Practice; Activity- Based Budgeting (LO 9-3, 9-4, 9-5) hiL25664_ch09_350-407.indd 389hiL25664_ch09_350-407.indd 389 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer 390 Chapter 9 Financial Planning and Analysis: The Master Budget Problems Sophisticates, Inc., a distributor of jewelry throughout California, is in the process of assembling a cash budget for the first quarter of 20x1. The following information has been extracted from the company’s accounting records: • All sales are on account. Sixty percent of customer accounts are collected in the month of sale; 35 percent are collected in the following month. Uncollectibles amounting to 5 percent of sales are anticipated, and management believes that only 20 percent of the accounts outstanding on December 31, 20x0, will be recovered and that the recovery will be in January 20x1. • Seventy percent of the merchandise purchases are paid for in the month of purchase; the remaining 30 percent are paid for in the month after acquisition. • The December 31, 20x0, balance sheet disclosed the following selected figures: cash, $60,000; accounts receivable, $165,000; and accounts payable, $66,000. • Sophisticates, Inc., maintains a $60,000 minimum cash balance at all times. Financing is available (and retired) in $1,000 multiples at an 8 percent interest rate, with borrowings taking place at the beginning of the month and repayments occurring at the end of the month. Interest is paid at the time of repaying principal and computed on the portion of principal repaid at that time. • Additional data: January February March Sales revenue ................................................ $450,000 $540,000 $555,000 Merchandise purchases ................................. 270,000 300,000 420,000 Cash operating costs ..................................... 93,000 72,000 135,000 Proceeds from sale of equipment .................... — — 15,000 Required: 1. Prepare a schedule that discloses the firm’s total cash collections for January through March. 2. Prepare a schedule that discloses the firm’s total cash disbursements for January through March. 3. Prepare a schedule that discloses the firm’s cash needs, if any, for January through March. The schedule should present the following information in the order cited: Beginning cash balance, total receipts (from requirement 1), total payments (from requirement 2), the cash excess (deficiency) before financing, borrowing needed to maintain minimum balance, loan principal repaid, loan interest paid, and ending cash balance. Shady Shades, Inc., manufactures artistic frames for sunglasses. Talia Demarest, controller, is respon- sible for preparing the company’s master budget. In compiling the budget data for 20x1, Demarest has learned that new automated production equipment will be installed on March 1. This will reduce the direct labor per frame from 1 hour to .75 hours. Labor-related costs include pension contributions of $.50 per hour, workers’ compensation insur- ance of $.20 per hour, employee medical insurance of $.80 per hour, and employer contributions to Social Security equal to 7 percent of direct-labor wages. The cost of employee benefits paid by the com- pany on its employees is treated as a direct-labor cost. Shady Shades, Inc., has a labor contract that calls for a wage increase to $18.00 per hour on April 1, 20x1. Management expects to have 32,000 frames on hand at December 31, 20x0, and has a policy of carrying an end-of-month inventory of 100 percent of the following month’s sales plus 50 percent of the second following month’s sales. These and other data compiled by Demarest are summarized in the following table. January February March April May Direct-labor hours per unit .................................. 1.0 1.0 .75 .75 .75 Wage per direct-labor hour ................................. $16.00 $16.00 $16.00 $18.00 $18.00 Estimated unit sales ........................................... 20,000 24,000 16,000 18,000 18,000 Sales price per unit ............................................ $50.00 $47.50 $47.50 $47.50 $47.50 Production overhead: Shipping and handling (per unit sold) ............................................ $3.00 $3.00 $3.00 $3.00 $3.00 Purchasing, material handling, and inspection (per unit produced) ................................... $4.50 $4.50 $4.50 $4.50 $4.50 Other production overhead (per direct-labor hour) .................................... $10.50 $10.50 $10.50 $10.50 $10.50 ■ Problem 9–31 Cash Budgeting (LO 9-3, 9-5) 2. Total cash disbursements in February: $363,000 ■ Problem 9–32 Production and Direct-Labor Budgets; Activity-Based Overhead Budget (LO 9-3, 9-4, 9-5, 9-6) 1. Total direct-labor cost, first quarter: $940,310 3. Total production overhead, first quarter $957,750 All applicable Problems are available with McGraw-Hill’s Connect Accounting ®. hiL25664_ch09_350-407.indd 390hiL25664_ch09_350-407.indd 390 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer Chapter 9 Financial Planning and Analysis: The Master Budget 391 Required: 1. Prepare a production budget and a direct-labor budget for Shady Shades, Inc., by month and in total for the first quarter of 20x1. Both budgets may be combined in one schedule. The direct-labor budget should include direct-labor hours and show the detail for each direct-labor cost category. 2. For each item used in the firm’s production budget and direct-labor budget, identify the other com- ponents of the master budget (except for financial statement budgets) that also, directly or indi- rectly, would use these data. 3. Prepare a production-overhead budget for each month and for the first quarter. (CMA, adapted) Niagra Chemical Company produces three products using three different continuous processes. The products are Yarex, Darol, and Norex. Projected sales in gallons for the three products for the years 20x2 and 20x3 are as follows: 20x2 20x3 Yarex ......................................................................................................................... 120,000 130,000 Darol .......................................................................................................................... 80,000 70,000 Norex ......................................................................................................................... 50,000 60,000 • Because of the continuous nature of Niagra’s processes, work-in-process inventory for each of the products remains constant throughout the year. • Inventories are planned for each product so that the projected finished-goods inventory at the begin- ning of each year is equal to 8 percent of that year’s projected sales. • The conversion requirements in hours per gallon for the three products are Yarex, .07 hours; Darol, .10 hours; and Norex, .16 hours. The conversion cost of $20 per hour is considered 100 percent variable. • The raw-material requirements of the three products are shown in the following chart. Raw Material Units Unit Price Yarex Darol Norex Gamma ............. pounds .............. $ 8.00 .............. .2 ................... .4 ..................... — Murad ............... pounds .............. 6.00 ............... .4 ................... — .................... .5 Islin ................... gallons .............. 5.00 ............... 1.0 ................... .7 ..................... .5 Tarden .............. gallons .............. 10.00 .............. — .................... .3 ..................... .5 • Raw-material inventories are planned so that each raw material’s projected inventory at the begin- ning of a year is equal to 10 percent of the previous year’s usage of that raw material. Required: 1. Determine Niagra Chemical Company’s production budget (in gallons) for the three products for 20x2. 2. Determine Niagra Chemical Company’s conversion cost budget for 20x2. 3. Assuming the 20x1 usage of Islin is 200,000 gallons, determine the company’s raw-material purchases budget (in dollars) for Islin for 20x2. 4. Assume that for 20x2 production, Niagra Chemical Company could replace the raw material Islin with the raw material Philin. The usage of Philin would be the same as the usage of Islin. However, Philin would cost 20 percent more than Islin and would cut production times on all three products by 10 percent. Determine whether management should use Philin or Islin for the 20x2 production, supporting your decision with appropriate calculations. For this requirement, ignore any impact of beginning and ending inventory balances. (CMA, adapted) Eastern State University (ESU) is preparing its master budget for the upcoming academic year. Currently, 12,000 students are enrolled on campus; however, the admissions office is forecasting a 5 percent growth in the student body despite a tuition hike to $75 per credit hour. The following additional information has been gathered from an examination of university records and conversations with university officials: • ESU is planning to award 180 tuition-free scholarships. • The average class has 25 students, and the typical student takes 15 credit hours each semester. Each class is three credit hours. ESU operates two semesters per year and has no summer term. ■ Problem 9–33 Production and Materials Budgets (LO 9-3, 9-6, 9-7) 2. Conversion hours required: Norex: 8,128 4. Increase in cost of raw material: $201,640 ■ Problem 9–34 Revenue and Labor Budgeting for a University; Budget Linkages (LO 9-5, 9-7, 9-8) 2. Total student class enrollments to be covered: 126,000 hiL25664_ch09_350-407.indd 391hiL25664_ch09_350-407.indd 391 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer 392 Chapter 9 Financial Planning and Analysis: The Master Budget • ESU’s faculty members are evaluated on the basis of teaching, research, and university and commu- nity service. Each faculty member teaches fives classes during the academic year. Required: 1. Prepare a tuition revenue budget for the upcoming academic year. 2. Determine the number of faculty members needed to cover classes. 3. Assume there is a shortage of full-time faculty members. List at least five actions that ESU might take to accommodate the growing student body. 4. You have been requested by the university’s administrative vice president (AVP) to construct bud- gets for other areas of operation (e.g., the library, grounds, dormitories, and maintenance). The AVP noted: “The most important resource of the university is its faculty. Now that you know the number of faculty needed, you can prepare the other budgets. Faculty members are indeed the key driver—without them we don’t operate.” Does the administrative vice president really understand the linkages within the budgeting process? Explain. School Days Furniture, Inc., manufactures a variety of desks, chairs, tables, and shelf units which are sold to public school systems throughout the midwest. The controller of the company’s Desk Division is currently preparing a budget for the third quarter of the year. The following sales forecast has been made by the division’s sales manager. July .................................................................................... 5,000 desk-and-chair sets August ............................................................................... 6,000 desk-and-chair sets September ......................................................................... 7,500 desk-and-chair sets Each desk-and-chair set requires 10 board feet of pine planks and 1.5 hours of direct labor. Each set sells for $60. Pine planks cost $.60 per board foot, and the division ends each month with enough wood to cover 10 percent of the next month’s production requirements. The division incurs a cost of $21.00 per hour for direct-labor wages and fringe benefits. The division ends each month with enough finished-goods inventory to cover 20 percent of the next month’s sales. Required: Complete the following budget schedules. 1. Sales budget: July August September Sales (in sets) ............................. 5,000 Sales price per set ...................... 3 $60 Sales revenue ............................. $300,000 2. Production budget (in sets): July August September Sales ........................................................................ 5,000 Add: Desired ending inventory .................................... 1,200 1,500 Total requirements ..................................................... 6,200 Less: Projected beginning inventory ............................ 1,000 Planned production .................................................... 5,200 3. Raw material purchases: July August September Planned production (sets) ........................................... 5,200 Raw material required per set (board feet) ................... 3 10 Raw material required for production (board feet) ........................................................... 52,000 Add: Desired ending inventory of raw material, in board feet (10% of next month’s requirement) ............................................. 6,300 8,000 Total requirements ..................................................... 58,300 ■ Problem 9–35 Completion of Budget Schedules (LO 9-3, 9-5, 9-6) 2. Planned production: September: 7,500 sets 4. Planned direct-labor cost, August: $198,450 (continues) hiL25664_ch09_350-407.indd 392hiL25664_ch09_350-407.indd 392 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer Chapter 9 Financial Planning and Analysis: The Master Budget 393 July August September Less: Projected beginning inventory of raw material, in board feet (10% of current month’s requirement) ............................................. 5,200 Planned purchases of raw material (board feet) ........................................................... 53,100 Cost per board foot .................................................... 3 $.60 Planned purchases of raw material (dollars) ................. $31,860 4. Direct-labor budget: July August September Planned production (sets) .................................. 5,200 Direct-labor hours per set .................................. 3 1.5 Direct-labor hours required ................................ 7,800 Cost per hour ................................................... 3 $21 Planned direct-labor cost .................................. $163,800 5. Build a spreadsheet: Construct an Excel spreadsheet to solve all of the preceding requirements. Show how the solution will change if the following information changes: each set sells for $62 and the direct-labor cost per hour is $22. Dakota Fan, Inc., manufactures an inexpensive household fan that it sells to retailers for $20 per unit. All sales are on account, with 40 percent of sales collected in the month of sale and 60 percent collected in the following month. The data that follow were extracted from the company’s accounting records. • Dakota Fan maintains a minimum cash balance of $15,000. Total payments in January 20x1 are budgeted at $195,000. • A schedule of cash collections for January and February of 20x1 revealed the following receipts for the period: Cash Receipts January February From December 31 accounts receivable ..................... $108,000 From January sales ................................................... 76,000 $114,000 From February sales .................................................. 78,400 • March 20x1 sales are expected to total 10,000 units. • Finished-goods inventories are maintained at 20 percent of the following month’s sales. • The December 31, 20x0, balance sheet revealed the following selected figures: cash, $22,500; accounts receivable, $108,000; and finished goods, $22,350. Required: 1. Determine the number of units that Dakota Fan sold in December 20x0. 2. Compute the sales revenue for March 20x1. 3. Compute the total sales revenue to be reported on Dakota Fan’s budgeted income statement for the first quarter of 20x1. 4. Determine the accounts receivable balance to be reported on the March 31, 20x1, budgeted balance sheet. 5. Calculate the number of units in the December 31, 20x0, finished-goods inventory. 6. Calculate the number of units of finished goods to be manufactured in January 20x1. 7. Calculate the financing required in January, if any, to maintain the firm’s minimum cash balance. Continental Security Systems, Inc. (CSSI), manufactures and sells security systems. The company started by installing photoelectric security systems in offices and has expanded into the private-home market. CSSI has a basic security system that has been developed into three standard products, each of which can be adapted to meet the specific needs of customers. The manufacturing operation is moder- ate in size, as the bulk of the component manufacturing is completed by independent contractors. The security systems are approximately 75 percent complete when received from contractors and require only final assembly in the CSSI plant. Each product passes through at least one of three assembly operations. ■ Problem 9–36 Relationships of the Master- Budget Components (LO 9-3, 9-5, 9-6) 3. February sales: $196,000 5. January sales: $190,000 ■ Problem 9–37 Interrelationships between Components of Master Budget (LO 9-2, 9-3, 9-5, 9-6, 9-8) hiL25664_ch09_350-407.indd 393hiL25664_ch09_350-407.indd 393 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer 394 Chapter 9 Financial Planning and Analysis: The Master Budget CSSI operates in a rapidly growing community. There is evidence that a great deal of new com- mercial construction will take place in the near future, and management has decided to pursue this new market. In order to be competitive, the firm will have to expand its operations. In view of the expected increase in business, Sandra Feldman, the controller, believes that CSSI should implement a complete budgeting system. Feldman has decided to make a formal presentation to the company’s president explaining the benefits of a budgeting system and outlining the budget sched- ules and reports that would be necessary. Required: 1. Explain the benefits that CSSI would gain from implementing a budgeting system. 2. If Sandra Feldman develops a master budget: a. Identify, in order, the schedules that will have to be prepared. b. Identify the subsequent schedules that would be based on the schedules identified above. Use the following format for your answer. Schedule Subsequent Schedule (CMA, adapted) Condor Corporation manufactures two different types of coils used in electric motors. In the fall of the current year, the controller compiled the following data. • Sales forecast for 20x3 (all units to be shipped in 20x3): Product Units Price Light coil .............................................................................................................. 60,000 $240 Heavy coil ............................................................................................................. 40,000 $340 • Raw-material prices and inventory levels: Raw Material Expected Inventories January 1, 20x3 Desired Inventories, December 31, 20x3 Anticipated Purchase Price Sheet metal .................... 32,000 lb. 36,000 lb. $16 Copper wire .................... 29,000 lb. 32,000 lb. 10 Platform ......................... 6,000 units 7,000 units 6 • Use of raw material: Amount Used per Unit Raw Material Light Coil Heavy Coil Sheet metal ................................................................ 4 lb. 5 lb. Copper wire ................................................................ 2 lb. 3 lb. Platform ..................................................................... 1 unit • Direct-labor requirements and rates: Product Hours per Unit Rate per Hour Light coil ............................................................... 4 $15 Heavy coil .............................................................. 6 20 • Finished-goods inventories (in units): Product Expected January 1, 20x3 Desired December 31, 20x3 Light coil ................................................ 20,000 25,000 Heavy coil ............................................... 8,000 9,000 • Production overhead: Overhead Cost Item Activity-Based Budget Rate Purchasing and material handling ....................................... $.50 per pound of sheet metal and copper wire purchased Depreciation, utilities, and inspection ................................... $8.00 per coil produced (either type) Shipping ............................................................................ $2.00 per coil shipped (either type) General production overhead .............................................. $6.00 per direct-labor hour ■ Problem 9–38 Sales, Production, and Purchases Budgets; Activity- Based Overhead Budget (LO 9-3, 9-4, 9-5, 9-6) 2. Production required (units), light coils: 65,000 4. Total raw-material purchases: $10,316,000 hiL25664_ch09_350-407.indd 394hiL25664_ch09_350-407.indd 394 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer Chapter 9 Financial Planning and Analysis: The Master Budget 395 Required: Prepare the following budgets for 20x3. 1. Sales budget (in dollars). 2. Production budget (in units). 3. Raw material purchases budget (in quantities). 4. Raw material purchases budget (in dollars). 5. Direct-labor budget (in dollars). 6. Production-overhead budget (in dollars). (CPA, adapted) Edgeworth Box Corporation manufactures two types of cardboard boxes used in shipping canned food, fruit, and vegetables. The canned food box (type C) and the perishable food box (type P) have the fol- lowing material and labor requirements. Type of Box C P Direct material required per 100 boxes: Corrugating medium ($.15 per pound) ................................. 20 pounds 30 pounds Paperboard ($.30 per pound) .............................................. 30 pounds 70 pounds Direct labor required per 100 boxes ($18.00 per hour) .............. .25 hour .50 hour The unit production costs for each product are expected to be the same this year and next year. The following production-overhead costs are anticipated for the next year. The predetermined over- head rate is based on a production volume of 495,000 units for each type of box. Production overhead is applied on the basis of direct-labor hours. Indirect material ...................................................................................................................... $ 15,750 Indirect labor .......................................................................................................................... 75,000 Utilities ................................................................................................................................... 37,500 Property taxes ........................................................................................................................ 27,000 Insurance ............................................................................................................................... 24,000 Depreciation ........................................................................................................................... 43,500 Total ....................................................................................................................................... $222,750 The following selling and administrative expenses are anticipated for the next year. Salaries and fringe benefits of sales personnel .......................................................................... $112,500 Advertising ............................................................................................................................. 22,500 Management salaries and fringe benefits ................................................................................. 135,000 Clerical wages and fringe benefits ............................................................................................ 39,000 Miscellaneous administrative expenses .................................................................................... 6,000 Total ....................................................................................................................................... 315,000 The sales forecast for the next year is as follows: Sales Volume Sales Price Box type C ......................................................... 500,000 boxes $135 per hundred boxes Box type P ......................................................... 500,000 boxes 195 per hundred boxes The following inventory information is available for the next year. Expected Inventory January 1 Desired Ending Inventory December 31 Finished goods: Box type C ...................................................... 10,000 boxes 5,000 boxes Box type P ...................................................... 20,000 boxes 15,000 boxes Raw material: Corrugating medium ....................................... 5,000 pounds 10,000 pounds Paperboard .................................................... 15,000 pounds 5,000 pounds Required: Prepare a master budget for Edgeworth Box Corporation for the next year. Assume an income tax rate of 35 percent. Include the following schedules. ■ Problem 9–39 Preparation of Master Budget (LO 9-3, 9-4, 9-5, 9-6) 1. Total sales revenue: $1,650,000 4. Total direct-labor cost: $66,825 Ex hiL25664_ch09_350-407.indd 395hiL25664_ch09_350-407.indd 395 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer 396 Chapter 9 Financial Planning and Analysis: The Master Budget 1. Sales budget. 2. Production budget. 3. Direct-material budget. 4. Direct-labor budget. 5. Production-overhead budget. 6. Selling and administrative expense budget. 7. Budgeted income statement. ( Hint: To determine cost of goods sold, first compute the production cost per unit for each type of box. Include applied production overhead in the cost. Carry these cal- culations to three decimal places.) Vancouver Consulting Associates, a division of Maple Leaf Services Corporation, offers management and computer consulting services to clients throughout Canada and the northwestern United States. The division specializes in website development and other Internet applications. The corporate management at Maple Leaf Services is pleased with the performance of Vancouver Consulting Associates for the first nine months of the current year and has recommended that the division manager, Richard Howell, submit a revised forecast for the remaining quarter, as the division has exceeded the annual plan year-to- date by 20 percent of operating income. An unexpected increase in billed hour volume over the original plan is the main reason for this increase in income. The original operating budget for the first three quarters for Vancouver Consulting Associates follows. VANCOUVER CONSULTING ASSOCIATES 20x4 OPERATING BUDGET 1st Quarter 2nd Quarter 3rd Quarter Total for First Three Quarters Revenue: Consulting fees: Computer system consulting ..... $ 843,750 $ 843,750 $ 843,750 $2,531,250 Management consulting ............ 630,000 630,000 630,000 1,890,000 Total consulting fees ............. $1,473,750 $1,473,750 $1,473,750 $4,421,250 Other revenue .............................. 20,000 20,000 20,000 60,000 Total revenue ............................ $1,493,750 $1,493,750 $1,493,750 $4,481,250 Expenses: Consultant salary expenses ........... $ 773,500 $ 773,500 $ 773,500 $2,320,500 Travel and related expenses .......... 91,250 91,250 91,250 273,750 General and administrative expenses ................................. 200,000 200,000 200,000 600,000 Depreciation expense .................... 80,000 80,000 80,000 240,000 Corporate expense allocation ......... 100,000 100,000 100,000 300,000 Total expenses .......................... $1,244,750 $1,244,750 $1,244,750 $3,734,250 Operating income ............................. $ 249,000 $ 249,000 $ 249,000 $ 747,000 Howell will reflect the following information in his revised forecast for the fourth quarter. • Vancouver Consulting Associates currently has 25 consultants on staff, 10 for management con- sulting and 15 for computer systems consulting. Three additional management consultants have been hired to start work at the beginning of the fourth quarter in order to meet the increased client demand. • The hourly billing rate for consulting revenue will remain at $180 per hour for each management consultant and $150 per hour for each computer consultant. However, due to the favorable increase in billing hour volume when compared to the plan, the hours for each consultant will be increased by 50 hours per quarter. • The budgeted annual salaries and actual annual salaries, paid monthly, are the same: $100,000 for a management consultant and $92,000 for a computer consultant. Corporate management has approved a merit increase of 10 percent at the beginning of the fourth quarter for all 25 existing consultants, while the new consultants will be compensated at the planned rate. ■ Problem 9–40 Revised Operating Budget; Consulting Firm (LO 9-2, 9-5, 9-7) 1. Operating income: $359,200 Management consulting, total compensation: $490,000 hiL25664_ch09_350-407.indd 396hiL25664_ch09_350-407.indd 396 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer Chapter 9 Financial Planning and Analysis: The Master Budget 397 • The planned salary expense includes a provision for employee fringe benefits amounting to 30 per- cent of the annual salaries. However, the improvement of some corporatewide employee programs will increase the fringe benefits to 40 percent. • The original plan assumes a fixed hourly rate for travel and other related expenses for each billing hour of consulting. These are expenses that are not reimbursed by the client, and the previously determined hourly rate has proven to be adequate to cover these costs. • Other revenue is derived from temporary rentals and interest income and remains unchanged for the fourth quarter. • General and administrative expenses have been favorable at 7 percent below the plan; this 7 percent savings on fourth quarter expenses will be reflected in the revised plan. • Depreciation of office equipment and personal computers will stay constant at the projected straight-line rate. • Due to the favorable experience for the first three quarters and the division’s increased ability to absorb costs, the corporate management at Maple Leaf Services has increased the corporate expense allocation by 50 percent. Required: 1. Prepare a revised operating budget for the fourth quarter for Vancouver Consulting Associates that Richard Howell will present to corporate management. 2. Discuss the reasons why an organization would prepare a revised operating budget. (CMA, adapted) Fit-for-Life Foods Inc., a manufacturer of breakfast cereals and snack bars, has experienced several years of steady growth in sales, profits, and dividends while maintaining a relatively low level of debt. The board of directors has adopted a long-run strategy to maximize the value of the shareholders’ investment. In order to achieve this goal, the board of directors established the following five-year financial objectives. • Increase sales by 12 percent per year. • Increase income before taxes by 15 percent per year. • Maintain long-term debt at a maximum of 16 percent of assets. These financial objectives have been attained for the past three years. At the beginning of last year, the president of Fit-for-Life Foods, Andrea Donis, added a fourth financial objective of maintaining cost of goods sold at a maximum of 70 percent of sales. This goal also was attained last year. The company’s budgeting process is to be directed toward attaining these goals for the forthcoming year, a difficult task with the economy in a prolonged recession. In addition, the increased emphasis on eating healthful foods has driven up the price of ingredients used by the company significantly faster than the expected rate of inflation. John Winslow, cost accountant at Fit-for-Life Foods, has responsibil- ity for preparation of the profit plan for next year. Winslow assured Donis that he could present a budget that achieved all of the financial objectives. Winslow believed that he could overestimate the ending inventory and reclassify fruit and grain inspection costs as administrative rather than production costs to attain the desired objective. The actual statements for 20x4 and the budgeted statements for 20x5 that Winslow prepared are as follows: FIT-FOR-LIFE FOODS INC. INCOME STATEMENT 20x4 Actual 20x5 Budgeted Sales ......................................................................................................... $1,700,000 $1,895,500 Less: Variable costs: Cost of goods sold .................................................................................. 1,020,000 1,149,450 Selling and administrative ....................................................................... 180,000 175,000 Contribution margin .................................................................................... $ 500,000 $ 571,050 Less: Fixed costs: Production .............................................................................................. 170,000 189,550 Selling and administrative ....................................................................... 120,000 140,000 Income before taxes .................................................................................... $ 210,000 $ 241,500 ■ Problem 9–41 Budgeting; Financial Objectives; Ethics (LO 9-1, 9-2, 9-3, 9-5, 9-6, 9-7) 2. Increase in sales: 11.5% hiL25664_ch09_350-407.indd 397hiL25664_ch09_350-407.indd 397 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer 398 Chapter 9 Financial Planning and Analysis: The Master Budget FIT-FOR-LIFE FOODS INC. BALANCE SHEET 20x4 Actual 20x5 Budgeted Assets: Cash ................................................................................................................ $ 20,000 $ 34,000 Accounts receivable .......................................................................................... 120,000 136,000 Inventory .......................................................................................................... 600,000 730,000 Plant and equipment (net of accumulated depreciation) ....................................... 3,260,000 3,200,000 Total ............................................................................................................ $4,000,000 $4,100,000 Liabilities: Accounts payable .............................................................................................. $ 220,000 $ 244,000 Long-term debt ................................................................................................ 640,000 616,000 Stockholders’ equity: Common stock ................................................................................................. 800,000 800,000 Retained earnings ............................................................................................. 2,340,000 2,440,000 Total ............................................................................................................ $4,000,000 $4,100,000 The company paid dividends of $55,440 in 20x4, and the expected tax rate for 20x5 is 34 percent. Required: 1. Describe the role of budgeting in a firm’s strategic planning. 2. For each of the financial objectives established by the board of directors and the president of Fit- for-Life Foods Inc. determine whether John Winslow’s budget attains these objectives. Support your conclusion in each case by presenting appropriate calculations, and use the following format for your answer. Objective Attained/Not Attained Calculations 3. Explain why the adjustments contemplated by John Winslow are unethical, citing specific stan- dards of ethical conduct for management accountants. (CMA, adapted) “We really need to get this new material-handling equipment in operation just after the new year begins. I hope we can finance it largely with cash and marketable securities, but if necessary we can get a short- term loan down at MetroBank.” This statement by Beth Davies-Lowry, president of Global Electronics Company, concluded a meeting she had called with the firm’s top management. Global is a small, rapidly growing wholesaler of consumer electronic products. The firm’s main product lines are small kitchen appliances and power tools. Marcia Wilcox, Global Electronics’ general manager of marketing, has recently completed a sales forecast. She believes the company’s sales during the first quarter of 20x1 will increase by 10 percent each month over the previous month’s sales. Then Wilcox expects sales to remain constant for several months. Global’s projected balance sheet as of December 31, 20x0 is as follows: Cash .............................................................................................................................................. $ 70,000 Accounts receivable ........................................................................................................................ 540,000 Marketable securities ...................................................................................................................... 30,000 Inventory ........................................................................................................................................ 308,000 Buildings and equipment (net of accumulated depreciation) ............................................................... 1,252,000 Total assets .................................................................................................................................... $2,200,000 Accounts payable ........................................................................................................................... $ 352,800 Bond interest payable ..................................................................................................................... 25,000 Property taxes payable .................................................................................................................... 7,200 Bonds payable (10%; due in 20x6) .................................................................................................. 600,000 Common stock ............................................................................................................................... 1,000,000 Retained earnings ........................................................................................................................... 215,000 Total liabilities and stockholders’ equity ............................................................................................ $2,200,000 ■ Problem 9–42 Comprehensive Master Budget; Borrowing; Acquisition of Automated Material-Handling System (LO 9-2, 9-3, 9-5, 9-6) 1. Sales on account, first quarter: $2,184,600 3. Purchases: first quarter: $2,103,640 5. Cash receipts, first quarter: $2,734,060 7. Net income: $321,312 hiL25664_ch09_350-407.indd 398hiL25664_ch09_350-407.indd 398 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer Chapter 9 Financial Planning and Analysis: The Master Budget 399 Jack Hanson, the assistant controller, is now preparing a monthly budget for the first quarter of 20x1. In the process, the following information has been accumulated: 1. Projected sales for December of 20x0 are $800,000. Credit sales typically are 75 percent of total sales. Global’s credit experience indicates that 10 percent of the credit sales are collected during the month of sale, and the remainder are collected during the following month. 2. Global Electronics’ cost of goods sold generally runs at 70 percent of sales. Inventory is purchased on account, and 40 percent of each month’s purchases are paid during the month of purchase. The remainder is paid during the following month. In order to have adequate stocks of inventory on hand, the firm attempts to have inventory at the end of each month equal to half of the next month’s projected cost of goods sold. 3. Hanson has estimated that Global’s other monthly expenses will be as follows: Sales salaries ..................................................................................................................................... $42,000 Advertising and promotion ................................................................................................................... 32,000 Administrative salaries ........................................................................................................................ 42,000 Depreciation ....................................................................................................................................... 50,000 Interest on bonds ................................................................................................................................ 5,000 Property taxes ..................................................................................................................................... 1,800 In addition, sales commissions run at the rate of 1 percent of sales. 4. Global Electronics’ president, Davies-Lowry, has indicated that the firm should invest $250,000 in an automated inventory-handling system to control the movement of inventory in the firm’s warehouse just after the new year begins. These equipment purchases will be financed primarily from the firm’s cash and marketable securities. However, Davies-Lowry believes that the company needs to keep a minimum cash balance of $50,000. If necessary, the remainder of the equipment purchases will be financed using short-term credit from a local bank. The minimum period for such a loan is three months. Hanson believes short-term interest rates will be 10 percent per year at the time of the equipment purchases. If a loan is necessary, Davies-Lowry has decided it should be paid off by the end of the first quarter if possible. 5. Global Electronics’ board of directors has indicated an intention to declare and pay dividends of $100,000 on the last day of each quarter. 6. The interest on any short-term borrowing will be paid when the loan is repaid. Interest on Global Electronics’ bonds is paid semiannually on January 31 and July 31 for the preceding six-month period. 7. Property taxes are paid semiannually on February 28 and August 31 for the preceding six-month period. Required: Prepare Global Electronics Company’s master budget for the first quarter of 20x1 by com- pleting the following schedules and statements. 1. Sales budget: 20x0 20x1 December January February March 1st Quarter Total sales ................................ Cash sales ................................ Sales on account ...................... 2. Cash receipts budget: 20x1 January February March 1st Quarter Cash sales ........................................................... Cash collections from credit sales made during current month .............................. Cash collections from credit sales made during preceding month .......................... Total cash receipts ............................................... hiL25664_ch09_350-407.indd 399hiL25664_ch09_350-407.indd 399 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer 400 Chapter 9 Financial Planning and Analysis: The Master Budget 3. Purchases budget: 20x0 20x1 December January February March 1st Quarter Budgeted cost of goods sold ................................ Add: Desired ending inventory ....................... Total goods needed ....................... Less: Expected beginning inventory ................... Purchases .................................... 4. Cash disbursements budget: 20x1 January February March 1st Quarter Inventory purchases: Cash payments for purchases during the current month* ........................ Cash payments for purchases during the preceding month† .................... Total cash payments for inventory purchases ................................. Other expenses: Sales salaries .............................................. Advertising and promotion ............................ Administrative salaries ................................. Interest on bonds‡ ........................................ Property taxes‡ ............................................ Sales commissions Total cash payments for other expenses ........................................ Total cash disbursements ................................. *40% of the current month’s purchases (schedule 3). †60% of the prior month’s purchases (schedule 3). ‡Bond interest is paid every six months, on January 31 and July 31. Property taxes also are paid every six months, on February 28 and August 31. 5. Complete the first three lines of the summary cash budget. Then do the analysis of short-term financing needs in requirement (6). Then finish requirement (5). Summary cash budget: 20x1 January February March 1st Quarter Cash receipts (from schedule 2) ...................... Less: Cash disbursements (from schedule 4) ....................................... Change in cash balance during period due to operations ............................. Sale of marketable securities (1/2/x1) ............. Proceeds from bank loan (1/2/x1) ................... Purchase of equipment .................................. Repayment of bank loan (3/31/x1) .................. Interest on bank loan ...................................... Payment of dividends ..................................... Change in cash balance during first quarter ..... Cash balance, 1/1/x1 ..................................... Cash balance, 3/31/x1 ................................... hiL25664_ch09_350-407.indd 400hiL25664_ch09_350-407.indd 400 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer Chapter 9 Financial Planning and Analysis: The Master Budget 401 6. Analysis of short-term financing needs: Projected cash balance as of December 31, 20x0 ................................................................................. $ Less: Minimum cash balance ............................................................................................................... Cash available for equipment purchases ............................................................................................... $ Projected proceeds from sale of marketable securities .......................................................................... Cash available .................................................................................................................................... $ Less: Cost of investment in equipment ................................................................................................. Required short-term borrowing ............................................................................................................ $ 7. Prepare Global Electronics’ budgeted income statement for the first quarter of 20x1. (Ignore income taxes.) 8. Prepare Global Electronics’ budgeted statement of retained earnings for the first quarter of 20x1. 9. Prepare Global Electronics’ budgeted balance sheet as of March 31, 20x1. ( Hint: On March 31, 20x1, Bond Interest Payable is $10,000 and Property Taxes Payable is $1,800.) Jack Riley, controller in the division of social services for the state, recognizes the importance of the budgetary process for planning, control, and motivational purposes. He believes that a properly imple- mented participative budgetary process for planning purposes and an evaluation procedure will motivate the managers to improve productivity within their particular departments. Based upon this philosophy, Riley has implemented the following budgetary procedures. • An appropriation target figure is given to each department manager. This amount is the maximum funding that each department can expect to receive in the next year. • Department managers develop their individual budgets within the following spending constraints as directed by the controller’s staff. • Expenditure requests cannot exceed the appropriation target. • All fixed expenditures should be included in the budget. Fixed expenditures would include such items as contracts and salaries at current levels. • All government projects directed by higher authority should be included in the budget in their entirety. • The controller’s staff consolidates the budget requests from the various departments into a master budget submission for the entire division. • Upon final budget approval by the legislature, the controller’s staff allocates the appropriation to the various departments on instructions from the division manager. However, a specified percentage of each department’s appropriation is held back in anticipation of budget cuts and special funding needs. The amount and use of this contingency fund is left to the discretion of the division manager. • Each department is allowed to adjust its budget when necessary to operate within the reduced appropriation level. However, as stated in the original directive, specific projects authorized by higher authority must remain intact. • The final budget is used as the basis of control. Excessive expenditures by account for each depart- ment are highlighted on a monthly basis. Department managers are expected to account for all expenditures over budget. Fiscal responsibility is an important factor in the overall performance evaluation of department managers. Riley believes his policy of allowing the department managers to participate in the budgetary pro- cess and then holding them accountable for their performance is essential, especially during times of limited resources. He further believes that the department managers will be positively motivated to increase the efficiency and effectiveness of their departments because they have provided input into the initial budgetary process and are required to justify any unfavorable performances. Required: 1. Describe several operational and behavioral benefits that are generally attributed to a participative budgetary process. 2. Identify at least four deficiencies in Jack Riley’s participative policy for planning and performance evaluation purposes. For each deficiency identified, recommend how it can be corrected. (CMA, adapted) ■ Case 9–43 Participative Budgeting (LO 9-2, 9-3, 9-9) Cases hiL25664_ch09_350-407.indd 401hiL25664_ch09_350-407.indd 401 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer 402 Chapter 9 Financial Planning and Analysis: The Master Budget Triple-F Health Club (Family, Fitness, and Fun) offers tennis, swimming, and other physical fitness facilities to its members. There are four of these clubs in the metropolitan area. Each club has between 1,700 and 2,500 members. Revenue is derived from annual membership fees and hourly court fees. The annual membership fees are as follows: Individual ................................................................................. $ 45 Student ................................................................................... 30 Family ..................................................................................... 100 The hourly court fees vary from $8 to $12 depending upon the season and the time of day (prime versus non-prime time). The peak racquetball season is considered to run from September through April. During this period court usage averages 90 to 100 percent of capacity during prime time (5:00–9:00 p.m. ) and 50 to 60 percent of capacity during the remaining hours. Daily court usage during the off-season (i.e., sum- mer) averages only 20 to 40 percent of capacity. Most of Triple-F’s memberships have September expirations. A substantial amount of the cash receipts are collected during the early part of the racquetball season due to the renewal of the annual membership fees and heavy court usage. However, cash receipts are not as large in the spring and drop significantly in the summer months. Triple-F is considering changing its membership and fee structure in an attempt to change its cash receipts. Under the new membership plan, only an annual membership fee would be charged, rather than a membership fee plus hourly court fees. There would be two classes of membership: Individual ................................................................................... $300 Family ....................................................................................... 500 The annual fee would be collected in advance at the time the membership application is completed. Members would be allowed to use the racquetball courts as often as they wish during the year under the new plan. All future memberships would be sold under these new terms. Current memberships would be honored on the old basis until they expire. However, a special promotional campaign would be insti- tuted to attract new members and to encourage current members to convert to the new membership plan immediately. The annual fees for individual and family memberships would be reduced to $250 and $450, respectively, during the two-month promotional campaign. In addition, all memberships sold or renewed during this period would be for 15 months rather than the normal one-year period. Current members also would be given a credit toward the annual fee for the unexpired portion of their membership fee, and for all prepaid hourly court fees for league play which have not yet been used. Triple-F’s management estimates that 60 to 70 percent of the present membership would continue with the club. The most active members (45 percent of the present membership) would convert immedi- ately to the new plan, while the remaining members who continue would wait until their current mem- berships expire. Those members who would not continue are not considered active (i.e., they play five or fewer times during the year). Management estimates that the loss of members would be offset fully by new members within six months of instituting the new plan. Furthermore, many of the new members would be individuals who would play during non-prime time. Management estimates that adequate court time will be available for all members under the new plan. If the new membership plan is adopted, it would be instituted on February 1, well before the sum- mer season. The special promotional campaign would be conducted during March and April. Once the plan is implemented, annual renewal of memberships and payment of fees would take place as each individual or family membership expires. Required: Your consulting firm has been hired to help Triple-F Health Club evaluate its new fee structure. Write a letter to the club’s president answering the following questions. 1. Will Triple-F Health Club’s new membership plan and fee structure improve its ability to plan its cash receipts? Explain your answer. 2. Triple-F Health Club should evaluate the new membership plan and fee structure completely before it decides to adopt or reject it. a. Identify the key factors that Triple-F should consider in its evaluation. b. Explain what type of financial analyses Triple-F should prepare in order to make a complete evaluation. ■ Case 9–44 Using Budgets to Evaluate Business Decisions (LO 9-1, 9-2, 9-3, 9-7) hiL25664_ch09_350-407.indd 402hiL25664_ch09_350-407.indd 402 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer Chapter 9 Financial Planning and Analysis: The Master Budget 403 3. Explain how Triple-F Health Club’s cash management would differ from the present if the new membership plan and fee structure were adopted. (CMA, adapted) Jay Rexford, president of Photo Artistry Company, was just concluding a budget meeting with his senior staff. It was November of 20x4, and the group was discussing preparation of the firm’s master budget for 20x5. “I’ve decided to go ahead and purchase the industrial robot we’ve been talking about. We’ll make the acquisition on January 2 of next year, and I expect it will take most of the year to train the personnel and reorganize the production process to take full advantage of the new equipment.” In response to a question about financing the acquisition, Rexford replied as follows: “The robot will cost $950,000. There will also be an additional $50,000 in ancillary equipment to be purchased. We’ll finance these purchases with a one-year $1,000,000 loan from Shark Bank and Trust Company. I’ve negotiated a repayment schedule of four equal installments on the last day of each quarter. The interest rate will be 10 percent, and interest payments will be quarterly as well.” With that the meeting broke up, and the budget process was on. Photo Artistry Company is a manufacturer of metal picture frames. The firm’s two product lines are designated as S (small frames; 5 3 7 inches) and L (large frames; 8 3 10 inches). The primary raw materials are flexible metal strips and 9-inch by 24-inch glass sheets. Each S frame requires a 2-foot metal strip; an L frame requires a 3-foot strip. Allowing for normal breakage and scrap glass, the com- pany can get either four S frames or two L frames out of a glass sheet. Other raw materials, such as cardboard backing, are insignificant in cost and are treated as indirect materials. Emily Jackson, Photo Artistry’s controller, is in charge of preparing the master budget for 20x5. She has gathered the follow- ing information: 1. Sales in the fourth quarter of 20x4 are expected to be 50,000 S frames and 40,000 L frames. The sales manager predicts that over the next two years, sales in each product line will grow by 5,000 units each quarter over the previous quarter. For example, S frame sales in the first quarter of 20x5 are expected to be 55,000 units. 2. Photo Artistry’s sales history indicates that 60 percent of all sales are on credit, with the remainder of the sales in cash. The company’s collection experience shows that 80 percent of the credit sales are collected during the quarter in which the sale is made, while the remaining 20 percent is col- lected in the following quarter. (For simplicity, assume the company is able to collect 100 percent of its accounts receivable.) 3. The S frame sells for $10, and the L frame sells for $15. These prices are expected to hold constant throughout 20x5. 4. The production manager attempts to end each quarter with enough finished-goods inventory in each product line to cover 20 percent of the following quarter’s sales. Moreover, an attempt is made to end each quarter with 20 percent of the glass sheets needed for the following quarter’s production. Since metal strips are purchased locally, the company buys them on a just-in-time basis; inventory is negligible. 5. All direct-material purchases are made on account, and 80 percent of each quarter’s purchases are paid in cash during the same quarter as the purchase. The other 20 percent is paid in the next quarter. 6. Indirect materials are purchased with cash as needed. Work-in-process is negligible. 7. Projected production costs in 20x5 are as follows: S Frame L Frame Direct material: Metal strips: S: 2 ft. @ $1 per foot ............................................ $2 L: 3 ft. @ $1 per foot ............................................ $3 Glass sheets: S: ¼ sheet @ $8 per sheet ....................................... 2 L: ½ sheet @ $8 per sheet ........................................ 4 Direct labor: .1 hour @ $20 ......................................................... 2 2 Production overhead: .1 direct-labor hour × $10 per hour ........................... 1 1 Total production cost per unit ......................................... $7 $10 ■ Case 9–45 Comprehensive Master Budget; Short-Term Financing; Acquisition of Robotic Equipment (LO 9-2, 9-3, 9-5, 9-6) 1. Total sales revenue, 4th quarter: $1,600,000 7. Cost of goods sold: $3,850,000 8. Gross margin: $1,800,000 Ex hiL25664_ch09_350-407.indd 403hiL25664_ch09_350-407.indd 403 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer 404 Chapter 9 Financial Planning and Analysis: The Master Budget 8. The predetermined overhead rate is $10 per direct-labor hour. The following production-overhead costs are budgeted for 20x5. 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter Entire Year Indirect material ............ $ 10,200 $ 11,200 $ 12,200 $ 13,200 $ 46,800 Indirect labor ................ 40,800 44,800 48,800 52,800 187,200 Other overhead ............. 31,000 36,000 41,000 46,000 154,000 Depreciation ................. 20,000 20,000 20,000 20,000 80,000 Total overhead .............. $102,000 $112,000 $122,000 $132,000 $468,000 All of these costs will be paid in cash during the quarter incurred except for depreciation. 9. Photo Artistry’s quarterly selling and administrative expenses are $100,000, paid in cash. 10. Jackson anticipates that dividends of $50,000 will be declared and paid in cash each quarter. 11. Photo Artistry’s projected balance sheet as of December 31, 20x4, follows: Cash ...................................................................................................................................... $ 95,000 Accounts receivable ................................................................................................................ 132,000 Inventory: Raw material ...................................................................................................................... 59,200 Finished goods ................................................................................................................... 167,000 Plant and equipment (net of accumulated depreciation) ............................................................. 8,000,000 Total assets ............................................................................................................................ $8,453,200 Accounts payable .................................................................................................................... $ 99,400 Common stock ....................................................................................................................... 5,000,000 Retained earnings ................................................................................................................... 3,353,800 Total liabilities and stockholders’ equity .................................................................................... $8,453,200 Required: Prepare Photo Artistry Company’s master budget for 20x5 by completing the following schedules and statements. 1. Sales budget: 20x4 20x5 4th Quarter 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter Entire Year S frame unit sales ...................... 3 S sales price ......................... S frame sales revenue ................ L frame unit sales ...................... 3 L sales price .......................... L frame sales revenue ................ Total sales revenue .................... Cash sales* ............................... Sales on account† ...................... *40% of total sales. †60% of total sales. 2. Cash receipts budget: 20x5 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter Entire Year Cash sales ................................................ Cash collections from credit sales made during current quarter* ................ Cash collections from credit sales made during previous quarter† ............... Total cash receipts .................................... *80% of current quarter’s credit sales. †20% of previous quarter’s credit sales. hiL25664_ch09_350-407.indd 404hiL25664_ch09_350-407.indd 404 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer Chapter 9 Financial Planning and Analysis: The Master Budget 405 3. Production budget: 20x4 20x5 4th Quarter 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter Entire Year S frames: Sales (in units) ............................. Add: Desired ending inventory ...... Total units needed ........................ Less: Expected beginning inventory ................. Units to be produced .................... L frames: Sales (in units) ............................. Add: Desired ending inventory ...... Total units needed ........................ Less: Expected beginning inventory ................. Units to be produced .................... 4. Direct-material budget: 20x4 20x5 4th Quarter 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter Entire Year Metal strips: S frames to be produced ......................... 3 Metal quantity per unit (ft.) .................. Needed for S frame production ................ L frames to be produced ......................... 3 Metal quantity per unit (ft.) .................. Needed for L frame production ................ Total metal needed for production; to be purchased (ft.) .................................... 3 Price per foot ..................................... Cost of metal strips to be purchased ..................................... Glass sheets: S frames to be produced ......................... 3 Glass quantity per unit (sheets) ............ Needed for S frame production ................ L frames to be produced ......................... 3 Glass quantity per unit (sheets) ............ Needed for L frame production ................ Total glass needed for production (sheets) ............................. Add: Desired ending inventory ..................... 10,400 10,400 Total glass needs ........................................ Less: Expected beginning inventory ................................. Glass to be purchased ................................. 3 Price per glass sheet .............................. Cost of glass to be purchased ...................... Total raw-material purchases (metal and glass) ................................ hiL25664_ch09_350-407.indd 405hiL25664_ch09_350-407.indd 405 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer 406 Chapter 9 Financial Planning and Analysis: The Master Budget 5. Cash disbursements budget: 20x5 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter Entire Year Raw-material purchases: Cash payments for purchases during the current quarter ............. Cash payments for purchases during the preceding quarter ......... Total cash payments for raw-material purchases ................ Direct labor: Frames produced (S and L) ................ 3 Direct-labor hours per frame ......... Direct-labor hours to be used ............ 3 Rate per direct-labor hour ............. Total cash payments for direct labor ... Production overhead: Indirect material ................................ Indirect labor .................................... Other ............................................... Total cash payments for production overhead ..................... Cash payments for selling and administrative expenses .................... Total cash disbursements ...................... 6. Summary cash budget: 20x5 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter Entire Year Cash receipts (from schedule 2) ............... Less: Cash disbursements (from schedule 5) ................................ Change in cash balance due to operations Payment of dividends .............................. Proceeds from bank loan (1/2/x5) ............ Purchase of equipment ........................... Quarterly installment on loan principal ...... Quarterly interest payment ....................... Change in cash balance during the period Cash balance, beginning of period ........... Cash balance, end of period .................... 7. Prepare a budgeted schedule of cost of goods manufactured and sold for the year 20x5. ( Hint: In the budget, actual and applied overhead will be equal.) 8. Prepare Photo Artistry’s budgeted income statement for 20x5. (Ignore income taxes.) 9. Prepare Photo Artistry’s budgeted statement of retained earnings for 20x5. 10. Prepare Photo Artistry’s budgeted balance sheet as of December 31, 20x5. hiL25664_ch09_350-407.indd 406hiL25664_ch09_350-407.indd 406 7/16/13 8:06 PM7/16/13 8:06 PM Final PDF to printer This page intentionally left blank 10 THIS CHAPTER’S FOCUS COMPANY is DCdesserts.com , which supplies fancy desserts to a variety of restaurants, caterers, and upscale food stores in Washington, D.C. The company’s order-taking system is entirely Web-based. Each day, DCdesserts.com posts its dessert menu on its website, and orders are accepted via the Internet. In this chapter, we explore DCdesserts.com’s use of standard costing. A standard-costing system sets predetermined (or standard) costs for each of a product’s inputs, such as direct material and direct labor. Then the actual costs to produce the product are compared with the standard costs that should have been incurred. DCdesserts.com’s management uses the standard-costing system to help control the company’s production costs. FOCUS COMPANY >>>
Standard Costing and
Analysis of Direct Costs
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<<< IN CONTRAST In contrast to the food-processing setting of DCdesserts.com , we will turn our attention to the financial-services industry. Here we will explore Forest Home National Bank’s (FHNB) implementation of a standard cost- ing system to better manage its business. FHNB uses direct-labor standards to under- stand and manage its performance of the various service tasks that are required in a modern bank, and variance analysis helps the company to pinpoint opportunities for improvement. hiL25664_ch10_408-451.indd 409hiL25664_ch10_408-451.indd 409 7/16/13 9:01 PM7/16/13 9:01 PM Final PDF to printer 410 The Financial Planning and Analysis (FP&A) process, introduced in Chapter 9, includes steps prior to operations ( planning ) and after operations ( analysis ). A budget provides a plan for managers to follow in making decisions and directing an organization’s activi- ties. At the end of a budget period, after operations are completed, the budget serves another useful purpose. At that time, managers use the budget as a benchmark against which to compare the results of actual operations. Did the company make as much profit as anticipated in the budget? Were costs greater or less than expected? In this chapter, we will study standard costing and variance analysis, tools used by accountants and manag- ers for analyzing and controlling an organization’s operations and costs. Managing Costs Any control system has three basic parts: a predetermined or standard performance level, a measure of actual performance, and a comparison between standard and actual perfor- mance. A thermostat is a control system with which we are all familiar. First, a thermostat has a predetermined or standard temperature, which can be set at any desired level. If you want the temperature in a room to be 68 degrees, you set the thermostat at the standard of 68 degrees. Second, the thermostat contains a thermometer that measures the actual temperature in the room. Third, the thermostat compares the preset or standard tempera- ture with the actual room temperature. If the actual temperature deviates from the preset or standard temperature, the thermostat activates a heating or cooling device. The three features of a control system are depicted in Exhibit 10–1 . A financial planning and analysis system includes a cost-control system that works like a thermostat. First, a predetermined or standard cost is set. In essence, a standard cost is the company’s best estimate of the average cost to produce a single unit of product Managing Costs 10-1 Describe the elements of a cost control system. 10-2 Describe two ways to set cost standards and distinguish between perfection and practical standards. 10-3 Compute and interpret the direct-material price and quantity variances and the direct-labor rate and efficiency variances. 10-4 Explain several methods for determining the significance of cost variances. 10-5 Describe some behavioral effects of standard costing. 10-6 Explain how standard costs are used in product costing. 10-7 Summarize some advantages of standard costing. 10-8 Explain several common criticisms of standard costing. 10-9 Prepare journal entries to record and close out cost variances (appendix). After completing this chapter, you should be able to: Learning Objective 10-1 Describe the elements of a cost control system. hiL25664_ch10_408-451.indd 410hiL25664_ch10_408-451.indd 410 7/16/13 9:01 PM7/16/13 9:01 PM Final PDF to printer Chapter 10 Standard Costing and Analysis of Direct Costs 411 or service. This cost estimate serves as the starting point for creating the relevant budgets. When the firm plans to produce multiple units, managers use the standard unit cost to determine the total standard or budgeted cost of production. For example, suppose the standard direct-material cost for one unit of product is $5 and the firm expects to manu- facture 100,000 units. The total standard or budgeted direct-material cost for 100,000 units is $500,000 ($5 3 100,000). Second, the cost-control system measures the actual cost incurred in the pro- duction process. For our example, suppose the firm does produce 100,000 units, as planned, and the actual cost of materials used is measured by the cost-control system at $550,000. Third, the manager compares the actual cost with the budgeted or standard cost. Any difference between the two is called a cost variance. Cost variances then are used in con- trolling costs. The $50,000 cost variance in this example ($550,000 2 $500,000) tells the company that their planning figures were incorrect and that they were unable to produce the quantity of product anticipated at the cost for materials anticipated. This information may well lead the company to look for an explanation for the incorrect prediction. Notice that because the variance in the example above was measured specifically for direct materials, we can imagine specific reasons for the cost variance. For example, maybe the price paid for that material was higher than the manager expected at the time she produced the budget. By setting standard costs and measuring cost variances for spe- cific types of costs, we can find meaningful explanations for the variances. For that reason, standards are set and variances are measured for many different direct materials, many classes of direct labor, and sometimes many different categories of overhead. We will discuss these in more detail later in this chapter and the next. Management by Exception Although many different cost variances are measured, they are not all investigated. Man- agers are busy people. They do not have time to look into the causes of every variance between actual and standard costs. However, they do take the time to investigate the causes of significant cost variances. This process of following up on only significant cost variances is called management by exception. When operations are going along as planned, actual costs and profit will typically be close to the budgeted amounts. How- ever, if there are significant departures from planned operations, such effects will show up as significant cost variances. Managers investigate these variances to determine their causes, if possible, and take corrective action when indicated. What constitutes a significant variance? No precise answer can be given to this ques- tion, since it depends on the size and type of the organization and its production process. We will consider this issue later in the chapter when we discuss common methods for determining the significance of cost variances. First, however, we will turn our attention to the process of setting standards. “I have been struck by how important measurement is to improving the human condition. You can achieve incredible progress if you set a clear goal and find a mea- sure that will drive progress toward that goal.” (10a) Bill and Melinda Gates Foundation Exhibit 10–1 Control System: A Thermostat. 50 60 70 80 90 100 10 20 30 40 50 60 70 80 90 1. Predetermined or standard performance (The thermostat is set to a standard temperature.) 2. Measure of actual performance (The thermometer measures the actual room temperature.) 3. Comparison of actual and standard performance (The thermostat compares the preset or standard temperature with the actual temperature.) hiL25664_ch10_408-451.indd 411hiL25664_ch10_408-451.indd 411 7/16/13 9:01 PM7/16/13 9:01 PM Final PDF to printer 412 Chapter 10 Standard Costing and Analysis of Direct Costs Setting Standards Methods for Setting Standards Cost standards generally are established by a company’s managerial accountants, who use two methods for setting them: analysis of historical data and task analysis. Analysis of Historical Data One indicator of future costs is historical cost data. In a mature production process, where the firm has a lot of production experience, historical costs can provide a good basis for predicting future costs. The methods for analyzing cost behavior that we studied in Chapter 6 are used in making cost predictions. The company often will need to adjust these predictions to reflect movements in price levels or techno- logical changes in the production process. For example, the amount of rubber required to manufacture a particular type of tire will likely be the same this year as last year, unless there has been a significant change in the process used to manufacture tires. However, the price of rubber is likely to be different this year than last, and this fact must be reflected in the new standard cost of a tire. Despite the relevance of historical cost data in setting cost standards, managers must guard against relying on them blindly. Understanding how standards were derived can provide important insights into their reliability. For example, even a seemingly minor change in the way a product is manufactured may make historical data almost totally irrelevant. Moreover, new products also require new cost standards. For new products, such as genetically engineered medicines, there are no historical cost data upon which to base standards. In such cases, the manager should turn to another approach. Task Analysis Another way to set cost standards is to analyze the process of manu- facturing a product to determine what it should cost. The emphasis shifts from what the product did cost in the past to what it should cost in the future. In using task analysis, the manager or accountant typically works with engineers who are intimately familiar with the production process. Together they conduct studies to determine exactly how much direct material should be required and how machinery should be used in the production process. Time and motion studies are conducted to determine how long each step per- formed by direct laborers should take. A Combined Approach Managerial accountants often apply both historical cost analysis and task analysis in setting cost standards. It may be, for example, that the tech- nology has changed for only one step in the production process. In such a case, the mana- gerial accountant would work with engineers to set cost standards for the technologically changed part of the production process. However, the accountant would likely rely on the less time-consuming method of analyzing historical cost data to update the cost standards for the remainder of the production process. Participation in Setting Standards Standards should not be determined by the managerial accountant alone. Besides need- ing to assess the standard’s reliability, as discussed above, managers generally will be more committed to meeting standards if they participate in setting them. For example, production supervisors should have a role in setting production cost standards, and sales managers should be involved in setting targets for sales prices and volume. In addition, knowledgeable staff personnel should participate in the standard-setting process. For example, task analysis should be carried out by a team consisting of production engi- neers, production supervisors, and managerial accountants. Setting Standards Learning Objective 10-2 Describe two ways to set cost standards and distinguish between perfection and practical standards. hiL25664_ch10_408-451.indd 412hiL25664_ch10_408-451.indd 412 7/16/13 9:01 PM7/16/13 9:01 PM Final PDF to printer Chapter 10 Standard Costing and Analysis of Direct Costs 413 Perfection versus Practical Standards: A Behavioral Issue How difficult should it be to attain standard costs? Should standards be set so that actual costs rarely exceed standard costs? Or should it be so hard to attain standards that actual costs frequently exceed them? The answers to these questions depend on the purpose for which standards will be used and how standards affect behavior. Perfection Standards A perfection ( or ideal) standard is one that can be attained only under nearly perfect operating conditions. Such standards assume peak efficiency, the lowest possible input prices, the best-quality materials obtainable, and no disrup- tions in production due to such causes as machine breakdowns or power failures. Some managers believe that perfection standards help achieve the lowest production cost by motivating employees to achieve the lowest cost possible. They claim that since the stan- dard is theoretically attainable, employees will have an incentive to come as close as possible to achieving it. Other managers and many behavioral scientists disagree. They feel that perfection standards discourage employees, since they are so unlikely to be attained. Moreover, setting unrealistically difficult standards may encourage employees to sacrifice product quality to achieve lower costs. By skimping on raw-material quality or the attention given to manual production tasks, employees may be able to lower the production cost. How- ever, this lower cost may come at the expense of a higher rate of defective units. Thus, the firm ultimately may incur higher costs than necessary as defective products are returned by customers or scrapped upon inspection. Practical Standards Standards that are as tight as practical, but still are expected to be attained, are called practical ( or attainable) standards. Such standards assume a production process that is as efficient as practical under normal operating conditions. Practical standards allow for such occurrences as occasional machine breakdowns and normal amounts of raw-material waste. Attaining a practical standard keeps employees on their toes, without demanding miracles. Most behavioral theorists believe that practi- cal standards encourage more positive and productive employee attitudes than do perfec- tion standards. Use of Standards by Service Organizations Many service industry firms, nonprofit organizations, and governmental units make use of standards. For example, FedEx allows its crews 18 minutes to unload the 9 to 12 containers of packages from a Boeing 727. A delay of over a minute must be explained at a daily 5 a.m. meet- ing. Burger King sets a standard for the amount of meat in a hamburger. Airlines such as American or United set standards for fuel and maintenance costs. Insurance companies such as Allstate or State Farm set standards for the amount of time to process an insurance appli- cation. Even a county motor vehicle office may have a standard for the number of days required to process and return an application for vehicle registration. These and similar organizations use standards in budgeting and cost control in much the same way that manufacturers use standards. “At Best Foods, standard costs are set at attainable levels.” (10b) Best Foods (a subsidiary of Unilever) Insurance companies use standards to manage how long it takes to underwrite a new policy or settle a claim. hiL25664_ch10_408-451.indd 413hiL25664_ch10_408-451.indd 413 7/16/13 9:01 PM7/16/13 9:01 PM Final PDF to printer 414 Chapter 10 Standard Costing and Analysis of Direct Costs Cost Variance Analysis To illustrate the use of standards in managing costs, we will focus on a producer of fancy desserts located in the Washington, D.C., area. You might be surprised to learn that the fancy desserts available in a lot of restaurants are not actually made there. A pastry chef is a luxury that not all restaurants can afford. That is where DCdesserts.com comes in. DCdesserts.com supplies fresh and frozen desserts to a variety of restaurants, cater- ers, and upscale food stores. The company’s order-taking system is entirely Web-based. DCdesserts.com posts its menu of fresh fancy dessert products for each day on its web- site four days in advance of the delivery date. Orders are accepted via the Internet three days in advance of delivery. For example, the menu of desserts to be available for deliv- ery on Friday afternoon is posted to DCdesserts.com’s website on Monday, and orders are accepted up to midnight on Tuesday. The company places orders for ingredients on Wednesday and accepts delivery on Thursday. DCdesserts.com’s ordering is also done largely via the Internet. Production then takes place throughout the day on Friday, and the desserts are delivered Friday afternoon. DCdesserts.com uses three independent delivery services to deliver its dessert products: Capital Couriers, Potomac Door-to-Door, and Washington Delivery Service. DCdesserts.com also produces frozen dessert products for upscale grocery stores. Unlike the fresh desserts, which vary daily, the frozen desserts are stock items that are var- ied less frequently. Like the fresh desserts, however, the frozen dessert menu is posted to DCdesserts.com’s website, and orders are accepted entirely via the Internet. The company produces its fresh fancy desserts and frozen desserts in two different production facilities, both located on the outskirts of central Washington, D.C. The production process for the fresh fancy desserts involves a combination of semiau- tomated equipment and manual labor. Even in this era of widespread automation, making fancy desserts still involves considerable direct labor. In the words of DCdesserts.com’s founder and owner, “making a Black Forest cake or a Linzer torte to be served in the U.S. Senate dining room is not the same as making your basic pumpkin pie. There’s a lot of touch labor by skilled people in doing these fancy desserts.” The basic steps in the production process are much as you might expect. These steps include selecting ingredi- ents, mixing, baking, cooling, and finishing. The finishing work, of course, involves the most skilled direct labor. In making a six-layer chocolate raspberry cake, for example, each individual cake layer must be sliced into two pieces, and then fillings and icings are spread on each layer. The cake’s top is finished artistically, and any additional toppings are carefully applied. DCdesserts.com’s director of cost management has set standards for direct material and direct labor as follows for a category of dessert products generically referred to as multilayer fancy cakes. Direct-Material Standards The standard quantity and price of ingredients for one multilayer fancy cake, such as a Black Forest cake, are shown in the following table: Standard quantity: Ingredients in finished product ................................................................................................ 4.75 pounds Allowance for normal waste .................................................................................................... .25 pound Total standard quantity required per multilayer fancy cake ........................................................ 5.00 pounds Standard price: Purchase price per pound of ingredients (net of purchase discounts) ........................................ $1.30 Transportation cost per pound ................................................................................................ .10 Total standard price per pound of ingredients .......................................................................... $1.40 Cost Variance Analysis Learning Objective 10-3 Compute and interpret the direct-material price and quantity variances and the direct-labor rate and efficiency variances. hiL25664_ch10_408-451.indd 414hiL25664_ch10_408-451.indd 414 7/16/13 9:01 PM7/16/13 9:01 PM Final PDF to printer Chapter 10 Standard Costing and Analysis of Direct Costs 415 The standard quantity of ingredients needed to produce one cake is 5 pounds, even though only 4.75 pounds actually remain in the finished product. One-quarter pound of ingre- dients is wasted as a normal result of the production process. Therefore, the entire amount of ingredients needed to produce a fancy cake is included in the standard quantity of material. The standard price of ingredients reflects all of the costs incurred to acquire the material and transport it to the plant. Notice that the cost of transportation is added to the purchase price. Any purchase discounts would be subtracted out from the purchase price to obtain a net price. To summarize, the standard direct-material quantity is the total amount of direct material normally required to produce one unit of finished product, including allowances for normal waste or inefficiency. The standard direct-material price is the total deliv- ered cost, after subtracting any purchase discounts, of one direct-material unit. Notice that the standard price is expressed in the same units that are used to describe the standard quantity. At DCdesserts.com , standard direct-material quantity is expressed in pounds per unit, so standard direct-material price is expressed per pound. If a similar company were based in Paris, the quantity would be measured in kilograms per unit and the price would be expressed per kilogram (and in euros per kilogram, not dollars). Direct-Labor Standards The standard quantity and rate for direct labor for the production of one multilayer fancy cake are as follows: The standard direct-labor quantity is the number of direct-labor hours normally needed to manufacture one unit of product. The standard direct-labor rate is the total hourly cost of compensation, including fringe benefits. Standard Costs Given Actual Output During September, DCdesserts.com produced 2,000 multilayer fancy cakes. The total standard or budgeted costs for direct material and direct labor are computed as follows: Notice that the total standard cost for the direct-material and direct-labor inputs is based on DCdesserts.com’s actual output. The company should incur costs of $34,000 for direct material and direct labor, given that it produced 2,000 multilayer fancy cakes. The total standard costs for direct material and direct labor serve as the manager’s bench- marks against which to compare actual costs. This comparison then serves as the basis for controlling direct-material and direct-labor costs. Standard quantity: Direct labor required per multilayer fancy cake .................................................................................... .5 hour Standard rate: Hourly wage rate ............................................................................................................................... $16 Fringe benefits (25% of wages) .......................................................................................................... 4 Total standard rate per hour ................................................................................................................ $20 Direct material: Standard direct-material cost per cake (5 pounds 3 $1.40 per pound) ............................................... $ 7 Actual output ................................................................................................................................... 3 2,000 Total standard direct-material cost .................................................................................................... $14,000 Direct labor: Direct-labor cost per cake (.5 hour 3 $20.00 per hour) ..................................................................... $ 10 Actual output ................................................................................................................................... 3 2,000 Total standard direct-labor cost ......................................................................................................... $20,000 hiL25664_ch10_408-451.indd 415hiL25664_ch10_408-451.indd 415 7/16/13 9:01 PM7/16/13 9:01 PM Final PDF to printer 416 Chapter 10 Standard Costing and Analysis of Direct Costs Actual versus Budgeted Output: A Key Point The use of actual output in vari- ance calculations is a common point of confusion for students. When DCdesserts.com prepared its budget, it estimated its costs of production based on its standard costs per unit and a forecast of the demand for its products. Suppose that DCdesserts.com’s demand forecast resulted in a budgeted production output of 2,200 multilayer fancy cakes in September. Based on that level of output, the September budget would have included the following costs: Direct material: Standard direct-material cost per cake (5 pounds 3 $1.40 per pound) .................................................... $ 7 Forecast output .................................................................................................................................... 3 2,200 Total budgeted direct-material cost ........................................................................................................ $15,400 Direct labor: Direct-labor cost per cake (.5 hour 3 $20.00 per hour) .......................................................................... $ 10 Forecast output .................................................................................................................................... 3 2,200 Total budgeted direct-labor cost ............................................................................................................. $22,000 But we know, from the prior section, that DCdesserts.com only produced 2,000 multilayer fancy cakes in September. Is it surprising that the budgeted output would differ from the actual output? Not really. After all, the current year’s budget was finalized almost a year earlier, late in the prior year! But while the costs in the budget were useful for planning, they are outdated for analyzing performance. DCdesserts.com should now compare actual costs to the standard cost for the actual output. For example, if DCdesserts.com compares its actual direct-material cost, reported by the accounting system to be $14,555 in September, against its budgeted direct-material cost, they will observe that the cost was $845 less than expected ($15,400 2 $14,555). Should DCdesserts.com conclude from this comparison that costs were effectively con- trolled? Of course not! It should not have cost as much to make 2,000 cakes as it would have cost to make 2,200 cakes. So, during cost variance analysis, we will update our expectation about the cost of production inputs to what it should have cost to make the actual output. We conclude that, because DCdesserts.com would have expected pro- duction of 2,000 cakes to cost $14,000 for direct material (not the $15,400 originally budgeted), direct-material costs were actually $555 more than expected in September ($14,555 2 $14,000). Analysis of Cost Variances During September, DCdesserts.com incurred the following actual costs for direct mate- rial and direct labor in the production of multilayer fancy cakes. Direct material used: actual cost 10,250 pounds at $1.42 per pound ............................................................... $14,555 Direct labor: actual cost 980 hours at $21 per hour ......................................................................................... $20,580 Compare these actual expenditures with the total standard costs for the production of 2,000 multilayer fancy cakes. DCdesserts.com spent more than the expected amount for both direct material and direct labor. When spending is higher than expected, the excess spending is called an unfavorable variance, abbreviated U. And when spend- ing is lower than expected, the amount by which spending is less than planned is called a favorable variance (F). For DCdesserts.com , the overall direct-material variance is unfavorable ($14,555 2 $14,000 5 $555 U ) and so is the overall direct-labor variance ($20,580 2 $20,000 5 $580 U). But why were these excess costs incurred? A manager would need to do additional analysis in order to answer this question. Cost variance analysis is the process of sys- tematically comparing expected costs (standards) against actual costs, analyzing the hiL25664_ch10_408-451.indd 416hiL25664_ch10_408-451.indd 416 7/16/13 9:01 PM7/16/13 9:01 PM Final PDF to printer Chapter 10 Standard Costing and Analysis of Direct Costs 417 differences, and explaining significant deviations. We begin our systematic comparison by analyzing the variance in spending on direct material. Direct-Material Variances What caused DCdesserts.com to spend more than the anticipated amount on direct mate- rial? First, the company purchased ingredients at a higher price ($1.42 per pound) than the standard price ($1.40 per pound). Second, the company used more ingredients than the stan- dard amount. The amount actually used was 10,250 pounds instead of the standard amount of 10,000 pounds, which is based on actual output of 2,000 multilayer fancy cakes. The financial planning and analysis system can identify both of these deviations from standards by computing a direct-material price variance and a direct-material quantity variance. The computation of these variances is depicted in Exhibit 10–2 . Direct-Material Price Variance As illustrated in Exhibit 10–2 , we compute the portion of the spending difference that is caused by a difference in the price of direct material by establishing a benchmark cost for the actual amount of material used, which we label the projected material cost. The deviation between the actual and projected material costs is caused by a difference in the price of material, and it is called the direct-material price variance. This can be seen in the formula for the direct-material price variance as follows: Direct-material price variance 5 (AQ 3 AP) 2 (AQ 3 SP) 5 AQ(AP 2 SP) where AQ 5 Actual quantity used AP 5 Actual price SP 5 Standard price DCdesserts.com’s direct-material price variance for September’s production of mul- tilayer fancy cakes is computed as follows: Direct-material price variance 5 AQ(AP 2 SP) 5 10,250($1.42 2 $1.40) 5 $205 Unfavorable This variance is unfavorable, because the actual purchase price exceeded the standard price. Actual Material Cost Projected Material Cost Standard Material Cost Actual Actual Actual Standard Standard Standard Quantity Price Quantity Price Quantity Price 10,250 $1.42 10,250 $1.40 10,000* $1.40 pounds per pounds per pounds per used pound used pound allowed pound $14,555 $14,350 $14,000 $205 Unfavorable $350 Unfavorable Direct-material price variance Direct-material quantity variance $555 Unfavorable Direct-material variance *Actual output Standard quantity per unit 2,000 units 5 pounds per unit 10,000 pounds allowed. Exhibit 10–2 Direct-Material Price and Quantity Variances hiL25664_ch10_408-451.indd 417hiL25664_ch10_408-451.indd 417 7/16/13 9:01 PM7/16/13 9:01 PM Final PDF to printer Standard quantity allowed, given actual output Actual quantity used in the production of actual output Comparison of these quantities is the basis of the direct-material quantity variance 418 Chapter 10 Standard Costing and Analysis of Direct Costs Direct-Material Quantity Variance The direct-material quantity variance is the por- tion of the difference in spending on direct material that is explained by a difference in the quantity of material used in production, when compared to the amount of material we would expect to use for the actual output, called the standard quantity allowed. To compute the direct-material quan- tity variance, we fix the direct material price at its standard and then compute the difference between the projected material cost and the standard material cost. As Exhibit 10–2 shows, the following formula defines the direct-material quantity variance. Direct-material quantity variance 5 (AQ 3 SP) 2 (SQ 3 SP) 5 SP(AQ 2 SQ) where SQ 5 Standard quantity allowed DCdesserts.com’s direct-material quantity variance for September’s production of multi- layer fancy cakes is computed as follows: Direct-material quantity variance 5 SP(AQ 2 SQ) 5 $1.40(10,250 2 10,000) 5 $350 Unfavorable This variance is unfavorable, because the actual quantity of direct material used in September exceeded the standard quantity allowed for actual September output of 2,000 multilayer fancy cakes. Notice that the direct-material price variance ($205 U) and direct-material quantity variance ($350 U) together explain the overall direct-material variance of $555 U. This is the purpose of cost variance analysis, to help managers analyze and understand the reasons for the difference in spending between actual costs and the costs expected based on standards. Alternate Version of the Direct-Material Price Variance As discussed above, the direct-material price variance is based on the actual quantity of material used in produc- tion (AQ), and it helps explain why spending on direct material for production differed from what we would have expected. However, deviations between the actual and standard price of direct material originate in the purchasing function of the firm, not the produc- tion function. The purchasing department is charged with the responsibility for acquir- ing the materials needed in production. The standard direct-material price represents the price at which the purchasing department is expected to be able to buy them. To help control this function, some companies compute a second version of the direct-material price variance, called the direct-material purchase price variance. The purpose of this alternate version is to determine if the company was able to acquire direct materials at the planned price and to analyze the performance of the purchasing depart- ment in meeting the price standards. Consistent with its goal of measuring purchasing performance, the quantity used in computing the direct-material purchase price variance is the actual quantity of direct material purchased. This calculation stands in contrast to the computation of the direct- material price variance earlier in the chapter, which was based on the actual quantity used “In most cases, purchases account for one of the largest if not the largest part of the total cost . . . Deciding what to purchase from which supplier is a key purchasing decision, and one of the key factors in this decision is the net cost of goods.” (10c) Vereeniging Refractories (South African manufacturer of heat-resistant products) hiL25664_ch10_408-451.indd 418hiL25664_ch10_408-451.indd 418 7/16/13 9:01 PM7/16/13 9:01 PM Final PDF to printer Chapter 10 Standard Costing and Analysis of Direct Costs 419 in production. (When all material purchased is used in production, there is no difference between the two versions of the direct-material price variance.) Suppose that during September DCdesserts.com made the following purchases of direct material: Direct material purchased: actual cost 12,500 pounds at $1.42 per pound ........................................................... $17,750 The formula for the direct-material purchase price variance is as follows: Direct-material purchase price variance 5 (PQ 3 AP) 2 (PQ 3 SP) 5 PQ(AP 2 SP) where PQ 5 Quantity purchased DCdesserts.com’s direct-material purchase price variance for September is com- puted as follows: Direct-material purchase price variance 5 PQ(AP 2 SP) 5 12,500($1.42 2 $1.40) 5 $250 Unfavorable This variance is unfavorable, because the actual purchase price for materials purchased during the month exceeded the standard price, causing spending on purchases during the month to be higher than planned. 1 Timely action to follow up a significant purchase price variance will be facilitated by calculating this variance as soon as possible after the mate- rial is purchased. Direct-Labor Variances Why did DCdesserts.com spend more than the anticipated amount on direct labor during September? First, the division incurred a cost of $21 per hour for direct labor instead of the standard amount of $20 per hour. Second, the division used only 980 hours of direct labor, which is less than the standard quantity allowed of 1,000 hours for the actual out- put of 2,000 multilayer fancy cakes. We analyze direct-labor costs by computing a direct- labor rate variance and a direct-labor efficiency variance. Exhibit 10–4 depicts the computation of these variances. Exhibit 10–3 Direct-Material Purchase Price Variance Actual Material Cost Of Purchases Projected Material Cost Of Purchases Actual Actual Actual Standard Quantity Price Quantity Price 12,500 $1.42 12,500 $1.40 pounds per pounds per purchased pound purchased pound $17,750 $17,500 $250 Unfavorable Direct-material purchase price variance 1In the DCdesserts.com example, the price paid for materials purchased is the same as the price paid for materials used in production. Often the price paid for materials purchased during the month will differ from the price that was paid for materials in a prior month and that are now being used in production. In that case, the price used in calcu- lating the two different direct-material price variances would be different. hiL25664_ch10_408-451.indd 419hiL25664_ch10_408-451.indd 419 7/16/13 9:01 PM7/16/13 9:01 PM Final PDF to printer 420 Chapter 10 Standard Costing and Analysis of Direct Costs Notice that the direct-labor rate variance and the direct-material price variance that we discussed earlier are related: both measure the difference in spending that is caused by the price of an input into production. The “price” paid for labor is generally called the “labor rate,” so the name of that variance is changed to match. Similarly, the direct-labor efficiency variance corresponds to the direct-material quantity variance: both refer to the difference in spending caused by the amount of an input needed to produce the produc- tion output. Direct-Labor Rate Variance Similar to the process we used for materials, we com- pute the portion of the spending difference that is caused by a difference in the direct- labor rate by establishing a benchmark cost for the actual amount of direct labor used, which we label the projected direct-labor cost. The deviation between the actual and pro- jected direct-labor cost is caused by a difference in the direct-labor rate, and it is called the direct-labor rate variance. The formula for the direct-labor rate variance is shown below. Direct-labor rate variance 5 (AH 3 AR) 2 (AH 3 SR) 5 AH(AR 2 SR) where AH 5 Actual hours used AR 5 Actual rate per hour SR 5 Standard rate per hour DCdesserts.com’s direct-labor rate variance for September’s production of multi- layer fancy cakes is computed as follows: Direct-labor rate variance 5 AH(AR 2 SR) 5 980($21 2 $20) 5 $980 Unfavorable This variance is unfavorable because the actual rate exceeded the standard rate during September, causing spending to be higher than projected. Direct-Labor Efficiency Variance As Exhibit 10–4 shows, the formula for the direct- labor efficiency variance is as follows: Direct-labor efficiency variance 5 (AH 3 SR) 2 (SH 3 SR) 5 SR(AH 2 SH) where SH 5 Standard hours allowed Exhibit 10–4 Direct-Labor Rate and Efficiency Variances Actual Labor Cost Standard Labor Cost Actual Actual Actual Standard Standard Standard Hours Rate Hours Rate Hours Rate 980 $21 980 $20 1,000* $20 hours per hours per hours per used hour used hour allowed hour $20,580 $19,600 $20,000 $980 Unfavorable $400 Favorable Direct-labor rate variance Direct-labor efficiency variance $580 Unfavorable Direct-labor variance *Actual output Standard hours per unit 2,000 units .5 hour per unit 1,000 hours allowed. Projected Labor Cost hiL25664_ch10_408-451.indd 420hiL25664_ch10_408-451.indd 420 7/16/13 9:01 PM7/16/13 9:01 PM Final PDF to printer Chapter 10 Standard Costing and Analysis of Direct Costs 421 DCdesserts.com’s direct-labor efficiency variance for September is computed as follows: Direct-labor efficiency variance 5 SR(AH 2 SH) 5 $20(980 2 1,000) 5 $400 Favorable This variance is favorable, because the actual direct-labor hours used in September were less than the standard hours allowed for actual September output of 2,000 multilayer fancy cakes. Notice that the direct-labor rate and efficiency variances add up to the total direct- labor variance. However, the rate and efficiency variances have opposite signs, since one variance is unfavorable and the other is favorable. Direct-labor rate variance ................................. $980 Unfavorable Different signs of variances cancel just as plus Direct-labor efficiency variance ......................... 400 Favorable and minus signs cancel in arithmetic. Direct-labor variance ........................................ $580 Unfavorable ⎫ ⎬ ⎭ PARKER HANNIFIN CORPORATION’S BRASS PRODUCTS DIVISION Parker Hannifin ’s Brass Products Division, a world-class manufacturer of brass fit- tings, valves, and tubing, is a standard-costing success story. 2 “Parker Brass uses its standard-costing system and variance analyses as important business tools to target problem areas so it can develop solutions for continuous improvement. Variances are reported for each product line, and if any production variance exceeds 5 percent of product-line sales, the product-line manager is required to provide an explanation. Also required is a plan to correct the problems underlying any unfavorable variances. Vari- ance reports, which are generated within one day of the completion of a job order, are distributed to managers and production schedulers. A variance database is kept, which can be accessed by product-line managers, to provide variance data by part number, by job-order number, or by dollar amount.” From the perspective of Parker Brass’s management, the division has modified its standard-costing system to provide disaggregated and timely cost information to enable timely corrective action in a rapidly changing business environment. Parker Hannifin anagement ccounting ractice M A P 2David Johnsen and Parvez Sopariwala, “Standard Costing Is Alive and Well at Parker Brass,” Management Accounting Quarterly 1, no. 2 (Winter 2000), pp. 12–20. Multiple Types of Direct Material or Direct Labor Manufacturing processes usually involve several types of direct material. In such cases, direct-material price and quantity variances are computed for each type of material. Then these variances are added to obtain a total price variance and a total quantity variance. For example, a more detailed analysis of direct-material costs at DCdesserts.com might reveal the following: Price Variance Quantity Variance Flour ............................................................................................................ $105 F $225 U Eggs ............................................................................................................ 265 U 140 U Sugar ........................................................................................................... 50 U 25 F Flavorings and other ...................................................................................... 5 F 10 U Overall direct material variance ...................................................................... $205 U $350 U This level of detail can provide greater insight into the reasons that costs were not incurred as expected. hiL25664_ch10_408-451.indd 421hiL25664_ch10_408-451.indd 421 7/16/13 9:01 PM7/16/13 9:01 PM Final PDF to printer 422 Chapter 10 Standard Costing and Analysis of Direct Costs Similarly, if a production process involves several types of direct labor, rate and effi- ciency variances are computed for each labor type. Then they are added to obtain a total rate variance and a total efficiency variance. Allowing for Production Loss In many production processes, a certain amount of production loss is normal. This can be inherent in the production process (evaporation, chemical reaction) or it can be due to unavoidable spoilage or defective production. Whatever the reason, the loss must be taken into account when the standard quantity of material is computed. To illustrate, sup- pose that 100 quarts of cream are normally required to obtain 80 quarts of pastry filling, due to evaporation during the cooking process. If DCdesserts.com’s September produc- tion output of 2,000 multilayer fancy cakes is expected to require 500 quarts of pastry filling, what is the standard allowed quantity of input (cream)? Good output quantity 5 80% 3 Input quantity Dividing both sides of the equation by 80% Good output quantity __________________ 80% 5 Input quantity allowed Using the numbers in the illustration 500 quarts of good output ______________________ 80% 5 625 quarts of input allowed The total standard allowed input is 625 quarts of cream, which should yield 500 quarts of good output of pastry filling. Significance of Cost Variances Managers do not have time to investigate the causes of every cost variance. Management by exception enables managers to look into the causes of only significant variances. But what constitutes an exception? How does the manager know when to follow up on a cost variance and when to ignore it? These questions are difficult to answer, because to some extent the answers are part of the art of management. A manager applies judgment and experience in making guesses, pursuing hunches, and relying on intuition to determine when a variance should be inves- tigated. Nevertheless, there are guidelines and rules of thumb that managers often apply. We will explore these and other issues relating to the implementation of a standard costing system by considering the operations of Forest Home National Bank (FHNB). FHNB is a regional financial services firm based in Boise, Idaho. The firm develops standards relating to the provision of services in its five branch offices and its central loan processing facility. In a bank, most direct-cost standards relate to the direct labor associ- ated with providing financial services. This may include handling customer deposits, fill- ing ATM machines, processing loan applications, and many other services. Size of Variances When deciding which variances to investigate, the absolute size of a variance is an important consideration. Managers are more likely to follow up on large variances than on small ones. But the relative size of the variance is probably even more important. A manager is more likely to investigate a $20,000 material quantity variance that is 20 percent of the standard direct-material cost of $100,000 than a $50,000 labor efficiency variance that is only 2 percent of the standard direct-labor cost of $2,500,000. The relative magnitude of the $20,000 material quantity variance (20 percent) is greater than the relative magnitude of the $50,000 labor efficiency variance (2 percent). For this reason, cost variance reports often show the relative magnitude of variances. Significance of Cost Variances Learning Objective 10-4 Explain several methods for determining the significance of cost variances. hiL25664_ch10_408-451.indd 422hiL25664_ch10_408-451.indd 422 7/16/13 9:01 PM7/16/13 9:01 PM Final PDF to printer Chapter 10 Standard Costing and Analysis of Direct Costs 423 For example, the April cost variance report for FHNB’s financial services includes the items shown in Exhibit 10–5 . Managers often apply a rule of thumb that takes into account both the absolute and the relative magnitudes of a variance. As indicated in Exhibit 10–5 , the rule at FHNB is the following: Investigate variances that are either greater than $1,000 or greater than 10 percent of standard cost. Recurring Variances Another consideration in deciding when to investigate a vari- ance is whether the variance occurs repeatedly or only infrequently. Suppose FHNB man- agers use the rule of thumb stated above and direct-labor rate variances for consumer-loan processing occur as shown in the following Excel spreadsheet. A strict adherence to the rule of thumb indicates no investigation, since none of the monthly variances is greater than $1,000 or 10 percent of standard cost. Nevertheless, the FHNB loan office manager might investigate this variance in April, since it has recurred at a reasonably high level for several consecutive months. In this case, the consistency of the variance triggers an investigation, not its absolute or relative magnitude. Trends A trend in a variance also may call for investigation. Suppose the FHNB loan office manager observes the consumer-loan direct-labor efficiency variances shown in the following Excel spreadsheet. None of these variances is large enough to trigger an investigation if the manager uses the “$1,000 or 10 percent” rule of thumb. However, the three-month trend is worri- some. An alert manager will likely follow up on this unfavorable trend to determine its causes before costs get out of hand. Indeed, as we saw in Exhibit 10–5 , left uncorrected Amount Percentage of Standard Cost Investigate? * Teller operations Standard cost allowed (for 15,800 actual transactions) .................. $31,600 Direct-labor rate variance ............................................................. $ 1,060 U 3.4% Yes Direct-labor efficiency variance ...................................................... $ 3,400 F 10.8% Yes Consumer-loan processing Standard cost allowed (for 190 actual loan applications) .................. $ 7,600 Direct-labor rate variance ............................................................... $ 680 U 8.9% No Direct-labor efficiency variance ....................................................... $ 840 U 11.1% Yes *Investigate variances greater than $1,000 or 10% of standard cost. Exhibit 10–5 Cost Variance Report for April: FHNB, All Branches hiL25664_ch10_408-451.indd 423hiL25664_ch10_408-451.indd 423 7/16/13 9:01 PM7/16/13 9:01 PM Final PDF to printer 424 Chapter 10 Standard Costing and Analysis of Direct Costs the direct-labor efficiency variance for consumer loans triggers an investigation in April. However, investigating the trend in March might have avoided the continued deteriora- tion in performance. Controllability Another important consideration in deciding when to look into the causes of a variance is the manager’s view of the controllability of the cost item. A man- ager is more likely to investigate the variance for a cost that is controllable by someone in the organization than one that is not. For example, there may be little point in investi- gating a labor rate variance if the organization has no control over the staffing decisions. This could happen, for example, if FHNB’s tellers operate under a union contract that specifies who does what work according to seniority and how much they will be paid. In contrast, the manager responsible for tellers is likely to follow up on a variance that should be controllable, such as a direct-labor efficiency variance. Favorable Variances It is just as important to investigate significant favorable vari- ances as significant unfavorable variances. The fact that a significant variance has occurred indicates that something has not gone as planned, which warrants attention even if it is favorable. For example, the significant and favorable direct-labor efficiency vari- ance for teller operations at FHNB may indicate that tellers at one branch have developed a more efficient way of performing their transactions. By investigating the variance, man- agement will become aware of the improved method and may be able to implement it in other FHNB branches. On the other hand, favorable variances can sometimes indicate a problem. For exam- ple, an alternative explanation for the significant and favorable direct-labor efficiency variance for teller operations might be that tellers are being pressured to perform faster and to do so they are taking shortcuts that result in more errors. These errors could lead to higher customer dissatisfaction and additional cost and effort by FHNB to correct them after the fact. Remember, “favorable” is not necessarily equivalent to “good”! Costs and Benefits of Investigation The decision whether to investigate a cost variance is a cost-benefit decision. The costs of investigation include the time spent by the investigating manager and the employees in the department where the investigation occurs. Other potential costs include disruption of the production process as the investi- gation is conducted, and corrective actions taken to eliminate the cause of a variance. The benefits of a variance investigation include reduced future production costs if the cause of an unfavorable variance is eliminated. Another potential benefit is the cost saving associ- ated with the lowering of cost standards or avoiding problems in other areas when the cause of a favorable variance is discovered. Weighing these considerations takes the judgment of skillful and experienced man- agers. Key to this judgment is an intimate understanding of the organization’s production process and day-to-day contact with its operations. hiL25664_ch10_408-451.indd 424hiL25664_ch10_408-451.indd 424 7/16/13 9:01 PM7/16/13 9:01 PM Final PDF to printer Chapter 10 Standard Costing and Analysis of Direct Costs 425 A Statistical Approach There are many reasons for cost variances. For example, a direct-labor efficiency vari- ance could be caused by inexperienced employees, employee inefficiency, poor-quality raw materials, poorly maintained machinery, an intentional work slowdown due to employee grievances, or many other factors. In addition to these substantive reasons, there are purely random causes of variances. People are not robots, and they are not per- fectly consistent in their work habits. Random fluctuations in direct-labor efficiency vari- ances can be caused by such factors as employee illnesses, workers experimenting with different production methods, or simply random fatigue. Ideally, managers would be able to sort out the randomly caused variances from those with substantive and controllable underlying causes. It is impossible to accomplish this with 100 percent accuracy, but a statistical control chart can help. A statistical control chart plots cost variances across time and compares them with a statistically determined critical value that triggers an investigation. This critical value is usually determined by assuming that cost variances have a normal probability distribu- tion with a mean of zero. The critical value is set at some multiple of the distribution’s standard deviation. Variances greater than the critical value are investigated. Exhibit 10–6 shows a statistical control chart with a critical value of 1 standard devi- ation. The manager would investigate the variance observed in May, since it falls further than 1 standard deviation from the mean (zero). The variances for the remaining five months would not be investigated. The presumption is that these minor variances are due to random causes and are not worth investigating. Behavioral Impact of Standard Costing Standard costs and variance analysis are useful in diagnosing organizational perfor- mance. These tools help managers discern “the story behind the story”—the details of operations that underlie reported cost and profit numbers. Standard costs, budgets, and variances also are used to evaluate the performance of individuals and departments. The performance of individuals, relative to standards or budgets, often is used to help deter- mine salary increases, bonuses, and promotions. When standards and variances affect employee reward structures, they can profoundly influence behavior. For example, suppose a hotel’s food and beverage department manager earns a bonus when food and beverage costs are below the budgeted amount. This reward structure will provide a concrete incentive for the manager to keep food and beverage costs under Behavioral Impact of Standard Costing Exhibit 10–6 Statistical Control Chart 1 standard deviation 1 standard deviation 0 Favorable variances Unfavorable variances x x x x x x January February March April May June Time Learning Objective 10-5 Describe some behavioral effects of standard costing. hiL25664_ch10_408-451.indd 425hiL25664_ch10_408-451.indd 425 7/16/13 9:01 PM7/16/13 9:01 PM Final PDF to printer 426 Chapter 10 Standard Costing and Analysis of Direct Costs control. But such an incentive can have either positive or negative effects. The bonus may induce the manager to seek the most economical food suppliers and to watch more care- fully for employee theft and waste. However, the bonus also could persuade the manager to buy cheaper but less tender cuts of meat for the restaurant. This could ultimately result in lost patronage for the restaurant and the hotel. One aspect of skillful management is knowing how to use standards, budgets, and variances to get the most out of an organi- zation’s employees. Unfortunately, there are no simple answers or formulas for success in this area. Despite such difficulties, standards, budgets, and variances are used in the executive compensation schemes of many well-known companies. Controllability of Variances Cost control is accomplished through the efforts of individual managers in an organiza- tion. Who is responsible for the direct-material price and quantity variances? The direct- labor rate and efficiency variances? Answering these questions is often difficult, because it is rare that any one person completely controls any event. Nevertheless, it is often pos- sible to identify the manager who is most able to influence a particular variance, even if he or she does not exercise complete control over the outcome. Direct-Material Price Variance The purchasing manager is generally in the best position to influence material price variances. Through skillful purchasing practices, an expert purchasing manager can get the best prices available for purchased goods and services. To achieve this goal, the purchasing manager uses such practices as buying in quantity, negotiating purchase contracts, comparing prices among vendors, and global sourcing. Despite these purchasing skills, the purchasing manager is not in complete control of prices. The need to purchase component parts with precise engineering specifications, the all-too-frequent rush requests from the production department, and worldwide shortages of critical materials all contribute to the challenges faced by the purchasing manager. The material prices negotiated by the purchasing manager affect the reported cost of production, so to identify the variance in production cost that is attributable to purchas- ing, we compute the direct-material price variance based on usage of materials. How- ever, to get a more timely report of the purchasing manager’s success or failure, we also compute and report the alternate version of the direct-material price variance, the direct- material purchase price variance, that was discussed earlier in the chapter. Direct-Material Quantity Variance The production supervisor is usually in the best position to influence material quantity variances. Skillful supervision and motivation of production employees, coupled with the careful use and handling of materials, contribute to minimal waste. Production engineers are also partially responsible for material quan- tity variances, since they determine the grade and technical specifications of materials and component parts. In some cases, using a low-grade material may result in greater waste than using a high-grade material. Direct-Labor Rate Variance Direct-labor rate variances generally result from using a different mix of employees than that anticipated when the standards were set. Wage rates differ among employees due to their skill levels and their seniority with the organization. Using a higher proportion of more senior or more highly skilled employees than a task requires can result in unfavorable direct-labor rate variances. The production supervisor is generally in the best position to influence the work schedules of employees. Direct-Labor Efficiency Variance Once again, the production supervisor is usually most responsible for the efficient use of employee time. Through motivation toward pro- duction goals and effective work schedules, the efficiency of employees can be maximized. Controllability of Variances “We designate variances as controllable or uncontrolla- ble. Plant managers are held accountable for the control- lable variances.” (10d) Best Foods (a subsidiary of Unilever) hiL25664_ch10_408-451.indd 426hiL25664_ch10_408-451.indd 426 7/16/13 9:01 PM7/16/13 9:01 PM Final PDF to printer Chapter 10 Standard Costing and Analysis of Direct Costs 427 Interaction among Variances Interactions among variances often occur, making it even more difficult to determine the responsibility for a particular variance. To illustrate, consider the following anecdote from a manufacturer of brass musical instruments. The purchasing manager obtained a special price on brass alloy from a new supplier. When the material was placed into pro- duction, it turned out to be a lower grade of material than the production employees were used to. The alloy was of a slightly different composition, which made the material bend less easily during the formation of brass instruments. The company could have returned the material to the supplier, but that would have interrupted production and kept the divi- sion from filling its orders on time. Since using the off-standard material would not affect the quality of the company’s finished products, the division manager decided to keep the material and make the best of the situation. The ultimate result was that the company incurred four interrelated variances during May. The material was less expensive than normal, so the direct-material price variance was favorable. However, the employees had difficulty using the material, which resulted in more waste than expected. Hence, the division incurred an unfavorable direct-material quantity variance. What were the labor implications of the off-standard material? Due to the difficulty in working with the metal alloy, the employees required more than the standard amount of time to form the instruments. This resulted in an unfavorable direct-labor efficiency variance. Finally, the production supervisor had to use his most senior employees to work with the off-standard material. Since these people earned relatively high wages, the direct-labor rate variance was also unfavorable. To summarize, the purchase of off-standard material resulted in the following inter- related variances. Purchase of off-standard material Favorable direct-material price variance Unfavorable direct-material quantity variance Unfavorable direct-labor rate variance Unfavorable direct-labor efficiency variance Such interactions of variances make it more difficult to assign responsibility for any par- ticular variance. Trade-Offs among Variances Does the incident described above mean that the deci- sion to buy and use the off-standard material was a poor one? Not necessarily. Perhaps these variances were anticipated, and a conscious decision was made to buy the material anyway. How could this be a wise decision? Suppose the amounts of the variances attrib- utable to buying the cheaper brass were as follows: $(8,500) Favorable direct-material price variance 1,000 Unfavorable direct-material quantity variance 2,000 Unfavorable direct-labor rate variance 1,500 Unfavorable direct-labor efficiency variance $(4,000) Favorable net overall variance The company saved money overall on the decision to use a different grade of brass alloy. Given that the quality of the final product was not affected, the company’s manage- ment acted wisely. Standard Costs and Product Costing Our discussion of standard costing has focused on its use in controlling costs. But firms that use standard costs for control also use them for product costing. Recall from Chapter 3 that product costing is the process of accumulating the costs of a production process and assigning them to the completed products. Product costs are used for various purposes in both financial and managerial accounting. → g Standard Costs and Product Costing Learning Objective 10-6 Explain how standard costs are used in product costing. hiL25664_ch10_408-451.indd 427hiL25664_ch10_408-451.indd 427 7/24/13 3:04 AM7/24/13 3:04 AM Final PDF to printer 428 Chapter 10 Standard Costing and Analysis of Direct Costs As production takes place, product costs are added to the Work-in-Process Inventory account. The flow of product costs through a firm’s production accounts is depicted in Exhibit 10–7 . Different types of product-costing systems are distinguished by the type of costs that are entered into Work-in-Process Inventory. In Chapter 3, we studied actual - and normal - costing systems. In these product-costing systems, the actual costs of direct material and direct labor are charged to Work-in-Process Inventory. In a standard-costing system, the standard costs of direct material and direct labor are entered into Work-in-Process Inventory. Further explanation of the use of standard costs for product-costing purposes is pro- vided in the appendix at the end of this chapter, which can be studied now if desired. Evaluation of Standard Costing Systems Standard costing has been the predominant accounting system in manufacturing com- panies, for both cost control and product-costing purposes, for several decades. This remains true today, and the use of standard costing is spreading to nonmanufacturing firms such as Forest Home National Bank as well. The widespread use of standard cost- ing over such a long time period suggests that it has traditionally been perceived as offer- ing several advantages. However, today’s production environment for both goods and services is changing dramatically. Some managers are calling into question the useful- ness of the traditional standard-costing approach. They argue that the role of standard- costing systems must change. Advantages of Standard Costing In this section, we will list some of the advantages traditionally attributed to standard- costing systems. In the next section, we will discuss some of the criticisms of the stan- dard-costing approach, and suggest several ways in which the role of standard costing is beginning to change. Some advantages traditionally attributed to standard costing include the following: 1. Standard costs provide a basis for sensible cost comparisons. As we discussed earlier, it would make no sense to compare budgeted costs at one (planned) activ- ity level with actual costs incurred at a different (actual) activity level. Standard costs enable the manager to see the standard allowed cost, given actual output, which then serves as a sensible benchmark to compare with the actual cost. Evaluation of Standard Costing Systems “[I]nnovation and knowledge of the technology led to . . . a significant reduction in standard costs, enabling new business opportunities in the government transport market.” (10e) Rockwell Collins Exhibit 10–7 Flow of Product Costs through Production Accounts *Cost of Goods Sold is an expense. Although it is more descriptive, the term cost-of-goods-sold expense is not used as much in practice as the simpler term cost of goods sold. Income SummaryCost of Goods Sold* Finished-Goods InventoryWork-in-Process Inventory Direct-material cost Direct-labor cost Production overhead Product cost transferred when product is finished Expense closed into Income Summary at end of accounting period Product cost transferred when product is sold Learning Objective 10-7 Summarize some advantages of standard costing. hiL25664_ch10_408-451.indd 428hiL25664_ch10_408-451.indd 428 7/16/13 9:01 PM7/16/13 9:01 PM Final PDF to printer Chapter 10 Standard Costing and Analysis of Direct Costs 429 2. Computation of standard costs and cost variances enables managers to employ management by exception. This approach conserves valuable management time. 3. Variances provide a means of performance evaluation and rewards for employees. 4. Since the variances are used in performance evaluation, they provide motiva- tion for employees to adhere to standards. 5. Use of standard costs in product costing results in more stable product costs than if actual production costs are used. Actual costs often fluctuate erratically, whereas standard costs are changed only periodically. Like any tool, a standard-costing system can be misused. When employees are criti- cized for every cost variance, the positive motivational effects will quickly vanish. More- over, if standards are not revised often enough, they will become outdated. Then the benefits of cost benchmarks and product costing will disappear. Criticisms of Standard Costing in Today’s Manufacturing Environment Listed below are several drawbacks attributed to standard costing in an advanced manu- facturing setting. 3 1. The variances calculated under standard costing are at too aggregate a level and come too late to be useful. A production process comprises many activities that result in costs. By focusing on the activities that cause costs to be incurred, by eliminating non-value-added activities, and by continu- ally improving performance in value-added activities, costs will be minimized and profit maximized. 4 What is needed are perfor- mance measures that focus directly on per- formance in the activities that management wants to improve. For example, such activi- ties could include product quality, process- ing time, and delivery performance. (We will explore such measures in Chapter 12.) 2. Traditional cost variances are also too aggre- gate in the sense that they are not tied to spe- cific product lines or production batches. The aggregate nature of the variances makes it dif- ficult for managers to determine their cause. 3. Traditional standard-costing systems focus too much on the cost and efficiency of direct labor, which is rapidly becoming a relatively unim- portant factor of production in manufacturing. “Many people have con- demned standard costing, saying it is irrelevant to the current just-in-time, fast-paced business environment. Yet surveys consistently show that most industrial companies in the U.S. and abroad still use it. Apparently, these companies have successfully adapted their standard-costing sys- tem to their particular busi- ness environments.” (10f) Brass Products Division, Parker Hannifin Corporation This Texas Instruments manufacturing facility relies on its suppliers for high-quality raw materials delivered on a timely basis. Texas Instruments, like many other companies, employs a sophisticated supplier rating sys- tem to measure the performance of its vendors. 3The sources for this material are Robert S. Kaplan, “Limitations of Cost Accounting in Advanced Manufacturing Environments,” in Measures for Manufacturing Excellence, ed. Robert S. Kaplan (Boston: Harvard Business School Press, 1990), pp. 1–14; H. Thomas Johnson, “Performance Measurement for Competitive Excellence,” in Measures for Manufacturing Excellence, ed. Robert S. Kaplan (Boston: Harvard Business School Press, 1990), pp. 63–90; Robert A. Bonsack, “Does Activity-Based Costing Replace Standard Costing?” Journal of Cost Management 4, no. 4 (Winter 1991), pp. 46, 47; and Michiharu Sukurai, “The Influence of Factory Automation on Management Accounting Practices: A Study of Japanese Companies,” in Measures for Manufacturing Excellence, ed. Robert S. Kaplan (Boston: Harvard Business School Press, 1990), pp. 39–62. 4Cost management systems and activity-based management are covered in Chapter 5. Elimination of non-value- added costs also is covered in Chapter 5. Learning Objective 10-8 Explain several common criticisms of standard costing. hiL25664_ch10_408-451.indd 429hiL25664_ch10_408-451.indd 429 7/16/13 9:01 PM7/16/13 9:01 PM Final PDF to printer 430 Chapter 10 Standard Costing and Analysis of Direct Costs 4. One of the most important conditions for the successful use of standard costing is a stable production process. Yet the introduction of flexible manufacturing systems has reduced this stability, with frequent switching among a variety of products on the same production line. 5. Shorter product life cycles mean that standards are relevant for only a short time. When new products are introduced, new standards must be developed. 6. Traditional standard costs are not defined broadly enough to capture various important aspects of performance. For example, the standard direct-material price does not capture all of the costs of ownership. In addition to the purchase price and transportation costs, the cost of ownership includes the costs of order- ing, paying bills, scheduling delivery, receiving, inspecting, handling and storing, and any production-line disruptions resulting from untimely or incorrect delivery. 7. Traditional standard-costing systems tend to focus too much on cost minimiza- tion, rather than increasing product quality or customer service. For example, buying the least expensive materials of a given quality, in order to avoid a mate- rial price variance, may result in using a vendor whose delivery capabilities are not consistent with supply-chain requirements. WORKING WITH SUPPLIERS TO MANAGE COSTS Many companies have developed supplier rating systems that contribute to cost com- petitiveness by identifying the various costs of ownership. Standard costs often serve as a reference point in such systems. By targeting aspects of performance that affect the standard cost of production, these rating systems help companies achieve cost control and even reductions in standard costs. ABB has developed a supplier rating system that is designed to minimize the costs of direct materials by focusing on costly defects and shipping errors. “The process consists of a data-driven approach to regularly measure and provide feedback to suppliers. This feedback enables ongoing communication, continuous process improvement, and sup- plier development.” 5 Bosch Chassis Systems tracks various elements of supplier performance through its Monthly Supplier Performance Rating System. Bosch’s model provides for an annual “Supplier of the Year Award,” which includes criteria relating to cost reduction, achieving cost targets, and the supplier’s role in “value management activities which bring about incremental improvement.” 6 Cost of quality is a significant component of standard cost but one that is difficult to measure. Hewlett-Packard uses a supplier measurement system to engage suppliers in the effort to identify and reduce these costs. “By forming a concrete set of standards regarding product technology, quality, responsiveness, delivery, cost, and environmental impact, HP has been able to weed out noncompliant suppliers, and drive performance higher in others. . . . Several quality metrics are measured weekly for cost of quality impact, including annualized failure rate (AFR), annualized return rate (ARR), defects parts per million (PPM), and component failure rate.” 7 ABB, Bosch Chassis Systems, and Hewlett-Packard M A P anagement ccounting ractice 5ABB website, “Supplier Performance Assessment,” March 15, 2006, www.abb.com/cawp/seitp161/e4d128636 caefa9ec12569ac0032f1c2.aspx. 6Bosch Chassis Systems Work Instruction WIG 11-005, “Monthly Supplier Performance Rating System,” May 8, 2008, www.pbr.com.au/supplier/documents/WIG11-005 . 7Maria Varmazis, “How HP Measures Supplier Performance and Compliance,” Purchasing 135, issue 13 (September 21, 2006), pp. 47–49. hiL25664_ch10_408-451.indd 430hiL25664_ch10_408-451.indd 430 7/16/13 9:02 PM7/16/13 9:02 PM Final PDF to printer Chapter 10 Standard Costing and Analysis of Direct Costs 431 Focus on Ethics SACRIFICING QUALITY TO CUT STANDARD COSTS Pressures to control costs, coupled with bonus systems based on adherence to standards, can present a tempta- tion to engage in ethical lapses. The following hypothetical scenario describes such a situation. Keystone Company manufactures small wooden household items such as cutting boards and knife racks. Keystone’s controller, Marc Rigas, recently completed the installation of a new standard-costing system, which has been in place now for six months. Jack Smith, the pur- chasing manager, is about to place an order for wood to be used in Keystone’s cutting boards. Smith has found a supplier that will furnish the necessary wood at $2.00 per board foot, rather than the standard cost of $3.00. This is very appealing to Smith, since his annual bonus is influenced by any favorable price variances he is able to obtain. Smith is due to be transferred at the end of the year to Keystone’s Allentown Division, which manufac- tures metal kitchen utensils. The transfer is a promotion for Smith. After further discussions with the potential supplier, Smith realized that the wood being offered would not be well-suited for use in cutting boards. Although the wood would seem fine in the manufacturing process, and it would result in an attractive product, it would not hold up well over time. This particular type of wood, after repeated cycles of getting wet and then drying out, would tend to crack. Smith figured that it would take about a year for the cutting boards to deteriorate, and then Keystone Com- pany would be beset with customer complaints. Smith mulled over the situation for a while and then decided to accept the new supplier’s offer. The $2.00 price would help him get a nice annual bonus, which he could use to help with the down payment on a new home. By the time the cutting boards cracked and customers started to complain, he would be long gone. Someone else could worry about the problem then, he reasoned. After all, he thought, people shouldn’t expect a cutting board to last forever. Several weeks later, when the invoice for the first shipment of wood came through, Rigas noticed the large, favorable price variance. When he ran into Smith on the golf course, Rigas congratulated Smith on the purchase. The following conversation resulted. Rigas (C): “That was quite a price break on that wood, Jack. How’d you swing it?” Smith (PM): “Hard-ball negotiating, Marc. It’s as simple as that.” Rigas (C): “Is it good wood? And how about the sup- plier, Jack? Will they deliver on time?” Smith (PM): “This supplier is very timely in their deliveries. I made sure of that.” Rigas (C): “How about the quality, Jack? Did you check into that?” Smith (PM): “Sure I did, Marc. Hey, what is this? An interrogation? I thought we were here to play golf.” Rigas was left feeling puzzled and disconcerted by Smith’s evasiveness. The next day, Rigas talked to the production manager, Amy Wilcox, about his concerns. Later that day, Wilcox raised the issue with Smith. After a lengthy and sometimes heated exchange, the story came out. Discuss the ethical issues involved in this scenario. Did the purchasing manager, Jack Smith, act ethically? Did the controller, Marc Rigas, act ethically when he asked Smith about the quality of the wood? Did Rigas act ethi- cally when he went to the production manager with his concerns? What should the controller do now? hiL25664_ch10_408-451.indd 431hiL25664_ch10_408-451.indd 431 7/16/13 9:02 PM7/16/13 9:02 PM Final PDF to printer 432 Chapter 10 Standard Costing and Analysis of Direct Costs LO10-1 Describe the elements of a cost control system. Managers and managerial accountants set standard costs for direct material, direct labor, and production overhead through either historical cost analysis or task analysis. They use the standard cost as a benchmark against which to compare actual costs incurred. Managers use management by exception to determine the causes of significant cost variances. LO10-2 Describe two ways to set cost standards and distinguish between perfection and practical standards. One way to set standards is to analyze historical data, which will show how much it has cost in the past to produce a product or service. Another way to set standards is to perform task analysis, in which the production process is analyzed to determine what it should cost to produce. A perfection (or ideal) standard is one that can be attained only under nearly perfect operating conditions. A practical (or attainable) standard can be achieved with a production process that is as efficient as practical under normal operating conditions. LO10-3 Compute and interpret the direct-material price and quantity variances and the direct- labor rate and efficiency variances. The direct-material price variance calculates the effect on produc- tion cost of deviations between actual and standard direct-material prices. The direct-material quantity variance calculates the effect on production cost of deviations between actual and standard direct-mate- rial quantities allowed, given actual production output. The direct-labor rate variance calculates the effect on production cost of deviations between actual and standard direct-labor rates. The direct-labor efficiency variance calculates the effect on production cost of deviations between actual and standard direct-labor hours allowed, given actual production output. In addition, the direct-material purchase price variance calculates the effect on spending for material purchases that is caused by deviations between actual and standard direct-material prices. LO10-4 Explain several methods for determining the significance of cost variances. Managers determine the significance of cost variances through judgment and rules of thumb. The absolute and relative sizes of variances, recurrence of variances, variance trends, and controllability of variances are all considered in deciding whether variances warrant investigation. In some cases a statistical control chart can help determine the significance of cost variances. LO10-5 Describe some behavioral effects of standard costing. When variances can affect employ- ees’ reward structures, such as pay increases or promotions, they can significantly affect employee behavior. For example, an unfavorable direct-material price variance may cause a purchasing manager to purchase a lower quality of material than what is specified or needed. LO10-6 Explain how standard costs are used in product costing. The standard-costing system achieves its product-costing purpose by recording the standard cost of production into Work-in-Pro- cess Inventory as a product cost. This standard cost then flows through the Finished-Goods Inventory account and into the Cost of Goods Sold account. LO10-7 Summarize some advantages of standard costing. Standard-costing systems offer an orga- nization many advantages. Among these are: sensible cost comparisons; management by exception; performance evaluation; employee motivation; and more stable product costs. LO10-8 Explain several common criticisms of standard costing. Some common criticisms of stan- dard costing include: too high a level of aggregation exhibited by variances; untimely reporting of vari- ances; excessive focus on direct labor; inconsistency with flexible manufacturing systems; quick outdating of standards; narrow focus of standard costs, such as ignoring the total cost of ownership; and an excessive focus on cost minimization. LO10-9 Prepare journal entries to record and close out cost variances (appendix). The managerial accountant prepares journal entries: to enter the standard cost of production into Work-in-Process Inven- tory as a product cost; to transfer the standard production cost to Finished-Goods Inventory; and to close the standard production cost into Cost of Goods Sold. Chapter Summary Review Problem on Standard Costing and Analysis of Direct Costs In November DCdesserts.com produced 3,000 multilayer fancy cakes and incurred the following actual costs for direct material and direct labor. Purchased 16,500 pounds of ingredients at $1.44 per pound. Used 15,500 pounds of ingredients at $1.44 per pound. Used 1,520 hours of direct labor at $22 per hour. hiL25664_ch10_408-451.indd 432hiL25664_ch10_408-451.indd 432 7/16/13 9:02 PM7/16/13 9:02 PM Final PDF to printer Chapter 10 Standard Costing and Analysis of Direct Costs 433 The standard costs for production of multilayer fancy cakes were the same in November as those given earlier in the chapter for September. Compute DCdesserts.com ’s direct-material variances (price, quantity, and purchase price) and direct-labor variances (rate and efficiency) for November using the format shown in Exhibits 10–2, 10-3, and 10–4 . Solution to Review Problem Using Formulas Direct-material variance 5 Actual cost 2 Standard cost 5 (AQ 3 AP) 2 (SQ 3 SP) 5 (15,500 3 $1.44) 2 (15,000 3 $1.40) 5 $22,320 2 $21,000 5 $1,320 Unfavorable Direct-material price variance 5 AQ(AP 2 SP) 5 15,500($1.44 2 $1.40) 5 $620 Unfavorable Direct-material quantity variance 5 SP(AQ 2 SQ) 5 $1.40(15,500 2 15,000) 5 $700 Unfavorable Using Formula Direct-material purchase price variance 5 PQ(AP 2 SP) 5 16,500($1.44 2 $1.40) 5 $660 Unfavorable Direct-Material Price and Quantity Variances Actual Material Cost Projected Material Cost Standard Material Cost Actual Actual Actual Standard Standard Standard Quantity 3 3 3Price Quantity Price Quantity Price 15,500 $1.44 15,500 $1.40 15,000* $1.40 pounds used pounds used per per pounds per pound pound allowed pound $22,320 $21,700 $21,000 $620 Unfavorable $700 Unfavorable Direct-material price variance Direct-material quantity variance $1,320 Unfavorable Direct-material variance *Actual output Standard quantity per unit 3,000 units 5 pounds per unit 15,000 pounds allowed. Check: Price variance 1 Quantity variance 5 $620 U 1 $700 U 5 $1,320 U Direct-Material Purchase Price Variance Actual Material Cost of Purchases Projected Material Cost of Purchases Actual Actual Actual Standard Quantity 3 3Price Quantity Price 16,500 $1.44 16,500 $1.40 pounds purchased pounds purchased per per pound pound $23,760 $23,100 $660 Unfavorable Direct-material purchase price variance hiL25664_ch10_408-451.indd 433hiL25664_ch10_408-451.indd 433 7/16/13 9:02 PM7/16/13 9:02 PM Final PDF to printer 434 Chapter 10 Standard Costing and Analysis of Direct Costs 5 $660 Unfavorable Using Formulas Direct-labor variance 5 Actual cost 2 Allowed cost 5 (AQ 3 AR) 2 (SQ 3 SR) 5 (1,520 3 $22) 2 (1,500 3 $20) 5 $33,440 2 $30,000 5 $3,440 Unfavorable Direct-labor rate variance 5 AH(AR 2 SR) 5 1,520($22 2 $20) 5 $3,040 Unfavorable Direct-labor efficiency variance 5 SR(AH 2 SH) 5 $20(1,520 2 1,500) 5 $400 Unfavorable Direct-Labor Rate and Efficiency Variances Actual Labor Cost Projected Labor Cost Standard Labor Cost Actual Actual Actual Standard Standard Standard Hours Rate Hours Rate Hours Rate 1,520 $22 1,520 $20 1,500* $20 hours per hours per hours per used hour used hour allowed hour $33,440 $30,400 $30,000 $3,040 Unfavorable $3,440 Unfavorable Direct-labor variance Unfavorable Direct-labor rate variance $400 Direct-labor efficiency variance .*Actual output Standard hours per unit 3,000 units .5 hour per unit 1,500 hours allowed ⎫⎪⎪⎪⎪⎬⎪⎪⎪⎪⎭⎫⎪⎪⎪⎪⎬⎪⎪⎪⎪⎭⎫⎪⎪⎪⎬⎪⎪⎪⎭ � � � Check: Price variance 1 Quantity variance 5 $3,040 U 1 $400 U 5 $3,440 U Key Terms For each term’s definition refer to the indicated page, or turn to the glossary at the end of the text. controllability, 424 cost variance, 411 cost variance analysis, 416 direct-labor efficiency variance, 419 direct-labor rate variance, 419 direct-material price variance, 417 direct-material purchase price variance, 418 direct-material quantity variance, 417 favorable variance, 416 management by exception, 411 perfection (or ideal) standard, 413 practical (or attainable) standard, 413 standard cost, 410 standard-costing system, 428 standard direct-labor quantity, 415 standard direct-labor rate, 415 standard direct-material price, 415 standard direct-material quantity, 415 standard quantity allowed, 418 statistical control chart, 425 task analysis, 412 unfavorable variance, 416 variance, see cost variance variance analysis, see cost variance analysis hiL25664_ch10_408-451.indd 434hiL25664_ch10_408-451.indd 434 7/16/13 9:02 PM7/16/13 9:02 PM Final PDF to printer Chapter 10 Standard Costing and Analysis of Direct Costs 435 Journal Entries under Standard Costing To illustrate the use of standard costs in product costing, we will continue our illustration of DCdesserts.com . For September’s production of multilayer fancy cakes, the company purchased 12,500 pounds of direct material for $17,750. The actual quantity of material used in production was 10,250 pounds. However, the standard cost of direct material, given September’s actual output of 2,000 multilayer fancy cakes, was only $14,000. The following journal entries record these facts and isolate the direct-material price and quantity variances. Notice that the material purchase is recorded in the Raw-Material Inventory account at its standard price for the actual amount purchased ($17,500 5 12,500 pounds purchased 3 $1.40 per pound) which we referred to earlier as the projected material cost of purchases. The difference of $250 between that amount and the $17,750 actually paid for the materials is the direct-material purchase price variance that we discussed in this chapter. The $14,000 debit entry to Work-in-Process Inventory adds only the standard cost of the material allowed to Work-in-Process Inventory as a product cost ($14,000 5 10,000 pounds allowed 3 $1.40 per pound). But the actual quantity of material used in production is removed from the Raw-Material Inven- tory account at its standard cost ($14,350 5 10,250 pounds 3 $1.40 per pound). The two variances are isolated in their own variance accounts. Since they are both unfavorable, they are represented by debit entries. You might be wondering about the direct-material price variance that was calculated based on mate- rial used, not material purchased. That variance is used for control purposes only and not for recording cost of inventory. The reason is that it simply represents a portion of the total materials purchased, some of which was used in production and some of which remains in inventory. As such it is already a part of the first journal entry above. The following journal entry records the actual September cost of direct labor, as an addition to Wages and Benefits Payable (the actual wages that will be paid to employees and the benefit costs to be paid to benefit providers). The entry also adds the standard cost of direct labor to Work-in-Process Inventory. Raw-Material Inventory .............................................................................................. 17,500 Direct-Material Purchase Price Variance ..................................................................... 250 Accounts Payable ............................................................................................. 17,750 To record the purchase of raw material and the incurrence of an unfavorable purchase price variance. Work-in-Process Inventory ......................................................................................... 14,000 Direct-Material Quantity Variance ............................................................................... 350 Raw-Material Inventory ..................................................................................... 14,350 To record the use of direct material in production and the incurrence of an unfavorable quantity variance. APPENDIX TO CHAPTER 10 Use of Standard Costs for Product Costing In addition to providing a tool for cost management, standard-costing systems also provide the neces- sary information to be used in product costing. As shown in Exhibit 10–7 , under standard costing it is the standard costs that are entered into Work-in-Process Inventory as a product cost. Learning Objective 10-9 Prepare journal entries to record and close out cost variances Work-in-Process Inventory ......................................................................................... 20,000 Direct-Labor Rate Variance ........................................................................................ 980 Direct-Labor Efficiency Variance ........................................................................ 400 Wages and Benefits Payable .............................................................................. 20,580 To record the usage of direct labor and the direct-labor variances for September. hiL25664_ch10_408-451.indd 435hiL25664_ch10_408-451.indd 435 7/16/13 9:02 PM7/16/13 9:02 PM Final PDF to printer 436 Chapter 10 Standard Costing and Analysis of Direct Costs Notice that the direct-labor cost added (debited) to Work-in-Process Inventory is the standard cost based on the labor quantity allowed for the actual number of multilayer fancy cakes produced ($20,000 5 1,000 direct-labor hours allowed 3 $20 per direct-labor hour). The journal entry also accounts for the difference between the amount actually payable and the amount added to inventory by isolating the direct-labor variances. Since the direct-labor efficiency variance is favorable, it is recorded as a credit entry. The variances and other numbers in this and the preceding journal entries were calculated in Exhibits 10–2, 10–3, and10–4. Disposition of Variances Variances are temporary accounts, like revenue and expense accounts, and they are closed out at the end of each accounting period. Most companies close their variance accounts directly into Cost of Goods Sold. The journal entry required to close out the September vari- ances incurred in the production of multilayer fancy cakes is as follows: The increase of $1,180 in Cost of Goods Sold is explained as follows: The unfavorable variances represent costs of operating inefficiently, relative to the standards, and thus cause Cost of Goods Sold to be higher. The opposite is true for favorable variances. An alternative method of variance disposition is to apportion all variances among Work-in-Process Inventory, Finished-Goods Inventory, and Cost of Goods Sold. This accounting treatment reflects the effects of unusual inefficiency or efficiency in all of the accounts through which the production costs flow. This method, called variance proration, is covered more fully in cost accounting texts. Cost Flow Under Standard Costing In a standard-costing system, since standard costs are entered into Work-in-Process Inventory, standard costs flow through all of the production accounts. Thus, as depicted in Exhibit 10–7 , all of the product costs flowing through the accounts are standard costs. To illustrate, suppose DCdesserts.com produced 2,000 multilayer fancy cakes in September and sold all 2,000 of them. The journal entries to record the flow of standard direct-material and direct-labor costs are shown below. Our illustration is not really complete yet, because we have not discussed production-overhead costs. This topic is covered in the next chapter. The important point at this juncture is that in a standard- costing system, standard costs rather than actual costs flow through the production accounts. A Note on Perishable Products and JIT Production Management Systems Tra- ditional manufacturing systems typically exhibit the cost flows explained in this section. Direct-material, direct-labor, and production-overhead costs are entered in Work-in-Process Inventory, from which they Cost of Goods Sold .................................................................................................... 1,180 Direct-Labor Efficiency Variance ................................................................................. 400 Direct-Labor Rate Variance ................................................................................ 980 Direct-Material Purchase Price Variance ............................................................. 250 Direct-Material Quantity Variance ....................................................................... 350 Unfavorable Variances Increase Cost of Goods Sold Favorable Variance Decreases Cost of Goods Sold Net Increase in Cost of Goods Sold Direct-labor efficiency variance ....................... $400 Direct-labor rate variance ............................... $ 980 Direct-material purchase price variance .......... 250 Direct-material quantity variance ..................... 350 Total .......................................................... $1,580 2 $400 5 $1,180 Finished-Goods Inventory .......................................................................................... 34,000* Work-in-Process Inventory ..................................................................................... 34,000 *Total standard cost of direct material and direct labor: $34,000 5 $14,000 1 $20,000. Cost of Goods Sold .................................................................................................... 34,000* Finished-Goods Inventory ...................................................................................... 34,000 * All 2,000 multilayer fancy cakes were sold. hiL25664_ch10_408-451.indd 436hiL25664_ch10_408-451.indd 436 7/16/13 9:02 PM7/16/13 9:02 PM Final PDF to printer Chapter 10 Standard Costing and Analysis of Direct Costs 437 Exercises 10–1. List the three parts of a control system, and explain how such a system works. 10–2. What is meant by the phrase management by exception? 10–3. Describe two methods of setting standards. 10–4. Distinguish between perfection and practical standards. Which type of standard is likely to produce the best motivational effects? 10–5. Describe how a bank might use standards. 10–6. Explain how standard material prices and quantities are set. 10–7. What is the interpretation of the direct-material price variance and the direct-material purchase price variance? 10–8. What manager is usually in the best position to influence the direct-material price variance? 10–9. What is the interpretation of the direct-material quantity variance? 10–10. What manager is usually in the best position to influence the direct-material quantity variance? 10–11. Explain why the quantity purchased (PQ) is used in computing the direct-material purchase price variance, but the actual quantity consumed (AQ) is used in com- puting the direct-material price and quantity variances. 10–12. What is the interpretation of the direct-labor rate variance? What are some possible causes? 10–13. What manager is generally in the best position to influence the direct-labor rate variance? 10–14. What is the interpretation of the direct-labor efficiency variance? 10–15. What manager is generally in the best position to influ- ence the direct-labor efficiency variance? 10–16. Refer to Review Question 10–11 . Why does an analo- gous question not arise in the context of the di rect-labor variances? 10–17. Describe five factors that managers often consider when determining the significance of a va riance. 10–18. Discuss several ways in which standard-costing sys- tems should be adapted in today’s ma nufacturing environment. 10–19. Describe how standard costs are used for product costing. 10–20. List six advantages of a standard-costing system. 10–21. List seven criticisms of standard costing in an advanced manufacturing environment. Review Questions All applicable Exercises are available with McGraw-Hill’s Connect Accounting ® . During April, Dryden Company’s material purchases amounted to 6,500 pounds at a price of $7.40 per pound. Actual costs incurred in the production of 2,000 units were as follows: Direct labor: $118,035 ($18.30 per hour) Direct material: $31,820 ($7.40 per pound) The standards for one unit of Dryden Company’s product are as follows: Direct labor: Direct material: Quantity, 3 hours per unit Quantity, 2 pounds per unit Rate, $18.00 per hour Price, $7.20 per pound Required: Compute the direct-material price and quantity variances, the direct material purchase price variance, and the direct-labor rate and efficiency variances. Indicate whether each variance is favorable or unfavorable. ■ Exercise 10–22 Straightforward Calculation of Variances (LO 10-1, 10-3) flow into Finished-Goods Inventory when the goods are finished, and then on into Cost of Goods Sold. Since DCdesserts.com produces perishable goods, which are produced and sold on the same day, a simpler procedure could be used. In DCdesserts.com ’s case, the standard costs of direct material, direct labor, and production overhead could be entered directly into Cost of Goods Sold as they are incurred. This simplified procedure could be used, because the production process is very short and the goods are sold immediately. Thus, there is never any work-in-process inventory or finished-goods inventory on hand. Such situations are common with producers of perishable goods. An analogous situation occurs in manufacturers that employ a just-in-time (JIT) production and inventory control system. In a JIT environment, raw materials are delivered just in time to be entered into production, and parts or components are manufactured in each stage of the production process just in time for the next production stage. Thus, like the case of perishable goods, there is little or no work-in-process or finished-goods inventory at any given time in a JIT environment. For this reason, many manufacturers that employ the JIT approach make use of highly simplified cost accounting proce- dures similar to those explained in the preceding paragraph for DCdesserts.com . hiL25664_ch10_408-451.indd 437hiL25664_ch10_408-451.indd 437 7/16/13 9:02 PM7/16/13 9:02 PM Final PDF to printer 438 Chapter 10 Standard Costing and Analysis of Direct Costs Refer to the data in the preceding exercise. Draw diagrams depicting the d irect-material and direct-labor variances similar to the diagrams in Exhibits 10–2 , 10–3 , and 10–4 . Seneca Hardwoods produces handcrafted jewelry boxes. A standard-size b ox requires 7 board feet of hardwood in the finished product. In addition, 1.5 board feet of scrap lumber is normally left from the production of one box. Hardwood costs $5.00 per board foot, plus $1.20 in transportation charges per board foot. Required: Compute the standard direct-material cost of a jewelry box. Canandaigua Container Company manufactures recyclable soft-drink cans. A unit of p roduction is a case of 12 dozen cans. The following standards have been set by the production-engineering staff and the controller. Direct labor: Direct material: Quantity, .25 hour Quantity, 4 kilograms Rate, $12 per hour Price, $.60 per kilogram Actual material purchases amounted to 240,000 kilograms at $.62 per kilogram. Actual costs incurred in the production of 50,000 units were as follows: Direct labor: $158,600 for 13,000 hours Direct material: $130,200 for 210,000 kilograms Required: 1. Use the variance formulas to compute the direct-material price and quantity variances, the direct material purchase price variance, and the direct-labor rate and efficiency variances. Indicate whether each variance is favorable or unfavorable. 2. Build a spreadsheet: Construct an Excel spreadsheet to solve the preceding requirement. Show how the solution will change if the following information changes: the standard direct-labor rate is $14 per hour, and the standard direct-material price is $.59 per kilogram. Refer to the d a ta in the preceding exercise. Use diagrams similar to those in Exhibits 10–2 , 10–3 , and 10–4 to determine the direct-material and direct-labor variances. Indicate whether each variance is favorable or unfavorable. Choose one of the following man u facturers (or any manufacturer of your choosing), and use the Internet to gather information about any new products the company has recently introduced or plans to introduce. Boeing www.boeing.com Kodak www.kodak.com Caterpillar www.caterpillar.com Pfizer www.pfizer.com Ford www.ford.com/us Xerox www.xerox.com Required: Discuss the steps you think the company would go through in establishing standard costs for its new product. Due to evaporation d uring production, Plasto Company requires 4 pounds of material input for every 3 pounds of good plastic sheets manufactured. During May, the company produced 6,000 pounds of good sheets. Required: Compute the total standard allowed input quantity, given the good output produced. Part of your company’s a c counting database was destroyed when Godzilla attacked the city. You have been able to gather the following data from your files. Reconstruct the remaining information using the available data. All of the raw material purchased during the period was used in production. ( Hint: It is helpful to solve for the unknowns in the order indicated by the letters in the following table.) ■ Exercise 10–23 Diagramming Direct-Material and Direct-Labor Variances (LO 10-3) ■ Exercise 10–24 Computing Standard Direct-Material Cost (LO 10-2) ■ Exercise 10–25 Straightforward Computation of Variances (LO 10-1, 10-3) ■ Exercise 10–26 Determination of Variances Using Diagrams (LO 10-3) ■ Exercise 10–27 Developing Standards for New Products; Use of Internet (LO 10-2) ■ Exercise 10–28 Standard Allowed Input (LO 10-2) ■ Exercise 10–29 Reconstructing Standard-Cost Information from Partial Data (LO 10-1, 10-3) hiL25664_ch10_408-451.indd 438hiL25664_ch10_408-451.indd 438 7/16/13 9:02 PM7/16/13 9:02 PM Final PDF to printer Chapter 10 Standard Costing and Analysis of Direct Costs 439 January ......................... $ 500 F April .............................. $1,800 U February ....................... 1,600 U May .............................. 2,100 U March ........................... 1,400 U June ............................. 2,400 U Problems All applicable Problems are available with McGraw-Hill’s Connect Accounting ®. During March, Manhattan Fabrics Corporation manufactured 1,000 units of a special m ultilayer fabric with the trade name Stylex. The following information from the Stylex production department also per- tains to March. The standard prime costs for one unit of Stylex are as follows: ■ Problem 10–33 Direct-Material and Direct-Labor Variances (LO 10-1, 10-3) 4. Direct-labor rate variance: $630 Unfavorable Direct material purchased: 36,000 yards at $1.38 per yard ....................................................................... $49,680 Direct material used: 19,000 yards at $1.38 per yard ............................................................................... 26,220 Direct labor: 4,200 hours at $9.15 per hour ............................................................................................. 38,430 Direct material: 20 yards at $1.35 per yard ................................................................................................... $27 Direct labor: 4 hours at $9.00 per hour ......................................................................................................... 36 Total standard prime cost per unit of output ................................................................................................... $63 Direct Material Direct Labor Standard price or rate per unit of input ............................................... $16 per pound e Standard quantity per unit of output ................................................... c g Actual quantity used per unit of output ............................................... a 3.5 hours Actual price or rate per unit of input ................................................... $14 per pound $21 per hour Actual output .................................................................................... 20,000 units 20,000 units Standard input quantity allowed ......................................................... 55,000 pounds f Direct-material purchase price variance ............................................. $120,000 F — Direct-material quantity variance ........................................................ b — Direct-labor rate variance .................................................................. — d Direct-labor efficiency variance .......................................................... — $200,000 F Total direct-labor variance ................................................................. — $130,000 F The director of cost management for Odessa Company uses a statistical control chart to help manage- ment determine when to investigate variances. The critical value is 1 standard deviation. The company incurred the following direct-labor efficiency variances during the first six months of the current year. The standard direct-labor cost during each of these months was $38,000. The controller has esti- mated that the firm’s monthly direct-labor variances have a standard deviation of $1,900. Required: 1. Draw a statistical control chart and plot the variance data given above. Which variances will be investigated? 2. Suppose the controller’s rule of thumb is to investigate all variances equal to or greater than 6 per- cent of standard cost. Then which variances will be investigated? 3. Would you investigate any of the variances listed above other than those indicated by the rules dis- cussed in requirements (1) and (2)? Why? Refer to the data in Exercise 10–25 , regarding Canandaigua Container Company. P repare journal entries to: 1. Record the purchase of direct material on account. 2. Record the direct-material variances and add direct-material cost to Work-in-Process Inventory. 3. Record the direct-labor variances and add direct-labor cost to Work-in-Process Inventory. 4. Close these variances into Cost of Goods Sold. Refer to your answer for Exercise 10–31 . Set up T-accounts, and post the journal e ntries to the general ledger. ■ Exercise 10–31 Journal Entries under Standard Costing (Appendix) (LO 10-6, 10-9) ■ Exercise 10–32 Posting Journal Entries for Variances (Appendix) (LO 10-6, 10-9) ■ Exercise 10–30 Cost Variance Investigation (LO 10-4) hiL25664_ch10_408-451.indd 439hiL25664_ch10_408-451.indd 439 7/16/13 9:02 PM7/16/13 9:02 PM Final PDF to printer 440 Chapter 10 Standard Costing and Analysis of Direct Costs Required: Compute the following variances for the month of March, indicating whether each vari- ance is favorable or unfavorable. 1. Direct-material price variance. 2. Direct-material quantity variance. 3. Direct-material purchase price variance. 4. Direct-labor rate variance. 5. Direct-labor efficiency variance. (CPA, adapted) Gandolph Game Company has established the following standards for the prime costs of o n e unit of its chief product, dartboards. During September, Gandolph purchased 320,000 kilograms of direct material at a total cost of $608,000. The total wages for September were $84,000, 90 percent of which were for direct labor. Gandolph manufactured 38,000 dartboards during September, using 285,000 kilograms of the direct material purchased in September and 10,000 direct-labor hours. Required: Compute the following variances for September, and indicate whether each is favorable or unfavorable. 1. The direct-material price variance. 2. The direct-material quantity variance. 3. Direct-material purchase price variance. 4. The direct-labor rate variance. 5. The direct-labor efficiency variance. (CMA, adapted) South Atlantic Che m ical Company manufactures industrial chemicals in Rio de Janeiro, Brazil. The company plans to introduce a new chemical solution and needs to develop a standard product cost. The new chemical solution is made by combining a chemical compound (nyclyn) and a solution (salex), heating the mixture, adding a second compound (protet), and bottling the resulting solution in 10-liter containers. The initial mix, which is 11 liters in volume, consists of 12 kilograms of nyclyn and 9.6 liters of salex. A 1-liter reduction in volume occurs during the boiling process. The solution is cooled slightly before 5 kilograms of protet are added. The addition of protet does not affect the total liquid volume. The purchase price of the direct materials used in the manufacture of this new chemical solution are given below. (The real, abbreviated R$, is Brazil’s national currency. On the day this problem was writ- ten, one real was equivalent to .480 U.S. dollar.) Required: Determine the standard material cost of a 10-liter container of the new product. (Remem- ber to express your answer in R$.) (CMA, adapted) Harrison Wolfe operates a residential landscaping business in an affluent suburb of Atlanta. In an effort to provide quality serv i ce, he has concentrated solely on the design and installation of upscale landscap- ing plans (e.g., trees, shrubs, fountains, and lighting). With his clients continually requesting additional services, Wolfe recently expanded into lawn maintenance, including fertilization. The following data relate to his first year’s experience with 55 fertilization clients. Each client required six applications throughout the year and was billed $40 per application. ■ Problem 10–34 Direct-Material and Direct-Labor Variances (LO 10-1, 10-3) 2. Direct-material quantity variance: $33,250 Favorable Standard Cost Standard Quantity Standard Price or Rate Direct material ......................................... $14.00 8 kilograms $1.75 per kilogram Direct labor ............................................. 2.00 .25 hour $8.00 per hour Total ........................................................ $16.00 ■ Problem 10–35 Determining Standard Material Cost (LO 10-2) Protet, standard material cost: R$ 36.00 Nyclyn ............................................................................................................................ R$ 4.35 per kilogram Salex .............................................................................................................................. R$ 5.40 per liter Protet ............................................................................................................................. R$ 7.20 per kilogram ■ Problem 10–36 Variance Calculation; Analysis; Service Business (LO 10-1, 10-3) 1. Type I fertilizer, direct- material quantity variance: $350 Favorable 2. Direct-labor efficiency variance: $495 Favorable hiL25664_ch10_408-451.indd 440hiL25664_ch10_408-451.indd 440 7/16/13 9:02 PM7/16/13 9:02 PM Final PDF to printer Chapter 10 Standard Costing and Analysis of Direct Costs 441 • Two applications involved Type I fertilizer, which contains a special ingredient for weed control. The remaining four applications involved Type II fertilizer. • Wolfe purchased 5,000 pounds of Type I fertilizer at $.53 per pound and 10,000 pounds of Type II fertilizer at $.40 per pound. Actual usage amounted to 3,700 pounds of Type I and 7,800 pounds of Type II. • A new, part-time employee was hired to spread the fertilizer. Wolfe had to pay premium wages of $11.50 per hour because of a very tight labor market; the employee logged a total of 165 hours at client residences. • Based on previous knowledge of the operation, articles in trade journals, and conversations with other landscapers, Wolfe established the following standards: Typical hourly wage rate of landscape personnel: $9 Labor time per application: 40 minutes Fertilizer purchase price per pound: Type I, $.50; Type II, $.42 Fertilizer usage: 40 pounds per application Unfortunately, Wolfe’s new lawn fertilization service did not go as smoothly as planned, with cus- tomer complaints being much higher than expected. Required: 1. Compute Wolfe’s direct-material variances for each type of fertilizer. 2. Compute the direct-labor variances. 3. Compute the actual cost of the client applications. ( Note: Exclude any fertilizer in inventory, as remaining fertilizer can be used next year.) Was the new service a financial success? Explain. 4. Analyze the variances that you computed in requirements (1) and (2). a. Was the new service a success from an overall cost-control perspective? Briefly discuss. b. What seems to have happened that would give rise to customer complaints? 5. In view of the complaints, should the fertilizer service be continued next year? Why? The following data pertain to Colgate Palmolive ’s liquid filling line during the first 10 mon t hs of a par- ticular year. The standard ratio of direct-labor hours to machine hours is 4:1. The standard direct-labor rate is $15.08. Required: 1. Show how the following amounts were calculated for the month of January: a. Standard direct-labor hours. b. Direct-labor efficiency variance. ■ Problem 10–37 Direct-Labor Variances at Colgate Palmolive Company;8 Cost Variance Investigation (LO 10-3, 10-4) 1. Standard direct-labor hours: 662 Colgate Palmolive: Direct-Labor Efficiency Variance Data Units Produced Machine Hours Standard Direct-Labor Hours Actual Direct-Labor Hours Direct-Labor Efficiency Variance January ............... 50,478 ..... 165.5 ..... 662.00 ..... 374.00 ..... $ 4,343 February ............. 31,943 ..... 100.3 ..... 401.20 ..... 214.00 ..... 2,823 March ................. 185,179 ..... 552.0 ..... 2,208.00 ..... 1,068.00 ..... 17,191 April .................... 212,274 ..... 713.8 ..... 2,855.20 ..... 1,495.75 ..... 20,501 May .................... 48,390 ..... 160.0 ..... 640.00 ..... 364.00 ..... 4,162 June ................... 82,436 ..... 232.0 ..... 928.00 ..... 536.50 ..... 5,904 July ..................... 36,208 ..... 104.0 ..... 416.00 ..... 283.00 ..... 2,006 August ................ 33,483 ..... 96.0 ..... 384.00 ..... 317.50 ..... 1,003 September .......... 31,560 ..... 96.0 ..... 384.00 ..... 328.50 ..... 837 October ............... 28,191 ..... 72.0 ..... 288.00 ..... 158.00 ..... 1,960 8Source of data: Alan S. Levitan and Sidney J. Baxendale, “Analyzing the Labor Efficiency Variance to Signal Process Engineering Problems,” Journal of Cost Management 6, no. 2 (Summer 1992), p. 70. hiL25664_ch10_408-451.indd 441hiL25664_ch10_408-451.indd 441 7/16/13 9:02 PM7/16/13 9:02 PM Final PDF to printer 442 Chapter 10 Standard Costing and Analysis of Direct Costs 2. Calculate the following amounts. a. The standard direct-labor cost for each of the 10 months. b. For each month, 20 percent of the standard direct-labor cost. 3. Suppose management investigates all variances in excess of 20 percent of standard cost. Which variances will be investigated? 4. Suppose the standard deviation for the direct-labor efficiency variance is $5,000. Draw a statistical control chart, and plot the variance data. 5. Using the chart developed in requirement (4), which variances will be investigated? 6. The variances for March, April, and June are much larger than the others. Suggest at least one rea- son for this. Valport Valve Company manufactured 15,600 units during March of a control valve used by milk pro- cessors in its Shreveport plant. Records indicated the following: The control valve has the following standard prime costs. Required: 1. Prepare a schedule of standard production costs for March, based on actual production of 15,600 units. 2. For the month of March, compute the following variances, indicating whether each is favorable or unfavorable. a. Direct-material price variance. b. Direct-material quantity variance. c. Direct-material purchase price variance. d. Direct-labor rate variance. e. Direct-labor efficiency variance. 3. Build a spreadsheet: Construct an Excel spreadsheet to solve all of the preceding requirements. Show how the solution will change if the following information changes: the standard direct-labor rate is $12 per hour, and the standard direct-material price is $4.90 per pound. SolarPrime, In c . uses a standard-costing system to assist in the evaluation of operations. The company has had considerable trouble in recent months with suppliers and employees, so much so that manage- ment hired a new production supervisor, Marc Hoctor. The new supervisor has been on the job for five months and has seemingly brought order to an otherwise chaotic situation. The vice president of manufacturing recently commented that “. . . Hoctor has really done the trick. The change to a new direct-material supplier and Hoctor’s team-building/morale-boosting train- ing exercises have truly brought things under control.” The VP’s comments were based on both a plant tour, where he observed a contented work force, and a review of a performance report. Included in the report were the following variances: direct material, $4,620 favorable; and direct labor, $6,175 favorable. These variances are especially outstanding, given that the amounts are favorable and small. (SolarPrime’s budgeted material and labor costs generally each average about $350,000 for similar peri- ods.) Additional data follow: • The company purchased and consumed 45,000 pounds of direct material at $7.70 per pound, and paid $16.25 per hour for 20,900 direct-labor hours of activity. Total completed production amounted to 9,500 units. • A review of the firm’s standard cost records found that each completed unit requires 4.2 pounds of direct material at $8.80 per pound and 2.6 direct-labor hours at $14 per hour. ■ Problem 10–38 Direct-Material and Direct-Labor Variances (LO 10-1, 10-3) 2(b). Standard quantity: 46,800 lb. Direct labor ................................................................................................................... 80,200 hr. at $10.95 Direct material purchased .............................................................................................. 50,000 lb. at $5.20 Direct material used ....................................................................................................... 46,200 lb. Direct material: 3 lb. at $5.00 per lb ....................................................................... $15.00 Direct labor: 5 hr. at $11.25 per hr .................................................................... 56.25 Standard prime cost per unit ............................................................................................ $71.25 ■ Problem 10–39 Analyzing Performance and Responsibility; Computing Variances (LO 10-1, 10-3, 10-4, 10-5) 2. Standard quantity allowed: 39,900 pounds Standard hours allowed: 24,700 hours hiL25664_ch10_408-451.indd 442hiL25664_ch10_408-451.indd 442 7/16/13 9:02 PM7/16/13 9:02 PM Final PDF to printer Chapter 10 Standard Costing and Analysis of Direct Costs 443 Required: 1. On the basis of the information contained in the performance report, should SolarPrime’s manage- ment be concerned about its variances? Why? 2. Calculate the company’s direct-material variances and direct-labor variances. 3. On the basis of your answers to requirement (2), should SolarPrime’s management be concerned about its variances? Why? 4. Are things going as smoothly as the vice president believes? Evaluate the company’s variances and determine whether the change to a new supplier and Hoctor’s team-building/morale-boosting train- ing exercises appear to be working. Explain. 5. Is it possible that some of the company’s current problems lie outside Hoctor’s area of responsibil- ity? Explain. The director of c ost management for Peoria Instrument Corporation compares each month’s actual results with a monthly plan. The standard direct-labor rates for the year just ended and the standard hours allowed, given the actual output in April, are shown in the following schedule. A new union contract negotiated in March resulted in actual wage rates that differed from the stan- dard rates. The actual direct-labor hours worked and the actual direct-labor rates per hour experienced for the month of April were as follows: Required: 1. Compute the following variances for April. Indicate whether each is favorable or unfavorable. a. Direct-labor rate variance for each labor class. b. Direct-labor efficiency variance for each labor class. 2. Discuss the advantages and disadvantages of a standard-costing system in which the standard direct-labor rates are not changed during the year to reflect such events as a new labor contract. 3. Build a spreadsheet: Construct an Excel spreadsheet to solve requirement (1) above. Show how the solution will change if the following information changes: the actual labor rates were $27.00, $22.90, and $17.00 for labor classes III, II, and I, respectively. (CMA, adapted) Instructional Resources International (IRI) is a rapidly expanding company involved in the m ass repro- duction of instructional materials. Ralph Boston, owner and manager of IRI, has made a concentrated effort to provide a quality product at a fair price, with delivery on the promised date. Boston is finding it increasingly difficult to personally supervise the operations of IRI, and he is beginning to institute an organizational structure that would facilitate management control. One change recently made was the transfer of control over departmental operations from Boston to each departmental manager. However, the Quality Control Department still reports directly to Boston, as do the Finance and Accounting Departments. A materials manager was hired to purchase all raw materials and to oversee the material-handling (receiving, storage, etc.) and recordkeeping functions. The materials manager also is responsible for maintaining an adequate inventory based on planned production levels. The loss of personal control over the operations of IRI caused Boston to look for a method of effi- ciently evaluating performance. Dave Cress, a new managerial accountant, proposed the use of a standard- costing system. Variances for material and labor could then be calculated and reported directly to Boston. ■ Problem 10–40 Direct-Labor Variances (LO 10-1, 10-3) 1. Direct-labor rate variance, labor class III: $ 1,980 U Actual Direct-Labor Rate per Hour Actual Direct-Labor Hours Labor class III ............................................ $25.80 ..................................................... 1,100 Labor class II ............................................. 22.50 .................................................... 1,300 Labor class I .............................................. 16.20 .................................................... 750 ■ Problem 10–41 Setting Standards; Responsibility for Variances (LO 10-2) Standard Direct-Labor Rate per Hour Standard Direct-Labor Hours Allowed, Given April Output Labor class III ........................................... $24.00 ..................................... 1,000 Labor class II ............................................ 21.00 ..................................... 1,000 Labor class I ............................................. 15.00 ..................................... 1,000 hiL25664_ch10_408-451.indd 443hiL25664_ch10_408-451.indd 443 7/16/13 9:02 PM7/16/13 9:02 PM Final PDF to printer 444 Chapter 10 Standard Costing and Analysis of Direct Costs Concord Farms produces items made from local farm products that are distributed to su p ermarkets. For many years, Concord’s products have had strong regional sales on the basis of brand recognition; however, other companies have begun marketing similar products in the area, and price competition has become increasingly important. Doug Gilbert, the company’s controller, is planning to implement a standard cost system for Concord and has gathered considerable information from his co-workers on production and material requirements for Concord’s products. Gilbert believes that the use of standard costing will allow Concord to improve cost control and make better pricing decisions. Concord’s most popular product is strawberry jam. The jam is produced in 10-gallon batches, and each batch requires six quarts of good strawberries. The fresh strawberries are sorted by hand before entering the production process. Because of imperfections in the strawberries and normal spoilage, one quart of berries is discarded for every four quarts of acceptable berries. Three minutes is the standard direct-labor time for sorting required to obtain one quart of acceptable strawberries. The acceptable strawberries are then blended with the other ingredients. Blending requires 12 minutes of direct-labor time per batch. After blending, the jam is packaged in quart containers. Gilbert has gathered the follow- ing information from Joe Adams, Concord’s cost accountant. • Concord purchases strawberries at a cost of $1.60 per quart. All other ingredients cost a total of $.90 per gallon. • Direct labor is paid at the rate of $18.00 per hour. • The total cost of material and labor required to package the jam is $.76 per quart. Adams has a friend who owns a strawberry farm that has been losing money in recent years. Because of good crops, there has been an oversupply of strawberries, and prices have dropped to $1.00 per quart. Adams has arranged for Concord to purchase strawberries from his friend and hopes that $1.60 per quart will help his friend’s farm become profitable again. Required: 1. Develop the standard cost for the direct-cost components of a 10-gallon batch of strawberry jam. The standard cost should identify the following amounts for each direct-cost component of a batch of strawberry jam: ( a ) standard quantity, ( b ) standard price or rate, and ( c ) standard cost per batch. 2. Citing the specific ethical standards of competence, confidentiality, integrity, and credibility for management accountants ( see “IMA Statement of Ethical Professional Practice” in Chapter 1), explain why Joe Adams’s behavior regarding the cost information provided to Doug Gilbert is unethical. 3. As part of the implementation of a standard-costing system at Concord Farms, Doug Gilbert plans to train those responsible for maintaining the standards in the use of variance analysis. Gilbert is particularly concerned with the causes of unfavorable variances. Discuss the possible causes of the following unfavorable variances and identify the individual(s) who should be held responsible: ( a ) direct-material purchase price variance and ( b ) direct-labor efficiency variance. (CMA, adapted) ■ Problem 10–42 Determining Standard Costs; Ethics (LO 10-1, 10-2, 10-5) 1. Standard cost per 10-gallon batch, blending labor: $3.60 Required: 1. Assume that IRI’s management is going to implement a standard-costing system and establish standards for materials and labor. Identify and discuss for each of these cost components: a. Who should be involved in setting the standards? b. What factors should be considered in establishing the standards? 2. Describe the basis for assignment of responsibility for variances under a standard-costing system. (CMA, adapted) hiL25664_ch10_408-451.indd 444hiL25664_ch10_408-451.indd 444 7/16/13 9:02 PM7/16/13 9:02 PM Final PDF to printer Chapter 10 Standard Costing and Analysis of Direct Costs 445 McKeag’s controller uses the following rule of thumb: Investigate all variances equal to or greater than $60,000, which is 6 percent of standard cost. Required: 1. Which variances would have been investigated during the year? (Indicate month and type of variance.) 2. What characteristics of the variance pattern shown in the report should draw the controller’s atten- tion, regardless of the usual investigation rule? Explain. Given these considerations, which vari- ances would you have investigated? Why? 3. Is it important to follow up on favorable variances, such as those shown in the report? Why? 4. The controller believes that the firm’s direct-labor rate variance has a normal probability distribu- tion with a mean of zero and a standard deviation of $10,000. Prepare a statistical control chart, and plot the company’s direct-labor rate variances for each month. The critical value is 1 standard deviation. Which variances would have been investigated under this approach? California Housewares’ Merced Division is a small manufacturer of wooden household items. Al Rivkin, divisional controller, plans to implement a standard-costing system. Rivkin has collected information from several co-workers that will assist him in developing standards. One of the Merced Division’s products is a wooden cutting board. Each cutting board requires 1.25 board feet of lumber and 12 minutes of direct-labor time to prepare and cut the lumber. The cutting boards are inspected after they are cut. Because the cutting boards are made of a natural material that has imperfections, one board is normally rejected for each five that are accepted. Four rubber foot pads are attached to each good cut- ting board. A total of 15 minutes of direct-labor time is required to attach all four foot pads and finish each cutting board. The lumber for the cutting boards costs $4.00 per board foot, and each foot pad costs $.10. Direct labor is paid at the rate of $8.00 per hour. Required: 1. Develop the standard cost for direct material and direct labor of a cutting board. 2. Explain the role of each of the following people in developing standards. a. Purchasing manager. b. Industrial engineer. c. Managerial accountant. 3. The production manager complained that the standards are unrealistic, stifle motivation by con- centrating only on unfavorable variances, and are out of date too quickly. He noted that his recent switch to cherry for the cutting boards has resulted in higher material costs but decreased labor hours. The net result was no increase in the total cost to produce the product. The monthly reports ■ Problem 10–44 Development of Standard Costs; Ethics (LO 10-2, 10-5) MCKEAG CORPORATION Direct-labor Variance Report Direct-Labor Rate Variance Direct-Labor Efficiency Variance Amount Standard Cost, % Amount Standard Cost, % January .................................. $ 1,600 F .16% $ 10,000 U 1.00% February ................................ 9,800 F .98% 15,000 U 1.50% March .................................... 200 U .02% 19,400 U 1.94% April ....................................... 4,000 U .40% 25,600 U 2.56% May ....................................... 7,600 F .76% 40,200 U 4.02% June ...................................... 7,800 F .78% 34,000 U 3.40% July ........................................ 8,400 F .84% 57,000 U 5.70% August ................................... 10,200 F 1.02% 76,000 U 7.60% September ............................. 9,600 F .96% 74,000 U 7.40% October .................................. 11,400 F 1.14% 84,000 U 8.40% November .............................. 8,400 F .84% 120,000 U 12.00% December .............................. 8,600 F .86% 104,000 U 10.40% McKeag Corporation manufactures agricultural machinery. At a recent staff meeting, the following direct-labor variance report for the year just ended was presented by the controller. ■ Problem 10–43 Investigating Cost Variances (LO 10-4) hiL25664_ch10_408-451.indd 445hiL25664_ch10_408-451.indd 445 7/16/13 9:02 PM7/16/13 9:02 PM Final PDF to printer 446 Chapter 10 Standard Costing and Analysis of Direct Costs Ozarks Camping Equipment, Inc., has established the following direct-materi a l standards for its two products. During May, the company purchased 4,200 yards of tent fabric for its standard model at a cost of $26,880. The actual May production of the standard tent was 200 tents, and 2,500 yards of fabric were used. Also during May, the company purchased 1,600 yards of tent fabric for its deluxe backpacking tent at a cost of $12,640. The firm used 1,440 yards of the fabric during May in the production of 240 deluxe tents. Required: 1. Compute the direct-material purchase price variance and quantity variance for May. 2. Prepare journal entries to record the purchase of material, use of material, and incurrence of vari- ances in May. Execucraft, Inc., manufactures upholstered office chairs. The standard cost for material a nd labor is $89.20 per chair. This includes 8 kilograms of direct material at a standard cost of $5.00 per kilogram, and 6 hours of direct labor at $8.20 per hour. The following data pertain to September. • Units completed: 5,600 chairs. • Purchases of materials: 50,000 kilograms for $249,250. • Total actual labor costs: $300,760. • Actual hours of labor: 36,500 hours. • Direct-material quantity variance: $1,500 unfavorable. • Work-in-process inventory on September 1: none. • Work-in-process inventory on September 30: 800 chairs (75 percent complete as to labor; material is issued at the beginning of processing). Required: 1. Compute the following amounts. Indicate whether each variance is favorable or unfavorable. a. Direct-labor rate variance for September. b. Direct-labor efficiency variance for September. c. Actual kilograms of material used in the production process during September. d. Actual price paid per kilogram of direct material in September. e. Total amounts of direct-material and direct-labor cost transferred to Finished-Goods Inventory during September. f. The total amount of direct-material and direct-labor cost in the ending balance of Work-in- Process Inventory at the end of September. 2. Prepare journal entries to record the following: a. Purchase of raw material. b. Adding direct material to Work-in-Process Inventory. c. Adding direct labor to Work-in-Process Inventory. d. Recording of variances. (CMA, adapted) ■ Problem 10–45 Direct-Material Variances; Journal Entries (Appendix) (LO 10-1, 10-3, 10-9) 1(a). Direct-material purchase price variance: $1,520 U Standard Quantity Standard Price Standard camping tent ................................................................. 12 yards $6 per yard Deluxe backpacking tent .............................................................. 6 yards $8 per yard ■ Problem 10–46 Variances; Journal Entries; Missing Data (Appendix) (LO 10-3, 10-6, 10-9) 1(b). Standard allowed direct- labor hours: 37,200 hrs. continue to show an unfavorable material variance and a favorable labor variance despite indica- tions that the workers are slowing down. a. Explain why a standard-costing system can strengthen cost management. b. Give at least two reasons to explain why a standard-costing system could negatively impact the motivation of production employees. (CMA, adapted) hiL25664_ch10_408-451.indd 446hiL25664_ch10_408-451.indd 446 7/16/13 9:02 PM7/16/13 9:02 PM Final PDF to printer Chapter 10 Standard Costing and Analysis of Direct Costs 447 McCartney Company manufa c tures guitars. The company uses a standard, job-order cost account i ng system in two production departments. In the Construction Department the wooden guitars are built by highly skilled craftspeople and coated with several layerst of lacquer. Then the units are transferred to the Finishing Department, where the bridge of the guitar is attached and the strings are installed. The guitars also are tuned and inspected in the Finishing Department. The diagram below depicts the pro- duction process. Each finished guitar contains seven pounds of veneered wood. In addition, one pound of wood is typically wasted in the production process. The veneered wood used in the guitars has a standard price of $12 per pound. The other parts needed to complete each guitar, such as the bridge and strings, cost $15 per guitar. The labor standards for McCartney’s two production departments are as follows: Construction Department: 6 hours of direct labor at $20 per hour Finishing Department: 3 hours of direct labor at $15 per hour The following pertains to the month of July. 1. There were no beginning or ending work-in-process inventories in either production department. 2. There was no beginning finished-goods inventory. 3. Actual production was 750 guitars, and 450 guitars were sold on account for $390 each. 4. The company purchased 9,000 pounds of veneered wood at a price of $12.50 per pound. 5. Actual usage of veneered wood was 6,750 pounds. 6. Enough parts (bridges and strings) to finish 900 guitars were purchased at a cost of $13,500. 7. The Construction Department used 4,275 direct-labor hours. The total direct-labor cost in the Construction Department was $81,225. 8. The Finishing Department used 2,355 direct-labor hours. The total direct-labor cost in that depart- ment was $37,680. 9. There were no direct-material variances in the Finishing Department. Required: 1. Prepare a schedule that computes the standard costs of direct material and direct labor in each pro- duction department and in total for the month of July. 2. Prepare three exhibits which compute the July direct-material and direct-labor variances in the Construction Department and the July direct-labor variances in the Finishing Department. (Refer to Exhibits 10–2 , 10–3 , and 10–4 for guidance.) 3. Prepare a cost variance report for July similar to that shown in Exhibit 10–5 . McCartney Company investigates all variances greater than $5,000 or 5%. Refer to your solution for the preceding problem regarding Mc C artney Company. Required: 1. Prepare journal entries to record all of the events listed for McCartney Company during July. Spe- cifically, these journal entries should reflect the following events. a. Purchase of direct material. b. Use of direct material. c. Incurrence of direct-labor costs. d. Addition of production costs to the Work-in-Process Inventory account for each department. e. Incurrence of all variances. ■ Problem 10–47 Comprehensive Problem on Variance Analysis (LO 10-1, 10-3, 10-4) 1. Construction, total standard cost of direct material: $72,000 3. Finishing, direct-labor rate variance: 2,355 U Ex Construction Department (Basic guitar built from veneered wood.) Finishing Department (Bridge and strings attached; guitar tuned and inspected.) ■ Problem 10–48 Journal Entries under Standard Costing;Continuation of Preceding Problem (Appendix) (LO 10-6, 10-9) hiL25664_ch10_408-451.indd 447hiL25664_ch10_408-451.indd 447 7/16/13 9:02 PM7/16/13 9:02 PM Final PDF to printer 448 Chapter 10 Standard Costing and Analysis of Direct Costs Cases f. Completion of 750 guitars. g. Sale of 450 guitars. h. Closing of all variance accounts into Cost of Goods Sold. 2. Draw T-accounts, and post the journal entries prepared in requirement (1). Assume the beginning balance in all accounts is zero. Metro Fashions, Inc., manufactures women’s blouses of one quality, which are produced in lots to fill each special order. Its customers are department stores in various cities. Metro Fashions sews the par- ticular stores’ labels on the blouses. During November the company worked on three orders, for which the month’s job-cost records disclose the following data. The following additional information is available: 1. The firm purchased 190,000 yards of material during November at a cost of $212,800. 2. Direct labor during November amounted to $330,000. According to payroll records, production employees were paid $15 per hour. 3. There was no work in process on November 1. During November, lots N42 and N43 were com- pleted. All material was issued for lot N44, which was 80 percent completed as to conversion (i.e., direct labor and overhead). 4. The standard costs for a box of six blouses are as follows: Required: 1. Prepare a schedule computing the standard cost of lots N42, N43, and N44 for November. 2. Prepare a schedule showing, for each lot produced during November: a. Direct-material purchase price variance. ( Hint: Must be computed in total, across all three pro- duction lots.) b. Direct-material quantity variance. c. Direct-labor efficiency variance. d. Direct-labor rate variance. Indicate whether each variance is favorable or unfavorable. 3. Prepare journal entries to record each of the following events. a. Purchase of material. b. Incurrence of direct-labor cost. c. Addition of direct-material and direct-labor cost to Work-in-Process Inventory. d. Recording of direct-material and direct-labor variances. (CPA, adapted) ■ Case 10–49 Direct-Material and Direct- Labor Variances; Job-Order Costing; Journal Entries (Appendix) (LO 10-1, 10-3, 10-6, 10-9) 1. Lot N44, standard cost per box: $90.48 2. Lot N43, direct-labor efficiency variance: $882 U Ex Lot Number Boxes in Lot Material Used (yards) Hours Worked N42 ...................................... 2,000 48,200 5,960 N43 ...................................... 3,400 80,880 10,260 N44 ...................................... 2,400 57,650 5,780 Direct material ................................................. 24 yards at $1.10 ................................................... $ 26.40 Direct labor ..................................................... 3 hours at $14.70 ................................................ 44.10 Production overhead ........................................ 3 hours at $12.00 ................................................ 36.00 Standard cost per box ........................................................................................................................ $106.50 hiL25664_ch10_408-451.indd 448hiL25664_ch10_408-451.indd 448 7/16/13 9:02 PM7/16/13 9:02 PM Final PDF to printer Chapter 10 Standard Costing and Analysis of Direct Costs 449 MacGyver Corporation manufactures a product called Miracle Goo, which comes in handy for just about anything. The thick tarry substance is sold in six-gallon drums. Two raw materials are used; these are referred to by people in the business as A and B. Two types of labor are required also. These are mixers (labor class I) and packers (labor class II). You were recently hired by the company president, Pete Thorn, to be the controller. You soon learned that MacGyver uses a standard-costing system. Vari- ances are computed and closed into Cost of Goods Sold monthly. After your first month on the job, you gathered the necessary data to compute the month’s variances for direct material and direct labor. You finished everything up by 5:00 p.m. on the 31st, including the credit to Cost of Goods Sold for the sum of the variances. You decided to take all your notes home to review them prior to your formal presenta- tion to Thorn first thing in the morning. As an afterthought, you grabbed a drum of Miracle Goo as well, thinking it could prove useful in some unanticipated way. You spent the evening boning up on the data for your report and were ready to call it a night. As luck would have it though, you knocked over the Miracle Goo as you rose from the kitchen table. The stuff splattered everywhere, and, most unfortunately, obliterated most of your notes. All that remained legible is the following information. Other assorted data gleaned from your notes: • The standards for each drum of Miracle Goo include 10 pounds of material A at a standard price of $5 per pound. • The standard cost of material B is $15 for each drum of Miracle Goo. • Purchases of material A were 18,000 pounds at $4.50 per pound. • Given the actual output for the month, the standard allowed quantity of material A was 15,000 pounds. The standard allowed quantity of material B was 7,500 gallons. • Although 9,000 gallons of B were purchased, only 7,200 gallons were used. • The standard wage rate for mixers is $15 per hour. The standard labor cost per drum of product for mixers is $30 per drum. • The standards allow 4 hours of direct labor II (packers) per drum of Miracle Goo. The standard labor cost per drum of product for packers is $48 per drum. • Packers were paid $11.90 per hour during the month. You happened to remember two additional facts. There were no beginning or ending inventories of either work in process or finished goods for the month. The increase in accounts payable relates to direct-material purchases only. Required: Now you have a major problem. Somehow you’ve got to reconstruct all the missing data in order to be ready for your meeting with the president. You start by making the following list of the facts you want to use in your presentation. Before getting down to business, you need a brief walk to clear your head. Out to the trash you go, and toss the remaining Miracle Goo. ■ Case 10–50 Missing Data; Variances, Ledger Accounts (Appendix) (LO 10-1, 10-3, 10-6, 10-9) 2(a). Standard quantity per drum, material B: 5 gal. 3(g). Rate variance, labor class II: $615 F Direct Material A: Quantity Variance 3,750 Direct Labor I: Rate Variance 900 Cost of Goods Sold 214,500 2,265 Direct Material B: Purchase Price Variance 1,800 Direct Labor II: Efficiency Variance 1,800 Accounts Payable 2,250 Beg. bal. 105,000 109,800 7,050 End. bal. hiL25664_ch10_408-451.indd 449hiL25664_ch10_408-451.indd 449 7/16/13 9:02 PM7/16/13 9:02 PM Final PDF to printer 450 Chapter 10 Standard Costing and Analysis of Direct Costs Fill in the missing amounts in the following list, using the available facts. 1. Actual output (in drums): 2. Direct material: A B a. Standard quantity per drum: b. Standard price: c. Standard cost per drum: d. Standard quantity allowed, given actual output: e. Actual quantity purchased: f. Actual price: g. Actual quantity used: h. Purchase Price variance: i. Quantity variance: 3. Direct labor: I (mixers) II (packers) a. Standard hours per drum: b. Standard rate per hour: c. Standard cost per drum: d. Standard quantity allowed, given actual output: e. Actual rate per hour: f. Actual hours: g. Rate variance: h. Efficiency variance: 4. Total of all variances for the month: hiL25664_ch10_408-451.indd 450hiL25664_ch10_408-451.indd 450 7/16/13 9:02 PM7/16/13 9:02 PM Final PDF to printer This page intentionally left blank 11 THIS CHAPTER’S FOCUS COMPANY is DCdesserts.com , and con- tinues our discussion from the previous chapter. DCdesserts.com sup- plies fancy desserts to a variety of restaurants, caterers, and upscale food stores in Washington, D.C. In this chapter, we explore DCdesserts.com’s use of flexible budgeting to plan for and control overhead costs. A flexible budget allows for a variety of levels of activity. As activity increases, the costs in the flexible budget rise as well. This tool enables management to compare the actual overhead costs incurred with the costs that should have been incurred, given the actual level of production activity. FOCUS COMPANY >>>
Flexible Budgeting and
Analysis of Overhead Costs
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<<< IN CONTRAST In contrast to the food-processing setting of DCdesserts.com , we turn our attention to flexible budgeting in the service industry. Upstate Auto Rentals is a small automobile rental company in upstate New York. The company has four rental locations in and around Syracuse and specializes in short-term car rentals, primar- ily for local use when a customer’s car is in the repair shop. Upstate’s flexible budget uses two cost drivers: the number of miles driven by its rental cars and the number of customer contracts. hiL25664_ch11_452-497.indd 453hiL25664_ch11_452-497.indd 453 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer 454 After completing this chapter, you should be able to: How do service industry companies, such as Aetna, Baskin-Robbins, Budget Rent-a-Car, Chase Bank, Days Inn, and United Airlines control the overhead costs they incur in pro- ducing their services? Similarly, how do manufacturing firms such as General Motors, Hewlett-Packard, and Whirlpool control the many overhead costs incurred in their produc- tion processes? Unlike direct material and direct labor, overhead costs are not traceable to individual products. Moreover, overhead is a pool of many different kinds of costs. Indirect material, indirect labor, and other indirect production costs often exhibit different relation- ships to productive activity. Some overhead costs are variable, and some are fixed. Moreover, different individuals in an organization are responsible for different types of overhead costs. Considering all of these issues together, controlling overhead presents a challenge for companies and the managers who run them. In this chapter, we will explore ways in which the financial planning and analysis (FP&A) system discussed in Chapters 9 and 10 can be extended to analyze and control overhead costs. Overhead Budgets Since direct material and direct labor are traceable to products, it is straightforward to determine standard costs for these inputs. If the top of a conference table requires 220 board feet of mahagony lumber at $15 per board foot, the standard direct-material cost for the tabletop is $3,300. But how much electricity does it take to produce a tabletop? How much supervisory time, equipment depreciation, or machinery repair services does the table require? Since all of these overhead costs are indirect costs of production, we cannot set overhead cost standards for the mahogany tabletop. If standard costs do not provide the answer to controlling overhead, what does? Overhead Budgets 11-1 Distinguish between static and flexible budgets and explain the advantages of a flexible overhead budget. 11-2 Prepare a flexible overhead budget, using both a formula and a columnar format. 11-3 Explain how overhead is applied to Work-in-Process Inventory under standard costing. 11-4 Explain some important issues in choosing an activity measure for overhead budgeting and application. 11-5 Compute and interpret the variable-overhead spending and efficiency variances and the fixed-overhead budget and volume variances. 11-6 Prepare an overhead cost performance report. 11-7 Explain how an activity-based flexible budget differs from a conventional flexible budget. 11-8 Prepare journal entries to record production overhead under standard costing (Appendix A). 11-9 Compute and interpret the sales-price and sales-volume variances (Appendix B). Learning Objective 11-1 Distinguish between static and flexible budgets and explain the advantages of a flexible overhead budget. hiL25664_ch11_452-497.indd 454hiL25664_ch11_452-497.indd 454 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer Chapter 11 Flexible Budgeting and Analysis of Overhead Costs 455 Flexible Budgets The tool used by most companies to control overhead costs is called a flexible budget . A flexible budget resembles the budgets we studied in Chapter 9, with one important differ- ence: A flexible budget is not based on only one level of activity. Instead, a flexible budget covers a range of activity within which the firm may operate. A flexible overhead budget is defined as a detailed plan for controlling overhead costs that is valid in the firm’s rel- evant range of activity. In contrast, a static budget is based on a particular planned level of activity. At DCdesserts.com , the measure of activity used for planning the overhead costs is process time. The process time for a dessert is the total amount of time the product is in production including selecting ingredients, mixing, baking, cooling, assembly and finish- ing, and packaging. DCdesserts.com’s director of cost management estimates that the average process time required for fancy desserts is three hours. To illustrate the flexible budgeting concept, suppose DCdesserts.com’s director of cost management has determined that electricity is a variable cost, incurred at the rate of $.50 per hour of process time. Two different budgets for electricity cost are shown in Exhibit 11–1 . The static budget is based on management’s predicted level of activity for September—7,500 hours of process time. This estimate is based on planned production of 2,500 multilayer fancy cakes, where each cake requires three hours of total process time. The flexible budget includes three different production activity levels within the relevant range: 6,000, 7,500, and 9,000 hours of process time. Advantages of Flexible Budgets Why is the distinction between static and flexible budgets so important? Suppose DCdesserts.com produced 2,000 multilayer fancy cakes during September, used 6,000 hours of process time, and incurred electricity costs of $3,200. Does this constitute good control or poor control of electricity costs? Which budget in Exhibit 11–1 is more useful in answering this question? A manager using the static budget makes the following comparison. Actual Electricity Cost Budgeted Electricity Cost (static budget) Cost Variance $3,200 ....................................................... $3,750 ............................. $550 Favorable This comparison suggests that operating personnel maintained excellent control over electricity costs during September, generating a favorable variance of $550. Is this a valid analysis and conclusion? The fault with this analysis is that the manager is comparing the electricity cost incurred at the actual activity level, 2,000 multilayer fancy cakes, with the budgeted elec- tricity cost at the planned activity level, 2,500 multilayer fancy cakes. Since these activity levels are different, we should expect the electricity cost to be different. Static Budget Flexible Budget Activity (process hours)* ................. 7,500 Activity (process hours) .................... 6,000 7,500 9,000 Budgeted electricity cost ................. $3,750 Budgeted electricity cost .................. $3,000 $3,750 $4,500 Static budget: Flexible budget: based on only includes several one anticipated possible activity activity level. levels. *Based on planned September production of 2,500 multilayer fancy cakes, at three hours of process time per cake. ⎫⎪⎪⎪⎪⎬⎪⎪⎪⎪⎭ Exhibit 11–1 Static Budget versus Flexible Budget hiL25664_ch11_452-497.indd 455hiL25664_ch11_452-497.indd 455 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer 456 Chapter 11 Flexible Budgeting and Analysis of Overhead Costs A more sensible approach is to compare the actual electricity cost incurred with the cost that should be incurred when 2,000 multilayer fancy cakes are produced. At this production level, 6,000 process hours should be used (3 per cake). The flexible budget in Exhibit 11–1 shows that the manager should expect $3,000 of electricity cost at the 6,000 process-hour level of activity. Therefore, an analysis based on the flexible budget gives the following comparison. Actual Electricity Cost Budgeted Electricity Cost (flexible budget) Cost Variance $3,200 ...................................................... $3,000 ....................................... $200 Unfavorable Now the manager’s conclusion is different; the revised analysis indicates an unfavor- able variance. Electricity cost was greater than it should have been, given the actual level of output. The flexible budget provides the correct basis for comparison between actual and expected costs, given actual activity. The Activity Measure Notice that the flexible budget for electricity cost in Exhibit 11–1 is based on hours of process time, which is an input in the production process. The process-hour activity levels shown in the flexible budget are the standard allowed process hours given various levels of output. If 2,000 multilayer fancy cakes are produced, and the standard allow- ance per cake is 3 process hours, then the standard allowed number of process hours is 6,000. Why are the activity levels in the flexible budget based on process hours, an input measure, instead of the number of multilayer fancy cakes produced, an output measure? When only a single product is produced, it makes no difference whether the flexible bud- get is based on input or output. In our illustration, either of the flexible budgets shown in Exhibit 11–2 could be used. Now suppose that during August, DCdesserts.com produced three different products: 1,000 multilayer fancy cakes, 1,500 single-layer sheet cakes, and 600 specialty cakes (such as wedding cakes). The following standards have been assigned to these products. Product Standard Process Hours per Unit Multilayer fancy cakes ................................................................................................................... 3 Single-layer sheet cakes ................................................................................................................ 2 Specialty cakes ............................................................................................................................. 6 During August, the company’s production output was 3,100 cakes. Is 3,100 cakes a meaningful output measure? Adding numbers of multilayer fancy cakes, sheet cakes, and specialty cakes, which require different amounts of productive inputs, is like adding apples and oranges. It would not make sense to base a flexible budget for electricity cost on units of output when the output consists of different products with different electric- ity requirements. In this case, the flexible budget must be based on an inpu t measure. The standard allowed number of process hours for the August production is computed as follows: Product Units Produced Standard Process Hours per Unit Total Standard Allowed Process Hours Multilayer fancy cakes ................... 1,000 ................. 3 .................. 3,000 Single-layer sheet cakes ............... 1,500 ................. 2 .................. 3,000 Specialty cakes ............................. 600 ................. 6 .................. 3,600 Total .................................................................................................................................... 9,600 “I will give you an example of when we were supporting budgets. We would have to go out to the person and say, ‘What is going on in your budget? I don’t understand why you are overspending or under- spending.’ Now a person looks at their budget and comes to accounting and will say, ‘Can you help me with this problem?’” (11a) Abbott Laboratories hiL25664_ch11_452-497.indd 456hiL25664_ch11_452-497.indd 456 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer Chapter 11 Flexible Budgeting and Analysis of Overhead Costs 457 Recall that the controller estimates electricity cost at $.50 per process hour. Thus, the flexible-budget cost of electricity during August is computed as follows: Standard allowed process hours given August output ................................................................................... 9,600 Electricity cost per process hour .................................................................................................................. 3 $.50 Flexible budget for electricity cost ............................................................................................................... $4,800 The important point is that units of output usually is not a meaningful measure in a multiproduct firm, because it would require us to add numbers of unlike products. To avoid this problem, output is measured in terms of the standard allowed input, given actual output. The flexible overhead budget is then based on this standard input measure. Flexible Overhead Budget Illustrated DCdesserts.com’s monthly flexible overhead budget is shown in the Excel spreadsheet in Exhibit 11–3 . The overhead costs on the flexible budget are divided into variable and fixed costs. The total budgeted variable overhead cost increases proportionately with increases in the activity. Thus, when the number of process hours increases by 50 percent, from 6,000 hours to 9,000 hours, the total budgeted variable overhead cost also increases by 50 percent, from $30,000 to $45,000. In contrast, the total budgeted fixed overhead does not change with increases in activity; it remains constant at $15,000 per month. Formula Flexible Budget When overhead costs can be divided into variable and fixed categories, we can express the flexible overhead budget differently. The format used in Exhibit 11–3 is called a columnar flexible budget. The budgeted overhead cost for each overhead item is listed in a column under a particular activity level. Notice that the columnar format allows for only a limited number of activity levels. DCdesserts.com’s flexible budget shows only three. A more general format for expressing a flexible budget is called a formula flexible budget. In this format, we express the relationship between activity and total budgeted overhead cost by the following formula: Total budgeted monthly overhead cost 5 ( Budgeted variable- overhead cost per activity unit 3 Total activity units ) 1 Budgeted fixed- overhead cost per month To use this formula for DCdesserts.com , we first need to compute the budgeted variable- overhead cost per process hour. Dividing total budgeted variable-overhead cost by the associated activity level yields a budgeted variable-overhead rate of $5 per process hour. Notice that this variable-overhead rate is the same for every activity level in Exhibit 11–3 . Flexible Overhead Budget Illustrated Exhibit 11–2 Flexible Budgets: Input versus Output 3 standard allowed process hours per multilayer fancy cake Flexible Budget (based on input) Activity: standard allowed process hours ................................ 6,000 7,500 9,000 Budgeted electricity cost ....................................................... $3,000 $3,750 $4,500 Flexible Budget (based on output) Activity: multilayer fancy cakes produced ................................ 2,000 2,500 3,000 Budgeted electricity cost ....................................................... $3,000 $3,750 $4,500 Learning Objective 11-2 Prepare a flexible overhead budget, using both a formula and a columnar format. hiL25664_ch11_452-497.indd 457hiL25664_ch11_452-497.indd 457 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer 458 Chapter 11 Flexible Budgeting and Analysis of Overhead Costs Exhibit 11–3 Flexible Overhead Budget $30,000 _______ 6,000 5 $37,500 ________ 7,500 5 $45,000 _______ 9,000 5 $5 per process hour DCdesserts.com’s formula flexible overhead budget is shown below. Total budgeted monthly overhead cost 5 ($5 3 Total process hours) 1 $15,000 To check the accuracy of the formula, compute the total budgeted overhead cost at each of the activity levels shown in Exhibit 11–3 . hiL25664_ch11_452-497.indd 458hiL25664_ch11_452-497.indd 458 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer Chapter 11 Flexible Budgeting and Analysis of Overhead Costs 459 Activity (process hours) Formula Flexible Overhead Budget Budgeted Monthly Overhead Cost 6,000 ..................... ($5 3 6,000) 1 $15,000 5 $45,000 7,500 ..................... ($5 3 7,500) 1 $15,000 5 $52,500 9,000 ..................... ($5 3 9,000) 1 $15,000 5 $60,000 The budgeted monthly overhead cost computed above is the same as that shown in Exhibit 11–3 for each activity level. The formula flexible budget is more general than the columnar flexible budget, because the formula allows managers to compute budgeted overhead costs at any activity level. Then the flexible-budgeted overhead cost can be used at the end of the period as a benchmark against which to compare the actual overhead costs incurred. Overhead Application in a Standard-Costing System Recall that overhead application refers to the addition of overhead cost to the Work- in-Process Inventory account as a product cost. In a normal-costing system, described in Chapter 3, overhead is applied as shown in the top panel of Exhibit 11–4 . Overhead application is based on actual hours. In a standard-costing system, overhead application is based on standard hours allowed, given actual output. This system is depicted in the bottom panel of Exhibit 11–4 . Notice that the difference between normal costing and standard costing, insofar as overhead is concerned, lies in the quantity of hours used. Both normal- and standard-costing systems use a predetermined overhead rate. In a standard-costing system, the predetermined overhead rate also is referred to as the standard overhead rate. DCdesserts.com calculates its predetermined or standard over- head rate annually. The rate for the current year, computed in Exhibit 11–5 , is based on planned activity of 7,500 process hours per month. Notice that DCdesserts.com breaks its predetermined overhead rate into a variable rate and a fixed rate. We will discuss further the use of standard costs for product costing in Appendix A at the end of this chapter. Overhead Application in a Standard-Costing System “It’s critical to understand variable and fixed overhead costs. When activity levels change, what costs will change and how?” (11b) A. T. Kearney Learning Objective 11-3 Explain how overhead is applied to Work-in-Process Inventory under standard costing. Production Overhead* Actual Applied overhead overhead: Actual hours Predetermined overhead rate Work-in-Process Inventory Applied overhead: Actual hours Predetermined overhead rate Normal Costing Production Overhead* Actual Applied overhead overhead: Standard allowed hours Predetermined (standard) rate Work-in-Process Inventory Applied overhead: Standard allowed hours Predetermined (standard) rate Standard Costing Difference lies in the quantity of hours used. *Prior to Chapter 9, the overhead cost of the production process was referred to as “manufacturing overhead.” Beginning with the master budget in Chapter 9, we changed to the less-specific term “production overhead” to generalize beyond manufacturing and include service and merchandising operations. A manufacturing company would still refer to production overhead as manufacturing overhead. Exhibit 11–4 Overhead Application hiL25664_ch11_452-497.indd 459hiL25664_ch11_452-497.indd 459 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer 460 Chapter 11 Flexible Budgeting and Analysis of Overhead Costs Choice of Activity Measure DCdesserts.com’s flexible overhead budget is based on process hours. A variety of activ- ity measures are used in practice. Machine hours, direct-labor hours, direct-labor cost, total process time, and direct-material cost are among the most common measures. Choosing the appropriate activity measure for the flexible overhead budget is important, because the flexible budget is the chief tool for managing overhead costs. Criteria for Choosing the Activity Measure How should a manager select the activity measure for the flexible budget? The activity measure should be one that varies in a similar pattern to the way that variable overhead varies. As productive activity increases, both variable-overhead cost and the activity mea- sure should increase in roughly the same proportion. As productive activity declines, both variable-overhead cost and the activity measure should decline in roughly the same pro- portion. In short, variable-overhead cost and the activity measure should move together as overall productive activity changes. Changing Manufacturing Technology Direct-labor time has traditionally been a popular activity measure in manufacturing firms. However, as automation increases, more and more firms are switching to such measures as machine hours or process time for their flexible overhead budgets. Machine hours and process time are linked more closely than direct-labor hours to the robotic technology and computer-integrated manu- facturing (CIM) systems common in today’s manufacturing environment. Choice of Activity Measure Exhibit 11–5 Predetermined Overhead Rate: DCdesserts.com Budgeted Overhead Planned Monthly Activity Predetermined Overhead Rate Variable ........................ $37,500* .................... 7,500 process hours ..................... $5.00 per process hour Fixed ............................ 15,000 * .................... 7,500 process hours ..................... 2.00 per process hour Total ............................. $52,500 ..................... 7,500 process hours ..................... $7.00 per process hour *From the flexible budget (Exhibit 11–3) for planned monthly activity of 7,500 process hours. As manufacturing has become increasingly automated, direct labor is becoming less appropriate as an activity measure in flexible budgeting. Increased automation brings greater overhead costs while also reducing the amount of direct labor used. Left, employees inspect and pack clothes at the Zipsa industrial park near Managua, Nicaragua (a labor-intensive activity). Right, a robot assembles washing machines at the BSH Bosch und Siemens consumer appliances factory in Nauen, Germany (a high-tech process). Learning Objective 11-4 Explain some important issues in choosing an activity measure for overhead budgeting and application. hiL25664_ch11_452-497.indd 460hiL25664_ch11_452-497.indd 460 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer Chapter 11 Flexible Budgeting and Analysis of Overhead Costs 461 Cost Drivers As we discussed in Chapter 5, some companies have refined their cost management systems even further. Cost drivers are identified as the most significant fac- tors affecting overhead costs. Then multiple overhead rates based on these cost drivers are used to compute product costs and control overhead expenditures. A relentless search for non-value-added costs is an integral part of such a cost management system. We will discuss the role of activity-based costing in flexible budgeting later in the chapter. Beware of Dollar Measures Dollar measures, such as direct-labor or raw-material costs, often are used as the basis for flexible overhead budgeting. However, such mea- sures have significant drawbacks, and they should be avoided. Dollar measures are sub- ject to price-level changes and fluctuate more than physical measures. For example, the direct-labor hours required to produce a fancy dessert will be relatively stable over time. However, the direct-labor cost will vary as wage levels and fringe-benefit costs change with inflation and conditions in the labor market. The choice of an activity measure upon which to base the flexible budget for variable overhead is really a cost-estimation problem, which is the topic addressed in Chapter 7. Cost Management Using Overhead Cost Variances The flexible overhead budget is one of a company’s primary tools for the control of production-overhead costs. At the end of each accounting period, the company’s manage- rial accountants use the flexible overhead budget to determine the level of overhead cost that should have been incurred, given the actual level of activity. They then compare the overhead cost in the flexible budget with the actual overhead cost incurred. With this information, the accountants can report to managers four separate overhead variances, each of which conveys information useful in controlling overhead costs. To illustrate overhead variance analysis, we will continue our illustration for DCdesserts.com . Recall that the company uses process hours as the activity measure for budgeting overhead costs. Flexible Budget DCdesserts.com’s monthly flexible overhead budget, displayed in Exhibit 11–3 , shows budgeted variable and fixed production-overhead costs at three lev- els of production output. During September, DCdesserts.com produced 2,000 multilayer fancy cakes. Since production standards allow three process hours per cake, the total standard allowed number of process hours is 6,000 hours. Actual production output ............................................................................................... 2,000 multilayer fancy cakes Standard allowed process hours per multilayer fancy cake ............................................... 3 3 Total standard allowed process hours ............................................................................. 6,000 process hours From the 6,000 process-hour column in Exhibit 11–3 , the budgeted overhead cost for September is as follows: From the cost accounting records, DCdesserts.com’s director of cost management determines that the following overhead costs were actually incurred during September. Actual Cost for September Variable overhead .................................................................................................................... $34,650 Fixed overhead ........................................................................................................................ 16,100 Total overhead ......................................................................................................................... $50,750 Cost Management Using Overhead Cost Variances Budgeted Overhead Cost for September Variable overhead ................................................................................................................... $30,000 Fixed overhead ....................................................................................................................... 15,000 Learning Objective 11-5 Compute and interpret the variable-overhead spending and efficiency variances and the fixed-overhead budget and volume variances. hiL25664_ch11_452-497.indd 461hiL25664_ch11_452-497.indd 461 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer 462 Chapter 11 Flexible Budgeting and Analysis of Overhead Costs The production supervisor’s records indicate that the actual total process time in September was as follows: Actual process hours for September ................................................................................................................ 6,300 Notice that the actual number of process hours used (6,300) exceeds the standard allowed number of process hours, given actual production output (6,000). We now have assembled all of the information necessary to compute DCdesserts .com’s overhead variances for September. Variable Overhead DCdesserts.com’s total variable-overhead variance for September is computed below. Actual variable overhead .......................................................................................................... $34,650 Budgeted variable overhead ...................................................................................................... 30,000 Total variable-overhead variance ............................................................................................... $ 4,650 Unfavorable What caused the company to spend $4,650 more than the budgeted amount on variable overhead? To discover the reasons behind this performance, the financial planning and anal- ysis system computes a variable-overhead spending variance and a variable- overhead efficiency variance . The computation of these variances is depicted in Exhibit 11–6 . Variable-Overhead Spending Variance Multiplying the actual quantity of the activity measure by the standard variable-overhead rate (AQ 3 SVR) gives a revised estimate of expected spending on variable overhead, given that we now know the actual quantity of the activity measure. This figure, which we designate the projected variable overhead, provides a benchmark against which the actual spending on variable overhead can be assessed. Any difference between the actual and projected variable overhead cost is called the variable-overhead spending variance. Two equivalent formulas for the variable-overhead spending variance are shown below. 1. Variable-overhead spending variance 5 Actual variable overhead 2 (AQ 3 SVR), or 2. Variable-overhead spending variance 5 (AQ 3 AVR) 2 (AQ 3 SVR) where AQ denotes actual activity level (actual quantity of the activity measure) AVR denotes actual variable-overhead rate (actual variable overhead 4 AQ) SVR denotes standard variable-overhead rate These two formulas are equivalent because actual variable overhead is equal to the actual activity level times the actual variable overhead rate (AQ 3 AVR). Formula 2 above can be simplified as follows: 3. Variable-overhead spending variance 5 AQ(AVR 2 SVR) DCdesserts.com’s variable-overhead spending variance for September is computed as follows (using formula 1): Variable-overhead spending variance 5 Actual variable overhead 2 (AQ 3 SVR), 5 $34,650 2 (6,300 3 $5.00) 5 $3,150 Unfavorable This variance is unfavorable because the actual variable-overhead cost exceeded the expected amount, after adjusting that expectation for the actual number of process hours used. hiL25664_ch11_452-497.indd 462hiL25664_ch11_452-497.indd 462 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer Chapter 11 Flexible Budgeting and Analysis of Overhead Costs 463 Variable-Overhead Efficiency Variance As Exhibit 11–6 shows, the following formula defines the variable-overhead efficiency variance. Variable-overhead efficiency variance 5 (AQ 3 SVR) 2 (SQ 3 SVR) where SQ denotes standard allowed activity level (standard quantity of the activity measure) Writing this formula more simply, we have the following expression. Variable-overhead efficiency variance 5 SVR(AQ 2 SQ) DCdesserts.com’s variable-overhead efficiency variance for September is computed as follows: Variable-overhead efficiency variance 5 SVR(AQ 2 SQ) 5 $5.00(6,300 2 6,000) 5 $1,500 Unfavorable This variance is unfavorable because actual process hours exceeded standard allowed process hours, given actual output. Product Costing versus Cost Management Columns (1), (2), and (3) in Exhibit 11–6 are used to compute the variances for cost management purposes. Column (4) in the exhibit shows the variable overhead applied to work in process for the product-costing purpose. Notice that the variable-overhead cost on the flexible budget, $30,000, is the same as the amount applied to work in process. Graphing Variable-Overhead Variances Exhibit 11–7 provides a graphical analysis of DCdesserts.com’s variable-overhead variances for September. The graph shows the variable- overhead rate per process hour on the vertical axis. The standard rate is $5.00 per process hour, while the actual rate is $5.50 per process hour (actual variable-overhead cost of $34,650 divided by actual process hours of 6,300). Process hours are shown on the horizontal axis. The green area on the graph represents the flexible-budget amount for variable over- head, given actual September output of 2,000 multilayer fancy cakes. The large area on the graph enclosed by colored lines on the top and right sides represents actual variable- overhead cost. The colored area in between, representing the total variable-overhead variance, is divided into the spending and efficiency variances. Exhibit 11–6 Variable-Overhead Spending and Efficiency Variances (1) (2) (3) (4)† Flexible Budget: Variable Overhead Applied Actual Variable Overhead Projected Variable Overhead Variable Overhead to Work in Process Actual Actual Actual Standard Standard Allowed Standard Standard Allowed Standard Activity Level Rate Activity Level Rate Activity Level Rate Activity Level Rate (AQ) (AVR) (AQ) (SVR) (SQ) (SVR) (SQ) (SVR) 6,300 $5.50 per 6,300 $5.00 per 6,000 $5.00 per 6,000 $5.00 per process process process process process process process process hours hour* hours hour hours hour hours hour $34,650 $31,500 $30,000 $30,000 $3,150 Unfavorable $1,500 Unfavorable Variable-overhead Variable-overhead No difference spending variance efficiency variance * †Column (4) is not used to compute the variances. It is included to point out that the flexible-budget amount for variable overhead, $30,000, is the amount that will be applied to Work-in-Process Inventory for product-costing purposes. For variable overhead, columns (3) and (4) are always equal. Actual variable-overhead rate (AVR) Actual variable-overhead cost Actual process hours $34,650 6,300 $5.50 hiL25664_ch11_452-497.indd 463hiL25664_ch11_452-497.indd 463 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer 464 Chapter 11 Flexible Budgeting and Analysis of Overhead Costs Managerial Interpretation of Variable-Overhead Variances What do the vari- able-overhead variances mean? What information do they convey to management? The formulas for computing the variable-overhead variances resemble those used to compute the direct-cost variances. To see this, compare Exhibit 11–6 (variable overhead) with Exhibit 10–4 (direct labor). Despite the similar formulas, the interpretation of the variable-overhead variances is quite different from that applicable to the direct-labor variances. Efficiency Variance Recall that an unfavorable direct-labor efficiency variance results when more direct labor is used than the standard allowed quantity. Thus, direct labor has been used inefficiently, relative to the standard. However, that is not the proper interpreta- tion of an unfavorable variable-overhead efficiency variance. DCdesserts.com’s variable- overhead efficiency variance did not result from using more of the variable- overhead items, such as electricity and indirect material, than the standard allowed amount. Instead, this variance resulted when the division used more process hours than the standard quan- tity, given actual output. Recall that the company’s director of cost management chose process hours as the activity measure for overhead because variable-overhead costs vary in a pattern similar to that with which process hours vary. Since 300 more process hours were used than the standard quantity, the division’s management should expect that vari- able-overhead costs will be greater. Thus, the variable-overhead efficiency variance has nothing to do with efficient or inefficient usage of electricity, indirect material, and other variable-overhead items. This variance simply reflects an adjustment in the company’s expectation about variable-overhead costs, because the division used more than the stan- dard quantity of process hours. What is the important difference between direct labor and variable overhead that causes this different interpretation of the efficiency variance? Direct labor is a traceable cost and is budgeted on the basis of direct-labor hours. Variable overhead, on the other hand, is a pool of indirect costs that are budgeted on the basis of an activity measure, process hours. The indirect nature of variable-overhead costs causes the different interpretation. Spending Variance An unfavorable direct-labor rate variance is straightforward to interpret; the actual labor rate per hour exceeds the standard rate. Although the formula for computing the variable-overhead spending variance is similar to that for the direct- labor rate variance, its interpretation is quite different. Exhibit 11–7 Graphical Analysis of Variable- Overhead Variances (Actual) $5.50 0 Rate 6,000 (Standard) 6,300 (Actual) Activity level (process hours) Key: Total variable-overhead variance: blue areas Variable-overhead spending variance: dark blue area Variable-overhead efficiency variance: light blue area (Standard) $5.00 hiL25664_ch11_452-497.indd 464hiL25664_ch11_452-497.indd 464 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer Chapter 11 Flexible Budgeting and Analysis of Overhead Costs 465 An unfavorable spending variance simply means that the total actual cost of variable overhead is greater than expected, after adjusting for the actual quantity of process hours used. An unfavorable spending variance could result from paying a higher-than-expected price per unit for variable-overhead items. Or the variance could result from using more of the variable-overhead items than expected. Suppose, for example, that electricity were the only variable-overhead cost item. An unfavorable variable-overhead spending variance could result from paying a higher- than-expected price per kilowatt-hour for electricity, from using more than the expected amount of electricity, or from both. Management of Variable Overhead Costs Since the variable-overhead effi- ciency variance says nothing about efficient or inefficient usage of variable overhead, the spending variance is the real control variance for variable overhead. Managers can use the spending variance to alert them if variable-overhead costs are out of line with expectations. Fixed Overhead To analyze performance with regard to fixed overhead, the financial planning and analy- sis system calculates two fixed-overhead variances. Fixed-Overhead Budget Variance The variance used by managers to control fixed overhead is called the fixed-overhead budget variance . It is defined as follows: Fixed-overhead budget variance 5 Actual fixed overhead 2 Budgeted fixed overhead DCdesserts.com’s fixed-overhead budget variance for September is as follows: Fixed-overhead budget variance 5 Actual fixed overhead 2 Budgeted fixed overhead 5 $16,100 2 $15,000* 5 $1,100 Unfavorable *From the flexible budget ( Exhibit 11–3 ). The fixed-overhead budget variance is unfavorable, because the company spent more than the budgeted amount on fixed overhead. Notice that we need not specify an activity level to determine budgeted fixed overhead because, by definition, a fixed overhead cost is the same at every activity level. All three columns in the flexible budget ( Exhibit 11–3 ) specify $15,000 as budgeted fixed overhead. Fixed-Overhead Volume Variance The fixed-overhead volume variance is defined as follows: Fixed-overhead volume variance 5 Budgeted fixed overhead 2 Applied fixed overhead DCdesserts.com’s applied fixed overhead for September is $12,000: Applied fixed overhead 5 Predetermined fixed overhead rate 3 Standard allowed activity level (quantity of the activity measure) 5 $2.00 per process hour 3 6,000 process hours 5 $12,000 The $2.00 predetermined fixed-overhead rate was calculated in Exhibit 11–5 . The 6,000 standard allowed process hours is based on actual September production of 2,000 multi- layer fancy cakes, each with a standard allowance of three process hours. hiL25664_ch11_452-497.indd 465hiL25664_ch11_452-497.indd 465 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer 466 Chapter 11 Flexible Budgeting and Analysis of Overhead Costs DCdesserts.com’s fixed-overhead volume variance is calculated below. Fixed-overhead volume variance 5 Budgeted fixed overhead 2 Applied fixed overhead 5 $15,000 2 $12,000 5 $3,000 Unfavorable Managerial Interpretation of Fixed-Overhead Variances Exhibit 11–8 shows DCdesserts.com’s two fixed-overhead variances for September. The budget variance is the real control variance for fixed overhead, because it compares actual expenditures with budgeted fixed-overhead costs. The volume variance provides a way of reconciling two different purposes of the standard-costing system. For the control purpose, the system recognizes that fixed over- head does not change as production activity varies. Hence, budgeted fixed overhead is the same at all activity levels in the flexible budget. (Review Exhibit 11–3 to verify this.) Budgeted fixed overhead is the basis for controlling fixed overhead, because it provides the benchmark against which actual expenditures are compared. For the product-costing purpose of the system, budgeted fixed overhead is divided by planned activity to obtain a predetermined (or standard) fixed-overhead rate. For DCdesserts.com , this rate is $2.00 per process hour (budgeted fixed overhead of $15,000 divided by planned activity of 7,500 process hours). This predetermined rate is then used to apply fixed overhead to Work-in-Process Inventory. During any period in which the standard allowed number of process hours, given actual output, differs from the planned level of process hours, the budgeted fixed overhead differs from applied fixed overhead. Exhibit 11–9 illustrates this point graphically. Budgeted fixed overhead is constant at $15,000 for all levels of activity. However, applied fixed overhead increases with activ- ity, since fixed overhead is applied to Work-in-Process Inventory at the rate of $2.00 per standard allowed process hour. Notice that budgeted and applied fixed overhead are equal only if the number of standard allowed hours equals the planned activity level of 7,500 process hours. When this happens, there is no fixed-overhead volume variance. DCdes- serts.com has a $3,000 volume variance in September because the standard allowed hours and planned hours are different. Capacity Utilization A common, but faulty, interpretation of a positive volume vari- ance is that it measures the cost of underutilizing productive capacity. Some firms even designate a positive volume variance as unfavorable. The reasoning behind this view is Exhibit 11–8 Fixed-Overhead Budget and Volume Variances (1) (2) (3) Actual Budgeted Fixed Overhead Fixed Fixed Applied to Overhead Overhead Work in Process Standard Standard Allowed Fixed Activity Level Overhead Rate 6,000 $2.00 per process process hours hour $16,100 $15,000 $12,000 $1,100 Unfavorable $3,000 Unfavorable* Fixed-overhead Fixed-overhead budget variance volume variance *Consistent with our discussion of the fixed-overhead volume variance, some financial planning and analysis systems would designate a positive variance as “unfavorable.” hiL25664_ch11_452-497.indd 466hiL25664_ch11_452-497.indd 466 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer Chapter 11 Flexible Budgeting and Analysis of Overhead Costs 467 that the planned activity level used to compute the predetermined fixed-overhead rate is a measure of normal capacity utilization. Moreover, fixed-overhead costs, such as depre- ciation and property taxes, are costs incurred to create productive capacity. Therefore, the predetermined fixed-overhead rate measures the cost of providing an hour of productive capacity. If 7,500 process hours are planned, but output is such that only 6,000 standard process hours are allowed, then capacity has been underutilized by 1,500 hours. Since each hour costs $2.00 ( DCdesserts.com’s predetermined fixed-overhead rate), the cost of underutilization is $3,000 (1,500 3 $2.00), which is DCdesserts.com’s volume variance. The fault with this interpretation of the volume variance is that it ignores the real cost of underutilizing productive capacity. The real cost is due to the lost contribution margins of the products that are not produced when capacity is underutilized. Moreover, this inter- pretation fails to recognize that underutilizing capacity and reducing inventory may be a wise managerial response to slackening demand. For this reason, many managers interpret the volume variance merely as a way of rec- onciling the two purposes of the standard-costing system. Moreover, these managers would choose not to designate the volume variance as either favorable or unfavorable. However, some designate a positive volume variance as unfavorable. Their reasoning is that when the volume variance is closed into Cost of Goods Sold expense at the end of the accounting period (as explained in Appendix A), the effect is to increase Cost of Goods Sold, which in turn has an unfavorable effect on income. In contrast, other accountants argue that no sign (favorable or unfavorable) should be assigned to the fixed-overhead volume variance. Overhead Cost Performance Report The variable-overhead spending and efficiency variances and the fixed-overhead budget variance can be computed for each overhead cost item in the flexible budget. When these itemized variances are presented along with actual and budgeted costs for each over- head item, the result is an overhead cost performance report . DCdesserts.com’s perfor- mance report is displayed in Exhibit 11–10 . This report would be used by management to exercise control over each of the division’s overhead costs. Notice that the performance report includes spending and efficiency variances for the variable items, and only a budget variance for the fixed items. Upon receiving this report, a manager might investigate the relatively large variances for indirect maintenance labor, electricity, and production supervisory labor. Overhead Cost Performance Report Exhibit 11–9 Budgeted versus Applied Fixed Overhead Fixed overhead 6,000 7,500 Activity level (process hours) $12,000 Volume variance $3,000 $15,000 Standard allowed hours, given actual output Planned monthly activity, expressed in hours Budgeted fixed overhead Budgeted fixed overhead Applied fixed overhead in September Applied fixed overhead ($2.00 per standard allowed process hour) Learning Objective 11-6 Prepare an overhead cost performance report. hiL25664_ch11_452-497.indd 467hiL25664_ch11_452-497.indd 467 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer 468 Chapter 11 Flexible Budgeting and Analysis of Overhead Costs Activity-Based Flexible Budget The flexible budget shown in Exhibit 11–3 , which underlies our variance analysis for DCdesserts.com , is based on a single cost driver. Overhead costs that vary with respect to process hours are categorized as variable; all other overhead costs are treated as fixed. This approach is consistent with traditional, volume-based product-costing systems. Under the more accurate product-costing method called activity-based costing, several cost drivers are identified. 1 Costs that may appear fixed with respect to a sin- gle volume-based cost driver, such as process hours, may be variable with respect to some other cost driver. The activity-based costing approach also can be used as the basis for a flexible budget for planning and cost management purposes. Exhibit 11–11 displays an activity-based flexible budget for DCdesserts.com , using the same data as Exhibit 11–3 . Compare the conventional flexible budget ( Exhibit 11–3 ) and the activity-based flex- ible budget ( Exhibit 11–11 ). The key difference lies in the costs that were categorized as Activity-Based Flexible Budget Exhibit 11–10 Overhead Cost Performance Report: DCdesserts.com 1Activity-based costing is covered in Chapter 5. Learning Objective 11-7 Explain how an activity-based flexible budget differs from a conventional flexible budget. (1) (2) (3) (4) (5) (6) (7) Standard Rate per Process Hr. 6,300 Actual Flexible [variable costs Process Hr. Spending Efficiency Budget Budget only; col. (1) Variance Variance Variance (for 6,000 6,000 Standard Actual [col. (4) [col. (3) [col. (4) process hr.) process hr.] Rate Cost col. (3)] col. (1)] col. (1)] Variable costs: Indirect material: Nonstick cooking spray .................. $12,000 .............. .............. .............. .............. .............. .............. .............. .............. .............. .............. .............. .............. .............. .............. .............. .............. ..... ..... ..... ..... ..... ..... ..... ..... ..... .... ..... ..... ..... ..... ..... ..... ..... ..... ..... ..... ..... ..... ..... ..... $2.00 $12,600 $12,700 $ 100 U . $ 600 U Waxed paper ................................. 2,000 .33 2,079 2,090 11 U 79 U Other paper products ..................... 2,000 .33 2,079 2,000 (79) F 79 U Miscellaneous supplies .................. 6,000 1.00 6,300 6,500 200 U 300 U Indirect labor: Maintenance ................................. 4,000 .67 4,221 6,400 2,179 U 221 U Utilities: Electricity ...................................... 3,000 .50 3,150 4,050 900 U 150 U Natural gas ................................... 1,000 .17 1,071 910 (161) F 71 U Total variable cost .............................. $30,000 $5.00 $31,500 $34,650 $3,150 U $1,500 U Fixed costs: Indirect labor: Inspection ..................................... $ 2,200 ..................................................................... ..................................................................... ..................................................................... ..................................................................... ..................................................................... ..................................................................... ..................................................................... ..................................................................... ..................................................................... ..................................................... ..................................................... ..................................................... ..................................................... ..................................................... ..................................................... ..................................................... ..................................................... ..................................................... $ 2,210 . $ 10 U Production supervisors ................... 6,000 7,000 1,000 U Setup ............................................ 3,000 3,000 –0– Material handling ........................... 2,000 2,000 –0– Depreciation: Plant and equipment ...................... 500 500 –0– Insurance and property taxes .............. 100 100 –0– Test kitchen ....................................... 1,200 1,290 90 U Total fixed cost ................................... $15,000 $16,100 $1,100 U Total overhead cost ........................... $45,000 $50,750 $1,100 U Total variance between actual Sum of spending, efficiency, overhead cost and flexible budget $5,750 U and budget variances $5,750 U hiL25664_ch11_452-497.indd 468hiL25664_ch11_452-497.indd 468 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer Chapter 11 Flexible Budgeting and Analysis of Overhead Costs 469 COST MANAGEMENT SYSTEMS IN GERMANY Throughout the world, flexible budgeting is found in cost management systems as a means of controlling overhead costs. However, differences in terminology and design may be present in financial planning and control practices due to geographic varia- tions in the evolution of management practice or accounting philosophy. In Germany, for example, grenzplankostenrechnung (or “flexible standard costing”) exhibits many of the features illustrated in this chapter. Under the German approach, “each cost center distinguishes between variable costs (e.g., energy) and fixed costs (e.g., a manager’s sal- ary).” The number of machine hours is a common activity measure. “For purposes of cost planning and control, companies budget each cost center’s expenses and then distrib- ute the expenses to each month of the budget year. The budgeted costs are standards for efficient resource consumption. . . .” The cost and performance information “allows for effective discussions about productivity improvement” among department managers, managerial accountants, and plant managers. Among the companies using the flexible standard costing system is Stihl , a well- known German manufacturer of chain saws and other landscaping equipment. 2 “ABC provides a methodol- ogy for tracking costs by product and establishing more appropriate linkages of resources to products through the use of activity analysis.” (11c) Bluecross Blueshield of North Carolina fixed on the conventional flexible budget. These costs are fixed with respect to process hours but are not fixed with respect to other more appropriate cost drivers. For example, cost pool II includes inspection and setup costs, which vary with respect to the number of production runs. Effect on Performance Reporting The activity-based flexible budget provides a more accurate prediction (and benchmark) of overhead costs. For example, suppose that activity in December is as follows: Process hours ............................................................................................................... 6,000 December Production runs ............................................................................................................ 12 Activity New products tested ..................................................................................................... 40 Direct material handled (pounds) .................................................................................... 30,000 The following table compares the budgeted cost levels for several overhead items on the conventional and activity-based flexible budgets. Overhead Cost Item Conventional Flexible Budget Activity-Based Flexible Budget Electricity ............................................................................... $3,000 $3,000 Inspection .............................................................................. 2,200 3,300 Setup .................................................................................... 3,000 4,500 Test kitchen ........................................................................... 1,200 2,400 Material handling ................................................................... 2,000 3,000 Insurance and property taxes .................................................. 100 100 The budgeted electricity cost is the same on both budgets, because both use the same cost driver (process hours). Insurance and property taxes are also the same, because both bud- gets recognize these as facility-level fixed costs. However, the other overhead costs are budgeted at different levels, because the conventional and activity-based flexible budgets use different cost drivers for these items. While the conventional budget treats inspection, setup, test kitchen, and material-handling costs as fixed, the activity-based flexible bud- get shows that they are all variable with respect to the appropriate cost driver. “In the past decade, Whirlpool has faced increasing com- petition, higher overhead, and greater product diversity. Managers initiated and sup- ported ABC to obtain accurate information for dealing with these challenges.” (11d) Whirlpool Stihl, Inc. M A P anagement ccounting ractice 2 Kip R. Krumwiede, “Rewards and Realities of German Cost Accounting,” Strategic Finance 86, no. 10 (April 2005), pp. 27–34; Carl S. Smith, “Going for GPK,” Strategic Finance 86, no. 10 (April 2005), pp. 36–39; and Bernd Gaiser, “German Cost Management Systems,” Journal of Cost Management 11, no. 5 (September/October 1997), pp. 35–41. hiL25664_ch11_452-497.indd 469hiL25664_ch11_452-497.indd 469 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer 470 Chapter 11 Flexible Budgeting and Analysis of Overhead Costs “ABC has enhanced our clients’ ability to manage overhead costs through flex- ible budgeting systems.” (11e) A. T. Kearney DCDESSERTS.COM Monthly Flexible Overhead Budget Budgeted Cost Level of Activity Cost Pool I (cost driver: process hours) .................................. 6,000 7,500 9,000 Indirect material: Nonstick cooking spray ............................................................. $ 12,000 $ 15,000 $ 18,000 Waxed paper ............................................................................ 2,000 2,500 3,000 Other paper products ................................................................ 2,000 2,500 3,000 Miscellaneous supplies ............................................................. 6,000 7,500 9,000 Indirect labor: maintenance ........................................................... 4,000 5,000 6,000 Utilities: Electricity ................................................................................. 3,000 3,750 4,500 Natural gas ............................................................................... 1,000 1,250 1,500 Total of cost pool I ......................................................................... $ 30,000 $ 37,500 $ 45,000 Cost Pool II (cost driver: production runs) .............................. 8 12 16 Indirect labor: Inspection ................................................................................. $ 2,200 $ 3,300 $ 4,400 Setup ....................................................................................... 3,000 4,500 6,000 Total of cost pool II ........................................................................ $ 5,200 $ 7,800 $ 10,400 Cost Pool III (cost driver: new products tested) ...................... 20 30 40 Test kitchen .................................................................................. $ 1,200 $ 1,800 $ 2,400 Total of cost pool III ....................................................................... $ 1,200 $ 1,800 $ 2,400 Cost Pool IV (cost driver: pounds of material handled) .......... 20,000 30,000 40,000 Material handling .......................................................................... $ 2,000 $ 3,000 $ 4,000 Total of cost pool IV ....................................................................... $ 2,000 $ 3,000 $ 4,000 Cost Pool V (facility level costs) Indirect labor: production supervisors ............................................. $ 6,000 $ 6,000 $ 6,000 Depreciation: plant and equipment ................................................. 500 500 500 Insurance and property taxes ......................................................... 100 100 100 Total of cost pool V ........................................................................ $ 6,600 $ 6,600 $ 6,600 Total overhead cost ................................................................. $45,000 $56,700 $68,400 Exhibit 11–11 Activity-Based Flexible Budget: DCdesserts.com These differences are important for performance reporting. The activity-based flex- ible budget provides a more accurate benchmark against which to compare actual costs. Suppose the actual inspection cost in December is $3,000. Using the conventional flexible budget would result in an unfavorable variance of $800 ($3,000 2 $2,200). However, the activity-based flexible budget yields a favorable variance of $300 ($3,000 2 $3,300). To summarize, activity-based flexible budgeting provides a richer view of cost behavior and the underlying cost drivers, and it provides a valuable tool for cost management. Flexible Budgeting in the Service Industry All kinds of organizations benefit from the concept of a flexible budget. Like manufactur- ing firms, service-industry organizations incur overhead costs that vary with appropri- ately chosen cost drivers. At Cornell University, for example, the cost of operating the admissions department depends in part on the number of applicants. At GEICO Insurance Company, the cost of administering the claims department depends in part on the num- ber of claims. At the Mayo Clinic, the cost of operating the patient records department depends in part on the number of patients. Flexible Budgeting in the Service Industry hiL25664_ch11_452-497.indd 470hiL25664_ch11_452-497.indd 470 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer Chapter 11 Flexible Budgeting and Analysis of Overhead Costs 471 Exhibit 11–12 Flexible Budget: Upstate Auto Rentals 3 Key cost drivers used in activity-based flexible budgeting at Cornell University include the number of students enrolled and the number of student credit hours. For further reading on activity-based budgeting, see Jay Collins, “Advanced Use of ABM: Using ABC for Target Costing, Activity-Based Budgeting, and Benchmarking,” in Activity-Based Management: Arthur Andersen’s Lessons from the ABM Battlefield, ed. Steve Player and David E. Keys (New York: John Wiley & Sons, 1999), pp. 152–58. Let’s briefly turn our attention to Upstate Auto Rentals, a small automo- bile rental company in upstate New York. The company has four rental locations in and around Syracuse and specializes in short-term car rentals, primarily for local use when a customer’s car is in the repair shop. Upstate’s flexible budget is dis- played in Exhibit 11–12 . Notice that unlike DCdessert.com ’s flexible overhead bud- get, Upstate Auto Rentals’ flexible bud- get lists its operating expenses. All of this service industry firm’s costs are operating expenses. Upstate’s management has cho- sen two cost drivers for its activity-based flexible budget: the number of miles driven and the number of customer contracts. An activity-based flexible budget is based on many cost drivers. Think about the costs that are incurred at your college. The cost of staffing the college’s faculty, for example, depends on fac- tors such as the number of students enrolled, the number of courses offered, and the average class size. The cost of operating the admissions department would depend in part on the number of applicants. 3 hiL25664_ch11_452-497.indd 471hiL25664_ch11_452-497.indd 471 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer 472 Chapter 11 Flexible Budgeting and Analysis of Overhead Costs Some operating expenses (cost pool I in the flexible budget) vary with the number of miles driven by the rental cars. Automobile maintenance and tire replacement expenses increase as the cars drive more miles. Similarly, such operating expenses as insurance and leasing costs increase with the number of miles driven, because the company needs more cars on hand. Other operating expenses (cost pool II) vary with the number of cus- tomer contracts, regardless of how many miles each customer drives a rental car. Such expenses as rental reservations, filling out contracts, and cleaning up a rental car upon return depend on the number of times the cars are rented. Finally, some fixed operating expenses (cost pool III), such as the office managers’ salaries and rental charges on the office locations, do not vary with any cost driver. Upstate Auto Rentals’ management can use this flexible budget to predict operating expenses at varying levels of activity, as measured by the two cost drivers. Focus on Ethics MISSTATED STANDARDS AFFECT ACCURACY OF REPORTS The scenario described here, while placed in the context of a fictitious enterprise, is based on an actual situation that occurred at NuTone Housing Group, which at the time was a subsidiary of Scoville, Inc.* To set the stage, consider these facts about the standard-costing system in place at Shrood Division, a subsidiary of Gigantic Enterprises, Inc. Shrood Divi- sion manufactures a wide range of electric household products, such as lighting, fans, water pumps, and security systems. The division manufactures approxi- mately 10,000 products, made from over 70,000 com- ponents. Tom Cleverly has run the division in what he calls a hands-on manner for over a quarter century. When Shrood Division was acquired by Gigantic Enterprises a decade ago, Cleverly was at first unhappy with the merger, but it soon became apparent that Gigantic’s top management would let him run the business the way he was used to running it. Three aspects of Cleverly’s man- agement style are noteworthy. First, he insists on being involved in all major pricing decisions; he’s not a delega- tor. Second, he has developed a second-level manage- ment that is loyal and supportive of his approach. Third, he has refused to lower the direct-labor time standards for years, even though many productivity improvements have been made. At present, the actual direct-labor times are on average only about a third of the standard times. Moreover, since production overhead is applied on the basis of direct labor, both the standard direct-labor and the standard overhead costs are inflated relative to actual costs. The implications of this practice are that huge favor- able variances are experienced all year long in both direct labor and overhead. Cleverly has used these favorable variances to “manage the quarterly earnings” reported by Shrood Division to corporate. Cleverly has instructed his manager of accounting, Evan Twixt, to release just enough of the favorable variances into Cost of Goods Sold (CGS) on a quarterly basis to ensure that Shrood Division just meets its earnings target in the budget. Then, at the end of the year, the remainder of this large favorable variance is released into CGS, with the result that Shrood Division ends each year with fourth-quarter earnings far in excess of the target. Like a knight in shin- ing white armor, Shrood Division saves the day for Gigan- tic Enterprises year after year. Shrood has come to be known in corporate circles as “the jewel in the crown of Gigantic Enterprises.” Now for the conflict. Gigantic has hired a new corpo- rate controller, Jeffrey Fixit, whose charge is to introduce more consistency in the reporting methods of Gigantic’s various divisions. When Fixit visited Shrood Division and discovered what was going on, he tried to get Tom Clev- erly to instruct Evan Twixt to correct the direct-labor stan- dards to reflect attainable results (i.e., reality). Cleverly has refused, though, and Fixit doesn’t have the power to force him to do so. Meanwhile, poor Twixt is caught in the middle. * K. Merchant and L. Ferreira,“Scoville: NuTone Housing Group,” a management accounting case (Boston: President and Fellows of Harvard College). hiL25664_ch11_452-497.indd 472hiL25664_ch11_452-497.indd 472 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer 473 Here is what each of them had to say about the situation. Cleverly (division manager): “I’ve been running this business for 25 years. And you know what? We’ve been profitable for 25 years! The high labor standards help me make sure that neither I nor my salespeople shave prices too much. It’s like setting the clock 10 minutes ahead to make sure you’re not late. We always make budget. We always report the highest profits in the company. And we are, in fact, the ‘jewel in the crown.’” Fixit (corporate controller): “This is a really bad situation. Shrood is reporting fictitious num- bers to corporate on a quarterly basis, which then get rolled up into Gigantic’s quarterly results. Then these numbers get published to the shareholders. We’re misleading them. I don’t have the authority to get Tom Cleverly to fix the problem. I can, however, go to the board of directors and explain to them that they need to get Cleverly to do what needs to be done.” Twixt (Shrood’s accounting manager): “I’m caught in the middle. We basically have two sets of books: the ones based on Mr. Cleverly’s labor standards, and the ones based on the more accurate results that Mr. Fixit wants. I can report either set of results. I feel like I’m serv- ing two gods—and so far I’m getting away with it.” What do you make of this situation? Can a company that keeps two sets of books be well managed? What eth- ical issues do you see here? What actions should Cleverly, Twixt, and Fixit take? Chapter Summary LO11-1 Distinguish between static and flexible budgets and explain the advantages of a flexible overhead budget. A static budget is based on a single, predicted volume of production activity. A flexi- ble budget allows for many possible activity levels. The flexible overhead budget is based on some activ- ity measure that varies in a pattern similar to that of variable overhead. Management uses the amount of overhead cost specified by the flexible budget, given actual output, as a benchmark against which to compare actual overhead costs. LO11-2 Prepare a flexible overhead budget, using both a formula and a columnar format. A columnar flexible budget is based on several distinct activity levels, while a formula flexible budget is valid for a continuous range of activity. The flexible overhead budget is based on some activity measure that varies in a pattern similar to that of variable overhead. LO11-3 Explain how overhead is applied to Work-in-Process Inventory under standard costing. The amount of overhead cost entered into Work-in-Process Inventory is equal to the standard overhead rate multiplied by the standard allowed amount of the activity base, given actual output. LO11-4 Explain some important issues in choosing an activity measure for overhead budgeting and application. The flexible overhead budget is based on some activity measure that varies in a pat- tern similar to that of variable overhead. Machine hours, process time, and direct-labor hours are com- mon activity bases. LO11-5 Compute and interpret the variable-overhead spending and efficiency variances and the fixed overhead budget and volume variances. The variable-overhead spending variance calculates the effect on production cost of deviations between the actual and standard variable overhead rates. The variable-overhead efficiency variance calculates the effect on production cost of deviations between actual and standard amounts of the cost driver, multiplied by the standard variable overhead rate. The fixed overhead budget variance calculates the effect on production cost of deviations between actual and budgeted fixed overhead. The fixed overhead volume variance calculates the effect of deviations between budgeted and applied fixed overhead. LO11-6 Prepare an overhead cost performance report. The overhead cost performance report shows the actual and budgeted costs for each overhead item, along with the four overhead variances: the hiL25664_ch11_452-497.indd 473hiL25664_ch11_452-497.indd 473 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer 474 Chapter 11 Flexible Budgeting and Analysis of Overhead Costs variable-overhead spending and efficiency variances, and the fixed-overhead budget and volume vari- ances. These variances help management to control overhead costs. LO11-7 Explain how an activity-based flexible budget differs from a conventional flexible budget. In an activity-based flexible budget, each overhead item may have a different cost driver identified upon which the flexible overhead budget for that cost item is based. Such a flexible budget is more accurate than conventional flexible budgets, because multiple cost drivers are identified to explain the behavior of overhead costs. LO11-8 Prepare journal entries to record production overhead under standard costing (Appendix A). The left (debit) side of the production-overhead account accumulates actual overhead costs incurred. The right (credit) side of the overhead account records production overhead applied to Work-in-Process Inventory. The cumulative difference between the amounts on the left and right sides of the overhead account is equal to the sum of the four overhead variances. LO11-9 Compute and interpret the sales-price and sales-volume variances (Appendix B). The sales-price variance is the difference between the actual and budgeted sales prices multiplied by the actual sales volume. This variance measures the effect on sales revenue of sales price deviations. The sales- volume variance is the difference between the actual and budgeted sales volumes multiplied by the bud- geted sales price. This variance measures the effect on sales revenue of deviations in sales volume. Review Problem on Flexible Budgeting and Analysis of Overhead Costs In November, DCdesserts.com produced 3,000 multilayer fancy cakes, used 9,100 hours of process time, and incurred the following production-overhead costs. Variable overhead .................................................................................................................................. $45,955 Fixed overhead ...................................................................................................................................... $15,800 DCdesserts.com’s monthly flexible overhead budget for November is the same as that given in Exhibit 11–3 . Compute DCdesserts.com’s variable-overhead variances using the format shown in Exhibit 11–6 . Compute the company’s fixed-overhead variances using the format shown in Exhibit 11–8 . Solution to Review Problem The solution to the review problem is given in Exhibits 11–13 and 11–14 . (1) (2) (3) (4)† Flexible Budget: Variable Overhead Applied Actual Variable Overhead Projected Variable Overhead Variable Overhead to Work in Process Actual Actual Actual Standard Standard Allowed Standard Standard Allowed Standard Activity Level Rate Activity Level Rate Activity Level Rate Activity Level Rate (AQ) (AVR) (AQ) (SVR) (SQ) (SVR) (SQ) (SVR) 9,100 $5.05 per 9,100 $5.00 per 9,000 $5.00 per 9,000 $5.00 per process process process process process process process process hours hour* hours hour hours hour hours hour $45,955 $45,500 $45,000 $45,000 $455 Unfavorable $500 Unfavorable Variable-overhead Variable-overhead No difference spending variance efficiency variance * †Column (4) is not used to compute the variances. It is included to point out that the flexible-budget amount for variable overhead, $45,000, is the amount that will be applied to Work-in- Process Inventory for product-costing purposes. Actual variable-overhead rate (AVR) Actual variable-overhead cost Actual process hours $45,955 9,100 $5.05 Exhibit 11–13 Variable-Overhead Spend- ing and Efficiency Variances: Review Problem hiL25664_ch11_452-497.indd 474hiL25664_ch11_452-497.indd 474 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer Chapter 11 Flexible Budgeting and Analysis of Overhead Costs 475 Standard Costs and Product Costing In a standard-costing system, the standard costs are used for product costing as well as for cost control. The costs of direct material, direct labor, and production overhead are all entered into Work-in-Process Inventory at their standard costs. (Review Exhibit 11–4 .) Journal Entries under Standard Costing During September, DCdesserts.com incurred actual production-overhead costs of $50,750, which includes $34,650 of variable overhead and $16,100 of fixed overhead. A summary journal entry to record these actual expenditures follows. Production Overhead ................................................................................................ 50,750 Indirect-Material Inventory ................................................................................ 23,290* Wages Payable ................................................................................................ 20,610* Utilities Payable ............................................................................................... 4,960 Accumulated Depreciation ................................................................................ 500 Prepaid Insurance and Property Taxes ............................................................... 100 Test Kitchen Salaries Payable ........................................................................... 1,290 *The credit amounts can be verified in column (4) of Exhibit 11–10. For example, indirect-material costs amounted to $23,290 ($12,700 1 $2,090 1 $2,000 1 $6,500). The credit to Wages Payable is for indirect-labor costs, which amounted to $20,610 ($6,400 1 $2,210 1 $7,000 1 $3,000 1 $2,000). Exhibit 11–14 Fixed-Overhead Budget and Volume Variances: Review Problem variable-overhead efficiency variance, 462 variable-overhead spending variance, 462 (1) (2) (3) Actual Budgeted Fixed Overhead Fixed Fixed Applied to Overhead Overhead Work in Process Standard Standard Allowed Fixed Activity Level Overhead Rate 9,000 $2.00 per process process hours hour $15,800 $15,000 $18,000 $800 Unfavorable $3,000 Favorable* Fixed-overhead Fixed-overhead budget variance volume variance *Some financial planning and analysis systems would designate a negative fixed-overhead volume variance as “favorable.” Key Terms For each term’s definition refer to the indicated page, or turn to the glossary at the end of the text. activity-based flexible budget, 468 fixed-overhead budget variance, 465 fixed-overhead volume variance, 465 flexible budget, 455 overhead cost performance report, 467 sales-price variance, * 478 sales-volume variance, * 478 static budget, 455 total contribution margin, * 477 unit contribution margin, * 477 *Term appears in Appendix B. APPENDIX A TO CHAPTER 11 Learning Objective 11-8 Prepare journal entries to record production overhead under standard costing. hiL25664_ch11_452-497.indd 475hiL25664_ch11_452-497.indd 475 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer 476 Chapter 11 Flexible Budgeting and Analysis of Overhead Costs The application of production overhead to Work-in-Process Inventory is based on a predetermined overhead rate of $7.00 per process hour (the total of the variable and the fixed rates) and 6,000 standard allowed process hours, given an actual output of 2,000 multilayer fancy cakes. The summary journal entry is as follows: Work-in-Process Inventory ......................................................................................... 42,000 Production Overhead ........................................................................................ 42,000* *Applied overhead 5 $7.00 3 6,000 5 $42,000 Now the Production Overhead account appears as follows: Production Overhead Actual $50,750 $42,000 Applied The underapplied overhead for September is $8,750 ($50,750 2 $42,000). This means that the overhead applied to Work-in-Process Inventory in September was $8,750 less than the actual overhead cost incurred. Notice that the underapplied overhead is equal to the sum of the four overhead variances for September. The total of the four overhead variances will always be equal to the overapplied or under- applied overhead for the accounting period. 4 Disposition of Variances As explained in the preceding chapter, variances are temporary accounts, and most companies close them directly into Cost of Goods Sold at the end of each accounting period. The journal entry required to close out DCdesserts.com’s underapplied overhead for September is as follows: Cost of Goods Sold .................................................................................................. 8,750 Production Overhead ..................................................................................... 8,750 The journal entry to close out underapplied or overapplied overhead typically is made annually, rather than monthly. An alternative accounting treatment is to prorate underapplied or overapplied overhead among Work- in-Process Inventory, Finished-Goods Inventory, and Cost of Goods Sold, as explained in Chapter 3. A Note on Perishable Products and JIT Production Management Systems As noted in the preceding chapter, traditional manufacturing systems typically exhibit the cost flows explained in this section. Direct-material, direct-labor, and production-overhead costs are entered in Work-in-Process Inventory, from which they flow into Finished-Goods Inventory when the goods are finished, and then on into Cost of Goods Sold. Since DCdesserts.com produces perishable goods, which are produced and sold on the same day, a simpler procedure could be used. In DCdesserts.com’s case, the standard costs of direct material, direct labor, and production overhead could be entered directly into Cost of Goods Sold as they are incurred. This simplified procedure could be used, because the produc- tion process is very short and the goods are sold immediately. Thus, there is never any work-in-process inventory or finished-goods inventory on hand. Such situations are common with producers of perish- able goods. An analogous situation occurs in manufacturers that employ a just-in-time (JIT) production and inventory control system. In a JIT environment, raw materials are delivered just in time to be entered into production, and parts or components are manufactured in each stage of the production process just in time for the next production stage. Thus, like the case of perishable goods, there is little or no work- in-process or finished-goods inventory at any given time in a JIT environment. For this reason, many manufacturers that employ the JIT approach make use of highly simplified cost accounting procedures similar to those explained in the preceding paragraph for DCdesserts.com . 4Overapplied and underapplied production overhead in the manufacturing setting are discussed in Chapter 3. hiL25664_ch11_452-497.indd 476hiL25664_ch11_452-497.indd 476 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer Chapter 11 Flexible Budgeting and Analysis of Overhead Costs 477 APPENDIX B TO CHAPTER 11 Sales Variances The variances discussed in Chapters 10 and 11 focus on production costs. Companies also compute vari- ances to help management analyze the firm’s sales performance. To illustrate two commonly used sales variances, we will continue our discussion of DCdesserts.com . The expected sales price and standard variable cost for a multilayer fancy cake are as follows: Budgeted sales price ......................................................................................................................................... $38 Standard variable costs: Direct material .............................................................................................................................................. $ 7 Direct labor .................................................................................................................................................. 10 Variable overhead (3 process hours at $5 per hour) ......................................................................................... 15 Total unit variable cost ................................................................................................................................... $32 The difference between the sales price and the unit variable cost is called the unit contribution margin . DCdesserts.com’s unit contribution margin is $6 per multilayer fancy cake ($38 2 $32). This is the amount that the sale of one multilayer fancy cake contributes toward covering the company’s fixed costs and making a profit. During October, DCdesserts.com’s management expects to sell 1,500 multilayer fancy cakes. Based on this sales forecast, the controller computed the following budgeted total contribution margin . Budgeted sales revenue (1,500 multilayered fancy cakes 3 $38) .................................................................. $57,000 Budgeted variable costs (1,500 multilayered fancy cakes 3 $32) .................................................................. 48,000 Budgeted total contribution margin (1,500 multilayered fancy cakes 3 $6) .................................................... $ 9,000 The actual results for October were as follows: Actual sales volume ............................................................................................................................... 1,600 cakes Actual sales price ................................................................................................................................... $37 Actual unit variable cost ......................................................................................................................... $32 Using these actual results, the actual total contribution margin for October is as follows: Actual sales revenue (1,600 multilayered fancy cakes 3 $37) ....................................................................... $59,200 Actual variable costs (1,600 multilayered fancy cakes 3 $32) ........................................................................ 51,200 Actual total contribution margin (1,600 multilayered fancy cakes 3 $5) .......................................................... $ 8,000 DCdesserts’ actual and budgeted results for October are summarized in the following table. Notice that actual sales revenue exceeded budgeted sales revenue by $2,200. However, this favorable vari- ance was more than offset by the additional $3,200 in variable costs resulting from actual sales volume exceeding budgeted sales volume. So the actual total contribution margin was $1,000 less than the bud- geted total contribution margin, as the table shows. Budget Actual Variance Revenue ....................................... $57,000 $59,200 $2,200 F Variable costs ............................... 48,000 51,200 3,200 U Contribution margin ...................... $ 9,000 $ 8,000 $1,000 U The financial planning and analysis system computes two sales variances to explain the $2,200 favorable variance in sales revenue. These variances are defined and computed as follows: Sales-price variance 5 ( Actual sales price 2 Budgeted sales price ) 3 Actual sales volume 5 ($37 2 $38) 3 1,600 5 $1,600 Unfavorable Learning Objective 11-9 Compute and interpret the sales-price and sales-volume variances. hiL25664_ch11_452-497.indd 477hiL25664_ch11_452-497.indd 477 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer 478 Chapter 11 Flexible Budgeting and Analysis of Overhead Costs Sales-volume variance 5 ( Actual sales volume 2 Budgeted sales volume ) 3 Budgeted sales price 5 (1,600 2 1,500) 3 $38 5 $3,800 Favorable Together, the sales-price and sales-volume variances explain the $2,200 favorable variance between actual and budgeted sales revenue. Sales-price variance ................................................................................................................. $1,600 Unfavorable Sales-volume variance ............................................................................................................. 3,800 Favorable Variance between actual and budgeted sales revenue ................................................................ $2,200 Favorable We have only just introduced sales variance analysis here. This topic is covered more extensively in cost management textbooks. 5 5 For example, see Ronald W. Hilton, Michael W. Maher, and Frank H. Selto, Cost Management: Strategies for Business Decisions, 4th ed. (New York: McGraw-Hill/Irwin, 2008), pp. 728–735. Review Questions 11–1. Distinguish between static and flexible budgets. 11–2. Explain the advantage of using a flexible budget. 11–3. Why are flexible overhead budgets based on activity measures, such as hours of process time, machine time, or direct-labor hours? 11–4. Distinguish between a columnar and a formula flexible budget. 11–5. Show, using T-accounts, how production overhead is added to Work-in-Process Inventory when standard costing is used. 11–6. How have advances in manufacturing technology affected overhead application? 11–7. What is the interpretation of the variable-overhead spending variance? 11–8. Jeffries Company’s only variable-overhead cost is elec- tricity. Does an unfavorable variable-overhead spending variance imply that the company paid more than the anticipated rate per kilowatt-hour? 11–9. What is the interpretation of the variable-overhead effi- ciency variance? 11–10. Distinguish between the interpretations of the direct- labor and variable-overhead efficiency variances. 11–11. What is the fixed-overhead budget variance? 11–12. What is the correct interpretation of the fixed-overhead volume variance? 11–13. Describe a common but misleading interpretation of the fixed-overhead volume variance. Why is this interpreta- tion misleading? 11–14. Draw a graph showing budgeted and applied fixed overhead, and show an unfavorable (or positive) volume variance on the graph. 11–15. What types of organizations use flexible budgets? 11–16. What is the conceptual problem of applying fixed production overhead as a product cost? 11–17. Distinguish between the control purpose and the product-costing purpose of standard costing and flexible budgeting. 11–18. Why are fixed-overhead costs sometimes called capac- ity-producing costs? 11–19. Draw a graph showing both budgeted and applied variable overhead. Explain why the graph appears as it does. 11–20. Give one example of a plausible activity base to use in flexible budgeting for each of the following orga- nizations: an insurance company, an express deliv- ery service, a restaurant, and a state tax-collection agency. 11–21. Explain how an activity-based flexible budget differs from a conventional flexible budget. hiL25664_ch11_452-497.indd 478hiL25664_ch11_452-497.indd 478 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer Chapter 11 Flexible Budgeting and Analysis of Overhead Costs 479 Exercises The following data are the actual results for Marvelous Marshmallow Company for August. Actual output ..................................................................................................................... 13,500 cases Actual variable overhead .................................................................................................... $607,500 Actual fixed overhead ......................................................................................................... $183,000 Actual machine time .......................................................................................................... 60,750 machine hours Standard cost and budget information for Marvelous Marshmallow Company follows: Standard variable-overhead rate .......................................................................... $9.00 per machine hour Standard quantity of machine hours ..................................................................... 4 hours per case of marshmallows Budgeted fixed overhead ..................................................................................... $180,000 per month Budgeted output ................................................................................................. 15,000 cases per month Required: 1. Use any of the methods explained in the chapter to compute the following variances. Indicate whether each variance is favorable or unfavorable, where appropriate. a. Variable-overhead spending variance. b. Variable-overhead efficiency variance. c. Fixed-overhead budget variance. d. Fixed-overhead volume variance. 2. Build a spreadsheet: Construct an Excel spreadsheet to solve the preceding requirement. Show how the solution will change if the following information changes: actual output was 13,350 cases, and actual variable overhead was $609,000. Mankato Control Company, which manufactures electrical switches, uses a s tandard-costing system. The standard production overhead costs per switch are based on direct-labor hours and are as follows: Variable overhead (5 direct-labor hours @ $12.00 per hour) .......................................................................... $ 60 Fixed overhead (5 direct-labor hours @ $18.00 per hour)* ............................................................................. 90 Total overhead ......................................................................................................................................... $150 *Based on practical capacity of 300,000 direct-labor hours per month. The following information is available for the month of October. • Variable overhead costs were $3,510,000. • Fixed overhead costs were $5,625,000. • 56,000 switches were produced, although 60,000 switches were scheduled to be produced. • 275,000 direct-labor hours were worked at a total cost of $3,825,000. Required: Compute the variable-overhead spending and efficiency variances and the fixed-overhead budget and volume variances for October. Indicate whether a variance is favorable or unfavorable where appropriate. (CMA, adapted) Outdoor Optics Company produces binoculars of two quality levels: f ield and professional. The field model requires four direct-labor hours, while the professional binoculars require six hours. The firm uses direct-labor hours as the activity level for flexible budgeting. Required: 1. How many standard hours are allowed in May, when 300 field models and 400 professional binoculars are manufactured? 2. Suppose the company based its flexible overhead budget for May on the number of binoculars manufactured, which is 700. What difficulties would this approach cause? ■ Exercise 11–22 Straightforward Computation of Overhead Variances (LO 11-5) ■ Exercise 11–23 Overhead Variances (LO 11-5) ■ Exercise 11–24 Standard Hours Allowed; Flexible Budgeting; Multiple Products (LO 11-1, 11-2) All applicable Exercises are available with McGraw-Hill’s Connect Accounting®. hiL25664_ch11_452-497.indd 479hiL25664_ch11_452-497.indd 479 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer 480 Chapter 11 Flexible Budgeting and Analysis of Overhead Costs Starlig h t Glassware Company has the following standards and flexible-budget data. Standard variable-overhead rate ...................................................................... $18.00 per direct-labor hour Standard quantity of direct labor ...................................................................... 2 hours per unit of output Budgeted fixed overhead ................................................................................. $300,000 Budgeted output ............................................................................................. 25,000 units Actual results for February are as follows: Actual output ................................................................................................... 20,000 units Actual variable overhead .................................................................................. $960,000 Actual fixed overhead ....................................................................................... $291,000 Actual direct labor ............................................................................................ 50,000 hours Required: Use the variance formulas to compute the following variances. Indicate whether each vari- ance is favorable or unfavorable, where appropriate. 1. Variable-overhead spending variance. 2. Variable-overhead efficiency variance. 3. Fixed-overhead budget variance. 4. Fixed-overhead volume variance. Refer to the data in the preceding exercise. Use diagrams similar to those in Exhibits 11–6 and 11–8 to compute (1) the variable-overhead spending and efficiency variances, and (2) the fixed-overhead budget and volume variances. Refer to the data in Exercise 11–25 for Starlight Glassware Company. Draw graphs similar to those in Exhibit 11–7 (variable overhead) and Exhibit 11–9 (fixed overhead) to depict the overhead variances. You recently received the f ollowing note from the production supervisor of the company where you serve as controller. “I don’t understand these crazy variable-overhead efficiency variances. My employ- ees are very careful in their use of electricity and production supplies, and we use very little indirect labor. What are we supposed to do?” Write a brief memo responding to the production supervisor’s concern. Choose a c ity or state in the United States (or a Canadian city or province), and use the Internet to explore the annual budget for the governmental unit you selected. For example, you could check out the annual budget for Los Angeles at www.losangeles.com , or the state of Florida at www.ebudget.state. fl.us . Required: 1. Select three items in the budget and explain how these items would be treated if the budget were converted to an activity-based flexible budget. 2. What would be appropriate cost drivers for the budgetary items you selected? Refer to D Cdesserts.com’s activity-based flexible budget in Exhibit 11–11 . Suppose that the company’s activity in June is described as follows: Process hours ........................................................................................................................................... 9,000 Production runs ........................................................................................................................................ 12 New products tested ................................................................................................................................. 40 Direct material handled (pounds) ................................................................................................................ 30,000 ■ Exercise 11–25 Straightforward Computation of Overhead Variances (LO 11-5) ■ Exercise 11–26 Diagram of Overhead Variances (LO 11-5) ■ Exercise 11–27 Graphing Overhead Variances (LO 11-5) ■ Exercise 11–28 Interpretation of Variable- Overhead Efficiency Variance (LO 11-5) ■ Exercise 11–29 City or State Budget; Activity- Based Flexible Budget; Cost Drivers; Use of Internet (LO 11-4, 11-7) ■ Exercise 11–30 Activity-Based Flexible Budget (LO 11-2, 11-7) hiL25664_ch11_452-497.indd 480hiL25664_ch11_452-497.indd 480 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer Chapter 11 Flexible Budgeting and Analysis of Overhead Costs 481 Required: 1. Determine the flexible budgeted cost for each of the following: a. Indirect material d. Test kitchen b. Utilities e. Material handling c. Inspection f. Total overhead cost 2. Compute the variance for setup cost during the month, assuming that the actual setup cost was $3,500: a. Using the activity-based flexible budget. b. Using DCdesserts.com’s conventional flexible budget ( Exhibit 11–3 ). You brought your work home one evening, and your nephew spilled his chocolate m ilk shake on the variance report you were preparing. Fortunately, knowing that overhead was applied based on machine hours, you were able to reconstruct the obliterated information from the remaining data. Fill in the miss- ing numbers below. ( Hint: It is helpful to solve for the unknowns in the order indicated by the letters in the following table.) Budgeted fixed overhead ................................................................................................................ $ 25,000 Actual fixed overhead ..................................................................................................................... a Budgeted production in units .......................................................................................................... 12,500 Actual production in units ............................................................................................................... c Standard machine hours per unit of output ...................................................................................... 4 hours Standard variable-overhead rate per machine hour ........................................................................... $8.00 Actual variable-overhead rate per machine hour .............................................................................. b Actual machine hours per unit of output .......................................................................................... d Variable-overhead spending variance ............................................................................................... $ 36,000 U Variable-overhead efficiency variance .............................................................................................. $ 96,000 F Fixed-overhead budget variance ...................................................................................................... $ 7,500 U Fixed-overhead volume variance ..................................................................................................... g Total actual overhead ..................................................................................................................... $356,500 Total budgeted overhead (flexible budget) ........................................................................................ e Total budgeted overhead (static budget) .......................................................................................... f Total applied overhead ................................................................................................................... $408,000 The controller for Rainbow Children’s Hospital, located in Munich, Germany, estimates t hat the hospital uses 25 kilowatt-hours of electricity per patient-day, and that the electric rate will be €.13 per kilowatt- hour. The hospital also pays a fixed monthly charge of €2,000 to the electric utility to rent emergency backup electric generators. * Required: Construct a flexible budget for the hospital’s electricity costs using each of the following techniques. 1. Formula flexible budget. 2. Columnar flexible budget for 30,000, 40,000, and 50,000 patient-days of activity. List variable and fixed electricity costs separately. Refer to the data in Exercise 11–25 for Starlight Glassware Company. Prepare journal e ntries to: • Record the incurrence of actual variable overhead and actual fixed overhead. • Add variable and fixed overhead to Work-in-Process Inventory. • Close underapplied or overapplied overhead into Cost of Goods Sold. ■ Exercise 11–31 Reconstruct Missing Informa- tion from Partial Data (LO 11-2, 11-5) ■ Exercise 11–32 Construct a Flexible Overhead Budget; Hospital (LO 11-1, 11-2) ■ Exercise 11–33 Journal Entries for Overhead (Appendix A) (LO 11-8) *The European monetary unit €, the euro, is used by most European countries. hiL25664_ch11_452-497.indd 481hiL25664_ch11_452-497.indd 481 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer 482 Chapter 11 Flexible Budgeting and Analysis of Overhead Costs The following data pertain to Alexis E lectronics for the month of April. Static Budget Actual Units sold ........................................................................................... 15,000 13,500 Sales revenue ..................................................................................... $180,000 $155,250 Variable production cost ...................................................................... 60,000 54,000 Fixed production cost .......................................................................... 30,000 30,000 Variable selling and administrative cost ................................................ 15,000 13,500 Fixed selling and administrative cost .................................................... 15,000 15,000 Required: Compute the sales-price and sales-volume variances for April. ■ Exercise 11–34 Sales Variances (Appendix B) (LO 11-9) Problems Manitoba Paper C ompany packages paper for photocopiers. The company has developed standard over- head rates based on a monthly practical capacity of 90,000 direct-labor hours as follows: Standard costs per unit (one box of paper): Variable overhead (2 hours @ $6) ................................................................................................................ $12 Fixed overhead (2 hours @ $10) ...................................................................................................................... 20 Total ........................................................................................................................................................... $32 During June, 45,000 units were scheduled for production; however, only 40,000 units were actually produced. The following data relate to June. 1. Actual overhead incurred totaled $1,371,500, of which $511,500 was variable and $860,000 was fixed. 2. Actual direct-labor cost incurred was $1,567,500 for 82,500 actual hours of work. Required: Prepare two exhibits similar to Exhibits 11–6 and 11–8 in the chapter, which show the fol- lowing variances. State whether each variance is favorable or unfavorable, where appropriate. 1. Variable-overhead spending variance. 2. Variable-overhead efficiency variance. 3. Fixed-overhead budget variance. 4. Fixed-overhead volume variance. (CMA, adapted) Countrytime Studios is a r e cording studio in Nashville. The studio budgets and applies overhead costs on the basis of production time. Countrytime’s controller anticipates 10,000 hours of production time to be available during the year. The following overhead amounts have been budgeted for the year. Variable overhead ..................................................................................................................................... $80,000 Fixed overhead ......................................................................................................................................... 90,000 Required: 1. Draw two graphs, one for variable overhead and one for fixed overhead. The variable on the horizontal axis of each graph should be production time in hours, ranging from 5,000 to 15,000 hours. The variable on the vertical axis of each graph should be overhead cost (variable or fixed). Each graph should include lines representing the flexible-budget amount of overhead and applied overhead. ■ Problem 11–35 Straightforward Overhead Variances (LO 11-5) Actual variable-overhead rate: $6.20 per direct-labor hour Budgeted fixed overhead: $900,000 ■ Problem 11–36 Graphing Budgeted and Applied Overhead; Recording Studio (LO 11-1, 11-2, 11-3) All applicable Problems are available with McGraw-Hill’s Connect Accounting ®. hiL25664_ch11_452-497.indd 482hiL25664_ch11_452-497.indd 482 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer Chapter 11 Flexible Budgeting and Analysis of Overhead Costs 483 2. Write a brief memo to Countrytime Studio’s general manager, explaining the graphs so that she will understand the concepts of budgeted and applied overhead. Wilmington Composites, Inc., developed its overhead application rate f rom the annual budget. The bud- get is based on an expected total output of 720,000 units requiring 3,600,000 machine hours. The com- pany is able to schedule production uniformly throughout the year. The cost driver for overhead costs is machine hours. A total of 66,000 units requiring 315,000 machine hours were produced during March. Actual overhead costs for March amounted to $750,000. The actual costs, as compared to the annual budget and to one-twelfth of the annual budget, are as follows: WILMINGTON COMPOSITES, INC. Annual Budget Total Amount Per Unit Per Machine Hour Monthly Budget Actual Costs for March Variable overhead: Indirect material ........ $2,448,000 $ 3.40 $ .68 $204,000 $222,000 Indirect labor ............ 1,800,000 2.50 .50 150,000 150,000 Fixed overhead: Supervision .............. 1,296,000 1.80 .36 108,000 102,000 Utilities ..................... 1,080,000 1.50 .30 90,000 108,000 Depreciation ............. 2,016,000 2.80 .56 168,000 168,000 Total .................... $8,640,000 $12.00 $2.40 $720,000 $750,000 Required: 1. Prepare a schedule showing the following amounts for Wilmington Composites, Inc., for March. a. Applied overhead costs. b. Variable-overhead spending variance. c. Fixed-overhead budget variance. d. Variable-overhead efficiency variance. e. Fixed-overhead volume variance. Where appropriate, be sure to indicate whether each variance is favorable or unfavorable. 2. Draw a graph similar to Exhibit 11–7 to depict the variable-overhead variances. 3. Why does your graph differ from Exhibit 11–7 , other than the fact that the numbers differ? (CMA, adapted) Rock Solid Insurance Company uses a flexible overhead budget for its a pplication-processing department. The firm offers five types of policies, with the following standard hours allowed for clerical processing. Automobile ........................................................................................................................................... 1 hour Renter’s ............................................................................................................................................... 1.5 hours Homeowner’s ....................................................................................................................................... 2 hours Health .................................................................................................................................................. 2 hours Life ...................................................................................................................................................... 5 hours The following numbers of insurance applications were processed during May. Automobile ................................................................................................................................................... 375 Renter’s ....................................................................................................................................................... 300 Homeowner’s ............................................................................................................................................... 150 Health .......................................................................................................................................................... 600 Life .............................................................................................................................................................. 300 The controller estimates that the variable-overhead rate in the application-processing department is $5.00 per hour, and that fixed-overhead costs will amount to $3,000 per month. ■ Problem 11–37 Overhead Variances (LO 11-5) 1(a). Applied overhead costs: $792,000 ■ Problem 11–38 Standard Hours Allowed; Flex- ible Budget; Multiple Prod- ucts; Insurance Company (LO 11-1, 11-2, 11-4) 1. Total standard clerical hours allowed, 3,825 hiL25664_ch11_452-497.indd 483hiL25664_ch11_452-497.indd 483 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer 484 Chapter 11 Flexible Budgeting and Analysis of Overhead Costs Required: 1. How many standard clerical hours are allowed in May, given actual application activity? 2. Why would it not be sensible to base the company’s flexible budget on the number of applications processed instead of the number of clerical hours allowed? 3. Construct a formula flexible-overhead budget for the company. 4. What is the flexible budget for total overhead cost in May? Lackawanna L icorice Company uses a standard cost accounting system and applies production overhead to products on the basis of machine hours. The following information is available for the year just ended: Actual variable overhead: $166,320 Actual total overhead: $467,700 Actual machine hours worked: 23,100 Standard variable-overhead rate per hour: $7.50 Standard fixed-overhead rate per hour: $12.00 Planned activity during the period: 20,000 machine hours Actual production: 10,700 finished units Machine-hour standard: Two completed units per machine hour Required: 1. Calculate the budgeted fixed overhead for the year. 2. Compute the variable-overhead spending variance. 3. Calculate the company’s fixed-overhead volume variance. 4. Did the company spend more or less than anticipated for fixed overhead? How much? 5. Was variable overhead underapplied or overapplied during the year? By how much? 6. On the basis of the data presented, does it appear that the company suffered a lengthy strike during the year by its production workers? Briefly explain. Midwest V entilation, Inc., produces industrial ventilation fans. The company plans to manufacture 72,000 fans evenly over the next quarter at the following costs: direct material, $2,880,000; direct labor, $720,000; variable production overhead, $900,000; and fixed production overhead, $1,800,000. The fixed-overhead amount includes $144,000 of straight-line depreciation and $216,000 of supervisory salaries. Shortly after the conclusion of the quarter’s first month, Midwest reported the following costs: Direct material ................................................................................................................................... $ 865,000 Direct labor ....................................................................................................................................... 221,200 Variable production overhead .............................................................................................................. 304,000 Depreciation ...................................................................................................................................... 48,000 Supervisory salaries ........................................................................................................................... 75,600 Other fixed production overhead ......................................................................................................... 478,000 Total .............................................................................................................................................. $1,991,800 Dave Kellerman and his crews turned out 20,000 fans during the month—a remarkable feat given that the firm’s manufacturing plant was closed for several days because of storm damage and flooding. Kellerman was especially pleased with the fact that overall financial performance for the period was favorable when compared with the budget. His pleasure, however, was very short-lived, as Midwest’s general manager issued a stern warning that performance must improve, and improve quickly, if Kellerman had any hopes of keeping his job. Required: 1. Explain the difference between a static budget and a flexible budget. 2. Which of the two budgets would be more useful when planning the company’s cash needs over a range of activity? 3. Prepare a performance report that compares budgeted and actual costs for the period just ended (i.e., the report that Kellerman likely used when assessing his performance). 4. Prepare a performance report that compares budgeted and actual costs for the period just ended (i.e., the report that the general manager likely used when assessing Kellerman’s performance). ■ Problem 11–39 Overhead Calculations; Variance Interpretation (LO 11-5) 3. Standard machine hours allowed: 5,350 hours 5. Applied overhead: $40,125 ■ Problem 11–40 Budgets and Performance Evaluation (LO 11-1, 11-6) 3. Direct material used: $40.00 per unit 4. Total variance: $141,800 U hiL25664_ch11_452-497.indd 484hiL25664_ch11_452-497.indd 484 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer Chapter 11 Flexible Budgeting and Analysis of Overhead Costs 485 5. Which of the two reports is preferred? Should Kellerman be praised for outstanding performance or is the general manager’s warning appropriate? Explain, citing any apparent problems for the firm. Valley View Hospital has an outpatient clinic. Jeffrey Harper, the hospital’s chief administrator, is v ery concerned about cost control and has asked that performance reports be prepared that compare budgeted and actual amounts for medical assistants, clinic supplies, and lab tests. Past financial studies have shown that the cost of clinic supplies used is driven by the number of medical assistant labor hours worked, whereas lab tests are highly correlated with the number of patients served. The following information is available for June: • Lab tests: Actual lab tests for June cost $159,027 and averaged 3.3 per patient. Each patient is anticipated to have three lab tests, at an average budgeted cost of $65 per test. • Medical assistants: Valley View’s standard wage rate is $14 per hour, and each assistant is expected to spend 30 minutes with a patient. Assistants totaled 420 hours in helping the 790 patients seen, at an average pay rate of $15.50 per hour. • Clinic supplies: The cost of clinic supplies used is budgeted at $12 per labor hour, and the actual cost of supplies used was $4,575. Required: 1. Prepare a report that shows budgeted and actual costs for the 790 patients served during June. Compute the differences (variances) between these amounts and label them as favorable or unfavorable. 2. On the basis of your answer to requirement (1), determine whether Valley View Hospital has any significant problems with respect to clinic supplies and lab tests. Briefly discuss your findings. 3. By performing a detailed analysis, determine the spending and efficiency variances for lab tests. Does it appear that Valley View Hospital has any significant problems with the cost of its lab tests? Briefly explain. ( Hint: In applying the overhead variance formulas, think of the number of tests as the activity level, and think of the cost per test as analogous to the variable overhead rate.) 4. Compare the lab test variance computed in requirement (1), a flexible-budget variance, with the sum of the variances in requirement (3). Discuss your findings and explain the relationship of flexible-budget variances and standard cost variances for variable overhead. LakeMaster Company manufactures outboard motors that are sold throughout the U nited States and Canada. The company uses a comprehensive budgeting process and compares actual results to budgeted amounts on a monthly basis. Each month, LakeMaster’s accounting department prepares a variance analysis and distributes the report to all responsible parties. Al Richmond, production manager, is upset about the results for June. Richmond, who is responsible for the cost of goods manufactured, has imple- mented several cost-cutting measures in the manufacturing area and is discouraged by the unfavorable variance in variable costs. LAKEMASTER COMPANY Operating Results For the Month of June Budget Actual Variance Units sold ..................................................................... 5,000 4,800 200 U Revenue ....................................................................... $1,800,000 $1,728,000 $ 72,000 U Variable cost ................................................................. 1,140,000 1,170,000 30,000 U Contribution margin .................................................. $ 660,000 $ 558,000 $102,000 U Fixed overhead ............................................................. 270,000 270,000 — Fixed general and administrative cost ............................. 180,000 172,500 7,500 F Operating income ..................................................... $ 210,000 $ 115,500 $ 94,500 U When the master budget was prepared, LakeMaster’s cost accountant, Joan Ballard, supplied the following unit costs: direct material, $90; direct labor, $66; variable overhead, $54; and variable selling, $18. ■ Problem 11–41 Linkages between the Flexible Budget and Variances (LO 11-1, 11-2, 11-5) 1. Lab tests, variance: $4,977 U 3. Variable-overhead effi- ciency variance: $15,405 U ■ Problem 11–42 Flexible Budgeting; Variances; Impact on Behavior (LO 11-1, 11-2, 11-5) 1. Flexible budget, operating income: $183,600 2. Flexible-budget variance, operating income: $68,100 U Ex hiL25664_ch11_452-497.indd 485hiL25664_ch11_452-497.indd 485 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer 486 Chapter 11 Flexible Budgeting and Analysis of Overhead Costs The total variable costs of $1,170,000 for June include $480,000 for direct material, $288,000 for direct labor, $264,000 for variable overhead, and $138,000 for variable selling expenses. Ballard believes that monthly reports would be more meaningful to everyone if the company adopted flexible budgeting and prepared more detailed analyses. Required: 1. Prepare a flexible budget for LakeMaster Company for the month of June that includes separate variable-cost budgets for each type of cost (direct material, etc.). 2. Determine the variance between the flexible budget and actual cost for each cost item. 3. Discuss how the revised budget and variance data are likely to impact the behavior of Al Rich- mond, the production manager. 4. Build a spreadsheet: Construct an Excel spreadsheet to solve requirements (1) and (2) above. Show how the solution will change if the following information changes: actual sales amounted to 4,700 units, and actual fixed overhead was $272,000. (CMA, adapted) Vermont Sky T ours is a small sightseeing tour company based in Burlington, Vermont. The firm special- izes in aerial tours of the New England countryside during September and October, when the fall color is at its peak. Until recently, the company had no accounting department. Routine bookkeeping tasks, such as billing, were handled by an individual who had little formal training in accounting. As the business began to grow, however, the owner recognized the need for more formal accounting procedures. Jacque- line Frost was recently hired as the new controller, and she will have the authority to hire an assistant. During her first week on the job, Frost was given the following performance report. The report was prepared by Red Leif, the company’s manager of aircraft operations, who was planning to present it to the owner the next morning. “Look at these favorable variances for fuel and so forth,” Leif pointed out, as he showed the report to Frost. “My operations people are really doing a great job.” Later that day, Frost looked at the performance report more carefully. She immediately realized that it was improperly prepared and would be misleading to the company’s owner. VERMONT SKY TOURS Performance Report For the Month of September Formula Flexible Budget (per air mile) Actual (32,000 air miles) Static Budget (35,000 air miles) Variance Passenger revenue .......................... $10.50 $336,000 $367,500 $31,500 U Less: Variable expenses: Fuel ............................................. 1.50 $ 51,000 $ 52,500 $ 1,500 F Aircraft maintenance .................... 2.25 70,500 78,750 8,250 F Flight crew salaries ....................... 1.20 39,300 42,000 2,700 F Selling and administrative ............ 2.40 74,700 84,000 9,300 F Total variable expenses ............. $ 7.35 $235,500 $257,250 $21,750 F Contribution margin ......................... $ 3.15 $100,500 $110,250 9,750 U Per Month Less: Fixed expenses: Depreciation on aircraft ...................... $ 8,700 $ 8,700 $ 8,700 $ 0 Landing fees ..................................... 2,700 3,000 2,700 300 U Supervisory salaries ........................... 27,000 25,800 27,000 1,200 F Selling and administrative .................. 33,000 37,200 33,000 4,200 U Total fixed expenses ....................... $71,400 $ 74,700 $ 71,400 $ 3,300 U Operating income .............................. $ 25,800 $ 38,850 $13,050 U ■ Problem 11–43 Preparing and Using a Colum- nar Flexible Budget; Tour Company; Ethical Issues (LO 11-1, 11-2, 11-6) 1. Activity level (32,000 air miles), total expenses: $306,600 4. Variance, total expenses: $3,600 U hiL25664_ch11_452-497.indd 486hiL25664_ch11_452-497.indd 486 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer Chapter 11 Flexible Budgeting and Analysis of Overhead Costs 487 Required: 1. Prepare a columnar flexible budget for Vermont Sky Tours’ expenses, using air miles as the cost driver at the following activity levels: 32,000 air miles, 35,000 air miles, and 38,000 air miles. 2. In spite of several favorable expense variances shown on the report above, the company’s Septem- ber operating income was only about two-thirds of the expected level. Why? 3. Write a brief memo to the manager of aircraft operations explaining why the original variance report is misleading. 4. Prepare a revised expense variance report for September, which is based on the flexible budget prepared in requirement (1). 5. Jacqueline Frost presented the revised expense report to Leif along with the memo explaining why the original performance report was misleading. Leif did not take it well. He complained of Frost’s “interference” and pointed out that the company had been doing just fine without her. “I’m taking my report to the owner tomorrow,” Leif insisted. “Yours just makes us look bad.” What are Frost’s ethical obligations in this matter? What should she do? EduSoft Corporation’s president, Mark Fletcher, was looking forward to seeing the p erformance reports for October because he knew the company’s sales for the month had exceeded budget by a consider- able margin. EduSoft, a distributor of educational software packages, had been growing steadily for approximately two years. Fletcher’s biggest challenge at this point was to ensure that the company did not lose control of expenses during this growth period. When Fletcher received the October reports, he was dismayed to see the large unfavorable variance in the company’s Monthly Selling Expense Report that follows. EDUSOFT CORPORATION Monthly Selling Expense Report For the Month of October Annual Budget October Budget October Actual October Variance Dollar sales .............................................. $160,000,000 $22,400,000 $24,800,000 $2,400,000 Unit sales ................................................. 2,000,000 280,000 310,000 30,000 Orders processed ..................................... 54,000 6,500 5,800 (700) Sales personnel per month ........................ 90 90 96 (6) Advertising ............................................... $ 39,600,000 $ 3,300,000 $ 3,320,000 $ 20,000 U Staff salaries ............................................ 3,000,000 250,000 250,000 — Sales salaries ........................................... 2,592,000 216,000 230,800 14,800 U Commissions ............................................ 6,400,000 896,000 992,000 96,000 U Per diem expense ..................................... 3,564,000 297,000 325,200 28,200 U Office expenses ........................................ 8,160,000 760,000 716,800 43,200 F Shipping expenses ..................................... 13,500,000 1,805,000 1,953,000 148,000 U Total expenses ........................................... $ 76,816,000 $ 7,524,000 $ 7,787,800 $ 263,800 U Fletcher called in the company’s new controller, Susan Porter, to discuss the implications of the variances reported for October and to plan a strategy for improving performance. Porter suggested that the company’s reporting format might not be giving Fletcher a true picture of the company’s operations. She proposed that EduSoft implement flexible budgeting. Porter offered to redo the Monthly Selling Expense Report for October using flexible budgeting so that Fletcher could compare the two reports and see the advantages of flexible budgeting. Porter discovered the following information about the behavior of EduSoft’s selling expenses. • The total compensation paid to the sales force consists of a monthly base salary and a commission; the commission varies with sales dollars. • Sales office expense is a semivariable cost with the variable portion related to the number of orders processed. The fixed portion of office expense is $6,000,000 annually and is incurred uniformly throughout the year. • Subsequent to the adoption of the annual budget for the current year, EduSoft decided to open a new sales territory. As a consequence, approval was given to hire six additional salespeople ■ Problem 11–44 Flexible Budget; Performance Report (LO 11-1, 11-6) 2. Variance, total expenses: $18,400 (F) Ex hiL25664_ch11_452-497.indd 487hiL25664_ch11_452-497.indd 487 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer 488 Chapter 11 Flexible Budgeting and Analysis of Overhead Costs effective October 1. Porter decided that these additional six people should be recognized in her revised October report. • Per diem reimbursement to the sales force, while a fixed amount per day, is variable with the number of sales personnel and the number of days spent traveling. The original budget was based on an average sales force of 90 people throughout the year with each salesperson traveling 15 days per month. • The company’s shipping expense is a semivariable cost with the variable portion, $6.00 per unit, dependent on the number of units sold. The fixed portion is incurred uniformly throughout the year. Required: 1. Citing the benefits of flexible budgeting, explain why Susan Porter would propose that EduSoft use flexible budgeting in this situation. 2. Prepare a revised Monthly Selling Expense Report for October that would permit Mark Fletcher to more clearly evaluate EduSoft’s control over selling expenses. The report should have a line for each selling expense item showing the appropriate budgeted amount, the actual selling expense, and the monthly dollar variance. (CMA, adapted) For e ach of the following independent Cases A and B, fill in the missing information. The company bud- gets and applies production-overhead costs on the basis of direct-labor hours. (U denotes unfavorable variance; F denotes favorable variance . ) Case A Case B 1. Standard variable-overhead rate ................................................. $7.50 per hour ? per hour 2. Standard fixed-overhead rate ..................................................... ? per hour ? per hour 3. Total standard overhead rate ...................................................... ? per hour $13.00 per hour 4. Flexible budget for variable overhead .......................................... $270,000 ? 5. Flexible budget for fixed overhead .............................................. $630,000 ? 6. Actual variable overhead ............................................................ ? ? 7. Actual fixed overhead ................................................................. $621,000 ? 8. Variable-overhead spending variance ........................................... $16,650 U $8,000 U 9. Variable-overhead efficiency variance ......................................... ? $1,600 F 10. Fixed-overhead budget variance ................................................. ? $4,320 U 11. Fixed-overhead volume variance ................................................. ? $14,400 U (positive sign) 12. Under- (or over-) applied variable overhead ................................. ? ? 13. Under- (or over-) applied fixed overhead ...................................... ? ? 14. Budgeted production (in units) .................................................... 5,000 units ? 15. Standard direct-labor hours per unit. .......................................... 6 hours per unit 8 hours per unit 16. Actual production (in units) ......................................................... ? ? 17. Standard direct-labor hours allowed, given actual production ........ 36,000 hours 6,400 hours 18. Actual direct-labor hours ............................................................. 37,000 hours 6,000 hours 19. Applied variable overhead .......................................................... ? ? 20. Applied fixed overhead ............................................................... ? ? Western A uto Parts Company manufactures replacement parts for automobile repair. The company recently installed a flexible manufacturing system (FMS), which has significantly changed the produc- tion process. The installation of the new FMS was not anticipated when the current year’s budget and cost structure were developed. The installation of the new equipment was hastened by several major breakdowns in the company’s old production machinery. The new equipment was very expensive, but management expects it to cut the labor time required by a substantial amount. Management also expects the new equipment to allow a reduction in direct- material waste. On the negative side, the FMS requires a more highly skilled labor force to operate it than the company’s old equipment. The following cost variance report was prepared for the month of May, the first full month after the equipment was installed. ■ Problem 11–45 Finding Missing Data; Overhead Accounting (LO 11-1, 11-5) Case A(2): Standard fixed overhead rate, $21 per direct- labor hour Case B(2): Standard fixed overhead rate, $9 per direct- labor hour ■ Problem 11–46 Interactions between Vari- ances; Flexible Manufacturing System (LO 11-5) hiL25664_ch11_452-497.indd 488hiL25664_ch11_452-497.indd 488 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer Chapter 11 Flexible Budgeting and Analysis of Overhead Costs 489 WESTERN AUTO PARTS COMPANY Cost Variance Report For the Month of May Direct material: Standard cost ........................................................................................................................ $301,225 Actual cost ............................................................................................................................ 299,350 Direct-material price variance ................................................................................................. 75 U* Direct-material quantity variance ............................................................................................. $ 1,950 F Direct labor: Standard cost ........................................................................................................................ 196,500 Actual cost ............................................................................................................................ 191,900 Direct-labor rate variance ....................................................................................................... 2,400 U Direct-labor efficiency variance ............................................................................................... 7,000 F Production overhead: Applied to work in process ..................................................................................................... 200,000 Actual cost ............................................................................................................................ 204,000 Variable-overhead spending variance ...................................................................................... 4,000 U Variable-overhead efficiency variance ...................................................................................... 5,000 F Fixed-overhead budget variance ............................................................................................. 15,000 U Fixed-overhead volume variance ............................................................................................. (10,000)† *F denotes favorable variance; U denotes unfavorable variance. †The sign of the volume variance is negative, applied fixed overhead exceeded budgeted fixed overhead. Required: Comment on the possible interactions between the variances listed in the report. Which ones are likely to have been caused by the purchase of the new production equipment? The company budgets and applies production overhead on the basis of direct-labor hours. (You may find it helpful to review the discussion of variance interactions in Chapter 10.) Williamsport Wheel and Axle, Inc., has an automated production process, and p roduction activity is quantified in terms of machine hours. The company uses a standard-costing system. The annual static budget for 20x4 called for 6,000 units to be produced, requiring 30,000 machine hours. The standard overhead rate for the year was computed using this planned level of production. The 20x4 manufactur- ing cost report follows. WILLIAMSPORT WHEEL AND AXLE, INC. Manufacturing Cost Report For 20x4 (in thousands of dollars) Static Budget Flexible Budget Cost Item 30,000 Machine Hours 31,000 Machine Hours 32,000 Machine Hours Actual Cost Direct material: A42 aluminum ............................ $ 504.0 $ 520.8 $ 537.6 $ 540.0 S18 steel alloy ............................ 156.0 161.2 166.4 166.0 Direct labor: Assembler .................................. 546.0 564.2 582.4 574.0 Grinder ....................................... 468.0 483.6 499.2 500.0 Production overhead: Maintenance .............................. 48.0 49.6 51.2 50.0 Supplies ...................................... 258.0 266.6 275.2 260.0 Supervision ................................ 160.0 164.0 168.0 162.0 Inspection .................................. 288.0 294.0 300.0 294.0 Insurance ................................... 100.0 100.0 100.0 100.0 Depreciation ............................... 400.0 400.0 400.0 400.0 Total cost ............................... $2,928.0 $3,004.0 $3,080.0 $3,046.0 ■ Problem 11–47 Using a Flexible Budget (LO 11-1, 11-2, 11-5) 7. Actual variable overhead: $618,000 11. Standard allowed machine hours: 30,250 hiL25664_ch11_452-497.indd 489hiL25664_ch11_452-497.indd 489 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer 490 Chapter 11 Flexible Budgeting and Analysis of Overhead Costs The company’s controller develops flexible budgets for different levels of activity for use in evalu- ating performance. A total of 6,200 units was produced during 20x4, requiring 32,000 machine hours. The preceding manufacturing cost report compares the company’s actual cost for the year with the static budget and the flexible budget for two different activity levels. Required: Compute the following amounts. For variances, indicate whether favorable or unfavorable where appropriate. Answers should be rounded to two decimal places when necessary. 1. The standard number of machine hours allowed to produce one unit of product. 2. The actual cost of direct material used in one unit of product. 3. The cost of material that should be processed per machine hour. 4. The standard direct-labor cost for each unit produced. 5. The variable-overhead rate per machine hour in a flexible-budget formula. ( Hint: Separate the overhead costs from direct material and direct labor, and then use the high-low method to estimate cost behavior.) 6. The standard fixed-overhead rate per machine hour used for product costing. 7. The variable-overhead spending variance. (Assume management has determined that the actual fixed overhead cost in 20x4 amounted to $648,000.) 8. The variable-overhead efficiency variance. 9. The fixed-overhead budget variance. 10. The fixed-overhead volume variance. [Make the same assumption as in requirement (7).] 11. The total budgeted manufacturing cost (in thousands of dollars) for an output of 6,050 units. ( Hint: Use the flexible-budget formula.) (CMA, adapted) Albuquerque Wood Crafts, Inc., is a manufacturer of furniture for specialty shops throughout the south- west and has an annual sales volume of $24 million. The company has four major product lines: book- cases, magazine racks, end tables, and bar stools. Each line is managed by a production manager. Since production is spread fairly evenly over the 12 months of operation, Sara McKinley, the controller, has prepared an annual budget divided into 12 periods for monthly reporting purposes. Albuquerque Wood Crafts uses a standard-costing system and applies variable overhead on the basis of process hours. Fixed production cost is allocated on the basis of square footage occupied using a predetermined plantwide rate; the size of the space occupied varies considerably among the product lines. All other costs are assigned on the basis of revenue dollars earned. At the monthly meeting to review November performance, Steve Clark, manager of the bookcase line, received the following report. ALBUQUERQUE WOOD CRAFTS, INC. Bookcase Production Performance Report For the Month of November Actual Budget Variance Units ............................................................................... 3,000 2,500 500 F Revenue ........................................................................... $483,000 $412,500 $70,500 F Variable production costs: Direct material ............................................................. $ 69,300 $ 60,000 $ 9,300 U Direct labor ................................................................. 54,900 45,000 9,900 U Machine time .............................................................. 57,600 48,750 8,850 U Production overhead .................................................... 123,000 105,000 18,000 U Fixed production costs: Indirect labor ............................................................... 28,200 18,000 10,200 U Depreciation ................................................................. 16,500 16,500 — Property taxes ............................................................. 7,200 6,900 300 U Insurance ..................................................................... 13,500 13,500 — Administrative expenses ................................................... 36,000 27,000 9,000 U Marketing expenses ......................................................... 24,900 21,000 3,900 U Research and development .............................................. 18,000 13,500 4,500 U Total expenses ................................................................. $449,100 $375,150 $73,950 U Operating income ............................................................ $ 33,900 $ 37,350 $ 3,450 U ■ Problem 11–48 Flexible Budget; Improved Performance Report; Behavioral Issues (LO 11-1, 11-6) hiL25664_ch11_452-497.indd 490hiL25664_ch11_452-497.indd 490 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer Chapter 11 Flexible Budgeting and Analysis of Overhead Costs 491 While distributing the monthly reports at the meeting, McKinley remarked to Clark, “We need to talk about getting your division back on track. Be sure to see me after the meeting.” Clark had been so convinced that his division did well in November that McKinley’s remark was a real surprise. He spent the balance of the meeting avoiding the looks of his fellow managers and trying to figure out what could have gone wrong. The monthly performance report was no help. Required: 1. a. Identify three weaknesses in Albuquerque Wood Crafts, Inc.’s monthly Bookcase Production Performance Report. b. Discuss the behavioral implications of Sara McKinley’s remarks to Steve Clark during the meeting. 2. The company could do a better job of reporting monthly performance to the production managers. a. Recommend how the report could be improved to eliminate weaknesses, and revise it accordingly. b. Discuss how the recommended changes in reporting are likely to affect Steve Clark’s behavior. (CMA, adapted) Ice Box Gourmet, Inc., produces containers of frozen food. During April, The company p roduced 725 cases of food and incurred the following actual costs. Variable overhead ................................................................................................................................. $ 5,500 Fixed overhead ..................................................................................................................................... 13,000 Actual labor cost (4,000 direct-labor hours) ............................................................................................ 75,600 Actual material cost (15,000 pounds purchased and used) ...................................................................... 33,000 Overhead is budgeted and applied using direct-labor hours. Standard cost and annual budget infor- mation are as follows: Standard Costs per Case Direct labor (5 hours at $18) ................................................................................................................. $ 90.00 Direct material (20 pounds at $2) ......................................................................................................... 40.00 Variable overhead (5 hours at $1.50) .................................................................................................... 7.50 Fixed overhead (5 hours at $3) ............................................................................................................. 15.00 Total .................................................................................................................................................... $152.50 Annual Budget Information Variable overhead ........................................................................................................ $ 75,000 Fixed overhead ............................................................................................................ $150,000 Planned activity for year ............................................................................................... 50,000 direct-labor hours Required: 1. Prepare as complete an analysis of cost variances as is possible from the available data. 2. Build a spreadsheet: Construct an Excel spreadsheet to solve the preceding requirement. Show how the solution will change if the following information changes: the standard rates were $17.50 per hour for direct labor, and $1.60 per direct-labor hour for variable overhead. Vancouver Scholastic Supply Company uses a standard-costing system. The firm estimates t hat it will operate its manufacturing facilities at 600,000 machine hours for the year. The estimate for total bud- geted overhead is $1,500,000. The standard variable-overhead rate is estimated to be $2 per machine hour or $6 per unit. The actual data for the year are presented below. Actual finished units .......................................................................................................................... 187,500 Actual machine hours ....................................................................................................................... 573,000 Actual variable overhead .................................................................................................................... $1,275,750 Actual fixed overhead ........................................................................................................................ $ 294,000 ■ Problem 11–49 Complete Analysis of Cost Variances; Review of Chapters 10 and 11 (LO 11-5) 1. Standard direct-material quantity: 14,500 lbs. Standard direct-labor hours: 3,625 hrs. ■ Problem 11–50 Overhead Variances; Journal Entries (Appendix A) (LO 11-3, 11-5, 11-8) 1(b). Standard machine hours: 562,500 2. Cost of Goods Sold, debit: $163,500 hiL25664_ch11_452-497.indd 491hiL25664_ch11_452-497.indd 491 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer 492 Chapter 11 Flexible Budgeting and Analysis of Overhead Costs Required: 1. Compute the following variances. Indicate whether each is favorable or unfavorable, where appropriate. a. Variable-overhead spending variance. b. Variable-overhead efficiency variance. c. Fixed-overhead budget variance. d. Fixed-overhead volume variance. 2. Prepare journal entries to: a. Record the incurrence of actual variable overhead and actual fixed overhead. b. Add variable and fixed overhead to Work-In-Process Inventory. c. Close underapplied or overapplied overhead into Cost of Goods Sold. (CMA, adapted) EuroGuide , Inc., publishes European Tour Guide Books in New York City. A monthly flexible overhead budget for the firm follows. EUROGUIDE, INC. Monthly Flexible Overhead Budget Direct-Labor Hours Budgeted Cost 1,500 1,750 2,000 Variable costs: Indirect material: Glue .......................................................................... $ 1,500 $ 1,750 $ 2,000 Tape ........................................................................... 600 700 800 Miscellaneous supplies ............................................... 6,000 7,000 8,000 Indirect labor .................................................................. 15,000 17,500 20,000 Utilities: Electricity ................................................................... 3,000 3,500 4,000 Natural gas ................................................................. 900 1,050 1,200 Total variable cost ............................................................... $27,000 $31,500 $36,000 Fixed costs: Supervisory labor ............................................................ 25,000 25,000 25,000 Depreciation ................................................................... 6,800 6,800 6,800 Property taxes and insurance .......................................... 8,200 8,200 8,200 Total fixed cost .................................................................... $40,000 $40,000 $40,000 Total overhead cost ............................................................. $67,000 $71,500 $76,000 The planned monthly production is 6,400 guide books. The standard direct-labor allowance is .25 hours per book and overhead is budgeted and applied on the basis of direct-labor hours. During February, EuroGuide, Inc., produced 8,000 books and actually used 2,100 direct-labor hours. The actual overhead costs for the month were as follows: Actual variable overhead .......................................................................................................................... $39,060 Actual fixed overhead ............................................................................................................................... 75,200 Required: 1. Determine the formula flexible overhead budget for EuroGuide, Inc. 2. Prepare a display similar to Exhibit 11–6 , which shows the variable-overhead variances for Febru- ary. Indicate whether each variance is favorable or unfavorable. 3. Draw a graph similar to Exhibit 11–7 , which shows the variable-overhead variances for February. 4. Explain how to interpret each of the variances computed in requirement (2). 5. Prepare a display similar to Exhibit 11–8 , which shows the fixed-overhead variances for February. 6. Draw a graph similar to Exhibit 11–9 , which depicts the company’s applied and budgeted fixed overhead for February. Show the February volume variance on the graph. ■ Problem 11–51 Comprehensive Problem on Overhead Accounting under Standard Costing; Journal Entries (Appendix A ) (LO 11-2, 11-3, 11-5, 11-8) 1. Standard variable-overhead rate: $18 per direct-labor hour 5. Fixed-overhead budget variance: $35,200 U hiL25664_ch11_452-497.indd 492hiL25664_ch11_452-497.indd 492 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer Chapter 11 Flexible Budgeting and Analysis of Overhead Costs 493 7. Explain the interpretation of the variances computed in requirement (5). 8. Prepare journal entries to record each of the following: a. Incurrence of February’s actual overhead cost. b. Application of February’s overhead cost to Work-in-Process Inventory. c. Close underapplied or overapplied overhead into Cost of Goods Sold. 9. Draw T-accounts for all of the accounts used in the journal entries of requirement (8). Then post the journal entries to the T-accounts. Bear Mountain Sled Company manufactures children’s snow sleds. The company’s p erformance report for December is as follows. Actual Budget Sleds sold .......................................................................................................... 7,500 9,000 Sales .................................................................................................................. $360,000 $450,000 Variable costs ..................................................................................................... 225,000 270,000 Contribution margin ............................................................................................ $135,000 $180,000 Fixed costs ......................................................................................................... 126,000 120,000 Operating income ............................................................................................... $ 9,000 $ 60,000 The company uses sales variance analysis to explain the difference between budgeted and actual sales revenue. Required: Compute the following variances and indicate whether each is favorable or unfavorable. 1. December sales-price variance. 2. December sales-volume variance. (CMA, adapted) Kalamazoo Computer Accessory Company (KCAC) distributes keyboard trays to computer s tores. The keyboard trays can be attached to the underside of a desk, effectively turning it into a computer table. The keyboard trays are purchased from a manufacturer that attaches KCAC’s private label to the trays. The wholesale selling prices to the computer stores are $120 for the business grade keyboard tray and $60 for the residential grade product. The 20x5 budget and actual results are as follows. The budget was adopted in late 20x4 and was based on KCAC’s estimated share of the market for the two types of keyboard trays. KALAMAZOO COMPUTER ACCESSORY COMPANY Income Statement For the Year Ending December 31, 20x5 (in thousands) Business Grade Residential Grade Total Budget Actual Budget Actual Budget Actual Variance Sales in units .......................... 40 37 60 43 100 80 20 Revenue ................................. $4,800 $4,255 $3,600 $2,537 $8,400 $6,792 $(1,608) Cost of goods sold .................. 3,200 3,034 3,000 2,150 6,200 5,184 1,016 Gross margin .......................... $1,600 $1,221 $ 600 $ 387 $2,200 $1,608 $ (592) Unallocated costs: Selling ........................................................................................................... $ 500 $ 500 $ — Advertising ..................................................................................................... 500 530 (30) Administrative ................................................................................................. 200 203 (3) Income taxes (45%) ......................................................................................... 450 169 281 Total unallocated costs ................................................................................ $1,650 $1,402 $ 248 Net income...................................................................................................... $ 550 $ 206 $ (344) ■ Problem 11–52 Sales Variances (Appendix B) (LO 11-9) 2. Budgeted sales price: $50 ■ Problem 11–53 Analyzing Sales Variances (Appendix B) (LO 11-9) 1. Sales-price variance, residential: $43,000 U hiL25664_ch11_452-497.indd 493hiL25664_ch11_452-497.indd 493 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer 494 Chapter 11 Flexible Budgeting and Analysis of Overhead Costs During the first quarter of 20x5, management estimated that the total market for these products actually would be 10 percent below the original estimates. In an attempt to prevent unit sales from declining as much as industry projections, management implemented a marketing program. Included in the program were dealer discounts and increased direct advertising. The business grade line was empha- sized in this program. Required: 1. Compute the sales-price and sales-volume variances for each product line. Indicate whether each variance is favorable or unfavorable. 2. Discuss the apparent effect of KCAC’s special marketing program (i.e., dealer discounts and addi- tional advertising) on the 20x5 operating results. (CMA, adapted) Your next-door neighbor recently began a new job as assistant controller for Conundrum C orporation. As her first assignment, she prepared a performance report for March. She was scheduled to present the report to management the next morning, so she brought it home to review. As the two of you chatted in the backyard, she decided to show you the report she had prepared. Unfortunately, your dog thought the report was an object to be fetched. The pup made a flying leap and got a firm grip on the report. After chasing the dog around the block you managed to wrest the report from its teeth. Needless to say, it was torn to bits. Only certain data are legible on the report. This information follows: CONUNDRUM CORPORATION Performance Report for the Month of March Direct Material Direct Labor Variable Overhead Fixed Overhead Standard allowed cost given actual output ................................... ? ? (? kilograms at $18 per kilogram) (2 hours at $21 per hour) Flexible overhead budget ............................... ? $60,000 Actual cost ................................................... $283,500 ? ? ? (14,000 kilograms at $20.25 per kilogram) (8,800 hours at ? per hour) Direct-material price variance ........................ ? Direct-material quantity variance .................... $9,000 U Direct-labor rate variance .............................. $13,200 U Direct-labor efficiency variance ...................... 4,200 F Variable-overhead spending variance ................................................... $3,960 U Variable-overhead efficiency variance ................................................... 1,800 F Fixed-overhead budget variance .................... $4,875 U Fixed-overhead volume variance .................... ? In addition to the fragmentary data still legible on the performance report, your neighbor happened to remember the following facts. • Planned production of Conundrum’s sole product was 500 units more than the actual production. • All of the direct material purchased in March was used in production. • There were no beginning or ending inventories. • Variable and fixed overhead are applied on the basis of direct-labor hours. The fixed overhead rate is $6.00 per hour. ■ Case 11–54 Integrative Case on Chapters 10 and 11; Drawing Conclu- sions from Missing Data (LO 11-1, 11-3, 11-5) 5. Direct-labor rate variance: $13,200 U 8. Direct-material quantity variance: $9,000 U Cases hiL25664_ch11_452-497.indd 494hiL25664_ch11_452-497.indd 494 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer Chapter 11 Flexible Budgeting and Analysis of Overhead Costs 495 Required: Feeling guilty, you have agreed to help your neighbor reconstruct the following facts, which will be necessary for her presentation. 1. Planned production (in units). 2. Actual production (in units). 3. Actual fixed overhead. 4. Total standard allowed direct-labor hours. 5. Actual direct-labor rate. 6. Standard variable-overhead rate. 7. Actual variable-overhead rate. 8. Standard direct-material quantity per unit. 9. Direct-material price variance. 10. Applied fixed overhead. 11. Fixed-overhead volume variance. Colonial Cookies, Inc., bakes cookies for retail stores. The company’s best-selling c ookie is choco- late nut supreme which is marketed as a gourmet cookie and regularly sells for $8.00 per pound. The standard cost per pound of chocolate nut supreme, based on Colonial’s normal monthly production of 200,000 pounds, is as follows: Cost Item Quantity Standard Unit Cost Total Cost Direct material: Cookie mix ....................................................... 10 oz. $.02 per oz. $ .20 Milk chocolate .................................................. 5 oz. .15 per oz. .75 Almonds ........................................................... 1 oz. .50 per oz. .50 $1.45 Direct labor:* Mixing .............................................................. 1 min. 14.40 per hr. $ .24 Baking ............................................................. 2 min. 18.00 per hr. .60 $ .84 Variable overhead† ................................................ 3 min. 32.40 per direct-labor hr. $1.62 Total standard cost per pound ....................... $3.91 *Direct-labor rates include employee benefits. †Applied on the basis of direct-labor hours. Colonial’s management accountant, Karen Blair, prepares monthly budget reports based on these standard costs. February’s contribution report, which compares budgeted and actual performance, is shown in the following schedule. Contribution Report for February Static Budget Actual Variance Units (in pounds) ........................................................... 200,000 225,000 25,000 F Revenue ....................................................................... $1,600,000 $1,777,500 $177,500 F Direct material .............................................................. $ 290,000 $ 432,500 $142,500 U Direct labor .................................................................. 168,000 174,000 6,000 U Variable overhead ......................................................... 324,000 375,000 51,000 U Total variable costs ................................................... $ 782,000 $ 981,500 $199,500 U Contribution margin ...................................................... $ 818,000 $ 796,000 $ 22,000 U Justine Madison, president of the company, is disappointed with the results. Despite a sizable increase in the number of cookies sold, the product’s expected contribution to the overall profitability of the firm decreased. Madison has asked Blair to identify the reason why the contribution margin decreased. Blair has gathered the following information to help in her analysis of the decrease. ■ Case 11–55 Comprehensive Variance Analysis Used to Explain Operational Results; Review of Chapters 10 and 11; Activity-Based Costing; Sales Variances (Appendix B) (LO 11-4, 11-5, 11-7, 11-9) 4(a). Direct-material price variance, milk chocolate: $66,500 U 4(e). Variable-overhead spending variance: $37,500 U hiL25664_ch11_452-497.indd 495hiL25664_ch11_452-497.indd 495 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer 496 Chapter 11 Flexible Budgeting and Analysis of Overhead Costs Usage Report for February Cost Item Quantity Actual Cost Direct materials: Cookie mix ...................................................................... 2,325,000 oz. $ 46,500 Milk chocolate ................................................................. 1,330,000 oz. 266,000 Almonds .......................................................................... 240,000 oz. 120,000 Direct labor: Mixing ............................................................................. 225,000 min. 54,000 Baking ............................................................................ 400,000 min. 120,000 Variable overhead ................................................................ 375,000 Total variable costs ...................................................... $981,500 Required: 1. Prepare a new contribution report for February, in which: • The static budget column in the contribution report is replaced with a flexible budget column. • The variances in the contribution report are recomputed as the difference between the flexible budget and actual columns. 2. What is the total contribution margin in the flexible budget column of the new report prepared for requirement (1)? 3. Explain (i.e., interpret) the meaning of the total contribution margin in the flexible budget column of the new report prepared for requirement (1). 4. What is the total variance between the flexible budget contribution margin and the actual contribu- tion margin in the new report prepared for requirement (1)? Explain this total contribution margin variance by computing the following variances. (Assume that all materials are used in the month of purchase.) a. Direct-material price variance. b. Direct-material quantity variance. c. Direct-labor rate variance. d. Direct-labor efficiency variance. e. Variable-overhead spending variance. f. Variable-overhead efficiency variance. g. Sales-price variance. 5. a. Explain the problems that might arise in using direct-labor hours as the basis for applying overhead. b. How might activity-based costing (ABC) solve the problems described in requirement (5a)? (CMA, adapted) hiL25664_ch11_452-497.indd 496hiL25664_ch11_452-497.indd 496 7/16/13 9:43 PM7/16/13 9:43 PM Final PDF to printer This page intentionally left blank 12 THIS CHAPTER’S FOCUS COMPANY is Aloha Hotels and Resorts, a chain of luxury hotels and resorts in Hawaii. In this chapter, we will explore this hospitality company’s responsibility-accounting system. Responsi- bility accounting refers to the various concepts and tools used to measure the performance of both people and departments in an organization. The manage- ment of Aloha Hotels and Resorts uses detailed performance reports about the company’s divisions, hotels, and departments to help ensure that everyone in the organization is working toward the same overall corporate goals. FOCUS COMPANY >>>
Responsibility Accounting,
Operational Performance
Measures, and the
Balanced Scorecard
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<<< IN CONTRAST In contrast to the hospitality setting of Aloha Hotels and Resorts, we will turn our attention to the financial-services industry. Here we will explore how Forest Home National Bank (FHNB), first introduced in Chapter 10, uses the balanced scorecard to measure and direct performance. FHNB’s balanced scorecard helps management and employees focus on the customer, internal operations, and learning and growth areas of the business, so that ultimately the bank’s long-term financial goals will be attained. hiL25664_ch12_498-541.indd 499hiL25664_ch12_498-541.indd 499 7/16/13 9:53 PM7/16/13 9:53 PM Final PDF to printer 500 After completing this chapter, you should be able to: Most organizations are divided into smaller units, each of which is assigned particular responsibilities. These units are called by various names, including divisions, segments, business units, and departments. Each department is composed of individuals who are responsible for particular tasks or managerial functions. The managers of an organization should ensure that the people in each department are striving toward the same overall goals. Goal congruence results when the managers of subunits throughout an organiza- tion strive to achieve the goals set by top management. How can an organization’s managerial accounting system promote goal congruence? Responsibility accounting refers to the various concepts and tools used by managers to measure the performance of people and departments in order to foster goal congruence. Responsibility Centers The basis of a responsibility-accounting system is the designation of each subunit in the organization as a particular type of responsibility center. A responsibility center is a sub- unit in an organization whose manager is held accountable for specified financial results of the subunit’s activities. There are four common types of responsibility centers. Cost Center A cost center is an organizational subunit, such as a department or divi- sion, whose manager is held accountable for the costs incurred in the subunit. The Paint- ing Department in an automobile plant and the Supply Chain Management Department of an on-line retailer are examples of cost centers. Revenue Center The manager of a revenue center is held accountable for the rev- enue generated by the subunit. For example, the Reservations Department of an airline and the Advertising Sales Department of a mobile app developer are revenue centers. Profit Center A profit center is an organizational subunit whose manager is held accountable for profit. Since profit is equal to revenue minus expenses, profit-center man- agers are held accountable for both the revenue and expenses attributed to their subunits. Examples of profit centers include a company-owned restaurant in a fast-food chain and a local office of an investment brokerage firm. Learning Objective 12-1 Explain the role of responsibility accounting in fostering goal congruence. Responsibility Centers Learning Objective 12-2 Define and give an example of a cost center, a revenue center, a profit center, and an invest- ment center. 12-1 Explain the role of responsibility accounting in fostering goal congruence. 12-2 Define and give an example of a cost center, a revenue center, a profit center, and an investment center. 12-3 Prepare a performance report and explain the relationships between the performance reports for various responsibility centers. 12-4 Use a cost allocation base to allocate costs. 12-5 Prepare a segmented income statement. 12-6 Describe the operational performance measures appropriate for today’s production environment. 12-7 Describe the balanced scorecard concept and explain the reasoning behind it. hiL25664_ch12_498-541.indd 500hiL25664_ch12_498-541.indd 500 7/16/13 9:53 PM7/16/13 9:53 PM Final PDF to printer Chapter 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard 501 Investment Center The manager of an investment center is held accountable for the subunit’s profit and the invested capital used by the subunit to generate its profit. An investment-center manager also decides whether the profits of the investment center are paid as bonuses, reinvested in research and development, used for expansion, distributed to shareholders, and so forth. A small start-up company and a geographic division of a large corporation are both typically designated as investment centers. 1 Illustration of Responsibility Accounting To illustrate the concepts used in responsibility accounting, we will focus on a hotel chain. Aloha Hotels and Resorts operates 10 luxury hotels in the state of Hawaii. The company is divided into the Maui Division, which operates seven hotels on the island of Maui, and the Oahu Division, with three properties on the island of Oahu. Exhibit 12–1 shows the com- pany’s organization chart, and Exhibit 12–2 depicts the responsibility-accounting system. 1 Although there is an important conceptual difference between profit centers and investment centers, the latter term is not always used in practice. Some managers use the term profit center to refer to both types of responsibility cen- ters. Hence, when businesspeople use the term profit center, they may be referring to a true profit center (as defined in this chapter) or to an investment center. Clockwise from upper left: This aircraft maintenance department in Gwinn, Michigan, is a cost center. However, a telemarketing center like the one shown next is usually treated as a revenue center. This McDonald’s in Riyadh, Saudi Arabia, is a profit center. And this power plant in the Loire Valley, France, is an investment center. What sort of responsibility center designation would be appropriate for your local auto repair shop, hair salon, and dry cleaner? hiL25664_ch12_498-541.indd 501hiL25664_ch12_498-541.indd 501 7/16/13 9:53 PM7/16/13 9:53 PM Final PDF to printer 502 Chapter 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard Corporate Level The chief executive officer of Aloha Hotels and Resorts, Inc., is the company’s president. The president, who is responsible to the company’s stockholders, is accountable for corporate profit in relation to the capital (assets) invested in the company. Therefore, the entire company is an investment center. The president has the autonomy to make significant decisions that affect the company’s profit and invested capital. For example, the final decision to add a new luxury tower to any of the company’s resort properties would be made by the president. Division Level The vice president of the Oahu Division is accountable for the profit earned by the three resort hotels on Oahu in relation to the capital invested in those properties. Hence, the Oahu Division is also an investment center. The vice president has the authority to make major investment decisions regarding the properties on Oahu, up to a limit of $300,000. For example, the vice president could decide to land- scape a swimming pool at one of the Oahu resort hotels, but could not decide to add a new wing. Hotel Level The Waikiki Sands Hotel, in Honolulu, is one of the properties in the Oahu Division. The general manager of the Waikiki Sands Hotel is accountable for the profit earned by the hotel. The general manager does not have the authority to make major investment decisions, but is responsible for operational decisions. For example, the gen- eral manager hires all of the hotel’s departmental managers, sets wage rates, determines procedures and standards for operations, approves decorating decisions, and generally oversees the hotel’s operation. Since the hotel’s general manager has no authority to “Responsibility accounting is an integral part of our reporting process in this company. Always has been. Always will.” (12a) Chrysler Aloha Hotels and Resorts, Inc. Maui Division Oahu Division Food and Beverage Department KitchenRestaurantsBanquets and Catering Hospitality Department Recreational Services Department Housekeeping and Custodial Department Grounds and Maintenance Department Seven hotels on the island of Maui Two other hotels on the island of Oahu Waikiki Sands Hotel (Honolulu) Exhibit 12–1 Organization Chart: Aloha Hotels and Resorts hiL25664_ch12_498-541.indd 502hiL25664_ch12_498-541.indd 502 7/16/13 9:54 PM7/16/13 9:54 PM Final PDF to printer Chapter 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard 503 make major investment decisions, she is held accountable only for the hotel’s profit, not the capital invested in the property. Thus, the Waikiki Sands Hotel is a profit center. Departmental Level The Waikiki Sands Hotel has five departments, as shown in Exhibit 12–1 . The Grounds and Maintenance Department includes landscaping, build- ing and equipment maintenance, and hotel security. The Housekeeping and Custodial Services Department covers laundry and janitorial services. These two departments are called service departments, since they provide services to the hotel’s other departments but do not deal directly with hotel guests. The Recreational Services Department oper- ates the hotel’s swimming pools, saunas, fitness center, and tennis courts. The Hospitality Department includes the hotel’s reservations desk, rooms, bell staff, and shopping facili- ties. Finally, the Food and Beverage Department operates the resort’s restaurants, coffee shop, lounges, poolside snack bar, banquet operations, and catering service. The director of the Food and Beverage Department is accountable for the profit earned on all food and beverage operations. Therefore, this department is a profit center. The director has the authority to approve the menu, set food and beverage prices, hire the wait staff, schedule entertainers, and generally oversee all food and beverage operations. Kitchen Level The Food and Beverage Department is divided further into subunits responsible for Banquets and Catering, Restaurants, and the Kitchen. The head chef manages the kitchen and is accountable for the costs incurred there. Thus, the Kitchen is a cost center. The head chef hires the kitchen staff, orders food sup- plies, and oversees all food preparation. The head chef is responsible for providing high- quality food at the lowest possible cost. “You have to wear the hat of the management team you are on to help them achieve the goals. You also have to wear the corporate finance hat to recognize that you have a duty, to the corporate finance function, to do things right and do them correctly, to stand up for what has to be done, and to say no when no is the appropriate thing to say.” (12b) Abbott Laboratories President of Aloha Hotels and Resorts, Inc. Vice President of Oahu Division General Manager of Waikiki Sands Hotel Director of Food and Beverage Department Head Chef Manager Investment Center Investment Center Profit Center Profit Center Cost Center Responsibility Center Exhibit 12–2 Responsibility Accounting System: Aloha Hotels and Resorts hiL25664_ch12_498-541.indd 503hiL25664_ch12_498-541.indd 503 7/16/13 9:54 PM7/16/13 9:54 PM Final PDF to printer 504 Chapter 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard Performance Reports The performance of each responsibility center is summarized periodically on a perfor- mance report. A performance report shows the budgeted and actual amounts, and the variances between these amounts, of key financial results appropriate for the type of responsibility center involved. For example, a cost center’s performance report concen- trates on budgeted and actual amounts for various cost items attributable to the cost cen- ter. Performance reports also typically show the variance between budgeted and actual amounts for the financial results conveyed in the report. The data in a performance report help managers use management by exception to control an organization’s operations effectively. The performance report for the kitchen of the Waikiki Sands Hotel for February is shown in the Excel spreadsheet in Exhibit 12–3 . As the organization chart in Exhibit 12–1 shows, Aloha Hotels and Resorts is a hier- archy. Each subunit manager reports to one higher-level manager, from the head chef all the way up to the president. In such an organization, there is also a hierarchy of perfor- mance reports, since the performance of each subunit constitutes part of the performance of the next higher-level subunit. For example, the cost performance in the kitchen of the Waikiki Sands Hotel constitutes part of the profit performance of the hotel’s Food and Beverage Department. Exhibit 12–4 shows the relationships between the February performance reports for several subunits of Aloha Hotels and Resorts. Notice that the numbers for the Grounds and Maintenance Department, the Housekeeping and Custodial Department, and the Kitchen are in parentheses. These subunits are cost centers, so the numbers shown are expenses. All of the other subunits shown in Exhibit 12–4 are either profit centers or investment centers. The numbers shown for these subunits are profits, so they are not enclosed in parentheses. In addition to the profit figures shown, the performance reports for the investment centers should include data about invested capital. The Maui Division, the Oahu Division, and the company as a whole are investment centers. Performance evaluation in investment centers is covered in the next chapter. Notice the relationships between the performance reports in Exhibit 12–4 . The kitchen is the lowest-level subunit shown, and its performance report is the same as that displayed in Exhibit 12–3 . The total expense line from the kitchen performance report is Performance Reports Learning Objective 12-3 Prepare a performance report and explain the relationships between the performance reports for various responsibility centers. Exhibit 12–3 Performance Report for February: Kitchen, Waikiki Sands Hotel hiL25664_ch12_498-541.indd 504hiL25664_ch12_498-541.indd 504 7/16/13 9:54 PM7/16/13 9:54 PM Final PDF to printer Chapter 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard 505 included as one line in the performance report for the Food and Beverage Department. Also included are the total profit figures for the department’s other two subunits: Ban- quets and Catering, and Restaurants. How is the total profit line for the Food and Bever- age Department used in the performance report for the Waikiki Sands Hotel? Follow the relationships emphasized with arrows in Exhibit 12–4 . The hierarchy of performance reports starts at the bottom and builds toward the top, just as the organization structure depicted in Exhibit 12–1 builds from the bottom upward. Each manager in the organization receives the performance report for his or her own sub- unit in addition to the performance reports for the major subunits in the next lower level. For example, the general manager of the Waikiki Sands Hotel receives the reports for the hotel, and each of its departments: Grounds and Maintenance, Housekeeping and Custo- dial, Recreational Services, Hospitality, and Food and Beverage. With these reports, the hotel’s general manager can evaluate her subordinates as well as her own performance. This will help the general manager in improving the hotel’s performance, motivating employees, and planning future operations. Exhibit 12–4 Performance Reports for February: Selected Subunits of Aloha Hotels and Resorts (numbers in thousands) Flexible Budget * Actual Results * Variance † February Year to Date February Year to Date February Year to Date Company ........................................ $ 30,660 $ 64,567 $ 30,716 $64,570 $56 F $ 3 F Maui Division ................................ $ 18,400 $ 38,620 $ 18,470 $38,630 $70 F $10 F Oahu Division ............................... 12,260 25,947 12,246 25,940 14 U 7 U Total profit .................................... $ 30,660 $ 64,567 $ 30,716 $64,570 $56 F $ 3 F Oahu Division Waimea Beach Resort ................... $ 6,050 $ 12,700 $ 6,060 $12,740 $10 F $40 F Diamond Head Lodge .................... 2,100 4,500 2,050 4,430 50 U 70 U Waikiki Sands Hotel ...................... 4,110 8,747 4,136 8,770 26 F 23 F Total profit .................................... $ 12,260 $ 25,947 $ 12,246 $25,940 $14 U $ 7 U Waikiki Sands Hotel Grounds and Maintenance ............ $ (45) $ (90) $ (44) $ (90) $ 1 F — Housekeeping and Custodial ......... (40) (90) (41) (90) 1 U — Recreational Services .................... 40 85 41 88 1 F $ 3 F Hospitality .................................... 2,800 6,000 2,840 6,030 40 F 30 F Food and Beverage ....................... 1,355 2,842 1,340 2,832 15 U 10 U Total profit .................................... $ 4,110 $ 8,747 $ 4,136 $ 8,770 $26 F $23 F Food and Beverage Department Banquets and Catering .................. $ 600 $ 1,260 $ 605 $ 1,265 $ 5 F $ 5 F Restaurants .................................. 1,785 3,750 1,760 3,740 25 U 10 U Kitchen ........................................ (1,030) (2,168) (1,025) (2,173) 5 F 5 U Total profit .................................... $ 1,355 $ 2,842 $ 1,340 $ 2,832 $15 U $10 U Kitchen Kitchen staff wages ...................... $ (80) $ (168) $ (78) $ (169) $ 2 F $ 1 U Food ............................................ (675) (1,420) (678) (1,421) 3 U 1 U Paper products ............................. (120) (250) (115) (248) 5 F 2 F Variable overhead ......................... (70) (150) (71) (154) 1 U 4 U Fixed overhead ............................. (85) (180) (83) (181) 2 F 1 U Total expense ............................... $ (1,030) $ (2,168) $ (1,025) $(2,173) $ 5 F $ 5 U *Numbers without parentheses denote profit; numbers with parentheses denote expenses; numbers in thousands. † F denotes favorable variance; U denotes unfavorable variance. hiL25664_ch12_498-541.indd 505hiL25664_ch12_498-541.indd 505 7/16/13 9:54 PM7/16/13 9:54 PM Final PDF to printer 506 Chapter 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard Budgets, Variance Analysis, and Responsibility Accounting Notice that the performance reports in Exhibit 12–4 make heavy use of budgets and variance analysis. Thus, the topics of budgeting, variance analysis, and responsibility accounting are closely interrelated. The flexible budget provides the benchmark against which actual revenues, expenses, and profits are compared. As you saw in Chapter 11, it is important to use a flexible budget so that appropriate comparisons can be made. It would make no sense, for example, to compare the actual costs incurred in the kitchen at Waikiki Sands Hotel with budgeted costs established for a different level of hotel occupancy. The performance reports in Exhibit 12–4 also show variances between budgeted and actual performance. These variances often are broken down into smaller components to help management pinpoint responsibility and diagnose performance. Variance analysis, which was discussed in detail in Chapters 10 and 11, is an important tool in a responsi- bility-accounting system. Cost Allocation Many costs incurred by an organization are the joint result of several subunits’ activities. For example, the property taxes and utility costs incurred by Aloha Hotels and Resorts for the Waikiki Sands Hotel are the joint result of all of the hotel’s activities. One func- tion of a responsibility-accounting system is to assign all of an organization’s costs to the subunits that cause them to be incurred. A collection of costs to be assigned is called a cost pool. At the Waikiki Sands Hotel, for example, all utility costs are combined into a utility cost pool, which includes the costs of electricity, water, sewer, trash collection, television cable, and telephone. The responsibility centers, products, or services to which costs are to be assigned are called cost objects. The Waikiki Sands’ cost objects are its major departments. (See the orga- nization chart in Exhibit 12–1 .) The process of assigning the costs in the cost pool to the cost objects is called cost allocation or cost distribution. Cost Allocation Bases To distribute (or allocate) costs to responsibility centers, the company’s managerial accountant chooses an allocation base for each cost pool. An allocation base is a mea- sure of activity, physical characteristic, or economic characteristic that is associated with the responsibility centers, which are the cost objects in the allocation process. The alloca- tion base chosen for a cost pool should reflect some characteristic of the various respon- sibility centers that is related to the incurrence of costs. An allocation base also may be referred to as a cost driver. Exhibit 12–5 shows the Waikiki Sands Hotel’s February cost distribution for selected cost pools. Each cost pool is distributed to each responsibility center in proportion to that center’s relative amount of the allocation base. For example, the Food and Beverage Department receives 30 percent of the total administrative costs, $25,000, because that department’s 36 employees constitute 30 percent of the hotel’s employees. Notice that no marketing costs are allocated to either the Grounds and Maintenance Department or the Housekeeping and Custodial Department. Neither of these responsibility centers gener- ates any sales revenue. Allocation Bases Based on Budgets At the Waikiki Sands Hotel, administrative and marketing costs are distributed on the basis of budgeted amounts of the relevant allocation bases, rather than actual amounts. The managerial accountant should design an allocation procedure so that the behavior of one responsibility center does not affect the costs allocated to other responsibility centers. “It is real important for accountants or finance peo- ple, when you get into the numbers, to be able to take a spreadsheet that has a zil- lion numbers on it and then turn around and present that to somebody at a high enough level in a meaning- ful manner that they can understand. I think probably in the last five years that is what I spend most of my time on—working on communications.” (12c) Caterpillar Learning Objective 12-4 Use a cost allocation base to allocate costs. hiL25664_ch12_498-541.indd 506hiL25664_ch12_498-541.indd 506 7/16/13 9:54 PM7/16/13 9:54 PM Final PDF to printer Chapter 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard 507 Suppose, for example, that the budgeted and actual February sales revenues for the hotel were as shown in Exhibit 12–6 . Notice that the Hospitality Department’s actual sales revenue is close to the budget. However, the actual sales of the Recreational Services Department and the Food and Beverage Department are substantially below the budget. If the distribution of marketing costs is based on actual sales, instead of budgeted sales, then the cost distributed to the Hospitality Department jumps from $40,000 to $45,000, an increase of 12.5 percent. Why does this happen? As a result of a sales performance substantially below the budget for the other two departments, the Hospitality Department is penalized with a hefty increase in its cost distribution. This is misleading and unfair to the Hospitality Department manager. A preferable cost distribution procedure is to use budgeted sales revenue as the allocation base, rather than actual sales revenue. Then the marketing costs distributed to each department do not depend on the performance in the other two departments. Activity-Based Responsibility Accounting Traditional responsibility-accounting systems tend to focus on the financial performance measures of cost, revenue, and profit for the subunits of an organization. Contempo- rary cost management systems, however, focus more on activities. Costs are incurred Exhibit 12–5 Cost Distribution to Responsibility Centers: Waikiki Sands Hotel Cost Pool Responsibility Center Allocation Base Percentage of Total Costs Distributed Administration Grounds and Maintenance .............................................. 12 employees 10.0% $ 2,500 Housekeeping and Custodial ........................................... 24 employees 20.0 5,000 Recreational Services ..................................................... 12 employees 10.0 2,500 Hospitality ..................................................................... 36 employees 30.0 7,500 Food and Beverage ........................................................ 36 employees 30.0 7,500 Total .............................................................................. 120 employees 100.0% $25,000 Facilities Grounds and Maintenance .............................................. 2,000 sq. ft. 1.0% $ 300 Housekeeping and Custodial ........................................... 2,000 sq. ft. 1.0 300 Recreational Services ..................................................... 5,000 sq. ft. 2.5 750 Hospitality ..................................................................... 175,000 sq. ft. 87.5 26,250 Food and Beverage ........................................................ 16,000 sq. ft. 8.0 2,400 Total .............................................................................. 200,000 sq. ft. 100.0% $30,000 Marketing Grounds and Maintenance .............................................. — — — Housekeeping and Custodial ........................................... — — — Recreational Services ..................................................... $ 20,000 of sales 4.0% $ 2,000 Hospitality ..................................................................... 400,000 of sales 80.0 40,000 Food and Beverage ........................................................ 80,000 of sales 16.0 8,000 Total $500,000 of sales 100.0% $50,000 Marketing Cost Distribution Responsibility Center Budgeted Sales Revenue Actual Sales Revenue Based on Budget Based on Actual Recreational Services ............... $ 20,000 (4%) * $ 4,500 (1%) * $ 2,000 $ 500 Hospitality ............................... 400,000 (80%) 405,000 (90%) 40,000 45,000 Food and Beverage .................. 80,000 (16%) 40,500 (9%) 8,000 4,500 Total ........................................ $500,000 $450,000 $50,000 $50,000 *Percentage of column total. Exhibit 12–6 Cost Distribution: Budgeted versus Actual Allocation Bases hiL25664_ch12_498-541.indd 507hiL25664_ch12_498-541.indd 507 7/16/13 9:54 PM7/16/13 9:54 PM Final PDF to printer 508 Chapter 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard in organizations and their subunits because of activities. Activity-based costing (ABC) systems associate costs with the activities that drive those costs. The database created by an ABC system, coupled with nonfinancial measures of operational performance for each activity, enables management to employ activity-based responsibility accounting. Under this approach, management’s attention is directed not only to the cost incurred in an activity but also to the activity itself. Is the activity necessary? Does it add value to the organization’s product or service? Can the activity be improved? By seeking answers to these questions, managers can eliminate non-value-added activities and increase the cost- effectiveness of the activities that do add value. 2 Behavioral Effects of Responsibility Accounting Responsibility-accounting systems can influence behavior significantly. Whether the behavioral effects are positive or negative, however, depends on how responsibility accounting is implemented. Information versus Blame The proper focus of a responsibility-accounting system is information. The system should identify the individual in the organization who is in the best position to explain each par- ticular event or financial result. The emphasis should be on providing that individual and higher-level managers with information to help them understand the reasons behind the organization’s performance. When properly used, a responsibility-accounting system does not emphasize blame. If managers feel they are beaten over the head with criticism and rebukes when unfavorable variances occur, they are unlikely to respond in a positive way. Instead, they will tend to undermine the system and view it with skepticism. But when the responsibility-accounting system emphasizes its informational role, managers tend to react constructively, and strive for improved performance. Controllability Some organizations use performance reports that distinguish between controllable and uncontrollable costs or revenues. For example, the head chef at the Waikiki Sands Hotel can influence the hours and efficiency of the kitchen staff, but he probably cannot change the wage rates. A performance report that distinguishes between the financial results influenced by the head chef and those he does not influence has the advantage of provid- ing complete information to the head chef. Yet the report recognizes that certain results are beyond his control. Identifying costs as controllable or uncontrollable is not always easy. Many cost items are influenced by more than one person. The time frame also may be important in deter- mining controllability. Some costs are controllable over a long time frame, but not within a short time period. To illustrate, suppose the Waikiki Sands’ head chef has signed a one-year contract with a local seafood supplier. The cost of seafood can be influenced by the head chef if the time period is a year or more, but the cost cannot be controlled on a weekly basis. Motivating Desired Behavior Management often uses the responsibility-accounting system to motivate actions they consider desirable. Sometimes the responsibility-accounting system can solve behavioral Behavioral Effects of Responsibility Accounting “[P]rofitability improved sufficiently to absorb uncontrollable cost. . . . [This] was accomplished through continuous improvement activities . . . that enhance efficiency and productivity.” (12d) Univar N.V. 2 Activity-based costing is covered in Chapter 5. Activity analysis and the elimination of non-value-added activities are also covered in Chapter 5. hiL25664_ch12_498-541.indd 508hiL25664_ch12_498-541.indd 508 7/16/13 9:54 PM7/16/13 9:54 PM Final PDF to printer Chapter 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard 509 problems as well. As a case in point, consider the problem of rush orders. To accept or reject a rush order is a cost-benefit decision: The following real-world example involving rush orders provides a case in point. The production scheduler in a manufacturing firm was frequently asked to interrupt production of one product with a rush order for another product. Rush orders typically resulted in greater costs because more product setups were required. Since the produc- tion scheduler was evaluated on the basis of costs, he was reluctant to accept rush orders. The sales manager, on the other hand, was evaluated on the basis of sales revenue. By agreeing to customers’ demands for rush orders, the sales manager satisfied his custom- ers. This resulted in more future sales and favorable performance ratings for the sales manager. As the rush orders became more and more frequent, the production manager began to object. The sales manager responded by asking if the production scheduler wanted to take the responsibility for losing a customer by refusing a rush order. The production scheduler did not want to be blamed for lost sales, so he grudgingly accepted the rush orders. However, considerable ill will developed between the sales manager and produc- tion scheduler. The company’s managerial accountant came to the rescue by redesigning the respon- sibility-accounting system. The system was modified to accumulate the extra costs associ- ated with rush orders and charge them to the sales manager’s responsibility center, rather than the production scheduler’s center. The ultimate result was that the sales manager chose more carefully which rush-order requests to make, and the production manager accepted them gracefully. The problem described in the preceding illustration developed because two different managers were considering the costs and benefits of the rush-order decision. The produc- tion manager was looking only at the costs, while the sales manager was looking only at the benefits. The modified responsibility-accounting system made the sales manager look at both the costs and the benefits associated with each rush order. Then the sales manager could make the necessary trade-off between costs and benefits in considering each rush order. Some rush orders were rejected, because the sales manager decided the costs exceeded the benefits. Other rush orders were accepted, when the importance of the customer and potential future sales justified it. This example illustrates how a well-designed responsibility-accounting system can make an organization run more smoothly and achieve higher performance. Segmented Reporting Subunits of an organization are often called segments. Segmented reporting refers to the preparation of accounting reports by segment and for the organization as a whole. Many organizations prepare segmented income statements, which show the income for major segments and for the entire enterprise. In preparing segmented income statements, management must decide how to treat costs that are incurred to benefit more than one segment. Such costs are called common costs. The salary of the president of Aloha Hotels and Resorts is a common cost. The president manages the entire company. Some of her time is spent on matters related spe- cifically to the Maui Division or the Oahu Division, but much of it is spent on tasks that Costs of Accepting Rush Order Benefits of Accepting Rush Order Disrupted production Satisfied customers More setups Greater future sales Higher costs Segmented Reporting Learning Objective 12-5 Prepare a segmented income statement. hiL25664_ch12_498-541.indd 509hiL25664_ch12_498-541.indd 509 7/16/13 9:54 PM7/16/13 9:54 PM Final PDF to printer 510 Chapter 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard are not traced easily to either division. The president works with the company’s board of directors, develops strategic plans for the company, and helps set policy and goals for the entire enterprise. Thus, the president’s compensation is a common cost, which is not related easily to any segment’s activities. Many managerial accountants believe that it is misleading to allocate common costs to an organization’s segments. Since these costs are not traceable to the activities of seg- ments, they can be allocated to segments only on the basis of some highly arbitrary allo- cation base. Consider the salary of Aloha Hotels and Resorts’ president. What allocation base would you choose to reflect the contribution of the president’s managerial efforts to the company’s two divisions? The possible allocation bases include budgeted divisional sales revenue, the number of hotels or employees in each division, or some measure of divisional size, such as total assets. However, all of these allocation bases would yield arbitrary cost allocations and possibly misleading segment profit information. For this reason, many organizations choose not to allocate common costs on segmented income statements. Exhibit 12–7 shows February’s segmented income statement (on a budgeted basis) for Aloha Hotels and Resorts. Each segment’s income statement is presented in the con- tribution format discussed in Chapter 8. Notice that Exhibit 12–7 shows income state- ments for the following segments. Aloha Hotels and Resorts ui DivisionMa Oahu Diivision a Beach Resort ond Head LLodge Waime Diam Waikiki Sands Hotel Three numbers in Exhibit 12–7 require special emphasis. First, the $10,000,000 of common fixed expenses in the left-hand column is not allocated to the company’s two divisions. Included in this figure are such costs as the company president’s salary. These costs cannot be allocated to the divisions, except in some arbitrary manner. Second, $1,000,000 of controllable fixed expense in the right-hand column constitutes part of the Oahu Division’s $9,000,000 of controllable fixed expense. All $9,000,000 of expense is controllable by the vice president of the Oahu Division. However, $1,000,000 of these expenses cannot be traced to the division’s three hotels, except on an arbitrary basis. For example, this $1,000,000 of expense includes the salary of the Oahu Division’s vice president. Therefore, the $1,000,000 of expense is not allocated among the divi- sion’s three hotels. This procedure illustrates an important point. Costs that are traceable to segments at one level in an organization may become common costs at a lower level in the organization. The vice president’s salary is traceable to the Oahu Division, but it cannot be allocated among the division’s three hotels except arbitrarily. Thus, the vice president’s salary is a traceable cost at the divisional level, but it becomes a common cost at the hotel level. Third, the $200,000,000 of fixed expenses controllable by others in the right-hand column constitutes part of the Oahu Division’s $250,000,000 of fixed expenses control- lable by others. However, the $200,000,000 portion cannot be allocated among the divi- sion’s three hotels, except arbitrarily. Segments versus Segment Managers One advantage of segmented reports like the one in Exhibit 12–7 is that they make a distinction between segments and segment managers. Some costs that are traceable to a segment may be completely beyond the influence of the segment manager. Property taxes on the Waikiki Sands Hotel, for example, are traceable to the hotel, but the hotel’s general manager cannot influence them. To properly evaluate the Waikiki Sands Hotel as an investment of the company’s resources, the property taxes should be included in the hotel’s costs. However, in evaluating the general manager’s performance, the property-tax cost should be excluded, since the manager has no control over it. “Senior management wants to know yesterday. So the pace has quickened and there’s more pressure to get information much sooner and at the same time there is so much more information there.” (12e) Qwest (now CenturyLink) hiL25664_ch12_498-541.indd 510hiL25664_ch12_498-541.indd 510 7/16/13 9:54 PM7/16/13 9:54 PM Final PDF to printer Chapter 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard 511 Key Features of Segmented Reporting To summarize, Exhibit 12–7 illustrates three important characteristics of segmented reporting: 1. Contribution format. These income statements use the contribution format. The statements subtract variable expenses from sales revenue to obtain the contribution margin. 2. Controllable versus uncontrollable expenses. The income statements in Exhibit 12–7 highlight the costs that can be controlled, or heavily influenced, by each segment manager. This approach is consistent with responsibility accounting. 3. Segmented income statement. Segmented reporting shows income statements for the company as a whole and for its major segments. Customer-Profitability Analysis and Activity-Based Costing Analyzing profitability by segments of the company can help managers gain insight into the factors that are driving the company’s performance. In addition to focusing on the major organizational subunits in the company, profitability analysis can focus on major market segments, geographical regions, distribution channels, or customers. Customer-profitability analysis uses the concept of activity-based costing to deter- mine how serving particular customers causes activities to be performed and costs to be incurred. Suppose, for example, that customer A frequently changes its orders after they are placed, but customer B typically does not. Then the costs incurred in updating sales orders for changes should be recorded in a manner that reflects the fact that customer A is more responsible for those activities and costs than is customer B. Many factors can result in some customers being more profitable than others. Cus- tomers that order in small quantities, order frequently, often change their orders, require Exhibit 12–7 Segmented Income Statements: Aloha Hotels and Resorts (in thousands) Segment of Company Segment of Oahu Division Aloha Hotels and Resorts Maui Division Oahu Division Waimea Beach Resort Diamond Head Lodge Waikiki Sands Hotel Not Allocated Sales revenue ................................... $2,500,000 $1,600,000 $900,000 $450,000 $150,000 $300,000 — Variable operating expenses: Personnel ..................................... $ 820,900 $ 510,400 $310,500 $155,500 $ 50,000 $105,000 — Food, beverages, and supplies ....... 738,000 458,600 279,400 139,700 46,400 93,300 — Other ........................................... 83,000 58,000 25,000 12,500 4,000 8,500 — Total ............................................. $1,641,900 $1,027,000 $614,900 $307,700 $100,400 $206,800 — Segment contribution margin ............. $ 858,100 $ 573,000 $285,100 $142,300 $ 49,600 $ 93,200 — Less: Fixed expenses controllable by segment manager .................... 30,000 21,000 9,000 4,000 1,000 3,000 $ 1,000 Profit margin controllable by segment manager .................... $ 828,100 $ 552,000 $276,100 $138,300 $ 48,600 $ 90,200 $ (1,000) Less: Fixed expenses, traceable to segment, but controllable by others ...................................... 750,000 500,000 250,000 26,000 8,000 16,000 200,000 Segment profit margin ...................... $ 78,100 $ 52,000 $ 26,100 $112,300 $ 40,600 $ 74,200 $(201,000) Less: Common fixed expenses ........... 10,000 Income before taxes .......................... $ 68,100 Less: Income tax expense .................. 37,440 Net income ....................................... $ 30,660 hiL25664_ch12_498-541.indd 511hiL25664_ch12_498-541.indd 511 7/16/13 9:54 PM7/16/13 9:54 PM Final PDF to printer 512 Chapter 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard special packaging or handling, demand faster delivery, or need special parts or engi- neering design generally are less profitable than customers who demand less in terms of customized services. If managers have a good understanding of which customers are generating the greatest profit, they can make more-informed decisions about customer service. Moreover, customers can be educated as to the costs they are causing by demand- ing special services. In many cases, customers’ behavior can be changed in a way that reduces costs to the supplier. Then these cost savings can be shared by the supplier and the customer. (Customer-profitability analysis is covered more extensively in Chapter 5.) Operational Performance Measures in Today’s Production Environment In today’s production environment, operational performance measures carry great impor- tance. Under the philosophy of activity-based management, the goal is to focus on con- tinually improving each activity. As a result, the emerging operational control measures focus on the key activities in which the organization engages. For example, Zappos.com , the Internet shoe retailer owned by Amazon.com , measures the percentage of time that each customer service representative spends on the telephone, because customer service is the cornerstone of its strategy. Exhibit 12–8 lists some commonly-used operational performance measures. The measures listed in Exhibit 12–8 are representative, but not exhaustive, of those used in practice. In using these measures to control operations, management emphasizes trends over time. The goal is to continually improve all critical aspects of production. Raw Material and Scrap Raw material continues to be a significant cost element in any manufacturing process, whether labor-intensive or highly automated. Worldwide material sourcing and international competition have resulted in the purchasing function taking on greater importance in many firms. As a result, purchasing performance has become an important area of measurement; criteria include total raw-material cost, devia- tions between actual and budgeted material prices, the quality of raw materials, and the delivery performance of vendors. Inventory Inventory is a significant investment for any manufacturing or distribution company. The essence of the just-in-time production environment is low inventories at every stage of production. Thus, inventory control is of paramount importance in achiev- ing the benefits of the JIT philosophy. Inventory control measures include the average value of inventory, the average amount of time various inventory items are held, and other inventory turnover measures, such as the ratio of inventory value to sales revenue. Machinery If inventories are to be kept low and customers are to be satisfied, then the production process must be capable of producing and delivering goods and services quickly. This goal requires that machinery must work when it is needed, which means that routine maintenance schedules must be adhered to scrupulously. Performance controls in this area include measures of machine downtime and machine availability, and detailed maintenance records. Some companies make a distinction between bottleneck machinery and nonbottle- neck machinery. A bottleneck operation is one that limits the production capacity of the entire facility. It is vital that the machinery in bottleneck operations be available 100 percent of the time, excluding time for routine required maintenance. This emphasis on bottleneck opera- tions is consistent with the management philosophy known as the theory of constraints (TOC), which seeks to maximize long-run profit through proper management of organiza- tional bottlenecks or constrained resources. The key idea in TOC is to identify the constraints in a system that are preventing the organization from achieving a higher level of success and then to seek to relieve or relax those constraints. Moreover, TOC recommends subordinating all other management goals to the objective of solving the constraint problems. 3 Operational Performance Measures in Today’s Production Environment Learning Objective 12-6 Describe the operational performance measures appro- priate for today’s production environment. hiL25664_ch12_498-541.indd 512hiL25664_ch12_498-541.indd 512 7/16/13 9:54 PM7/16/13 9:54 PM Final PDF to printer Chapter 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard 513 Product and Service Quality The competitive market demands adherence to strict qual- ity standards for raw materials, manufactured components, and products and services sold. Various nonfinancial data are vital for assessing a company’s effectiveness in maintaining product and service quality. Customer acceptance measures focus on the extent to which a firm’s customers perceive its outputs to be of high quality. Typical performance measures include the number of customer complaints, the number of warranty claims, the number of products returned, and the cost of repeat service visits. In-process quality controls refer to procedures designed to assess product and service quality before production is completed. For example, in a quality audit program, partially completed jobs are inspected at various stages of production. Defect rates are measured, and corrective actions are suggested. Production and Delivery A company will achieve little success if it produces a great product but delivers it to the customer a week late. World-class companies are striving toward a goal of filling 100 percent of their orders on time. Common measures of deliv- ery performance include the percentage of on-time deliveries and the percentage of orders filled. Another measure is delivery cycle time, the average time between the receipt of a customer order and delivery of the goods. “We have to be the best in cost throughout the world. And cycle time is also very important.” (12f) MiCRUS (joint venture of IBM and Cirrus Logic, now part of NXP Semiconductor) Exhibit 12–8 Operational Performance Measures for the Modern Production Environment Raw Material and Scrap Number of vendors Raw material as a percentage of total cost Lead time for material delivery Percentage of orders received on time Material purchase-price variances Scrap as a percentage of raw-material cost Quality of raw material Inventory Average value of inventory Average amount of time various inventory items are held Ratio of inventory value to sales revenue Number of inventoried parts Machinery Hours of machine downtime Percentage of machine availability Percentage of bottleneck machine availability Percentage of on-time routine maintenance procedures Setup time Product switchover times Product and Service Quality Customer acceptance measures: Number of customer complaints Number of warranty claims Cost of repeat service visits Number of products returned Cost of repairing returned products In-process quality measures: Number of defects found Cost of rework Quality costs Production and Delivery Manufacturing cycle time Velocity Manufacturing cycle efficiency Percentage of on-time deliveries Percentage of orders filled Delivery cycle time Productivity Financial measures: Aggregate or total productivity (output in dollars 4 total input in dollars) Partial or component productivity (output in dollars 4 a particular input in dollars) Operational (physical) measures: Partial or component productivity measures. These measures express relationships between inputs and outputs, in physical terms. For example: Service visits made per day per employee Square feet of floor space required per finished product per day Electricity required per finished product Innovation and Learning New products or services: Percentage of sales from new products New services introduced by this firm versus introductions by competitors Process improvements: Number of process improvements made Cost savings from process improvements 3 Eliyahu M. Goldratt, Theory of Constraints (Croton-on-Hudson, New York: North River Press, 1990). hiL25664_ch12_498-541.indd 513hiL25664_ch12_498-541.indd 513 7/16/13 9:54 PM7/16/13 9:54 PM Final PDF to printer 514 Chapter 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard Delivering goods on time requires that they be produced on time. Various operational performance measures have been developed to assess the timeliness of the production pro- cess. For example, in a manufacturing firm, manufacturing cycle time is the total amount of production time (or throughput time) required per unit. It can be computed by dividing the total time required to produce a batch by the number of units in the batch. Velocity is defined as the number of units produced in a given time period. Perhaps an even more important operational measure is the manufacturing cycle efficiency (MCE), defined as follows: Manufacturing cycle efficiency 5 Processing time ____________________________ Processing time 1 Inspection time 1 Waiting time 1 Move time The value of the MCE measure lies in its comparison between value-added time (pro- cessing) and non-value-added time (inspection, waiting, and moving). In many manu- facturing companies, MCE is less than 10 percent. Firms with advanced manufacturing systems strive for as high an MCE measure as possible. Productivity Global competitiveness has forced virtually all companies to strive for greater productivity. One financial productivity measure is aggregate (or total ) productivity, defined as total output divided by total input. A firm’s total output is measured as the sum, across all of the goods and services produced, of those products and services times their sales prices. Total input is the sum of the direct-material, direct-labor, and overhead costs incurred in production. Another financial measure is a partial (or component ) productivity mea- sure, in which total output (in dollars) is divided by the cost of a particular input. A preferable approach to productivity measurement is to record multiple physical measures that capture the most important determinants of a company’s productivity. These operational (or physical) measures are also partial productivity measures, since each one focuses on a particular input. For example, a large automobile manufacturer routinely records the following data for one of its plants: the number of engines produced per day per employee and the number of square feet of floor space required per engine produced in a day. Data such as these convey more information to management than a summary financial measure such as aggregate productivity. Innovation and Learning Global competition requires that companies continually improve and innovate. New products must be developed and introduced to replace those that have become obsolete. New processes must continually be developed to make pro- duction more efficient. In a world-class manufacturer or service firm, the one thing that is most constant is change. Improvement Targets To summarize, nonfinancial measures are being used increas- ingly to augment financial planning and analysis systems. These operational performance measures assist management in its goal of continuous process improvement. To be most effective, operational controls should be tied to the strategic objectives of the organiza- tion. Specific improvement targets can be set for various measures to provide motivation for improvement in the areas deemed most important by management. One widely used method to improve operational efficiency is benchmarking. This is the continual search for the most effective method of accomplishing a task by compar- ing existing methods and performance levels with those of other organizations, or with other subunits within the same organization. For example, hospitals routinely benchmark their costs of patient care by diagnostic-related groups (such as circulatory disorders) by comparing them with the costs of other hospitals. Gain-Sharing Plans One widely used method of providing incentives to employees to improve their perfor- mance on various operational control measures is gain sharing. A gain-sharing plan is an incentive system that specifies a formula by which cost or productivity gains achieved hiL25664_ch12_498-541.indd 514hiL25664_ch12_498-541.indd 514 7/16/13 9:54 PM7/16/13 9:54 PM Final PDF to printer Chapter 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard 515 by a company are shared with the workers who helped accomplish the improvements. For example, suppose an Internet retailer reduced its returns due to late shipment by 2 percent for a savings of $100,000. A gain-sharing formula might call for 25 percent of the savings to be shared with the employees in the distribution center. The Balanced Scorecard Managers of the most successful organizations do not rely on either financial or nonfinan- cial performance measures alone. They recognize that financial performance measures summarize the results of past actions. These measures are important to a firm’s owners, creditors, employees, and so forth. Thus, they must be watched carefully by management as well. Nonfinancial performance measures concentrate on current activities, which will be the drivers of future financial performance. Thus, effective management requires a bal- anced perspective on performance measurement, a viewpoint that some call the balanced scorecard perspective. To illustrate the balanced scorecard, we will explore its use by Forest Home National Bank (FHNB), located in Boise, Idaho. The bank’s balanced scorecard, which is depicted in Exhibit 12–9 , integrates performance measures in four key areas: financial, The Balanced Scorecard Learning Objective 12-7 Describe the balanced score- card concept and explain the reasoning behind it. Exhibit 12–9 Balanced Scorecard: Forest Home National Bank Financial Perspective Goals Measures How do we look to the firm’s owners? How do our customers see us? In which activities must we excel? Profit growth % Revenue growth % Return on assets Financial growth Learning and Growth Perspective Goals Measures % participation in voluntary continuing-education programs Number of employees in required training programs Employee suggestions per month Employee suggestions adopted New services introduced by FHNB Customer suggestions adopted Motivated and prepared employees Innovative banking services Customer Perspective Goals Measures Satisfying the customer Market penetration Internal Business Process Perspective Goals Measures Customer satisfaction survey % customer retention % profitable customers Customer complaints per month Market share in coverage area How can we continually improve and create value? % of automated transactions Response time for online transactions % of manual transaction errors Cost per customer transaction Average loan-processing time Loan approve/reject ratio Transaction efficiency Loan processing efficiency hiL25664_ch12_498-541.indd 515hiL25664_ch12_498-541.indd 515 7/16/13 9:54 PM7/16/13 9:54 PM Final PDF to printer 516 Chapter 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard internal business process, customer, and learning and growth. 4 What is the rationale behind FHNB’s balanced scorecard? The bank’s overarching, long-term goal is financial growth. This goal will be assessed by the following financial measures: profit growth percentage, revenue growth percentage, and return on assets. This begs the question, though, as to what FHNB should be doing right now to ensure that its long-term financial goals will be met. The bank’s management has decided on several key goals that must be achieved in the near term in order for the company’s long-term financial goals to be met. Let’s first look at the customer perspective in the balanced scorecard. The ques- tion for FHNB’s management is “How do the bank’s customers see us?” Management has expressed its customer-perspective goal as “satisfying the customer.” How, then, can management measure progress on this short-term, day-to-day objective? Manage- ment has chosen five measures: (1) A customer satisfaction survey is conducted annu- ally among all the bank’s customers. Moreover, a more detailed customer satisfaction survey is aimed at the bank’s key customers, which account for about 20 percent of the customer base. (2) FHNB’s management keeps track of the percentage of its custom- ers that it retains from one year to the next. The assumption is that a customer who stays with FHNB is largely satisfied with the service. (3) Not all of FHNB’s customers are profitable. (This is true of almost all banks.) For example, customers that keep low account balances, pay off their credit cards each month, and avoid service charges tend to be unprofitable. Therefore, the percentage of profitable customers is a very important measure. A trend in the wrong direction here would almost certainly spell trouble for the company’s financial goals in the future. (4) FHNB’s management has found that a particularly sensitive customer-satisfaction measure is the number of complaints received in a month. If something is going awry in FHNB’s customer interface, customers are not shy about letting the bank know about it—and quickly. (5) Finally, FHNB’s market share in its coverage area is a key measure of market penetration. Increasing this key measure would most likely translate into revenue and profit growth in the future. What about Forest Home National Bank’s internal operations? In what busi- ness processes must FHNB excel in order to achieve its long-term financial goals? Management has decided to focus on two important goals: completing routine bank transac- tions efficiently and processing loan applications efficiently. For routine bank transactions “Because of the balanced scorecard, the nature of the monthly financial meetings changed from a focus on the things Pitney Bowes is doing well to the three things we need to improve, with the emphasis on an appropriate action plan.” (12g) Pitney Bowes 4 Many banking institutions have developed a balanced scorecard. This balanced scorecard is an amalgamation of bank scorecards from a number of sources, including the authors’ research as well as the following resources: Robert S. Kaplan and David P. Norton, The Strategy-Focused Organization: How Balanced Scorecard Companies Thrive in the New Business Environment (Boston: Harvard Business School Press, 2001); Norman Klein and Robert S. Kaplan, “Chemical Bank: Implementing the Balanced Scorecard,” an HBS management case (Boston: President and Fellows of Harvard College, 1995); and Robert L. Simons and Antonio Davila, “Citibank: Performance Evaluation,” an HBS management case (Boston: President and Fellows of Harvard College, 1997). A company’s balanced scorecard should measure the aspects of its per- formance that are most important for its success. In a retail bank, such as Ulster Bank pictured here in Dublin, Ireland, the customer dimension of the scorecard would be likely to include measures of satisfaction that are influenced by customer-facing services such as ATM availability. In addition, the internal business processes dimension can reflect the stra- tegic use of technological innovations such as ATMs, as we see in the Forest Home National Bank example. hiL25664_ch12_498-541.indd 516hiL25664_ch12_498-541.indd 516 7/16/13 9:54 PM7/16/13 9:54 PM Final PDF to printer Chapter 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard 517 (e.g., making deposits, withdrawals, or loan payments), FHNB’s management focuses on three key measures: (1) Customers can complete automated transactions in three ways. They can bank online, use an ATM, or use a touch-tone telephone to make phone-automated inquiries. FHNB’s management believes that the greater the percentage of automated transactions, as opposed to transactions involving a bank teller, the more efficient will be the bank’s transaction operations. (2) Another measure of transaction efficiency is the average time that it takes a customer to complete an online transaction. The smaller this time interval is, FHNB’s management believes, the more likely customers will be to use online banking. (3) As far as manual, teller-assisted transactions go, FHNB’s management keeps track of the percentage of these transactions that exhibit errors. THE BALANCED SCORECARD For many companies, the balanced scorecard plays a key role in formulating strategy. According to a survey by Bain & Company, approximately 50 percent of Fortune 1000 com- panies in North America and roughly 40 percent in Europe use some version of the bal- anced scorecard (often abbreviated as BSC). Among them are both manufacturers and service industry companies. 5 Managers at United Parcel Service (UPS) believe that its balanced scorecard has played a critical strategic role in moving the organization forward. The company’s scorecard was widely accepted by its employees, who felt that the BSC helped them link their jobs to the big picture of overall company success. UPS includes the following key measures in the four perspectives of its balanced scorecard. 6 Financial Profit Revenue Cost Volume Internal operations Quality (e.g., timeliness of delivery, care in handling parcels) Operations (i.e., operational efficiency) Customer Customer claims (e.g., lost parcels) Customer concerns Data integrity (e.g., accuracy of the parcel tracking process) Learning & growth * Employee injuries Employee retention Employee relation index *Referred to as people in the UPS scorecard. anagement ccounting ractice M A P United Parcel Service (UPS) 5 Raef Lawson, William Stratton, and Toby Hatch, “Scorecarding Goes Global,” Strategic Finance 87, no. 9 (March 2006), pp. 35–41; and Thomas Wunder, “New Strategy Alignment in Multinational Corporations,” Strategic Finance 87, no. 5 (November 2005), pp. 35–41. 6 Robert S. Kaplan and David P. Norton, The Strategy-Focused Organization: How Balanced Scorecard Companies Thrive in the New Business Environment (Boston: Harvard Business School Press, 2001); and Bruce Stanley, “UPS Battles Traffic Jams to Gain Ground in India,” The Wall Street Journal, January 25, 2008, p. B1. hiL25664_ch12_498-541.indd 517hiL25664_ch12_498-541.indd 517 7/16/13 9:54 PM7/16/13 9:54 PM Final PDF to printer 518 Chapter 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard On the loan side of FHNB’s internal operations, management tracks two measures of loan processing efficiency: (1) The average time to process a loan application is a key indicator of how smoothly this aspect of the bank’s operations is running. (2) FHNB’s management also believes that the higher the ratio of approved to rejected loans, the more successful the bank has been in communicating its loan criteria to the bank’s customer base. Finally, let’s look at the learning and growth perspective in Forest Home National Bank’s balanced scorecard. Management has highlighted two goals: motivated and prepared employees and innovative banking services. To assess the goal of motivated and prepared employees, FHNB’s management has established three measures: (1) The bank’s human resource management team believes that the percentage of employees par- ticipating in voluntary continuing education programs is an indicator of both employee motivation and preparation. (2) On the other hand, the number of employees in required training programs speaks to both the company’s training program offerings as well as employee preparation. (3) The number of employee suggestions per month, as well as the number of those suggestions adopted, also speaks to both employee motivation and prep- aration. A motivated employee is more likely to submit a suggestion, and a well-prepared employee is more likely to make an adoptable suggestion. The second goal under learning and growth on FHNB’s scorecard involves innova- tive banking services. (1) The number of new banking services first offered by FHNB in its coverage area, as opposed to those first offered by competing banks, is a measure of just how innovative FHNB’s management is. (2) When the bank is able to act positively on a customer suggestion, this too speaks to FHNB’s ability to learn from its customer base. All in all, FHNB’s management team believes that if the bank meets its current goals for its customer, internal business process, and learning and growth perspectives, the bank will ultimately be successful in achieving its long-term goal of financial growth. Lead and Lag Measures: The Key to the Balanced Scorecard Key to understanding the value and construction of the balanced scorecard is the distinc- tion between lead and lag indicators of performance. Lead indicators of performance are measures of nonfinancial and financial outcomes that guide management in making cur- rent decisions that will result in desirable results in the future. In other words, lead indica- tors guide management to take actions now that will have positive effects on enterprise performance later. For example, Forest Home National Bank’s scorecard includes the bank’s market share in its coverage area as an indicator of future market growth, which will ultimately translate into growth of the bank’s profitability. By including this key lead indicator in its scorecard, management is directed to take actions now that will increase the bank’s market share. Lag indicators are measures of the final outcomes of earlier management decisions. Examples of lag indicators are a company’s profit and cash flow. These key financial measures, while important, only change well after management has already made the important decisions that affect key operational results. As such, lag indicators are less useful for performance management and control. The whole idea of the balanced scorecard is to use lead indicators to communicate with, motivate, and evaluate individuals with the expectation that their current actions will result in improvements in the company’s important lag measures (e.g., profitabil- ity) in the future. Exhibit 12–10 shows this relationship and gives examples of several key lead and lag measures used in a variety of organizations’ balanced scorecards. In addition, note that most of the operational performance measures listed in Exhibit 12–8 (page 513) could be (and are) used in balanced scorecards. Many companies, in all types of industries, have developed a balanced scorecard to help management and employees understand the important lead indicators of perfor- mance that will ultimately bring success on the company’s key long-term goals. Among hiL25664_ch12_498-541.indd 518hiL25664_ch12_498-541.indd 518 7/16/13 9:54 PM7/16/13 9:54 PM Final PDF to printer Chapter 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard 519 the many service-industry firms that have developed a balanced scorecard are Bank of America, CIGNA, Citigroup, Duke Children’s Hospital, Fannie Mae, JPMorgan Chase, Northwestern Mutual, and UPS. Retailers too have made use of the balanced scorecard. Among them are Ann Taylor, IKEA, and Tesco. Among the well-known manufacturers making use of the balanced score card con- cept are Anheuser-Busch, Apple, Caterpillar, Chrysler, ExxonMobil, General Motors, Microsoft, Motorola, Phillips Electronics, and Pfizer. Finally, governmental units also have benefited from a balanced scorecard, among them the city of Charlotte, North Caro- lina, the state of Washington, and the U.S. Department of Defense. Linking the Balanced Scorecard to Organizational Strategy A key to making successful use of the balanced scorecard is linking the scorecard’s lead and lag measures to the organization’s strategy. As depicted in the diagram in Exhibit 12–11 , the organization’s vision and strategy drive the specification of both goals and metrics in the scorecard’s financial, customer, internal business process, and learning and growth perspectives. 7 The precise form of the linkage between strategy and the goals and measures in the balanced scorecard will, of course, depend on the nature of the organization and its strat- egy. However, the linkage can be visualized as a chain of cause and effect between the company’s scorecard elements and its strategy and goals. The chain of cause and effect occurs because an important change may not directly result in the company’s reaching its strategic goal. Instead, that change may be necessary before another type of orga- nizational change can occur. And the second change may be the one that leads to the strategic goal. 8 Exhibit 12–10 Selected Performance Measures Used in Balanced Scorecards Financial Perspective Earnings Cash flow Earnings per share Cash flow from operations Customer Perspective Customer contacts Customer satisfaction (surveyed) Repeat customers Customer complaints New customers Market share Internal Business Process Perspective Product quality/defect rates Finished products per day per employee Number of vendors Floor space per finished product Cycle time Cost of inventories held Throughput Number of common parts Machine downtime Number of part numbers Learning and Growth Perspective Employee training hours New processes Employee promotion rate Employee suggestions New products or services Employee retention 7 Robert S. Kaplan and David P. Norton, The Strategy-Focused Organization: How Balanced Scorecard Companies Thrive in the New Business Environment (Boston: Harvard Business School Press, 2001). See also Raef Lawson, William Stratton, and Toby Hatch, “Scorecarding Goes Global,” Strategic Finance 87, no. 9 (March 2006), pp. 35–41. “Defining our [balanced scorecard] measures, align- ing our initiatives, and pro- viding greater visibility into our performance objectives has enabled us to make bet- ter management decisions for our future growth.” (12h) Columbia Sportswear 8 This material is based on Peter Brewer, “Putting Strategy into the Balanced Scorecard,” Strategic Finance 83, no. 7 (January 2002), pp. 44–52. Further development is found in Wilhelm Schmeisser et al, “5: Balanced Scorecard as an Indicator System,” Controlling and Berlin Balanced Scorecard Approach (Munich: Oldenberg Verlag, 2011) pp. 68–94. hiL25664_ch12_498-541.indd 519hiL25664_ch12_498-541.indd 519 7/16/13 9:54 PM7/16/13 9:54 PM Final PDF to printer 520 Chapter 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard Using the balanced scorecard model, we can define the chain of cause and effect by following the sequence of lead or lag relationships in the scorecard’s measures. For example, Sears once confronted challenges to its strategic profitability goals by construct- ing a balanced scorecard to measure the links between employee training and profits. The path to the profitability goal flowed through a chain of cause and effect: an increase in employee training hours (learning and growth) led to an increase in service quality (internal business process), which led in turn to increased repeat customers (customer) which finally led to the strategic goal of profitability (financial). 9 Notice that the learn- ing and growth measure of increased employee training did not lead directly to increased profits: training so many employees cost a lot of money, so its direct effect was actually to reduce profits! But through the chain of cause and effect it eventually helped the com- pany achieve its strategic profitability goals. The following case in point explores this linkage for Amazon.com , Inc., which is arguably one of the most successful companies of our time. Exhibit 12–11 Linkage between the Balanced Scorecard and Organizational Strategy Customer Internal Business Process Financial Learning and Growth Vision and Strategy 9 Anthony J. Rucci, Steven P. Kirn, and Richard T. Quinn, “The Employee-Customer-Profit Chain at Sears,” Harvard Business Review, January–February 1998, pp. 82–97. 10 This example is derived from Amazon.com ’s mission and strategy. For more information, refer to the Investor Relations section of the Amazon.com website at http://www.amazon.com/ir . LINKING THE BALANCED SCORECARD TO ORGANIZATIONAL STRATEGY One key to successfully using the balanced scorecard is linking the scorecard’s lead and lag measures to the organization’s strategy. According to the Amazon.com , Inc., website, the company’s strategy is “to be Earth’s most customer-centric company; to build a place where people can come to find and discover anything they might want to buy online.” 10 Leaving aside the issue of whether there might be a more customer-centric company on another planet elsewhere in the universe, Amazon.com ’s strategy of providing unpar- alleled customer service via its online-only sales model drives the company’s efforts in each of the perspectives that comprise a balanced scorecard. anagement ccounting ractice M A P Amazon.com (continues) hiL25664_ch12_498-541.indd 520hiL25664_ch12_498-541.indd 520 7/16/13 9:54 PM7/16/13 9:54 PM Final PDF to printer Chapter 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard 521 The following selected balanced scorecard measures are among those relevant for Amazon.com to successfully implement its strategy. Notice the frequency of the word customer in these measures. Amazon.com ’s strategy and its relevant balanced scorecard measures are dominated by its customer-focused online sales business model. Improved internal processes and operations such as customer return handling Higher customer satisfaction Success for the company, as measured in financial terms Leading to Leading to Leading toDrives Learning and growth initiatives such as employee training Amazon .com's strategy of success through customer service Financial Profit (in relation to assets invested) Cash flow Revenue growth by customer segment Gross margin by customer segment Customer Average revenue per customer Customer satisfaction survey score Number of customer complaints received Percent of customers subscribing to "Prime" service Internal business process Return rate due to Amazon.com error Percent of orders delivered on time Order-to-shipment cycle time Number of customer-focused process innovations Learning and growth Training expenditures per employee Employee turnover rate Number of new patents that protect Amazon.com's online sales business model Employee satisfaction survey score Amazon.com's vision and strategy hiL25664_ch12_498-541.indd 521hiL25664_ch12_498-541.indd 521 7/16/13 9:54 PM7/16/13 9:54 PM Final PDF to printer 522 Chapter 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard Focus on Ethics SHORT-SIGHTED VIEW OF COST CUTTING Jamie Ericsson, the controller for Handico, has just com- piled a cost report for the second quarter. The report is prepared each quarter for corporate headquarters. She has taken particular notice of several major cost catego- ries that show significant reductions in expenditures when compared to the first quarter. She made the following list of the major cost cuts: Cost Item Cost Reduction ($) Cost Reduction (%) General employee training $12,000 25% Routine machine maintenance 13,500 20 Process improvement 12,000 12 Quality training 18,000 8 Raw-material inspection 6,500 9 Concerned that there may have been errors in com- piling the data, Ericsson scheduled an appointment with her supervisor, Les Winters, the divisional vice president. At the meeting, the conversation went like this. Ericsson (C): “Les, I’m concerned about these cost cuts. Are these mistakes, or are we really mak- ing such substantial cuts in these areas?” Winters (VP): “Your numbers look right, Jamie. I ordered these cutbacks myself. I think there’s a lot of fat in this operation that can be cut, and I’m just getting started.” Ericsson (C): “But these are all important areas to invest in, Les. I see the invoices for these costs every month, and I don’t think it’s wasted money at all.” Winters (VP): “Corporate wants a lean company, Jamie. I’m just trying to give them one.” Ericsson (C): “Have you thought through the implica- tions, Les? Cutting general employee training will eventually take a toll on our productivity gains. Same thing for the cuts in process improvements. And cutting routine machine maintenance could mean breakdowns later on. Maybe not for a year or so, but eventually it’ll take its toll.” Winters (VP): Becoming annoyed, “Those are my concerns, Ms. Ericsson, not yours.” Ericsson (C): “Look, Les, we’re all on the same team. I’m just concerned, that’s all. I feel as though I need to highlight these cost cuts in my report to corporate. They should at least be made aware of these issues. I’ll need your authorization for that.” Winters (VP): “No can do, Jamie. You are instructed to make your usual quarterly report using the standard format.” After the meeting, Ericsson was commiserating with her close friend, Amy Ling, the chief of engineering. Ericsson (C): “Amy, I just had a very unsatisfactory meeting with Les Winters. I shouldn’t go into the details, but I’m concerned about some things.” Ling (E): “Well, I have good news for you then. The grapevine has it that Les is on the very short list for taking over as president of our Japanese subsidiary. That would be a huge promotion for him. Word is that all he’s got to do is turn in a good performance for the year here. If he does that, the job’s his.” Ericsson (C): “That explains a lot, Amy. Thanks for the heads up. I’ve got some thinking to do.” What do you think is going on here? What is the VP, Les Winters, up to? Is he acting ethically? What steps should the controller, Jamie Ericsson, take? (Refer to the “Resolution of Ethical Conflict” section of the IMA State- ment of Ethical Professional Practice, discussed in Chap- ter 1 and reproduced on page 26.) How could a balanced scorecard help mitigate the problems apparent in this scenario? Rockwater, owned by Halliburton, is a global undersea oil services com- pany headquartered in Aberdeen, Scotland. Doing the undersea engi- neering and construction for drilling rigs such as the one pictured here requires diverse technical operations, both on- and offshore. Rockwater’s management found the balanced scorecard to be an invaluable tool in clarifying the company’s goals and communicating them to the employ- ees. Among the measures in Rockwater’s balanced scorecard are the following: cash flow and project profitability (financial); project pricing and customer satisfaction (customer); safety index and hours spent with cus- tomers on new work (internal); percentage of revenue from new services and number of employee suggestions (learning and growth). 11 11 Robert S. Kaplan and David P. Norton, The Strategy-Focused Organization: How Balanced Scorecard Companies Thrive in the New Business Environment (Boston: Harvard Business School Press, 2001). hiL25664_ch12_498-541.indd 522hiL25664_ch12_498-541.indd 522 7/24/13 3:10 AM7/24/13 3:10 AM Final PDF to printer Chapter 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard 523 Chapter Summary LO12-1 Explain the role of responsibility accounting in fostering goal congruence. Responsibil- ity-accounting systems are designed to foster goal congruence among the managers in decentralized organizations by specifying the performance measures upon which managers of various organizational subunits will be evaluated. LO12-2 Define and give an example of a cost center, a revenue center, a profit center, and an investment center. A cost center is an organizational subunit, the manager of which is held account- able for the subunit’s costs. Examples include the assembly department of an auto manufacturer and the maintenance department of a hotel. A revenue center is an organizational subunit, the manager of which is held accountable for the subunit’s revenue. Examples include the sales departments of a cruise line or an insurance company. A profit center is an organizational subunit, the manager of which is held accountable for the subunit’s profit. Examples include an individual branch bank or an individual fast food restaurant. An investment center is an organizational subunit, the manager of which is held accountable for the relationship between the subunit’s profit and its invested capital. A division of a large corporation (manufacturing, service, or retail) is usually designated as an investment center. LO12-3 Prepare a performance report and explain the relationships between the performance reports for various responsibility centers. The performance of each of an organization’s responsibility accounting centers is summarized periodically on a performance report. This report shows the budgeted and actual performance results for a specified time period for each responsibility accounting center. LO 12-4 Use a cost allocation base to allocate costs. A cost allocation base is a measure of activity, physical characteristic, or economic characteristic associated with a group of organizational subunits or activities, which is the basis for allocating costs among those subunits or activities. LO12-5 Prepare a segmented income statement. Segmented income statements often are included in a responsibility-accounting system to show the performance of the organization and its various seg- ments. To be most effective, such reports should distinguish between the performance of segments and segment managers. LO12-6 Describe the operational performance measures appropriate for today’s production envi- ronment. Nonfinancial measures of operational performance are widely used to augment the control information provided by the accounting system. These measures typically focus on raw material and scrap, inventory, machinery, product and service quality, production and delivery, productivity, and inno- vation and learning. LO12-7 Describe the balanced scorecard concept and explain the reasoning behind it. The bal- anced scorecard is an important tool designed to focus management’s attention on key current goals which, if achieved, will facilitate the attainment of the organization’s long-term goals. By achieving cur- rent goals in the customer, internal business process, and learning and growth perspectives, the company will ultimately achieve its long-term financial goals. Problem 1 James Madison National Bank has a division for each of the two counties in which it operates, Cayuga and Oneida. Each divisional vice president is held accountable for both profit and invested capital. Each division consists of two branch banks, East and West. Each branch manager is responsible for that bank’s profit. The Cayuga Division’s East Branch has a Deposit Department, a Loan Department, and an Administrative Services Department. The department supervisors of the Loan and Deposit Depart- ments are accountable for departmental revenues; the Administrative Services Department supervisor is accountable for costs. All of James Madison National Bank’s advertising and promotion is done centrally. The advertising and promotion cost pool for the year just ended, which amounted to $40,000, is allocated across the four branch banks on the basis of budgeted branch revenue. Budgeted revenue for the year is shown below. Cayuga Division: West Branch ............................................................................................ $400,000 East Branch ............................................................................................. 200,000 Oneida Division: West Branch ............................................................................................ 250,000 East Branch ............................................................................................. 150,000 Review Problems on Responsibility Accounting and Operational Performance Measures hiL25664_ch12_498-541.indd 523hiL25664_ch12_498-541.indd 523 7/16/13 9:54 PM7/16/13 9:54 PM Final PDF to printer 524 Chapter 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard Required: 1. Draw an organization chart for James Madison National Bank that shows each subunit described above, its manager’s title, and its designation as a responsibility center. 2. Distribute (allocate) the bank’s advertising cost pool to the four branch banks. Problem 2 Tuscarora Door Company manufactures high-quality wooden doors used in home construction. The fol- lowing information pertains to operations during April. Processing time (average per batch) ............................................ 6 hours Inspection time (average per batch) .............................................. 1 hour Waiting time (average per batch) .................................................. 4 hours Move time (average per batch) ..................................................... 5 hours Units per batch ........................................................................... 40 units Compute the following operational measures: (1) average value-added time per batch; (2) average non- value-added time per batch; (3) manufacturing cycle efficiency; (4) manufacturing cycle time; (5) velocity. Solutions to Review Problems Problem 1 1. Organization chart (subunits, managers, responsibility center designation) is shown below. James Madison National Bank (investment center; managed by bank president) Cayuga Division (investment center; managed by vice president) Oneida Division (investment center; managed by vice president) West Branch (profit center; managed by branch manager) East Branch (profit center; managed by branch manager) West Branch (profit center; managed by branch manager) East Branch (profit center; managed by branch manager) Deposit Department (revenue center; managed by department supervisor) Loan Department (revenue center; managed by department supervisor) Administrative Services Department (cost center; managed by department supervisor) 2. Cost distribution (or allocation): Cost Pool Responsibility Center Allocation Base: Revenue Percentage of Total* Costs Distributed Advertising Cayuga, West Branch ...................... $ 400,000 40% $16,000 and Cayuga, East Branch ....................... 200,000 20 8,000 promotion Oneida, West Branch ....................... 250,000 25 10,000 costs Oneida, East Branch ....................... 150,000 15 6,000 Total .............................................. $1,000,000 100% $40,000 *Branch revenue as a percentage of total revenue, $1,000,000. hiL25664_ch12_498-541.indd 524hiL25664_ch12_498-541.indd 524 7/16/13 9:54 PM7/16/13 9:54 PM Final PDF to printer Chapter 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard 525 Problem 2 1. Average value-added time per batch 5 Processing time 5 6 hours 2. Average non-value-added time per batch 5 Inspection time 1 Waiting time 1 Move time 5 10 hours 3. Manufacturing cycle efficiency 5 Processing time ____________________________ Processing time 1 Inspection time 1 Waiting time 1 Move time 5 6 hours _____________________________ 6 hours 1 1 hour 1 4 hours 1 5 hours 5 37.5% 4. Manufacturing cycle time 5 Total production time per batch __________________________ Units per batch 5 16 hours ________________ 40 units per batch 5 .4 hour (or 24 minutes) per unit 5. Velocity 5 Units per batch __________________________ Total production time per batch 5 40 units ________ 16 hours 5 2.5 units per hour Key Terms For each term’s definition refer to the indicated page, or turn to the glossary at the end of the text. activity-based responsibility accounting, 508 aggregate (total) productivity, 514 allocation base, 506 balanced scorecard, 515 benchmarking, 514 common costs, 509 cost allocation ( or distribution), 506 cost center, 500 cost objects, 506 cost pool, 506 customer acceptance measures, 513 customer profitability analysis, 511 delivery cycle time, 513 gain-sharing plan, 514 goal congruence, 500 in-process quality controls, 513 investment center, 501 lag indicators, 518 lead indicators, 518 manufacturing cycle efficiency (MCE), 514 manufacturing cycle time, 514 partial (component) productivity, 514 performance report, 504 profit center, 500 responsibility accounting, 500 responsibility center, 500 revenue center, 500 segmented income statement, 509 theory of constraints (TOC), 512 velocity, 514 Review Questions 12–1. Why is goal congruence important to an organization’s success? How does a responsibility-accounting system foster goal congruence? 12–2. Define and give examples of the following terms: cost center, revenue center, profit center, and investment center. 12–3. Under what circumstances would it be appropriate to change the Waikiki Sands Hotel from a profit center t o an investment center? 12–4. Explain the relationship between performance reports and flexible budgeting. 12–5. What is the key feature of activity-based responsibility accounting? Briefly explain. 12–6. Explain how to get positive behavioral effects from a responsibility-accounting system. 12–7. “Performance reports based on controllability are impossible. Nobody really controls anything in an organization!” Do you agree or disagree? Explain your answer. 12–8. Define and give examples of the following terms: cost pool, cost object, and cost allocation (or distribution ). 12–9. Give an example of a common resource in an organiza- tion. List some of the opportunity costs associated w ith using the resource. Why might allocation of the cost of the common resource to its users be useful? 12–10. Explain how and why cost allocation might be used to assign the costs of a mainframe computer system u sed for research purposes in a university. 12–11. Define the term cost allocation base. What would be a sensible allocation base for assigning advertising costs to the various components of a large theme park? 12–12. Referring to Exhibit 12–5 , why are marketing costs distributed to the Waikiki Sands Hotel’s departments o n the basis of budgeted sales dollars? 12–13. Explain what is meant by a segmented income statement. 12–14. Why do some managers and accountants choose not to allocate common costs in segmented reports? 12–15. Why is it important in responsibility accounting to dis- tinguish between segments and segment managers? 12–16. List and explain three key features of the segmented income statement shown in Exhibit 12–7 . hiL25664_ch12_498-541.indd 525hiL25664_ch12_498-541.indd 525 7/16/13 9:54 PM7/16/13 9:54 PM Final PDF to printer 526 Chapter 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard 12–17. Can a common cost for one segment be a traceable cost for another segment? Explain your answer. 12–18. What is meant by customer profitability analysis? Give an example of an activity that might be performed more commonly for one customer than for another. 12–19. List seven areas in which nonfinancial, operational per- formance measures are receiving increased emphasis in today’s manufacturing environment. 12–20. Define the term manufacturing cycle efficiency. 12–21. List four examples of customer acceptance measures. 12–22. What is meant by aggregate productivity, and what are its limitations? 12–23. Give an example of a gain sharing plan that could be implemented by an airline. 12–24. Using the Internet, identify the organizational strategy for a company of your choosing and suggest two per- formance measures in each of the four balanced score- card categories. 12–25. Using the measures selected in question 12-24, explain the difference between lead and lag measures. 12–26. Explain how an improvement in employee retention (a learning and growth measure) could flow through each of the balanced scorecard perspectives to result in improved financial performance. All applicable Exercises are available with McGraw-Hill’s Connect Accounting ®. Exercises Oradell E lectronics Company manufactures complex circuit boards for the aerospace industry. Demand for the company’s products has fallen in recent months, and the firm has cut its production significantly. Many unskilled workers have been temporarily laid off. Top management has made a decision, however, not to lay off any highly skilled employees, such as inspectors and machinery operators. Management was concerned that these highly skilled employees would easily find new jobs elsewhere and not return when production returned to normal levels. To occupy the skilled employees during the production cutback, they have been reassigned tem- porarily to the Maintenance Department. Here they are performing general maintenance tasks, such as repainting the interior of the factory, repairing the loading dock, and building wooden storage racks for the warehouse. The skilled employees continued to receive their normal wages, which average $19 per hour. However, the normal wages for Maintenance Department employees average $11 per hour. The supervisor of the Maintenance Department recently received the March performance report, which indicated that his department’s labor cost exceeded the budget by $21,230. The department’s actual labor cost was approximately 85 percent over the budget. The department supervisor complained to the controller. Required: As the controller, how would you respond? Would you make any modification in Oradell’s responsibility-accounting system? If so, list the changes you would make. Explain your reasoning. For each of the following o rganizational subunits, indicate the type of responsibility center that is most appropriate. 1. An orange juice factory operated by a large orange grower. 2. The College of Engineering at a large state university. 3. The European Division of a multinational manufacturing company. 4. The outpatient clinic in a profit-oriented hospital. 5. The Mayor’s Office in a large city. 6. A movie theater in a company that operates a chain of theaters. 7. A radio station owned by a large broadcasting network. 8. The claims department in an insurance company. 9. The ticket sales division of a major airline. 10. A bottling plant of a soft drink company. The following data p ertain to the Waikiki Sands Hotel for the month of March. Flexible Budget March (in thousands)* Actual Results March (in thousands)* Banquets and Catering ................................................. $ 650 ........................ $ 658 Restaurants ................................................................. 1,800 ........................ 1,794 Kitchen staff wages ...................................................... (85) ........................ (86) Food ........................................................................... (690) ....................... (690) Paper products ............................................................ (125) ....................... (122) Variable overhead ........................................................ (75) ....................... (78) Fixed overhead ............................................................ (90) ....................... (93) *Numbers without parentheses denote profit; numbers with parentheses denote expenses. ■ Exercise 12–27 Assigning Responsibility for Skilled Employees’ Wages (LO 12-1) ■ Exercise 12–28 Designating Responsibility Centers (LO 12-2) ■ Exercise 12–29 Performance Report; Hotel (LO 12-3) hiL25664_ch12_498-541.indd 526hiL25664_ch12_498-541.indd 526 7/16/13 9:54 PM7/16/13 9:54 PM Final PDF to printer Chapter 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard 527 Required: Prepare a March performance report similar to the lower portion of Exhibit 12–4 . The report should have six numerical columns with headings analogous to those in Exhibit 12–4 . Your per- formance report should cover only the Food and Beverage Department and the Kitchen. Draw arrows to show the relationships between the numbers in the report. Refer to Exhibit 12–4 for guidance. For the year-to-date columns in your report, use the data given in Exhibit 12–4 . You will need to update those figures using the March data given above. How should a responsibility-accounting system handle each of the following s cenarios? 1. Department A manufactures a component, which is then used by Department B. Department A recently experienced a machine breakdown which held up production of the component. As a result, Department B was forced to curtail its own production, thereby incurring large costs of idle time. An investigation revealed that Department A’s machinery had not been properly maintained. 2. Refer to the scenario above, but suppose the investigation revealed the machinery in Department A had been properly maintained. Xerox Corporation has been an innovator in its responsibility-accounting system. I n one initiative, management changed the responsibility-center orientation of its Logistics and Distribution Department from a cost center to a profit center. The department manages the inventories and provides other logis- tical services to the company’s Business Systems Group. Formerly, the manager of the Logistics and Distribution Department was held accountable for adherence to an operating expense budget. Now the department “sells” its services to the company’s other segments, and the department’s manager is evalu- ated partially on the basis of the department’s profit. Xerox Corporation’s management feels that the change has been beneficial. The change has resulted in more innovative thinking in the department and has moved decision making down to lower levels in the company. Required: Comment on the new responsibility-center designation for the Logistics and Distribution Department. Wyoming Community College has three divisions: Liberal Arts, Sciences, and B usiness Administration. The college’s comptroller is trying to decide how to allocate the costs of the Admissions Department, the Registrar’s Department, and the Computer Services Department. The comptroller has compiled the following data for the year just ended. Department Annual Cost Admissions ...................................................................................................................................... $117,000 Registrar ......................................................................................................................................... 195,000 Computer Services ........................................................................................................................... 416,000 Division Budgeted Enrollment Budgeted Credit Hours Planned Courses Requiring Computer Work Liberal Arts .................................................... 1,000 30,000 12 Sciences ....................................................... 800 28,000 24 Business Administration ................................. 700 22,000 24 Required: 1. For each department, choose an allocation base and distribute the departmental costs to the college’s three divisions. Justify your choice of an allocation base. 2. Would you have preferred a different allocation base than those available using the data compiled by the comptroller? Why? 3. Build a spreadsheet: Construct an Excel spreadsheet to solve requirement (1) above. Show how the solution will change if the following information changes: the costs incurred by the depart- ments were $120,000, $200,000, and $420,000, for Admissions, Registrar, and Computer Services, respectively. ■ Exercise 12–30 Responsibility Accounting; Equipment Breakdown (LO 12-1, 12-2) ■ Exercise 12–31 Responsibility-Accounting Centers; Xerox Corporation (LO 12-1, 12-2) ■ Exercise 12–32 Cost Allocation in a College (LO 12-4) hiL25664_ch12_498-541.indd 527hiL25664_ch12_498-541.indd 527 7/16/13 9:54 PM7/16/13 9:54 PM Final PDF to printer 528 Chapter 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard Tri-County Cable Services, Inc., is organized with three segments: Metro, Suburban, and Outlying. D ata for these segments for the year just ended follow. Metro Suburban Outlying Service revenue ...................................................... $950,000 $750,000 $350,000 Variable expenses ................................................... 150,000 100,000 50,000 Controllable fixed expenses ..................................... 350,000 270,000 100,000 Fixed expenses controllable by others ...................... 180,000 150,000 40,000 In addition to the expenses listed above, the company has $45,000 of common fixed expenses. Income-tax expense for the year is $245,000. Required: 1. Prepare a segmented income statement for Tri-County Cable Services, Inc. Use the contribution format. 2. Build a spreadsheet: Construct an Excel spreadsheet to solve the preceding requirement. Show how the solution will change if the following information changes: the sales revenues were $960,000 and $780,000 for Metro and Suburban, respectively. Visit the w ebsite for one of the following companies, or a different company of your choosing. Marriott Hotels www.marriott.com Pizza Hut www.yum.com McDonald’s www.mcdonalds.com Wyndham Hotels www.wyndhamworldwide.com Bank of America www.bankofamerica.com Xerox www.xerox.com Required: Read about the company’s activities and operations. Then do as good a job as you can in preparing an organization chart for the firm. For each subunit in the organization chart, indicate what type of responsibility accounting center designation you believe would be most appropriate. (Refer to Exhibits 12–1 and 12–2 for guidance.) Ontario Bank and T rust Company’s total output of financial services during the year just ended was valued at $11 million. The total cost of the firm’s inputs, primarily direct labor and overhead, was $10 million. Required: 1. Compute Ontario’s aggregate (or total) productivity for the year. 2. Do you believe this is a useful measure? Why? Suggest an alternative approach that Ontario Bank and Trust might use to measure productivity. Data Screen C orporation is a highly automated manufacturing firm. The vice president of finance has decided that traditional standards are inappropriate for performance measures in an automated environ- ment. Labor is insignificant in terms of the total cost of production and tends to be fixed, material quality is considered more important than minimizing material cost, and customer satisfaction is the number one priority. As a result, production and delivery performance measures have been chosen to evaluate perfor- mance. The following information is considered typical of the time involved to complete and ship orders. Waiting time: From order being placed to start of production ............................................................................... 16 days From start of production to completion .......................................................................................... 14 days Inspection time ................................................................................................................................ 3 days Processing time ............................................................................................................................... 6 days Move time ....................................................................................................................................... 5 days Required: 1. Calculate the manufacturing cycle efficiency. 2. Calculate the delivery cycle time. (CMA, adapted) ■ Exercise 12–33 Segmented Income State- ment; TV Cable Company (LO 12-5) ■ Exercise 12–34 Responsibility Accounting; Use of Internet (LO 12-1, 12-2) ■ Exercise 12–35 Productivity Measurement (LO 12-6) ■ Exercise 12–36 Performance Measures for Production and Delivery (LO 12-6) hiL25664_ch12_498-541.indd 528hiL25664_ch12_498-541.indd 528 7/16/13 9:54 PM7/16/13 9:54 PM Final PDF to printer Chapter 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard 529 Hiawatha Hydrant Company manufactures fire hydrants in Oswego, New York. The following i nforma- tion pertains to operations during May. Processing time (average per batch) ............................................................................................. 4.25 hours Inspection time (average per batch) ............................................................................................... .25 hour Waiting time (average per batch) ................................................................................................... .25 hour Move time (average per batch) ...................................................................................................... .25 hour Units per batch ............................................................................................................................ 20 units Required: Compute the following operational measures: (1)manufacturing cycle efficiency; (2) man- ufacturing cycle time; (3) velocity. Think carefully about the overall mission and goals of your college or u niversity. Required: 1. How does the task of building a balanced scorecard for an educational institution differ from that for a profit-seeking enterprise? 2. Design a simple balanced scorecard for your institution, with a minimum of two measures in each of the scorecard’s perspectives. ■ Exercise 12–37 Operational Performance Measures (LO 12-6) ■ Exercise 12–38 Balanced Scorecard; Higher Education (LO 12-7) Problems Here is your chance to be a tycoon. Create your own company. You will be the president and c hief executive officer. It could be a manufacturer, retailer, or service industry firm, but not a hotel or bank. Draw an organization chart for your company, similar to the one in Exhibit 12–1 . Identify divisions and departments at all levels in the organization. Then prepare a companion chart similar to the one in Exhibit 12–2 . This chart should designate the title of the manager of a subunit at each level in the orga- nization. It also should designate the type of responsibility center appropriate for each of these subunits. Finally, write a letter to your company’s stockholders summarizing the major responsibilities of each of the managers you identified in your chart. For guidance, refer to the discussion of Exhibits 12–1 and 12–2 in the chapter. (Have some fun, and be creative.) After designing your company in the preceding problem, design a set of performance reports for the subunits you i dentified in your chart. Make up numbers for the performance reports, and show the rela- tionship between the reports. Refer to Exhibit 12–4 for guidance. The following partial organization chart is an extension of Exhibit 12–1 for Aloha Hotels and R esorts. ■ Problem 12–39 Create an Organization (LO 12-1, 12-2) ■ Problem 12–40 Design Performance Reports; Continuation of Preceding Problem (LO 12-3) ■ Problem 12–41 Designating Responsibility Centers; Hotel (LO 12-2) All applicable Problems are available with McGraw-Hill’s Connect Accounting ®. Waikiki Sands Hotel Grounds and Maintenance Department Front Desk Housekeeping and Custodial Department Food and Beverage Department Hospitality Department Bell Staff Guest Services Recreational Services Department hiL25664_ch12_498-541.indd 529hiL25664_ch12_498-541.indd 529 7/16/13 9:54 PM7/16/13 9:54 PM Final PDF to printer 530 Chapter 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard Each of the hotel’s five main departments is managed by a director (e.g., director of hospitality). The Front Desk subunit, which is supervised by the front desk manager, handles the hotel’s reserva- tions, room assignments, guest payments, and key control. The Bell Staff, managed by the bell captain, is responsible for greeting guests, front door service, assisting guests with their luggage, and deliver- ing room-service orders. The Guest Services subunit, supervised by the manager of Guest Services, is responsible for assisting guests with local transportation arrangements, advising guests on tourist attrac- tions, and such conveniences as valet and floral services. Required: As an outside consultant, write a memo to the hotel’s general manager suggesting a respon- sibility-center designation for each of the subunits shown in the organization chart above. Justify your choices. Mount R anier General Hospital serves three counties in the state of Washington. The hospital is a non- profit organization which is supported by patient billings, county and state funds, and private donations. The hospital’s organization chart follows. ■ Problem 12–42 Preparation of Performance Reports; Hospital. (LO 12-3) 1. Flexible budget, August, Cafeteria, total cost: $32,400 Ex Mount Ranier General Hospital General Medicine Division Surgical Division Medical Support Division Administrative Division Nursing Department Radiology and Laboratory Department Nutrition Department Housekeeping Department Maintenance Department Registered Dietitians' Section Food Service Section Kitchen Patient Food Service Cafeteria The following cost information has been compiled for August. Budget Actual August Year to Date August Year to Date Cafeteria: Food servers’ wages ............................... $ 16,000 $ 128,000 $ 18,000 $ 144,000 Paper products ....................................... 9,000 72,000 8,800 72,400 Utilities ................................................... 2,000 16,000 2,100 16,200 Maintenance .......................................... 800 6,400 200 2,200 Custodial ................................................ 2,200 17,600 2,200 17,200 Supplies ................................................. 2,400 19,200 1,800 19,200 Patient Food Service ................................... 34,000 272,000 37,000 274,000 Registered Dietitians’ Section ...................... 15,000 120,000 15,000 120,000 Kitchen ...................................................... 62,000 496,000 58,800 492,000 hiL25664_ch12_498-541.indd 530hiL25664_ch12_498-541.indd 530 7/16/13 9:54 PM7/16/13 9:54 PM Final PDF to printer Chapter 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard 531 Budget Actual August Year to Date August Year to Date Nursing Department .................................... 140,000 1,120,000 150,000 1,160,000 Radiology and Laboratory Department .......... 36,000 288,000 36,200 288,000 Housekeeping Department .......................... 20,000 160,000 23,200 172,000 Maintenance Department ............................ 26,000 208,000 12,000 154,000 General Medicine Division ........................... 420,000 3,360,000 408,000 3,341,800 Surgical Division ......................................... 280,000 2,240,000 282,000 2,231,600 Administrative Division ................................ 100,000 800,000 107,000 812,000 Required: 1. Prepare a set of cost performance reports similar to Exhibit 12–4 . The report should have six col- umns, as in Exhibit 12–4 . The first four columns will have the same headings as those used above. The last two columns will have the following headings: Variance—August, and Variance—Year to Date. Since all of the information in the performance reports for Mount Ranier General Hospital is cost information, you do not need to show these data in parentheses. Use F or U to denote whether each variance in the reports is favorable or unfavorable. 2. Using arrows, show the relationships between the numbers in your performance reports for Mount Ranier General Hospital. Refer to Exhibit 12–4 for guidance. 3. Put yourself in the place of the hospital’s administrator. Which variances in the performance reports would you want to investigate further? Why? Refer to the organization chart for Mount Ranier General Hospital g iven in the preceding problem. Ignore the rest of the data in that problem. The following table shows the cost application bases used to distribute various costs among the hospital’s divisions. Cost Pool Cost Allocation Base Annual Cost Facilities: Building depreciation Square feet of space $380,0000 Equipment depreciation Insurance Utilities: Electricity Cubic feet of space 48,000 Waste disposal Water and sewer Cable TV and phone Heat General administration: Administrator Budgeted number of employees 440,000 Administrative staff Office supplies Community outreach: Public education Budgeted dollars of patient billings 80,000 School physical exams Shown below are the amounts of each cost allocation base associated with each division. Square Feet Cubic Feet Number of Employees Patient Billings General Medicine Division ................... 15,000 135,000 30 $ 4,000,000 Surgical Division ................................. 8,000 100,000 20 2,500,000 Medical Support Division ..................... 9,000 90,000 20 1,500,000 Administrative Division ........................ 8,000 75,000 30 0 Total ................................................... 40,000 400,000 100 $ 8,000,000 ■ Problem 12–43 Cost Distribution Using Allocation Bases; Hospital (LO 12-4) 1. Facilities cost distributed to General Medicine, $142,500 hiL25664_ch12_498-541.indd 531hiL25664_ch12_498-541.indd 531 7/16/13 9:54 PM7/16/13 9:54 PM Final PDF to printer 532 Chapter 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard Required: 1. Prepare a table similar to Exhibit 12–5 which distributes each of the costs listed in the preceding table to the hospital’s divisions. 2. Comment on the appropriateness of patient billings as the basis for distributing community out- reach costs to the hospital’s divisions. Can you suggest a better allocation base? 3. Is there any use in allocating utilities costs to the divisions? What purposes could such an alloca- tion process serve? 4. Build a spreadsheet: Construct an Excel spreadsheet to solve requirement (1) above. Show how the solution will change if the following information changes: the costs incurred were $400,000, $50,000, $400,000, and $90,000, for facilities, utilities, general administration, and community outreach, respectively. Buckeye Department S tores, Inc., operates a chain of department stores in Ohio. The company’s organi- zation chart appears below. Operating data for 20x5 follow. ■ Problem 12–44 Prepare Segmented Income Statement; Contribution- Margin Format; Retail (LO 12-5) 1. Profit margin traceable to segment, Cleveland Division: $10,950,000 Profit margin traceable to segment, Scioto Store: $(1,320,000) Ex Buckeye Department Stores Columbus Division Cleveland Division Olentangy Store Scioto Store Downtown Store Individual Stores BUCKEYE DEPARTMENT STORES, INC. Operating Data for 20x5 (in thousands) Columbus Division Olentangy Store Scioto Store Downtown Store Cleveland Division (total for all stores) Sales revenue $15,000 $7,200 $33,000 $63,000 Variable expenses: Cost of merchandise sold 9,000 6,000 18,000 36,000 Sales personnel—salaries 1,200 900 2,250 4,800 Sales commissions 150 120 270 600 Utilities 240 180 450 900 Other 180 105 360 750 Fixed expenses: Depreciation—buildings 360 270 750 1,410 Depreciation—furnishings 240 150 420 870 Computing and billing 120 90 225 480 Warehouse 210 180 600 1,350 Insurance 120 75 270 600 Property taxes 105 60 240 510 Supervisory salaries 450 300 1,200 2,700 Security 90 90 240 630 The following fixed expenses are controllable at the divisional level: depreciation—furnishings, computing and billing, warehouse, insurance, and security. In addition to these expenses, each division annually incurs $150,000 of computing costs, which are not allocated to individual stores. hiL25664_ch12_498-541.indd 532hiL25664_ch12_498-541.indd 532 7/16/13 9:54 PM7/16/13 9:54 PM Final PDF to printer Chapter 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard 533 The following fixed expenses are controllable only at the company level: depreciation—building, property taxes, and supervisory salaries. In addition to these expenses, each division incurs costs for supervisory salaries of $300,000, which are not allocated to individual stores. Buckeye Department Stores incurs common fixed expenses of $360,000, which are not allocated to the two divisions. Income-tax expense for 20x5 is $5,850,000. Required: 1. Prepare a segmented income statement similar to Exhibit 12–7 for Buckeye Department Stores, Inc. The statement should have the following columns: Segments of Company Segments of Columbus Division Buckeye Department Stores, Inc. Cleveland Division Columbus Division Olentangy Store Scioto Store Downtown Store Not Allocated Prepare the statement in the contribution format, and indicate the controllability of expenses. Sub- tract all variable expenses, including cost of merchandise sold, from sales revenue to obtain the contribution margin. 2. How would the segmented income statement help the president of Buckeye Department Stores manage the company? RELY Cleaning Services, Inc., was started a number of years ago by Rick Ely to provide c leaning ser- vices to both large and small businesses in their home city. Over the years, as local businesses reduced underutilized building maintenance staffs, more and more cleaning services were subcontracted to RELY. RELY also expanded into other building services, such as painting and local moving. RELY maintains a pool of skilled workers who are contracted to perform the noncleaning ser- vices because these services do not recur on a day-to-day basis for the individual buildings. Many of RELY’s full-time employees have been with the firm for a number of years. Five zone managers are each responsible for furnishing recurring nightly cleaning services to several businesses. In addition, the zone manager sells and schedules noncleaning service jobs for the company’s central pool of skilled employees. Informal meetings are held periodically to discuss RELY’s performance, personnel alloca- tions, and scheduling problems. RELY’s budgeting and planning have been done by Ely, who also man- ages variations from budgets. Ely recently decided to retire and sold the business to Commercial Maintenance, Inc. (CMI), which provides similar services in a number of metropolitan locations that surround RELY’s business area. After news of the sale, several of RELY’s long-term employees appeared resentful of the change in ownership and did not know what to expect. CMI’s senior management met with RELY’s managers and announced that George Fowler would become president of RELY and that RELY would continue to operate as a separate subsidiary of CMI. Furthermore, in accordance with CMI’s management philosophy, a responsibility-accounting system is to be implemented at RELY. Also, in line with other CMI subsidiaries, a participatory budgeting process is being considered. However, no decision will be made until an evaluation of RELY’s existing policies, operational culture, and management is completed. In view of the significant change in management philosophy, CMI has taken considerable time in explaining how each system operates and assuring RELY’s managers that they are expected and encouraged to participate in both the planning and imple- mentation of any of the systems that are to be adopted. Required: Two new initiatives are being considered at RELY Cleaning Services, Inc. • Responsibility-accounting system • Participatory budgeting system For each of these new approaches: 1. Identify at least two behavioral advantages that could arise. 2. Identify at least two potential problems that could arise. 3. Discuss the likelihood that the new approach will contribute to the alignment of organizational and personal goals. (CMA, adapted) ■ Problem 12–45 Responsibility Accounting; Participation; Behavioral Issues (LO 12-1, 12-2, 12-3) hiL25664_ch12_498-541.indd 533hiL25664_ch12_498-541.indd 533 7/16/13 9:54 PM7/16/13 9:54 PM Final PDF to printer 534 Chapter 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard Piedmont Novelties, Inc., sells merchandise through three retail outlets—in Raleigh, Charlotte, and Savannah—and operates a general corporate headquarters in Charlotte. A review of the company’s income statement indicates a record year in terms of sales and profits. Management, though, desires additional insights about the individual stores and has asked that Judson Wyatt, a newly hired intern, prepare a segmented income statement. The following information has been extracted from Piedmont’s accounting records: • Sales volume, sales price, and purchase price data: Raleigh Charlotte Savannah Sales volume ........................................................ 37,000 units 41,000 units 46,000 units Unit selling price ................................................... $18.00 $16.50 $14.25 Unit purchase price ............................................... 8.25 8.25 9.00 • The following expenses were incurred for sales commissions, local advertising, property taxes, management salaries, and other noncontrollable (but traceable) costs: Raleigh Charlotte Savannah Sales commissions ............................................... 6% 6% 6% Local advertising ................................................... $16,500 $33,000 $72,000 Local property taxes .............................................. 6,750 3,000 9,000 Sales manager salary ............................................ — — 48,000 Store manager salaries ......................................... 46,500 58,500 57,000 Other noncontrollable costs ................................... 8,700 6,900 26,700 Local advertising decisions are made at the store manager level. The sales manager’s salary in Savannah is determined by the Savannah store manager; in contrast, store manager salaries are set by Piedmont Novelties’s vice president. • Nontraceable fixed corporate expenses total $288,450. • The company uses a responsibility accounting system. Required: 1. Assume the role of Judson Wyatt and prepare a segmented income statement for Piedmont. 2. Determine the weakest-performing store and present an analysis of the probable causes of poor performance. 3. Assume that an opening has arisen at the Charlotte corporate headquarters and the company’s chief executive officer (CEO) desires to promote one of the three existing store managers. In evaluating the store managers’ performance, should the CEO use a store’s segment contribution margin, the profit margin controllable by the store manager, or a store’s segment profit margin? Justify your answer. Ujvari E quipment Company, which is located in Stutgardt, Germany, manufactures heavy construction equipment. The company’s primary product, an especially powerful bulldozer, is among the best produced in Europe. The company operates in a very price-competitive industry, so it has little control over the price of its products. It must meet the market price. To do so, the firm has to keep production costs in check by operating as efficiently as possible. Mathew Basler, the company’s president, has stated that to be success- ful, the company must provide a very high-quality product and meet its delivery commitments to custom- ers on time. Ujvari Equipment Company is organized as shown in the diagram at the top of the next page. There is currently a disagreement between the company’s two vice presidents regarding the respon- sibility-accounting system. The vice president for manufacturing claims that the 10 plants should be cost centers. He recently expressed the following sentiment: “The plants should be cost centers because the plant managers do not control the sales of our products. Designating the plants as profit centers would result in holding the plant managers responsible for something they can’t control.” A contrary view is held by the vice president for marketing. He recently made the following remarks: “The plants should be profit centers. The plant managers are in the best position to affect the company’s overall profit.” ■ Problem 12–46 Segmented Income State- ment; Responsibility Accounting (LO 12-3, 12-5) 1. Segment contribution margin, Piedmont Novelties: $820,620 ■ Problem 12–47 Designing a Responsibility- Accounting System (LO 12-1, 12-2) hiL25664_ch12_498-541.indd 534hiL25664_ch12_498-541.indd 534 7/16/13 9:54 PM7/16/13 9:54 PM Final PDF to printer Chapter 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard 535 Required: As the company’s new controller, you have been asked to make a recommendation to Mathew Basler, the company president, regarding the responsibility center issue. Write a memo to the president making a recommendation and explaining the reasoning behind it. In your memo address the following points. 1. Assuming that Ujvari Equipment Company’s overall goal is profitability, what are the company’s critical success factors? A critical success factor is a variable that meets these two criteria: It is largely under the company’s control, and the company must succeed in this area in order to reach its overall goal of profitability. 2. Which responsibility-accounting arrangement is most consistent with achieving success on the company’s critical success factors? 3. What responsibility-center designation is most appropriate for the company’s sales districts? 4. As a specific example, consider the rush-order problem illustrated in the chapter. Suppose that Ujvari Equipment Company often experiences rush orders from its customers. Which of the two proposed responsibility-accounting arrangements is best suited to making good decisions about accepting or rejecting rush orders? Specifically, should the plants be cost centers or profit centers? Diagnostic Technology, Inc., manufactures diagnostic testing equipment used in hospitals. The com- pany practices just-in-time inventory management and has a state-of-the-art manufacturing system. The following nonfinancial data were collected biweekly in the Albany plant during the first quarter of the current year. Biweekly Measurement Period 1 2 3 4 5 6 Cycle time (days) ............................................................... 1.7 1.5 1.5 1.4 1.4 1.3 Number of defective finished products ................................ 3 3 2 3 2 2 Manufacturing-cycle efficiency ........................................... 95% 94% 96% 96% 97% 96% Customer complaints ......................................................... 5 6 5 4 6 7 Unresolved complaints ....................................................... 2 1 0 0 0 0 Products returned .............................................................. 3 3 2 2 1 1 Warranty claims .................................................................. 2 2 2 0 1 0 In-process products rejected .............................................. 5 5 7 9 10 10 Aggregate productivity ........................................................ 1.5 1.5 1.5 1.5 1.4 1.5 Number of units produced per day per employee .................. 410 405 412 415 415 420 Percentage of on-time deliveries ......................................... 94% 95% 95% 97% 100% 100% Percentage of orders filled .................................................. 100% 100% 100% 98% 100% 100% Inventory value/sales revenue ............................................. 2% 2% 2% 1.5% 2% 1.5% Machine downtime (minutes) ............................................... 80 80 120 80 70 75 Bottleneck machine downtime (minutes) .............................. 25 20 15 0 60 10 Overtime (minutes) per employee ........................................ 20 0 0 10 20 10 Average setup time (minutes) ............................................. 119 119 114 111 107 100 ■ Problem 12–48 Manufacturing Performance Measurement (LO 12-6) Ujvari Equipment Company President and Chief Executive Officer Manufacturing Division Vice President for Manufacturing Sales Division Vice President for Sales 10 Manufacturing Plants 5 Sales Districts hiL25664_ch12_498-541.indd 535hiL25664_ch12_498-541.indd 535 7/16/13 9:54 PM7/16/13 9:54 PM Final PDF to printer 536 Chapter 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard Required: 1. For each nonfinancial performance measure, indicate which of the following areas of manufactur- ing performance is involved: ( a ) production processing, ( b ) product quality, ( c ) customer accep- tance, ( d ) in-process quality control, ( e ) productivity, ( f ) delivery performance, ( g ) raw material and scrap, ( h ) inventory, ( i ) machine maintenance. Some measures may relate to more than one area. 2. Write a memo to management commenting on the performance data collected for the Albany plant. Be sure to note any trends or other important results you see in the data. Evaluate the Albany plant in each of the areas listed in requirement (1). Southern P l astics Corporation manufactures a range of molded plastic products, such as kitchen utensils and desk accessories. The production process in the Baton Rouge plant utilizes a just-in-time inventory and production management system. Each month the controller prepares a production efficiency report, which is sent to corporate headquarters. The data compiled in these reports, for the first six months of the year, are as follows: PRODUCTION EFFICIENCY REPORT Southern Plastics Corporation Baton Rouge Plant January through June Jan. Feb. Mar. Apr. May June Average Overtime hours ............................................. 59 69 74 79 84 104 78.2 Total setup time ........................................... 69 69 64 63 61 61 64.5 Cycle time (average in hours) ........................ 19 19 18 17 18 16 17.8 Manufacturing-cycle efficiency ..................... 95% 94% 96% 90% 89% 90% 92.3% Percentage of orders filled ............................ 100% 100% 100% 100% 100% 100% 100% Percentage of on-time deliveries ................... 99% 98% 99% 100% 96% 94% 97.7% Inventory value/sales revenue ....................... 5% 5% 5% 4% 5% 5% 4.8% Number of defective units, finished goods ..... 80 82 75 40 25 22 54 Number of defective units, in process ............ 9 29 34 39 59 59 38.2 Number of raw-material shipments with defective materials ................................... 3 3 2 0 0 0 1.3 Number of products returned ........................ 0 0 0 0 0 0 0 Aggregate productivity .................................. 1.3 1.3 1.2 1.25 1.2 1.15 1.23 Power consumption (thousands of kilowatt-hours) ........................................ 800 795 802 801 800 800 799.7 Machine downtime (hours) ........................... 30 25 25 20 20 10 21.7 Bottleneck machine downtime ...................... 0 0 2 0 15 2 3.2 Number of unscheduled machine maintenance calls .................................... 0 0 1 0 2 3 1 Required: 1. Write a memo to the company president evaluating the Baton Rouge plant’s performance. Struc- ture your report by dividing it into the following parts: (a) production processing and productivity, (b) product quality and customer acceptance, (c) delivery performance, (d) raw material, scrap, and inventory, and (e) machine maintenance. 2. If you identify any areas of concern in your memo, indicate an appropriate action for management. CommLine E quipment Corporation specializes in the manufacture of communications equipment, a field that has become increasingly competitive. Approximately two years ago, Ben Harrington, president of CommLine, became concerned that the company’s bonus plan, which focused on division profitabil- ity, was not helping CommLine remain competitive. Harrington decided to implement a gain-sharing plan that would encourage employees to focus on operational areas that were important to customers and that added value without increasing cost. In addition to a profitability incentive, the revised plan also includes incentives for reduced rework costs, reduced sales returns, and on-time deliveries. Bonuses are calculated and awarded semiannually on the following basis. The bonuses are distributed among the relevant employees according to a formula developed by the division manager. • Profitability: Two percent of operating income. • Rework: Costs in excess of 2 percent of operating income are deducted from the bonus amount. ■ Problem 12–49 Production Efficiency Report; Operational Performance Measures (LO 12-6) ■ Problem 12–50 Gain Sharing; Operational Performance Measures; Cost Reduction (LO 12-6) 1(a). Second semiannual bonus awarded: $13,200 2(a). Second semiannual bonus awarded: $22,240 hiL25664_ch12_498-541.indd 536hiL25664_ch12_498-541.indd 536 7/16/13 9:54 PM7/16/13 9:54 PM Final PDF to printer Chapter 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard 537 • On-time delivery: $10,000 if over 98 percent of deliveries are on time, $4,000 if 96 to 98 percent of deliveries are on time, and no increment if on-time deliveries are below 96 percent. • Sales returns: $6,000 if returns are less than 1.5 percent of sales. Fifty percent of any amount in excess of 1.5 percent of sales is deducted from the bonus amount. • Note: If the calculation of the bonus results in a negative amount for a particular period, there is no bonus, and the negative amount is not carried forward to the next period. The revised bonus plan was implemented on January 1, 20x1. Presented in the following table are the results for two of CommLine’s divisions, Charter and Mesa Divisions, for the first year under the new bonus plan. Both of these divisions had similar sales and operating income results for the prior year, when the old bonus plan was in effect. Based on the 20x0 results, the employees of the Charter Division earned a bonus of $54,120 while the employees of the Mesa Division earned $44,880. Charter Division Mesa Division January 20x1– June 20x1 July 20x1– December 20x1 January 20x1– June 20x1 July 20x1– December 20x1 Sales ..................................... $8,400,000 $8,800,000 $5,700,000 $5,800,000 Operating income .................. $924,000 $880,000 $684,000 $812,000 On-time delivery .................... 95.4% 97.3% 98.2% 94.6% Rework costs ......................... $23,000 $22,000 $12,000 $16,000 Sales returns ......................... $168,000 $140,000 $89,500 $85,000 Required: 1. For the Charter Division: a. Compute the semiannual installments and total bonus awarded for 20x1. b. Discuss the likely behavior of the Charter Division employees under the revised bonus plan. 2. For the Mesa Division: a. Compute the semiannual installments and total bonus awarded for 20x1. b. Discuss the likely behavior of the Mesa Division employees under the revised bonus plan. 3. Citing specific examples, evaluate whether or not Harrington’s revisions to the bonus plan at CommLine Equipment Corporation have achieved the desired results, and recommend any changes that might improve the plan. (CMA, adapted) Visit the website of a major bank, e.g., BBVA Compass at www.bbvacompass.com . Explore the w ebsite to learn about the bank’s services and operations. Required: 1. What do you think the bank’s overall, long-term goals are? 2. Develop a balanced scorecard for the bank. Include two to five measures in each of the scorecard’s perspectives. 3. How would the balanced scorecard affect the way managers develop the bank’s strategy? 4. Explain the concept of lead and lag measures in the context of the scorecard you have developed. ■ Problem 12–51 Balanced Scorecard; Banking; Use of Internet (LO 12-7) North American Industries is a diversified company w h ose products are marketed both domestically and internationally. The company’s major product lines are furniture, sports equipment, and house- hold appliances. At a recent meeting of the board of directors, there was a lengthy discussion on ways to improve overall corporate profitability. The members of the board decided that they required additional financial information about individual corporate operations in order to target areas for improvement. Danielle Murphy, the controller, has been asked to provide additional data that would assist the board in its investigation. Murphy believes that income statements, prepared along both product lines and geographic areas, would provide the directors with the required insight into corporate operations. Murphy had several discussions with the division managers for each product line and compiled the fol- lowing information from these meetings. ■ Case 12–52 Segmented Income State- ment; International Operations (LO 12-1, 12-5) 1. Total unit sales, Mexico: 106,000 Operating income, United States: $488,600 Cases Ex hiL25664_ch12_498-541.indd 537hiL25664_ch12_498-541.indd 537 7/16/13 9:54 PM7/16/13 9:54 PM Final PDF to printer 538 Chapter 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard Product Lines Furniture Sports Housewares Total Production and sales in units .............................. 80,000 90,000 80,000 250,000 Average selling price per unit .............................. $16.00 $40.00 $30.00 Average variable production cost per unit ............ 8.00 19.00 16.50 Average variable selling expense per unit ............ 4.00 5.00 4.50 Fixed production overhead, excluding depreciation ................................... $ 500,000 Depreciation of plant and equipment ................... 400,000 Administrative and selling expense ...................... 1,160,000 1. The division managers concluded that Murphy should allocate fixed production overhead to both product lines and geographic areas on the basis of the ratio of the variable costs expended to total variable costs. 2. Each of the division managers agreed that a reasonable basis for the allocation of depreciation on plant and equipment would be the ratio of units produced per product line (or per geographical area) to the total number of units produced. 3. There was little agreement on the allocation of administrative and selling expenses, so Murphy decided to allocate only those expenses that were traceable directly to a segment. For example, manufacturing staff salaries would be allocated to product lines, and sales staff salaries would be allocated to geographic areas. Murphy used the following data for this allocation. 4. The division managers were able to provide reliable sales percentages for their product lines by geographical area. Murphy prepared the following product-line income statement based on the preceding data. NORTH AMERICAN INDUSTRIES Segmented Income Statement by Product Lines For the Fiscal Year Ended April 30, 20x4 Product Lines Furniture Sports Housewares Unallocated Total Sales in units ................................................ 80,000 90,000 80,000 Sales ............................................................ $1,280,000 $3,600,000 $2,400,000 — $7,280,000 Variable production and selling costs .............. 960,000 2,160,000 1,680,000 — 4,800,000 Contribution margin ...................................... $ 320,000 $1,440,000 $ 720,000 — $2,480,000 Fixed costs: Fixed production overhead ........................ $ 100,000 $ 225,000 $ 175,000 $ — $ 500,000 Depreciation ........................................... 128,000 144,000 128,000 — 400,000 Administrative and selling expenses ......... 120,000 140,000 80,000 820,000 1,160,000 Total fixed costs ................................. $ 348,000 $ 509,000 $ 383,000 $ 820,000 $2,060,000 Operating income (loss) ................................. $ (28,000) $ 931,000 $ 337,000 $(820,000) $ 420,000 Production Staff Sales Staff Furniture .................................... $120,000 United States .......................... $ 60,000 Sports ........................................ 140,000 Canada .................................. 100,000 Housewares ............................... 80,000 Mexico ................................... 250,000 Percentage of Unit Sales United States Canada Mexico Furniture ............................................................ 40% 10% 50% Sports ................................................................ 40% 40% 20% Housewares ........................................................ 20% 20% 60% hiL25664_ch12_498-541.indd 538hiL25664_ch12_498-541.indd 538 7/16/13 9:54 PM7/16/13 9:54 PM Final PDF to printer Chapter 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard 539 Required: 1. Prepare a segmented income statement for North American Industries based on the company’s geographical areas. The statement should show the operating income for each segment. 2. As a result of the information disclosed by both segmented income statements (by product line and by geographical area), recommend areas where North American Industries should focus its atten- tion in order to improve corporate profitability. (CMA, adapted) Elite Classic Clothes is a retailer that sells to professional women in the northeast. The firm leases space for stores in upscale shopping centers, and the organizational structure consists of regions, districts, and stores. Each region consists of two or more districts; each district consists of three or more stores. Each store, district, and region has been established as a profit center. At all levels, the company uses a responsibility-accounting system focusing on information and knowledge rather than blame and control. Each year, managers, in consultation with their supervisors, establish financial and nonfinancial goals, and these goals are integrated into the budget. Actual performance is measured each month. The New England Region consists of the Coastal District and the Inland District. The Coastal District includes the New Haven, Boston, and Portland stores. The Coastal District’s performance has not been up to expectations in the past. For the month of May, the district manager has set performance goals with the managers of the New Haven and Boston stores, who will receive bonuses if certain performance measures are exceeded. The manager in Portland decided not to participate in the bonus scheme. Since the district manager is unsure what type of bonus will encourage better performance, the New Haven manager will receive a bonus based on sales in excess of budgeted sales of $1,140,000, while the Boston manager will receive a bonus based on operating income in excess of budget. The company’s operating income goal for each store is 12 percent of sales. The budgeted sales revenue for the Boston store is $1,060,000. Other pertinent data for May are as follows: • Coastal District sales revenue was $3,000,000, and its cost of goods sold amounted to $1,267,500. • The Coastal District spent $150,000 on advertising. • General and administrative expenses for the Coastal District amounted to $360,000. • At the New Haven store, sales were 40 percent of Coastal District sales, while sales at the Boston store were 35 percent of district sales. The cost of goods sold in both New Haven and Boston was 42 percent of sales. • Variable selling expenses (sales commissions) were 6 percent of sales for all stores, districts, and regions. • Variable administrative expenses were 2.5 percent of sales for all stores, districts, and regions. • Maintenance cost includes janitorial and repair services and is a direct cost for each store. The store manager has complete control over this outlay. Maintenance costs were incurred as follows: New Haven, $15,000; Boston, $1,200; and Portland, $9,000. • Advertising is considered a direct cost for each store and is completely under the control of the store manager. The New Haven store spent two-thirds of the Coastal District total outlay for adver- tising, which was 10 times the amount spent in Boston on advertising. • Coastal District rental expense amounted to $300,000. • The rental expenses at the New Haven store were 40 percent of the Coastal District’s total, while the Boston store incurred 30 percent of the district total. • District expenses were allocated to the stores based on sales. • New England Region general and administrative expenses of $330,000 were allocated to the Coastal District. These expenses were, in turn, allocated equally to the district’s three stores. Required: 1. Prepare the May segmented income statement for the Coastal District and for the New Haven and Boston stores. 2. Compute the Portland store’s operating income for May. ■ Case 12–53 Segmented Income State- ment; Responsibility Account- ing; Bonuses; Motivation; Ethics (LO 12-1, 12-2, 12-5) 1. Gross margin, Coastal District: $1,732,500 Operating income, Coastal District: $312,300 hiL25664_ch12_498-541.indd 539hiL25664_ch12_498-541.indd 539 7/16/13 9:54 PM7/16/13 9:54 PM Final PDF to printer 540 Chapter 12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard 3. Discuss the impact of the responsibility-accounting system and bonus structure on the managers’ behavior and the effect of their behavior on the financial results for the New Haven store and the Boston store. 4. The assistant controller for the New England Region, Jack Isner, has been a close friend of the New Haven store manager for over 20 years. When Isner saw the segmented income statement [as prepared in requirement (1)], he realized that the New Haven store manager had really gone over- board on advertising expenditures. To make his friend look better to the regional management, he reclassified $50,000 of the advertising expenditures as miscellaneous expenses, and buried them in rent and other costs. Comment on the ethical issues in the assistant controller’s actions. (Refer to specific ethical standards, which were given in Chapter 1.) (CMA, adapted) hiL25664_ch12_498-541.indd 540hiL25664_ch12_498-541.indd 540 7/16/13 9:54 PM7/16/13 9:54 PM Final PDF to printer This page intentionally left blank 13 THIS CHAPTER’S FOCUS COMPANY is Suncoast Food Centers, a chain of retail grocery stores in Florida. The company has three divisions. The Gulf and Atlantic divisions operate individual grocery stores in six coastal Floridian cities. The Food Processing Division operates dairy plants, bakeries, and meat- processing facilities in Miami, Orlando, and Jacksonville in order to supply the Suncoast grocery stores with fresh food products. In this chapter, we will explore how companies evaluate the performance of investment cen- ters, such as Suncoast’s three divisions. Investment centers are organizational subunits whose managers have the authority to make significant investment decisions, such as building a new store or expanding an existing one. FOCUS COMPANY >>>
Investment Centers
and Transfer Pricing
hiL25664_ch13_542-585.indd 542hiL25664_ch13_542-585.indd 542 7/16/13 10:01 PM7/16/13 10:01 PM
Final PDF to printer

In contrast to the evaluation of investment center performance explored in
the first part of the chapter, we will turn our attention to transfer pricing. The
amount charged when one division of a company sells products or services to
another division is called a transfer price. We can continue to use Suncoast Food Centers for
our illustration, because the Suncoast food processing facilities sell their dairy, bakery, and
meat products to the Suncoast grocery stores at a transfer price. We will explore different
ways to set such transfer prices.
<<< IN CONTRAST hiL25664_ch13_542-585.indd 543hiL25664_ch13_542-585.indd 543 7/16/13 10:01 PM7/16/13 10:01 PM Final PDF to printer 544 How do the top managers of large companies such as Allstate Insurance Company and General Electric Company evaluate their divisions and other major subunits? The larg- est subunits within these and similar organizations usually are designated as investment centers. The manager of this type of responsibility center is held accountable not only for the investment center’s profit but also for the capital invested to earn that profit. Invested capital refers to assets, such as buildings and equipment, used in a subunit’s operations. In this chapter, we will study the methods that managerial accountants use to evaluate investment centers and the performance of their managers. 1 In many organizations, one subunit manufactures a product or produces a service that is then transferred to another subunit in the same organization. For example, automobile parts manufactured in one division of General Motors are then transferred to another GM division that assembles vehicles. The price at which products or services are transferred between two subunits in an organization is called a transfer price. Since a transfer price affects the profit of both the buying and selling divisions, the transfer price affects the performance evaluation of these responsibility centers. Later in this chapter, we will study the methods that manage- rial accountants use to determine transfer prices. Delegation of Decision Making Most large organizations are decentralized. Managers throughout these organizations are given autonomy to make decisions for their subunits. Decentralization takes advan- tage of the specialized knowledge and skills of managers, permits an organization to Delegation of Decision Making Learning Objective 13-1 Explain the role of managerial accounting in achieving goal congruence. 13-1 Explain the role of managerial accounting in achieving goal congruence. 13-2 Compute an investment center’s return on investment (ROI), residual income (RI), and economic value added (EVA). 13-3 Explain how a manager can improve ROI by increasing either the sales margin or capital turnover. 13-4 Describe some advantages and disadvantages of both ROI and residual income as divisional performance measures. 13-5 Explain how to measure a division’s income and invested capital. 13-6 Use the general economic rule to set an optimal transfer price. 13-7 Explain how to base a transfer price on market prices, costs, or negotiations. 13-8 Understand the behavioral issues of incentives, goal congruence, and internal controls. After completing this chapter, you should be able to: 1 Recall from Chapter 12 that in practice the term profit center sometimes is used interchangeably with the term investment center. To be precise, however, the term profit center should be reserved for a subunit whose manager is held accountable for profit but not for invested capital. hiL25664_ch13_542-585.indd 544hiL25664_ch13_542-585.indd 544 7/16/13 10:01 PM7/16/13 10:01 PM Final PDF to printer Chapter 13 Investment Centers and Transfer Pricing 545 respond quickly to events, and relieves top management of the need to direct the orga- nization’s day-to-day activities. The biggest challenge in making a decentralized orga- nization function effectively is to obtain goal congruence among the organization’s autonomous managers. Obtaining Goal Congruence: A Behavioral Challenge Goal congruence is obtained when the managers of subunits throughout an organiza- tion strive to achieve the goals set by top management. This desirable state of affairs is difficult to achieve for a variety of reasons. Managers often are unaware of the effects of their decisions on the organization’s other subunits. Also, it is only human for people to be more concerned with the performance of their own subunit than with the effectiveness of the entire organization. The behavioral challenge in designing any management control system is to come as close as possible to obtaining goal congruence. To obtain goal congruence, the behavior of managers throughout an organization must be directed toward top management’s goals. Successful managers not only have their sights set on these organizational goals, but also have been given positive incentives to achieve them. The managerial accountant’s objective in designing a responsibility- accounting system is to provide these incentives to the organization’s subunit managers. The key factor in deciding how well the responsibility-accounting system works is the extent to which it directs managers’ efforts toward organizational goals. Thus, the accounting measures used to evaluate investment-center managers should provide them with incentives to act in the interests of the overall organization. Management by Objectives (MBO) An emphasis on obtaining goal congruence is consistent with a broad managerial approach called management by objectives, or MBO. Under the MBO philosophy, managers participate in setting goals that they then strive to achieve. The goals usually are expressed in financial or other quantitative terms, and the responsibility-accounting system is used to evaluate performance in achieving them. Adaptation of Management Control Systems When an organization begins its operations, it is usually small and decision making generally is centralized. The chief executive can control operations without a for- mal responsibility-accounting system. It is relatively easy in a small organization for managers to keep in touch with routine operations through face-to-face contact with employees. As an organization grows, however, its managers need more formal informa- tion systems, including managerial accounting information, in order to maintain control. Accounting systems are established to record events and provide the frame- work for internal and external financial reports. Budgets become necessary to plan the organization’s activity. As the organization gains experience in producing its goods or services, cost standards and flexible budgets often are established to help control operations. As the organization continues to grow, some delegation of deci- sion making becomes necessary. Decentralization is often the result of this tendency toward delegation. Ultimately, a fully developed responsibility-accounting system emerges. Managerial accountants designate cost centers, revenue centers, profit cen- ters, and investment centers, and develop appropriate performance measures for each subunit. Thus, an organization’s accounting and managerial control systems usually adapt and become more complex as the organization grows and changes. hiL25664_ch13_542-585.indd 545hiL25664_ch13_542-585.indd 545 7/16/13 10:01 PM7/16/13 10:01 PM Final PDF to printer 546 Chapter 13 Investment Centers and Transfer Pricing Measuring Performance in Investment Centers In our study of investment-center performance evaluation, we will focus on Suncoast Food Centers. This Florida chain of retail grocery stores has three divisions, as depicted by the organization chart in Exhibit 13–1 . The Gulf and Atlantic divisions consist of individual grocery stores located in six coastal cities. The company’s Food Processing Division operates dairy plants, baker- ies, and meat-processing plants in Miami, Orlando, and Jacksonville. These facilities provide all Suncoast Food Centers with milk, ice cream, yogurt, cheese, breads and desserts, and packaged meat. These Suncoast-brand food products are transferred to the company’s Gulf and Atlantic divisions at transfer prices established by the corporate controller’s office. Suncoast Food Centers’ three divisions are investment centers. This responsibility- center designation is appropriate, because each division manager has the authority to make decisions that affect both profit and invested capital. For example, the Gulf Division manager approves the overall pricing policies in the Gulf Division’s stores, and also has the autonomy to sign contracts to buy food and other products for resale. These actions influence the division’s profit. In addition, the Gulf Division manager has the authority to build new Suncoast Food Centers, rent space in shopping centers, or close existing stores. These decisions affect the amount of capital invested in the division. The primary goals of any profit-making enterprise include maximizing its profit- ability and using its invested capital as effectively as possible. Managerial accountants use three different measures to evaluate the performance of investment centers: return on investment (ROI), residual income (RI), and economic value added (EVA ® ). (EVA ® is a registered trademark of Stern Stewart & Co. ) We will illustrate each of these measures for Suncoast Food Centers. Return on Investment The most common investment-center performance measure is return on investment, or ROI, which is defined as follows: Return on investment (ROI) 5 Income _____________ Invested capital “Accounting is changing. You’re no longer sitting behind a desk just working on a computer, just crunch- ing the numbers. You’re actually getting to be a part of the day to day functions of the business.” (13a) Abbott Laboratories Learning Objective 13-2 Compute an investment center’s return on investment (ROI), residual income (RI), and economic value added (EVA). Exhibit 13–1 Organization Chart: Suncoast Food Centers Gulf Division Individual grocery stores in Tampa, St. Petersburg, and Sarasota Individual grocery stores in Miami, Daytona Beach, and Jacksonville Food Processing Division Suncoast Food Centers (Top Management) Atlantic Division Dairy Processing Plants Bakeries Meat Processing Plants hiL25664_ch13_542-585.indd 546hiL25664_ch13_542-585.indd 546 7/16/13 10:01 PM7/16/13 10:01 PM Final PDF to printer Chapter 13 Investment Centers and Transfer Pricing 547 The most recent year’s ROI calculations for Suncoast Food Centers’ three divi- sions are : Notice how the ROI calculation for each division takes into account both divisional income and the capital invested in the division. Why is this important? Suppose each division were evaluated only on the basis of its divisional profit. The Atlantic Division reported a higher divisional profit than the Gulf Division. Does this mean the Atlantic Division performed better than the Gulf Division? The answer is no. Although the Atlan- tic Division’s profit exceeded the Gulf Division’s profit, the Atlantic Division used a much larger amount of invested capital to earn its profit. The Atlantic Division’s assets are more than two times the assets of the Gulf Division. Considering the relative size of the two divisions, we should expect the Atlantic Division to earn a larger profit than the Gulf Division. The important question is not how much profit each division earned, but rather how effectively each division used its invested capital to earn a profit. Factors Underlying ROI We can rewrite the ROI formula as follows: Return on investment 5 Income _____________ Invested capital 5 Income ____________ Sales revenue 3 Sales revenue _____________ Invested capital Notice that the sales revenue term cancels out in the denominator and numerator when the two right-hand fractions are multiplied. Writing the ROI formula in this way highlights the factors that determine a division’s return on investment. Income divided by sales revenue is called the sales margin. This term measures the percentage of each sales dollar that remains as profit after all expenses are covered. Sales revenue divided by invested capital is called the capital turnover. This term focuses on the number of sales dollars generated by every dollar of invested capital. The sales margin and capital turnover for Suncoast Food Centers’ three divisions are cal- culated below for the most recent year. The Gulf Division’s sales margin is 5 percent ($3,000,000 of profit 4 $60,000,000 of sales revenue). Thus, each dollar of divisional sales resulted in a five-cent profit. The division’s capital turnover was 3 ($60,000,000 of sales revenue 4 $20,000,000 of invested capital). Thus, three dollars of sales revenue were generated by each dollar of Income _____________ Invested capital 5 Return on investment (ROI) Gulf Division ...................................................................... $3,000,000 __________ $20,000,000 5 15% Food Processing Division .................................................... $3,600,000 __________ $18,000,000 5 20% Atlantic Division ................................................................. $6,750,000 __________ $45,000,000 5 15% “The ROI of pollution prevention rises radically when ‘hidden’ environmental management costs are revealed.” (13b) Kestrel Management Services (an environmental consulting firm) Sales margin 3 Capital turnover 5 ROI Income ____________ Sales revenue 3 Sales revenue _____________ Invested capital 5 ROI Gulf Division ................................................... $3,000,000 __________ $60,000,000 3 $60,000,000 __________ $20,000,000 5 15% Food Processing Division ................................. $3,600,000 _________ $9,000,000 3 $9,000,000 __________ $18,000,000 5 20% Atlantic Division .............................................. $6,750,000 ___________ $135,000,000 3 $135,000,000 ___________ $45,000,000 5 15% hiL25664_ch13_542-585.indd 547hiL25664_ch13_542-585.indd 547 7/16/13 10:01 PM7/16/13 10:01 PM Final PDF to printer 548 Chapter 13 Investment Centers and Transfer Pricing capital invested in the division’s assets, such as store buildings, display shelves, checkout equipment, and inventory. Improving ROI How could the Gulf Division manager improve the division’s return on investment? Since ROI is the product of the sales margin and the capital turnover, ROI can be improved by increasing either or both of its components. For example, if the Gulf Division manager increased the division’s sales margin to 6 percent while holding the capital turnover constant at 3, the division’s ROI would climb from 15 percent to 18 percent, as follows: Gulf Division’s improved ROI 5 Improved sales margin 3 Same capital turnover 5 6% 3 3 5 18% To bring about the improved sales margin, the Gulf Division manager would need to increase divisional profit to $3,600,000 on sales of $60,000,000 ($3,600,000 4 $60,000,000 5 6%). How could profit be increased without changing total sales rev- enue? There are two possibilities: increase sales prices while selling less quantity, or decrease expenses. Neither of these is necessarily easy to do. In increasing sales prices, the division manager must be careful not to lose sales to the extent that total sales revenue declines. Similarly, reducing the expenses must not diminish product quality, customer service, or overall store atmosphere. Any of these changes could also result in lost sales revenue. An alternative way of increasing the Gulf Division’s ROI would be to increase its capital turnover. Suppose the Gulf Division manager increased the division’s capital turn- over to 4 while holding the sales margin constant at 5 percent. The division’s ROI would climb from 15 percent to 20 percent: Gulf Division’s improved ROI 5 Same sales margin 3 Improved capital turnover 5 5% 3 4 5 20% To obtain the improved capital turnover, the Gulf Division manager would need to either increase sales revenue or reduce the division’s invested capital. For example, the improved ROI could be achieved by reducing invested capital to $15,000,000 while maintaining sales revenue of $60,000,000. This would be a very tall order. The division manager can lower invested capital somewhat by reducing inventories and can increase sales revenue by using store space more effectively. But reducing inventories may lead to stockouts and lost sales, and crowded aisles may drive customers away. Improving ROI is a balancing act that requires all the skills of an effective man- ager. The ROI analysis above merely shows the arena in which the balancing act is performed. Residual Income Although ROI is the most popular investment-center performance measure, it has one major drawback. To illustrate, suppose Suncoast’s Food Processing Division manager can buy a new food processing machine for $500,000, which will save $80,000 in operat- ing expenses and thereby raise divisional profit by $80,000. The return on this investment in new equipment is 16 percent: Return on investment in new equipment 5 Increase in divisional profit _______________________ Increase in invested capital 5 $80,000 ________ $500,000 5 16% Now suppose it costs Suncoast Food Centers 12 cents for each dollar of capital to invest in operational assets. What is the optimal decision for the Food Processing Learning Objective 13-3 Explain how a manager can improve ROI by increasing either the sales margin or capital turnover. Learning Objective 13-2 Compute an investment center’s return on investment (ROI), residual income (RI), and economic value added (EVA). hiL25664_ch13_542-585.indd 548hiL25664_ch13_542-585.indd 548 7/16/13 10:01 PM7/16/13 10:01 PM Final PDF to printer Chapter 13 Investment Centers and Transfer Pricing 549 Division manager to make, viewed from the perspective of the company as a whole? Since it costs Suncoast Food Centers 12 percent for every dollar of capital, and the return on investment in new equipment is 16 percent, the equipment should be pur- chased. For goal congruence, the autonomous division manager should decide to buy the new equipment. Now consider what is likely to happen. The Food Processing Division manager’s performance is evaluated on the basis of his division’s ROI. Without the new equip- ment, the divisional ROI is 20 percent ($3,600,000 of divisional profit 4 $18,000,000 of invested capital). If he purchases the new equipment, his divisional ROI will decline: Why did this happen? Even though the investment in new equipment earns a return of 16 percent, which is greater than the company’s cost of raising capital (12 percent), the return is less than the division’s ROI without the equipment (20 percent). Averaging the new investment with those already in place in the Food Processing Division merely reduces the division’s ROI. Since the division manager is evaluated using ROI, he will be reluctant to decide in favor of acquiring the new equipment. The problem is that the ROI measure leaves out an important piece of information: it ignores the firm’s cost of raising investment capital. For this reason, many managers prefer to use a different investment-center performance measure instead of ROI. Computing Residual Income An investment center’s residual income is defined as follows: Residual income 5 Investment center’s profit 2 ( Investment center’s invested capital 3 Imputed interest rate ) where the imputed interest rate is the firm’s cost of acquiring investment capital. Residual income is a dollar amount, not a ratio like ROI. It is the amount of an investment center’s profit that remains (as a residual) after subtracting an imputed interest charge. The term imputed means that the interest charge is estimated by the managerial accountant. This charge reflects the firm’s minimum required rate of return on invested capital. In some firms, the imputed interest rate depends on the riskiness of the invest- ment for which the funds will be used. Thus, divisions that have different levels of risk sometimes are assigned different imputed interest rates. Food Processing Division’s Return on Investment Without Investment in New Equipment With Investment in New Equipment $3,600,000 __________ $18,000,000 5 20% $3,600,000 1 $80,000 ____________________ $18,000,000 1 $500,000 < 20% ROI and residual income are common performance measures for investment centers. Both measures relate the profit earned from selling the final product to the capital required to carry out produc- tion operations. Here the product is orange juice, and this bottling equipment repre- sents the capital investment. hiL25664_ch13_542-585.indd 549hiL25664_ch13_542-585.indd 549 7/16/13 10:01 PM7/16/13 10:01 PM Final PDF to printer 550 Chapter 13 Investment Centers and Transfer Pricing The residual income of Suncoast’s Food Processing Division is computed below, both with and without the investment in the new equipment. The imputed interest rate is 12 percent. Notice that the Food Processing Division’s residual income will increase if the new equipment is purchased. What will be the division manager’s incentive if he is evaluated on the basis of residual income instead of ROI? He will want to make the investment because that decision will increase his division’s residual income. Thus, goal congruence is achieved when the managerial accountant uses residual income to measure divisional performance. Why does residual income facilitate goal congruence while ROI does not? Because the residual-income formula incorporates an important piece of data that is excluded from the ROI formula: the firm’s minimum required rate of return on invested capital. To summarize, ROI and residual income are compared as follows: Three pieces of data Residual income 5 Investment center’s profit 2 Investment center’s invested capital 3 Imputed interest rate ROI 5 Investment center’s profit Investment center’s invested capital Two pieces of data ( ) Unfortunately, residual income also has a serious drawback: It should not be used to compare the performance of different-sized investment centers because it incorporates a bias in favor of the larger investment center. To illustrate, the following table compares the residual income of Suncoast Food Centers’ Gulf and Atlantic divisions. Notice that the Atlantic Divi- sion’s residual income is considerably higher than the Gulf Division’s. This is entirely due to the much greater size of the Atlantic Division, as evidenced by its far greater invested capital. Food Processing Division’s Residual Income Without Investment in New Equipment With Investment in New Equipment Divisional profit ..................................... $3,600,000 $3,680,000 Less imputed interest charge: Invested capital ................................ $18,000,000 $18,500,000 3 Imputed interest rate ........................ 3 .12 3 .12 Imputed interest charge ................... 2,160,000 2,220,000 Residual income ................................... $1,440,000 $1,460,000 Investment in new equipment raises residual income by $20,000. Learning Objective 13-4 Describe some advantages and disadvantages of both ROI and residual income as divisional performance measures Comparison of Residual Income: Two Divisions Gulf Division Atlantic Division Divisional profit ...................................... $3,000,000 $6,750,000 Less imputed interest charge: Invested capital ................................. $20,000,000 $45,000,000 3 Imputed interest rate ......................... 3 .12 3 .12 Imputed interest charge .................... 2,400,000 5,400,000 Residual income .................................... $ 600,000 $1,350,000 The Atlantic Division’s residual income is much higher simply because it is larger than the Gulf Division. hiL25664_ch13_542-585.indd 550hiL25664_ch13_542-585.indd 550 7/16/13 10:01 PM7/16/13 10:01 PM Final PDF to printer Chapter 13 Investment Centers and Transfer Pricing 551 In short, neither ROI nor residual income provides a perfect measure of investment- center performance. ROI can undermine goal congruence. Residual income distorts comparisons between investment centers of different sizes. As a result, some companies routinely use both measures for divisional performance evaluation. Shareholder Value Analysis Some companies apply the residual income con- cept to individual product lines. Shareholder value analysis calculates the residual income for a major product line, with the objective of determining how the product line affects the firm’s value to the shareholders. Suppose, for example, that Sun- coast Food Centers offers in-store, one-hour film development in selected stores. Let’s say that the company’s investment in this service is $200,000 and the annual profit is $40,000. Then the residual income on one-hour film development is $16,000 [$40,000 2 ($200,000 3 12%)]. Economic Value Added The most contemporary measure of investment center performance is economic value added (EVA), which is defined as follows: Economic value added 5 Investment center’s after-tax operating income 2 Investment center’s total assets 2 Investment center’s current liabilities 3 Weighted- average cost of capital( ( Like residual income, the economic value added is a dollar amount. However, it differs from residual income in two important ways. First, an investment center’s current liabili- ties are subtracted from its total assets. Second, the weighted-average cost of capital is used in the calculation. Weighted-Average Cost of Capital Suncoast Food Centers has two sources of long- term capital: debt and equity. The cost to Suncoast of issuing debt is the after-tax cost of the interest payments on the debt, taking account of the fact that the interest payments are tax deductible. The cost of Suncoast’s equity capital is the investment opportunity rate of Suncoast Food Centers’ investors, that is, the rate they could earn on investments of similar risk to that of investing in Suncoast Food Centers. The weighted-average cost of capital (WACC) is defined as follows: Weighted-average cost of capital After-tax cost of debt capital Market value of debt Cost of equity capital Market value of equity Market value of debt Market value of equity ( ( ( ( ( ( ( ( The interest rate on Suncoast Food Centers’ $40 million of debt is 9 percent, and the company’s tax rate is 30 percent. Therefore, Suncoast’s after-tax cost of debt is 6.3 percent [9% 3 (1 2 30%)]. Let’s assume that the cost of Suncoast’s equity capital is 12 percent. Moreover, the market value of the company’s equity is $60 million. 2 The following calculation shows that Suncoast Food Centers’ WACC is 9.72 percent. Learning Objective 13-2 Compute an investment center’s return on investment (ROI), residual income (RI), and economic value added (EVA). 2 The book value of Suncoast Food Centers’ equity is $41 million, but that amount does not reflect the current value of the company’s assets or the value of intangible assets such as the Suncoast Food Centers name. hiL25664_ch13_542-585.indd 551hiL25664_ch13_542-585.indd 551 7/16/13 10:01 PM7/16/13 10:01 PM Final PDF to printer 552 Chapter 13 Investment Centers and Transfer Pricing Weighted-average cost of capital 1.0632 1$40,000,0002 1.122 1$60,000,0002 $40,000,000 $60,000,000 .0972 Finally, Suncoast Food Centers had an average balance of $2 million in current liabilities, distributed as follows: Now we can compute the economic value added (or EVA) for each of Suncoast’s three divisions. The EVA analysis reveals that all three of Suncoast Food Centers’ divisions are con- tributing substantially to the company’s economic value. What does an EVA analysis tell us? EVA indicates how much shareholder wealth is being created, as Roberto Goizueta, Coca-Cola’s former CEO, explained: “We raise capital to make concentrate and sell it at an operating profit. Then we pay the cost of that capital. Shareholders pocket the difference (EVA amount).” Division Current Liabilities Gulf Division ................................................................................................................................. $ 400,000 Food Processing Division ............................................................................................................... 1,000,000 Atlantic Division ............................................................................................................................ 600,000 Gulf $3.00 (1 .30) [($20 $ .4) .0972] $194,880 Food Processing $3.60 (1 .30) [($18 $1.0) .0972] 867,600 Atlantic $6.75 (1 .30) [($45 $ .6) .0972] 409,320 Division After-tax operating income (in millions) Total assets (in millions) (in millions) Current liabilities WACC Economic value added( ( 3 S. Thurm, “Pay for Performance No Longer a Punchline,” The Wall Street Journal (on line), March 20, 2013; J. Greenwood, “RBC Boosts CEO’s Pay 25%” Financial Post, February 4, 2013, p. 1; K. Seannell and J. Lublin, “SEC Unhappy with Answers on Executive Pay,” The Wall Street Journal, January 29, 2008, p. 31; Louis Lavelle, “The Gravy Train Just Got Derailed—‘Pay for Performance’ Is Back in Vogue,” BusinessWeek, November 19, 2001; and T. Leahy, “All the Right Moves,” Business Finance 6, no. 1 (April 2000), p. 32. PAY FOR PERFORMANCE BASED ON EVA “Company directors say they pay CEOs based on performance. Now the numbers show they mean it.” In the wake of the excesses in top management compensation over the past few years, at many companies pay for performance is back in vogue. Top executives earn hefty bonuses when times are good, but are expected to share in the pain during a decline in business. Siemens, a global electronics firm, links the compensation of its top 500 managers to their business units’ economic value added (EVA) measure. Similarly, the Royal Bank of Canada (RBC), upon observing that its lower-level managers were not acting in accordance with the bank’s overall strategy, links their compensation to the bank’s EVA and revenue growth. 3 Siemens and Royal Bank of Canada anagement ccounting ractice M A P hiL25664_ch13_542-585.indd 552hiL25664_ch13_542-585.indd 552 7/16/13 10:01 PM7/16/13 10:01 PM Final PDF to printer Chapter 13 Investment Centers and Transfer Pricing 553 Exhibit 13–2 Assets and Liabilities Associated with Food Processing Division Assets * Current assets (cash, accounts receivable, inventories, etc.) .................................... $ 2,000,000 Long-lived assets (land, buildings, equipment, vehicles, etc.): Gross book value (acquisition cost) .................................................................... $19,000,000 Less: Accumulated depreciation ......................................................................... 4,000,000 Net book value ................................................................................................. 15,000,000 Plant under construction ........................................................................................ 1,000,000 Total assets .......................................................................................................... $18,000,000 Liabilities Current liabilities (accounts payable, salaries payable, etc.) ...................................... $ 1,000,000 *This is not a balance sheet, but rather a listing of certain assets and liabilities associated with the Food Processing Division. Measuring Income and Invested Capital The ROI, residual-income, and economic value added (EVA) measures of investment- center performance all use profit and invested capital in their formulas. This raises the question of how to measure divisional profit and invested capital. This section will illustrate various approaches to resolving these measurement issues. Invested Capital We will focus on Suncoast Food Centers’ Food Processing Division to illustrate sev- eral alternative approaches to measuring an investment center’s capital. Exhibit 13–2 lists the assets and liabilities associated with the Food Processing Division. Notice that Exhibit 13–2 does not constitute a complete balance sheet. First, there are no long-term liabilities, such as bonds payable, associated with the Food Processing Divi- sion. Although Suncoast Food Centers may have such long-term debt, it would not be meaningful to assign portions of that debt to the company’s individual divisions. Second, there is no stockholders’ equity associated with the Food Processing Division. The owners of the company own stock in Suncoast Food Centers, not in its individual divisions. Average Balances ROI, residual income, and EVA are computed for a period of time, such as a year or a month. Asset balances, on the other hand, are measured at a point in time, such as December 31. Since divisional asset balances generally will change over time, we use average balances in calculating ROI, residual income, and EVA. For example, if the Food Processing Division’s balance in invested capital was $19,000,000 on January 1 and $17,000,000 on December 31, we would use the year’s average invested capital of $18,000,000 in the ROI, residual income, and EVA calculations. Should Total Assets Be Used? Exhibit 13–2 shows that the Food Processing Division had average balances during the year of $2,000,000 in current assets, $15,000,000 in long-lived assets, and $1,000,000 tied up in a plant under construction. (Suncoast Food Centers is building a new high-tech dairy plant in Orlando to produce its innovative zero- calorie ice cream.) In addition, Exhibit 13–2 discloses that the Food Processing Division’s average balance of current liabilities was $1,000,000. Measuring Income and Invested Capital Learning objective 13-5 Explain how to measure a division’s income and invested capital hiL25664_ch13_542-585.indd 553hiL25664_ch13_542-585.indd 553 7/16/13 10:01 PM7/16/13 10:01 PM Final PDF to printer 554 Chapter 13 Investment Centers and Transfer Pricing What is the division’s invested capital? Several possibilities exist. 1. Total assets. The management of Suncoast Food Centers has decided to use average total assets for the year in measuring each division’s invested capi- tal. Thus, $18,000,000 is the amount used in the ROI, residual-income, and EVA calculations discussed earlier in this chapter. This measure of invested capital is appropriate if the division manager has considerable authority in making decisions about all of the division’s assets, including nonproductive assets. In this case, the Food Processing Division’s partially completed dairy plant is a nonproductive asset. Since the division manager had con- siderable influence in deciding to build the new plant and he is responsible for overseeing the project, average total assets provides an appropriate measure. 2. Total productive assets. In other companies, division managers are directed by top management to keep nonproductive assets, such as vacant land or construction in progress. In such cases, it is appropriate to exclude nonpro- ductive assets from the measure of invested capital. Then average total pro- ductive assets is used to measure invested capital. If Suncoast Food Centers had chosen this alternative, $17,000,000 would have been used in the ROI, residual-income, and EVA calculations (total assets of $18,000,000 less $1,000,000 for the plant under construction). 3. Total assets less current liabilities. Some companies allow division managers to secure short-term bank loans and other short-term credit. In such cases, invested capital often is measured by average total assets less average current liabilities. This approach encourages investment-center managers to mini- mize resources tied up in assets and maximize the use of short-term credit to finance operations. If this approach had been used by Suncoast Food Centers, the Food Processing Division’s invested capital would have been $17,000,000, total assets of $18,000,000 less current liabilities of $1,000,000. (Note that current liabilities are always subtracted from total assets for the measure of invested capital used in the EVA measure.) Gross or Net Book Value Another decision to make in choosing a measure of invested capital is whether to use the gross book value (acquisition cost) or the net book value of long-lived assets. (Net book value is the acquisition cost less accumulated depre- ciation.) Suncoast Food Centers’ management has decided to use the average net book value of $15,000,000 to value the Food Processing Division’s long-lived assets. If gross book value had been used instead, the division’s measure of invested capital would have been $22,000,000, as the following calculation shows. There are advantages and disadvantages associated with both gross and net book value as a measure of invested capital. The advantages of net book value are: 1. Using net book value maintains consistency with the balance sheet prepared for external reporting purposes. This allows for more meaningful comparisons of return-on-investment measures across different companies. 2. Using net book value to measure invested capital is also more consistent with the definition of income, which is the numerator in ROI calculations. In computing income, the current period’s depreciation on long-lived assets is deducted as an expense. Current assets ........................................................................................................................................ $ 2,000,000 Long-lived assets (at gross book value) .................................................................................................... 19,000,000 Plant under construction .......................................................................................................................... 1,000,000 Total assets (at gross book value) ............................................................................................................. $22,000,000 hiL25664_ch13_542-585.indd 554hiL25664_ch13_542-585.indd 554 7/16/13 10:01 PM7/16/13 10:01 PM Final PDF to printer Chapter 13 Investment Centers and Transfer Pricing 555 The following two advantages are often associated with using gross book value: 1. The usual methods of computing depreciation, such as the straight-line and the declining-balance methods, are arbitrary. Hence, they should not be allowed to affect ROI, residual-income, or EVA calculations. 2. When long-lived assets are depreciated, their net book value declines over time. This results in a misleading increase in ROI, residual income, and EVA across time. Exhibit 13–3 provides an illustration of this phenomenon for the ROI calculated on an equipment purchase under consideration by the Food Processing Division manager. Notice that the ROI rises steadily across the five-year horizon if invested capital is measured by net book value. However, using gross book value elimi- nates this problem. If an accelerated depreciation method were used instead of the straight-line method, the increasing trend in ROI would be even more pronounced. A Behavioral Problem The tendency for net book value to produce a misleading increase in ROI over time can have a serious effect on the incentives of investment-center managers. Investment centers with old assets will show much higher ROIs than invest- ment centers with relatively new assets. This can discourage investment-center managers from investing in new equipment. If this behavioral tendency persists, a division’s assets can become obsolete, making the division uncompetitive. Allocating Assets to Investment Centers Some companies control certain assets centrally, although these assets are needed to carry on operations in the divisions. Com- mon examples are cash and accounts receivable. Divisions need cash in order to operate, but many companies control cash balances centrally in order to minimize their total cash holdings. Some large retail firms manage accounts receivable centrally. A credit customer of some national department store chains can make a payment either at the local store or by mailing the payment to corporate headquarters. When certain assets are controlled centrally, some allocation basis generally is cho- sen to allocate these asset balances to investment centers, for the purpose of measuring invested capital. For example, cash may be allocated based on the budgeted cash needs in each division or on the basis of divisional sales. Accounts receivable usually are allocated on the basis of divisional sales. Divisions with less stringent credit terms are allocated proportionately larger balances of accounts receivable. Exhibit 13–3 Increase in ROI over Time (when net book value is used) Acquisition cost of equipment ...................................................................................................................... $500,000 Useful life ................................................................................................................................................... 5 years Salvage value at end of useful life ................................................................................................................ 0 Annual straight-line depreciation .................................................................................................................. $100,000 Annual income generated by asset (before deducting depreciation) ................................................................ $150,000 Year Income before Depreciation Annual Depreciation Income Net of Depreciation Average Net Book Value * ROI Based on Net Book Value † Average Gross Book Value ROI Based on Gross Book Value 1 $150,000 $100,000 $50,000 $450,000 11.1% $500,000 10% 2 150,000 100,000 50,000 350,000 14.3 500,000 10 3 150,000 100,000 50,000 250,000 20.0 500,000 10 4 150,000 100,000 50,000 150,000 33.3 500,000 10 5 150,000 100,000 50,000 50,000 100.0 500,000 10 *Average net book value is the average of the beginning and ending balances for the year in net book value. In year 1, for example, the average net book value is $ , $ ,500 000 400 000 2 1 † ROI rounded to nearest tenth of 1 percent. hiL25664_ch13_542-585.indd 555hiL25664_ch13_542-585.indd 555 7/16/13 10:01 PM7/16/13 10:01 PM Final PDF to printer 556 Chapter 13 Investment Centers and Transfer Pricing Measuring Investment-Center Income In addition to choosing a measure of investment-center capital, an accountant must also decide how to measure a center’s income. The key issue is controllability; the choice involves the extent to which uncontrollable items are allowed to influence the income measure. The Excel spreadsheet in Exhibit 13–4 illustrates several different possibili- ties for measuring the income of Suncoast Food Centers’ Food Processing Division. Suncoast Food Centers’ top management uses the profit margin controllable by divi- sion manager, $3,600,000, to evaluate the Food Processing Division manager. This profit measure is used in calculating ROI, residual income, or EVA. Some fixed costs traceable to the division have not been deducted from this $3,600,000 amount, but the division manager cannot control or significantly influence these costs. Hence they are excluded from the ROI calculation in evaluating the division manager. In calculating EVA, the $3,600,000 profit-margin amount is converted to an after-tax basis by multiplying it by 1 minus the tax rate of 30 percent. Pay for Performance Some companies reward investment-center managers with cash bonuses if they meet a predetermined target on a specified performance criterion, such as residual income, ROI, or EVA. Such payments often are referred to as pay for performance, merit pay, or incentive compensation. These cash bonuses generally are single payments, independent of a manager’s base salary. As the result of public outrage over the recent nearly catastrophic financial melt-down, as well as other perceived corporate excesses, many companies are beginning to rein in top management compensation packages. The U.S. government also reacted to the negative public mood by appointing a “pay czar” whose job it was to oversee top management com- pensation for the various companies that received “bailout” funds from government coffers during the recent financial crisis . Eventually, though, the office of the pay czar itself came under fire for its controversial decisions about executive compensation.4 Learning Objective 13-5 Explain how to measure a division’s income and invested capital. 4 “TARP Pay Czar Permitted Excessive Executive Pay at Bailed-Out Companies,” Huffington Post, January, 28, 2013. See also G. Chazan, “Shell Plans to Reduce Executive Salaries,” The Wall Street Journal, February 17, 2010, p. B1; and D. Brady, “The Pay Czar on the End of His Empire,” Bloomberg Businessweek, January 4, 2010, p. 15. Exhibit 13–4 Divisional Income Statement: Food Processing Division hiL25664_ch13_542-585.indd 556hiL25664_ch13_542-585.indd 556 7/16/13 10:01 PM7/16/13 10:01 PM Final PDF to printer Chapter 13 Investment Centers and Transfer Pricing 557 Managers versus Investment Centers It is important to make a distinction between an investment center and its manager. In evaluating the manager’s performance, only rev- enues and costs that the manager can control or significantly influence should be included in the profit measure. Remember that the overall objective of the performance measure is to provide incentives for goal-congruent behavior. No performance measure can motivate a manager to make decisions about costs he or she cannot control. This explains why Suncoast Food Centers’ top management relies on the profit margin controllable by divi- sion manager to compute the manager’s ROI performance measure. Evaluating the Food Processing Division as a viable economic investment is a differ- ent matter altogether. In this evaluation, traceability of costs, rather than controllability, is the issue. For this purpose, Suncoast Food Centers’ top management uses the profit margin traceable to division to compute the divisional ROI, residual income, or EVA. As Exhibit 13–4 shows, this amount is $2,400,000. Other Profit Measures The other measures of divisional profit shown in Exhibit 13–4 (lines 4, 5, and 6) also are used by some companies. The rationale behind these divisional income measures is that all corporate costs have to be covered by the operations of the divisions. Allocating corporate costs, interest, and income taxes to the divisions makes division managers aware of these costs. Inflation: Historical-Cost versus Current-Value Accounting Whether measuring investment-center income or invested capital, the impact of price- level changes should not be forgotten. During periods of inflation, historical-cost asset values soon cease to reflect the cost of replacing those assets. Therefore, some accountants argue that investment-center performance measures based on historical- cost accounting are misleading. Yet surveys of corporate managers indicate that an accounting system based on current values would not alter their decisions. Most man- agers believe that measures based on historical-cost accounting are adequate when used in conjunction with budgets and performance targets. As managers prepare those budgets, they build their expectations about inflation into the budgets and perfor- mance targets. Another reason for using historical-cost accounting for internal purposes is that it is required for external reporting. Thus, historical-cost data already are available, while installing current-value accounting would add substantial incremental costs to the organi- zation’s information system. Other Issues in Segment Performance Evaluation Alternatives to ROI, Residual Income, and Economic Value Added (EVA) ROI, residual income, and EVA are short-run performance measures. They focus on only one period of time. Yet an investment center is really a collection of assets (investments), each of which has a multiperiod life. Exhibit 13–5 portrays this perspective of an invest- ment center. To evaluate any one of these individual investments correctly requires a multiperiod viewpoint, which takes into account the timing of the cash flows from the investment. For example, investment E in Exhibit 13–5 may start out slowly in years 4 and 5, but it may be economically justified by its expected high performance in years 8, 9, and 10. Any evaluation of the investment center in year 5 that ignores the long-term performance of its various investments can result in a misleading conclusion. Thus, single-period Other Issues in Segment Performance Evaluation hiL25664_ch13_542-585.indd 557hiL25664_ch13_542-585.indd 557 7/16/13 10:01 PM7/16/13 10:01 PM Final PDF to printer 558 Chapter 13 Investment Centers and Transfer Pricing performance measures suffer from myopia. They focus on only a short time segment that slices across the division’s investments as portrayed in Exhibit 13–5 . To avoid this short-term focus, some organizations downplay ROI, residual income, and EVA in favor of an alternative approach. Instead of relating profit to invested capital in a single measure, these characteristics of investment-center performance are evaluated separately. Actual divisional profit for a time period is compared to a flexible budget, and variances are used to analyze performance. The division’s major investments are evalu- ated through a postaudit of the investment decisions. For example, investment E may have been undertaken because of expected high performance in years 8, 9, and 10. When that time comes, a review will determine whether the project lived up to expectations. Evaluating periodic profit through flexible budgeting and variance analysis, coupled with postaudits of major investment decisions, is a more complicated approach to evalu- ating investment centers. However, it does help management avoid the myopia of single- period measures such as ROI, residual income, and EVA. Importance of Nonfinancial Information Although financial measures such as segment profit, ROI, residual income, and EVA are widely used in performance evaluation, nonfinancial measures are important also. Manufacturers collect data on rates of defective products, airlines record information on lost bags and aircraft delays, and hotels keep track of occupancy rates. The proper evaluation of an organization and its segments requires that multiple performance mea- sures be defined and used. The balanced scorecard, with its lead and lag measures of performance, is one tool that is more and more widely used as a means of introducing nonfinancial measures into performance evaluation. See Chapter 10 for a discussion of the balanced scorecard. Measuring Performance in Nonprofit Organizations Management control in a nonprofit organization presents a special challenge. Such orga- nizations often are managed by professionals, such as physicians in a hospital. Moreover, many people participate in a nonprofit organization at some personal sacrifice, motivated by humanitarian or public service ideals. Often, such people are less receptive to formal control procedures than their counterparts in business. The goals of nonprofit organizations often are less clear-cut than those of busi- nesses. Public service objectives may be difficult to specify with precision and even more Exhibit 13–5 Investment Center Viewed as a Collection of Investments Assets or investments comprising investment center Time 1 A B C D E 2 3 4 5 6 7 8 9 10 11 hiL25664_ch13_542-585.indd 558hiL25664_ch13_542-585.indd 558 7/16/13 10:01 PM7/16/13 10:01 PM Final PDF to printer Chapter 13 Investment Centers and Transfer Pricing 559 difficult to measure in terms of achievement. For example, one community health center was established in an economically depressed area with three stated goals: 1. To reduce costs in a nearby hospital by providing a clinic for people to use instead of the hospital emergency room. 2. To provide preventive as well as therapeutic care, and establish outreach programs in the community. 3. To become financially self-sufficient. There is some conflict between these objectives, since goal 2 does not provide revenue to the center, while goals 1 and 3 focus on financial efficiency. Moreover, the health center was staffed with physicians who could have achieved much greater incomes in private practice. The management control tools described in this and the preceding three chapters can be used in nonprofit organizations. However, the challenges in doing so effectively often are greater. Transfer Pricing Measuring performance in profit centers or investment centers is made more compli- cated by transfers of goods or services between responsibility centers. The amount charged when one division sells goods or services to another division is called a trans- fer price. This price affects the profit measurement for both the selling division and the buying division. A high transfer price results in high profit for the selling division and low profit for the buying division. A low transfer price has the opposite effect. Consequently, the transfer-pricing policy can affect the incentives of autonomous divi- sion managers as they decide whether to make the transfer. Exhibit 13–6 depicts this scenario. Goal Congruence What should be management’s goal in setting transfer prices for internally transferred goods or services? In a decentralized organization, the managers of profit centers and investment centers often have considerable autonomy in deciding whether to accept or reject orders and whether to buy inputs from inside the organization or from outside. For example, a large manufacturer of farm equipment allows its Assembly Division managers to buy parts either from another division of the company or from independent manufacturers. The goal in setting transfer prices is to establish incentives for autono- mous division managers to make decisions that sup- port the overall goals of the organization. Suppose it is in the best interests of Suncoast Food Centers for the baked goods produced by the Food Pro- cessing Division’s Orlando Bakery to be transferred to the Gulf Division’s stores in the Tampa Bay area. Thus, if the firm were centralized, bakery products would be transferred from the Food Processing Division to the Gulf Division. However, Suncoast Food Centers is a decentralized company, and the Gulf Division manager is free to buy baked goods either from the Food Pro- cessing Division or from an outside bakery company. Similarly, the Food Processing Division manager is free to accept or reject an order for baked goods, at any given price, from the Gulf Division. The goal of the company’s controller in setting the transfer price is to provide incentives for each of these division managers to act in the company’s best interests. Transfer Pricing Transfer pricing is widely used in all kinds of businesses. When the chas- sis for this GM Corvette Stingray was transferred from the manufacturing division to the assembly division, a transfer price was specified. hiL25664_ch13_542-585.indd 559hiL25664_ch13_542-585.indd 559 7/16/13 10:01 PM7/16/13 10:01 PM Final PDF to printer 560 Chapter 13 Investment Centers and Transfer Pricing The transfer price should be chosen so that each division manager, when striving to maxi- mize his or her own division’s profit, makes the decision that maximizes the company’s profit. General Transfer-Pricing Rule Management’s objective in setting a transfer price is to encourage goal congruence among the division managers involved in the transfer. A general rule that will ensure goal congruence is given below. Transfer price 5 Additional outlay cost per unit incurred because goods are transferred + Opportunity cost per unit to the organization because of the transfer The general rule specifies the transfer price as the sum of two cost components. The first component is the outlay cost incurred by the division that produces the goods or services to be transferred. Outlay costs will include the direct variable costs of the product or ser- vice and any other outlay costs that are incurred only as a result of the transfer. The sec- ond component in the general transfer-pricing rule is the opportunity cost incurred by the organization as a whole because of the transfer. Recall from Chapter 2 that an opportunity cost is a benefit that is forgone as a result of taking a particular action. We will illustrate the general transfer-pricing rule for Suncoast Food Centers. The company’s Food Processing Division produces bread in its Orlando Bakery. The division transfers some of its products to the company’s Gulf and Atlantic divisions, and sells some of its products to other companies in the external market under different labels. Bread is transported to stores in racks containing one dozen loaves of packaged bread. In the Orlando bakery, the following variable costs are incurred to produce bread and transport it to a buyer. Learning Objective 13-6 Use the general economic rule to set an optimal transfer price. “Transfer pricing is a business issue as well as a tax issue that should be considered in the board room.” (13c) Ernst & Young Production: Standard variable cost per rack (including packaging) . . . . . . . Transportation: Standard variable cost per rack to transport bread . . . . . . . . . . . $7.00 .25 Exhibit 13–6 The Transfer-Pricing Scenario Boundary between the organization and parties outside the organization Assuming the transfer is made, the transfer price will not affect the company’s overall profit;* however it does affect the profit associated with each division. As a consequence, the transfer pricing policy can affect the decisions of autonomous divison managers who are deciding whether to make the transfer. *Assumes no tax complexities involving multinational companies. This issue is addressed later in the chapter. Purchases of productive inputs from vendors outside the organization Sales of finished goods to customers outside the organization Goods transferred at a transfer price Top management Selling division Buying division hiL25664_ch13_542-585.indd 560hiL25664_ch13_542-585.indd 560 7/16/13 10:01 PM7/16/13 10:01 PM Final PDF to printer Chapter 13 Investment Centers and Transfer Pricing 561 In applying the general transfer-pricing rule, we will distinguish between two different scenarios. Scenario I: No Excess Capacity Suppose the Food Processing Division can sell all the bread it can produce to outside buyers at a market price of $11 per rack. Since the division can sell all of its production, it has no excess capacity. Excess capacity exists only when more goods can be produced than the producer is able to sell, due to low demand for the product. What transfer price does the general rule yield under this scenario of no excess capacity? The transfer price is determined as follows: The outlay cost incurred by the Food Processing Division in order to transfer a rack of bread includes the standard variable production cost of $7.00 and the standard variable transportation cost of $.25. The opportunity cost incurred by Suncoast Food Centers when its Food Processing Division transfers a rack of bread to the Gulf Divi- sion instead of selling it in the external market is the forgone contribution margin from the lost sale, equal to $3.75. Why does the company lose a sale in the exter- nal market for every rack of bread transferred to the Gulf Division? The sale is lost because there is no excess capacity in the Food Processing Division. Every rack of bread transferred to another company division results in one less rack of bread sold in the external market. Goal Congruence How does the general transfer-pricing rule promote goal congru- ence? Suppose the Gulf Division’s grocery stores can sell a loaf of bread for $1.50, or $18 for a rack of 12 loaves ($18 5 12 3 $1.50). What is the best way for Suncoast Food Centers to use the limited production capacity in the Food Processing Division’s Orlando bakery? The answer is determined as follows: The best use of the bakery’s limited production capacity is to produce bread for transfer to the Gulf Division. If the transfer price is set at $11.00, as the general rule specifies, goal congruence is maintained. The Food Processing Division manager is willing to transfer bread to the Gulf Division, because the transfer price of $11.00 is equal to the external market price. The Gulf Division manager is willing to buy the bread, because her division will have a contribution margin of $7.00 on each rack of bread transferred ($18.00 sales price minus the $11.00 transfer price). Outlay Cost: Standard variable cost of production .................................................................................................. $ 7.00 per rack Standard variable cost of transportation ............................................................................................. .25 per rack Total outlay cost ................................................................................................................................ $ 7.25 per rack Opportunity cost: Selling price per unit in external market ............................................................................................. $11.00 per rack Less: Variable cost of production and transportation ............................................................................ 7.25 per rack Opportunity cost (forgone contribution margin) .................................................................................... $ 3.75 per rack General transfer-pricing rule: Transfer price 5 Outlay cost 1 Opportunity cost $11.00 5 $7.25 1 $3.75 Contribution to Suncoast Food Centers from Sale in External Market Contribution to Suncoast Food Centers from Transfer to Gulf Division Wholesale selling price per rack ........................... $11.00 Retail selling price per rack ............................ $18.00 Less: Variable costs ............................................. 7.25 Less: Variable costs ....................................... 7.25 Contribution margin ............................................ $ 3.75 Contribution margin ...................................... $10.75 hiL25664_ch13_542-585.indd 561hiL25664_ch13_542-585.indd 561 7/16/13 10:01 PM7/16/13 10:01 PM Final PDF to printer 562 Chapter 13 Investment Centers and Transfer Pricing Now consider a different situation. Suppose a local organization makes a special offer to the Gulf Division manager to buy several hundred loaves of bread to sell in a promotional campaign. The organization offers to pay $.80 per loaf, which is $9.60 per rack of a dozen loaves. What will the Gulf Division manager do? She must pay a transfer price of $11.00 per rack, so the Gulf Division would lose $1.40 per rack if the special offer were accepted ($1.40 5 $11.00 2 $9.60). The Gulf Division manager will decline the special offer. Is this decision in the best interests of Suncoast Food Centers as a whole? If the offer were accepted, the company as a whole would make a positive contri- bution of $2.35 per rack, as shown below. However, the company can make even more if its Food Processing Division sells bread directly in its external market. Then the contribution to the company is $3.75, as we have just seen. (The external market price of $11.00 per rack minus a variable cost of $7.25 per rack equals $3.75 per rack.) Thus, Suncoast Food Centers is better off, as a whole, if the Gulf Division’s special offer is rejected. Once again, the general transfer-pricing rule results in goal-congruent decision making. Scenario II: Excess Capacity Now let’s change our basic assumption, and sup- pose the Food Processing Division’s Orlando bakery has excess production capacity. This means that the total demand for its bread from all sources, including the Gulf and Atlantic divisions and the external market, is less than the bakery’s production capac- ity. Under this scenario of excess capacity, what does the general rule specify for a transfer price? Transfer price 5 Outlay cost 1 Opportunity cost $7.25 5 $7.25 1 0 The outlay cost in the Food Processing Division’s Orlando bakery is still $7.25, since it does not depend on whether there is idle capacity or not. The opportunity cost, how- ever, is now zero. There is no opportunity cost to the company when a rack of bread is transferred to the Gulf Division, because the Food Processing Division can still satisfy all of its external demand for bread. Thus, the general rule specifies a transfer price of $7.25, the total standard variable cost of production and transportation. Goal Congruence Let’s reconsider what will happen when the Gulf Division man- ager receives the local organization’s special offer to buy bread at $9.60 per rack. The Gulf Division will now show a positive contribution of $2.35 per rack on the special order. The Gulf Division manager will accept the special offer. This decision is also in the best interests of Suncoast Food Centers. The company, as a whole, also will make a contribution of $2.35 per rack on every rack transferred to the Gulf Division to satisfy the special order. Once again, the general transfer-pricing rule maintains goal-congruent decision-making behavior. Contribution to Suncoast Food Centers If Special Offer Is Accepted Special price per rack ........................................................................................................................... $9.60 per rack Less: Variable cost to company .............................................................................................................. 7.25 per rack Contribution to company, per rack .......................................................................................................... $2.35 per rack “It is difficult for people ‘doing the business’ to stop and consult about the trans- fer pricing implications of their moves, but they have to.” (13d) Respondent, Ernst & Young Survey Special price per rack ........................................................................................................................... $9.60 per rack Less: Transfer price paid by Gulf Division ................................................................................................ 7.25 per rack Contribution to Gulf Division ................................................................................................................... $2.35 per rack hiL25664_ch13_542-585.indd 562hiL25664_ch13_542-585.indd 562 7/16/13 10:01 PM7/16/13 10:01 PM Final PDF to printer Chapter 13 Investment Centers and Transfer Pricing 563 Notice that the general rule yields a transfer price that leaves the Food Processing Division manager indifferent as to whether the transfer will be made. At a transfer price of $7.25, the contribution to the Food Processing Division will be zero (transfer price of $7.25 less variable cost of $7.25). To avoid this problem, we can view the general rule as providing a lower bound on the transfer price. Some companies allow the producing division to add a markup to this lower bound in order to provide a positive contribution margin. This in turn provides a positive incentive to make the transfer. Difficulty in Implementing the General Rule The general transfer-pricing rule will always promote goal-congruent decision making if the rule can be implemented. However, the rule is often difficult or impossible to implement due to the difficulty of measuring opportunity costs. Such a cost-measurement problem can arise for a number of reasons. One reason is that the external market may not be perfectly competitive. Under perfect competition, the market price does not depend on the quantity sold by any one producer. Under imperfect competition, a single producer or group of pro- ducers can affect the market price by varying the amount of product available in the market. In such cases, the external market price depends on the production decisions of the producer. This in turn means that the opportunity cost incurred by the company as a result of internal transfers depends on the quantity sold externally. These interac- tions may make it impossible to measure accurately the opportunity cost caused by a product transfer. Other reasons for difficulty in measuring the opportunity cost associated with a prod- uct transfer include uniqueness of the transferred goods or services, a need for the pro- ducing division to invest in special equipment in order to produce the transferred goods, and interdependencies among several transferred products or services. For example, the producing division may provide design services as well as production of the goods for a buying division. What is the opportunity cost associated with each of these related out- puts of the producing division? In many such cases, it is difficult to sort out the opportu- nity costs. The general transfer-pricing rule provides a good conceptual model for the mana- gerial accountant to use in setting transfer prices. Moreover, in many cases, it can be implemented. When the general rule cannot be implemented, organizations turn to other transfer-pricing methods, as we shall see next. Transfers Based on the External Market Price A common approach is to set the transfer price equal to the price in the external market. In the Suncoast Food Centers illustration, the Food Processing Division would set the transfer price for bread at $11.00 per rack, since that is the price the division can obtain in its external market. When the producing division has no excess capacity and perfect competition prevails, where no single producer can affect the market price, the general transfer-pricing rule and the external market price yield the same transfer price. This fact is illustrated for Suncoast Food Centers as follows: Transfer price 5 Outlay cost 1 Opportunity cost 5 Variable cost of production and transportation 1 Forgone contribution margin of an external sale 5 $7.25 1 ($11.00 2 $7.25) 5 $11.00 Transfer price 5 External market price 5 $11.00 If the producing division has excess capacity or the external market is imperfectly competitive, the general rule and the external market price will not yield the same transfer price. Learning Objective 13-7 Explain how to base a transfer price on market prices, costs, or negotiations. hiL25664_ch13_542-585.indd 563hiL25664_ch13_542-585.indd 563 7/16/13 10:01 PM7/16/13 10:01 PM Final PDF to printer 564 Chapter 13 Investment Centers and Transfer Pricing If the transfer price is set at the market price, the producing division should have the option of either producing goods for internal transfer or selling in the external market. The buying division should be required to purchase goods from inside its organization if the producing division’s goods meet the product specifications. Otherwise, the buying division should have the autonomy to buy from a supplier outside its own organization. To handle pricing disputes that may arise, an arbitration process should be established. Transfer prices based on market prices are consistent with the responsibility- accounting concepts of profit centers and investment centers. In addition to encouraging division managers to focus on divisional profitability, market-based transfer prices help to show the contribution of each division to overall company profit. Suppose the Food Processing Division of Suncoast Food Centers transfers bread to the Gulf Division at a market-based transfer price of $11.00 per rack. The following contribution margins will be earned by the two divisions and the company as a whole. When aggregate divisional profits are determined for the year, and ROI and residual income are computed, the use of a market-based transfer price helps to assess the contri- butions of each division to overall corporate profits. Distress Market Prices Occasionally an industry will experience a period of signifi- cant excess capacity and extremely low prices. For example, when gasoline prices soared due to a foreign oil embargo, the market prices for recreational vehicles and power boats fell temporarily to very low levels. Under such extreme conditions, basing transfer prices on market prices can lead to decisions that are not in the best interests of the overall company. Basing transfer prices on artificially low distress market prices could lead the producing division to sell or close the productive resources devoted to producing the product for transfer. Under distress market prices, the producing division manager might prefer to move the division into a more profitable product line. While such a decision might improve the division’s profit in the short run, it could be contrary to the best interests of the company overall. It might be better for the company as a whole to avoid divesting itself of any productive resources and to ride out the period of market distress. To encourage an autonomous division man- ager to act in this fashion, some companies set the transfer price equal to the long-run average external market price, rather than the current (possibly depressed) market price. Negotiated Transfer Prices Many companies use negotiated transfer prices. Division managers or their representa- tives actually negotiate the price at which transfers will be made. Sometimes they start with the external market price and then make adjustments for various reasons. For exam- ple, the producing division may enjoy some cost savings on internal transfers that are not obtained on external sales. Commissions may not have to be paid to sales personnel on internally transferred products. In such cases, a negotiated transfer price may split the cost savings between the producing and buying divisions. In other instances, a negotiated transfer price may be used because no external mar- ket exists for the transferred product. Food Processing Division Gulf Division Transfer price .................................. $11.00 per rack Retail sales price ................................ $18.00 per rack Less: Variable costs .......................... 7.25 per rack Less: Transfer price ............................. 11.00 per rack Contribution margin ......................... $ 3.75 per rack Contribution margin ............................ $ 7.00 per rack Suncoast Food Centers Retail sales price .............................................................................................................................. $18.00 per rack Less: Variable costs ........................................................................................................................... 7.25 per rack Contribution margin .......................................................................................................................... $10.75 per rack hiL25664_ch13_542-585.indd 564hiL25664_ch13_542-585.indd 564 7/16/13 10:01 PM7/16/13 10:01 PM Final PDF to printer Chapter 13 Investment Centers and Transfer Pricing 565 Two drawbacks sometimes characterize negotiated transfer prices. First, negotia- tions can lead to divisiveness and competition between participating division managers. This can undermine the spirit of cooperation and unity that is desirable throughout an organization. Second, although negotiating skill is a valuable managerial talent, it should not be the sole or dominant factor in evaluating a division manager. If, for example, the producing division’s manager is a better negotiator than the buying division’s manager, then the producing division’s profit may look better than it should, simply because of its manager’s superior negotiating ability. Cost-Based Transfer Prices Organizations that do not base prices on market prices or negotiations often turn to a cost- based transfer-pricing approach. Variable Cost One approach is to set the transfer price equal to the standard variable cost. The problem with this approach is that even when the producing division has excess capacity, it is not allowed to show any contribution margin on the transferred products or services. To illustrate, suppose the Food Processing Division has excess capacity and the transfer price is set at the standard variable cost of $7.25 per rack of bread. There is no positive incentive for the division to produce and transfer bread to the Gulf Division. The Food Processing Division’s contribution margin from a transfer will be zero (transfer price of $7.25 minus variable costs of $7.25 equals zero). Some companies avoid this problem by setting the transfer price at standard variable cost plus a markup to allow the producing division a positive contribution margin. Full Cost An alternative is to set the transfer price equal to the full cost of the trans- ferred product or service. Full (or absorption ) cost is equal to the product’s variable cost plus an allocated portion of fixed overhead. Suppose the Food Processing Division’s Orlando bakery has budgeted annual fixed overhead of $500,000 and budgeted annual production of 200,000 racks of bread. The full cost of the bakery’s product is computed as follows: Full cost 5 Variable cost 1 Allocated fixed overhead 5 $7.25 per rack 1 $500,000 budgeted fixed overhead _____________________________ 200,000 budgeted racks of bread 5 $7.25 1 $2.50 5 $9.75 per rack Under this approach, the transfer price is set at $9.75 per rack of bread. Dysfunctional Decision-Making Behavior Basing transfer prices on full cost entails a serious risk of causing dysfunctional decision-making behavior. Full-cost-based trans- fer prices lead the buying division to view costs that are fixed for the company as a whole as variable costs to the buying division. This can cause faulty decision making. To illustrate, suppose the Food Processing Division has excess capacity, and the transfer price of bread is equal to the full cost of $9.75 per rack. What will happen if the Gulf Division receives the special offer discussed previously, where it can sell bread to a local organization at a special price of $9.60 per rack? The Gulf Division manager will reject the special order, since otherwise her division would incur a loss of $.15 per rack. Special price per rack ............................................................................................................................ $ 9.60 per rack Less: Transfer price based on full cost ..................................................................................................... 9.75 per rack Loss ...................................................................................................................................................... $( .15 ) per rack hiL25664_ch13_542-585.indd 565hiL25664_ch13_542-585.indd 565 7/16/13 10:01 PM7/16/13 10:01 PM Final PDF to printer 566 Chapter 13 Investment Centers and Transfer Pricing What is in the best interests of the company as a whole? Suncoast Food Centers would make a positive contribution of $2.35 per rack on the bread sold in the special order. What has happened here? Setting the transfer price equal to the full cost of $9.75 has turned a cost that is fixed in the Food Processing Division, and hence is fixed for the company as a whole, into a variable cost from the viewpoint of the Gulf Division man- ager. The manager would tend to reject the special offer, even though accepting it would benefit the company as a whole. Although the practice is common, transfer prices should not be based on full cost. The risk is too great that the cost behavior in the producing division will be obscured. This can all too easily result in poor decisions in the buying division. Standard versus Actual Costs Throughout our discussion of transfer prices, we have used standard costs rather than actual costs. This was true in our discussion of the general transfer-pricing rule as well as for cost-based transfer prices. Transfer prices should not be based on actual costs, because such a practice would allow an inefficient producing division to pass its excess production costs on to the buying division in the transfer price. When standard costs are used in transfer-pricing formulas, the buying division is not forced to pick up the tab for the producer’s inefficiency. Moreover, the producing division is given an incentive to control its costs, since any costs of inefficiency cannot be passed on. Undermining Divisional Autonomy Suppose the manager of Suncoast Food Centers’ Food Processing Division has excess capacity but insists on a transfer price of $9.75, based on full cost. The Gulf Division manager is faced with the special offer for bread at $9.60 per rack. She regrets that she will have to decline the offer because it would cause her division’s profit to decline, even though the company’s interests would be best served by accepting the special order. The Gulf Division manager calls the company president and explains the situation. She asks the president to intervene and force the Food Processing Division manager to lower his transfer price. As the company president, what would you do? If you stay out of the controversy, your company will lose the contribution on the special order. If you intervene, you will run the risk of undermining the autonomy of your division managers. You established a decentralized organization structure for Suncoast Centers and hired competent managers because you believed in the benefits of decentralized decision making. There is no obvious answer to this dilemma. In practice, central managers are reluctant to intervene in such disputes unless the negative financial consequences to the organization are quite large. Most managers believe the benefits of decentralized decision making are important to protect, even if it means an occasional dysfunctional decision. An International Perspective Two international issues arise in the case of multinational firms setting transfer prices between divisions in different countries. Income-Tax Rates Multinational companies often consider domestic and foreign income-tax rates when setting transfer prices. For example, suppose a company based in Special price per rack ............................................................................................................................ $9.60 per rack Less: Variable cost in Food Processing Division ........................................................................................ 7.25 per rack Contribution to company as a whole ........................................................................................................ $2.35 per rack “[Transfer pricing] affects nearly every aspect of mul- tinational operations—R&D, manufacturing, marketing and distribution, after-sale services.” (13e) Ernst & Young hiL25664_ch13_542-585.indd 566hiL25664_ch13_542-585.indd 566 7/16/13 10:01 PM7/16/13 10:01 PM Final PDF to printer Chapter 13 Investment Centers and Transfer Pricing 567 Europe also has a division in Asia. A European division produces a subassembly, which is transferred to the Asian division for assembly and sale of the final product. Suppose also that the income-tax rate for the company’s European division is higher than the rate in the Asian division’s country. How would these different tax rates affect the transfer price for the subassembly? The company’s management has an incentive to set a low transfer price for the sub- assembly. This will result in relatively low profits for the company’s European division and a relatively high income for the Asian division. Since the tax rate is lower in the Asian country, the overall company will save on income tax. By setting a low transfer price, the company will shift a portion of its income to a country with a lower tax rate. Tax laws vary among countries with regard to flexibility in setting transfer prices. Some countries’ tax laws prohibit the behavior described in our example, while other coun- tries’ laws permit it. Import Duties Another international issue that can affect a firm’s transfer pricing pol- icy is the imposition of import duties, or tariffs. These are fees charged to an importer, generally on the basis of the reported value of the goods being imported. Consider again the example of a firm with divisions in Europe and Asia. If the Asian country imposes an import duty on goods transferred in from the European division, the company has an incentive to set a relatively low transfer price on the transferred goods. This will minimize the duty to be paid and maximize the overall profit for the company as a whole. As in the “Transfer pricing has become the most difficult area of international taxation.” (13f) Ernst & Young TRANSFER PRICING AND TAX ISSUES The most difficult transfer-pricing issues arise in multinational corporations because of the complexity of the tax issues involved. According to a survey by Ernst & Young LLP, “transfer pricing is the top tax issue facing multinational corporations. Of the international tax directors at 582 multinational organizations polled in the survey, 75 percent expect their company to face a transfer-pricing audit within the next two years. Respondents cited related-party transactions (including the intercompany transfer of goods, services, properties, loans, and leases) involving administrative and management services as the most likely to be audited. Moreover, there has been an increase in transfer pricing audit activity in recent years. 5 “The Internal Revenue Service (IRS) is concerned that companies could use transfer prices to shift profits between related entities through cost of goods sold. Thus, transfer pricing manipulation could be used by taxpayers to shift income from high tax jurisdic- tions like the U.S. to low tax jurisdictions. The right price from the IRS’s perspective is the market value price. Because it’s difficult to prove that the transfer price was equal to the market price, companies often find themselves in disputes with the IRS. But now there’s help. The IRS’s Advanced Pricing Agreement Program provides companies an opportunity to avoid costly audits and litigation by allowing them to negotiate a pro- spective agreement with the IRS regarding the facts, the transfer pricing methodology, and an acceptable range of results. The program is aimed at multinational corporations interested in avoiding penalties, managing risk, and determining their tax liability with certainty.” 6 Ernst & Young, IRS M A P anagement ccounting ractice 5 2012 Transfer Pricing Global Reference Guide, Ernst & Young (London: 2012); 2010 Global Transfer Pricing Sur- veys, Ernst & Young (London: 2010). M. Gujarathi, “GlaxoSmithkline Plc.: International Transfer Pricing and Taxa- tion,” Issues in Accounting Education 22, no. 4 (November 2007), pp. 749–759; and E. Krell, “Scrutiny of Transfer Pricing Grows,” Business Finance 6, no. 4 (August 2000), p. 12. 6 S. C. Wrappe, K. Milani, and J. Joy, “The Transfer Price Is Right,” Strategic Finance 81, no. 1 (July 1999), p. 40. hiL25664_ch13_542-585.indd 567hiL25664_ch13_542-585.indd 567 7/16/13 10:01 PM7/16/13 10:01 PM Final PDF to printer 568 Chapter 13 Investment Centers and Transfer Pricing case of taxation, countries sometimes pass laws to limit a multinational firm’s flexibil- ity in setting transfer prices for the purpose of minimizing import duties. Transfer Pricing in the Service Industry Service industry firms and nonprofit orga- nizations also use transfer pricing when services are transferred between responsi- bility centers. In banks, for example, the interest rate at which depositors’ funds are transferred to the loan department is a form of transfer price. At Cornell University, if a student in the law school takes a course in the business school, a transfer price is charged to the law school for the credit hours of instruction provided to the law student. Since the transfer price is based on tuition charges, it is a market-price-based transfer price. Behavioral Issues: Risk Aversion and Incentives The designer of a performance-evaluation system for responsibility-center managers must consider many factors. Trade-offs often must be made between competing objectives. The overall objective is to achieve goal congruence by providing incentives for managers to act in the best interests of the organization as a whole. Financial performance measures such as divisional income, ROI, and residual income go a long way toward achieving this objective. However, these measures do have the disadvantage of imposing risk on a manager, because the measures also are affected by factors beyond the manager’s control. For example, the income of an orange-growing division of an agricultural company will be affected not only by the manager’s diligence and ability, but also by the weather and insect infestations. Since most people exhibit risk aversion, managers must be compensated for the risk they must bear. This compensation comes in the form of higher salaries or bonuses. Thus, the design of a managerial performance evaluation and reward system involves a trade- off between the following two factors: Behavioral Issues: Risk Aversion and Incentives Learning objective 13-8 Understand the behavioral issues of incentives, goal con- gruence, and internal controls. Transfer prices are used in the service industry as well as in manufacturing. Cornell University, for example, charges an accessory instruction fee to a campus unit when one of its students enrolls in a course offered in a different unit. Trade-offs in designing managerial performance evaluation and reward system. Evaluation of a manager on the basis of financial performance measures, which provide incen- tives for the manager to act in the organization’s interests. Imposition of risk on a manager who exhibits risk aversion, because financial performance measures are controllable only partially by the manager. hiL25664_ch13_542-585.indd 568hiL25664_ch13_542-585.indd 568 7/16/13 10:01 PM7/16/13 10:01 PM Final PDF to printer Chapter 13 Investment Centers and Transfer Pricing 569 Achieving the optimal trade-off between risk and incentives is a delicate balancing act that requires the skill and experience of top management. Goal Congruence and Internal Control Systems Although most business professionals have high ethical standards, there are unfortunately those who will cut corners. An internal control system is designed to provide reason- able assurance of the achievement of objectives in: (1) the effectiveness and efficiency of operations; (2) reliability of financial reporting; and (3) compliance with laws and regula- tions. Internal control procedures are designed to prevent the major lapses in responsible behavior described below. Fraud Theft or misuse of an organization’s resources constitutes fraud. To prevent and detect fraud, organizations establish well-defined procedures that prescribe how valuable resources will be handled. For example, many organizations require all checks above a particular amount to be authorized by two people. Financial Misrepresentation Internal control systems also are designed to pre- vent managers from intentionally (or accidentally) misstating an organization’s financial records. Most companies have an internal audit staff, which reviews finan- cial records throughout the organization to ensure their accuracy. (Appendix I on pages 760–765 explores the Sarbanes-Oxley Act and internal controls over financial reporting.) 7 Corruption Activities such as bribery, deceit, illegal political campaign contribu- tions, and kickbacks constitute corruption. Most organizations have internal control procedures and codes of conduct to prevent and detect corrupt practices. For example, many organizations forbid their purchasing personnel from accepting gifts or gratuities from the sales personnel with whom they conduct business. The Foreign Corrupt Prac- tices Act, passed by the U.S. Congress in 1977, prohibits a variety of corrupt practices in foreign business operations. For example, the law prohibits a company’s manage- ment from bribing officials of a foreign government in return for favorable treatment of their company. Unauthorized Action Sometimes a well-meaning employee is tempted to take an action that is not illegal or even unethical, but it is contrary to the organization’s policies. Internal control procedures also are designed to detect and prevent unauthorized actions by an organization’s employees, when those actions could reflect unfavorably on the organization. For example, a company may prohibit its employees from using company facilities for a rally in support of a controversial social cause. An internal control system constitutes an integral part of an organization’s efforts to achieve its goals. To be effective, internal control procedures require top management’s full support and intolerance of intentional violations. Goal Congruence and Internal Control Systems 7 The Sarbanes-Oxley Act, passed by the U.S. Congress in 2002, is designed to ensure that a company’s financial statements accurately portray its financial condition. See Appendix I (pp 760–765) for coverage of the Sarbanes- Oxley Act. hiL25664_ch13_542-585.indd 569hiL25664_ch13_542-585.indd 569 7/16/13 10:01 PM7/16/13 10:01 PM Final PDF to printer 570 Chapter 13 Investment Centers and Transfer Pricing Chapter Summary LO13-1 Explain the role of managerial accounting in achieving goal congruence. An important objective of any organization’s managerial accounting system is to promote goal congruence among its employees. Thus, the primary criterion for judging the effectiveness of performance measures for responsibility-center managers is the extent to which the measures promote goal congruence. LO13-2 Compute an investment center’s return on investment (ROI), residual income (RI), and economic value added (EVA). An investment center’s ROI is equal to its income divided by its invested capital. The investment center’s RI is equal to its profit minus the product of its invested capital and an imputed interest rate. The investment center’s EVA is computed as follows: After-tax operating income 2 [(Total assets 2 Current liabilities) 3 Weighted-average cost of capital]. LO13-3 Explain how a manager can improve ROI by increasing either the sales margin or capital turnover. An investment center’s ROI equals sales margin multiplied by capital turnover. Therefore, an investment center’s ROI may be improved by increasing either the sales margin or capital turnover. LO13-4 Describe some advantages and disadvantages of both ROI and residual income as divi- sional performance measures. Each of these performance measures relates an investment center’s income to the capital invested to earn it. However, residual income and EVA have the additional advan- tage of incorporating the organization’s cost of acquiring capital in the performance measure. LO13-5 Explain how to measure a division’s income and invested capital. There are several ways that investment centers’ invested capital is measured in practice. Among the commonly observed measures are: total assets, total productive assets, and total assets less current liabilities. Similarly, several measures of investment center income are observed in practice. As explained in the chapter, these income measures differ on the degree to which certain expenses are controllable at the invest- ment center level. LO13-6 Use the general economic rule to set an optimal transfer price. The general rule states that the transfer price should be equal to the outlay cost incurred to make the transfer plus the organization’s opportunity cost associated with the transfer. LO13-7 Explain how to base a transfer price on market prices, costs, or negotiations. Due to dif- ficulties in implementing the general transfer pricing rule, most companies base transfer prices on exter- nal market prices, costs, or negotiations. Market prices may be the best practical measure, as long as an external market for the transferred product exists. Alternatively, transfer prices may be based on full, absorption product costs or variable product costs. Negotiation, although widely used in setting transfer prices, can be time-consuming and divisive. LO13-8 Understand the behavioral issues of incentives, goal congruence, and internal controls. In general, companies use investment center performance measures and transfer pricing methods to provide incentives to managers to make goal-congruent decisions. In some cases, both investment center performance measures and transfer prices may result in dysfunctional decisions by mid-level managers. Top management then must weigh the benefits of intervening to prevent suboptimal decisions and the costs of undermining divisional autonomy. Internal controls also are used in organizations to promote the effectiveness and efficiency of operations, the reliability of financial reporting, and compliance with laws and regulations. Review Problems on Investment Centers and Transfer Pricing Problem 1 Stellar Systems Company manufactures guidance systems for rockets used to launch commercial satel- lites. The company’s Software Division reported the following results for 20x7. Stellar Systems’ weighted-average cost of capital (WACC) is 9 percent, and the company’s tax rate is 40 percent. Moreover, the company’s required rate of return on invested capital is 9 percent. Income ......................................................................................................................................................... $ 300,000 Sales revenue ............................................................................................................................................... 2,000,000 Invested capital (total assets) ......................................................................................................................... 3,000,000 Average balance in current liabilities .............................................................................................................. 20,000 hiL25664_ch13_542-585.indd 570hiL25664_ch13_542-585.indd 570 7/16/13 10:01 PM7/16/13 10:01 PM Final PDF to printer Chapter 13 Investment Centers and Transfer Pricing 571 Required: 1. Compute the Software Division’s sales margin, capital turnover, return on investment (ROI), residual income, and economic value added (EVA) for 20x7. 2. If income and sales remain the same in 20x8, but the division’s capital turnover improves to 80 percent, compute the following for 20x8: ( a ) invested capital and ( b ) ROI. Problem 2 Stellar Systems Company’s Microprocessor Division sells a computer module to the company’s Guid- ance Assembly Division, which assembles completed guidance systems. The Microprocessor Division has no excess capacity. The computer module costs $10,000 to manufacture, and it can be sold in the external market to companies in the computer industry for $13,500. Required: Compute the transfer price for the computer module using the general transfer-pricing rule. Solutions to Review Problems Problem 1 1. Sales margin Income $300,000 $300,000 $2,000,000 $2,000,000 $3,000,000 $3,000,000 Sales revenue 15% Capital turnover Sales revenue Invested capital Return on investment 67% Income Invested capital 10% Residual income: Divisional income ................................................................................................. $300,000 Less: Imputed interest charge: Invested capital $3,000,000 Imputed interest rate .09 000,072egrahctseretnidetupmI Residual income ..................................................................................................... $ 30,000 Economic value added (EVA): EVA Investment center’s after-tax operating inncome Investment center’s total assets Invesstment center’s current liabilities Weeighted-average cost of capital $ ,300 0000 1 40 3 000 000 20 000 09$ $(( , )88 200 2. a. Capital turnover Sales revenue Invested capittal Therefore: Invested capital $ , , ? % 2 000 000 80 $ , , . $ , , 2 000 000 80 2 500 000 .b New ROI 15% 80% %21 Problem 2 Transfer price Outlay cost Opportunity cost $ , ($ , $ , ) $ , 10 000 13 500 10 000 13 500 ( . ) [( $ , , , ) . ] )( The $3,500 opportunity cost of a transfer is the contribution margin that will be forgone if a com- puter module is transferred instead of sold in the external market. hiL25664_ch13_542-585.indd 571hiL25664_ch13_542-585.indd 571 7/16/13 10:01 PM7/16/13 10:01 PM Final PDF to printer 572 Chapter 13 Investment Centers and Transfer Pricing Review Questions Key Terms For each term’s definition refer to the indicated page, or turn to the glossary at the end of the text. capital turnover, 547 cash bonus, 556 economic value added (EVA), 551 full ( or absorption) cost, 565 goal congruence, 545 imperfect competition, 563 incentive compensation, 556 internal control system, 569 investment center, 544 management by objectives (MBO), 545 merit pay, 556 pay for performance, 556 perfect competition, 563 residual income, 549 return on investment (ROI), 546 sales margin, 547 shareholder value analysis, 551 transfer price, 544 weighted-average cost of capital (WACC), 551 13–1. What is the managerial accountant’s primary objective in designing a responsibility-accounting system? 13–2. Define goal congruence, and explain why it is impor- tant to an organization’s success. 13–3. Describe the managerial approach known as manage- ment by objectives or MBO. 13–4. Define and give three examples of an investment center. 13–5. Write the formula for ROI, showing sales margin and capital turnover as its components. 13–6. Explain how the manager of the Automobile Division of an insurance company could improve her division’s ROI. 13–7. Create an example showing how residual income is cal- culated. What information is used in computing residual income that is not used in computing ROI? 13–8. What is the chief disadvantage of ROI as an investment- center performance measure? How does the residual- income measure eliminate this disadvantage? 13–9. Why is there typically a rise in ROI or residual income across time in a division? What undesirable behavioral implications could this phenomenon have? 13–10. Define the term economic value added. How does it differ from residual income? 13–11. Distinguish between the following measures of invested capital, and briefly explain when each should be used: ( a ) total assets, ( b ) total productive assets, and ( c ) total assets less current liabilities. 13–12. Why do some companies use gross book value instead of net book value to measure a division’s invested capital? 13–13. Explain why it is important in performance evaluation to distinguish between investment centers and their managers. 13–14. How do organizations use pay for performance to moti- vate managers? 13–15. Describe an alternative to using ROI or residual income to measure investment-center performance. 13–16. How does inflation affect investment-center perfor- mance measures? 13–17. List three nonfinancial measures that could be used to evaluate a division of an insurance company. 13–18. Discuss the importance of nonfinancial information in measuring investment-center performance. 13–19. Identify and explain the managerial accountant’s pri- mary objective in choosing a transfer-pricing policy. 13–20. Describe four methods by which transfer prices may be set. 13–21. Explain the significance of excess capacity in the trans- ferring division when transfer prices are set using the general transfer-pricing rule. 13–22. Why might income-tax laws affect the transfer-pricing policies of multinational companies? 13–23. Explain the role of import duties, or tariffs, in affecting the transfer-pricing policies of multinational companies. Exercises All applicable Exercises are available with McGraw-Hill’s Connect Accounting ® . The following data pertain to Pensacola Division’s most recent year of operations. Required: Compute Pensacola Division’s sales margin, capital turnover, and return on investment for the year. Refer to the preceding exercise. Required: Demonstrate two ways Pensacola Division’s manager could improve the division’s ROI to 25 percent. ■ Exercise 13–24 Components of ROI (LO 13-2) ■ Exercise 13–25 Improving ROI (LO 13-3) Income ..................................................................................................................................................... $ 10,000,000 Sales revenue ........................................................................................................................................... 125,000,000 Average invested capital ............................................................................................................................ 50,000,000 hiL25664_ch13_542-585.indd 572hiL25664_ch13_542-585.indd 572 7/16/13 10:01 PM7/16/13 10:01 PM Final PDF to printer Chapter 13 Investment Centers and Transfer Pricing 573 Refer to the data for Exercise 13–24. Assume that the company’s minimum desired rate o f return on invested capital is 11 percent. Required: Compute Pensacola Division’s residual income for the year. The following data pertain to British Isles Aggregates Company, a producer of sand, gravel, a nd cement, for the year just ended. Sales revenue ........................................................................................................................................ £6,000,000 Cost of goods sold ................................................................................................................................ 3,300,000 Operating expenses ............................................................................................................................... 2,400,000 Average invested capital ........................................................................................................................ 3,000,000 £ denotes the British pound sterling, the national monetary unit of the United Kingdom. Although the euro is used in most European markets, the U.K. continues to use pounds sterling for its national currency. Required: 1. Compute the company’s sales margin, capital turnover, and ROI. 2. If the sales and average invested capital remain the same during the next year, to what level would total expenses have to be reduced in order to improve the firm’s ROI to 15 percent? 3. Assume expenses are reduced, as calculated in requirement (2). Compute the firm’s new sales margin. Show how the new sales margin and the old capital turnover together result in a new ROI of 15 percent. Select one of the following companies (or any company of your choosing) and use the Internet to explore the company’s most recent annual report. American Airlines (www.americanair.com) Deere and Company (www.deere.com) Bridgestone www.bridgestone.com IBM www.ibm.com Pizza Hut www.pizzahut.com Wyndham Hotels www.wyndham.com Walmart www.walmart.com Required: 1. Calculate the company’s overall return on investment (ROI). Also, calculate the company’s overall residual income. (Assume an imputed interest rate of 10 percent.) List and explain any assump- tions you make. 2. Does the company include a calculation of ROI in its on-line annual report? If it does, do your calculations agree with those of the company? If not, what would be some possible explanations? Suburban Lifestyles, Inc., has manufactured prefabricated houses for over 20 years. T h e houses are con- structed in sections to be assembled on customers’ lots. Suburban Lifestyles expanded into the precut housing market when it acquired Fairmont Company, one of its suppliers. In this market, various types of lumber are precut into the appropriate lengths, banded into packages, and shipped to customers’ lots for assembly. Suburban Lifestyles’ management designated the Fairmont Division as an investment center. Suburban uses return on investment (ROI) as a performance measure with investment defined as average productive assets. Management bonuses are based in part on ROI. All investments are expected to earn a minimum return of 15 percent before income taxes. Fairmont’s ROI has ranged from 19.3 to 22.1 percent since it was acquired. Fairmont had an investment opportunity in 20x1 that had an ■ Exercise 13–26 Residual Income (LO 13-2) ■ Exercise 13–27 Improving ROI ■ Exercise 13–28 ROI and Residual Income; Annual Reports; Use of Internet (LO 13-2) ■ Exercise 13–29 ROI; Residual Income (LO 13-1, 13-2) hiL25664_ch13_542-585.indd 573hiL25664_ch13_542-585.indd 573 7/16/13 10:02 PM7/16/13 10:02 PM Final PDF to printer 574 Chapter 13 Investment Centers and Transfer Pricing estimated ROI of 18 percent. Fairmont’s management decided against the investment because it believed the investment would decrease the division’s overall ROI. The 20x1 income statement for Fairmont Division follows. The division’s productive assets were $25,200,000 at the end of 20x1, a 5 percent increase over the balance at the beginning of the year. FAIRMONT DIVISION Income Statement For the Year Ended December 31, 20x1 (in thousands) Sales revenue .................................................................................................................................................. $48,000 Cost of goods sold ............................................................................................................................................ 31,600 Gross margin ............................................................................................................................................... $16,400 Operating expenses: Administrative ............................................................................................................................ $4,280 Selling ....................................................................................................................................... 7,200 11,480 Income from operations before income taxes ..................................................................................................... $ 4,920 Required: 1. Calculate the following performance measures for 20x1 for the Fairmont Division. a. Return on investment (ROI). b. Residual income. 2. Would the management of Fairmont Division have been more likely to accept the investment opportunity it had in 20x1 if residual income were used as a performance measure instead of ROI? Explain your answer. 3. Build a spreadsheet: Construct an Excel spreadsheet to solve requirement (1) above. Show how the solution will change if income from operations was $5,400,000. (CMA, adapted) Refer to Exhibit 13–3 . Assume that you are a consultant who has been hired by Suncoast Food Centers. Required: Write a memorandum to the company president explaining why the ROI based on net book value (in Exhibit 13–3 ) behaves as it does over the five-year time horizon. Galviston S upply Company is an auto parts supplier. At the end of each month, the employee who maintains all of the inventory records takes a physical inventory of the firm’s stock. When discrepancies occur between the recorded inventory and the physical count, the employee changes the physical count to agree with the records. Required: 1. What problems could arise as a result of Galviston Supply Company’s inventory procedures? 2. How could the internal control system be strengthened to eliminate the potential problems? Golden G ate Construction Associates, a real estate developer and building contractor in San Fran- cisco, has two sources of long-term capital: debt and equity. The cost to Golden Gate of issuing debt is the after-tax cost of the interest payments on the debt, taking into account the fact that the interest payments are tax deductible. The cost of Golden Gate’s equity capital is the investment opportunity rate of Golden Gate’s investors, that is, the rate they could earn on investments of similar risk to that of investing in Golden Gate Construction Associates. The interest rate on Golden Gate’s $90 million ■ Exercise 13–30 Increasing ROI over Time (LO 13-2, 13-4, 13-5) ■ Exercise 13–31 Internal Control (LO 13-1, 13-8) ■ Exercise 13–32 Calculate Weighted-Average Cost of Capital for EVA (LO 13-2) hiL25664_ch13_542-585.indd 574hiL25664_ch13_542-585.indd 574 7/16/13 10:02 PM7/16/13 10:02 PM Final PDF to printer Chapter 13 Investment Centers and Transfer Pricing 575 of long-term debt is 10 percent, and the company’s tax rate is 40 percent. The cost of Golden Gate’s equity capital is 15 percent. Moreover, the market value (and book value) of Golden Gate’s equity is $135 million. Required: Calculate Golden Gate Construction Associates’ weighted-average cost of capital. Refer to the data in the preceding exercise for Golden Gate Construction Associates. The company has two divisions: the real estate division and the construction division. The divisions’ total assets, current liabilities, and before-tax operating income for the most recent year are as follows: Division Total Assets Current Liabilities Before-Tax Operating Income Real estate ....................................................................... $150,000,000 $9,000,000 $30,000,000 Construction .................................................................... 90,000,000 6,000,000 27,000,000 Required: Calculate the economic value added (EVA) for each of Golden Gate Construction Associ- ates’ divisions. (You will need to use the weighted-average cost of capital, which was computed in the preceding exercise.) Milwaukee Metallurgy Corporation (MMC) has two divisions. The Fabrication Division t ransfers par- tially completed components to the Assembly Division at a predetermined transfer price. The Fabrica- tion Division’s standard variable production cost per unit is $450. The division has no excess capacity, and it could sell all of its components to outside buyers at $570 per unit in a perfectly competitive market. Required: 1. Determine a transfer price for MMC using the general rule. 2. How would the transfer price change if the Fabrication Division had excess capacity? Refer to the preceding exercise. The Fabrication Division’s full (absorption) cost of a c omponent is $510, which includes $60 of applied fixed-overhead costs. The transfer price has been set at $561, which is the Fabrication Division’s full cost plus a 10 percent markup. The Assembly Division has a special offer for its product of $700. The Assembly Division incurs variable costs of $150 in addition to the transfer price for the Fabrication Division’s components. Both divisions currently have excess production capacity. Required: 1. What is the Assembly Division’s manager likely to do regarding acceptance or rejection of the special offer? Why? 2. Is this decision in the best interests of the company as a whole? Why? 3. How could the situation be remedied using the transfer price? ■ Exercise 13–33 Economic Value Added (EVA); Continuation of Preceding Exercise (LO 13-2) ■ Exercise 13–34 General Transfer-Pricing Rule (LO 13-6) ■ Exercise 13–35 Cost-Based Transfer Pricing ; Continuation of Preceding Exercise (LO 13-7) Problems All applicable Problems are available with McGraw-Hill’s Connect Accounting ® . Omaha Grain Company has two divisions, which reported the following results for the m ost recent year. Division I Division II Income ................................................................................................... $2,700,000 $600,000 Average invested capital .......................................................................... $18,000,000 $3,000,000 ROI ......................................................................................................... 15% 20% Required: Which was the most successful division during the year? Think carefully about this, and explain your answer. ■ Problem 13–36 Comparing the Performance of Two Divisions (LO 13-2, 13-4) Imputed interest rate of 10%, Division I, residual income: $900,000 hiL25664_ch13_542-585.indd 575hiL25664_ch13_542-585.indd 575 7/16/13 10:02 PM7/16/13 10:02 PM Final PDF to printer 576 Chapter 13 Investment Centers and Transfer Pricing The following data pertain to three divisions of Calrisian Enterprises. The c ompany’s required rate of return on invested capital is 8 percent. Division I Division II Division III Sales revenue ..................................................... $40,000,000 ? ? Income ............................................................... $8,000,000 $1,600,000 ? Average investment ............................................. $10,000,000 ? ? Sales margin ...................................................... ? 20% 25% Capital turnover .................................................. ? 1 ? ROI .................................................................... ? ? 20% Residual income .................................................. ? ? $480,000 Required: Fill in the blanks above. Refer to the p receding problem about Calrisian Enterprises. Required: 1. Explain three ways the Division I manager could improve her division’s ROI. Use numbers to illustrate these possibilities. 2. Suppose Division II’s sales margin increased to 25 percent, while its capital turnover remained constant. Compute the division’s new ROI. Refer to the d ata for problem 13–36 regarding Omaha Grain Company. Required: Compute each division’s residual income for the year under each of the following assump- tions about the firm’s cost of acquiring capital. 1. 12 percent. 2. 15 percent. 3. 18 percent. Which division was most successful? Explain your answer. Megatronics Corporation, a massive retailer of electronic products, is organized in four separate divi- sions. The four divisional managers are evaluated at year-end, and bonuses are awarded based on ROI. Last year, the company as a whole produced a 13 percent return on its investment. During the past week, management of the company’s Western Division was approached about the possibility of buying a competitor that had decided to redirect its retail activities. (If the competitor is acquired, it will be acquired at its book value.) The data that follow relate to recent performance of the Western Division and the competitor: Western Division Competitor Sales .......................................................................................................... $4,200,000 $2,600,000 Variable costs .............................................................................................. 70% of sales 65% of sales Fixed costs .................................................................................................. $1,075,000 $835,000 Invested capital ........................................................................................... $925,000 $312,500 Management has determined that in order to upgrade the competitor to Megatronics’ standards, an addi- tional $187,500 of invested capital would be needed. Required: 1. Compute the current ROI of the Western Division and the division’s ROI if the competitor is acquired. 2. What is the likely reaction of divisional management toward the acquisition? Why? ■ Problem 13–37 ROI and Residual Income; Missing Data (LO 13-2, 13-3) Division I, capital turnover: 4 ■ Problem 13–38 Improving ROI ; Continuation of Preceding Exercise (LO 13-3) ■ Problem 13–39 Residual Income (LO 13-2, 13-4) 2. Imputed interest rate of 15%, Division I, residual income: $0 1. Western Division, income: $185,000 3. Variable costs: $1,690,000 ■ Problem 13–40 ROI and Residual Income; Investment Evaluation (LO 13-2, 13-3, 13-4, 13-8) hiL25664_ch13_542-585.indd 576hiL25664_ch13_542-585.indd 576 7/16/13 10:02 PM7/16/13 10:02 PM Final PDF to printer Chapter 13 Investment Centers and Transfer Pricing 577 3. What is the likely reaction of Megatronics’ corporate management toward the acquisition? Why? 4. Would the division be better off if it didn’t upgrade the competitor to Megatronics’ standards? Show computations to support your answer. 5. Assume that Megatronics uses residual income to evaluate performance and desires a 12 percent minimum return on invested capital. Compute the current residual income of the Western Division and the division’s residual income if the competitor is acquired. Will divisional management be likely to change its attitude toward the acquisition? Why? Refer to Exhibit 13–3 . Prepare a similar table of the changing ROI assuming the following a ccelerated depreciation schedule. Assume the same income before depreciation as shown in Exhibit 13–3 . (If there is a loss, leave the ROI column blank.) Year Depreciation 1 ........................................ $200,000 2 ........................................ 120,000 3 ........................................ 72,000 4 ........................................ 54,000 5 ........................................ 54,000 Total ....................................... $500,000 Required: 1. How does your table differ from the one in Exhibit 13–3 ? Why? 2. What are the implications of the ROI pattern in your table? Prepare a table similar to Exhibit 13–3 , which focuses on residual income. U se a 10 percent rate to com- pute the imputed interest charge. The table should show the residual income on the investment during each year in its five-year life. Assume the same income before depreciation and the same depreciation schedule as shown in Exhibit 13–3 . Hoosier Industries manufactures a variety of household products. Roy Washburn, head of the c ompany’s Hardware Division, has just completed a miserable nine months. “If it could have gone wrong, it did. Sales are down, income is down, inventories are bloated, and quite frankly, I’m beginning to worry about my job,” he moaned. Washburn is evaluated on the basis of ROI. Selected figures for the Hardware Division for the past nine months follow. Sales .................................................................................................................................................... $7,200,000 Operating income ................................................................................................................................. 540,000 Invested capital ..................................................................................................................................... 9,000,000 In an effort to make something out of nothing and to salvage the current year’s performance, Washburn was contemplating implementation of some or all of the following four strategies: a. Write off and discard $90,000 of obsolete inventory. The company will take a loss on the disposal. b. Accelerate the collection of $120,000 of overdue customer accounts receivable. c. Stop advertising through year-end and drastically reduce outlays for repairs and maintenance. These actions are expected to save the division $225,000 of expenses and will conserve cash resources. d. Acquire two competitors that are expected to have the following financial characteristics: Projected Sales Projected Operating Expenses Projected Invested Capital Anderson Manufacturing ................................... $4,500,000 $3,600,000 $7,500,000 Palm Beach Enterprises .................................... 6,750,000 6,180,000 7,125,000 ■ Problem 13–41 Increasing ROI over Time; Accelerated Depreciation (LO 13-2, 13-4, 13-5) ■ Problem 13–42 Increasing Residual Income over Time (LO 13-2, 13-4, 13-5) ■ Problem 13–43 ROI and Performance Evaluations (LO 13-2, 13-4, 13-8) 1. Capital turnover: 80% hiL25664_ch13_542-585.indd 577hiL25664_ch13_542-585.indd 577 7/16/13 10:02 PM7/16/13 10:02 PM Final PDF to printer 578 Chapter 13 Investment Centers and Transfer Pricing Required: 1. Briefly define sales margin, capital turnover, and return on investment and then compute these amounts for the Hardware Division over the past nine months. 2. Evaluate each of the first two strategies listed, with respect to its effect on the division’s last nine months’ performance, and make a recommendation to Washburn regarding which, if any, to adopt. 3. Are there possible long-term problems associated with strategy (c)? Briefly explain. 4. Determine the ROI of the investment in Anderson Manufacturing and do the same for the invest- ment in Palm Beach Enterprises. Should Washburn reject both acquisitions, acquire one company, or acquire both companies? Assume that sufficient capital is available to fund investments in both organizations. Maple L eaf Industries, headquartered in Toronto, is a multiproduct company with three divisions: Pacific Division, Plains Division, and Atlantic Division. The company has two sources of long-term capital: debt and equity. The interest rate on Maple Leaf’s $400 million debt is 9 percent, and the company’s tax rate is 30 percent. The cost of Maple Leaf’s equity capital is 12 percent. Moreover, the market value of the company’s equity is $600 million. (The book value of Maple Leaf’s equity is $430 million, but that amount does not reflect the current value of the company’s assets or the value of intangible assets.) The following data (in millions) pertains to Maple Leaf’s three divisions. Division Before-Tax Operating Income Current Liabilities Total Assets Pacific ............................................................ $14 $6 $ 70 Plains ............................................................ 45 5 300 Atlantic .......................................................... 48 9 480 Required: 1. Compute Maple Leaf’s weighted-average cost of capital (WACC). 2. Compute the economic value added (or EVA) for each of the company’s three divisions. 3. What conclusions can you draw from the EVA analysis? Cape Cod L obster Shacks, Inc. (CCLS), is a seafood restaurant chain operating throughout the north- east. The company has two sources of long-term capital: debt and equity. The cost to CCLS of issuing debt is the after-tax cost of the interest payments on the debt, taking into account the fact that the interest payments are tax deductible. The cost of CCLS’s equity capital is the investment opportunity rate of CCLS’s investors, that is, the rate they could earn on investments of similar risk to that of investing in Cape Cod Lobster Shacks, Inc. The interest rate on CCLS’s $120 million of long-term debt is 9 percent, and the company’s tax rate is 40 percent. The cost of CCLS’s equity capital is 14 percent. Moreover, the market value (and book value) of CCLS’s equity is $180 million. Cape Cod Lobster Shacks, Inc., consists of two divisions, the properties division and the food ser- vice division. The divisions’ total assets, current liabilities, and before-tax operating income for the most recent year are as follows: Division Total Assets Current Liabilities Before-Tax Operating Income Properties .............................................. $217,500,000 $4,500,000 $43,500,000 Food Service ......................................... 96,000,000 9,000,000 22,500,000 Required: 1. Calculate the weighted-average cost of capital for Cape Cod Lobster Shacks, Inc. 2. Calculate the economic value added (EVA) for each of CCLS’s divisions. 3. Build a spreadsheet: Construct an Excel spreadsheet to solve both of the preceding requirements. Show how the solution will change if the following information changes: before-tax operating income was $45,000,000 and $21,000,000 for Properties and Food Service, respectively. ■ Problem 13–44 Weighted-Average Cost of Capital; Economic Value Added (EVA) (LO 13-2) 2. Weighted-average cost of capital: .0972 ■ Problem 13–45 Weighted-Average Cost of Capital; Economic Value Added (EVA) (LO 13-2) 2. Economic value added, Food Service: $4.3128 million hiL25664_ch13_542-585.indd 578hiL25664_ch13_542-585.indd 578 7/16/13 10:02 PM7/16/13 10:02 PM Final PDF to printer Chapter 13 Investment Centers and Transfer Pricing 579 Mitachlordion T echnology, Inc. (MTI), has two divisions: Birmingham and Tampa. Birmingham cur- rently sells a diode reducer to manufacturers of aircraft navigation systems for $1,550 per unit. Variable costs amount to $1,000, and demand for this product currently exceeds the division’s ability to supply the marketplace. Despite this situation, MTI is considering another use for the diode reducer, namely, integration into a satellite positioning system that would be made by Tampa. The positioning system has an antici- pated selling price of $2,800 and requires an additional $1,340 of variable manufacturing costs. A trans- fer price of $1,500 has been established for the diode reducer. Top management is anxious to introduce the positioning system; however, unless the transfer is made, an introduction will not be possible because of the difficulty of obtaining needed diode reducers. Birmingham and Tampa are in the process of recovering from previous financial problems, and neither division can afford any future losses. The company uses responsibility accounting and ROI in measuring divisional performance, and awards bonuses to divisional management. Required: 1. How would Birmingham’s divisional manager likely react to the decision to transfer diode reducers to Tampa? Show computations to support your answer. 2. How would Tampa’s divisional management likely react to the $1,500 transfer price? Show computations to support your answer. 3. Assume that a lower transfer price is desired. Should top management lower the price or should the price be lowered by another means? Explain. 4. From a contribution margin perspective, does MTI benefit more if it sells the diode reducers externally or transfers the reducers to Tampa? By how much? Weathermaster Window Company manufactures windows for the home-building industry. T he window frames are produced in the Frame Division. The frames are then transferred to the Glass Division, where the glass and hardware are installed. The company’s best-selling product is a three-by-four-foot, double- paned operable window. The Frame Division can also sell frames directly to custom home builders, who install the glass and hardware. The sales price for a frame is $160. The Glass Division sells its finished windows for $380. The markets for both frames and finished windows exhibit perfect competition. The standard cost of the window is detailed as follows: Frame Division Glass Division Direct material ................................................. $ 30 ...................................... $ 60* Direct labor ...................................................... 40 ...................................... 30 Variable overhead ............................................ 60 ...................................... 60 Total ................................................................ $130 ...................................... $150 *Not including the transfer price for the frame. Required: 1. Assume that there is no excess capacity in the Frame Division. a. Use the general rule to compute the transfer price for window frames. b. Calculate the transfer price if it is based on standard variable cost with a 10 percent markup. 2. Assume that there is excess capacity in the Frame Division. a. Use the general rule to compute the transfer price for window frames. b. Explain why your answers to requirements (1 a ) and (2 a ) differ. c. Suppose the predetermined fixed-overhead rate in the Frame Division is 125 percent of direct- labor cost. Calculate the transfer price if it is based on standard full cost plus a 10 percent markup. d. Assume the transfer price established in requirement (2 c ) is used. The Glass Division has been approached by the U.S. Army with a special order for 1,000 windows at $310. From the perspective of Weathermaster Window Company as a whole, should the special order be accepted or rejected? Why? ■ Problem 13–46 Transfer Pricing; Negotiation (LO 13-7) 4. Produce diode, sell externally, contribution margin: $550 ■ Problem 13–47 Comprehensive Transfer- Pricing Problem; Ethics (LO 13-6, 13-7, 13-8) 2(a). Opportunity cost: 0 2(d). Total variable (incremen- tal) cost: $280 per unit hiL25664_ch13_542-585.indd 579hiL25664_ch13_542-585.indd 579 7/16/13 10:02 PM7/16/13 10:02 PM Final PDF to printer 580 Chapter 13 Investment Centers and Transfer Pricing e. Assume the same facts as in requirement (2 d ). Will an autonomous Glass Division manager accept or reject the special order? Why? f. Comment on any ethical issues you see in the questions raised in requirements (2 d ) and (2 e ). 3. Comment on the use of full cost as the basis for setting transfer prices. Redstone I ndustrial Resources Company (RIRC) has several divisions. However, only two divisions transfer products to other divisions. The Mining Division refines toldine, which is then transferred to the Metals Division. The toldine is processed into an alloy by the Metals Division, and the alloy is sold to customers at a price of $450 per unit. The Mining Division is currently required by RIRC to transfer its total yearly output of 400,000 units of toldine to the Metals Division at total actual manufacturing cost plus 10 percent. Unlimited quantities of toldine can be purchased and sold on the open market at $270 per unit. While the Mining Division could sell all the toldine it produces at $270 per unit on the open market, it would incur a variable selling cost of $15 per unit. Brian Jones, manager of the Mining Division, is unhappy with having to transfer the entire output of toldine to the Metals Division at 110 percent of cost. In a meeting with the management of RIRC, he said, “Why should my division be required to sell toldine to the Metals Division at less than market price? For the year just ended in May, Metals’ contribution margin was over $57 million on sales of 400,000 units, while Mining’s contribution was just over $15 million on the transfer of the same number of units. My division is subsidizing the profitability of the Metals Division. We should be allowed to charge the market price for toldine when transferring to the Metals Division.” The following table shows the detailed unit cost structure for both the Mining and Metals divisions during the most recent year. Mining Division Metals Division Transfer price from Mining Division .................................................................................. — $198 Direct material ................................................................................................................ $ 36 18 Direct labor ..................................................................................................................... 48 60 Manufacturing overhead .................................................................................................. 96* 75† Total cost per unit ....................................................................................................... $180 $351 *Manufacturing-overhead cost in the Mining Division is 25 percent fixed and 75 percent variable. †Manufacturing-overhead cost in the Metals Division is 60 percent fixed and 40 percent variable. Required: 1. Explain why transfer prices based on total actual costs are not appropriate as the basis for divi- sional performance measurement. 2. Using the market price as the transfer price, determine the contribution margin for both the Mining Division and the Metals Division. 3. If Redstone Industrial Resources Company were to institute the use of negotiated transfer prices and allow divisions to buy and sell on the open market, determine the price range for toldine that would be acceptable to both the Mining Division and the Metals Division. Explain your answer. 4. Use the general transfer-pricing rule to compute the lowest transfer price that would be accept- able to the Mining Division. Is your answer consistent with your conclusion in requirement (3)? Explain. 5. Identify which one of the three types of transfer prices (cost-based, market-based, or negotiated) is most likely to elicit desirable management behavior at RIRC. Explain your answer. (CMA, adapted) Delta T elecom, Inc., which produces telecommunications equipment in the United States, has a very strong local market for its circuit board. The variable production cost is $390, and the company can sell its entire supply domestically for $510. The U.S. tax rate is 40 percent. ■ Problem 13–48 Transfer Pricing; Management Behavior (LO 13-6, 13-7, 13-8) 2. Metals Division, total contribution margin: $28,800,000 4. Outlay cost: $156 ■ Problem 13–49 Setting a Transfer Price; International Setting; Differential Tax Rates (LO 13-6, 13-7) 1. German operation, income after tax: $98.40 per board hiL25664_ch13_542-585.indd 580hiL25664_ch13_542-585.indd 580 7/16/13 10:02 PM7/16/13 10:02 PM Final PDF to printer Chapter 13 Investment Centers and Transfer Pricing 581 Alternatively, Delta Telecom can ship the circuit board to its division in Germany, to be used in a product that the German division will distribute throughout Europe. Information about the German product and the division’s operating environment follows. Selling price of final product: $1,080 Shipping fees to import circuit board: $60 Labor, overhead, and additional material costs of final product: $345 Import duties levied on circuit board (to be paid by the German division): 10% of transfer price German tax rate: 60% Assume that U.S. and German tax authorities allow a transfer price for the circuit board set at either U.S. variable manufacturing cost or the U.S. market price. Delta Telecom’s management is in the process of exploring which transfer price is best for the firm as a whole. Required: 1. Compute overall company profitability per unit if all units are transferred and U.S. variable manu- facturing cost is used as the transfer price. Show separate calculations for the U.S. operation and the German division. 2. Repeat requirement (1), assuming the use of the U.S. market price as the transfer price. Which of the two transfer prices is best for the firm? 3. Assume that the German division can obtain the circuit board in Germany for $465. a. If you were the head of the German division, would you rather do business with your U.S. division or buy the circuit board locally? Why? b. Rather than proceed with the transfer, is it in the best interest of Delta Telecom to sell its goods domestically and allow the German division to acquire the circuit board in Germany? Why? Show computations to support your answer. 4. Generally speaking, when tax rates differ between countries, what strategy should a company use in setting its transfer prices? 5. Build a spreadsheet: Construct an Excel spreadsheet to solve requirements (1) and (2) above. Show how the solution will change if the following information changes: the U.S. tax rate is 35 percent, the German tax rate is 55 percent, and the import duties are 8 percent of the transfer price. Cases Fun Times Entertainment Corporation (FTEC), a subsidiary of New Age Industries, m anufactures go- carts and other recreational vehicles. Family recreational centers that feature not only go-cart tracks but miniature golf, batting cages, and arcade games as well have increased in popularity. As a result, FTEC has been receiving some pressure from New Age’s management to diversify into some of these other recreational areas. Recreational Leasing, Inc. (RLI), one of the largest firms that leases arcade games to family recreational centers, is looking for a friendly buyer. New Age’s top management believes that RLI’s assets could be acquired for an investment of $1.6 million and has strongly urged Bill Grieco, division manager of FTEC, to consider acquiring RLI. Grieco has reviewed RLI’s financial statements with his controller, Marie Donnelly, and they believe the acquisition may not be in the best interest of FTEC. “If we decide not to do this, the New Age people are not going to be happy,” said Grieco. “If we could convince them to base our bonuses on something other than return on investment, maybe this acquisition would look more attractive. How would we do if the bonuses were based on residual income, using the company’s 15 percent cost of capital?” New Age Industries traditionally has evaluated all of its divisions on the basis of return on invest- ment. The desired rate of return for each division is 20 percent. The management team of any division reporting an annual increase in the ROI is automatically eligible for a bonus. The management of divi- sions reporting a decline in the ROI must provide convincing explanations for the decline in order to be eligible for a bonus. Moreover, this bonus is limited to 50 percent of the bonus paid to divisions report- ing an increase in ROI. ■ Case 13–50 ROI versus Residual Income; Incentive Effects (LO 13-1, 13-2, 13-4, 13-8) 2. Residual income, combined operations, $460,000 hiL25664_ch13_542-585.indd 581hiL25664_ch13_542-585.indd 581 7/16/13 10:02 PM7/16/13 10:02 PM Final PDF to printer 582 Chapter 13 Investment Centers and Transfer Pricing In the following table are condensed financial statements for both FTEC and RLI for the most recent year. RLI FTEC Sales revenue ........................................................................................... — $4,750,000 Leasing revenue ...................................................................................... $1,550,000 — Variable expenses .................................................................................... (650,000) (3,000,000) Fixed expenses ........................................................................................ (600,000) (750,000) Operating income ................................................................................ $ 300,000 $1,000,000 Current assets ......................................................................................... $ 950,000 $1,150,000 Long-lived assets ..................................................................................... 550,000 2,850,000 Total assets ......................................................................................... $1,500,000 $4,000,000 Current liabilities ....................................................................................... $ 425,000 $ 700,000 Long-term liabilities ................................................................................. 600,000 1,900,000 Stockholders’ equity ................................................................................. 475,000 1,400,000 Total liabilities and stockholders’ equity ................................................. $1,500,000 $4,000,000 Required: 1. If New Age Industries continues to use ROI as the sole measure of divisional performance, explain why FTEC would be reluctant to acquire Recreational Leasing, Inc. 2. If New Age Industries could be persuaded to use residual income to measure the performance of FTEC, explain why FTEC would be more willing to acquire RLI. 3. Discuss how the behavior of division managers is likely to be affected by the use of the following performance measures: ( a ) return on investment and ( b ) residual income. (CMA, adapted) General Instrumentation C orporation manufactures dashboard instruments for heavy construction equipment. The firm is based in Baltimore, but operates several divisions in the United States, Canada, and Europe. The Hudson Bay Division manufactures complex electrical panels that are used in a variety of the firm’s instruments. There are two basic types of panels. The high-density panel (HDP) is capable of many functions and is used in the most sophisticated instruments, such as tachometers and pressure gauges. The low-density panel (LDP) is much simpler and is used in less complicated instruments. Although there are minor differences among the different high-density panels, the basic manufacturing process and production costs are the same. The high-density panels require considerably more skilled labor than the low-density panels, but the unskilled labor needs are about the same. Moreover, the direct materials in the high-density panel run substantially more than the cost of materials in the low-density panels. Production costs are summarized as follows: LDP HDP Unskilled labor (.5 hour @ $10) ........................................................................................... $ 5 $ 5 Skilled labor: LDP (.25 hour @ $20) ...................................................................................................... 5 HDP (1.5 hours @ $20).................................................................................................... 30 Raw material ....................................................................................................................... 3 8 Purchased components ....................................................................................................... 5 15 Variable overhead ............................................................................................................... 4 12 Total variable cost ............................................................................................................... $22 $70 The annual fixed overhead in the Hudson Bay Division is $1,000,000. There is a limited sup- ply of skilled labor available in the area, and the division must constrain its production to 40,000 hours of skilled labor each year. This has been a troublesome problem for Jacqueline Ducharme, the ■ Case 13–51 Minimum and Maximum Acceptable Transfer Prices; Multinational (LO 13-6, 13-7, 13-8) 2. Unit contribution margin, LDP: $6 Unit contribution margin, TCH-320 using imported control pack: $47 hiL25664_ch13_542-585.indd 582hiL25664_ch13_542-585.indd 582 7/16/13 10:02 PM7/16/13 10:02 PM Final PDF to printer Chapter 13 Investment Centers and Transfer Pricing 583 division manager. Ducharme has successfully increased demand for the LDP line to the point where it is essentially unlimited. Each LDP sells for $28. Business also has increased in recent years for the HDP, and Ducharme estimates the division could now sell anywhere up to 6,000 units per year at a price of $115. On the other side of the Atlantic, General Instrumentation operates its Volkmar Tachometer Divi- sion in Berlin. A recent acquisition of General Instrumentation, the division was formerly a German company known as Volkmar Construction Instruments. The division’s main product is a sophisticated tachometer used in heavy-duty cranes, bulldozers, and backhoes. The instrument, designated as a TCH– 320, has the following production costs. TCH–320 Unskilled labor (.5 hour @ $9) . ................................................................................................................. $ 4.50 Skilled labor (3 hours @ $17) .................................................................................................................... 51.00 Raw material ........................................................................................................................................... 10.50 Purchased components ............................................................................................................................ 150.00 Variable overhead .................................................................................................................................... 12.00 Total variable cost .................................................................................................................................... $228.00 The cost of purchased components includes a $145 control pack currently imported from an Asian electronics company. Fixed overhead in the Volkmar Tachometer Division runs about $800,000 per year. Both skilled and unskilled labor are in abundant supply. The TCH–320 sells for $275. Bertram Mueller, the division manager of the Volkmar Tachometer Division, recently attended a high-level corporate meeting in Baltimore. In a conversation with Jacqueline Ducharme, it was apparent that Hudson Bay’s high-density panel might be a viable substitute for the control pack currently imported from Asia and used in Volkmar’s TCH–320. Upon returning to Berlin, Muel- ler asked his chief engineer to look into the matter. Hans Schmidt obtained several HDP units from Hudson Bay, and a minor R&D project was mounted to determine if the HDP could replace the imported control pack. Several weeks later, the following conversation occurred in Mueller’s office: Schmidt: There’s no question that Hudson Bay’s HDP unit will work in our TCH–320. In fact, it could save us some money. Mueller: That’s good news. If we can buy our components within the company, we’ll help Baltimore’s bottom line without hurting ours. Also, it will look good to the brass at corporate if they see us working hard to integrate our division into General Instrumentation’s overall production program. Schmidt: I’ve also been worried about the reliability of supply of the imported control pack. I don’t like being dependent on such a critical supplier that way. Mueller: I agree. Let’s look at your figures on the HDP replacement. Schmidt: I got together with the controller’s people, and we worked up some numbers. If we replace the imported control pack with the HDP from Canada, we’ll avoid the $145 control pack cost we’re now incurring. In addition, I figure we’ll save $5.50 on the basic raw materi- als. There is one catch, though. The HDP will require some adjustments in order to use it in the TCH–320. We can make the adjustments here in Berlin. I’m guessing it will require an additional two hours of skilled labor to make the necessary modifications. I don’t think variable overhead would be any different. Then there is the cost of transporting the HDPs to Berlin. Let’s figure on $4.50 per unit. Mueller: Sounds good. I’ll give Jacqueline Ducharme a call and talk this over. We can use up to 10,000 of the HDP units per year given the demand for the TCH–320. I wonder what kind of a transfer price Hudson Bay will want. Required: 1. Draw a simple diagram depicting the two divisions and their products. Also show the two alternatives that the Volkmar Tachometer Division has in the production of its TCH–320. 2. From the perspective of General Instrumentation’s top management, should any of the TCH–320 units be produced using the high-density panel? If so, how many? hiL25664_ch13_542-585.indd 583hiL25664_ch13_542-585.indd 583 7/16/13 10:02 PM7/16/13 10:02 PM Final PDF to printer 584 Chapter 13 Investment Centers and Transfer Pricing 3. Suppose Hudson Bay transfers 10,000 HDP units per year to Volkmar. From the perspective of General Instrumentation’s top management, what effect will the transfer price have on the company’s income? 4. What is the minimum transfer price that the Hudson Bay Division would find acceptable for the HDP? 5. What is the maximum transfer price that the Volkmar Tachometer Division would find acceptable for the HDP? 6. As the corporate controller for General Instrumentation, recommend a transfer price. Continental Industries is a diversified corporation with separate operating divisions. E ach division’s performance is evaluated on the basis of profit and return on investment. The Air Comfort Division manufactures and sells air-conditioner units. The coming year’s budgeted income statement, which fol- lows, is based upon a sales volume of 15,000 units. AIR COMFORT DIVISION Budgeted Income Statement (In thousands) Total Per Unit Sales revenue ........................................................................................................................ $12,000 $800 Manufacturing costs: Compressor ....................................................................................................................... $ 2,100 $140 Other direct material .......................................................................................................... 1,110 74 Direct labor ....................................................................................................................... 900 60 Variable overhead .............................................................................................................. 1,350 90 Fixed overhead .................................................................................................................. 960 64 Total manufacturing costs .............................................................................................. $ 6,420 $428 Gross margin .......................................................................................................................... $ 5,580 $372 Operating expenses: Variable selling .................................................................................................................. $ 540 $ 36 Fixed selling ...................................................................................................................... 570 38 Fixed administrative ............................................................................................................ 1,140 76 Total operating expenses ................................................................................................ $ 2,250 $150 Net income before taxes ......................................................................................................... $ 3,330 $222 Air Comfort’s division manager believes sales can be increased if the price of the air-conditioners is reduced. A market research study by an independent firm indicates that a 5 percent reduction in the selling price would increase sales volume 16 percent or 2,400 units. The division has sufficient produc- tion capacity to manage this increased volume with no increase in fixed costs. The Air Comfort Division uses a compressor in its units, which it purchases from an outside sup- plier at a cost of $140 per compressor. The Air Comfort Division manager has asked the manager of the Compressor Division about selling compressor units to Air Comfort. The Compressor Division cur- rently manufactures and sells a unit to outside firms which is similar to the unit used by the Air Comfort Division. The specifications of the Air Comfort Division compressor are slightly different, which would reduce the Compressor Division’s direct material cost by $3 per unit. In addition, the Compressor Divi- sion would not incur any variable selling costs in the units sold to the Air Comfort Division. The man- ager of the Air Comfort Division wants all of the compressors it uses to come from one supplier and has offered to pay $100 for each compressor unit. The Compressor Division has the capacity to produce 75,000 units. Its budgeted income statement for the coming year, which follows, is based on a sales volume of 64,000 units without considering Air Comfort’s proposal. ■ Case 13–52 Interdivisional Transfers; Pric- ing the Final Product (LO 13-6, 13-7, 13-8) 1. Contribution margin per unit, before 5% price reduction: $400 2. Contribution margin per unit, Air Comfort sales: $43 hiL25664_ch13_542-585.indd 584hiL25664_ch13_542-585.indd 584 7/16/13 10:02 PM7/16/13 10:02 PM Final PDF to printer Chapter 13 Investment Centers and Transfer Pricing 585 COMPRESSOR DIVISION Budgeted Income Statement (In thousands) Total Per Unit Sales revenue ......................................................................................................................... $12,800 $200 Manufacturing costs: Direct material ..................................................................................................................... $ 1,536 $ 24 Direct labor ........................................................................................................................ 1,024 16 Variable overhead ............................................................................................................... 1,280 20 Fixed overhead .................................................................................................................... 1,408 22 Total manufacturing costs ............................................................................................... $ 5,248 $ 82 Gross margin .......................................................................................................................... $ 7,552 $118 Operating expenses: Variable selling ................................................................................................................... $ 768 $ 12 Fixed selling ....................................................................................................................... 512 8 Fixed administrative ............................................................................................................. 896 14 Total operating expenses ................................................................................................. $ 2,176 $ 34 Net income before taxes .......................................................................................................... $ 5,376 $ 84 Required: 1. Should the Air Comfort Division institute the 5 percent price reduction on its air-conditioner units even if it cannot acquire the compressors internally for $100 each? Support your conclusion with appropriate calculations. 2. Independently of your answer to requirement (1), assume the Air Comfort Division needs 17,400 units. Should the Compressor Division be willing to supply the compressor units for $100 each? Support your conclusions with appropriate calculations. 3. Independently of your answer to requirement (1), assume Air Comfort needs 17,400 units. Suppose Continental’s top management has specified a transfer price of $100. Would it be in the best interest of Continental Industries for the Compressor Division to supply the compressor units at $100 each to the Air Comfort Division? Support your conclusions with appropriate calculations. 4. Is $100 a goal-congruent transfer price? [Refer to your answers for requirements (2) and (3).] (CMA, adapted) hiL25664_ch13_542-585.indd 585hiL25664_ch13_542-585.indd 585 7/16/13 10:02 PM7/16/13 10:02 PM Final PDF to printer 14 THIS CHAPTER’S FOCUS COMPANY is Worldwide Airways, an interna- tional airline based in Atlanta, Georgia. Using this service-industry com- pany for our illustration, we will explore a variety of decisions that managers make routinely. Examples of such decisions are accepting or rejecting a special offer for the company’s services, outsourcing a service, and add- ing or dropping a service or department. We will find in this chapter that different kinds of cost information are relevant, depending on the type of decision to be made. FOCUS COMPANY >>>
Decision Making: Relevant
Costs and Benefits
hiL25664_ch14_586-637.indd 586hiL25664_ch14_586-637.indd 586 7/16/13 10:26 PM7/16/13 10:26 PM
Final PDF to printer

In contrast to the transportation-services setting of Worldwide Airways,
we will explore certain types of decisions that most often arise in a
manufacturing setting. Our illustration will be based on International
Chocolate Company, which produces a variety of chocolate products. In addition to
producing chocolate candy, the company processes cocoa beans into cocoa powder
and cocoa butter. The cocoa powder can then be processed further into instant cocoa
mix. We will explore a variety of decisions faced by International Chocolate Company’s
management.
<<< IN CONTRAST hiL25664_ch14_586-637.indd 587hiL25664_ch14_586-637.indd 587 7/16/13 10:26 PM7/16/13 10:26 PM Final PDF to printer 588 Decision making is a fundamental part of management. Decisions about the acquisi- tion of equipment, mix of products, methods of production, and pricing of products and services confront managers in all types of organizations. This chapter covers the role of managerial accounting information in a variety of common decisions. The next chapter examines pricing decisions. The Managerial Accountant’s Role in Decision Making Managerial accountants are increasingly playing important roles as full-fledged members of cross-functional management teams. These management teams face a broad array of decisions, including production, marketing, financial, and other decisions. All managers and management teams need information pertinent to their decisions. In support of the decision-making process, managerial accountants play a specific role in providing The Managerial Accountant’s Role in Decision Making 14-1 Describe seven steps in the decision-making process and the managerial accoun- tant’s role in that process. 14-2 Explain the relationship between quantitative and qualitative analyses in decision making. 14-3 List and explain two criteria that must be satisfied by relevant information. 14-4 Identify relevant costs and benefits, giving proper treatment to sunk costs, opportunity costs, and unit costs. 14-5 Prepare analyses of various special decisions, properly identifying the relevant costs and benefits. 14-6 Analyze manufacturing decisions involving joint products and limited resources. 14-7 Explain the impact of an advanced manufacturing environment and activity-based costing on a relevant-cost analysis. 14-8 Formulate a linear program to solve a product-mix problem with multiple constraints (appendix). After completing this chapter, you should be able to: Cross-functional management teams (including managerial accountants) who make production, marketing, and finance decisions Make substantive economic decisions affecting operations Designs and implements accounting information system Managerial accountant hiL25664_ch14_586-637.indd 588hiL25664_ch14_586-637.indd 588 7/16/13 10:26 PM7/16/13 10:26 PM Final PDF to printer Chapter 14 Decision Making: Relevant Costs and Benefits 589 relevant information. Thus, the managerial accountant must have a good understanding of the decisions faced by managers throughout the organization. Steps in the Decision-Making Process Seven steps characterize the decision-making process: 1. Clarify the decision problem. Sometimes the decision to be made is clear. For example, if a company receives a special order for its product at a price below the usual price, the decision problem is to accept or reject the order. But the decision problem is seldom so clear and unambiguous. Perhaps demand for a company’s most popular product is declining. What exactly is causing this problem? Increasing competition? Declining quality control? A new alternative product on the market? Before a decision can be made, the problem needs to be clarified and defined in more specific terms. Considerable managerial skill is required to define a decision problem in terms that can be addressed effectively. 2. Specify the criterion. Once a decision problem has been clarified, the manager should specify the criterion upon which a decision will be made. Is the objective to maxi- mize profit, increase market share, minimize cost, or improve public service? Sometimes the objectives are in conflict, as in a decision problem where produc- tion cost is to be minimized but product quality must be maintained. In such cases, one objective is specified as the decision criterion—for example, cost minimiza- tion. The other objective is established as a constraint—for example, product qual- ity must not be worse than one defective part in 1,000 manufactured units. 3. Identify the alternatives. A decision involves selecting between two or more alternatives. If a machine breaks down, what are the alternative courses of action? The machine can be repaired or replaced, or a replacement can be leased. But perhaps repair will turn out to be more costly than replacement. Determining the possible alternatives is a critical step in the decision process. 4. Develop a decision model. A decision model is a simplified representation of the choice problem. Unnecessary details are stripped away, and the most important elements of the problem are highlighted. Thus, the decision model brings together the elements listed above: the criterion, the constraints, and the alternatives. 5. Collect the data. Although the managerial accountant often is involved in steps 1 through 4, he or she is chiefly responsible for step 5. Selecting data pertinent to deci- sions is one of the managerial accountant’s most important roles in an organization. 6. Select an alternative. Once the decision model is formulated and the pertinent data are collected, the appropriate manager makes a decision. 7. Evaluate decision effectiveness. After a decision has been implemented, the results of the decision are evaluated with the objective of improving future decisions. Quantitative versus Qualitative Analysis Decision problems involving accounting data typically are specified in quantitative terms. The criteria in such problems usually include objectives such as profit maximization or cost minimization. When a manager makes a final decision, however, the qualitative character- istics of the alternatives can be just as important as the quantitative measures. Qualitative characteristics are the factors in a decision problem that cannot be expressed effectively in numerical terms. To illustrate, suppose Worldwide Airways’ top management is con- sidering the elimination of its hub operation in London. Airlines establish hubs at air- ports where many of their routes intersect. Hub operations include facilities for in-flight food preparation, aircraft maintenance and storage, and administrative offices. A careful quantitative analysis indicates that Worldwide Airways’ profit-maximizing alternative is to eliminate the London hub. In making its decision, however, the company’s managers will consider such qualitative issues as the effect of the closing on its London employees and on the morale of its remaining employees in the airline’s Paris, Atlanta, and Tokyo hubs. Learning Objective 14-1 Describe seven steps in the decision-making process and the managerial accountant’s role in that process. Learning Objective 14-2 Explain the relationship between quantitative and qualitative analyses in decision making. “We are looked upon as more business advisors than just accountants, and that has a lot to do with the additional analysis and the forward looking goals we are setting.” (14a) Caterpillar hiL25664_ch14_586-637.indd 589hiL25664_ch14_586-637.indd 589 7/16/13 10:26 PM7/16/13 10:26 PM Final PDF to printer 590 Chapter 14 Decision Making: Relevant Costs and Benefits To clarify what is at stake in such qualitative analyses, quantitative analysis can allow the decision maker to put a “price” on the sum total of the qualitative characteristics. For example, suppose Worldwide Airways’ controller gives top management a quantita- tive analysis showing that elimination of the London hub will increase annual profits by $2,000,000. However, the qualitative considerations favor the option of continuing the London operation. How important are these qualitative considerations to the top man- agers? If they decide to continue the London operation, the qualitative considerations must be worth at least $2,000,000 to them. Weighing the quantitative and qualitative considerations in making decisions is the essence of management. The skill, experience, judgment, and ethical standards of managers all come to bear on such difficult choices. Exhibit 14–1 depicts the seven steps in the decision process, and the relationship between quantitative and qualitative analysis. Obtaining Information: Relevance, Accuracy, and Timeliness What criteria should the managerial accountant use in designing the accounting informa- tion system that supplies data for decision making? Three characteristics of information determine its usefulness. Relevance Information is relevant if it is pertinent to a decision problem. Different decisions typically will require different data. The primary theme of this chapter is how to decide what information is relevant to various common decision problems. Accuracy Information that is pertinent to a decision problem also must be accurate, or it will be of little use. This means the information must be precise. For example, the cost incurred by Worldwide Airways to rent facilities at London’s Heathrow Airport is Exhibit 14–1 The Decision-Making Process Primarily the responsibility of the managerial accountant Managerial accountant participates as part of cross-functional management team 1. Clarify the decision problem 2. Specify the criterion 3. Identify the alternatives 4. Develop a decision model 5. Collect the data 6. Make a decision Quantitative Analysis Qualitative Considerations 7. Evaluate decision effectiveness hiL25664_ch14_586-637.indd 590hiL25664_ch14_586-637.indd 590 7/16/13 10:26 PM7/16/13 10:26 PM Final PDF to printer Chapter 14 Decision Making: Relevant Costs and Benefits 591 relevant to a decision about eliminating the airline’s London hub. However, if the rental cost data are imprecise, due to incomplete or misplaced records, the usefulness of the information will be diminished. Conversely, highly accurate but irrelevant data are of no value to a decision maker. Suppose Worldwide Airways will continue its daily round-trip flight between New York and London regardless of its decision about eliminating the London hub. Precise data about fuel consumption on the New York–London route are irrelevant to the decision about closing down the London hub. Timeliness Relevant and accurate data are of value only if they are timely, that is, available in time for a decision. Thus, timeliness is the third important criterion for deter- mining the usefulness of information. Some situations involve a trade-off between the accuracy and the timeliness of information. More accurate information may take lon- ger to produce. Therefore, as accuracy improves, timeliness suffers, and vice versa. For example, a company may test-market a potential new product in a particular city. The longer the test-marketing program runs, the more accurate will be the marketing data generated. However, a long wait for the accurate marketing report may unduly delay management’s decision to launch the new product nationally. To summarize, the managerial accountant’s primary role in the decision-making process is twofold: 1. Decide what information is relevant to each decision problem. 2. Provide accurate and timely data, keeping in mind the proper balance between these often-conflicting criteria. Relevant Information What makes information relevant to a decision problem? Two criteria are important. Bearing on the Future The consequences of decisions are borne in the future, not the past. To be relevant to a decision, cost or benefit information must involve a future event. The cost information relevant to Worldwide Airways’ decision concerning its London operations involves the costs that will be incurred in the future under the airline’s two alternatives. Costs incurred in the past in the airline’s London operations will not change regardless of management’s decision, and they are irrelevant to the decision at hand. Since relevant information involves future events, the managerial accountant must predict the amounts of the relevant costs and benefits. In making these predictions, the accountant often will use estimates of cost behavior based on historical data. There is an important and subtle issue here. Relevant information must involve costs and benefits to be realized in the future. However, the accountant’s predictions of those costs and ben- efits often are based on data from the past. Different under Competing Alternatives Relevant information must involve costs or benefits that differ among the alternatives. Costs or benefits that are the same across all the available alternatives have no bearing on the decision. For example, suppose Worldwide Airways’ management decides to keep its reservations and ticketing office in London regardless of whether its London hub is eliminated. Then the costs of the reserva- tions and ticketing office will not differ between the two alternatives regarding elimina- tion of the London hub. Hence, those costs are irrelevant to that decision. Unique versus Repetitive Decisions Unique decisions arise infrequently or only once. Worldwide Airways’ decision regarding its London hub is an example. Compiling data for unique decisions usually Relevant Information Learning Objective 14-3 List and explain two criteria that must be satisfied by relevant information. “You have to try to sum- marize numbers. You can’t just give numbers. People in marketing are going to make decisions based on your numbers. They have to understand what those numbers mean.” (14b) Abbott Laboratories hiL25664_ch14_586-637.indd 591hiL25664_ch14_586-637.indd 591 7/16/13 10:26 PM7/16/13 10:26 PM Final PDF to printer 592 Chapter 14 Decision Making: Relevant Costs and Benefits requires a special analysis by the managerial accountant. The relevant information often will be found in many diverse places in the organization’s overall information system. In contrast, repetitive decisions are made over and over again, at either regular or irregular intervals. For example, Worldwide Airways makes route-scheduling deci- sions every six months. Such a routine decision makes it worthwhile for the manage- rial accountant to keep a special file of the information relevant to the scheduling decision. Cost predictions relevant to repetitive decisions typically can draw on a large amount of historical data. Since the decisions have been made repeatedly in the past, the data from those decisions should be readily available. Information relevant to unique deci- sions is harder to generate. The managerial accountant typically will have to give more thought to deciding which data are relevant, and will have less historical data available upon which to base predictions. Importance of Identifying Relevant Costs and Benefits Why is it important for the managerial accountant to isolate the relevant costs and ben- efits in a decision analysis? The reasons are twofold. First, generating information is a costly process. The relevant data must be sought, and this requires time and effort. By focusing on only the relevant information, the managerial accountant can simplify and shorten the data-gathering process. Second, people can effectively use only a limited amount of information. Beyond this, they experience information overload, and their decision-making effectiveness declines. By routinely providing only information about relevant costs and benefits, the managerial accountant can reduce the likelihood of information overload. Identifying Relevant Costs and Benefits To illustrate how managerial accountants determine relevant costs and benefits, we will consider several decisions faced by the management of Worldwide Airways. Based in Atlanta, the airline flies routes between the United States and Europe, between various cities in Europe, and between the United States and several Asian cities. Sunk Costs Sunk costs are costs that have already been incurred. They do not affect any future cost and cannot be changed by any current or future action. Sunk costs are irrelevant to deci- sions, as the following two examples show. Book Value of Equipment At Charles de Gaulle Airport in Paris, Worldwide Air- ways has a three-year-old loader truck used to load in-flight meals onto airplanes. The box on the truck can be lifted hydraulically to the level of a jumbo jet’s side doors. The book value of this loader, defined as the asset’s acquisition cost less the accumulated depreciation to date, is computed as follows: Acquisition cost of old loader ......................................................................................................................... $100,000 Less: Accumulated depreciation ..................................................................................................................... 75,000 Book value .................................................................................................................................................... $ 25,000 The loader has one year of useful life remaining, after which its salvage value will be zero. However, it could be sold now for $5,000. In addition to the annual Identifying Relevant Costs and Benefits Learning Objective 14-4 Identify relevant costs and ben- efits, giving proper treatment to sunk costs, opportunity costs, and unit costs. hiL25664_ch14_586-637.indd 592hiL25664_ch14_586-637.indd 592 7/16/13 10:26 PM7/16/13 10:26 PM Final PDF to printer Chapter 14 Decision Making: Relevant Costs and Benefits 593 depreciation of $25,000, Worldwide Airways annually incurs $80,000 in variable costs to operate the loader. These include the costs of operator labor, gasoline, and maintenance. John Orville, Worldwide Airways’ ramp manager at Charles de Gaulle Airport, faces a decision about replacement of the loader. A new kind of loader uses a conveyor belt to move meals into an airplane. The new loader is much cheaper than the old hydraulic loader and costs less to operate. However, the new loader would be operable for only one year before it would need to be replaced. Pertinent data about the new loader are as follows: Acquisition cost of new loader ......................................................................................................................... $15,000 Useful life ....................................................................................................................................................... 1 year Salvage value after one year ............................................................................................................................ 0 Annual depreciation ........................................................................................................................................ $15,000 Annual operating costs .................................................................................................................................... $45,000 Orville’s initial inclination is to continue using the old loader for another year. He exclaims, “We can’t dump that equipment now. We paid $100,000 for it, and we’ve only used it three years. If we get rid of that loader now, we’ll lose $20,000 on the disposal.” Orville reasons that the old loader’s book value of $25,000, less its current salvage value of $5,000, amounts to a loss of $20,000. Fortunately, Orville’s comment is overheard by Joan Wilbur, the managerial accoun- tant in the company’s Charles de Gaulle Airport administrative offices. Wilbur points out to Orville that the book value of the old loader is a sunk cost. It cannot affect any future cost the company might incur. To convince Orville that she is right, Wilbur prepares the analysis shown in Exhibit 14–2 . Regardless of which alternative is selected, the $25,000 book value of the old loader will be an expense or loss in the next year. If the old loader is kept in service, the $25,000 will be recognized as depreciation expense; otherwise, the $25,000 cost will be incurred by the company as a write-off of the asset’s book value. Thus, the current book value of the old loader is a sunk cost and irrelevant to the replacement decision. Notice that the relevant data in the equipment replacement decision are items (3), (4), and (5). Each of these items meets the two tests of relevant information: 1. The costs or benefits relate to the future. 2. The costs or benefits differ between the alternatives. The proceeds from selling the old loader, item (3), will be received in the future only under the “replace” alternative. Similarly, the acquisition cost (depreciation) of the new “[We are continually moving] from being the scorekeeper to being an active, involved participant in crafting business solutions.” (14c) Boeing Costs of Two Alternatives (a) Do Not Replace Old Loader* (b) Replace Old Loader* (c) Differential Cost: (a) 2 (b) Sunk cost (1) Depreciation of old loader ........................... $ 25,000 OR –0– (2) Write-off of old loader’s book value .............. $25,000 Relevant data (3) Proceeds from disposal of old loader ........... –0– (5,000)† $ 5,000 (4) Depreciation (cost) of new loader ................ –0– 15,000 (15,000) (5) Operating costs .......................................... 80,000 45,000 35,000 Total cost ................................................... $105,000 $80,000 $25,000 *Since costs are the focus of the analysis in this exhibit, costs are shown in columns (a) and (b) without parentheses. †Parentheses denote a cash inflow in this case. ⎫⎪ ⎬ ⎪⎭⎫ ⎪ ⎬ ⎪⎭ ⎫⎪ ⎬ ⎪ ⎭ Exhibit 14–2 Equipment Replacement Decision: Worldwide Airways hiL25664_ch14_586-637.indd 593hiL25664_ch14_586-637.indd 593 7/16/13 10:26 PM7/16/13 10:26 PM Final PDF to printer 594 Chapter 14 Decision Making: Relevant Costs and Benefits loader, item (4), is a future cost incurred only under the “replace” alternative. The operat- ing cost, item (5), is also a future cost that differs between the two alternatives. Differential Costs Exhibit 14–2 includes a column entitled Differential Cost. A differential cost is the difference in a cost item under two decision alternatives. The com- putation of differential costs is a convenient way of summarizing the relative advantage of one alternative over the other. John Orville can make a correct equipment-replacement decision in either of two ways: (1) by comparing the total cost of the two alternatives, shown in columns (a) and (b); or (2) by focusing on the total differential cost, shown in column (c), which favors the “replacement” option. Cost of Inventory on Hand Never having taken a managerial accounting course in college, John Orville is slow to learn how to identify sunk costs. The next week he goofs again. The inventory of spare aircraft parts held by Worldwide Airways at Charles de Gaulle includes some obsolete parts originally costing $20,000. The company no longer uses the planes for which the parts were purchased. The obsolete parts include spare passenger seats, luggage racks, and galley equipment. The spare parts could be sold to another air- line for $17,000. However, with some modifications, the obsolete parts could still be used in the company’s current fleet of aircraft. Using the modified parts would save World- wide Airways the cost of purchasing new parts for its airplanes. John Orville decides not to dispose of the obsolete parts, because doing so would entail a loss of $3,000. Orville reasons that the $20,000 book value of the parts, less the $17,000 proceeds from disposal, would result in a $3,000 loss on disposal. Joan Wilbur, the managerial accountant, comes to the rescue again, demonstrating that the right deci- sion is to dispose of the parts. Wilbur’s analysis is shown in Exhibit 14–3 . Notice that the book value of the obsolete inventory is a sunk cost. If the parts are modified, the $20,000 book value will be an expense during the period when the parts are used. Otherwise, the $20,000 book value of the asset will be written off when the parts are sold. As a sunk cost, the book value of the obsolete inventory will not affect any future cash flow of the company. As the managerial accountant’s analysis reveals, the relevant data include the $17,000 proceeds from disposal, the $12,000 cost to modify the parts, and the $26,000 cost to buy new parts. All of these data meet the two tests of relevance: they affect future cash flows and they differ between the two alternatives. As Joan Wilbur’s analysis shows, World- wide Airways’ cost will be $3,000 less if the obsolete parts are sold and new parts are purchased. Costs of Two Alternatives (a) Modify and Use Parts* (b) Dispose of Parts* (c) Differential Cost: (a) 2 (b) Sunk cost Book value of parts inventory: asset value written off whether parts are used or not ........................ $20,000 $20,000 $ –0– Relevant data Proceeds from disposal of parts ............ –0– (17,000)† 17,000 Cost to modify parts ............................. 12,000 –0– 12,000 Cost incurred to buy new parts for current aircraft fleet .................... –0– 26,000 (26,000) Total cost ............................................. $32,000 $29,000 $ 3,000 *Since costs are the focus of the analysis in this exhibit, costs are shown in columns (a) and (b) without parentheses. †Parentheses denote a cash inflow in this case. ⎫⎪ ⎬ ⎪⎭ ⎫ ⎪ ⎬ ⎪ ⎭ Exhibit 14–3 Obsolete Inventory Decision: Worldwide Airways hiL25664_ch14_586-637.indd 594hiL25664_ch14_586-637.indd 594 7/16/13 10:26 PM7/16/13 10:26 PM Final PDF to printer Chapter 14 Decision Making: Relevant Costs and Benefits 595 Irrelevant Future Costs and Benefits At Worldwide Airways’ headquarters in Atlanta, Amy Earhart, manager of flight schedul- ing, is in the midst of making a decision about the Atlanta to Honolulu route. The flight is currently nonstop, but she is considering a stop in San Francisco. She feels that the route would attract additional passengers if the stop is made, but there also would be additional variable costs. Her analysis appears in Exhibit 14–4 . The analysis indicates that the preferable alternative is the route that includes a stop in San Francisco. Notice that the cargo revenue [item (2)] and the aircraft maintenance cost [item (8)] are irrelevant to the flight-route decision. Although these data do affect future cash flows, they do not differ between the two alternatives. All of the other data in Exhibit 14–4 are relevant to the decision, because they do differ between the two alterna- tives. The analysis in Exhibit 14–4 could have ignored the irrelevant data; the same deci- sion would have been reached. (Exercise 14–30, at the end of the chapter, will ask you to prove this assertion by redoing the analysis without the irrelevant data.) Opportunity Costs Another decision confronting Amy Earhart is whether to add two daily round-trip flights between Atlanta and Montreal. Her initial analysis of the relevant costs and benefits indi- cates that the additional revenue from the flights will exceed their costs by $30,000 per month. Hence, she is ready to add the flights to the schedule. However, Chuck Lindbergh, Worldwide Airways’ hangar manager in Atlanta, points out that Earhart has overlooked an important consideration. Worldwide Airways currently has excess space in its hangar. A commuter airline has offered to rent the hangar space for $40,000 per month. However, if the Atlanta-to- Montreal flights are added to the schedule, the additional aircraft needed in Atlanta will require the excess hangar space. If Worldwide Airways adds the Atlanta-to-Montreal flights, it will forgo the oppor- tunity to rent the excess hangar space for $40,000 per month. Thus, the $40,000 in rent forgone is an opportunity cost of the alternative to add the new flights. An opportunity cost is the potential benefit given up when the choice of one action precludes a different action. Although people tend to overlook or underestimate the importance of opportunity costs, they are just as relevant as out-of-pocket costs in evaluating decision alternatives. In Worldwide Airways’ case, the best action is to rent the excess warehouse space to the commuter airline, rather than adding the new flights. The analysis in Exhibit 14–5 supports this conclusion. Revenues and Costs under Two Alternatives Relevant or Irrelevant (a) Nonstop Route* (b) With Stop in San Francisco* (c) Differential Amount†: (a) – (b) Relevant (1) Passenger revenue ...................... $240,000 $258,000 $(18,000) Irrelevant (2) Cargo revenue ............................ 80,000 80,000 –0– Relevant (3) Landing fee in San Francisco ....... –0– (5,000) 5,000 Relevant (4) Use of airport gate facilities .......... –0– (3,000) 3,000 Relevant (5) Flight crew cost .......................... (2,000) (2,500) 500 Relevant (6) Fuel ............................................ (21,000) (24,000) 3,000 Relevant (7) Meals and services ..................... (4,000) (4,600) 600 Irrelevant (8) Aircraft maintenance ................... (1,000) (1,000) –0– Total revenue less costs ............... $292,000 $297,900 $ (5,900) *In columns (a) and (b), parentheses denote costs and numbers without parentheses are revenues. †In column (c), parentheses denote differential items favoring option (b). Exhibit 14–4 Flight-Route Decision: Worldwide Airways hiL25664_ch14_586-637.indd 595hiL25664_ch14_586-637.indd 595 7/16/13 10:26 PM7/16/13 10:26 PM Final PDF to printer 596 Chapter 14 Decision Making: Relevant Costs and Benefits It is a common mistake for people to overlook or underweigh opportunity costs. The $40,000 hangar rental, which will be forgone if the new flights are added, is an opportu- nity cost of the option to add the flights. It is a relevant cost of the decision, and it is just as important as any out-of-pocket expenditure. Summary Relevant costs and benefits satisfy the following two criteria: 1. They affect the future. 2. They differ between alternatives. Sunk costs are not relevant costs, because they do not affect the future. An example of a sunk cost is the book value of an asset, either equipment or inventory. Future costs or benefits that are identical across all decision alternatives are not relevant. They can be ignored when making a decision. Opportunity costs are relevant costs. Such costs deserve particular attention because many people tend to overlook them when making decisions. Analysis of Special Decisions What are the relevant costs and benefits when a manager must decide whether to add or drop a product or service? What data are relevant when deciding whether to produce or buy a service or component? These decisions and certain other nonroutine decisions merit special attention in our discussion of relevant costs and benefits. Accept or Reject a Special Offer Jim Wright, Worldwide Airways’ vice president for operations, has been approached by a Japanese tourist agency about flying chartered tourist flights from Japan to Hawaii. The tourist agency has offered Worldwide Airways $150,000 per round-trip flight on a jumbo jet. Given the airline’s usual occupancy rate and air fares, a round-trip jumbo-jet flight between Japan and Hawaii typically brings in revenue of $250,000. Thus, the tourist agency’s specially priced offer requires a special analysis by Jim Wright. Wright knows that Worldwide Airways has two jumbo jets that are not currently in use. The airline has just eliminated several unprofitable routes, freeing these aircraft for other uses. The airline was not currently planning to add any new routes, and therefore the two jets were idle. To help make his decision, Wright asks for cost data from the con- troller’s office. The controller provides the information in Exhibit 14–6 , which pertains to a typical round-trip jumbo-jet flight between Japan and Hawaii. The variable costs cover aircraft fuel and maintenance, flight-crew costs, in-flight meals and services, and landing fees. The fixed costs allocated to each flight cover World- wide Airways’ fixed costs, such as aircraft depreciation, maintenance and depreciation of facilities, and fixed administrative costs. “I would say that they [line managers] view us as business partners.” (14d) Boeing Analysis of Special Decisions Learning Objective 14-5 Prepare analyses of various special decisions, properly identifying the relevant costs and benefits. Exhibit 14–5 Decision to Add Flights: Worldwide Airways (a) Add Flights (b) Do Not Add Flights (c) Differential Amount: (a) 2 (b) Additional revenue from new flights less additional costs .......................................................... $30,000 –0– $ 30,000 Rental of excess hangar space ............................................... –0– $40,000 (40,000)* Total ..................................................................................... $30,000 $40,000 $(10,000) *Parentheses denote that differential benefit favors option (b). hiL25664_ch14_586-637.indd 596hiL25664_ch14_586-637.indd 596 7/16/13 10:26 PM7/16/13 10:26 PM Final PDF to printer Chapter 14 Decision Making: Relevant Costs and Benefits 597 If Jim Wright had not understood managerial accounting, he might have done the following incorrect analysis. Special price for charter ............................................................................................................................... $150,000 Total cost per flight ....................................................................................................................................... 190,000 Loss on charter flight ................................................................................................................................... $ (40,000) This calculation suggests that the special charter offer should be rejected. What is the error in this analysis? The mistake is the inclusion of allocated fixed costs in the cost per flight. This is an error, because the fixed costs will not increase in total if the charter flight is added. Since the fixed costs will not change under either of the alternate choices, they are irrelevant. Fortunately, Jim Wright does not make this mistake. He knows that only the variable costs of the proposed charter are relevant. Moreover, Wright determines that the variable cost of the charter would be less than that of a typical flight, because Worldwide Airways would not incur the variable costs of reservations and ticketing. These variable expenses amount to $5,000 for a scheduled flight. Thus, Wright’s analysis of the charter offer is as shown below. Assumes excess capacity (idle aircraft) Special price for charter ............................................................................ $150,000 Variable cost per routine flight .................................................................... $90,000 Less: Savings on reservations and ticketing ................................................. 5,000 Variable cost of charter .............................................................................. 85,000 Contribution from charter ........................................................................... $ 65,000 Wright’s analysis shows that the special charter flight will contribute $65,000 toward covering the airline’s fixed costs and profit. Since the airline has excess flight capacity, due to the existence of idle aircraft, the optimal decision is to accept the special charter offer. No Excess Capacity Now let’s consider how Wright’s analysis would appear if Worldwide Airways had no idle aircraft. Suppose that in order to fly the charter between Japan and Hawaii, the airline would have to cancel its least profitable route, which is between Japan and Hong Kong. This route contributes $80,000 toward covering the air- line’s fixed costs and profit. Thus, if the charter offer is accepted, the airline will incur an opportunity cost of $80,000 from the forgone contribution of the Japan–Hong Kong route. Now Wright’s analysis should appear as shown below. Assumes no excess capacity (no idle aircraft) Special price for charter ............................................................................ $150,000 Variable cost per routine flight .................................................................... $90,000 Less: Savings on reservations and ticketing ................................................ 5,000 Variable cost of charter .............................................................................. $85,000 Add: Opportunity cost, forgone contribution on canceled Japan–Hong Kong route ..................................................... 80,000 165,000 Loss from charter ...................................................................................... $ (15,000) “I’ve seen it (managerial accounting) evolve to become more of a team player and being involved in major projects and being looked to as a business advisor or consultant to help leverage our expertise on profitability of certain products or sourcing deci- sions.” (14e) Caterpillar Exhibit 14–6 Data for Typical Flight Between Japan and Hawaii: Worldwide Airways Revenue: Passenger ................................................................................................................... $250,000 Cargo .......................................................................................................................... 30,000 Total revenue ............................................................................................................... $280,000 Expenses: Variable expenses of flight ............................................................................................ $ 90,000 Fixed expenses allocated to each flight .......................................................................... 100,000 Total expenses ............................................................................................................. 190,000 Profit ............................................................................................................................... $ 90,000 hiL25664_ch14_586-637.indd 597hiL25664_ch14_586-637.indd 597 7/16/13 10:26 PM7/16/13 10:26 PM Final PDF to printer 598 Chapter 14 Decision Making: Relevant Costs and Benefits Thus, if Worldwide Airways has no excess flight capacity, Jim Wright should reject the special charter offer. Summary The decision to accept or reject a specially priced order is common in both service-industry and manufacturing firms. Manufacturers often are faced with decisions about selling products in a special order at less than full price. The cor- rect analysis of such decisions focuses on the relevant costs and benefits. Fixed costs, which often are allocated to individual units of product or service, are usually irrel- evant. Fixed costs typically will not change in total, whether the order is accepted or rejected. When excess capacity exists, the only relevant costs usually will be the variable costs associated with the special order. When there is no excess capacity, the opportunity cost of using the firm’s facilities for the special order is also relevant to the decision. Outsource a Product or Service Ellie Rickenbacker is Worldwide Airways’ manager of in-flight services. She super- vises the airline’s flight attendants and all of the firm’s food and beverage operations. Rickenbacker currently faces a decision regarding the preparation of in-flight dinners at the airline’s Atlanta hub. In the Atlanta flight kitchen, full-course dinners are prepared and packaged for long flights that pass through Atlanta. In the past, all of the desserts were baked and packaged in the flight kitchen. However, Rickenbacker has received an offer from an Atlanta bakery to bake the airline’s desserts. Thus, her decision is whether to outsource the dessert portion of the in-flight dinners. An outsourcing decision, also called a make-or-buy decision, entails a choice between producing a product or ser- vice in-house and purchasing it from an outside supplier. To help guide her decision, Rickenbacker has assembled the cost information in Exhibit 14–7 , which shows a total cost per dessert of 25 cents. The Atlanta bakery has offered to supply the desserts for 21 cents each. Ricken- backer’s initial inclination is to accept the bakery’s offer, since it appears that the airline would save 4 cents per dessert. However, the controller reminds Rickenbacker that not all of the costs listed in Exhibit 14–7 are relevant to the outsourcing decision. The controller modifies Rickenbacker’s analysis as shown in Exhibit 14–8 . If Worldwide Airways stops making desserts, it will save all of the variable costs but only 1 cent of fixed costs. The 1-cent saving in supervisory salaries would result because the airline could get along with two fewer kitchen supervisors. The remainder of the fixed costs would be incurred even if the desserts were purchased. These remain- ing fixed costs of supervision and depreciation would have to be reallocated to the flight kitchen’s other products. In light of the controller’s revised analysis, Rickenbacker real- izes that the airline should continue to make its own desserts. To outsource the desserts would require an expenditure of 21 cents per dessert, but only 15 cents per dessert would be saved. Cost per Dessert Variable costs: Direct material (food and packaging) ............................................................................................... $.06 Direct labor ................................................................................................................................... .04 Variable overhead .......................................................................................................................... .04 Fixed costs (allocated to products): Supervisory salaries ....................................................................................................................... .04 Depreciation of flight-kitchen equipment ......................................................................................... .07 Total cost per dessert ......................................................................................................................... $.25 Exhibit 14–7 Cost of In-Flight Desserts: Worldwide Airways hiL25664_ch14_586-637.indd 598hiL25664_ch14_586-637.indd 598 7/16/13 10:26 PM7/16/13 10:26 PM Final PDF to printer Chapter 14 Decision Making: Relevant Costs and Benefits 599 INSOURCING MAKES A COME-BACK After many years of outsourcing key business processes and offshoring of domestic jobs to overseas manufacturers, the trend may finally be reversing. K’Nex Brands is a small, family-owned manufacturer of snap-together building toys in the Philadelphia suburb of Hatfield, Pennsylvania. “Over the past few years, K’Nex has brought most of its produc- tion of its plastic building toys back to its factory in Hatfield from subcontractors in China.” To carry out this decision, the company has redesigned some of its toys. “In the long run, it’s much better for us to manufacture here,” said K’Nex Brands’ chairman. “By moving production closer to U.S. retailers, K’Nex said it can react faster to the fickle shifts in toy demand and deliver hot-selling items to stores faster. It also has greater control over qual- ity and materials, often a critical safety issue for toys. And as wages and transport costs rise in China, the advantages of producing there for the U.S. market are waning.” On the other end of the company-size continuum is General Electric. “After years of offshore production, the company is moving much of its appliance-manufacturing opera- tions back home.” GE’s Appliance Park in Louisville, Kentucky, is one of the company’s focal points for its new insourcing (or onshoring) strategy. GE is “spending some $800 million to bring the place back to life,” after years of decline as the company had been pursuing an outsourcing strategy for its appliance manufacturing. What has happened to cause K’Nex, GE, and many other companies to choose an insourcing strategy? Here are some of the factors in this all-important decision: “Oil prices are three times what they were in 2000, making cargo-ship fuel much more expen- sive now than it was then. The natural-gas boom in the U.S. has dramatically lowered the cost for running something as energy-intensive as a factory.” Moreover, “Wages in China are some five times what they were in 2000, and they are expected to keep rising.” In addition to these key cost drivers in the economy at large, every company faces many cost and operational issues that are more specific to its own operations. The key point, from a managerial accounting perspective, is that whether a company chooses to outsource or insource key business processes or production operations is an important decision that will rely heavily on managerial accounting information. General Electric and K’Nex Brands M A P anagement ccounting ractice 1 See J. R. Hagerty, “A Toy Maker Comes Home to U.S.A.,” The Wall Street Journal, March 11, 2013, p. B1, for the information and quotations presented here about K’nex Brands. The information and quotations about GE’s insourcing trend are from C. Fishman, “The Insourcing Boom,” The Atlantic, December 2012, p. 45. There is considerable confu- sion of terms in the popular business press, where the terms outsourcing and offshoring are often used synonymously, and similarly, insourcing and onshoring tend to be used interchangeably. The key distinction being made in both sets of terms, though, is whether business functions or production operations are performed in country or otherwise. Cost per Dessert Costs Saved by Purchasing Desserts Variable costs: Direct material .......................................................................................... $ .06 $ .06 Direct labor .............................................................................................. .04 .04 Variable overhead ..................................................................................... .04 .04 Fixed costs (allocated to products): Supervisory salaries .................................................................................. .04 .01 Depreciation of flight-kitchen equipment .................................................... .07 –0– Total cost per dessert .................................................................................... $ .25 $ .15 Cost of purchasing desserts (per dessert) ....................................................... $ .21 Loss per dessert if desserts are purchased (savings per dessert minus purchase cost per dessert, or $.15 2 $.21) ......................... $(.06) Exhibit 14–8 Cost Savings from Buying In-Flight Desserts: Worldwide Airways hiL25664_ch14_586-637.indd 599hiL25664_ch14_586-637.indd 599 7/16/13 10:26 PM7/16/13 10:26 PM Final PDF to printer 600 Chapter 14 Decision Making: Relevant Costs and Benefits To clarify her decision further, Rickenbacker asks the controller to prepare an analy- sis of the total costs per month of making or buying desserts. The controller’s report, displayed in Exhibit 14–9 , shows the total cost of producing 1,000,000 desserts, the flight kitchen’s average monthly volume. The total-cost analysis confirmed Rickenbacker’s decision to continue making des- serts in the airline’s flight kitchen. Beware of Unit-Cost Data Fixed costs often are allocated to individual units of prod- uct or service for product-costing purposes. For decision-making purposes, however, unit- ized fixed costs can be misleading. As the total-cost analysis in Exhibit 14–9 shows, only $10,000 in fixed monthly cost will be saved if the desserts are purchased. The remaining $100,000 in monthly fixed cost will continue whether the desserts are made or purchased. In today’s global economy, many companies outsource significant products and services. Gallo Winery, for exam- ple, buys a significant portion of its grapes from other vintners. Cummins Engine outsources many of its pistons, and Intel Corporation buys microchips. Chase Bank outsources its cafeteria and legal services. Many pharmaceuti- cal companies, such as Japan’s Yamanouchi Pharmaceutical, have outsourced much of their production to cut costs. 2 Pictured here are grape harvesting and pharmaceutical production. 2 Peter Landers, “Japan’s Local Drug Makers to Outsource to Suppliers,” The Wall Street Journal, March 26, 2002, p. A20. Exhibit 14–9 Total-Cost Analysis of Outsourcing Decision: Worldwide Airways Cost per Month Costs Saved by Purchasing Desserts Variable costs: Direct material ...................................................................................................... $ 60,000 $ 60,000 Direct labor .......................................................................................................... 40,000 40,000 Variable overhead ................................................................................................ 40,000 40,000 Fixed costs (allocated to products): Supervisory salaries .............................................................................................. 40,000 10,000* Depreciation of flight-kitchen equipment ................................................................ 70,000 –0– Total cost per month ................................................................................................. $250,000 $150,000 Cost of purchasing desserts (per month) ..................................................................... $210,000 Total loss if desserts are purchased (total savings minus total cost of purchasing, or $150,000 2 $210,000) ............................................... $ (60,000) *Cost of monthly compensation for two kitchen supervisors, who will not be needed if desserts are purchased. hiL25664_ch14_586-637.indd 600hiL25664_ch14_586-637.indd 600 7/16/13 10:26 PM7/16/13 10:26 PM Final PDF to printer Chapter 14 Decision Making: Relevant Costs and Benefits 601 Rickenbacker’s initial cost analysis in Exhibit 14–7 implies that each dessert costs the airline 25 cents, but that 25-cent cost includes 11 cents of unitized fixed costs. Most of these costs will remain unchanged regardless of the outsourcing decision. By allocating fixed costs to individual products or services, they are made to appear variable even though they are not. Add or Drop a Service, Product, or Department Worldwide Airways offers its passengers the opportunity to join its World Express Club. Club membership entitles a traveler to use the club facilities at the airport in Atlanta. Club privileges include a private lounge and restaurant, discounts on meals and beverages, and use of a small health spa. Jayne Wing, the president of Worldwide Airways, is worried that the World Express Club might not be profitable. Her concern is caused by the statement of monthly operat- ing income shown in the Excel spreadsheet in Exhibit 14–10 . In her weekly staff meeting, Wing states her concern about the World Express Club’s profitability. The controller responds by pointing out that not all of the costs on the club’s income statement would be eliminated if the club were discontinued. The vice president for sales adds that the club helps Worldwide Airways attract passengers who it might oth- erwise lose to a competitor. As the meeting adjourns, Wing asks the controller to prepare an analysis of the relevant costs and benefits associated with the World Express Club. The controller’s analysis is displayed in Exhibit 14–11 . The controller’s analysis in Exhibit 14–11 contains two parts. Part I focuses on the relevant costs and benefits of the World Express Club only, while ignoring any impact of the club on other airline operations. In column (a), the controller has listed the club’s revenues and expenses from the income statement presented in Exhibit 14–10 . Column (b) in Exhibit 14–11 lists the expenses that will continue if the club is eliminated. These expenses are called unavoidable expenses. In contrast, the expenses appearing in column (a) but not column (b) are avoidable expenses. The airline will no longer incur these expenses if the club is eliminated. Exhibit 14–10 World Express Club Monthly Operating Income Statement: Worldwide Airways hiL25664_ch14_586-637.indd 601hiL25664_ch14_586-637.indd 601 7/16/13 10:26 PM7/16/13 10:26 PM Final PDF to printer 602 Chapter 14 Decision Making: Relevant Costs and Benefits Notice that all of the club’s variable expenses are avoidable. The depreciation expense, $30,000, is an allocated portion of the depreciation on a Worldwide Airways building, part of which is used by the World Express Club. If the Club is discontinued, the airline will continue to own and use the building, and the depreciation expense will continue. Thus, it is an unavoidable expense. The fixed supervisory salaries are avoidable, since these employees will no longer be needed if the club is elimi- nated. The fixed insurance expense of $10,000 is not avoidable; the $5,000 fee paid to the airport for the privilege of operating the club is avoidable. Finally, the club’s allocated portion of general overhead expenses, $10,000, is not avoidable. World- wide Airways will incur these expenses regardless of its decision about the World Express Club. The conclusion shown by Part I of the controller’s report is that the club should not be eliminated. If the club is closed, the airline will lose more in contribution margin, $65,000, than it saves in avoidable fixed expenses, $25,000. Thus, the club’s $65,000 contribution margin is enough to cover the avoidable fixed expenses of $25,000 and still contribute $40,000 toward covering the overall airline’s fixed expenses. World Express Club’s contribution margin ............................................................................................................ $65,000 Avoidable fixed expenses .................................................................................................................................... 25,000 Contribution of club toward covering overall airline’s fixed expenses ...................................................................... $40,000 Now consider Part II of the controller’s analysis in Exhibit 14–11 . As the vice presi- dent for sales pointed out, the World Express Club is an attractive feature to many trav- elers. The controller estimates that if the club were discontinued, the airline would lose $60,000 each month in forgone contribution margin from general airline operations. Exhibit 14–11 Relevant Costs and Benefits of World Express Club: Worldwide Airways (a) Keep Club (b) Eliminate Club (c) Differential Amount: (a) 2 (b) Part I: Sales revenue .............................................................. $200,000 –0– $200,000 Less: Variable expenses: Food and beverages ................................................. (70,000) –0– (70,000) Personnel ................................................................ (40,000) –0– (40,000) Variable overhead .................................................... (25,000) –0– (25,000) Contribution margin ..................................................... $ 65,000 –0– $ 65,000 Less: Fixed expenses: Depreciation ............................................................ $ (30,000) $(30,000) $ –0– Supervisory salaries ................................................. (20,000) –0– (20,000) Insurance ................................................................ (10,000) (10,000) –0– Airport fees .............................................................. (5,000) –0– (5,000) General overhead (allocated) ..................................... (10,000) (10,000) –0– Total fixed expenses ................................................. $ (75,000) $(50,000) $ (25,000) Profit (loss) .................................................................. $ (10,000) $(50,000) $ 40,000* Expenses in the column above are unavoidable expenses Expenses in the column above are avoidable expenses Part II: Contribution margin from general airline operations that will be forgone if club is eliminated ..................... $ 60,000 –0– $ 60,000 *The positive $40,000 differential amount reflects the fact that the company is $40,000 better off by keeping the club. hiL25664_ch14_586-637.indd 602hiL25664_ch14_586-637.indd 602 7/16/13 10:26 PM7/16/13 10:26 PM Final PDF to printer Chapter 14 Decision Making: Relevant Costs and Benefits 603 This loss in contribution margin would result from losing to a competing airline cur- rent passengers who are attracted to Worldwide Airways by its World Express Club. This $60,000 in forgone contribution margin is an opportunity cost of the option to close down the club. Considering both Parts I and II of the controller’s analysis, Worldwide Airways’ monthly profit will be greater by $100,000 if the club is kept open. Recognition of two issues is key to this conclusion: 1. Only the avoidable expenses of the club will be saved if it is discontinued. 2. Closing the club will adversely affect the airline’s other operations. Special Decisions in Manufacturing Firms Some types of decisions are more likely to arise in manufacturing companies than in service-industry firms. We will examine two of these decisions. Joint Products: Sell or Process Further A joint production process results in two or more products, called joint products. An example is the processing of cocoa beans into cocoa powder and cocoa butter. Cocoa beans constitute the input to the joint production process, and the two joint products are cocoa powder and cocoa butter. The point in the production process where the joint Special Decisions in Manufacturing Firms Learning Objective 14-6 Analyze manufacturing decisions involving joint products and limited resources. ADDING A SERVICE Changing business conditions can cause a company to rethink its business model and add new services. A classic case of this phenomenon occurred when Federal Express found that a sizable portion of its overnight letter delivery business was eliminated by e-mail. Customers no longer needed to ship a hard-copy document overnight, when the same document could be sent instantaneously via e-mail. FedEx also found a decline in the need for overnight repair parts shipments. Many customers’ improved supply chain systems resulted in better spare parts preparedness and less need for last-minute overnight shipments. FedEx responded by adding slower ground shipment services to compete more directly with UPS and the U.S. Postal Service. While FedEx still excels when an overnight shipment is needed, its ground transport business has become an increasingly important part of its operations. And FedEx has recently added new express package services in China, where the company has invested in a new hub for its business to and from Asia. Caterpillar has added heavy equipment overhaul services to its already successful manufacturing operations. The company uses available capacity in its manufactur- ing plants to disassemble and rebuild heavy diesel engines, after cleaning, inspect- ing, and repairing them. This new service component of Caterpillar’s operations has become one of the company’s fastest-growing business units. 3 FedEx and Caterpillar M A P anagement ccounting ractice 3 B. Sechler, “FedEx, UPS Get a Toehold in China’s Express Delivery,” The Wall Street Journal, September 11, 2012, p. B1; J. Hagerty and B. Tita, “Caterpillar Builds Optimism,” The Wall Street Journal, January 27, 2012, p. B3. D. Foust, “The Ground War at FedEx,” BusinessWeek, November 28, 2005, pp. 42, 43; “Overnight, Everything Changed for FedEx; Can It Reinvent Itself?” The Wall Street Journal, November 4, 1999, p. A1; and M. Arndt, “Cat Sinks Its Claws into Services,” BusinessWeek, December 5, 2005, pp. 56–59. hiL25664_ch14_586-637.indd 603hiL25664_ch14_586-637.indd 603 7/16/13 10:26 PM7/16/13 10:26 PM Final PDF to printer 604 Chapter 14 Decision Making: Relevant Costs and Benefits products are identifiable as separate products is called the split-off point. Other exam- ples of joint production processes include the slaughtering of animals for various cuts of meat and the processing of petroleum into various products, such as kerosene and gasoline. Manufacturers with joint production processes sometimes must decide whether a joint product should be sold at the split-off point or processed further before being sold. Such a decision recently confronted Bill Candee, the president of International Chocolate Company. Candee’s firm imports cocoa beans and processes them into cocoa powder and cocoa butter. Only a portion of the cocoa powder is used by Interna- tional Chocolate Company in the production of chocolate candy. The remainder of the cocoa powder is sold to an ice cream producer. Candee is considering the possibility of processing his remaining cocoa powder into an instant cocoa mix to be marketed under the brand name ChocoTime. Data pertaining to Candee’s decision are displayed in Exhibit 14–12 . Notice from the diagram that cocoa beans are processed in 1-ton batches. The total cost of the cocoa beans and the joint processing is $1,100. This is called the joint cost. The output of the joint process is 1,500 pounds of cocoa butter and 500 pounds of cocoa powder. How should Bill Candee approach the decision about processing the cocoa powder into instant cocoa mix? What are the relevant costs and benefits? First, let’s consider the joint cost of $1,100. Is this a relevant cost in the decision at hand? The joint cost is not a relevant cost, because it will not change regardless of the decision Candee makes. Suppose the $1,100 joint cost had been allocated to the two joint products for product- costing purposes. A common method of allocating a joint cost is the relative-sales-value method, in which the joint cost is allocated between the joint products in proportion to their sales value at the split-off point. 4 International Chocolate Company would make the following joint cost allocation. Joint Cost Joint Products Sales Value at Split-Off Point Relative Proportion Allocation of Joint Cost $1,100 Cocoa butter .................................... $750 .60 $ 660 Cocoa powder ................................. 500 .40 440 Total joint cost allocated ............................................................................................ $1,100 ⎫ ⎬ ⎭ 4 Other methods of allocating joint costs are covered in Chapter 17. Cocoa beans costing $500 per 1-ton batch Total joint cost: $1,100 per 1-ton batch Split-off point Joint production process costing $600 per ton Cocoa butter sales value: $750 for 1,500 pounds Cocoa powder sales value: $500 for 500 pounds Separable process costing $800 Instant cocoa mix sales value: $2,000 for 500 pounds Cocoa Beans Exhibit 14–12 Joint Processing of Cocoa Beans: International Chocolate Company hiL25664_ch14_586-637.indd 604hiL25664_ch14_586-637.indd 604 7/16/13 10:26 PM7/16/13 10:26 PM Final PDF to printer Chapter 14 Decision Making: Relevant Costs and Benefits 605 Does this allocation of the $1,100 joint cost make it relevant to the decision about processing cocoa powder into instant cocoa mix? The answer is no. The $1,100 joint cost still does not change in total, whether the cocoa powder is processed further or not. The joint cost is irrelevant to the decision at hand. The only costs and benefits relevant to Candee’s decision are those that differ between the two alternatives. The proper analysis is shown in Exhibit 14–13 . There is a shortcut method that arrives at the same conclusion as Exhibit 14–13 . In this approach, the incremental revenue from the further processing of cocoa powder is compared with the separable processing cost, which is the cost incurred after the split- off point, as follows: Sales value of instant cocoa mix ........................................................................................................................... $2,000 Sales value of cocoa powder ................................................................................................................................. 500 Incremental revenue from further processing ......................................................................................................... $1,500 Less: Separable processing cost ........................................................................................................................... (800) Net benefit from further processing ....................................................................................................................... $ 700 Both analyses indicate that Bill Candee should process his excess cocoa powder into instant cocoa mix. The same conclusion is reached if the analysis is done on a per-unit basis rather than a total basis: Sales value of instant cocoa mix ($2,000 4 500 pounds) ........................................................................ $4.00 per pound Sales value of cocoa powder ($500 4 500 pounds) ................................................................................ 1.00 per pound Incremental revenue from further processing ........................................................................................... $3.00 per pound Less: Separable processing cost ($800 4 500 pounds) ........................................................................... (1.60) per pound Net benefit from further processing ......................................................................................................... $1.40 per pound Once again, the analysis shows that Bill Candee should decide to process the cocoa powder into instant cocoa mix. Decisions Involving Limited Resources Organizations typically have limited resources. Limitations on floor space, machine time, labor hours, or raw materials are common. Operating with limited resources, a firm often must choose between sales orders, deciding which orders to fill and which ones to decline. In making such decisions, managers must decide which product or service is the most profitable. Relevant or Irrelevant (a) Process Cocoa Powder into Instant Cocoa Mix (b) Sell Cocoa Powder at Split-Off Point (c) Differential Amount: (a) 2 (b) Sales revenue: Irrelevant Cocoa butter ................................. $ 750 $ 750 –0– Relevant Instant cocoa mix .......................... 2,000 $1,500 Relevant Cocoa powder .............................. 500 Less: Costs: Irrelevant Joint cost ..................................... (1,100) (1,100) –0– Relevant Separable cost of processing cocoa powder into instant cocoa mix ................................ (800) –0– (800) Total ................................................. $ 850 $ 150 $ 700 ⎫ ⎬ ⎭ Exhibit 14–13 Decision to Sell or Process Further: International Chocolate Company hiL25664_ch14_586-637.indd 605hiL25664_ch14_586-637.indd 605 7/16/13 10:26 PM7/16/13 10:26 PM Final PDF to printer 606 Chapter 14 Decision Making: Relevant Costs and Benefits To illustrate, suppose International Chocolate Company’s Phoenix plant makes two candy-bar products, Chewies and Chompo Bars. The contribution margin for a case of each of these products is computed in Exhibit 14–14 . A glance at the contribution-margin data suggests that Chompo Bars are more profit- able than Chewies. It is true that a case of Chompo Bars contributes more toward cover- ing the company’s fixed cost and profit. However, an important consideration has been ignored in the analysis so far. The Phoenix plant’s capacity is limited by its available machine time. Only 700 machine hours are available in the plant each month. Interna- tional Chocolate Company can sell as many cases of either candy bar as it can produce, so production is limited only by the constraint on machine time. To maximize the plant’s total contribution toward covering fixed cost and profit, management should strive to use each machine hour as effectively as possible. This real- ization alters the analysis of product profitability. The relevant question is not, Which candy bar has the highest contribution margin per case? The pertinent question is, Which product has the highest contribution margin per machine hour? This question is answered with the calculation in Exhibit 14–15 . A machine hour spent in the production of Chewies will contribute $50 toward cover- ing fixed cost and profit, while a machine hour devoted to Chompo Bars contributes only $40. Hence, the Phoenix plant’s most profitable product is Chewies, when the plant’s scarce resource is taken into account. Suppose International Chocolate Company’s Phoenix plant manager, Candace Barr, is faced with a choice between two sales orders, only one of which can be accepted. Only 100 hours of unscheduled machine time remains in the month, and it can be used to pro- duce either Chewies or Chompos. The analysis in Exhibit 14–16 shows that Barr should devote the 100-hour block of machine time to filling the order for Chewies. As Exhibit 14–16 demonstrates, a decision about the best use of a limited resource should be made on the basis of the contribution margin per unit of the scarce resource. Multiple Scarce Resources Suppose the Phoenix plant had a limited amount of both machine hours and labor hours. Now the analysis of product profitability is more complicated. The choice as to which product is most profitable typically will involve a trade-off between the two scarce resources. Solving such a problem requires a power- ful mathematical tool called linear programming, which is covered in the appendix to this chapter. Exhibit 14–14 Contribution Margin per Case: International Chocolate Company Chewies Chompo Bars Sales price ............................................................................................................ $10.00 $14.00 Less: Variable costs: Direct material ................................................................................................... $ 3.00 $ 3.75 Direct labor ....................................................................................................... 2.00 2.50 Variable overhead .............................................................................................. 3.00 3.75 Variable selling and administrative costs .............................................................. 1.00 2.00 Total variable costs ............................................................................................. $ 9.00 $12.00 Contribution margin per case .................................................................................. $ 1.00 $ 2.00 Exhibit 14–15 Contribution Margin per Machine Hour: International Chocolate Company Chewies Chompo Bars (a) Contribution margin per case ....................................................... $1.00 $2.00 (b) Machine hours required per case ................................................. .02 .05 (a) 4 (b) Contribution margin per machine hour ......................................... $50 $40 hiL25664_ch14_586-637.indd 606hiL25664_ch14_586-637.indd 606 7/16/13 10:26 PM7/16/13 10:26 PM Final PDF to printer Chapter 14 Decision Making: Relevant Costs and Benefits 607 Theory of Constraints As the previous analysis suggests, a binding constraint can limit a company’s profitability. For example, a manufacturing company may have a bot- tleneck operation, through which every unit of a product must pass before moving on to other operations. The theory of constraints (TOC) calls for identifying such limiting constraints and seeking ways to relax them. Also referred to as managing constraints, this management approach can significantly improve an organization’s level of goal attain- ment. Among the ways that management can relax a constraint by expanding the capacity of a bottleneck operation are the following: • Outsourcing (subcontracting) all or part of the bottleneck operation. • Investing in additional production equipment and employing parallel process- ing, in which multiple product units undergo the same production operation simultaneously. • Working overtime at the bottleneck operation. • Retraining employees and shifting them to the bottleneck. • Eliminating any non-value-added activities at the bottleneck operation. Uncertainty Our analyses of the decisions in this chapter assumed that all relevant data were known with certainty. In practice, of course, decision makers are rarely so fortunate. One com- mon technique for addressing the impact of uncertainty is sensitivity analysis. Sensitivity analysis is a technique for determining what would happen in a decision analysis if a key prediction or assumption proved to be wrong. To illustrate, let’s return to Candace Barr’s decision about how to use the remaining 100 hours of machine time in International Chocolate Company’s Phoenix plant. The calculation in Exhibit 14–15 showed that Chewies have the higher contribution margin per machine hour. Suppose Barr is uncertain about the contribution margin per case of Chewies. A sensitivity analysis shows how sensitive her decision is to the value of this uncertain parameter. As Exhibit 14–17 shows, the Chewies contribution margin could decline to $.80 per case before Barr’s decision would change. As long as the contribution Chewies Chompo Bars Contribution margin per case .................................................................................. $1.00 $2.00 Number of cases produced in 100 hours of machine time ........................................ 3 5,000* 3 2,000† Total contribution toward covering fixed cost and profit ............................................. $5,000 $4,000 *Chewies: 100 hours 4 .02 hour per case 5 5,000 cases †Chompo Bars: 100 hours 4 .05 hour per case 5 2,000 cases Exhibit 14–16 Total Contribution from 100 Machine Hours: International Chocolate Company Chewies Chompo Bars Original Analysis (a) Contribution margin per case predicted ............................................ $1.00 $2.00 (b) Machine hours required per case ..................................................... .02 .05 (a) 4 (b) Contribution per machine hour ......................................................... $50.00 $40.00 Sensitivity Analysis (c) Contribution margin per case hypothesized in sensitivity analysis ................................................................... $.80 (d) Machine hours required per case ..................................................... .02 same (c) 4 (d) Contribution per machine hour ......................................................... $40.00 Exhibit 14–17 Sensitivity Analysis: International Chocolate Company hiL25664_ch14_586-637.indd 607hiL25664_ch14_586-637.indd 607 7/16/13 10:26 PM7/16/13 10:26 PM Final PDF to printer 608 Chapter 14 Decision Making: Relevant Costs and Benefits margin per case of Chewies exceeds $.80 per case, the 100 hours of available machine time should be devoted to Chewies. Sensitivity analysis can help the managerial accountant decide which parameters in an analysis are most critical to estimate accurately. In this case, the managerial accountant knows that the contribution margin per case of Chewies could be as much as 20 percent lower than the original $1.00 prediction without changing the outcome of the analysis. Expected Values Another approach to dealing explicitly with uncertainty is to base the decision on expected values. The expected value of a random variable is equal to the sum of the possible values for the variable, each weighted by its probability. To illus- trate, suppose the contribution margins per case for Chewies and Chompos are uncer- tain, as shown in Exhibit 14–18 . As the exhibit shows, the choice as to which product to produce with excess machine time may be based on the expected value of the contri- bution per machine hour. Statisticians have developed many other methods for dealing with uncertainty in decision making. These techniques are covered in statistics and deci- sion analysis courses. Activity-Based Costing and Today’s Advanced Manufacturing Environment In this chapter we have explored how to identify the relevant costs and benefits in various types of decisions. How will the relevant-costing approach change in an advanced manu- facturing environment, characterized by just-in-time (JIT) production methods and flex- ible manufacturing systems (FMS)? How would a relevant-costing analysis change if a company uses an activity-based costing (ABC) system? 5 The concepts underlying a relevant-costing analysis continue to be completely valid in an advanced manufacturing setting and in a situation where activity-based costing is used. The objective of the decision analysis is to determine the costs and benefits that are relevant to the decision. As we found earlier in this chapter, relevant costs and benefits have a bearing on the future and differ among the decision alternatives. What will be different in a setting where activity-based costing is used is the decision maker’s ability to determine what costs are relevant to a decision. Under ABC, the deci- sion maker typically can associate costs with the activities that drive them much more accurately than under a conventional product-costing system. Let’s explore these issues with an illustration. Activity-Based Costing and Today’s Advanced Manufacturing Environment Learning Objective 14-7 Explain the impact of an advanced manufacturing environment and activity-based costing on a relevant-cost analysis. Chewies Chompo Bars Possible Values of Contribution Margin Probability Possible Values of Contribution Margin Probability $ .75 .................................................. .5 $1.50 ......................................... .3 1.25 .................................................. .5 2.00 ......................................... .4 2.50 ......................................... .3 Expected value (.5)($.75) 1 (.5)($1.25) 5 $1.00 (.3)($1.50) 1 (.4)($2.00) 1 (.3)($2.50) 5 $2.00 Machine hours required per case .02 .05 Expected value of contribution per machine hour $50 > $40
Exhibit 14–18
Use of Expected Values:
International Chocolate
Company
5 This section can be studied most effectively after completing Chapter 5 , in which activity-based costing (ABC) is covered.
Also, just-in-time (JIT) production and inventory systems are explored in Appendix III at the end of the text (pp 777–779).
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Chapter 14 Decision Making: Relevant Costs and Benefits 609
Conventional Outsourcing (Make-or-Buy) Analysis
International Chocolate Company makes fine chocolates in its Savannah plant. The choc-
olates are packaged in two-pound and five-pound gift boxes. The company also manu-
factures the gift boxes in the Savannah plant. The plant manager, Marsha Mello, was
approached recently by a packaging company with an offer to supply the gift boxes at
a price of $.45 each. Mello concluded that the offer should be rejected on the basis of
the relevant-costing analysis in Exhibit 14–19 . International Chocolate Company’s tradi-
tional, volume-based product-costing system showed a unit product cost of $.80 per box.
However, Mello realized that not all of the costs would be avoided. She reasoned that all
of the direct material, direct labor, and variable overhead would be avoided, but only a
small part of the assigned fixed overhead would be saved. She concluded that $60,000
of supervisory salaries and $20,000 of machinery depreciation could be traced directly
to gift package production. These costs would be avoided, she felt, but the remaining
A. Manufacturing Overhead Budget for Savannah Plant
Variable overhead:
Electricity …………………………………………………………………………………………………………………………. $ 700,000
Oil and lubricants ……………………………………………………………………………………………………………….. 120,000
Equipment maintenance ………………………………………………………………………………………………………. 180,000
Total variable overhead ………………………………………………………………………………………………………… $1,000,000
Variable overhead rate: $1,000,000 4 100,000 direct-labor hours 5 $10 per hour
Fixed overhead:
Plant depreciation ………………………………………………………………………………………………………………. $1,650,000
Product development ………………………………………………………………………………………………………….. 300,000
Supervisory salaries ……………………………………………………………………………………………………………. 600,000
Material handling ……………………………………………………………………………………………………………….. 800,000
Purchasing ……………………………………………………………………………………………………………………….. 250,000
Inspection ………………………………………………………………………………………………………………………… 300,000
Setup ………………………………………………………………………………………………………………………………. 400,000
Machinery depreciation ……………………………………………………………………………………………………….. 200,000
Total fixed overhead ……………………………………………………………………………………………………………. $4,500,000
Fixed overhead rate: $4,500,000 4 100,000 direct-labor hours 5 $45 per hour
B. Conventional Product-Costing Data: Gift Boxes
Direct material ………………………………………………………………………………………………………………………. $ 100,000
Direct labor (10,000 hr. at $15 per hr.) ……………………………………………………………………………………….. 150,000
Variable overhead ($10 per direct-labor hr.) …………………………………………………………………………………. 100,000
Fixed overhead ($45 per direct-labor hr.) …………………………………………………………………………………….. 450,000
Total cost ……………………………………………………………………………………………………………………………… $ 800,000
Unit cost: $800,000 4 1,000,000 boxes 5 $.80 per box
C. Conventional Outsourcing Analysis: Gift Boxes
Relevant costs (costs that will be avoided if the gift boxes are purchased):
Direct material ………………………………………………………………………………………………………………………. $ 100,000
Direct labor …………………………………………………………………………………………………………………………… 150,000
Variable overhead ………………………………………………………………………………………………………………….. 100,000
Fixed overhead:
Supervision ………………………………………………………………………………………………………………………. 60,000
Machinery depreciation ……………………………………………………………………………………………………….. 20,000
Total costs to be avoided by purchasing ………………………………………………………………………………………. $ 430,000
Total cost of purchasing (1,000,000 boxes 3 $.45 per box) ……………………………………………………………. $ 450,000
Exhibit 14–19
Conventional Product-Costing
Data and Outsourcing
Analysis: International
Chocolate Company
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610 Chapter 14 Decision Making: Relevant Costs and Benefits
fixed costs would not. Mello concluded that only $430,000 of costs would be avoided by
purchasing, while $450,000 would be spent to buy the boxes. The decision was clear; the
supplier’s offer should be rejected.
Activity-Based Costing Analysis of the Outsourcing
Decision
At a staff meeting, Mello mentioned her tentative decision to Dave Mint, the plant
controller. Mint then explained to Mello that he was completing a pilot project using
activity-based costing. Mint offered to analyze the outsourcing decision using the new
ABC database. Mello agreed, and Mint proceeded to do the ABC analysis shown in
Exhibit 14–20 .
In stage one of the ABC analysis, Mint designated 11 activity cost pools correspond-
ing to the major items in the Savannah plant’s overhead budget. These activity cost pools
were categorized as facility-level, product-sustaining level, batch-level, or unit-level
activities. In stage two of the ABC project, cost drivers were identified and pool rates
were computed. The ABC analysis showed that $243,000 of overhead should be assigned
to the gift boxes, rather than $550,000 as the conventional product-costing system had
indicated.
Using the ABC database, Mint completed a new relevant-costing analysis of
the outsourcing decision. Mint felt that all of the overhead costs assigned to the gift
box operation could be avoided if the boxes were purchased. Notice that none of the
A. Activity Cost Pools and Pool Rates
Activity Cost Pools Budgeted Cost Pool Rate and Cost Driver Cost Assigned to Gift Boxes
Facility level:
Plant depreciation ……………………………………………….. $1,650,000 —
Product-sustaining level:
Product development …………………………………………… 300,000 $600 per product spec $600 3 5* 5 $ 3,000
Supervisory salaries …………………………………………….. 600,000 $40 per supervisory hour $40 3 1,500 5 60,000
Batch level:
Material handling ………………………………………………… 800,000 $8 per material-handling hour $8 3 5,000 5 40,000
Purchasing ………………………………………………………… 250,000 $250 per purchase order $250 3 40 5 10,000
Inspection …………………………………………………………. 300,000 $300 per inspection $300 3 20 5 6,000
Setup ……………………………………………………………….. 400,000 $400 per setup $400 3 10 5 4,000
Unit level:
Electricity ………………………………………………………….. 700,000 $1.40 per machine hour $1.40 3 50,000 5 70,000
Oil and lubrication ……………………………………………….. 120,000 $.24 per machine hour $.24 3 50,000 5 12,000
Equipment maintenance ……………………………………….. 180,000 $.36 per machine hour $.36 3 50,000 5 18,000
Machinery depreciation ………………………………………… 200,000 $.40 per machine hour $.40 3 50,000 5 20,000
Total overhead for Savannah plant ………………………………. $5,500,000
Total overhead assigned to gift box production ………………………………………………………………………………………………………………………………….. $243,000
*The numbers in this column are the quantities of each cost driver required for gift box production.
B. ABC Outsourcing Analysis: Gift Boxes
Relevant costs (costs that will be avoided if the gift boxes are purchased):
Direct material …………………………………………………………………………………………………………………………………………………………………………… $100,000
Direct labor ……………………………………………………………………………………………………………………………………………………………………………….. 150,000
Overhead (from ABC analysis in panel A, above) ………………………………………………………………………………………………………………………………… 243,000
Total costs to be avoided by purchasing …………………………………………………………………………………………………………………………………………… $493,000
Total cost of purchasing (1,000,000 boxes 3 $.45 per box) ………………………………………………………………………………………………………………… $450,000
Exhibit 14–20
Activity-Based Costing
Analysis of Outsourcing
Decision: International
Chocolate Company
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Chapter 14 Decision Making: Relevant Costs and Benefits 611
facility-level costs are relevant to the analysis. They will not be avoided by purchasing
the gift boxes. Mint’s ABC analysis showed that a total of $493,000 of costs could be
avoided by purchasing the boxes at a cost of $450,000. This would result in a net saving
of $43,000.
Mint showed the ABC relevant-costing analysis to Mello. After some discussion,
they agreed that various qualitative issues needed to be explored before a final decision
was made. For example, would the new supplier be reliable, and would the gift boxes be
of good quality? Nevertheless, Mello and Mint agreed that the ABC data cast an entirely
different light on the decision.
The Key Point What has happened here? Why did the conventional and ABC analyses
of this decision reach different conclusions? Is the relevant-costing concept faulty?
The answer is no; the relevant-costing idea is alive and well. Both analyses sought to
identify the relevant costs as those that would be avoided by purchasing the gift boxes.
That approach is valid. The difference in the analyses lies in the superior ability of
the ABC data to properly identify what the avoidable costs are. This is the key point. The
conventional analysis relied on a traditional, volume-based product-costing system. That
system lumps all of the fixed overhead costs together and assigns them using a single,
unit-based cost driver (i.e., direct-labor hours). That analysis simply failed to note that
many of the so-called fixed costs are not really fixed with respect to the appropriate cost
driver. The more accurate ABC system correctly showed this fact, and identified addi-
tional costs that could be avoided by purchasing.
To summarize, under activity-based costing, the concepts underlying relevant- costing
analysis remain valid. However, the ABC system does enable the decision maker to apply
the relevant-costing decision model more accurately.
Other Issues in Decision Making
Incentives for Decision Makers
In this chapter, we studied how managers should make decisions by focusing on the rel-
evant costs and benefits. In previous chapters, we covered accounting procedures for
evaluating managerial performance. There is an important link between decision making
and managerial performance evaluation. Managers typically will make decisions that
maximize their perceived performance evaluations and rewards. This is human nature. If
we want managers to make optimal decisions by properly evaluating the relevant costs
and benefits, then the performance evaluation system and reward structure had better be
consistent with that perspective.
The proper treatment of sunk costs in decision making illustrates this issue.
Earlier in this chapter, we saw that sunk costs should be ignored as irrelevant. For
example, the book value of an outdated machine is irrelevant in making an equipment-
replacement decision. Suppose, however, that a manager correctly ignores an old
machine’s book value and decides on early replacement of the machine he purchased
a few years ago. Now suppose the hapless manager is criticized by his superior for
“taking a loss” on the old machine, or for “buying a piece of junk” in the first place.
What is our manager likely to do the next time he faces a similar decision? If he is like
many people, he will tend to keep the old machine in order to justify his prior decision
to purchase it. In so doing, he will be compounding his error. However, he also may
be avoiding criticism from a superior who does not understand the importance of goal
congruence.
The point is simply that if we want managers to make optimal decisions, we must
give them incentives to do so. This requires that managerial performance be judged on
the same factors that should be considered in making correct decisions.
Other Issues in Decision Making
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612 Chapter 14 Decision Making: Relevant Costs and Benefits
Short-Run versus Long-Run Decisions
The decisions we have examined in this chapter were treated as short-run decisions.
Short-run decisions affect only a short time period, typically a year or less. In reality,
many of these decisions would have longer-term implications. For example, managers
usually make a decision involving the addition or deletion of a product or service with a
relatively long time frame in mind. The process of identifying relevant costs and benefits
is largely the same whether the decision is viewed from a short-run or long-run perspec-
tive. One important factor that does change in a long-run analysis, however, is the time
value of money. When several time periods are involved in a decision, the analyst should
account for the fact that a $1.00 cash flow today is different from a $1.00 cash flow in five
years. A dollar received today can be invested to earn interest, while the dollar received in
five years cannot be invested over the intervening time period. The analysis of long-run
decisions requires a tool called capital budgeting, which is covered in Chapter 16.
Pitfalls to Avoid
Identification of the relevant costs and benefits is an important step in making any eco-
nomic decision. Nonetheless, analysts often overlook relevant costs or incorrectly include
irrelevant data. In this section, we review four common mistakes to avoid in decision
making.
1. Sunk costs. The book value of an asset, defined as its acquisition cost less the
accumulated depreciation, is a sunk cost. Sunk costs cannot be changed by any
current or future course of action, so they are irrelevant in decision making.
Nevertheless, a common behavioral tendency is to give undue importance to
book values in decisions that involve replacing an asset or disposing of obso-
lete inventory. People often seek to justify their past decisions by refusing to
dispose of an asset, even if a better alternative has been identified. The moral:
Ignore sunk costs.
2. Unitized fixed costs. For product-costing purposes, fixed costs often are
divided by some activity measure and assigned to individual units of product.
The result is to make a fixed cost appear variable. While there are legitimate
reasons for this practice from a product-costing perspective, it can create
havoc in decision making. Therefore, in a decision analysis, it is usually wise
to include a fixed cost in its total amount, rather than as a per-unit cost. The
moral: Beware of unitized fixed costs in decision making.
3. Allocated fixed costs. It is also common to allocate fixed costs across divisions,
departments, or product lines. A possible result is that a product or department
may appear unprofitable when in reality it does make a contribution toward
covering fixed costs and profit. Before deciding to eliminate a department, be
sure to ask which costs will be avoided if a particular alternative is selected.
A fixed cost that has been allocated to a department may continue, in total or
in part, even after the department has been eliminated. The moral: Beware of
allocated fixed costs; identify the avoidable costs.
4. Opportunity costs. People tend to overlook opportunity costs, or to treat such
costs as less important than out-of-pocket costs. Yet opportunity costs are just
as real and important to making a correct decision as are out-of-pocket costs.
The moral: Pay special attention to identifying and including opportunity costs
in a decision analysis.
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Chapter 14 Decision Making: Relevant Costs and Benefits 613
Focus on Ethics
EFFECTS OF DECISION TO CLOSE A DEPART-
MENT AND OUTSOURCE
Outsourcing has become a common way of reducing
costs in many organizations. Such decisions, though,
often have repercussions that may not be captured “by
the numbers.” Employee morale, product quality, and
vendor reliability are some of the issues that should be
considered. Let’s revisit the scenario described earlier
at the International Chocolate Company. Recall that the
Savannah plant manager, Marsha Mello (M), was con-
sidering outsourcing the production of gift boxes for the
company’s fine chocolates. A conventional analysis of the
decision pointed toward keeping the production operation
in-house. Now let’s change the scenario a bit, and con-
sider the following conversation between Dave Mint, plant
controller (C), and Jack Edgeworth, supervisor of the gift
box production department (SG). The conversation takes
place after the two friends’ weekly tennis game.
Mint (C): “Well, you took me again, Jack. I’m starting
to feel old.”
Edgeworth (SG): “It was a close match, Dave.
Always is. Fortunately, it looks like we’ll be able
to keep our matches up, too.”
Mint (C): “What do you mean?”
Edgeworth (SG): “I’m talking about the outsourcing
decision Marsha was considering. Fortunately,
the analysis showed her that we should keep
making our own gift boxes. So my department
stays in business. And I won’t have to consider
a transfer. My wife’s very happy about that, with
the twins in middle school and all.”
Mint (C): “Uh, Jack, I think there’s something you
need to know about.”
Edgeworth (SG): “What’s that?”
Mint (C): “I’ve been doing some preliminary studies
using a technique called activity-based costing.
I think it could improve our decision making in a
lot of areas.”
Edgeworth (SG): “So?”
Mint (C): “That outsourcing decision is one of the
areas where I tried out the new ABC approach.
I just finished the analysis yesterday. I was going
to schedule an appointment with Marsha and
you next week to discuss it.”
Edgeworth (SG): “I’m getting queasy about where
this is going, Jack. What did your analysis
show?”
Mint (C): “It changes the conclusion—pretty
dramatically, in fact. The ABC study shows
that we’d save over $40,000 each year by
outsourcing.”
Edgeworth (SG): “Is that really all that much, Dave?
Among friends, I mean?”
Mint (C): “It’s not a trivial amount, Jack.”
Edgeworth (SG): “Look, Dave, I don’t think I’ve ever
asked anything of you before. But can’t you
bury this one for me? Our family really doesn’t
need another move. And I’ve got people work-
ing for me who will probably lose their jobs.
We’ve done a good job for the company. Our
product is top notch. Nobody’s ever complained
about a thing.”
Mint (C): “I don’t see how I can withhold the analysis
from Marsha, Jack. She has a right to all the
information I have.”
Edgeworth (SG): “But you said you were just doing
preliminary studies, Dave. Marsha doesn’t know
anything about this one, does she?”
Mint (C): “Not yet, Jack, but I’ve got a professional
obligation to show it to her.”
Edgeworth (SG): “You’re opening a Pandora’s box,
Dave. What about employee morale if you
close my department? And what about product
quality, and reliability of the supply?”
Mint (C): “Those are valid issues, Jack. But they
need to be addressed on their own merits, in a
full and open discussion.”
Edgeworth (SG): “Could you at least share this
so-called ABC study with me before you show
it to Marsha? Maybe I’ll see something you’ve
missed.”
Mint (C): “I don’t see why not, Jack. Come by my
office tomorrow morning—say about 10:00.”
Identify any ethical issues you see in this scenario. How
would you resolve them? What should the controller do?
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614 Chapter 14 Decision Making: Relevant Costs and Benefits
Lansing Camera Company has received a special order for photographic equipment it does not normally
produce. The company has excess capacity, and the order could be manufactured without reducing pro-
duction of the firm’s regular products. Discuss the relevance of each of the following items in computing
the cost of the special order.
1. Equipment to be used in producing the order has a book value of $2,000. The equipment has
no other use for Lansing Camera Company. If the order is not accepted, the equipment will be
sold for $1,500. If the equipment is used in producing the order, it can be sold in three months
for $800.
Chapter Summary
LO 14-1 Describe seven steps in the decision-making process and the managerial accountant’s
role in that process. The decision-making steps are: (1) clarify the decision problem; (2) specify the
criterion; (3) identify the alternatives; (4) develop a decision model; (5) collect the data; (6) select an
alternative; and (7) evaluate decision effectiveness.
LO 14-2 Explain the relationship between quantitative and qualitative analyses in decision mak-
ing. The managerial accountant’s key role in the decision-making process is to provide data relevant
to the decision. Managers can then use these data in preparing a quantitative analysis of the decision.
Qualitative factors also are considered in making the final decision.
LO 14-3 List and explain two criteria that must be satisfied by relevant information. In order to
be relevant to a decision, a cost or benefit must (1) bear on the future and (2) differ under the various
decision alternatives.
LO 14-4 Identify relevant costs and benefits, giving proper treatment to sunk costs, opportu-
nity costs, and unit costs. Sunk costs, such as the book value of equipment or inventory, are not
relevant to decisions. Such costs do not have any bearing on the future. Opportunity costs frequently
are relevant to decisions, but they often are overlooked by decision makers. Unit costs bear particu-
lar scrutiny in decision-making situations. Fixed costs often are unitized and assigned to products
or services for product-costing purposes. For decision-making purposes, however, unit costs can
be misleading, since the total fixed cost will not increase as the total number of units produced
increases.
LO 14-5 Prepare analyses of various special decisions, properly identifying the relevant costs
and benefits. To analyze any special decision, the proper approach is to determine all of the costs
and benefits that will differ among the alternatives. Common decisions include the following:
(1) accept or reject a special offer; (2) outsource a product or service; and (3) add or drop a service,
product, or department.
LO 14-6 Analyze manufacturing decisions involving joint products and limited resources. A com-
mon decision that arises in a joint-product environment is whether to sell a joint product at the split-off
point or process it further. This decision should be based on the incremental costs and benefits occurring
after the split-off point. A common decision involving limited resources is which of several products to
produce. The correct decision is to produce the product with the highest contribution margin per unit of
the scarce resource.
LO 14-7 Explain the impact of an advanced manufacturing environment and activity-based cost-
ing on a relevant-cost analysis. The concepts underlying a relevant-cost analysis remain valid in an
advanced manufacturing environment and in situations where activity-based costing is used. However,
an ABC system typically enables a decision maker to estimate the relevant costs in a decision problem
more accurately.
LO 14-8 Formulate a linear program to solve a product-mix problem with multiple constraints
(appendix). A linear program can be used to solve a firm’s product-mix problem when the production
process is constrained by scarce resources. A linear program consists of a linear objective function and
a set of linear constraints. The solution to the optimization problem consists of finding the optimal solu-
tion point within the feasible region, as determined by the constraints.
Review Problem on Relevant Costs
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Chapter 14 Decision Making: Relevant Costs and Benefits 615
2. If the special order is accepted, the operation will require some of the storage space in the company’s
plant. If the space is used for this purpose, the company will rent storage space temporarily in a
nearby warehouse at a cost of $18,000. The building depreciation allocated to the storage space to
be used in producing the special order is $12,000.
3. If the special order is accepted, it will require a subassembly. Lansing Camera can purchase the
subassembly for $24 per unit from an outside supplier or make it for $30 per unit. The $30 cost per
unit was determined as follows:
Solution to Review Problem
1. The book value of the equipment is a sunk cost, irrelevant to the decision. The relevant cost of the
equipment is $700, determined as follows:
2. The $12,000 portion of building depreciation allocated to the storage space to be used for the
special order is irrelevant. First, it is a sunk cost. Second, any costs relating to the company’s
factory building will continue whether the special order is accepted or not. The relevant cost is the
$18,000 rent that will be incurred only if the special order is accepted.
3. Lansing Camera should make the subassembly. The subassembly’s relevant cost is $22 per unit.
Notice that the unitized fixed overhead, $8, is not a relevant cost of the subassembly. Lansing
Camera Company’s total fixed cost will not change, whether the special order is accepted or not.
Direct material …………………………………………………………………… $10.00
Direct labor ……………………………………………………………………….. 6.00
Variable overhead ………………………………………………………………. 6.00
Allocated fixed overhead ………………………………………………………. 8.00
Total unit cost of subassembly ………………………………………………. $30.00
Sales value of equipment now ………………………………………………………… $1,500
Sales value after producing special order …………………………………………… 800
Differential cost ……………………………………………………………………………. $ 700
Relevant Cost of Making Subassembly
(per unit)
Relevant Cost of Purchasing Subassembly
(per unit)
Direct material ……………………………………….. $10.00 Purchase price ………………………………. $24.00
Direct labor ……………………………………………. 6.00
Variable overhead …………………………………… 6.00
Total …………………………………………………….. $22.00
Key Terms
For each term’s definition refer to the indicated page, or turn to the glossary at the end of the text.
accurate information, 590
avoidable expenses, 601
constraints, * 616
decision variables, * 616
differential cost, 594
expected value, 608
feasible region, * 616
information overload, 592
joint cost, 604
joint production process, 603
make-or-buy decision, 598
objective function, * 616
opportunity cost, 595
outsourcing decision, 598
qualitative
characteristics, 589
relative-sales-value
method, 604
relevant information, 590
sensitivity analysis, 607
separable processing
cost, 605
split-off point, 604
sunk costs, 592
timely information, 591
unavoidable expenses, 601
*Term appears in the appendix.
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616 Chapter 14 Decision Making: Relevant Costs and Benefits
APPENDIX TO CHAPTER 14
Linear Programming
When a firm produces multiple products, management must decide how much of each output to pro-
duce. In most cases, the firm is limited in the total amount it can produce, due to constraints on resources
such as machine time, direct labor, or raw materials. This situation is known as a product-mix problem.
To illustrate, we will use International Chocolate Company’s Phoenix plant, which produces Chew-
ies and Chompo Bars. Exhibit 14–21 provides data pertinent to the problem.
Linear programming is a powerful mathematical tool, well suited to solving International Choco-
late Company’s product-mix problem. The steps in constructing the linear program are as follows:
1. Identify the decision variables, which are the variables about which a decision must be
made. International Chocolate’s decision variables are as follows:
Decision X 5 Number of cases of Chewies to produce each month
variables Y 5 Number of cases of Chompo Bars to produce each month
2. Write the objective function, which is an algebraic expression of the firm’s goal. Interna-
tional Chocolate’s goal is to maximize its total contribution margin. Since Chewies bring a con-
tribution margin of $1 per case, and Chompos result in a contribution margin of $2 per case, the
firm’s objective function is the following:
Objective function Maximize Z 5 X 1 2Y
3. Write the constraints, which are algebraic expressions of the limitations faced by the firm,
such as those limiting its productive resources. International Chocolate has a constraint for
machine time and a constraint for direct labor.
Machine-time constraint .02X 1 .05Y # 700
Labor-time constraint .20X 1 .25Y # 5,000
Suppose, for example, that management decided to produce 20,000 cases of Chewies and 6,000
cases of Chompos. The machine-time constraint would appear as follows:
(.02)(20,000) 1 (.05)(6,000) 5 700
Thus, at these production levels, the machine-time constraint would just be satisfied, with no
machine hours to spare.
Graphical Solution
To understand how the linear program described above will help International Chocolate’s management
solve its product-mix problem, examine the graphs in Exhibit 14–22 . The two colored lines in panel A
represent the constraints. The colored arrows indicate that the production quantities, X and Y, must lie on
or below these lines. Since the production quantities must be nonnegative, colored arrows also appear on
the graphs’ axes. Together, the axes and constraints form an area called the feasible region, in which
the solution to the linear program must lie.
The black slanted line in panel A represents the objective function. Rearrange the objective func-
tion equation as follows:
Z 5 X 1 2Y Y 5 Z __
2
2 1 __
2
X
Learning Objective 14-8
Formulate a linear program to
solve a product-mix problem
with multiple constraints.
Chewies Chompo Bars
Contribution margin per case ……………………………………………………………………………. $1.00 $2.00
Machine hours per case ………………………………………………………………………………….. .02 .05
Direct-labor hours per case ……………………………………………………………………………… .20 .25
Machine
Hours
Direct-Labor
Hours
Limited resources: hours available per month ………………………………………………………. 700 5,000
Exhibit 14–21
Data for Product-Mix
Problem: International
Chocolate Company
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Chapter 14 Decision Making: Relevant Costs and Benefits 617
This form of the objective function shows that the slope of the equation is 2 ½, which is the slope of
the objective-function line in the exhibit. Management’s goal is to maximize total contribution margin,
denoted by Z. To achieve the maximum, the objective-function line must be moved as far outward and
upward in the feasible region as possible, while maintaining the same slope. This goal is represented in
panel A by the arrow that points outward from the objective-function line.
Solution The result of moving the objective-function line as far as possible in the indicated direction
is shown in panel B of the exhibit. The objective-function line intersects the feasible region at exactly
one point, where X equals 15,000 and Y equals 8,000. Thus, International Chocolate’s optimal product
mix is 15,000 cases of Chewies and 8,000 cases of Chompos per month. The total contribution margin
is calculated as shown below.
Total contribution margin 5 (15,000)($1) 1 (8,000)($2) 5 $31,000
Simplex Method and Sensitivity Analysis Although the graphical method is instructive, it is
a cumbersome technique for solving a linear program. Fortunately, mathematicians have developed a more
Exhibit 14–22
Product-Mix Problem
Expressed as Linear Program:
International Chocolate
Company
Y (cases of Chompos)
20,000
15,000
10,000
5,000
35,00030,00025,00020,00015,00010,0005,000
X (cases of Chewies)
Objective function:
Z = X + 2Y
Feasible
region
Labor-time constraint
.20X + .25Y # 5,000
Machine-time constraint
.02X + .05Y # 700
Y (cases of Chompos)
20,000
15,000
10,000
8,000
5,000
35,00030,00025,00020,00015,00010,0005,000
X (cases of Chewies)
A. Constraints, Feasible Region, and Objective Function
Feasible
region
Optimum: X = 15,000; Y = 8,000
B. Solution of Linear Program
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618 Chapter 14 Decision Making: Relevant Costs and Benefits
efficient solution method called the simplex algorithm. A computer can apply the algorithm to a complex
linear program and determine the solution in seconds. In addition, most linear programming computer pack-
ages provide a sensitivity analysis of the problem. This analysis shows the decision maker the extent to
which the estimates used in the objective function and constraints can change without changing the solution.
Managerial Accountant’s Role
What is the managerial accountant’s role in International Chocolate’s product-mix decision? The pro-
duction manager in the company’s Phoenix plant makes this decision, with the help of a linear program.
However, the linear program uses information supplied by the managerial accountant. The coefficients
of X and Y in the objective function are unit contribution margins. Exhibit 14–14 shows that calculating
these contribution margins requires estimates of direct-material, direct-labor, variable-overhead, and
variable selling and administrative costs. These estimates were provided by a managerial accountant,
along with estimates of the machine time and direct-labor time required to produce a case of Chewies
or Chompos. All of these estimates were obtained from the standard-costing system, upon which the
Phoenix plant’s product costs are based. Thus, the managerial accountant makes the product-mix deci-
sion possible by providing the relevant cost data.
Linear programming is widely used in business decision making. Among the applications are
blending in the petroleum and chemical industries; scheduling of personnel, railroad cars, and aircraft;
and the mixing of ingredients in the food industry. In all of these applications, managerial accountants
provide information crucial to the analysis.
Review Questions
14–1. List the seven steps in the decision-making process.
14–2. Describe the managerial accountant’s role in the
decision-making process.
14–3. Distinguish between qualitative and quantitative
decision analyses.
14–4. Explain what is meant by the term decision model.
14–5. A quantitative analysis enables a decision maker to put
a “price” on the sum total of the qualitative c haracteris-
tics in a decision situation. Explain this statement, and
give an example.
14–6. What is meant by each of the following potential charac-
teristics of information: relevant, accurate, and t imely? Is
objective information always relevant? Accurate?
14–7. List and explain two important criteria that must be
satisfied in order for information to be relevant.
14–8. Explain why the book value of equipment is not a
relevant cost.
14–9. Is the book value of inventory on hand a relevant cost?
Why?
14–10. Why might a manager exhibit a behavioral tendency to
inappropriately consider sunk costs in making a decision?
14–11. Give an example of an irrelevant future cost. Why is it
irrelevant?
14–12. Define the term opportunity cost, and give an example
of one.
14–13. What behavioral tendency do people often exhibit with
regard to opportunity costs?
14–14. How does the existence of excess production capacity
affect the decision to accept or reject a special order?
14–15. What is meant by the term differential cost analysis?
14–16. Briefly describe the proper approach for making a
decision about adding or dropping a product line.
14–17. What is a joint production process? Describe a special
decision that commonly arises in the context of a
joint production process. Briefly describe the proper
approach for making this type of decision.
14–18. Are allocated joint processing costs relevant when
making a decision to sell a joint product at the split-off
point or process it further? Why?
14–19. Briefly describe the proper approach to making a
production decision when limited resources are
involved.
14–20. What is meant by the term contribution margin per unit
of scarce resource?
14–21. How is sensitivity analysis used to cope with uncer-
tainty in decision making?
14–22. There is an important link between decision making and
managerial performance evaluation. Explain.
14–23. List four potential pitfalls in decision making, which
represent common errors.
14–24. Why can unitized fixed costs cause errors in decision
making?
14–25. Give two examples of sunk costs, and explain why they
are irrelevant in decision making.
14–26. “Accounting systems should produce only relevant data
and forget about the irrelevant data. Then I’d know
what was relevant and what wasn’t!” Comment on this
remark by a company president.
14–27. Are the concepts underlying a relevant-cost analysis
still valid in an advanced manufacturing environment?
Are these concepts valid when activity-based costing is
used? Explain.
14–28. List five ways that management can seek to relax a
constraint by expanding the capacity of a bottleneck
operation.
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Chapter 14 Decision Making: Relevant Costs and Benefits 619
Choose an organization and a particular decision situation. Then give examples, u s ing that decision
context, of each step illustrated in Exhibit 14–1 .
Redo Exhibit 14–4 without the irrelevant data.
Day Street Deli’s owner is disturbed by the poor pr o fit performance of his ice cream counter. He has
prepared the following profit analysis for the year just ended.

Sales …………………………………………………………………………………………………………………. $67,500
Less: Cost of food ………………………………………………………………………………………………… 30,000
Gross profit …………………………………………………………………………………………………………. $37,500
Less: Operating expenses:
Wages of counter personnel ……………………………………………………………………………….. $18,000
Paper products (e.g., napkins) …………………………………………………………………………….. 6,000
Utilities (allocated) …………………………………………………………………………………………….. 4,350
Depreciation of counter equipment and furnishings ………………………………………………….. 3,750
Depreciation of building (allocated) ……………………………………………………………………….. 6,000
Deli manager’s salary (allocated) ………………………………………………………………………….. 4,500
Total ………………………………………………………………………………………………………………. 42,600
Loss on ice cream counter ……………………………………………………………………………………… $ (5,100)
Required: Criticize and correct the owner’s analysis.
Toon Town Toy Company is considering the elimination of its Packaging Department. M anagement has
received an offer from an outside firm to supply all Toon Town’s packaging needs. To help her in making
the decision, Toon Town’s president has asked the controller for an analysis of the cost of running Toon
Town’s Packaging Department. Included in that analysis is $11,100 of rent, which represents the Pack-
aging Department’s allocation of the rent on Toon Town’s factory building. If the Packaging Department
is eliminated, the space it used will be converted to storage space. Currently Toon Town rents storage
space in a nearby warehouse for $13,000 per year. The warehouse rental would no longer be necessary
if the Packaging Department were eliminated.
Required:
1. Discuss each of the figures given in the exercise with regard to its relevance in the department-
closing decision.
2. What type of cost is the $13,000 warehouse rental, from the viewpoint of the costs of the
Packaging Department?
If Toon Town Toy Company closes its Packaging Department, the department manager will be appointed
manager of the Cutting Department. The Packaging Department manager m a kes $51,000 per year. To
hire a new Cutting Department manager will cost Toon Town $66,000 per year.
Required: Discuss the relevance of each of these salary figures to the department-closing decision.
College Town Pizza’s owner bought his current pizza oven two years ago for $10,500, a nd it has
one more year of life remaining. He is using straight-line depreciation for the oven. He could pur-
chase a new oven for $2,200, but it would last only one year. The owner figures the new oven would
save him $3,000 in annual operating expenses compared to operating the old one. Consequently, he
has decided against buying the new oven, since doing so would result in a “loss” of $500 over the
next year.
■ Exercise 14–29
Steps in Decision-Making
Process
(LO 14-1)
■ Exercise 14–30
Irrelevant Future Costs and
Benefits
(LO 14-3, 14-4)
■ Exercise 14–31
Drop Product Line
(LO 14-4, 14-5)
■ Exercise 14–32
Closing a Department
(LO 14-4, 14-5)
■ Exercise 14–33
Continuation of Preceding
Exercise
(LO 14-4, 14-5)
■ Exercise 14–34
Machine Replacement
(LO 14-4, 14-5)
Exercises
All applicable Exercises are available with McGraw-Hill’s Connect Accounting ®.
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620 Chapter 14 Decision Making: Relevant Costs and Benefits
Required:
1. How do you suppose the owner came up with $500 as the loss for the next year if the new pizza
oven were purchased? Explain.
2. Criticize the owner’s analysis and decision.
3. Prepare a correct analysis of the owner’s decision.
Visit the website of one of the following c ompanies, or a different company of your choosing.

Burger King www.burgerking.com
Compaq www.compaq.com
Corning www.corning.com
Kmart www.kmart.com
Kodak www.kodak.com
NBC www.nbc.com
Required: Read about the company’s activities and operations. Choose an activity that is necessary
for the company’s operations, and then discuss the pros and cons of outsourcing that activity.
Armstrong C orporation manufactures bicycle parts. The company currently has a $19,500 inventory
of parts that have become obsolete due to changes in design specifications. The parts could be sold for
$7,000, or modified for $10,000 and sold for $20,300.
Required:
1. Which of the data above are relevant to the decision about the obsolete parts?
2. Prepare an analysis of the decision with regard to the inventory.
Thorpe Industries produces chemicals for the swimming pool industry. In one joint process, 10,000
gallons of GSX are processed into 7,000 gallons of xenolite and 3,000 gallons of banolide. The cost
of the joint process, including the GSX, is $17,500. The firm allocates $11,800 of the joint cost to the
xenolite and $5,700 of the cost to the banolide. The 3,000 gallons of banolide can be sold at the split-off
point for $3,500, or be processed further into a product called kitrocide. The sales value of 3,000 gallons
of kitrocide is $11,000, and the additional processing cost is $7,900.
Required: Thorpe’s president has asked your consulting firm to make a recommendation as to whether
the banolide should be sold at the split-off point or processed further. Write a letter providing an analysis
and a recommendation.
Juarez Corporation p roduces cleaning compounds and solutions for industrial and household use. While
most of its products are processed independently, a few are related. Grit 337, a coarse cleaning powder
with many industrial uses, costs $3.20 a pound to make and sells for $4.00 a pound. A small portion of
the annual production of this product is retained for further processing in the Mixing Department, where
it is combined with several other ingredients to form a paste, which is marketed as a silver polish selling
for $8.00 per jar. This further processing requires ¼ pound of Grit 337 per jar. Costs of other ingredients,
labor, and variable overhead associated with this further processing amount to $5.00 per jar. Variable
selling costs are $.60 per jar. If the decision were made to cease production of the silver polish, $11,200
of Mixing Department fixed costs could be avoided. Juarez has limited production capacity for Grit 337,
but unlimited demand for the cleaning powder.
Required: Calculate the minimum number of jars of silver polish that would have to be sold to justify
further processing of Grit 337.
(CMA, adapted)
Global C hemical Company, located in Buenos Aires, Argentina, recently received an order for a prod-
uct it does not normally produce. Since the company has excess production capacity, management is
considering accepting the order. In analyzing the decision, the assistant controller is compiling the
relevant costs of producing the order. Production of the special order would require 8,000 kilograms
of theolite. Global does not use theolite for its regular product, but the firm has 8,000 kilograms of the
■ Exercise 14–35
Outsourcing Decision; Use of
Internet
(LO 14-1, 14-2, 14-5)
■ Exercise 14–36
Obsolete Inventory
(LO 14-4, 14-5)
■ Exercise 14–37
Joint Products
(LO 14-4, 14-6)
■ Exercise 14–38
Joint Products; Relevant
Costs; Cost-Volume-Profit
Analysis
(LO 14-4, 14-6)
■ Exercise 14–39
Special Order
(LO 14-4, 14-5)
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Chapter 14 Decision Making: Relevant Costs and Benefits 621
chemical on hand from the days when it used theolite regularly. The theolite could be sold to a chemical
wholesaler for 21,750 p. The book value of the theolite is 3.00 p per kilogram. Global could buy theo-
lite for 3.60 p per kilogram. ( p denotes the peso, Argentina’s national monetary unit. Many countries
use the peso as their unit of currency. On the day this exercise was written, Argentina’s peso was worth
.1891 U.S. dollars.)
Required:
1. What is the relevant cost of theolite for the purpose of analyzing the special-order decision?
(Remember to express your answer in terms of Argentina’s peso.)
2. Discuss each of the numbers given in the exercise with regard to its relevance in making the
decision.
Global’s special o rder also requires 1,000 kilograms of genatope, a solid chemical regularly used in
the company’s products. The current stock of genatope is 8,000 kilograms at a book value of 12.15 p
per kilogram. If the special order is accepted, the firm will be forced to restock genatope earlier than
expected, at a predicted cost of 13.05 p per kilogram. Without the special order, the purchasing manager
predicts that the price will be 12.45 p, when normal restocking takes place. Any order of genatope must
be in the amount of 5,000 kilograms.
Required:
1. What is the relevant cost of genatope?
2. Discuss each of the figures in the exercise in terms of its relevance to the decision.
Plato Corporation manufactures two products, Alpha and Beta. Contribution m argin data follow.

Alpha Beta
Unit sales price ………………………………………………………………………………………………………. $39.00 $93.00
Less variable cost:
Direct material ……………………………………………………………………………………………………. $21.00 $15.00
Direct labor ……………………………………………………………………………………………………….. 3.00 18.00
Variable overhead ……………………………………………………………………………………………….. 3.75 22.50
Variable selling and administrative cost ……………………………………………………………………. 2.25 1.50
Total variable cost …………………………………………………………………………………………………… $30.00 $57.00
Unit contribution margin …………………………………………………………………………………………… $ 9.00 $36.00
Plato Corporation’s production process uses highly skilled labor, which is in short supply. The same
employees work on both products and earn the same wage rate.
Required: Which of Plato Corporation’s products is most profitable? Explain.
Refer to the data given in the preceding exercise for Plato Corporation. Assume that the d irect-labor
rate is $12 per hour, and 11,000 labor hours are available per year. In addition, the company has a short
supply of machine time. Only 9,000 hours are available each year. Alpha requires one machine hour per
unit, and Beta requires two machine hours per unit.
Required: Formulate the production planning problem as a linear program. Specifically identify (1)
the decision variables, (2) the objective function, and (3) the constraints.
New Jersey Chemical Company manufactures two industrial chemical products, called z anide and kreo-
lite. Two machines are used in the process, and each machine has 24 hours of capacity per day. The
following data are available:

Zanide Kreolite
Selling price per drum …………………………………………………………………………………………. $108 $126
Variable cost per drum ………………………………………………………………………………………… $ 84 $ 84
Hours required per drum on machine I ……………………………………………………………………. 2 hr. 2 hr.
Hours required per drum on machine II ……………………………………………………………………. 1 hr. 3 hr.
■ Exercise 14–40
Continuation of Preceding
Exercise
(LO 14-4, 14-5)
■ Exercise 14–41
Limited Resource
(LO 14-6)
■ Exercise 14–42
Linear Programming
(Appendix)
(LO 14-6, 14-8)
■ Exercise 14–43
Linear Programming;
Formulate and Solve
Graphically (Appendix)
(LO 14-8)
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622 Chapter 14 Decision Making: Relevant Costs and Benefits
The company can produce and sell partially full drums of each chemical. For example, a half drum of
zanide sells for $54.
Required:
1. Formulate the product-mix problem as a linear program.
2. Solve the problem graphically.
3. What is the value of the objective function at the optimal solution?
Problems
Contemporary Trends sells paint and paint supplies, carpet, and wallpaper at a single-store l ocation in
suburban Baltimore. Although the company has been very profitable over the years, management has
seen a significant decline in wallpaper sales and earnings. Much of this decline is attributable to the
Internet and to companies that advertise deeply discounted prices in magazines and offer customers
free shipping and toll-free telephone numbers. Recent figures follow.

Paint and
Supplies Carpeting Wallpaper
Sales ……………………………………………………………………. $190,000 $230,000 $70,000
Variable costs ………………………………………………………… $114,000 $161,000 $56,000
Fixed costs ……………………………………………………………. 28,000 37,500 22,500
Total costs …………………………………………………………. $142,000 $198,500 $78,500
Operating income (loss) ……………………………………………. $ 48,000 $ 31,500 $ (8,500)
Management is studying whether to drop wallpaper because of the changing market and accompanying
loss. If the line is dropped, the following changes are expected to occur:
• The vacated space will be remodeled at a cost of $6,200 and will be devoted to an expanded line of
high-end carpet. Sales of carpet are expected to increase by $60,000, and the line’s overall contribu-
tion margin ratio will rise by five percentage points.
• Contemporary Trends can cut wallpaper’s fixed costs by 40 percent. Remaining fixed costs will
continue to be incurred.
• Customers who purchased wallpaper often bought paint and paint supplies. Sales of paint and paint
supplies are expected to fall by 20 percent.
• The firm will increase advertising expenditures by $12,500 to promote the expanded carpet line.
Required:
1. Should Contemporary Trends close its wallpaper operation? Show your computations.
2. Assume that Contemporary Trends’ wallpaper inventory at the time of the closure decision
amounted to $11,850. How would you have treated this additional information in making the
decision?
3. What advantages might Internet- and magazine-based firms have over Contemporary Trends
that would allow these organizations to offer deeply discounted prices—prices far below what
Contemporary Trends can offer?
4. Build a spreadsheet: Construct an Excel spreadsheet to solve requirement (1) above. Show how
the solution will change if the following information changes: sales were $200,000, $225,000, and
$65,000, for paint and supplies, carpeting, and wallpaper, respectively.
Golden Gate Fashions, I nc. a high-fashion dress manufacturer, is planning to market a new cocktail
dress for the coming season. Golden Gate Fashions supplies retailers primarily on the west coast.
Four yards of material are required to lay out the dress pattern. Some material remains after cut-
ting, which can be sold as remnants. The leftover material also could be used to manufacture a matching
handbag and an accessory cape to be worn about the shoulders. However, if the leftover material is to be
used for the cape and handbag, more care will be required in the cutting operation, which will increase
the cutting costs.
■ Problem 14–44
Closing an Unprofitable
Department
(LO 14-4, 14-5)
1. Contribution margin,
carpeting: $69,000
■ Problem 14–45
Add a Product Line
(LO 14-4, 14-5)
1. Total incremental
contribution margin: $68,712
All applicable Problems are available with McGraw-Hill’s Connect Accounting ®.
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Chapter 14 Decision Making: Relevant Costs and Benefits 623
The company expects to sell 1,250 dresses. Market research reveals that dress sales will be 20
percent higher if a matching cape and handbag are available. The market research indicates that the cape
and handbag will be salable only as accessories with the dress. The combination of dresses, capes, and
handbags expected to be sold by retailers is as follows:

Percent of Total
Complete sets of dress, handbag, and accessory cape ……………….. 70%
Dress and accessory cape ……………………………………………………. 6
Dress and handbag …………………………………………………………….. 15
Dress only ………………………………………………………………………… 9
Total …………………………………………………………………………….. 100%
The material used in the dress costs $20.00 a yard or $80.00 for each dress. The cost of cutting the
dress if the accessory cape and handbag are not manufactured is estimated at $32.00 a dress, and the
resulting remnants can be sold for $8.00 per dress. If the accessory cape and handbag are manufactured,
the cutting costs will be increased by $14.40 per dress and there will be no salable remnants. The selling
prices and the costs to complete the three items once they are cut are as follows:
Selling Price
per Unit
Unit Cost to Complete
(excludes costs of material
and cutting operation)
Dress $320.00 $128.00
Accessory cape …………………………………………………….. 44.00 31.20
Handbag ……………………………………………………………… 15.20 10.40

Required:
1. Calculate Golden Gate Fashions’ incremental profit or loss from manufacturing the accessory
capes and handbags in conjunction with the dresses.
2. Identify any qualitative factors that could influence the company’s management in its decision to
manufacture accessory capes and handbags to match the dresses.
(CMA, adapted)
Chef Gourmet, Inc., has assembled the following data pertaining to its two most p opular products.

Blender Food Processor
Direct material ……………………………………………………………………………….. $18 $ 33
Direct labor …………………………………………………………………………………… 12 27
Manufacturing overhead @ $48 per machine hour ………………………………… 48 96
Cost if purchased from an outside supplier …………………………………………… 60 114
Annual demand (units) …………………………………………………………………….. 20,000 28,000
Past experience has shown that the fixed manufacturing overhead component included in the cost
per machine hour averages $30. Management has a policy of filling all sales orders, even if it means
purchasing units from outside suppliers.
Required:
1. If 50,000 machine hours are available, and management desires to follow an optimal strategy, how
many units of each product should the firm manufacture? How many units of each product should
be purchased?
2. With all other things constant, if management is able to reduce the direct material for a food pro-
cessor to $18 per unit, how many units of each product should be manufactured? Purchased?
3. Build a spreadsheet: Construct an Excel spreadsheet to solve requirement (1) above. Show how
the solution will change if the following information changes: the unit cost if purchased from an
outside supplier is $66 for the blender and $120 for the food processor.
(CMA, adapted)
■ Problem 14–46
Production Decisions; Limited
Capacity
(LO 14-5, 14-6)
1. Unit cost savings if
manufactured, blender: $12
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624 Chapter 14 Decision Making: Relevant Costs and Benefits
Dentech, Inc., uses 10 units of part RM67 each month in the production of dentistry e quipment. The cost
of manufacturing one unit of RM67 is the following:

Direct material ……………………………………………………………………. $ 3,000
Material handling (20% of direct-material cost) ………………………….. 600
Direct labor ……………………………………………………………………….. 24,000
Manufacturing overhead (150% of direct labor) …………………………. 36,000
Total manufacturing cost …………………………………………………… $63,600
Material handling represents the direct variable costs of the Receiving Department that are applied
to direct materials and purchased components on the basis of their cost. This is a separate charge in addi-
tion to manufacturing overhead. Dentech’s annual manufacturing overhead budget is one-third variable
and two-thirds fixed. Scott Supply, one of Dentech’s reliable vendors, has offered to supply part number
RM67 at a unit price of $45,000.
Required:
1. If Dentech purchases the RM67 units from Scott, the capacity Dentech used to manufacture these
parts would be idle. Should Dentech decide to purchase the parts from Scott, the unit cost of
RM67 would increase (or decrease) by what amount?
2. Assume Dentech is able to rent out all its idle capacity for $75,000 per month. If Dentech decides
to purchase the 10 units from Scott Supply, Dentech’s monthly cost for RM67 would increase (or
decrease) by what amount?
3. Assume that Dentech does not wish to commit to a rental agreement but could use its idle capacity
to manufacture another product that would contribute $156,000 per month. If Dentech’s manage-
ment elects to manufacture RM67 in order to maintain quality control, what is the net amount
of Dentech’s cost from using the space to manufacture part RM67?
(CMA, adapted)
Cincinnati F low Technology (CFT) has purchased 10,000 pumps annually from Kobec, Inc. Because
the price keeps increasing and reached $102.00 per unit last year, CFT’s management has asked for an
estimate of the cost of manufacturing the pump in CFT’s facilities. CFT makes stampings and castings
and has little experience with products requiring assembly.
The engineering, manufacturing, and accounting departments have prepared a report for manage-
ment which includes the following estimate for an assembly run of 10,000 pumps. Additional production
employees would be hired to manufacture the pumps but no additional equipment, space, or supervision
would be needed.
The report states that total costs for 10,000 units are estimated at $1,435,500 or $143.55 per unit. The
current purchase price is $102.00 per unit, so the report recommends continued purchase of the product.
Components (outside purchases) …………………………………………………………………………………………………… $ 180,000
Assembly labor* …………………………………………………………………………………………………………………………. 450,000
Manufacturing overhead† …………………………………………………………………………………………………………….. 675,000
General and administrative overhead‡ …………………………………………………………………………………………….. 130,500
Total costs …………………………………………………………………………………………………………………………….. $1,435,500
*Assembly labor consists of hourly production workers.
†Manufacturing overhead is applied to products on a direct-labor-dollar basis. Variable-overhead costs vary closely with direct-labor dollars.
Fixed overhead ……………………………………………………………………………… 50% of direct-labor dollars
Variable overhead ………………………………………………………………………….. 100% of direct-labor dollars
Manufacturing-overhead rate …………………………………………………………… 150% of direct-labor dollars
‡General and administrative overhead is applied at 10 percent of the total cost of material (or components), assembly labor, and manufacturing
overhead.

Required: Were the analysis prepared by Cincinnati Flow Technology’s engineering, manufactur-
ing, and accounting departments and their recommendation to continue purchasing the pumps correct?
Explain your answer and include any supporting calculations you consider necessary.
(CMA, adapted)
■ Problem 14–47
Outsource a Component;
Relevant Costs, Opportunity
Costs, and Quality Control
(LO 14-3, 14-4, 14-5)
1. Variable manufacturing
overhead: $12,000
2. Increase in monthly cost
of acquiring part RM67 if
purchased, $144,000
■ Problem 14–48
Make or Buy
(LO 14-4, 14-5)
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Chapter 14 Decision Making: Relevant Costs and Benefits 625
Martinez, Inc., i s a small firm involved in the production and sale of electronic business products. The
company is well known for its attention to quality and innovation.
During the past 15 months, a new product has been under development that allows users hand-
held access to e-mail and video images. Martinez named the product the Wireless Wizard and has been
quietly designing two models: Standard and Enhanced. Development costs have amounted to $181,500
and $262,500, respectively. The total market demand for each model is expected to be 40,000 units,
and management anticipates being able to obtain the following market shares: Standard, 25 percent;
Enhanced, 20 percent. Forecasted data follow.
Standard Enhanced
Projected selling price …………………………………………………………………………………. $375.00 $495.00
Production costs per unit:
Direct material ……………………………………………………………………………………….. 42.00 67.50
Direct labor …………………………………………………………………………………………… 22.50 30.00
Variable overhead …………………………………………………………………………………… 36.00 48.00
Marketing and advertising per product line ………………………………………………………. 195,000 300,000
Sales salaries per product line ………………………………………………………………………. 85,500 85,500
Sales commissions* ……………………………………………………………………………………. 10% 10%
*Computed on the basis of sales dollars.
Since the start of development work on the Wireless Wizard, advances in technology have altered
the market somewhat, and management now believes that the company can introduce only one of the
two models. Consultants confirmed this fact not too long ago, with Martinez paying $34,500 for an in-
depth market study. The total fixed overhead is expected to be the same regardless of which product is
manufactured.
Required:
1. Compute the per-unit contribution margin for both models.
2. Which of the data above should be ignored in making the product-introduction decision? For what
reason?
3. Prepare a financial analysis and determine which of the two models should be introduced.
4. What other factors should Martinez consider before a final decision is made?
Handy Dandy Tools Company manufactures electric carpentry tools. The Production D e partment has
met all production requirements for the current month and has an opportunity to produce additional
units of product with its excess capacity. Unit selling prices and unit costs for three different saw models
are as follows:

Basic Model Deluxe Model Pro Model
Selling price …………………………………………………………. $116 $130 $160
Direct material ………………………………………………………. 32 40 38
Direct labor ($20 per hour) ………………………………………. 20 30 40
Variable overhead ………………………………………………….. 16 24 32
Fixed overhead ……………………………………………………… 32 10 30
Variable overhead is applied on the basis of direct-labor dollars, while fixed overhead is applied
on the basis of machine hours. There is sufficient demand for the additional production of any model in
the product line.
Required:
1. If the company has excess machine capacity and can add more labor as needed (i.e., neither
machine capacity nor labor is a constraint), the excess production capacity should be devoted
to producing which product? (Assume that the excess capacity will be used for a single
product line.)
2. If the company has excess machine capacity but a limited amount of labor time, the excess produc-
tion capacity should be devoted to producing which product or products?
(CMA, adapted)
■ Problem 14–49
Introducing a New Product
(LO 14-4, 14-5)
1. Unit contribution margin,
Enhanced: $300
3. Income, Standard:
$2,175,000
■ Problem 14–50
Excess Production Capacity
(LO 14-5, 14-6)
1. Contribution margin,
Deluxe: $36 per unit
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626 Chapter 14 Decision Making: Relevant Costs and Benefits
Mercury Skateboard Company manufactures skateboards. Several w eeks ago, the firm received a
special-order inquiry from Venus, Inc. Venus desires to market a skateboard similar to one of Mercury’s
and has offered to purchase 11,000 units if the order can be completed in three months. The cost data for
Mercury’s Champion model skateboard follow.

Direct material ……………………………………………………………………….. $16.40
Direct labor: .25 hours at $18.00 ……………………………………………….. 4.50
Total manufacturing overhead:
.5 machine hours at $40.00 ………………………………………………….. 20.00
Total …………………………………………………………………………………. $40.90
The following additional information is available.
• The normal selling price of the Champion model is $53.00; however, Venus has offered Mercury
only $31.50 because of the large quantity it is willing to purchase.
• Venus requires a modification of the design that will allow a $4.20 reduction in direct-material
cost.
• Mercury’s production supervisor notes that the company will incur $7,400 in additional setup costs
and will have to purchase a $4,800 special device to manufacture these units. The device will be
discarded once the special order is completed.
• Total manufacturing overhead costs are applied to production at the rate of $40 per machine hour.
This figure is based, in part, on budgeted yearly fixed overhead of $1,500,000 and planned produc-
tion activity of 60,000 machine hours (5,000 per month).
• Mercury will allocate $3,600 of existing fixed administrative costs to the order as “. . . part of the
cost of doing business.”
Required:
1. Assume that present sales will not be affected. Should the order be accepted from a financial point
of view (i.e., is it profitable)? Why? Show calculations.
2. Assume that Mercury’s current production activity consumes 70 percent of planned machine-hour
activity. Can the company accept the order and meet Venus’ deadline?
3. What options might Mercury consider if management truly wanted to do business with Venus in
hopes of building a long-term relationship with the firm?
Treasure Island Beach E quipment, Inc., manufactures deluxe beach cabanas in Tampa, Florida. Its man-
ufacturing plant has the capacity to produce 2,500 cabanas each month. Current monthly production is
1,875 cabanas. The company normally charges $525 per cabana. Variable costs and fixed costs for the
current activity level of 75 percent of capacity are shown in the table below.
Management has just received a special one-time order for 625 cabanas at $300 per cabana. For
this particular order, no variable marketing costs will be incurred. Samantha Peters, the assistant control-
ler, has been assigned the task of analyzing this order and recommending whether the company should
accept or reject it. After examining the costs, Peters suggested to her supervisor, Katie Maas, who is
the controller, that they request competitive bids from vendors for the raw material as the current quote
seems high. Maas insisted that the prices are in line with other vendors and told her that she was not
to discuss her observations with anyone else. Peters later discovered that Maas is a sister-in-law of the
owner of the current raw-material supply vendor.

Current Product Costs (at 75% of Capacity)
Variable costs:
Manufacturing:
Direct labor …………………………………………………………………….. $281,250
Direct material …………………………………………………………………. 196,875
Marketing …………………………………………………………………………… 140,625
Total variable costs ………………………………………………………………….. $618,750
■ Problem 14–51
Special Order; Financial and
Production Considerations
(LO 14-4, 14-5)
1. Total contribution margin:
$80,300
2. Planned machine hours:
15,000
■ Problem 14–52
Special Order; Ethics
(LO 14-3, 14-5)
2. Total variable costs, com-
bined production: $778,125
Average unit cost, combined
production: $446.25
(Continues)
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Chapter 14 Decision Making: Relevant Costs and Benefits 627
Fixed costs:
Manufacturing ………………………………………………………………… $206,250
Marketing ……………………………………………………………………… 131,250
Total fixed costs ………………………………………………………………………. $337,500
Total costs ……………………………………………………………………………… $956,250
Variable cost per unit ……………………………………………………………….. $330
Fixed cost per unit …………………………………………………………………… 180
Average unit cost …………………………………………………………………….. $510
Required:
1. Identify and explain the costs that will be relevant to Peters’ analysis of the special order being
considered by Treasure Island Beach Equipment, Inc.
2. Determine if management should accept the special order. In explaining your answer, compute the
new average unit cost for ( a ) current monthly production alone; ( b ) the special order alone; and ( c )
total combined production.
3. Discuss any other considerations that Peters should include in her analysis of the special order.
4. What steps could Peters take to resolve the ethical conflict arising out of the controller’s insistence
that the company avoid competitive bidding?
5. Build a spreadsheet: Construct an Excel spreadsheet to solve requirement (2). Show how the
solution will change if the sales price is $535 per cabana.
(CMA, adapted)
Palisades Corporation’s Midwest Division manufactures subassemblies that are used in the corporation’s
final products. Lynn Hardt of Midwest’s Profit Planning Department has been assigned the task of deter-
mining whether a component, JY–65, should continue to be manufactured by Midwest or purchased
from Marley Company, an outside supplier. JY–65 is part of a subassembly manufactured by Midwest.
Marley has submitted a bid to manufacture and supply the 32,000 units of JY–65 that Palisades
will need for 20×1 at a unit price of $8.65. Marley has assured Palisades that the units will be delivered
according to Palisades’ production specifications and needs. While the contract price of $8.65 is only
applicable in 20×1, Marley is interested in entering into a long-term arrangement beyond 20×1.
Hardt has gathered the following information regarding Midwest’s cost to manufacture JY–65 in
20×0. These annual costs will be incurred to manufacture 30,000 units.

Direct material ………………………………………………………………………… $ 97,500
Direct labor ……………………………………………………………………………. 60,000
Factory space rental …………………………………………………………………. 42,000
Equipment leasing costs ……………………………………………………………. $ 18,000
Other manufacturing overhead ……………………………………………………. 112,500
Total manufacturing costs ………………………………………………………….. $330,000
Hardt has collected the following additional information related to manufacturing JY–65.
• Direct materials used in the production of JY–65 are expected to increase 8 percent in 20×1.
• Midwest’s direct-labor contract calls for a 5 percent increase in 20×1.
• The facilities used to manufacture JY–65 are rented under a month-to-month rental agreement.
Thus, Midwest can withdraw from the rental agreement without any penalty. Midwest will have no
need for this space if JY–65 is not manufactured.
• Equipment leasing costs represent special equipment that is used in the manufacture of JY–65. This
lease can be terminated by paying the equivalent of one month’s lease payment for each year left on the
lease agreement. Midwest has two years left on the lease agreement, through the end of the year 20×2.
• Forty percent of the other manufacturing overhead is considered variable. Variable overhead changes with
the number of units produced, and this rate per unit is not expected to change in 20×1. The fixed manufac-
turing overhead costs are expected to be the same across a relevant range of zero to 50,000 units produced.
Equipment other than the leased equipment can be used in Midwest’s other manufacturing operations.
John Porter, divisional manager of Midwest, stopped by Hardt’s office to voice his concern regard-
ing the outsourcing of JY–65. Porter commented, “I am really concerned about outsourcing JY–65.
■ Problem 14–53
Outsourcing Decision;
Relevant Costs; Ethics
(LO 14-3, 14-4, 14-5)
1(a). Total cost to make JY65:
$287,520
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628 Chapter 14 Decision Making: Relevant Costs and Benefits
I have a son-in-law and a nephew, not to mention a member of our bowling team, who work on JY–65.
They could lose their jobs if we buy that component from Marley. I really would appreciate anything
you can do to make sure the cost analysis comes out right to show we should continue making JY–65.
Corporate is not aware of the material increases, and maybe you can leave out some of those fixed costs.
I just think we should continue making JY–65!”
Required:
1. a. Prepare an analysis of relevant costs that shows whether or not the Midwest Division of
Palisades Corporation should make JY–65 or purchase it from Marley Company for 20×1.
b. Based solely on the financial results, recommend whether the 32,000 units of JY–65 for 20×1
should be made by Midwest or purchased from Marley.
2. Identify and briefly discuss three qualitative factors that the Midwest Division and Palisades
Corporation should consider before agreeing to purchase JY–65 from Marley Company.
3. By referring to the standards of ethical conduct for managerial accountants given in Chapter 1,
explain why Lynn Hardt would consider the request of John Porter to be unethical.
(CMA, adapted)
PennTech Corporation has been producing two precision bearings, components T79 and B81, f or use in
production in its central Pennsylvania plant. Data regarding these two components follow.
T79 B81
Machine hours required per unit …………………………………………………………………… 2.5 3.0
Standard cost per unit:
Direct material ………………………………………………………………………………………. $ 6.75 $11.25
Direct labor ………………………………………………………………………………………….. 12.00 13.50
Manufacturing overhead
Variable* ………………………………………………………………………………………….. 6.00 6.75
Fixed† ……………………………………………………………………………………………… 11.25 13.50
Total ……………………………………………………………………………………………………….. $36.00 $45.00
*Variable manufacturing overhead is applied on the basis of direct-labor hours.
†Fixed manufacturing overhead is applied on the basis of machine hours.
PennTech’s annual requirement for these components is 8,000 units of T79 and 11,000 units of
B81. Recently, management decided to devote additional machine time to other product lines, leaving
only 41,000 machine hours per year for producing the bearings. An outside company has offered to sell
PennTech its annual supply of bearings at prices of $33.75 for T79 and $40.50 for B81. Management
wants to schedule the otherwise idle 41,000 machine hours to produce bearings so that the firm can
minimize costs (maximize net benefits).
Required:
1. Compute the net benefit (loss) per machine hour that would result if PennTech Corporation accepts
the supplier’s offer of $40.50 per unit for component B81.
2. Choose the correct answer. PennTech Corporation will maximize its net benefits by:
a. Purchasing 4,800 units of T79 and manufacturing the remaining bearings.
b. Purchasing 8,000 units of T79 and manufacturing 11,000 units of B81.
c. Purchasing 11,000 units of B81 and manufacturing 8,000 units of T79.
d. Purchasing 4,000 units of B81 and manufacturing the remaining bearings.
e. Purchasing and manufacturing some amounts other than those given above.
3. Suppose management has decided to drop product T79. Independently of requirements (1) and
(2), assume that the company’s idle capacity of 41,000 machine hours has a traceable, avoidable
annual fixed cost of $132,000, which will be incurred only if the capacity is used. Calculate the
maximum price PennTech Corporation should pay a supplier for component B81.
(CMA, adapted)
Milwaukee Specialty C hemical Company (MSCC) is a diversified chemical processing company. The
firm manufactures swimming pool chemicals, chemicals for metal processing, specialized chemical
compounds, and pesticides.
■ Problem 14–54
Outsourcing Decision
(LO 14-4, 14-5)
1. Total variable cost per unit,
B81: $31.50
2. Total variable cost per unit,
T79: $24.75
■ Problem 14–55
Joint Products; Sell or
Process Further
(LO 14-6)
Total revenue from further
processing: $736,000
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Chapter 14 Decision Making: Relevant Costs and Benefits 629
Currently, the Noorwood plant is producing two derivatives, RNA–1 and RNA–2, from the chemi-
cal compound VDB developed by the company’s research labs. Each week 1,200,000 pounds of VDB
are processed at a cost of $393,600 into 800,000 pounds of RNA–1 and 400,000 pounds of RNA–2. The
proportion of these two outputs cannot be altered, because this is a joint process. RNA–1 has no market
value until it is converted into a pesticide with the trade name Fastkil. Processing RNA–1 into Fastkil
costs $384,000. Fastkil wholesales at $80 per 100 pounds.
RNA–2 is sold as is for $128 per hundred pounds. However, management has discovered that RNA–2
can be converted into two new products by adding 400,000 pounds of compound LST to the 400,000
pounds of RNA–2. This joint process would yield 400,000 pounds each of DMZ–3 and Pestrol, the two
new products. The additional direct-material and related processing costs of this joint process would be
$192,000. DMZ–3 and Pestrol would each be sold for $92.00 per 100 pounds. The company’s manage-
ment has decided not to process RNA–2 further based on the analysis presented in the following schedule.
Process Further
RNA–2 DMZ–3 Pestrol Total
Production in pounds ………………………………………….. 400,000 400,000 400,000
Revenue …………………………………………………………… $512,000 $368,000 $368,000 $736,000
Costs:
VDB costs …………………………………………………….. $131,200* $ 98,400 $ 98,400 $196,800†
Additional direct materials (LST)
and processing of RNA–2 …………………………….. — 96,000 96,000 192,000
Total costs …………………………………………………….. $131,200 $194,400 $194,400 $388,800
Weekly gross profit …………………………………………….. $380,800 $173,600 $173,600 $347,200
*$131,200 is one-third of the $393,600 cost of processing VDB. When RNA–2 is not processed further, one-third of the final output is
RNA–2 (400,000 out of a total of 1,200,000 pounds).
†$196,800 is one-half of the $393,600 cost of processing VDB. When RNA–2 is processed further, one-half of the final output consists of
DMZ–3 and Pestrol. The final products then are: 800,000 pounds of RNA–1; 400,000 pounds of DMZ–3; and 400,000 pounds of Pestrol.
Required: Evaluate MSCC’s management’s analysis, and make any revisions that are necessary. Your
critique and analysis should indicate:
a. Whether management made the correct decision.
b. The gross savings or loss per week resulting from the decision not to process RNA–2 further, if
different from management’s analysis.
(CMA, adapted)
In addition to fine chocolate, International Chocolate Company also produces c hocolate-covered pret-
zels in its Savannah plant. This product is sold in five-pound metal canisters, which also are manufac-
tured at the Savannah facility. The plant manager, Marsha Mello, was recently approached by Catawba
Canister Company with an offer to supply the canisters at a price of $.95 each. International Chocolate’s
traditional product-costing system assigns the following costs to canister production.
Direct material ……………………………………………………………………………………………………………………… $ 288,000
Direct labor (12,000 hr. at $16 per hr.) ………………………………………………………………………………………. 192,000
Variable overhead ($10 per direct-labor hr.) ………………………………………………………………………………… 120,000
Fixed overhead ($45 per direct-labor hr.) ……………………………………………………………………………………. 540,000
Total cost ……………………………………………………………………………………………………………………………. $1,140,000
Unit costs: $1,140,000 4 760,000 canisters 5 $1.50 per canister
Mello’s conventional make-or-buy analysis indicated that Catawba’s offer should be rejected, since
only $708,000 of costs would be avoided (including $80,000 of supervisory salaries and $28,000 of
machinery depreciation). In contrast, the firm would spend $722,000 buying the canisters. The con-
troller, Dave Mint, came to the rescue with an activity-based costing analysis of the decision. Mint
concluded that the cost-driver levels associated with canister production are as follows:

10 product specs 30 inspections
2,000 supervisory hours 15 setups
6,000 material-handling hours 70,000 machine hours
55 purchase orders
■ Problem 14–56
Conventional versus
Activity-Based-Costing
Analyses; Relevant Costs
(LO 14-5, 14-7)
2. Costs to be avoided by
purchasing, material handling:
$48,000
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630 Chapter 14 Decision Making: Relevant Costs and Benefits
Additional conventional and ABC data from the Savannah plant are given in Exhibits 14–19 and
14–20 on pages 609 and 610.
Required:
1. Show how Mello arrived at the $708,000 of cost savings in her conventional make-or-buy analysis.
2. Determine the costs that will be saved by purchasing canisters, using Mint’s ABC data.
3. Complete the ABC relevant-costing analysis of the make-or-buy decision. Should the firm buy
from Catawba?
4. If the conventional and ABC analyses yield different conclusions, briefly explain why.
Excalibur, Inc., received an order for a piece of special machinery from Rex Company. J ust as Excalibur
completed the machine, Rex Company declared bankruptcy, defaulted on the order, and forfeited the 10
percent deposit paid on the selling price of $217,500.
Excalibur’s manufacturing manager identified the costs already incurred in the production of the
special machinery for Rex Company as follows:

Direct material …………………………………………………………………………………………………………………….. $ 49,800
Direct labor ………………………………………………………………………………………………………………………… 64,200
Manufacturing overhead applied:
Variable …………………………………………………………………………………………………….. $32,100
Fixed ………………………………………………………………………………………………………… 16,050 48,150
Fixed selling and administrative costs ……………………………………………………………………………………….. 16,215
Total ………………………………………………………………………………………………………………………………….. $178,365
Another company, Kaytell Corporation, will buy the special machinery if it is reworked to Kaytell’s
specifications. Excalibur, Inc., offered to sell the reworked machinery to Kaytell as a special order for
$205,200. Kaytell agreed to pay the price when it takes delivery in two months. The additional identifi-
able costs to rework the machinery to Kaytell’s specifications are as follows:

Direct materials …………………………………………………………………… $18,600
Direct labor ………………………………………………………………………… 12,600
Total ………………………………………………………………………………….. $31,200
A second alternative available to Excalibur’s management is to convert the special machinery to the
standard model, which sells for $187,500. The additional identifiable costs for this conversion are as follows:

Direct materials ………………………………………………………………………. $ 8,550
Direct labor ……………………………………………………………………………. 9,900
Total ……………………………………………………………………………………… $18,450
A third alternative for Excalibur, Inc., is to sell the machine as is for a price of $156,000. However,
the potential buyer of the unmodified machine does not want it for 60 days. This buyer has offered a
$21,000 down payment, with the remainder due upon delivery.
The following additional information is available regarding Excalibur’s operations.
• The allocation rates for manufacturing overhead and fixed selling and administrative costs are:

Manufacturing costs:
Variable …………………………………………………………………… 50% of direct-labor cost
Fixed ………………………………………………………………………. 25% of direct-labor cost
Fixed selling and administrative costs ………………………………… 10% of the total of direct-material, direct-labor,
and manufacturing-overhead costs
• The sales commission rate on sales of standard models is 2 percent, while the rate on special orders
is 3 percent.
• Normal credit terms for sales of standard models are 2/10, net/30. This means that a customer
receives a 2 percent discount if payment is made within 10 days, and payment is due no later than
30 days after billing. Most customers take the 2 percent discount. Credit terms for a special order
are negotiated with the customer.
• Normal time required for rework is one month.
■ Problem 14–57
Analysis of Special Order
(LO 14-4, 14-5)
1. Net contribution, if sell
to Kaytell as special order:
$161,544
2. Contribution with reduced
price to Kaytell: $156,600
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Chapter 14 Decision Making: Relevant Costs and Benefits 631
Required:
1. Determine the dollar contribution each of the three alternatives will add to Excalibur’s before-tax profit.
2. If Kaytell makes Excalibur a counteroffer, what is the lowest price Excalibur should accept for the
reworked machinery from Kaytell? Explain your answer.
3. Discuss the influence fixed manufacturing-overhead cost should have on the sales price quoted by
Excalibur, Inc., for special orders.
(CMA, adapted)
Oceana C orporation manufactures and sells three products, which are manufactured in a factory with
four departments. Both labor and machine time are applied to the products as they pass through each
department. The machines and labor skills required in each department are so specialized that neither
machines nor labor can be switched from one department to another.
Inventory levels are satisfactory and need not be increased or decreased during the next six months.
Unit price and cost data that will be valid for the next six months are as follows:

Product
M50 T79 B81
Unit costs:
Direct material …………………………………………………………………………… $ 28 $ 52 $ 68
Direct labor:
Department 1 ………………………………………………………………………… 48 24 48
Department 2 ………………………………………………………………………… 84 56 56
Department 3 ………………………………………………………………………… $ 96 — $ 64
Department 4 ………………………………………………………………………… 36 $ 72 36
Variable overhead ………………………………………………………………………. 108 80 100
Fixed overhead ………………………………………………………………………….. 60 40 128
Variable selling expenses …………………………………………………………….. 12 8 16
Unit selling price ……………………………………………………………………………. 784 492 668
Oceana Corporation’s management is planning its production schedule for the next few months.
The planning is complicated, because there are labor shortages in the community and some machines
will be down several months for repairs.
The sales department believes that the monthly demand for the next six months will be as follows:

Product Monthly Unit Sales
M50 ………………………………………………………………………… 500
T79 …………………………………………………………………………. 400
B81 ………………………………………………………………………… 1,000
Management has assembled the following information regarding available machine and labor time
by department and the machine hours and direct-labor hours required per unit of product. These data
should be valid for the next six months.

Department
Monthly Capacity Availability 1 2 3 4
Normal machine capacity in machine hours …………………………. 3,500 3,500 3,000 3,500
Capacity of machines being repaired in machine hours ………….. (500) (400) (300) (200)
Available machine capacity in machine hours ………………………. 3,000 3,100 2,700 3,300
Available labor in direct-labor hours …………………………………… 3,700 4,500 2,750 2,600
Labor and Machine Specifications per Unit of Product
Product Labor and Machine Time
M50 ………… Direct-labor hours ………………………………… 2 3 3 1
Machine hours 1 1 2 2
T79 …………. Direct-labor hours ………………………………… 1 2 — 2
Machine hours 1 1 — 2
B81 ………… Direct-labor hours ………………………………… 2 2 2 1
Machine hours 2 2 1 1
■ Problem 14–58
Production Planning
(LO 14-5, 14-6)
1. Direct-labor hour require-
ments, Department 1, M50:
1,000
2. Contribution margin, T79:
$200 per unit
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632 Chapter 14 Decision Making: Relevant Costs and Benefits
Required:
1. Calculate the monthly requirement for machine hours and direct-labor hours for the production of
products M50, T79, and B81 to determine whether the monthly sales demand for the three prod-
ucts can be met by the factory.
2. What monthly production schedule should Oceana’s management select in order to maximize its
dollar profits? Explain how you selected this production schedule, and present a schedule of the
contribution to profit that would be generated by your production schedule.
3. Identify the alternatives management might consider so it can supply its customers with all the
product they demand.
(CMA, adapted)
Time Saver M eals, Inc., offers monthly service plans providing prepared meals that are delivered to
the customers’ homes. The target market for these meal plans includes double-income families with no
children and retired couples in upper income brackets. The firm offers two monthly plans: Premier Cui-
sine and Haute Cuisine. The Premier Cuisine plan provides frozen meals that are delivered twice each
month; this plan generates a contribution margin of $60 for each monthly plan sold. The Haute Cuisine
plan provides freshly prepared meals delivered on a daily basis and generates a contribution margin
of $45 for each monthly plan sold. The company’s reputation provides a market that will purchase all
the meals that can be prepared. All meals go through food preparation and cooking steps in the com-
pany’s kitchens. After these steps, the Premier Cuisine meals are flash frozen. The time requirements per
monthly meal plan and hours available per month are as follows:

Preparation Cooking Freezing
Hours required:
Premier Cuisine ……………………………………………….. 2 2 1
Haute Cuisine ………………………………………………….. 1 3 0
Hours available ……………………………………………………. 60 120 45
For planning purposes, management uses linear programming to determine the most profitable
number of Premier Cuisine and Haute Cuisine monthly meal plans to produce.
Required:
1. Using the notation P for Premier Cuisine and H for Haute Cuisine, state the objective function and
the constraints that management should use to maximize the total contribution margin generated
by the monthly meal plans.
2. Graph the constraints on the meal preparation process. Be sure to clearly label the graph.
3. Using the graph prepared in requirement (2), determine the optimal solution to the company’s
production planning problem in terms of the number of each type of meal plan to produce.
4. Calculate the value of the objective function at the optimal solution.
5. If the constraint on preparation time could be eliminated, determine the revised optimal
solution.
(CMA, adapted)
Galaxy C andy Company manufactures two popular candy bars, the Eclipse bar and the Nova bar. Both
candy bars go through a mixing operation where the various ingredients are combined, and the Coating
Department where the bars from the Mixing Department are coated with chocolate. The Eclipse bar is
coated with both white and dark chocolate to produce a swirled effect. A material shortage of an ingredi-
ent in the Nova bar limits production to 300 batches per day. Production and sales data are presented in
the following table. Both candy bars are produced in batches of 200 bars.

Use of Capacity in Hours per Batch of Product
Department
Available Daily
Capacity in Hours Eclipse Nova
Mixing …………………………………………………………… 525 1.5 1.5
Coating …………………………………………………………. 500 2.0 1.0
■ Problem 14–59
Linear Programming
(Appendix)
(LO 14-8)
1. Objective function:
Maximize 60P 1 45H
3. Contribution margin at
optimal solution: $2,250
■ Problem 14–60
Linear Programming;
Formulate and Solve
Graphically (Appendix)
(LO 14-8)
3. Total contribution margin:
$110,000
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Chapter 14 Decision Making: Relevant Costs and Benefits 633
Management believes that Galaxy can sell all of its daily production of both the Eclipse and Nova
bars. Other data follow.
Eclipse Nova
Selling price per batch …………………………………………………………………………. $ 600 $ 700
Variable cost per batch …………………………………………………………………………. 200 450
Monthly fixed costs (allocated evenly between both products) ……………………….. 750,000 750,000

Required:
1. Formulate the objective function and all of the constraints in order to maximize contribution
margin. Be sure to define the variables.
2. How many batches of each type of candy bar (Eclipse and Nova) should be produced to maximize
the total contribution margin?
3. Calculate the contribution margin at the optimal solution.
(CMA, adapted)
CoffeeTime, Inc., manufactures two types of electric coffeemakers, Regular and Deluxe. T h e major
difference between the two appliances is capacity. Both are considered top-quality units and sell for pre-
mium prices. Both coffeemakers pass through two manufacturing departments: Plating and Assembly.
The company has two assembly operations, one automated and one manual. The Automated Assembly
Department has been in operation for one year and was intended to replace the Labor Assembly Depart-
ment. However, business has expanded rapidly in recent months, and both assembly operations are still
being used. Workers have been trained for both operations and can be used in either department. The
only difference between the two departments is the proportion of machine time versus direct labor used.
Data regarding the two coffeemakers are presented in the following schedules.

Machine-Hour Data
Plating
Labor
Assembly
Automated
Assembly
Machine hours required per unit …………………………………………….. .15 .02 .05
Machine hours available per month …………………………………………. 25,000 1,500 5,000
Annual machine hours available ……………………………………………… 300,000 18,000 60,000

Unit Variable Manufacturing Costs
Plating Department
Regular Deluxe
Labor
Assembly
Automated
Assembly
Raw material:
Casing ………………………………………………………………. $15.50 $29.00 — —
Heating element ………………………………………………….. 12.00 12.00 — —
Other ………………………………………………………………… 16.50 16.50 — —
Direct labor:
At $20 per hour …………………………………………………… 4.00 4.00 — —
At $24 per hour …………………………………………………… — — $6.00 $1.20
Manufacturing overhead:
Supplies …………………………………………………………….. 2.50 2.50 3.00 3.00
Power ……………………………………………………………….. 2.40 2.40 1.50 3.60

Sales Data
Regular Model Deluxe Model
Selling price per unit ……………………………………………………………………… $ 90.00 $ 120.00
Variable selling cost per unit ……………………………………………………………. 6.00 6.00
Annual allocated fixed overhead ……………………………………………………….. 1,800,000 1,800,000
CoffeeTime produced and sold 600,000 Deluxe coffeemakers and 900,000 Regular coffeemakers
last year. Management estimates that total unit sales could increase by 20 percent or more if the units
can be produced. CoffeeTime already has contracts to produce and sell 35,000 units of each model each
month. CoffeeTime has a monthly maximum labor capacity of 30,000 direct-labor hours in the Plating
■ Problem 14–61
Linear Programming;
Formulate and Discuss
(Appendix)
(LO 14-8)
2. Contribution margin,
Regular Model in Labor
Assembly: $20.60 per unit
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634 Chapter 14 Decision Making: Relevant Costs and Benefits
Department and 40,000 direct-labor hours for the assembly operation (Automated Assembly and Labor
Assembly, combined). Sales, production, and costs occur uniformly throughout the year.
Required:
1. CoffeeTime’s management believes that linear programming could be used to determine the opti-
mum mix of Regular and Deluxe coffeemakers to produce and sell. Explain why linear program-
ming is appropriate to use in this situation.
2. Management has decided to use linear programming to determine the optimal product mix.
Formulate and label the following parts of the linear program. (Be sure to define your
variables.):
a. Objective function
b. Constraints
(CMA, adapted)
Cases
Ontario Pump C ompany, a small manufacturing company in Toronto, Ontario, manufactures three
types of pumps used in a variety of applications. For many years the company has been profitable and
has operated at capacity. However, in the last two years prices on all pumps were reduced and selling
expenses increased to meet competition and keep the plant operating at capacity. Second-quarter results
for the current year, which follow, typify recent experience.

ONTARIO PUMP COMPANY
Income Statement
Second Quarter
(in thousands)
R-Pump F-Pump S-Pump Total
Sales ………………………………………………………………… $4,800 $2,700 $2,700 $10,200
Cost of goods sold ……………………………………………….. 3,144 2,310 2,850 8,304
Gross margin ………………………………………………………. $1,656 $ 390 $ (150) $ 1,896
Selling and administrative expenses …………………………. 1,110 555 405 2,070
Income before taxes ……………………………………………… $ 546 $ (165) $ (555) $ (174)
Maria Carlo, the company’s president, is concerned about the results of the pricing, selling, and
production prices. After reviewing the second-quarter results she asked her management staff to con-
sider the following three suggestions:
• Discontinue the S-Pump line immediately. S-Pumps would not be returned to the product line
unless the problems with the pump can be identified and resolved.
• Increase quarterly sales promotion by $300,000 on the R-Pump product line in order to increase
sales volume by 15 percent.
• Cut production on the F-Pump line by 50 percent, and cut the traceable advertising and promotion
for this line to $60,000 each quarter.
Justin Sperry, the controller, suggested a more careful study of the financial relationships to deter-
mine the possible effects on the company’s operating results of the president’s proposed course of
action. The president agreed and assigned JoAnn Brower, the assistant controller, to prepare an analysis.
Brower has gathered the following information.
• The unit sales prices for the three pumps are as follows:

R-Pump ……………………………………………………………………………………… $600
F-Pump ………………………………………………………………………………………. 270
S-Pump ……………………………………………………………………………………… 540
• The company is manufacturing at capacity and is selling all the pumps it produces.
• All three pumps are manufactured with common equipment and facilities.
■ Case 14–62
Drop a Product Line
(LO 14-4, 14-5)
2(a). Unit contribution margin,
F-pump: $57
2(c). Contribution per
direct-labor dollar, R-pump:
$1.85
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Chapter 14 Decision Making: Relevant Costs and Benefits 635
• The selling and administrative expense is allocated to the three pump lines based on average sales
volume over the past three years.
• Special selling expenses (primarily advertising, promotion, and shipping) are incurred for each
pump as follows:

Quarterly Advertising
and Promotion Shipping Expenses
R-Pump ………………………………………… $630,000 $30 per unit
F-Pump …………………………………………. 300,000 12 per unit
S-Pump ………………………………………… 120,000 30 per unit
• The unit manufacturing costs for the three pumps are as follows:

R-Pump F-Pump S-Pump
Direct material ……………………………………………………………….. $ 93 $ 51 $150
Direct labor …………………………………………………………………… 120 60 180
Variable manufacturing overhead ……………………………………….. $135 $ 90 $180
Fixed manufacturing overhead …………………………………………… 45 30 60
Total …………………………………………………………………………….. $393 $231 $570
Required:
1. JoAnn Brower says that Ontario Pump Company’s product-line income statement for the
second quarter is not suitable for analyzing proposals and making decisions such as the ones
suggested by Maria Carlo. Write a memo to Ontario Pump’s president that addresses the
following points.
a. Explain why the product-line income statement as presented is not suitable for analysis and
decision making.
b. Describe an alternative income-statement format that would be more suitable for analysis and
decision making, and explain why it is better.
2. Use the operating data presented for Ontario Pump Company and assume that the president’s pro-
posed course of action had been implemented at the beginning of the second quarter. Then evalu-
ate the president’s proposal by specifically responding to the following points.
a. Are each of the three suggestions cost-effective? Support your discussion with an analysis that
shows the net impact on income before taxes for each of the three suggestions.
b. Was the president correct in proposing that the S-Pump line be eliminated? Explain your
answer.
c. Was the president correct in promoting the R-Pump line rather than the F-Pump line? Explain
your answer.
d. Does the proposed course of action make effective use of the company’s capacity? Explain
your answer.
3. Are there any qualitative factors that Ontario Pump Company’s management should consider
before it drops the S-Pump line? Explain your answer.
(CMA, adapted)
All Sports C ompany’s production manager, Chris Adler, had requested to have lunch with the com-
pany president. Adler wanted to put forward his suggestion to add a new product line. As they finished
lunch, Meg Thomas, the company president, said, “I’ll give your proposal some serious thought, Chris.
I think you’re right about the increasing demand for skateboards. What I’m not sure about is whether
the skateboard line will be better for us than our tackle boxes. Those have been our bread and butter the
past few years.”
Adler responded with, “Let me get together with one of the controller’s people. We’ll run a few
numbers on this skateboard idea that I think will demonstrate the line’s potential.”
All Sports is a wholesale distributor supplying a wide range of moderately priced sports equipment
to large chain stores. About 60 percent of All Sports’ products are purchased from other companies
while the remainder of the products are manufactured by All Sports. The company has a Plastics Depart-
ment that is currently manufacturing molded fishing tackle boxes. All Sports is able to manufacture and
■ Case 14–63
Adding a Product Line
(LO 14-4, 14-5)
1. Unit contribution margin,
purchased tackle boxes:
$14.00
2. Contribution from
manufacturing 8,000 boxes:
$264,000
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636 Chapter 14 Decision Making: Relevant Costs and Benefits
sell 8,000 tackle boxes annually, making full use of its direct-labor capacity at available work stations.
The selling price and costs associated with All Sports’ tackle boxes are as follows:

Selling price per box …………………………………………………………………………………………… $91.00
Costs per box:
Molded plastic ……………………………………………………………………………………………….. $13.00
Hinges, latches, handle ……………………………………………………………………………………. 9.00
Direct labor ($15.00 per hour) …………………………………………………………………………… 18.75
Manufacturing overhead ………………………………………………………………………………….. 12.50
Selling and administrative cost ………………………………………………………………………….. 17.00 70.25
Profit per box …………………………………………………………………………………………………….. $20.75
Because All Sports’ sales manager believes the firm could sell 12,000 tackle boxes if it had suffi-
cient manufacturing capacity, the company has looked into the possibility of purchasing the tackle boxes
for distribution. Maple Products, a steady supplier of quality products, would be able to provide up to
9,000 tackle boxes per year at a price of $73.00 per box delivered to All Sports’ facility.
All Sports’ production manager has come to the conclusion that the company could make better
use of its Plastics Department by manufacturing skateboards. Adler has a market study that indicates
an expanding market for skateboards and a need for additional suppliers. Adler believes that All Sports
could expect to sell 17,500 skateboards annually at a price of $50.00 per skateboard.
After his lunch with the company president, Adler worked out the following estimates with the
assistant controller.

Selling price per skateboard …………………………………………………………………………………. $50.00
Costs per skateboard:
Molded plastic ……………………………………………………………………………………………….. $10.50
Wheels, hardware …………………………………………………………………………………………… 7.00
Direct labor ($15.00 per hour) …………………………………………………………………………… 7.50
Manufacturing overhead ………………………………………………………………………………….. 5.00
Selling and administrative cost ………………………………………………………………………….. 9.00 39.00
Profit per skateboard …………………………………………………………………………………………… $11.00
In the Plastics Department, All Sports uses direct-labor hours as the application base for manufac-
turing overhead. Included in the manufacturing overhead for the current year is $50,000 of factorywide,
fixed manufacturing overhead that has been allocated to the Plastics Department. For each unit of prod-
uct that All Sports sells, regardless of whether the product has been purchased or is manufactured by
All Sports, there is an allocated $6.00 fixed overhead cost per unit for distribution that is included in the
selling and administrative cost for all products. Total selling and administrative costs for the purchased
tackle boxes would be $10.00 per unit.
Required: In order to maximize the company’s profitability, prepare an analysis that will show which
product or products All Sports Company should manufacture or purchase.
1. First determine which of All Sports’ options makes the best use of its scarce resources. How
many skateboards and tackle boxes should be manufactured? How many tackle boxes should be
purchased?
2. Calculate the improvement in All Sports’ total contribution margin if it adopts the optimal strategy
rather than continuing with the status quo.
(CMA, adapted)

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15
THIS CHAPTER’S FOCUS COMPANY is Sydney Sailing Supplies, a manufac-
turer of sailing supplies and equipment in Sydney, Australia. One of the com-
pany’s most popular products is the Wave Darter, a two-person sailboat. In this chapter, we will
explore a variety of issues surrounding how Sydney Sailing Supplies’ management could set a
price for the Wave Darter. We also will study a pricing method called target costing. Under
this approach, management determines what consumers are willing to pay for a particular
product. Then management must find a way to produce the product at a low
enough cost to justify the price that consumers are willing to pay.
FOCUS COMPANY >>>
Target Costing and
Cost Analysis for
Pricing Decisions
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In contrast to the product-pricing setting explored in the first part of the
chapter, we turn our attention to competitive bidding on projects, services,
or products. In a competitive-bidding situation, two or more companies submit sealed bids
for a job, and the buyer selects from among the bids. We will explore competitive bidding
in the context of Sydney Sailing Supplies’ Marine Services Division. The company’s Marine
Services Division specializes in marina maintenance and construction, and its management
is preparing a bid to build a new marina in Sydney harbor.
<<< IN CONTRAST hiL25664_ch15_638-677.indd 639hiL25664_ch15_638-677.indd 639 7/17/13 12:15 AM7/17/13 12:15 AM Final PDF to printer 640 Setting the price for an organization’s product or service is one of the most important decisions a manager faces. It is also one of the most difficult, due to the number and vari- ety of factors that must be considered. The pricing decision arises in virtually all types of organizations. Manufacturers set prices for the products they manufacture; merchan- dising companies set prices for their goods; service firms set prices for such services as insurance policies, train tickets, theme park admissions, and bank loans. Nonprofit orga- nizations often set prices also. For example, governmental units price vehicle registra- tions, park-use fees, and utility services. Art museums and symphonies set admission and ticket prices. The optimal approach to pricing often depends on the situation. Pricing a mature product or service that a firm has sold for a long time may be quite different from pricing a new product or service. Public utilities and TV cable companies face political considerations in pricing their products and services, since their prices often must be approved by a governmental commission. In this chapter, we will study pricing decisions, with an emphasis on the role of managerial accounting information. The setting for our discussion is Sydney Sailing Sup- plies, a manufacturer of sailing supplies and equipment located in Sydney, Australia. Major Influences on Pricing Decisions Four major influences govern the prices set by Sydney Sailing Supplies: 1. Customer demand. 2. Actions of competitors. 3. Costs. 4. Political, legal, and image-related issues. Major Influences on Pricing Decisions 15-1 List and describe the four major influences on pricing decisions. 15-2 Explain and use the economic, profit-maximizing pricing model. 15-3 Set prices using cost-plus pricing formulas. 15-4 Discuss the issues involved in the strategic pricing of new products. 15-5 List and discuss the key principles of target costing. 15-6 Explain the role of activity-based costing in setting a target cost. 15-7 Explain how product-cost distortion can undermine a firm’s pricing strategy. 15-8 Explain the process of value engineering and its role in target costing. 15-9 Determine prices using the time and material pricing approach. 15-10 Set prices in special-order or competitive-bidding situations by analyzing the rel- evant costs. 15-11 Describe the legal restrictions on setting prices. After completing this chapter, you should be able to: hiL25664_ch15_638-677.indd 640hiL25664_ch15_638-677.indd 640 7/17/13 12:15 AM7/17/13 12:15 AM Final PDF to printer Chapter 15 Target Costing and Cost Analysis for Pricing Decisions 641 Customer Demand The demands of customers are of paramount importance in all phases of business opera- tions, from the design of a product to the setting of its price. Product-design issues and pricing considerations are interrelated, so they must be examined simultaneously. For example, if customers want a high-quality sailboat, this will entail greater production time and more expensive raw materials. The result almost certainly will be a higher price. On the other hand, management must be careful not to price its product out of the market. Discerning customer demand is a critically important and continuous process. Compa- nies routinely obtain information from market research, such as customer surveys and test-marketing campaigns, and through feedback from sales personnel. To be successful, Sydney Sailing Supplies must provide the products its customers want at a price they perceive to be appropriate. Actions of Competitors Although Sydney Sailing Supplies’ managers would like the company to have the sailing market to itself, they are not so fortunate. Domestic and foreign competitors are striving to sell their products to the same customers. Thus, as Sydney Sailing Supplies’ manage- ment designs products and sets prices, it must keep a watchful eye on the firm’s competi- tors. If a competitor reduces its price on sailboats of a particular type, Sydney Sailing Supplies may have to follow suit to avoid losing its market share. Yet the company can- not follow its competitors blindly either. Predicting competitive reactions to its product- design and pricing strategy is a difficult but important task for Sydney Sailing Supplies’ management. In considering the reactions of customers and competitors, management must be careful to properly define its product. Should Sydney Sailing Supplies’ management define its product narrowly as sailing supplies, or more broadly as boating supplies? For example, if the company raises the price of its two-person sailboat, will this encour- age potential customers to switch to canoes, rowboats, and small motorboats? Or will most potential sailboat customers react to a price increase only by price-shopping among competing sailboat manufacturers? The way in which Sydney Sailing Supplies’ management answers these questions can profoundly affect its marketing and pricing strategies. Costs The role of costs in price setting varies widely among industries. In some industries, prices are determined almost entirely by market forces. An example is the agricultural industry, where grain and meat prices are market-driven. Farmers must meet the market price. To make a profit, they must produce at a cost below the market price. This is not always possible, so some periods of loss inevitably result. In other industries, manag- ers set prices at least partially on the basis of production costs. For example, cost-based pricing is used in the aircraft, household appliance, and gasoline industries. Prices are set by adding a markup to production costs. Managers have some latitude in determin- ing the markup, so market forces influence prices as well. In public utilities, such as electricity and natural gas companies, prices generally are set by a regulatory agency of the state government. Production costs are of prime importance in justifying utility rates. Typically, a public utility will make a request to the Public Utility Commission for a rate increase on the basis of its current and projected production costs. Balance of Market Forces and Cost-Based Pricing In most industries, both mar- ket forces and cost considerations heavily influence prices. No organization or indus- try can price its products below their production costs indefinitely. And no company’s Learning Objective 15-1 List and describe the four major influences on pricing decisions. hiL25664_ch15_638-677.indd 641hiL25664_ch15_638-677.indd 641 7/17/13 12:15 AM7/17/13 12:15 AM Final PDF to printer 642 Chapter 15 Target Costing and Cost Analysis for Pricing Decisions management can set prices blindly at cost plus a markup without keeping an eye on the market. In most cases, pricing can be viewed in either of the following ways. “You’re looked to for busi- ness expertise. You’re looked to also [for] business perspective, pricing strate- gies, manufacturing strate- gies, to see if they make sense financially.” (15a) Caterpillar Setting prices requires a balance between cost considerations and market forces. A good example is provided by the airlines, which keep a close eye on the fares of their competitors, while striving to cover operating costs. Prices are determined by the market, subject to the constraint that costs must be covered in the long run. Prices are based on costs, subject to the constraint that the reactions of customers and competitors must be heeded. Costs How Are Prices Set? Market forces Learning Objective 15-2 Explain and use the economic, profit-maximizing pricing model. In our illustration of Sydney Sailing Supplies’ pricing policies, we will assume the company responds to both market forces and costs. Political, Legal, and Image-Related Issues Beyond the important effects on prices of market forces and costs are a range of environmental considerations. In the legal area, managers must adhere to certain laws. The law generally prohibits companies from discriminating among their customers in setting prices. Also prohibited is collusion in price setting, where the major firms in an industry all agree to set their prices at high levels. Political considerations also can be relevant. For example, if the firms in an industry are perceived by the public as reaping unfairly large profits, there may be political pressure on legislators to tax those profits differentially or to intervene in some way to regulate prices. Companies also consider their public image in the price-setting process. A firm with a reputation for very- high-quality products may set the price of a new prod- uct high to be consistent with its image. As we have all discovered, the same brand-name product may be available in a discount store at half the price charged in a more exclusive store. Economic Profit-Maximizing Pricing Companies are sometimes price takers, which means their products’ prices are deter- mined totally by the market. Some agricultural commodities and precious metals are examples of such products. In most cases, however, firms have some flexibility in setting prices. Generally speaking, as the price of a product or service is increased, the quantity demanded declines, and vice versa. Total Revenue, Demand, and Marginal Revenue Curves The trade-off between a higher price and a higher sales quantity can be shown in the shape of the firm’s total revenue curve, which graphs the relationship between total sales revenue and quantity sold. Sydney Sailing Supplies’ total revenue curve for its two- person sailboat, the Wave Darter, is displayed in Exhibit 15–1 , panel A. The total revenue Economic Profit-Maximizing Pricing hiL25664_ch15_638-677.indd 642hiL25664_ch15_638-677.indd 642 7/17/13 12:15 AM7/17/13 12:15 AM Final PDF to printer Chapter 15 Target Costing and Cost Analysis for Pricing Decisions 643 Exhibit 15–1 Total Revenue, Demand, and Marginal Revenue Curves Dollars 0 a b Curve is increasing throughout its range, but at a declining rate Total revenue Quantity sold per month Dollars per unit Quantity sold per month Demand (or average revenue) Marginal revenue A. Total Revenue Curve B. Demand (or Average Revenue) Curve and Marginal Revenue Curve C. Tabulated Price, Quantity, and Revenue Data Quantity Sold Unit Total Revenue Changes in per Month Sales Price per Month Total Revenue 10 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $9,500 20 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 975 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,500 9,000 30 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 950 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,500 40 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 925 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37,000 8,500 50 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 900 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,000 8,000 60 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 875 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52,500 7,500 ot detaleRot detaleRot detaleR demand curve total revenue curve marginal revenue curve } } } } } hiL25664_ch15_638-677.indd 643hiL25664_ch15_638-677.indd 643 7/17/13 12:15 AM7/17/13 12:15 AM Final PDF to printer 644 Chapter 15 Target Costing and Cost Analysis for Pricing Decisions curve increases throughout its range, but the rate of increase declines as monthly sales quantity increases. To see this, notice that the increase in total revenue when the sales quantity increases from zero to a units is greater than the increase in total revenue when the sales quantity increases from a units to b units. Closely related to the total revenue curve are two other curves, which are graphed in panel B of Exhibit 15–1 . The demand curve shows the relationship between the sales price and the quantity of units demanded. The demand curve decreases throughout its range, because any decrease in the sales price brings about an increase in the monthly sales quantity. The demand curve is also called the average revenue curve, since it shows the average price at which any particular quantity can be sold. The marginal revenue curve shows the change in total revenue that accompanies a change in the quantity sold. The marginal revenue curve is decreasing throughout its range to show that total revenue increases at a declining rate as monthly sales quantity increases. A tabular presentation of the price, quantity, and revenue data for Sydney Sailing Supplies is displayed in panel C of Exhibit 15–1 . Study this table carefully to see how the data relate to the graphs shown in panels A and B of the exhibit. No matter what approach a manager takes to the pricing decision, a good understanding of the relationships shown in Exhibit 15–1 will lead to better decisions. Before we can fully use the revenue data, however, we must examine the cost side of Sydney Sailing Supplies’ business. Total Cost and Marginal Cost Curves Understanding cost behavior is important in many business decisions, and pricing is no exception. How does total cost behave as the number of Wave Darters produced and sold by Sydney Sailing Supplies changes? Panel A of Exhibit 15–2 displays the firm’s total cost curve, which graphs the relationship between total cost and the quantity produced and sold each month. 1 Total cost increases throughout its range. The rate of increase in total cost declines as quantity increases from zero to c units. To verify this, notice that the increase in total costs when quantity increases from zero to a units is greater than the increase in total costs when quantity increases from a units to b units. The rate of increase in total costs increases as quantity increases from c units upward. To verify this, notice that the increase in total costs as quantity increases from c units to d units is less than the increase in total costs as quantity increases from d units to e units. Closely related to the total cost curve is the marginal cost curve, which is graphed in panel B of Exhibit 15–2 . The marginal cost curve shows the change in total cost that accompanies a change in quantity produced and sold. Marginal cost declines as quantity increases from zero to c units; then it increases as quantity increases beyond c units. A tabular presentation of the cost and quantity data for Sydney Sailing Supplies is displayed in panel C of Exhibit 15–2 . Examine this table carefully, and trace the relation- ships between the data and the graphs shown in panels A and B of the exhibit. Profit-Maximizing Price and Quantity Now we have the tools we need to determine the profit-maximizing price and quantity. In Exhibit 15–3 , we combine the revenue and cost data presented in Exhibits 15–1 and 15–2 . Sydney Sailing Supplies’ profit-maximizing sales quantity for the Wave Darter is determined by the intersection of the marginal cost and marginal revenue curves. (See panel B of Exhibit 15–3 .) This optimal quantity is denoted by q * on the graph. The profit-maximizing price, denoted by p *, is determined from the demand curve for the quantity, q *. 1 Notice that the demand and revenue curves are based on the quantity sold, while the cost curves are based on the quantity produced. We will assume for simplicity that Sydney Sailing Supplies’ monthly sales and production quan- tities are the same. This assumption tends to be true in the pleasure boat industry. hiL25664_ch15_638-677.indd 644hiL25664_ch15_638-677.indd 644 7/17/13 12:15 AM7/17/13 12:15 AM Final PDF to printer Chapter 15 Target Costing and Cost Analysis for Pricing Decisions 645 Exhibit 15–2 Total Cost and Marginal Cost Curves Dollars a b Total cost increases at a declining rate in this range A. Total Cost Curve Total cost Quantity sold per monthc d e Dollars per unit B. Marginal Cost Curve Quantity sold per month Total cost increases at an increasing rate in this range Marginal cost c C. Tabulated Cost and Quantity Data Quantity Produced Average Cost Total Cost Changes in and Sold per Month per Unit per Month Total Cost 10 $1,920 . . . . . . . . . . . . . . . . . . . . . . . . . . . . $19,200 $ 5,600 20 1,240 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,800 4,300 30 970 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29,100 40 800 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,000 2,900 50 820 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41,000 9,000 60 940 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56,400 15,400 Related to total cost curve Related to marginal cost curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . } } } } } hiL25664_ch15_638-677.indd 645hiL25664_ch15_638-677.indd 645 7/17/13 12:15 AM7/17/13 12:15 AM Final PDF to printer 646 Chapter 15 Target Costing and Cost Analysis for Pricing Decisions Exhibit 15–3 Determining the Profit-Maxi- mizing Price and Quantity B. Marginal Revenue and Marginal Cost Curves Dollars Total profit at the profit-maximizing quantity and price A. Total Revenue and Total Cost Curves Total revenue Quantity produced and sold per month Dollars per unit Quantity produced and sold per month Demand (average revenue) Marginal revenue Total cost p* Marginal cost q* Intersection of marginal cost and marginal revenue curves C. Tabulated Revenue, Cost, and Profit Data Quantity Produced and Unit Total Revenue Total Cost Profit (Loss) Sold per Month Sales Price per Month per Month per Month 10 . . . . . . . . . . . . $1,000 $10,000 $19,200 $(9,200) 20 975 19,500 24,800 (5,300) 30 950 28,500 29,100 (600) 40 925 37,000 32,000 5,000 50 900 45,000 41,000 4,000 60 875 52,500 56,400 (3,900) Profit- maximizing quantity and price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . } Examine the total revenue and total cost curves in panel A of Exhibit 15–3 . At the profit-maximizing quantity (and price), the distance between these curves, which is equal to total profit, is maximized. hiL25664_ch15_638-677.indd 646hiL25664_ch15_638-677.indd 646 7/17/13 12:15 AM7/17/13 12:15 AM Final PDF to printer Chapter 15 Target Costing and Cost Analysis for Pricing Decisions 647 A tabular presentation of the revenue, cost, and profit data is shown in panel C of Exhibit 15–3 . Notice that monthly profit is maximized when the price is set at $925 and 40 Wave Darters are produced and sold each month. Price Elasticity The impact of price changes on sales volume is called the price elasticity. Demand is elastic if a price increase has a large negative impact on sales volume, and vice versa. Demand is inelastic if price changes have little or no impact on sales quantity. Cross- elasticity refers to the extent to which a change in a product’s price affects the demand for other substitute products. For example, if Sydney Sailing Supplies raises the price of its two-person sailboat, there may be an increase in demand for substitute recreational craft, such as small powerboats, canoes, or windsurfers. Measuring price elasticity and cross-elasticity is an important objective of market research. Having a good understanding of these economic concepts helps managers to determine the profit-maximizing price. Limitations of the Profit-Maximizing Model The economic model of the pricing decision serves as a useful framework for approach- ing a pricing problem. However, it does have several limitations. First, the firm’s demand and marginal revenue curves are difficult to discern with precision. Although market research is designed to gather data about product demand, it rarely enables management to predict completely the effects of price changes on the quantity demanded. Many other factors affect product demand in addition to price. Product design and quality, advertising and promotion, and company reputation also significantly influence consumer demand for a product. Second, the marginal-revenue, marginal-cost paradigm is not valid for all forms of market organization. In an oligopolistic market, where a small number of sellers com- pete among themselves, the simple economic pricing model is no longer appropriate. In an oligopoly, such as the automobile industry, the reactions of competitors to a firm’s pricing policies must be taken into account. While economists have studied oligopolistic pricing, the state of the theory is not sufficient to provide a thorough understanding of the impact of prices on demand. The third limitation of the economic pricing model involves the difficulty of measur- ing marginal cost. Cost accounting systems are not designed to measure the marginal changes in cost incurred as production and sales increase unit by unit. To measure mar- ginal costs would entail a very costly information system. Most managers believe that any improvements in pricing decisions made possible by marginal-cost data would not be sufficient to defray the cost of obtaining the information. Costs and Benefits of Information Managerial accountants always face a cost-benefit trade-off in the production of cost information for pricing and other decisions. As Exhibit 15–4 shows, only a sophisticated information system can collect marginal-cost data. However, such information is more costly to obtain. The result is that the optimal approach to pricing and other decisions is likely to lie in between the extremes shown in Exhibit 15–4 . For this reason, most man- agers make pricing decisions based on a combination of economic considerations and accounting product-cost information. In spite of its limitations, the marginal-revenue, marginal-cost paradigm of pricing serves as a useful conceptual framework for the pricing decision. Within this overall framework, managers typically rely heavily on a cost-based pricing approach, as we shall see next. hiL25664_ch15_638-677.indd 647hiL25664_ch15_638-677.indd 647 7/17/13 12:15 AM7/17/13 12:15 AM Final PDF to printer 648 Chapter 15 Target Costing and Cost Analysis for Pricing Decisions Role of Accounting Product Costs in Pricing Most managers base prices on accounting product costs, at least to some extent. There are several reasons for this. First, most companies sell many products or services. There simply is not enough time to do a thorough demand and marginal-cost analysis for every product or service. Managers must rely on a quick and straightforward method for setting prices, and cost-based pricing formulas provide it. Second, even though market consider- ations ultimately may determine the final product price, a cost-based pricing formula gives the manager a place to start. Finally, and most importantly, the cost of a product or service provides a floor below which the price cannot be set in the long run. Although a product may be “given away” initially, at a price below cost, a product’s price ultimately must cover its costs in order for the firm to remain in business. Even a nonprofit organization, unless it is heavily subsidized, cannot forever price products or services below their costs. Cost-Plus Pricing Cost-based pricing formulas typically have the following general form. Price 5 Cost 1 (Markup percentage 3 Cost) Such a pricing approach often is called cost-plus pricing, because the price is equal to cost plus a markup. Depending on how cost is defined, the markup percentage may differ. Several different definitions of cost, each combined with a different markup percentage, can result in the same price for a product or service. Exhibit 15–5 illustrates how Sydney Sailing Supplies’ management could use several different cost-plus pricing formulas and arrive at a price of $925 for the Wave Darter. Cost-plus formula (1) is based on variable manufacturing cost. Formula (2) is based on absorption (or full) manufacturing cost, which includes an allocated portion of fixed manufacturing costs. Formula (3) is based on all costs: both variable and fixed costs of the manufacturing, selling, and administrative functions. Formula (4) is based on all vari- able costs, including variable manufacturing, selling, and administrative costs. Notice that all four pricing formulas are based on a linear representation of the cost function, in which all costs are categorized as fixed or variable. As Sydney Sailing Supplies includes more costs in the cost base of the pricing for- mula, the required markup percentage declines. This reflects the fact that, one way or another, the price must cover all costs as well as a normal profit margin. If only variable manufacturing costs are included explicitly in the cost base, as in formula (1), then all of the other costs (and the firm’s profit) must be covered by the markup. However, if the cost base used in the pricing formula includes all costs, as in formula (3), the markup can be much lower, since it need cover only the firm’s normal profit margin. Role of Accounting Product Costs in Pricing “Today we spend more of our time analyzing and understanding . . . our margins, understanding our prices, understanding the markets in which we do business.” (15b) Caterpillar Learning Objective 15-3 Set prices using cost-plus pricing formulas. Exhibit 15–4 Cost-Benefit Trade-Off in Information Production Economic model of pricing Best approach, in terms of costs and benefits, typically lies between the extremes. Optimal Decisions Sophisticated decision model and information requirements Marginal-cost and marginal-revenue data Cost-based approach to pricing Suboptimal Decisions Simplified decision model and information requirements Accounting product- cost data More Costly Approach Less Costly Approach hiL25664_ch15_638-677.indd 648hiL25664_ch15_638-677.indd 648 7/17/13 12:15 AM7/17/13 12:15 AM Final PDF to printer Chapter 15 Target Costing and Cost Analysis for Pricing Decisions 649 Exhibit 15–5 Alternative Cost-Plus Pricing Formulas Each of the following cost-plus pricing formulas yields the same $925 price for the Wave Darter. Price and Cost Data Cost-Plus Pricing Formulas Variable manufacturing cost ................. $400 1 $925 $400 (131.25% $400) Variable maanufacturing cost Markup percentage Variiable manufacturing cost Applied fixed manufacturing cost ................. 250* Absorption manufacturing cost ................. 650 2 $925 $650 (42.3% $650) Absorption † mmanufacturing cost Markup percentage Abssorption manufacturing cost Variable selling and administrative cost ........... 50 Allocated fixed selling and administrative cost ........... 100* Total cost ............................... $800 3 $925 $800 (15.63% $800) Total cost † Markup percentage Total cost Variable manufacturing cost ................. $400 Variable selling and administrative cost ........... 50 Total variable cost ................... $450 4 $925 $450 (105.56% $450) Total vari† aable cost Markup percentage Total variablle cost * Based on planned monthly production of 40 units (or 480 units per year). † Rounded. ( ) ( ) ( ) ( ) A company typically uses only one of the four cost-plus pricing formulas illustrated in Exhibit 15–5 . Which formula is best? Let’s examine the advantages and disadvantages of each approach. Absorption-Cost Pricing Formulas Most companies that use cost-plus pricing use either absorption manufacturing cost or total cost as the basis for pricing products or services. [See formulas (2) and (3) in Exhibit 15–5 .] The reasons generally given for this tendency are as follows: 1. In the long run, the price must cover all costs and a normal profit margin. Basing the cost-plus formula on only variable costs could encourage managers to set too low a price in order to boost sales. This will not happen if managers understand that a variable cost-plus pricing formula requires a higher markup to cover fixed costs and profit. Nevertheless, many managers argue that people tend to view the cost base in a cost-plus pricing formula as the floor for setting prices. If prices are set too close to variable manufacturing cost, the firm will fail to cover its fixed costs. Ultimately, such a practice could result in the failure of the business. 2. Absorption-cost or total-cost pricing formulas provide a justifiable price that tends to be perceived as equitable by all parties. Consumers generally understand that a company must make a profit on its product or service in order to remain in business. Justifying a price as the total cost of production, sales, and administra- tive activities, plus a reasonable profit margin, seems reasonable to buyers. 3. When a company’s competitors have similar operations and cost structures, cost-plus pricing based on full costs gives management an idea of how com- petitors may set prices. 4. Absorption-cost information is provided by a firm’s cost accounting system, because it is required for external financial reporting under generally accepted hiL25664_ch15_638-677.indd 649hiL25664_ch15_638-677.indd 649 7/17/13 12:15 AM7/17/13 12:15 AM Final PDF to printer 650 Chapter 15 Target Costing and Cost Analysis for Pricing Decisions accounting principles. Since absorption-cost information already exists, it is cost-effective to use it for pricing. The alternative would involve preparing spe- cial product-cost data specifically for the pricing decision. In a firm with hun- dreds of products, such data could be expensive to produce. The primary disadvantage of absorption-cost or total-cost pricing formulas is that they obscure the cost behavior pattern of the firm. Since absorption-cost and total-cost data include allocated fixed costs, it is not clear from these data how the firm’s total costs will change as volume changes. Another way of stating this criticism is that absorption- cost data are not consistent with cost-volume-profit analysis. CVP analysis emphasizes the distinction between fixed and variable costs. This approach enables managers to pre- dict the effects of changes in prices and sales volume on profit. Absorption-cost and total- cost information obscures the distinction between variable and fixed costs. Variable-Cost Pricing Formulas To avoid blurring the effects of cost behavior on profit, some managers prefer to use cost- plus pricing formulas based on either variable manufacturing costs or total variable costs. [See formulas (1) and (4) in Exhibit 15–5 .] Three advantages are attributed to this pricing approach: 1. Variable-cost data do not obscure the cost behavior pattern by unitizing fixed costs and making them appear variable. Thus, variable-cost information is more consistent with cost-volume-profit analysis often used by managers to see the profit implications of changes in price and volume. 2. Variable-cost data do not require allocation of common fixed costs to individual product lines. For example, the annual salary of Sydney Sailing Supplies’ vice president of sales is a cost that must be borne by all of the company’s product lines. Arbitrarily allocating a portion of her salary to the Wave Darter product line is not meaningful. 3. Variable-cost data are exactly the type of information managers need when facing certain decisions, such as whether to accept a special order. This deci- sion, examined in detail in the preceding chapter, often requires an analysis that separates fixed and variable costs. The primary disadvantage of the variable-cost pricing formula was described earlier. If managers perceive the variable cost of a product or service as the floor for the price, they may tend to set the price too low for the firm to cover its fixed costs. Eventually this can spell disaster. Therefore, if variable-cost data are used as the basis for cost-plus pric- ing, managers must understand the need for higher markups to ensure that all costs are covered. Determining the Markup Regardless of which cost-plus formula is used, Sydney Sailing Supplies must determine its markup on the Wave Darter. If management uses a variable-cost pricing formula, the markup must cover all fixed costs and a reasonable profit. If management uses an absorp- tion-costing formula, the markup still must be sufficient to cover the firm’s profit on the Wave Darter product line. What constitutes a reasonable or normal profit margin? Return-on-Investment Pricing A common approach to determining the profit mar- gin in cost-plus pricing is to base profit on the firm’s target return on investment (ROI). To illustrate return-on-investment pricing, suppose Sydney Sailing Supplies’ pro- duction plan calls for 480 Wave Darters to be manufactured during the year. Based on the cost data shown in Exhibit 15–5 , this production plan will result in the following total costs. “An indemnity [insurance] company prices products by looking at existing costs and at what the trends have been. The company then predicts, or forecasts, costs for the next year and uses this information to set the price.” (15c) Bluecross Blueshield of North Carolina hiL25664_ch15_638-677.indd 650hiL25664_ch15_638-677.indd 650 7/17/13 12:15 AM7/17/13 12:15 AM Final PDF to printer Chapter 15 Target Costing and Cost Analysis for Pricing Decisions 651 Suppose the year’s average amount of capital invested in the Wave Darter product line is $300,000. If Sydney Sailing Supplies’ target return on investment for the Wave Darter line is 20 percent, the required annual profit is computed as follows: Average invested capital 3 Target ROI 5 Target profit $300,000 3 20% 5 $60,000 The markup percentage required to earn Sydney Sailing Supplies a $60,000 profit on the Wave Darter line depends on the cost-plus formula used. We will compute the markup percentage for two cost-plus formulas. 1. Cost-plus pricing based on total costs. The total cost of a Wave Darter is $800 per unit ( Exhibit 15–5 ). To earn a profit of $60,000 on annual sales of 480 sailboats, the company must make a profit of $125 per boat ($125 5 $60,000 4 480). This entails a markup percentage of 15.63 percent above total cost of $800. 15.63% 5 $925 _____ $800 2 100% A shortcut to the same conclusion uses the following formula. Markup percentage on total cost 5 Target profit _______________________________ Annual volume 3 Total cost per unit 15.63% 5 $60,000 ___________ 480 3 $800 2. Cost-plus pricing based on total variable costs. The total variable cost of a Wave Darter is $450 per unit ( Exhibit 15–5 ). The markup percentage applied to variable cost must be sufficient to cover both annual profit of $60,000 and total annual fixed costs of $168,000. The required markup percentage is computed as follows: Markup percentage on total variable cost 5 Target profit 1 Total annual fixed cost ______________________________________ Annual volume 3 Total variable cost per unit 105.56% 5 $60,000 1 $168,000 __________________ 480 3 $450 General Formula The general formula for computing the markup percentage in cost- plus pricing to achieve a target ROI is as follows: Markup percentage applied to cost base in cost-plus pricing formula 5 Profit required to achieve target ROI 1 Total annual costs not included in cost base ____________________________________ Annual volume 3 Cost base per unit used in cost-plus pricing formula Exercise 15–34 at the end of the chapter gives you an opportunity to employ this for- mula to compute the markup percentage for the other two cost-plus pricing formulas in Exhibit 15–5 . Variable costs: Manufacturing ............................................................................................................. $192,000 Selling and administrative ............................................................................................. 24,000 Total variable costs ....................................................................................................... $216,000 Fixed costs: Manufacturing ............................................................................................................. $120,000 Selling and administrative ............................................................................................. 48,000 Total fixed costs ........................................................................................................... 168,000 Total costs ....................................................................................................................... $384,000 hiL25664_ch15_638-677.indd 651hiL25664_ch15_638-677.indd 651 7/17/13 12:15 AM7/17/13 12:15 AM Final PDF to printer 652 Chapter 15 Target Costing and Cost Analysis for Pricing Decisions Cost-Plus Pricing: Summary and Evaluation We have examined two different approaches to setting prices: (1) the economic, profit- maximizing approach and (2) cost-plus pricing. Although the techniques involved in these methods are quite different, the methods complement each other. In setting prices, managers cannot ignore the market, nor can they ignore costs. Cost-plus pricing is used widely in prac- tice to establish a starting point in the process of determining a price. Cost-plus formulas are simple; they can be applied mechanically without taking the time of top management. They make it possible for a company with hundreds of products or services to cope with the tasks of updating prices for existing products and setting initial prices for new products. Cost-plus pricing formulas can be used effectively with a variety of cost definitions, but the markup percentage must be appropriate for the type of cost used. It is imperative that price-setting managers understand that ultimately the price must cover all costs and a normal profit margin. Absorption-cost-plus or total-cost-plus pricing has the advantage of keeping the manager’s attention focused on covering total costs. The variable-cost-plus formulas have the advantage of not obscuring important information about cost behavior. Cost-plus pricing formulas establish a starting point in setting prices. Then the price setter must weigh market conditions, likely actions of competitors, and general business conditions. Thus, effective price setting requires a constant interplay of market consider- ations and cost awareness. REAL TIME PRICE WARS Intense price competition, sometimes referred to as a price war, can occur in any industry. Now price wars are taking on a new flavor, though, as they play out in real time. As The Wall Street Journal reported, this phenomenon is happening in the retail industry, particularly around the all-important year-end holiday shopping period. “The historical race between e-commerce retailers and their physical-store rivals continues. But in a new development, bricks-and-mortar retailers are turning the tables, using their websites to match rivals’ mar- quee discounts more aggressively than ever. When Target advertised plans to sell a $400 Dyson Ball vacuum cleaner for $269, Best Buy responded by cutting its online price.” And Best Buy was not immune from the pricecutting either. “When the electronics retailer pub- lished a circular advertising it would sell a $1,500 Nikon camera for $1,000, Amazon.com” immediately responded by “cutting its price for the same camera to $997.” The fact that various retailers were responding in kind to their competitors’ price cuts is not new. What is new, though, is the retailers’ near instant reaction to their competi- tors’ prices through the use of technology. “The fast price changes during the year’s most competitive shopping period highlight a sea change in how retailing is done. The rise of e-commerce, along with an explosion in data and the power of technology for analyzing it, has made it possible for retailers of all stripes to monitor their rivals’ pricing strategies and react in seconds.” Consumers may be the beneficiaries in such a real-time price war, as prices decline. “For retailers, however, the risk is profit-killing discounting” as they compete ever more aggressively to stand out in the pack. Therefore, “to fight online competition, retailers try to shift as much as possible to exclusive gear that can’t easily be matched. They’re also matching more of their offline deals in their online stores.” In general, “the spread of e-commerce means that most retailers will have to get used to flexible pricing.”2 2Dana Mattioli, “Price War Rages in Real Time,” The Wall Street Journal, November 23, 2012, p. B1. M A P anagement ccounting ractice Target, Best Buy, and Amazon.com hiL25664_ch15_638-677.indd 652hiL25664_ch15_638-677.indd 652 7/17/13 12:15 AM7/17/13 12:15 AM Final PDF to printer Chapter 15 Target Costing and Cost Analysis for Pricing Decisions 653 Strategic Pricing of New Products Pricing a new product is an especially challenging decision problem. The newer the con- cept of the product, the more difficult the pricing decision is. For example, if Sydney Sailing Supplies comes out with a new two-person sailboat, its pricing problem is far easier than the pricing problem of a company that first markets products using a radically new technology. Genetic engineering, superconductivity, artificial hearts, and space- grown crystals are all examples of such frontier technologies. Pricing a new product is harder than pricing a mature product because of the magni- tude of the uncertainties involved. New products entail many uncertainties. For example, what obstacles will be encountered in manufacturing the product, and what will be the costs of production? Moreover, after the product is available, will anyone want to buy it, and at what price? If Sydney Sailing Supplies decides to market a new two-person sail- boat, management can make a good estimate of both the production costs and the poten- tial market for the product. The uncertainties here are far smaller than the uncertainties facing a company developing artificial hearts. In addition to the production and demand uncertainties, new products pose another sort of challenge. There are two widely differing strategies that a manufacturer of a new product can adopt. One strategy is called skimming pricing, in which the initial product price is set high, and short-term profits are reaped on the new product. The initial market will be small, due in part to the high initial price. This pricing approach often is used for unique products, where there are people who “must have it” whatever the price. As the product gains acceptance and its appeal broadens, the price is lowered gradually. Eventu- ally the product is priced in a range that appeals to several kinds of buyers. An example of a product for which skimming pricing was used is the high-definition television. Initially HDTVs were priced quite high and were affordable by only a few buyers. Eventually the price was lowered, and HDTVs were purchased by a wide range of consumers. An alternative initial pricing strategy is called penetration pricing, in which the initial price is set relatively low. By setting a low price for a new product, management hopes to penetrate a new market deeply, quickly gaining a large market share. This pric- ing approach often is used for products that are of good quality, but do not stand out as vastly better than competing products. The decision between skimming and penetration pricing depends on the type of prod- uct and involves trade-offs of price versus volume. Skimming pricing results in much slower acceptance of a new product, but higher unit profits. Penetration pricing results in greater initial sales volume, but lower unit profits. Regardless of the pricing strategy used, companies must closely monitor and manage costs in order to remain price competitive. Target Costing Earlier in this chapter, we described product pricing as a process whereby the cost of the product is determined, and then an appropriate price is chosen. Increasingly, the opposite approach is being taken. The company first uses market research to determine the price at which a new product can be sold. Given the likely sales price, management computes the cost for which the product must be manufactured in order to provide the firm with an acceptable profit margin. Finally, engineers and cost analysts work together to design a product that can be manufactured for the allowable cost. This process, called target costing, is used widely by companies in the development stages of new products. A new product’s target cost is the projected long-run cost that will enable a firm to enter and remain in the market for the product and compete successfully with the firm’s competitors. Strategic Pricing of New Products Target Costing Learning Objective 15-4 Discuss the issues involved in the strategic pricing of new products. “HMOs go to the market- place and ask what is the competitive market rate to sell business. Through mar- ket pricing, they determine what the rate has to be and then manage their costs accordingly.” (15d) BlueCross BlueShield of North Carolina Learning Objective 15-5 List and discuss the key principles of target costing. hiL25664_ch15_638-677.indd 653hiL25664_ch15_638-677.indd 653 7/17/13 12:15 AM7/17/13 12:15 AM Final PDF to printer 654 Chapter 15 Target Costing and Cost Analysis for Pricing Decisions DYNAMIC PRICING ON THE INTERNET BY “E-TAILERS” Pricing on the Internet “was expected to offer retailers a number of advantages.” First, “it would be far easier to raise or lower prices in response to demand, without the need of a clerk running through a store with a pricing gun. Online prices could be changed in far smaller increments—even by just a penny or two—as frequently as a merchant desired, making it possible to fine-tune pricing strategies.” The real payoff, though, “was supposed to be better information on exactly how price-conscious customers are. For instance, knowing that customer A doesn’t care whether the latest popular DVD in her shopping basket costs $21.95 or $25.95 would leave an enterprising merchant free to charge the higher price on the spot. By contrast, knowing that customer B is going to put author John Le Carre’s latest thriller back on the shelf unless it’s priced at $20, instead of $28, would open an opportunity for a bookseller to make the sale by cutting the price in real time.” However, putting this concept “into practice online has turned out to be exceptionally difficult, in part because the Internet also has empowered consumers to compare prices to find out if other merchants are offering a better deal or if other consumers are getting a bigger break.” It has also made it easier for consumers to register a complaint. For example, “ Amazon.com raised a furor . . . when customers learned they were paying different prices for the same DVD movies, the result of a marketing test in which the retailer varied prices to gauge the effect on demand.” After receiving many complaints from irate consumers, “Amazon announced it would refund the difference between the highest and lowest prices in the test.” 3 3 David P. Hamilton, “The Price Isn’t Right: Internet Pricing Has Turned Out to Be a Lot Trickier Than Retailers Expected,” The Wall Street Journal, February 12, 2001, p. R8; Also see Kate Kaye, “Retailers Embrace Data Tools for Rapid-Fire Price Changes,” Ad-Age Digital (on line), January 24, 2013, p. 1. 4This section is based on Shahid L. Ansari, Jan E. Bell, and the CAM-I Target Cost Core Group, Target Costing: The Next Frontier in Strategic Cost Management (Burr Ridge, IL: Irwin, 1997). A Strategic Profit and Cost Management Process Target costing can be a critical tool for management as it seeks to strategically manage the company’s costs and profits. By ensuring that products are designed so that they can be produced at a low enough cost to be priced competitively, management can achieve and maintain a sustainable competitive position in the market. Key Principles of Target Costing Target costing involves seven key principles. 4 • Price-led costing. Target costing sets the target cost by first determining the price at which a product can be sold in the marketplace. Subtracting the target profit margin from this target price yields the target cost, that is, the cost at which the product must be manufactured. This simple, but strategically impor- tant, relationship can be expressed in the following equation. Target cost 5 Target price 2 Target profit Notice that in a target costing approach, the price is set first, and then the target product cost is determined. This is opposite from the order in which the product cost and selling price are determined under traditional cost-plus pricing. • Focus on the customer. To be successful at target costing, management must lis- ten to the company’s customers. What products do they want? What features are important? How much are they willing to pay for a certain level of product qual- ity? Management needs to aggressively seek customer feedback, and then prod- ucts must be designed to satisfy customer demand and be sold at a price they are willing to pay. In short, the target costing approach is market driven. Amazon.com M A P anagement ccounting ractice hiL25664_ch15_638-677.indd 654hiL25664_ch15_638-677.indd 654 7/17/13 12:15 AM7/17/13 12:15 AM Final PDF to printer Chapter 15 Target Costing and Cost Analysis for Pricing Decisions 655 • Focus on product design. Design engineering is a key element in target costing. Engineers must design a product from the ground up so that it can be produced at its target cost. This design activity includes specifying the raw materials and components to be used as well as the labor, machinery, and other elements of the production process. In short, a product must be designed for manufacturability. • Focus on process design. As indicated in the preceding point, every aspect of the production process must be examined to make sure that the product is produced as efficiently as possible. The use of touch labor, technology, global sourcing in procurement, and every aspect of the production process must be designed with the product’s target cost in mind. • Cross-functional teams. Manufacturing a product at or below its target cost requires the involvement of people from many different functions in an orga- nization: market research, sales, design engineering, procurement, production engineering, production scheduling, material handling, and cost management. Individuals from all these diverse areas of expertise can make key contributions to the target costing process. Moreover, “a cross-functional team is not a set of specialists who contribute their expertise and then leave; they are responsible for the entire product.” 5 • Life-cycle costs. In specifying a product’s target cost, analysts must be careful to incorporate all of the product’s life-cycle costs. These include the costs of prod- uct planning and concept design, preliminary design, detailed design and test- ing, production, distribution, and customer service. Traditional cost-accounting systems have tended to focus only on the production phase and have not paid enough attention to the product’s other life-cycle costs. 6 • Value-chain orientation. Sometimes the projected cost of a new product is above the target cost. Then efforts are made to eliminate non-value-added costs to bring the projected cost down. 7 In some cases, a close look at the company’s entire value chain can help managers identify opportunities for cost reduction. For example, Procter & Gamble placed order-entry computers in Walmart stores. This resulted in substantial savings in order-processing costs for both companies. 8 5Ibid., p. 15. 6See Chapter 9 for further discussion of product life-cycle costing. 7The elimination of non-value-added costs is covered in Chapter 5 as part of the discussion of activity-based management. 8J. Shank and V. Govindarajan, “Strategic Cost Management and the Value Chain,” Journal of Cost Management 5, no. 4 (Winter 1992), p. 10. See also T. Tanaka, “Target Costing at Toyota,” Journal of Cost Management 7, no. 1 (Spring 1993), pp. 4–12. Ta rget C o s t Price-led costing Customer focus Product design Process design Cross-functional teams Life-cycle costing Value-chain orientation “Target costing is neither easily nor quickly done.” (15e) U.S. Navy Acquisition Center “Target costing with sup- pliers involves developing detailed cost models of both existing products and those in development. This necessitates the open shar- ing of cost information in an ethical and professional manner.” (15f) Eastman Kodak Company hiL25664_ch15_638-677.indd 655hiL25664_ch15_638-677.indd 655 7/17/13 12:15 AM7/17/13 12:15 AM Final PDF to printer 656 Chapter 15 Target Costing and Cost Analysis for Pricing Decisions Activity-Based Costing and Target Costing An activity-based costing (ABC) system can be particularly helpful as product design engineers try to achieve a product’s target cost. ABC enables designers to break down the production process for a new product into its component activities. Then designers can attempt cost improvement in particular activities to bring a new product’s projected cost in line with its target cost. To illustrate, Sydney Sailing Supplies’ Marine Instruments Division, located in Perth, Australia, wants to introduce a new depth finder. Target costing studies indicate that a target cost of $340 must be met in order to successfully compete in this market. Exhibit 15–6 shows how ABC was used to bring the depth finder’s initial cost estimate of $399 down to $337, just below the target cost. The company’s design engineers were able to focus on key activities in the production process, such as material handling and inspection, and reduce the projected costs. Computer-Integrated Manufacturing When a computer-integrated manufacturing (CIM) system is used, the process of target costing sometimes is computerized. A manu- facturer’s computer-aided design and cost-accounting software are interconnected. An engineer can try out many different design features and immediately see the product-cost implications, without ever leaving the computer terminal. Product-Cost Distortion and Pricing: The Role of Activity-Based Costing Use of a traditional, volume-based product-costing system may result in significant cost distortion among product lines. In many cases, high-volume and relatively simple Learning Objective 15-6 Explain the role of activity- based costing in setting a target cost. “A key Honda philosophy is that ‘cost is a result.’ To get better results, you must manage the cost drivers.” (15g) Honda of America Manufacturing, Inc. Exhibit 15–6 Target Costing and Cost Improvement for a New Product Learning Objective 15-7 Explain how product-cost dis- tortion can undermine a firm’s pricing strategy. A. Activity-Based Costing System Activity Cost Pool Cost Driver Pool Rate Purchasing Number of parts $1 per part Material handling Dollar value of parts $.20 per direct-material dollar Inspection Inspection hours $28 per inspection hour This is a highly simplified example of activity-based costing (ABC), which is covered in Chapter 5. B. Cost Projections for a New Product: Depth Finder Original Cost Projection Improved Cost Projection Direct material .......................................................... $200 $190 Direct labor ............................................................... 100 70 Purchasing: $1 per part (45 parts) ............................................ 45 $1 per part (32 parts) ............................................ 32 Material handling: $.20 per direct-material dollar ($200) .................... 40 $.20 per direct-material dollar ($190) .................... 38 Inspection: $28 per inspection hour (.5 hour) ........................... 14 $28 per inspection hour (.25 hour) ......................... 7 Total projected cost ................................................... $399 $337 Target cost ............................................................... $340 hiL25664_ch15_638-677.indd 656hiL25664_ch15_638-677.indd 656 7/17/13 12:15 AM7/17/13 12:15 AM Final PDF to printer Chapter 15 Target Costing and Cost Analysis for Pricing Decisions 657 products are overcosted while low-volume and complex products are undercosted. This results from the fact that high-volume and relatively simple products require propor- tionately less activity per unit for various manufacturing-support activities than do low- volume and complex products. Yet a traditional product-costing system, in which all overhead is assigned on the basis of a single unit-level activity like direct-labor hours, fails to capture the cost implications of product diversity. In contrast, an activity-based costing (ABC) system does measure the extent to which each product line drives costs in the key production-support activities. Managers should be aware that cost distortion can result in overpricing high-volume and relatively simple products, while low-volume and complex products are undercosted. This can undermine any effort to set prices competitively, even under the target-costing approach. The competitive implications of such strategic pricing errors can be disastrous. 9 Value Engineering and Target Costing Target costing is an outgrowth of the concept of value engineering, which is a cost- reduction and process-improvement technique that utilizes information collected about a product’s design and production processes and then examines various attributes of the design and processes to identify candidates for improvement efforts. Much of the historical development of the target-costing approach has taken place in Japanese industry, where “more than 80 percent of all assembly industries in Japan use target costing. Some of the best practitioners of target costing are leading Japanese companies.” 10 In recent years, however, many other companies, including Caterpillar, Chrysler, and Boeing have made significant contributions to target costing theory and practice. Isuzu Motors, Ltd. is a leading Japanese manufacturer of automobiles, buses, and both light- and heavy-duty trucks. “At Isuzu, value engineering (VE) has been developed to cover all stages of product design and manufacture. Indeed, three different stages of VE—zeroth, first, and second ‘looks’—are used in the design phase to increase the func- tionality of new products.” 11 • Zeroth look VE is applied at the earliest stages of new product design—“the con- cept proposal stage, when the basic concept of the product is developed and its preliminary quality, cost, and investment targets are established.” • First look VE is applied during the last half of the concept proposal stage and throughout the product planning phase. During this stage, a product’s qual- ity, functionality, and selling price are determined; a design plan is submitted; and target costs are determined for each of the new vehicle’s major functions (e.g., engine and transmission). Also, the degree of component commonality is set. “First look VE is used at this stage to increase the value of the product by increasing its functionality without increasing its cost.” • Second look VE is applied during the last half of the product planning stage and the first half of the product development and preparation stage. “The compo- nents of the vehicle’s major functions are identified, and hand-made prototypes are assembled. At this stage, VE works to improve the value and functionality of existing components, not to create new ones.” 9 This whole issue of cost distortion and the role of ABC in product pricing is covered extensively in Chapter 5. 10Shahid L. Ansari, Jan E. Bell, and the CAM-I Target Cost Core Group, Target Costing: The Next Frontier in Strategic Cost Management (Burr Ridge, IL: Irwin, 1997). See also Y. Kato, “Target Costing Support Systems: Lessons from Leading Japanese Companies,” Management Accounting Research 4 (1992), pp. 33–47; and T. Tani, H. Okano, N. Shimizu, Y. Iwabuchi, J. Fukuda, and S. Cooray, “Target Cost Management in Japanese Companies: Current State of the Art,” Management Accounting Research 6 (1994), pp. 67–81. 11This description of Isuzu’s target costing and value-engineering methods is drawn from Robin Cooper, When Lean Enterprises Collide (Boston, MA: Harvard Business School Press, 1995), pp. 165–83. Learning Objective 15-8 Explain the process of value engineering and its role in target costing. hiL25664_ch15_638-677.indd 657hiL25664_ch15_638-677.indd 657 7/17/13 12:15 AM7/17/13 12:15 AM Final PDF to printer 658 Chapter 15 Target Costing and Cost Analysis for Pricing Decisions In addition, various tear-down methods are used by Isuzu, and many other com- panies, “to analyze competitive products in terms of materials they contain, parts they use, ways they function, and ways they are manufactured.” At Isuzu, for example, dynamic tear-down focuses on reducing the number of vehicle assembly operations or the time required to perform them. Cost tear-down examines ways to reduce the cost of the com- ponents used in a vehicle. Material tear-down compares the materials and surface treat- ments of the components used by Isuzu with those of its competitors. Static tear-down disassembles a competitor’s product into its components to enable Isuzu’s engineers to compare Isuzu’s components with those used in the competitor’s product. Although the Isuzu approach is illustrative of target costing methods, many different approaches are used by the thousands of companies now engaged in target costing pro- grams. However, the Isuzu target costing and value-engineering process is indicative of the seriousness with which companies approach the problem of reducing costs in order to meet a product’s target cost and remain competitive in an ever more difficult market. Time and Material Pricing Another cost-based approach to pricing is called time and material pricing. Under this approach, the company determines one charge for the labor used on a job and another charge for the materials. The labor typically includes the direct cost of the employee’s time and a charge to cover various overhead costs. The material charge generally includes the direct cost of the materials used in a job plus a charge for material handling and stor- age. Time and material pricing is used widely by construction companies, printers, repair shops, and professional firms, such as engineering, law, and public accounting firms. To illustrate, we will examine a special job undertaken by Sydney Sailing Supplies. The company’s vice president for sales, Richard Moby, was approached by a successful local physician about refurbishing her yacht. She wanted an engine overhaul, complete refurbishment and redecoration of the cabin facilities, and stripping and repainting of the hull and deck. The work would be done in the Repair Department of the company’s Yacht Division, located in Melbourne, Australia. Data regarding the operations of the Repair Department are as follows: Time and Material Pricing “An old Japanese saying states that ‘there are many ways to the top of a moun- tain.’ Analogously, there is no one right way to do target costing.” (15h) Honda of America Manufacturing, Inc. Learning Objective 15-9 Determine prices using the time and material pricing approach. Labor rate, including fringe benefits ................................................................................................... $18.00 per hour Hourly charge to cover profit margin ................................................................................................... $7.00 per hour Annual labor hours ............................................................................................................................ 10,000 hours Annual overhead costs: Material handling and storage ........................................................................................................ $40,000 Other overhead costs (supervision, utilities, insurance, and depreciation) .......................................... $200,000 Annual cost of materials used in Repair Department ............................................................................ $1,000,000 Time Charges Hourly labor cost + Hourly charge to cover profit margin + Annual overhead (excluding material handling and storage) Annual labor hours $18 per hour + $7 per hour $45 per labor hour + = $200,000 10,000 hours Based on these data, the Repair Department computed its time and material prices as follows: hiL25664_ch15_638-677.indd 658hiL25664_ch15_638-677.indd 658 7/17/13 12:15 AM7/17/13 12:15 AM Final PDF to printer Chapter 15 Target Costing and Cost Analysis for Pricing Decisions 659 The effect of the material-charge formula is to include a charge for the costs incurred in the handling and storage of materials. Richard Moby estimates that the yacht refurbishment job will require 200 hours of labor and $8,000 in materials. Moby’s price quotation for the job is shown in the Excel spreadsheet in Exhibit 15–7 . Included in the $17,320 price quotation for the yacht refurbishment are charges for labor costs, overhead, material costs, material handling and storage costs, and a normal profit margin. Some companies also charge an additional markup on the materials used in a job in order to earn a profit on that component of their services. Sydney Sailing Sup- plies’ practice is to charge a high enough profit charge on its labor to earn an appropriate profit for the Repair Department. Competitive Bidding In a competitive bidding situation, two or more companies submit sealed bids (or prices) for a project, service, or product to a potential buyer. The buyer selects one of the companies for the job on the basis of the bid price and the design specifications for the job. Competi- tive bidding complicates a manager’s pricing problem, because now the manager is in direct Competitive Bidding Exhibit 15–7 Time and Material Pricing Learning Objective 15-10 Set prices in special-order or competitive-bidding situations by analyzing the relevant costs. Material Charges Material cost incurred on job Material cost incurred on job + 3 Material handling and storage costs Annual cost of materials used in Repair Department Material cost incurred on job Material cost incurred on job + 3 $40,000 $1,000,000 $.04 per dollar of material cost ( ) ( ) hiL25664_ch15_638-677.indd 659hiL25664_ch15_638-677.indd 659 7/17/13 12:15 AM7/17/13 12:15 AM Final PDF to printer 660 Chapter 15 Target Costing and Cost Analysis for Pricing Decisions competition with one or more competitors. If all of the companies submitting bids offer a roughly equivalent product or service, the bid price becomes the sole criterion for selecting the contractor. The higher the price that is bid, the greater will be the profit on the job, if the firm gets the contract. However, a higher price also lowers the probability of obtaining the contract to perform the job. Thus, there is a trade-off between bidding high, to make a good profit, and bidding low, to land the contract. Some say there is a “winner’s curse” in com- petitive bidding, meaning that the company bidding low enough to beat out its competitors probably bid too low to make an acceptable profit on the job. Despite the winner’s curse, competitive bidding is a common form of selecting contractors in many types of business. Richard Moby was approached recently by the city of Sydney about building a new marina for moderate-sized sailing vessels. Moby decided that his company’s Marine Ser- vices Division should submit a bid on the job. The Marine Services Division specializes in marina maintenance and construction. The city announced that three other firms also would be submitting bids. Since all four companies were equally capable of building the marina to the city’s specifications, Moby assumed that the bid price would be the decid- ing factor in selecting the contractor. Moby consulted with the controller and chief engineer of the Marine Services Divi- sion, and the following data were compiled. Estimated direct-labor requirements, 1,500 hours at $12.00 per hour ................................................................. $18,000 Estimated direct-material requirements .............................................................................................................. 30,000 Estimated variable overhead (allocated on the basis of direct labor), 1,500 direct-labor hours at $5.00 per hour ..... 7,500 Total estimated variable costs ............................................................................................................................ $55,500 Estimated fixed overhead (allocated on the basis of direct labor), 1,500 direct-labor hours at $8.00 per hour ......... 12,000 Estimated total cost ........................................................................................................................................... $67,500 The Marine Services Division allocates variable-overhead costs to jobs on the basis of direct-labor hours. These costs consist of indirect-labor costs, such as the wages of equipment-repair personnel, gasoline and lubricants, and incidental supplies such as rope, chains, and drill bits. Fixed-overhead costs, also allocated to jobs on the basis of direct-labor hours, include such costs as workers’compensation insurance, depreciation on vehicles and construction equipment, depreciation of the division’s buildings, and supervisory salaries. It was up to Richard Moby to decide on the bid price for the marina. In his meeting with the divisional controller and the chief engineer, Moby argued that the marina job was important to the company for two reasons. First, the Marine Services Division had been operating well below capacity for several months. The marina job would not preclude the firm from taking on any other construction work, so it would not entail an opportunity cost. Second, the marina job would be good advertising for Sydney Sailing Supplies. City residents would see the firm’s name on the project, and this would promote sales of the company’s boats and sailing supplies. Based on these arguments, Moby pressed for a bid price that just covered the firm’s variable costs and allowed for a modest contribution margin. The chief engineer was obstinate, however, and argued for a higher bid price that would give the division a good profit on the job. “My employees work hard to do an outstanding job, and their work is worth a premium to the city,” was the engineer’s final comment on the issue. After the threesome tossed the problem around all morning, the controller agreed with Moby. A bid price of $60,000 was finally agreed upon. This is a typical approach to setting prices for special jobs and competitively bid con- tracts. When a firm has excess capacity, a price that covers the incremental costs incurred because of the job will contribute toward covering the company’s fixed cost and profit. None of the Marine Services Division’s fixed costs will increase as a result of taking on the marina job. Thus, a bid price of $60,000 will cover the $55,500 of variable costs on the job and contribute $4,500 toward covering the division’s fixed costs. hiL25664_ch15_638-677.indd 660hiL25664_ch15_638-677.indd 660 7/17/13 12:15 AM7/17/13 12:15 AM Final PDF to printer Chapter 15 Target Costing and Cost Analysis for Pricing Decisions 661 Bid price ...................................................................................................................................................... $60,000 Variable costs of marina job (incremental costs incurred only if job is done) ..................................................... 55,500 Contribution from marina job (contribution to covering the division’s fixed costs) .............................................. $ 4,500 Naturally, Sydney Sailing Supplies’ management would like to make a larger profit on the marina job, but bidding a higher price means running a substantial risk of losing the job to a competitor. No Excess Capacity What if the Marine Services Division has no excess capac- ity? If management expects to have enough work to fully occupy the division, a dif- ferent approach is appropriate in setting the bid price. The fixed costs of the division are capacity-producing costs, which are costs incurred in order to create productive capacity. Depreciation of buildings and equipment, supervisory salaries, insurance, and property taxes are examples of fixed costs incurred to give a company the capacity to carry on its operations. When such costs are allocated to individual jobs, the cost of each job reflects an estimate of the opportunity cost of using limited capacity to do that particular job. For this reasoning to be valid, however, the organization must be at full capacity. If there is excess capacity, there is no opportunity cost in using that excess capacity. If the Marine Services Division has no excess capacity, it would be appropriate to focus on the estimated full cost of the marina job, $67,500, which includes an allocation of the division’s fixed capacity-producing costs. Now Richard Moby might legitimately argue for a bid price in excess of $67,500. If the division is awarded the marina contract by the city, a price above $67,500 will cover all the costs of the job and make a contribu- tion toward the division’s profit. However, as Richard Moby pointed out, there will be valuable promotional benefits to Sydney Sailing Supplies if its Marine Services Division builds the marina. This is a qualitative factor, because these potential benefits are difficult to quantify. Moby will have to make a judgment regarding just how important the marina job is to the company. The greater the perceived qualitative benefits, the lower the bid price should be set to maximize the likelihood that the company will be awarded the contract. Summary of Competitive-Bidding Analysis The Marine Services Division’s pric- ing problem is summarized in Exhibit 15–8 . As you can see, the final pricing decision requires managerial judgment to fully consider the quantitative cost data, the qualitative promotional benefits, and the trade-off between a higher profit and a greater likelihood of getting the marina contract. Accept or Reject a Special Order In the preceding chapter, we examined in detail the decision as to whether a special order should be accepted or rejected. The analysis focused on identifying the relevant costs of the special order. The existence of excess capacity was an important factor in that analysis. Accepting a special order when excess capacity exists entails no opportunity cost. But when there is no excess capacity, one rel- evant cost of accepting a special order is the opportunity cost incurred by using the firm’s limited capacity for the special order instead of some other job. After all relevant costs of the order have been identified, the decision maker compares the total relevant cost of the order with the price offered. If the price exceeds the relevant cost, the order generally should be accepted. The decision is conceptually very similar to the bid-pricing problem discussed in this chapter. Setting a price for a special order or competitive bid also entails an analysis of the relevant costs of the job. Whether the decision maker is setting a price or has been offered a price, he or she must identify the relevant costs of providing the product or ser- vice requested. hiL25664_ch15_638-677.indd 661hiL25664_ch15_638-677.indd 661 7/17/13 12:15 AM7/17/13 12:15 AM Final PDF to printer 662 Chapter 15 Target Costing and Cost Analysis for Pricing Decisions Effect of Antitrust Laws on Pricing Companies are not free to set any price they wish for their products or services. U.S. antitrust laws, including the Robinson-Patman Act, the Clayton Act, and the Sherman Act, restrict certain types of pricing behavior. These laws prohibit price discrimination, which means quoting different prices to different customers for the same product or ser- vice. Such price differences are unlawful unless they can be clearly justified by differ- ences in the costs incurred to produce, sell, or deliver the product or service. Managers should keep careful records justifying such cost differences when they exist, because the records may be vital to a legal defense if price differences are challenged in court. Another pricing practice prohibited by law is predatory pricing. This practice involves temporarily cutting a price to broaden demand for a product with the intention of later restricting the supply and raising the price again. In determining whether a price is predatory, the courts examine a business’s cost records. If the product is sold below cost, the pricing is deemed to be predatory. The laws and court cases are ambiguous as to the appropriate definition of cost. However, various court decisions make it harder to prove predatory pricing. Nevertheless, this is one area where a price-setting decision maker is well advised to have an accountant on the left and a lawyer on the right before setting prices that could be deemed predatory. Effect of Antitrust Laws on Pricing Learning Objective 15-11 Describe the legal restrictions on setting prices. Exhibit 15–8 Summary of Competitive-Bidding Analysis Assumption I: Division Has Excess Capacity Any price above the $55,500 variable cost will make a contribution to covering fixed overhead and profit. Assumption II: Division Has No Excess Capacity A price above the $67,500 full cost reflects the opportunity cost of using limited capacity on this job. Qualitative Factor Valuable promotional benefits to Sydney Sailing Supplies if the marina contract is awarded to the Marine Services Division. Trade-Off in Setting Bid Price High price means higher contribution to fixed cost and profit. Low price means greater likelihood that the company will get the contract. Estimated variable costs of marina job: Direct labor $18,000 Direct material 30,000 Variable overhead (allocated) 7,500 Total estimated variable cost $55,500 Estimated fixed cost (allocated) 12,000 Estimated total cost $67,500 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . hiL25664_ch15_638-677.indd 662hiL25664_ch15_638-677.indd 662 7/17/13 12:15 AM7/17/13 12:15 AM Final PDF to printer Chapter 15 Target Costing and Cost Analysis for Pricing Decisions 663 Chapter Summary LO15-1 List and describe the four major influences on pricing decisions. Many influences affect pricing decisions. Chief among these are: customer demand; the actions of competitors; the costs of the products or services; and political, legal, and image-related issues. LO15-2 Explain and use the economic, profit-maximizing pricing model. Under this approach to pricing, the profit-maximizing quantity is determined by the intersection of the marginal revenue and marginal cost curves. At this optimal sales quantity level, the profit-maximizing price is determined from the demand (or average-revenue) curve. LO15-3 Set prices using cost-plus pricing formulas. Cost-plus pricing formulas are commonly based on four product-cost measures: (1) variable manufacturing cost; (2) absorption manufacturing cost; (3) total cost; and (4) total variable cost. Markups often are set to earn the company a target profit on its products, based on a target rate of return on investment. LO15-4 Discuss the issues involved in the strategic pricing of new products. Strategic pricing of new products is an especially challenging problem for management. Various pricing approaches, such as skimming pricing or penetration pricing, may be appropriate depending on the product. LO15-5 List and discuss the key principles of target costing. Target costing often is used to design a new product that can be produced at a cost that will enable the firm to sell it at a competitive price. Value engineering and activity-based costing are valuable tools used in the target costing process. LO15-6 Explain the role of activity-based costing in setting a target cost. Activity-based costing helps to avoid product cost distortion, in which relatively high-volume and relatively simple products tend to be overcosted by traditional product-costing systems, and relatively low-volume and relatively complex products tend to be undercosted. LO15-7 Explain how product-cost distortion can undermine a firm’s pricing strategy. Product- cost distortion occurs when relatively high-volume and relatively simple products tend to be overcosted by traditional product-costing systems, and relatively low-volume and relatively complex products tend to be undercosted. This phenomenon can lead a company to lose sales by overpricing certain products and lose profit by selling other products at too low a price. LO15-8 Explain the process of value engineering and its role in target costing. Value engineer- ing analyzes a product’s design and production process to identify areas for cost reduction and process improvement. By reducing a product’s cost, management can bring a product’s production cost down to meet its target cost. LO15-9 Determine prices using the time and material pricing approach. In industries such as con- struction, repair, printing, and professional services, time and material pricing often is used. Under this approach, the price is determined as the sum of a labor-cost component and a material-cost component. Either or both of these components may include a markup to ensure that the company earns a profit on its services. LO15-10 Set prices in special-order or competitive-bidding situations by analyzing the relevant costs. Pricing special orders and determining competitive bid prices entail an analysis of the relevant costs to be incurred in completing the job. The relevant-cost analysis should incorporate the existence of excess capacity or the lack of it. LO15-11 Describe the legal restrictions on setting prices. The law prohibits price discrimination, which means quoting different prices to different customers for the same product or service. Also out- lawed is predatory pricing, which involves temporarily cutting a price to broaden demand for a product with the intention of later restricting the supply and raising the price again. Kitchenware Corporation manufactures high-quality copper pots and pans. Greta Cooke, one of the company’s price analysts, is involved in setting a price for the company’s new Starter Set. This set con- sists of seven of the most commonly used pots and pans. During the next year, the company plans to produce 10,000 Starter Sets, and the controller has provided Cooke with the following cost data. Review Problem on Cost-Plus Pricing hiL25664_ch15_638-677.indd 663hiL25664_ch15_638-677.indd 663 7/17/13 12:15 AM7/17/13 12:15 AM Final PDF to printer 664 Chapter 15 Target Costing and Cost Analysis for Pricing Decisions Predicted Costs of 10,000 Starter Sets Direct material per set ....................................................................................................... $60 Direct labor per set, 2 hours at $10.00 per hr ..................................................................... 20 Variable selling cost per set ............................................................................................... 5 Total ................................................................................................................................. $85 Variable-overhead rate ...................................................................................................... $ 8.00 per direct-labor hour Fixed-overhead rate .......................................................................................................... $12.00 per direct-labor hour In addition, the controller indicated that the Accounting Department would allocate $20,000 of fixed administrative expenses to the Starter Set product line. Required: 1. Compute the cost of a Starter Set using each of the four cost definitions commonly used in cost- plus pricing formulas. 2. Determine the markup percentage required for the Starter Set product line to earn a target operating income of $317,500 before taxes during the next year. Use the total cost as the cost definition in the cost-plus formula. Solution to Review Problem 1. Variable manufacturing cost* ...................................... $ 96 1 Applied fixed-overhead cost† ....................................... 24 Absorption manufacturing cost ................................... $120 2 Variable selling cost ................................................... 5 Allocated fixed administrative cost‡ ............................. 2 Total cost ................................................................... $127 3 Variable manufacturing cost ....................................... $ 96 Variable selling cost ................................................... 5 Total variable cost ...................................................... $101 4 *Direct material .......................................................... $ 60 Direct labor ............................................................... 20 Variable overhead ..................................................... 16 (2 3 $8.00 per hour) Total variable manufacturing cost ............................... $ 96 †Applied fixed overhead cost ...................................... $ 24 (2 3 $12 per hour) ‡Allocated fixed administrative cost ............................. $ 2 ($20,000 4 10,000 sets) 2. Markup percentage on total cost 5 $317,500 _____________ 10,000 3 $127 5 25% Proof: Price 5 Total cost 1 (.25 3 Total cost) 5 $127 1 (.25)($127) 5 $158.75 Income Statement Sales revenue (10,000 3 $158.75) ......................................................................... $1,587,500 Less: Variable costs: Direct material .................................................................................................... $600,000 Direct labor ........................................................................................................ 200,000 Variable overhead ............................................................................................... 160,000 Variable selling cost ............................................................................................ 50,000 Total variable costs .............................................................................................. 1,010,000 Contribution margin ................................................................................................ $ 577,500 Less: Fixed costs: Manufacturing overhead ...................................................................................... $240,000 Administrative cost .............................................................................................. 20,000 Total fixed costs .................................................................................................. 260,000 Operating income ................................................................................................... $ 317,500 hiL25664_ch15_638-677.indd 664hiL25664_ch15_638-677.indd 664 7/17/13 12:15 AM7/17/13 12:15 AM Final PDF to printer Chapter 15 Target Costing and Cost Analysis for Pricing Decisions 665 Key Terms For each term’s definition refer to the indicated page, or turn to the glossary at the end of the text. competitive bidding, 659 cost-plus pricing, 648 cross-elasticity, 647 demand curve (average revenue curve), 644 marginal cost curve, 644 marginal revenue curve, 644 oligopolistic market, 647 penetration pricing, 653 predatory pricing, 662 price discrimination, 662 price elasticity, 647 price taker, 642 return-on-investment pricing, 650 skimming pricing, 653 target cost, 652 target costing, 653 time and material pricing, 658 total cost curve, 644 total revenue curve, 642 value engineering, 657 Review Questions 15–1. Comment on the following remark made by a bank president: “The prices of our banking services are determined by the financial-services market. Costs are irrelevant.” 15–2. “All this marginal revenue and marginal cost stuff is just theory. Prices are determined by production costs.” Evaluate this assertion. 15–3. List and briefly describe four major influences on pric- ing decisions. 15–4. Explain what is meant by the following statement: “In considering the reactions of competitors, it is crucial t o define your product.” 15–5. Explain the following assertion: “Price setting gener- ally requires a balance between market forces and cost c onsiderations.” 15–6. Briefly explain the concept of economic, profit- maximizing pricing. It may be helpful to use graphs in your e xplanation. 15–7. Define the following terms: total revenue, marginal revenue, demand curve, price elasticity, and cross-elasticity. 15–8. Briefly define total cost and marginal cost. 15–9. Describe three limitations of the economic, profit- maximizing model of pricing. 15–10. Determining the best approach to pricing requires a cost-benefit trade-off. Explain. 15–11. Write the general formula for cost-plus pricing, and briefly explain its use. 15–12. List the four common cost bases used in cost-plus pricing. How can they all result in the same price? 15–13. List four reasons often cited for the widespread use of absorption cost as the cost base in cost-plus pricing f ormulas. 15–14. What is the primary disadvantage of basing the cost- plus pricing formula on absorption cost? 15–15. List three advantages of pricing based on variable cost. 15–16. Explain the behavioral problem that can result when cost-plus prices are based on variable cost. 15–17. Briefly explain the concept of return-on-investment pricing. 15–18. Explain the phrase price-led costing. 15–19. Why is a focus on the customer such a key principle of target costing? 15–20. Explain the role of value engineering in target costing. 15–21. Could tear-down methods be used effectively for target pricing in a service-industry company, such as a h otel or an airline? Explain. 15–22. Briefly describe the time-and-material pricing approach. 15–23. Explain the importance of the excess-capacity issue in setting a competitive bid price. 15–24. The decision to accept or reject a special order and the selection of a price for a special order are very similar decisions. Explain. 15–25. Describe the following approaches to pricing new prod- ucts: skimming pricing, penetration pricing, and t arget costing. 15–26. Explain what is meant by unlawful price discrimination and predatory pricing. 15–27. Briefly explain the potential negative consequences in pricing decisions from using a traditional, volume- based product-costing system. Exercises All applicable Exercises are available with McGraw-Hill’s Connect Accounting ®. The marginal cost, m arginal revenue, and demand curves for Houston Home and Garden’s deluxe wheelbarrow are shown in the graph at the top of the next page. Required: Before completing any of the following requirements, read over the entire list. 1. Trace the graph onto a blank piece of paper, and label all parts of the graph. 2. Draw a companion graph directly above the traced graph. Use this graph to draw the firm’s total revenue and total cost curves. 3. Show the company’s profit-maximizing price on the lower graph and its profit-maximizing quan- tity on both graphs. ■ Exercise 15–28 Marginal Revenue and Marginal Cost Curves (LO 15-1, 15-2) hiL25664_ch15_638-677.indd 665hiL25664_ch15_638-677.indd 665 7/17/13 12:15 AM7/17/13 12:15 AM Final PDF to printer 666 Chapter 15 Target Costing and Cost Analysis for Pricing Decisions Serendipity Sound, Inc., m anufactures home theater sound systems in its Minneapolis Division. The divisional sales manager has estimated the following demand-curve data. Quantity Sold per Month Unit Sales Price 20 ...................................................................................................................... $500 40 ...................................................................................................................... 475 60 ...................................................................................................................... 450 80 ...................................................................................................................... 425 100 ...................................................................................................................... 400 Required: 1. Prepare a table similar to panel C of Exhibit 15–1 summarizing Serendipity Sound’s price, quan- tity, and revenue data. 2. Draw a graph similar to panel A of Exhibit 15–1 reflecting the data tabulated in requirement (1). Refer to the preceding exercise. T he divisional controller at Serendipity Sound’s Minneapolis Division has estimated the following cost data for the division’s sound systems. (Assume there are no fixed costs.) Quantity Produced and Sold per Month Average Cost per Unit 20 ....................................................................................................................................... $450 40 ....................................................................................................................................... 425 60 ....................................................................................................................................... 410 80 ....................................................................................................................................... 430 100 ....................................................................................................................................... 445 Required: 1. Prepare a table similar to panel C of Exhibit 15–2 summarizing Serendipity Sound’s cost relationships. 2. Draw a graph similar to panel A of Exhibit 15–2 reflecting the data tabulated in requirement (1). ■ Exercise 15–29 Demand and Revenue Data (LO 15-1, 15-2) ■ Exercise 15–30 Continuation of Preceding Exercise; Cost Data (LO 15-1, 15-2) Dollars per unit Quantity sold per month hiL25664_ch15_638-677.indd 666hiL25664_ch15_638-677.indd 666 7/17/13 12:15 AM7/17/13 12:15 AM Final PDF to printer Chapter 15 Target Costing and Cost Analysis for Pricing Decisions 667 Refer to the data given in t he preceding two exercises. 1. Prepare a table of Serendipity Sound’s revenue, cost, and profit relationships. For guidance refer to panel C of Exhibit 15–3 . 2. Draw a graph similar to panel A of Exhibit 15–3 reflecting the data tabulated in requirement (1). 3. To narrow down the pricing decision, the Minneapolis Division’s sales manager has decided to price the home theater sound system at one of the following prices: $400, $425, $450, or $500. Which price do you recommend? Why? The following data pertain to L awnMate Corporation’s top-of-the-line lawn mower. Variable manufacturing cost ................................................................................................................................ $275 Applied fixed manufacturing cost ......................................................................................................................... 55 Variable selling and administrative cost ................................................................................................................ 66 Allocated fixed selling and administrative cost ....................................................................................................... ? To achieve a target price of $495 per lawn mower, the markup percentage is 12.5 percent on total unit cost. Required: 1. What is the fixed selling and administrative cost allocated to each unit of LawnMate’s top-of-the- line mower? 2. For each of the following cost bases, develop a cost-plus pricing formula that will result in a target price of $495 per mower: ( a ) variable manufacturing cost, ( b ) absorption manufacturing cost, and ( c ) total variable cost. Rosario Company produces a single product in its Buenos Aires plant, which currently s e lls for 7.50 p per unit. Fixed costs are expected to amount to 90,000 p for the year, and all variable manufacturing and administrative costs are expected to be incurred at a rate of 4.50 p per unit. Rosario has two salespeople who are paid strictly on a commission basis. Their commission is 10 percent of the sales dollars they generate. (Ignore income taxes.) ( p denotes the peso, Argentina’s national currency. Many countries use the peso as their national currency. On the day this exercise was written, Argentina’s peso was worth .1886 U.S. dollars.) Required: 1. Suppose management alters its current plans by spending an additional amount of 7,500 p on advertising and increases the selling price to 9.00 p per unit. Calculate the profit on 60,000 units. 2. The Salente Company has just approached Rosario to make a special one-time purchase of 10,000 units. These units would not be sold by the sales personnel, and, therefore, no commission would have to be paid. What is the price Rosario would have to charge per unit on this special order to earn additional profit of 30,000 p? (CMA, adapted) The following data pertain to Legion Lighting Company’s oak-clad, contemporary c handelier. Variable manufacturing cost ................................................................................................................................ $300 Applied fixed manufacturing cost ......................................................................................................................... 105 Variable selling and administrative cost ................................................................................................................ 45 Allocated fixed selling and administrative cost ....................................................................................................... 75 Required: For each of the following cost bases, develop a cost-plus pricing formula that will result in a price of $600 for the oak chandelier. 1. Variable manufacturing cost. 2. Absorption manufacturing cost. 3. Total cost. 4. Total variable cost. ■ Exercise 15–31 Continuation of Preceding Two Exercises; Profit- Maximizing Price (LO 15-1, 15-2) ■ Exercise 15–32 Cost-Plus Pricing Formulas; Missing Data (LO 15-1, 15-3) ■ Exercise 15–33 Pricing, Advertising, and Special-Order Decisions (LO 15-10) ■ Exercise 15–34 Cost-Plus Pricing Formulas (LO 15-1, 15-3) hiL25664_ch15_638-677.indd 667hiL25664_ch15_638-677.indd 667 7/17/13 12:15 AM7/17/13 12:15 AM Final PDF to printer 668 Chapter 15 Target Costing and Cost Analysis for Pricing Decisions Refer to the cost and p roduction data for the Wave Darter in Exhibit 15–5 . The target profit is $60,000. Required: Use the general formula for determining a markup percentage to compute the required markup percentages with the following two cost-plus formulas: 1. Variable manufacturing costs [formula (1) in Exhibit 15–5 ]. 2. Absorption manufacturing cost [formula (2) in Exhibit 15–5 ]. Refer to Exhibit 15–7 . S uppose the Repair Department of Sydney Sailing Supplies adds a markup of 5 percent on the material charges of a job (including the cost of material handling and storage). Required: 1. Rewrite the material component of the time and material pricing formula to reflect the markup on material cost. 2. Compute the new price to be quoted on the yacht refurbishment described in Exhibit 15–7 . Visit the w ebsite of one of the following companies, or a different company of your choosing. Nintendo www.nintendo.com Procter & Gamble www.pg.com Carnival Cruise Lines www.carnival.com JPMorganChase www.jpmorganchase.com General Electric Company www.ge.com Hewlett-Packard www.hp.com Intel Corporation www.intel.com Required: Read about a new product or service to be offered by the company. Then explain how the firm could use target costing to price the new product or service. ■ Exercise 15–35 Determining Markup Percent- age; Target ROI (LO 15-1, 15-3) ■ Exercise 15–36 Time and Material Pricing (LO 15-9) ■ Exercise 15–37 Target Costing for a New Product; Use of Internet (LO 15-4, 15-5, 15-8) Problems Note: Several of the problems and cases in Chapter 5 relate to pricing and may be assigned with Chapter 15 as well. These problems emphasize the impact of cost distortion on pricing decisions. They stress the differences between traditional, volume-based costing systems and activity-based costing sys- tems with respect to their role in pricing. These problems should be assigned only after Chapter 5 has been completed. The following problems are relevant: 5–54, 5–55, 5–59, 5–60, and 5–69. Heartland Corporation manufactures flour milling machinery according to customer specifications. The company operated at 75 percent of practical capacity during the year just ended, with the following results (in thousands): Sales revenue ............................................................................................................................................... $12,500 Less: Sales commissions (10%) ..................................................................................................................... 1,250 Net sales ...................................................................................................................................................... $11,250 Expenses: Direct material .......................................................................................................................................... $ 3,000 Direct labor .............................................................................................................................................. 3,750 Manufacturing overhead—variable ............................................................................................................ 1,125 Manufacturing overhead—fixed ................................................................................................................ 750 Corporate administration—fixed ................................................................................................................ 375 Total costs .................................................................................................................................................... $ 9,000 Income before taxes ...................................................................................................................................... $ 2,250 Income taxes (40%) ...................................................................................................................................... 900 Net income ................................................................................................................................................... $ 1,350 ■ Problem 15–38 Pricing of Special Order (LO 15-10) 1. Income before taxes: $23,250 2. Total manufacturing costs: $51,000 All applicable Problems are available with McGraw-Hill’s Connect Accounting ®. hiL25664_ch15_638-677.indd 668hiL25664_ch15_638-677.indd 668 7/17/13 12:15 AM7/17/13 12:15 AM Final PDF to printer Chapter 15 Target Costing and Cost Analysis for Pricing Decisions 669 Heartland, which expects continued operations at 75 percent of capacity, recently submitted a bid of $82,500 on custom-designed machinery for Premier Foods, Inc. In deriving the bid amount, Heart- land used a pricing approach based on last year’s operating results. The calculations are as follows. Estimated direct material ........................................................................................................................... $14,600 Estimated direct labor ............................................................................................................................... 28,000 Estimated manufacturing overhead at 50% of direct labor ........................................................................... 14,000 Estimated corporate overhead at 10% of direct labor .................................................................................. 2,800 Estimated total costs excluding sales commissions ..................................................................................... $59,400 Add 25% for profit and taxes ..................................................................................................................... 14,850 Suggested price (with profit) before sales commissions ............................................................................... $74,250 Suggested total price: $74,250 4 0.9 to adjust for 10% commission .......................................................... $82,500 Required: 1. Calculate the impact the order would have on Heartland’s net income if the $82,500 bid were accepted by Premier Foods, Inc. 2. Assume that Premier has rejected Heartland’s bid but has stated it is willing to pay $63,500 for the machinery. Should Heartland manufacture the machinery for the counteroffer of $63,500? Explain your answer and show calculations. 3. At what bid price will Heartland break even on the order? 4. Explain how the profit performance in the coming year would be affected if Heartland accepted all of its work at prices similar to Premier’s $63,500 counteroffer described in requirement (2). 5. Build a spreadsheet: Construct an Excel spreadsheet to solve requirements (1) and (2) above. Show how the solution will change if the following information changes: the direct material and direct labor for the year just ended were $2,900,000 and $3,800,000 respectively; and sales com- missions were 8%. (CMA, adapted) Suburban Heating, Inc., installs heating systems in n e w homes built in suburban Philadelphia. Jobs are priced using the time and materials method. The following predictions pertain to the company’s opera- tions for the next year. Labor rate, including fringe benefits ................................................................................................... $20.00 per hour Annual labor hours ............................................................................................................................ 12,000 hours Annual overhead costs: Material handling and storage ....................................................................................................... $31,250 Other overhead costs .................................................................................................................... $135,000 Annual cost of materials used ............................................................................................................ $312,500 The president of Suburban Heating, B. T. Ewing, is pricing a job involving the heating systems for six houses to be built by a local developer. He has made the following estimates. Material cost ...................................................................................................................................... $75,000 Labor hours ....................................................................................................................................... 400 Required: Suburban Heating adds a markup of $5.00 per hour on its time charges, but there is no markup on material costs. 1. Develop formulas for the company’s ( a ) time charges and ( b ) material charges. 2. Compute the price for the job described above. 3. What would be the price of the job if Suburban Heating also added a markup of 10 percent on all material charges (including material handling and storage costs)? ■ Problem 15–39 Time and Material Pricing (LO 15-9) 2. Material charges: $82,500 3. Markup on total material costs: $8,250 hiL25664_ch15_638-677.indd 669hiL25664_ch15_638-677.indd 669 7/17/13 12:15 AM7/17/13 12:15 AM Final PDF to printer 670 Chapter 15 Target Costing and Cost Analysis for Pricing Decisions Manhattan Pharmaceuticals, Inc., specializes in packaging b ulk drugs in standard dosages for local hos- pitals. Wyant Memorial Hospital has asked Manhattan Pharmaceuticals to bid on the packaging of one million doses of medication at total cost plus a return on total cost of no more than 15 percent. Wyant defines total cost as including all variable costs of performing the service, a reasonable amount of fixed overhead, and reasonable administrative costs. The hospital will supply all packaging materials and ingredients. Wyant’s administrator has indicated that any bid over $.03 per dose will be rejected. The controller for Manhattan Pharmaceuticals has accumulated the following data prior to the preparation of the bid. Direct labor ............................................................................................................. $16.00 per direct-labor hour (DLH) Variable overhead ................................................................................................... $12.00 per DLH Fixed overhead ....................................................................................................... $20.00 per DLH Incremental administrative costs .............................................................................. $2,000 for the order Production rate ....................................................................................................... 2,000 doses per DLH Required: 1. Calculate the minimum price per dose that Manhattan Pharmaceuticals could bid for the Wyant Memorial Hospital job that would not reduce the pharmaceutical company’s income. 2. Calculate the bid price per dose using total cost and the maximum allowable return specified by Wyant Memorial Hospital. 3. Independent of your answer to requirement (2), suppose that the price per dose that Manhattan Pharmaceuticals, Inc., calculated using the cost-plus criterion specified by Wyant Memorial Hos- pital is greater than the maximum bid of $.03 per dose allowed by Wyant. Discuss the factors that the pharmaceutical company’s management should consider before deciding whether or not to submit a bid at the maximum price of $.03 per dose that Wyant allows. (CMA, adapted) Wolverine V alve and Fitting Company, located in southern Michigan, manufactures a variety of indus- trial valves and pipe fittings. Currently, the company is operating at about 70 percent capacity. Manage- ment has been approached by Glasgow Industries Ltd. of Scotland with an offer to buy 120,000 units of a pressure valve. Glasgow Industries manufactures a valve that is almost identical to Wolverine’s pres- sure valve; however, a fire in Glasgow Industries’ valve plant has shut down its manufacturing opera- tions. Glasgow needs the 120,000 valves over the next four months to meet commitments to its regular customers. Glasgow is prepared to pay $28.50 each for the valves. Wolverine’s total product cost for the pressure valve is $30, calculated as follows: Direct material ................................................................................................................................................ $ 7.50 Direct labor ..................................................................................................................................................... 9.00 Manufacturing overhead .................................................................................................................................. 13.50 Total product cost ....................................................................................................................................... $30.00 Manufacturing overhead is applied to production at the rate of $27 per direct-labor hour. This over- head rate is made up of the following components. Variable manufacturing overhead ...................................................................................................................... $ 9.00 Fixed manufacturing overhead (traceable ........................................................................................................... 12.00 Fixed manufacturing overhead (allocated) .......................................................................................................... 6.00 Applied manufacturing overhead rate ............................................................................................................ $27.00 Additional costs incurred in connection with sales of the pressure valve include sales commissions of 5 percent and freight expense of $1.50 per unit. However, the company does not pay sales commis- sions on special orders that come directly to management. In determining selling prices, Wolverine adds a 40 percent markup to total product cost. This provides a $42.00 suggested selling price for the pressure valve. The Marketing Department, however, has set the current selling price at $40.50 in order to maintain market share. Production management believes that it can handle the Glasgow Industries order without disrupting its scheduled production. The order would, however, require additional fixed factory overhead of $18,000 per month in the form of supervision and clerical costs. If management accepts the order, 30,000 pressure valves will be manufactured and shipped to Glasgow Industries each ■ Problem 15–40 Cost-Plus Pricing; Bidding (LO 15-3, 15-10) 1. Total traceable out-of- pocket costs: $16,000 2. Variable overhead: $6,000 ■ Problem 15–41 Pricing a Special Order; International (LO 15-10) 2. Total incremental revenue: $3,420,000 Total incremental costs: $2,592,000 hiL25664_ch15_638-677.indd 670hiL25664_ch15_638-677.indd 670 7/17/13 12:15 AM7/17/13 12:15 AM Final PDF to printer Chapter 15 Target Costing and Cost Analysis for Pricing Decisions 671 month for the next four months. Glasgow’s management has agreed to pay the shipping charges for the valves. Required: 1. Determine how many direct-labor hours would be required each month to fill the Glasgow Indus- tries order. 2. Prepare an analysis showing the impact of accepting the Glasgow Industries order. 3. Calculate the minimum unit price that Wolverine Valve and Fitting Company’s management could accept for the Glasgow Industries order without reducing net income. 4. Identify the factors, other than price, that Wolverine’s management should consider before accept- ing the Glasgow Industries order. 5. Build a spreadsheet: Construct an Excel spreadsheet to solve requirements (2) and (3) above. Show how the solution will change if the following information changes: the direct material and direct labor per unit are $6.90 and $9.10, respectively. (CMA, adapted) For many years, L ehigh Corporation has used a straightforward cost-plus pricing system, marking its goods up approximately 25 percent of total cost. The company has been profitable; however, it has recently lost considerable business to foreign competitors that have become very aggressive in the mar- ketplace. These firms appear to be using target costing. An example of Lehigh’s problem is typified by item DC66, which has the following unit-cost characteristics: Direct material .................................................................................................................................................... $ 90 Direct labor ......................................................................................................................................................... 225 Manufacturing overhead ...................................................................................................................................... 150 Selling and administrative expenses ..................................................................................................................... 75 The going market price for an identical product of comparable quality is $585, which is significantly below what Lehigh is charging. Required: 1. Contrast cost-plus pricing and target costing. Which of the two approaches could be aptly labeled price-led costing? Why? 2. What is Lehigh’s current selling price of item DC66? 3. If Lehigh used target costing for item DC66, by how much must costs change if the company desires to meet the market price and maintain its current rate of profit on sales? 4. Would the identification of value-added and non-value-added costs assist Lehigh in this situation? Briefly explain. 5. Suppose that by previous cost-cutting drives, costs had already been “pared to the bone” on item DC66. What might Lehigh be forced to do with its markup on cost to remain competitive? By how much must the markup change? 6. Early in this chapter, the text noted that in many industries, prices are the result of an interaction between market forces and costs. Explain what is meant by this statement. 7. Build a spreadsheet: Construct an Excel spreadsheet to solve requirements (2) and (3) above. Show how the solution will change if the following information changes: the direct material and direct labor per unit are $85 and $220, respectively. Detroit Synthetic Fibers, Inc., specializes in the manufacture of s ynthetic fibers used in many products such as blankets, coats, and uniforms. The company applies overhead on the basis of direct-labor hours. Management has recently received a request to bid on the manufacture of 800,000 blankets scheduled for delivery to several military bases. The bid must be stated at full cost per unit plus a return on full cost of no more than 15 percent before income taxes. Full cost has been defined as including all variable costs of manufacturing the product, a reasonable amount of fixed overhead, and reasonable incremental administrative costs associated with the manufacture and sale of the product. The contractor has indi- cated that bids in excess of $50 per blanket are not likely to be considered. In order to prepare the bid for the 800,000 blankets, Andrea Lightner, director of cost manage- ment, has gathered the following information about the costs associated with the production of the blankets. ■ Problem 15–42 Cost-Plus Pricing vs. Target Costing (LO 15-1, 15-3, 15-5, 15-6, 15-8) 2. Markup: $135 ■ Problem 15–43 Bidding on a Special Order (LO 15-10) 1. Variable overhead: $1.50 2. Fixed overhead: $4.00 hiL25664_ch15_638-677.indd 671hiL25664_ch15_638-677.indd 671 7/17/13 12:15 AM7/17/13 12:15 AM Final PDF to printer 672 Chapter 15 Target Costing and Cost Analysis for Pricing Decisions Direct material .............................................................................................................. $3.00 per pound of fibers Direct labor ................................................................................................................... $14.00 per hour Direct machine costs* ................................................................................................... $20.00 per blanket Variable overhead ......................................................................................................... $6.00 per direct-labor hour Fixed overhead ............................................................................................................. $16.00 per direct-labor hour Incremental administrative costs .................................................................................... $5,000 per 1,000 blankets Special fee† .................................................................................................................. $1.00 per blanket Material usage .............................................................................................................. 6 pounds per blanket Production rate ............................................................................................................. 4 blankets per direct-labor hour *Direct machine costs consist of items such as special lubricants, replacement of needles used in stitching, and maintenance costs. These costs are not included in the normal overhead rates. †Detroit Synthetic Fibers recently developed a new blanket fiber at a cost of $1,500,000. In an effort to recover this cost, management has insti- tuted a policy of adding a $1.00 fee to the cost of each blanket using the new fiber. To date, the company has recovered $250,000. Lightner knows that this fee does not fit within the definition of full cost as it is not a cost of manufacturing the product. Required: 1. Calculate the minimum price per blanket that Detroit Synthetic Fibers, Inc., could bid without reducing the company’s net income. 2. Using the full-cost criteria and the maximum allowable return specified, calculate Detroit Syn- thetic Fibers, Inc.’s bid price per blanket. 3. Independent of your answer to requirement (2), assume that the price per blanket that Detroit Syn- thetic Fibers, Inc., calculated using the cost-plus criteria specified is greater than the maximum bid of $50 per blanket allowed. Discuss the factors that management should consider before deciding whether to submit a bid at the maximum acceptable price of $50 per blanket. (CMA, adapted) Maritime S ervices Corporation (MSC) will soon enter a very competitive marketplace in which it will have limited influence over the prices that are charged. Management and consultants are currently work- ing to fine-tune the company’s sole service, which they hope will generate a 12 percent first-year return (profit) on the firm’s $27,000,000 asset investment. Although the normal return in MSC’s industry is 14 percent, executives are willing to accept the lower figure because of various start-up inefficiencies. The following information is available for first-year operations: Hours of service to be provided: 25,000 Anticipated variable cost per service hour: $33 Anticipated fixed cost: $2,850,000 per year Required: 1. Assume that management is contemplating what price to charge in the first year of operation. The company can take its cost and add a markup to achieve a 12 percent return; alternatively, it can use target costing. Given MSC’s marketplace, which approach is probably more appropriate? Why? 2. How much profit must MSC generate in the first year to achieve a 12 percent return? 3. Calculate the revenue per hour that MSC must generate in the first year to achieve a 12 percent return. 4. Assume that prior to the start of business in year 1, management conducted a planning exercise to determine if MSC could attain a 14 percent return in year 2. Can the company achieve this return if ( a ) competitive pressures dictate a maximum selling price of $265 per hour and ( b ) service hours and the variable cost per service hour are the same as the amounts anticipated in year 1? Show calculations. 5. If your answer to requirement (4) is no, suggest and briefly describe a procedure that MSC might use to achieve the desired results. Portland Electronics Company’s (PEC) president, M arsha Kunselman, is concerned about the pros- pects of one of the firm’s major products. The president has been reviewing a marketing report with Jeff Keller, marketing product manager, for their top-of-the-line stereo amplifier. The report indicates another price reduction is needed to meet anticipated competitors’ reductions in sales prices. The cur- rent selling price for PEC’s amplifier is $700 per unit. It is expected that within three months PEC’s two major competitors will be selling their comparable amplifiers for $600 per unit. This concerns ■ Problem 15–44 Target Costing (LO 15-3, 15-5, 15-6, 15-8) 3. Revenue per hour: $276.60 4. Target profit: $3,780,000 ■ Problem 15–45 Target Costing; Value Engi- neering; ABC; JIT (LO 15-5, 15-6, 15-8) 4. Total cost, current: $630 Total cost, revised: $532 hiL25664_ch15_638-677.indd 672hiL25664_ch15_638-677.indd 672 7/17/13 12:15 AM7/17/13 12:15 AM Final PDF to printer Chapter 15 Target Costing and Cost Analysis for Pricing Decisions 673 Kunselman because PEC’s current cost of producing the amplifiers is $630, which yields a $70 profit on each unit sold. The situation is especially disturbing because PEC had implemented an activity-based costing (ABC) system about two years ago. The ABC system helped them better identify costs, cost pools, cost drivers, and cost reduction opportunities. Changes made when adopting ABC reduced costs on this product by approximately 15 percent during the last two years. Now it appears that costs will need to be reduced considerably more to remain competitive and to earn a profit on the amplifier. Total costs to produce, sell, and service the amplifiers are as follows: Amplifiers Cost Item Per Unit Material Purchased components ........................................................................... $215 All other material .................................................................................... 85 Labor Manufacturing, direct .............................................................................. 130 Setups ................................................................................................... 18 Material handling .................................................................................... 36 Inspection ............................................................................................... 46 Machining Cutting, shaping, and drilling .................................................................... 42 Bending and finishing .............................................................................. 28 Other Finished-goods warehousing ................................................................... 10 Warranty ................................................................................................ 20 Total unit cost ......................................................................................... $630 Kunselman has decided to hire Donald Collins, a consultant, to help decide how to proceed. After a value-engineering analysis, Collins suggested that PEC adopt a just-in-time (JIT) cell manufacturing process to help reduce costs. He also suggested that using target costing would help in meeting the new target price. By changing to a JIT cell manufacturing system, PEC expects that manufacturing direct labor will increase by $30 per finished unit. However, setup, material handling, inspection, and finished goods warehousing will all be eliminated. Machine costs will be reduced from $70 to $60 per unit, and warranty costs are expected to be reduced by 40 percent. Required: 1. Define target costing. 2. Define value engineering. 3. Determine Portland Electronics Company’s unit target cost at the $600 competitive sales price while maintaining the same percentage of profit on sales as is earned on the current $700 sales price. 4. If the just-in-time cell manufacturing process is implemented with the changes in costs noted, will PEC meet the unit target cost you determined in requirement (3)? Prepare a schedule detailing cost reductions and the unit cost under the proposed JIT cell manufacturing process. (CMA, adapted) Super Sounds, Inc. manufactures two models of stereo speaker sets. T he company uses an absorption (or full) product-costing system, which means that both variable and fixed overhead are included in the product cost. Cost estimates for the two models for the coming year are as follows: Standard Model Deluxe Model Direct material .......................................................................................... $240 $390 Direct labor (10 hours at $21 per hour) ...................................................... 210 210 Manufacturing overhead* .......................................................................... 150 150 Total cost per set ...................................................................................... $600 $750 *The predetermined overhead rate is $15 per direct-labor hour. Each stereo speaker set requires 10 hours of direct labor. Each Standard model set requires two hours in Department I and eight hours in Department II. Each set of the Deluxe model requires eight hours in Department I and two hours in Department II. The manufacturing overhead costs expected dur- ing the coming year in Departments I and II are as follows: ■ Problem 15–46 Product Cost Distortion and Product Pricing; Departmental Overhead Rates (LO 15-7) 1. Predetermined overhead rate: $15.00 per direct-labor hour 3. Predetermined overhead rate, Department I: $18.00 5. Mark up, Standard: $87.30 Ex hiL25664_ch15_638-677.indd 673hiL25664_ch15_638-677.indd 673 7/17/13 12:15 AM7/17/13 12:15 AM Final PDF to printer 674 Chapter 15 Target Costing and Cost Analysis for Pricing Decisions Department I Department II Variable overhead ............................................................. $12 per direct-labor hour $6 per direct-labor hour Fixed overhead ................................................................. $225,000 $225,000 The expected operating activity for the coming year is 37,500 direct-labor hours in each department. Required: 1. Show how Super Sounds, Inc., derived its predetermined overhead rate. 2. What will be the price of each model stereo speaker set if the company prices its products at absorption manufacturing cost plus 15 percent? 3. Suppose Super Sounds, Inc., were to use departmental overhead rates. Compute these rates for Departments I and II for the coming year. 4. Compute the absorption cost of each model stereo speaker set using the departmental overhead rates computed in requirement (3). 5. Suppose management sticks with its policy of setting prices equal to absorption cost plus 15 percent. Compute the new price for each speaker model using the product costs developed in requirement (4). 6. Should Super Sounds, Inc., use plantwide or departmental overhead rates? Explain your answer. Danish I nteriors, Ltd., manufactures easy-to-assemble wooden furniture for home and office. Manage- ment is considering modification of a table to make it more attractive to individuals and businesses that buy products through outlets such as Office Max, Office Depot, and Staples stores. The table is small, can be used to hold a computer printer or fax machine, and has several shelves for storage. The company’s marketing department surveyed potential buyers of the table regarding five pro- posed modifications. The 200 survey participants were asked to evaluate the modifications by using a five-point scale that ranged from 1 (strongly disagree) to 5 (strongly agree). Their responses, along with Danish Interiors’ related unit costs for the modifications, follow. 1 Strongly Disagree 2 Disagree 3 Neutral 4 Agree 5 Strongly Agree Add cabinet doors in storage area ($18.00) ......................... 10 20 30 60 80 Expand storage area ($7.50) ............................................... 10 40 70 50 30 Add security lock to storage area ($4.95) ............................ 30 60 50 40 20 Give table top a more rich, marble appearance ($12.75) ...... 10 20 50 60 60 Extend warranty to five years ($15.30) ................................ 40 70 30 35 25 The table currently costs $192 to produce and distribute, and Danish Interiors’ selling price for this unit averages $240. An analysis of competitive tables in the marketplace revealed a variety of features, with some models having all of the features that management is considering and other models having only a few. The current manufacturers’ selling prices for these tables averages $285. Required: 1. Why is there a need in target costing to ( a ) focus on the customer and ( b ) have a marketing team become involved with product design? 2. Danish Interiors’ marketing team will evaluate the survey responses by computing a weighted- average rating of each of the modifications. This will be accomplished by weighting (multiplying) the point values (1, 2, etc.) by the frequency of responses, summing the results, and dividing by 200. Rank the popularity of the five modifications using this approach. 3. Management desires to earn approximately the same rate of profit on sales that is being earned with the current design. a. If Danish Interiors uses target costing and desires to meet the current competitive selling price, what is the maximum cost of the modified table? b. Which of the modifications should management consider? 4. Assume that Danish Interiors wanted to add a modification or two that you excluded in your answer to requirement (3 b ). What process might management adopt to allow the company to make its target profit for the table? Briefly explain. ■ Problem 15–47 Target Costing; Selection of Product Features (LO 15-5, 15-6, 15-8) 3(b). Cost of additional features: $36.00 hiL25664_ch15_638-677.indd 674hiL25664_ch15_638-677.indd 674 7/17/13 12:15 AM7/17/13 12:15 AM Final PDF to printer Chapter 15 Target Costing and Cost Analysis for Pricing Decisions 675 Bair Company is a manufacturer of standard and c ustom-designed bottling equipment. Early in December 20x0 Lyan Company asked Bair to quote a price for a custom-designed bottling machine to be delivered in April. Lyan intends to make a decision on the purchase of such a machine by January 1, so Bair would have the entire first quarter of 20x1 to build the equipment. Bair’s pricing policy for custom-designed equipment is 50 percent markup on absorption manu- facturing cost. Lyan’s specifications for the equipment have been reviewed by Bair’s Engineering and Cost Management departments, which made the following estimates for direct material and direct labor. Direct material ............................................................................................................................................... $307,200 Direct labor (11,000 hours at $18) .................................................................................................................. 198,000 Manufacturing overhead is applied on the basis of direct-labor hours. Bair normally plans to run its plant at a level of 15,000 direct-labor hours per month and assigns overhead on the basis of 180,000 direct-labor hours per year. The overhead application rate for 20x1 of $10.80 per hour is based on the following budgeted manufacturing overhead costs for 20x1. Variable manufacturing overhead .............................................................................................................. $1,166,400 Fixed manufacturing overhead .................................................................................................................. 777,600 Total manufacturing overhead ................................................................................................................... $1,944,000 Bair’s production schedule calls for 12,000 direct-labor hours per month during the first quarter. If Bair is awarded the contract for the Lyan equipment, production of one of its standard products would have to be reduced. This is necessary because production levels can only be increased to 15,000 direct- labor hours each month on short notice. Furthermore, Bair’s employees are unwilling to work overtime. Sales of the standard product equal to the reduced production would be lost, but there would be no permanent loss of future sales or customers. The standard product for which the production schedule would be reduced has a unit sales price of $14,400 and the following cost structure. Direct material ................................................................................................................................................. $ 3,000 Direct labor (250 hours at $18) ......................................................................................................................... 4,500 Manufacturing overhead (250 hours at $10.80) ................................................................................................. 2,700 Total cost ..................................................................................................................................................... $10,200 Lyan needs the custom-designed equipment to increase its bottle-making capacity so that it will not have to buy bottles from an outside supplier. Lyan Company requires 5,000,000 bottles annually. Its present equipment has a maximum capacity of 4,500,000 bottles with a directly traceable cash outlay cost of 18 cents per bottle. Thus, Lyan has had to purchase 500,000 bottles from a supplier at 48 cents each. The new equipment would allow Lyan to manufacture its entire annual demand for bottles at a direct-material cost savings of 1.2 cents per bottle. Bair estimates that Lyan’s annual bottle demand will continue to be 5,000,000 bottles over the next five years, the estimated life of the special-purpose equipment. Required: Bair Company’s management plans to submit a bid to Lyan Company for the manufacture of the special-purpose bottling equipment. 1. Calculate the bid Bair would submit if it follows its standard pricing policy for special-purpose equipment. 2. Calculate the minimum bid Bair would be willing to submit on the Lyan equipment that would result in the same total contribution margin as planned for the first quarter of 20x1. 3. Suppose Bair has submitted a bid slightly above the minimum calculated in requirement (2). Upon receiving Bair’s bid, Lyan’s assistant purchasing manager telephoned his friend at Tygar Corpora- tion: “Hey Joe, we just got a bid from Bair on some customized equipment. I think Tygar would stand a good chance of beating it. Stop by the house this evening, and I’ll show you the details of Bair’s bid and the specifications on the machine.” Is Lyan Company’s assistant purchasing manager acting ethically? Explain. (CMA, adapted) ■ Case 15–48 Bidding on a Special Order; Ethics (LO 15-10) 1. Manufacturing overhead: $118,800 2. Direct material: $307,200 Cases hiL25664_ch15_638-677.indd 675hiL25664_ch15_638-677.indd 675 7/17/13 12:15 AM7/17/13 12:15 AM Final PDF to printer 676 Chapter 15 Target Costing and Cost Analysis for Pricing Decisions Handy H ousehold Products, Inc., is a multiproduct company with several manufacturing plants. The Shreveport Plant manufactures and distributes two household cleaning and polishing compounds, stan- dard and commercial, under the Clean & Bright label. The forecasted operating results for the first six months of the current year, when 100,000 cases of each compound are expected to be manufactured and sold, are presented in the following statement. CLEAN & BRIGHT COMPOUNDS—SHREVEPORT PLANT Forecasted Results of Operations For the Six-Month Period Ending June 30 (in thousands) Standard Commercial Total Sales ........................................................................................ $4,000 $6,000 $10,000 Cost of goods sold ..................................................................... 3,200 3,800 7,000 Gross profit ............................................................................... $ 800 $2,200 $ 3,000 Selling and administrative expenses: Variable ................................................................................. $ 800 $1,400 $ 2,200 Fixed* ................................................................................... 480 720 1,200 Total selling and administrative expenses ................................ $1,280 $2,120 $ 3,400 Income (loss) before taxes .......................................................... $ (480) $ 80 $ (400) *The fixed selling and administrative expenses are allocated between the two products on the basis of dollar sales volume. The standard compound sold for $40 a case and the commercial compound sold for $60 a case during the first six months of the year. The manufacturing costs, by case of product, are presented in the schedule below. Each product is manufactured on a separate production line. Annual normal manufac- turing capacity is 200,000 cases of each product. However, the plant is capable of producing 250,000 cases of standard compound and 350,000 cases of commercial compound annually. Cost per Case Standard Commercial Direct material ................................................................................................ $14.00 $16.00 Direct labor ..................................................................................................... 8.00 8.00 Variable manufacturing overhead ..................................................................... 2.00 4.00 Fixed manufacturing overhead* ........................................................................ 8.00 10.00 Total manufacturing cost ................................................................................. $32.00 $38.00 Variable selling and administrative costs ........................................................... $ 8.00 $14.00 *Depreciation charges are 50 percent of the fixed manufacturing overhead of each line. The following schedule reflects the consensus of top management regarding the price-volume alternatives for the Clean & Bright products for the last six months of the current year. These are essen- tially the same alternatives management had during the first six months of the year. Standard Compound Commercial Compound Alternative Prices (per case) Sales Volume (in cases) Alternative Prices (per case) Sales Volume (in cases) $38 .......................... 120,000 .............................. $52 ............................... 175,000 40 .......................... 100,000 .............................. 54 ............................... 140,000 42 .......................... 90,000 .............................. 60 ............................... 100,000 44 .......................... 80,000 .............................. 64 ............................... 55,000 46 .......................... 50,000 .............................. 70 ............................... 35,000 Handy Household Products’ top management believes the loss for the first six months reflects a tight profit margin caused by intense competition. Management also believes that many companies will leave this market by next year and profit should improve. ■ Case 15–49 Pricing in a Tight Market; Possible Plant Closing (LO 15-10) 2. Contribution margin, standard: $700 hiL25664_ch15_638-677.indd 676hiL25664_ch15_638-677.indd 676 7/17/13 12:15 AM7/17/13 12:15 AM Final PDF to printer Chapter 15 Target Costing and Cost Analysis for Pricing Decisions 677 Required: 1. What unit selling price should management select for each of the Clean & Bright compounds for the remaining six months of the year? Support your selection with appropriate calculations. 2. Independently of your answer to requirement (1), assume the optimum alternatives for the last six months were as follows: a selling price of $46 and volume of 50,000 cases for the standard com- pound, and a selling price of $70 and volume of 35,000 cases for the commercial compound. a. Should management consider closing down its operations until January 1 of the next year in order to minimize its losses? Support your answer with appropriate calculations. b. Identify and discuss the qualitative factors that should be considered in deciding whether the Shreveport Plant should be closed down during the last six months of the current year. (CMA, adapted) hiL25664_ch15_638-677.indd 677hiL25664_ch15_638-677.indd 677 7/17/13 12:15 AM7/17/13 12:15 AM Final PDF to printer 16 THIS CHAPTER’S FOCUS is on the City of Mountainview, New Mexico. Mountainview’s mayor and city council face a variety of decisions that involve cash flows over several periods of time. The decision tool used in making such multiperiod decisions is called discounted-cash-flow analysis, because it takes account of the timing of cash flows that occur in different time periods. Among the decisions that Mountainview’s leadership makes is whether to purchase a new computer system for the city government. Since the City of Mountain- view is not a profit-seeking enterprise, income taxes play no role in the decisions faced by the city’s leadership. FOCUS COMPANY >>>
Capital Expenditure
Decisions
hiL25664_ch16_678-731.indd 678hiL25664_ch16_678-731.indd 678 7/17/13 12:16 AM7/17/13 12:16 AM
Final PDF to printer

In contrast to the Mountainview city government setting, in which income
taxes play no role in decisions, we turn our attention to High Country
Department Stores. This chain of retail department stores, located in
Mountainview, also faces some significant decisions involving multiperiod cash flows. Since
High Country is a profit-seeking enterprise, it does pay income taxes. Therefore, when the
company’s management uses discounted-cash-flow analysis, it must take taxes into account.
Among the decisions faced by High Country’s management is whether to purchase a new
computerized checkout system.
<<< IN CONTRAST HIGH COUNTRY DEPARTMENT STORES hiL25664_ch16_678-731.indd 679hiL25664_ch16_678-731.indd 679 7/17/13 12:16 AM7/17/13 12:16 AM Final PDF to printer 680 Managers in all organizations periodically face major decisions that involve cash flows over several years. Decisions involving the acquisition of machinery, vehicles, buildings, or land are examples of such decisions. Other examples include decisions involving sig- nificant changes in a production process or adding a major new line of products or ser- vices to the organization’s activities. Decisions involving cash inflows and outflows beyond the current year are called capital-budgeting decisions. Managers encounter two types of capital-budgeting decisions. Acceptance-or-Rejection Decisions In acceptance-or-rejection decisions, manag- ers must decide whether they should undertake a particular capital investment project. In such a decision, the required funds are available or readily obtainable, and management must decide whether the project is worthwhile. For example, the controller for the city of Mountainview is faced with a decision as to whether to replace one of the city’s oldest street-cleaning machines. The funds are available in the city’s capital budget. The ques- tion is whether the cost savings with the new machine will justify the expenditure. Capital-Rationing Decisions In capital-rationing decisions, managers must decide which of several worthwhile projects makes the best use of limited investment funds. To illustrate, suppose the voters in the city of Mountainview have recently passed 16-1 Use the net-present-value method and the internal-rate-of-return method to evaluate an investment proposal. 16-2 Compare the net-present-value and internal-rate-of-return methods, and state the assumptions underlying each method. 16-3 Use both the total-cost approach and the incremental-cost approach to evaluate an investment proposal. 16-4 Determine the after-tax cash flows in an investment analysis. 16-5 Use the Modified Accelerated Cost Recovery System to determine an asset’s depreciation schedule for tax purposes. 16-6 Evaluate an investment proposal using a discounted-cash-flow analysis, giving full consideration to income-tax issues. 16-7 Discuss the difficulty of ranking investment proposals, and use the profitability index. 16-8 Use the payback method and accounting-rate-of-return method to evaluate capital investment projects. 16-9 Describe the impact of activity-based costing and advanced manufacturing technology on capital-budgeting decisions. 16-10 Explain the impact of inflation on a capital-budgeting analysis (Appendix B). After completing this chapter, you should be able to: hiL25664_ch16_678-731.indd 680hiL25664_ch16_678-731.indd 680 7/17/13 12:16 AM7/17/13 12:16 AM Final PDF to printer Chapter 16 Capital Expenditure Decisions 681 a proposition mandating the city government to undertake a cost-reduction program to trim administrative expenses. The voters also passed a bond issue, which enables the city government to raise $100,000 through the sale of bonds, to provide capital to finance the cost-reduction program. The mayor has in mind three cost-reduction programs, each of which would reduce administrative costs significantly over the next five years. However, the city can afford only two of the programs with the $100,000 of investment capital available. The mayor’s decision problem is to decide which projects to pursue. Focus on Projects Capital-budgeting problems tend to focus on specific projects or programs. Is it best for Mountainview to purchase the new street cleaner or not? Which cost-reduction programs will provide the city with the greatest benefits? Should a univer- sity buy a new electron microscope? Should a manufacturing firm acquire a computer- integrated manufacturing system? Over time, as managers make decisions about a variety of specific programs and projects, the organization as a whole becomes the sum total of its individual investments, activities, programs, and projects. The organization’s performance in any particular year is the combined result of all the projects under way during that year. Chapter Organization This chapter is divided into three modular sections, each of which explores a particular aspect of capital expenditure decisions. Section 1 should be studied first, after which either Section 2 or Section 3 may be studied. • Section 1: Discounted-Cash-Flow Analysis • Section 2: Income Taxes and Capital Budgeting • Section 3: Alternative Methods for Making Investment Decisions Section 1: Discounted-Cash-Flow Analysis How do managers evaluate capital investment projects? Our discussion will be illus- trated by several decisions made by the Mountainview city government. The controller of Mountainview routinely advises the mayor and city council on major capital-investment decisions. Currently under consideration is the purchase of a new street cleaner. The controller has estimated that the city’s old street-cleaning machine would last another five years. A new street cleaner, which also would last for five years, can be purchased for $50,470. It would cost the city $14,000 less each year to operate the new equipment than it costs to operate the old machine. The expected cost savings with the new machine are due to lower expected maintenance costs. Thus, the new street cleaner will cost $50,470 and save $70,000 over its five-year life ($70,000 5 5 3 $14,000 savings per year). Since the $70,000 in cost savings exceeds the $50,470 acquisition cost, one might be tempted to conclude that the new machine should be purchased. However, this analysis is flawed, since it does not account for the time value of money. The $50,470 acquisi- tion cost will occur now, but the cost savings are spread over a five-year period. It is a mistake to add cash flows occurring at different points in time. The proper approach is to use discounted-cash-flow analysis, which takes into account the timing of the cash flows. There are two widely used methods of discounted-cash-flow analysis: the net- present-value method and the internal-rate-of-return method. [Those who wish to review the basic concept of present value should read Appendix II (on pages 766–772) before continuing.] Section 1: Discounted-Cash-Flow Analysis Learning Objective 16-1 Use the net-present-value method and the internal-rate- of-return method to evaluate an investment proposal. hiL25664_ch16_678-731.indd 681hiL25664_ch16_678-731.indd 681 7/17/13 12:16 AM7/17/13 12:16 AM Final PDF to printer 682 Chapter 16 Capital Expenditure Decisions Net-Present-Value Method The following four steps constitute a net-present-value analysis of an investment proposal: 1. Prepare a table showing the cash flows during each year of the proposed investment. 2. Compute the present value of each cash flow, using a discount rate that reflects the cost of acquiring investment capital. This discount rate is often called the hurdle rate or minimum desired rate of return. 3. Compute the net present value, which is the sum of the present values of the cash flows. 4. If the net present value (NPV) is equal to or greater than zero, accept the invest- ment proposal. Otherwise, reject it. Exhibit 16–1 displays these four steps for the Mountainview controller’s street-cleaner decision. In step (2) the controller used a discount rate of 10 percent. Notice that the cost savings are $14,000 in each of the years 1 through 5. Thus, the cash flows in those years comprise a five-year, $14,000 annuity. The controller used the annuity discount factor to compute the present value of the five years of cost savings. (The discount factors are found in Table IV in Appendix A at the end of this chapter.) The net-present-value analysis indicates that the city should purchase the new street cleaner. The present value of the cost savings exceeds the new machine’s acquisition cost. Internal-Rate-of-Return Method An alternative discounted-cash-flow method for analyzing investment proposals is the internal-rate-of-return method. An asset’s internal rate of return (or time-adjusted rate of return ) is the true economic return earned by the asset over its life. Another way of stating the definition is that an asset’s internal rate of return (IRR) is the discount rate that would be required in a net-present-value analysis in order for the asset’s net present value to be exactly zero. What is the internal rate of return on Mountainview’s proposed street-cleaner acqui- sition? Recall that the asset has a positive net present value, given that the city’s cost of acquiring investment capital is 10 percent. Would you expect the asset’s IRR to be higher or lower than 10 percent? Think about this question intuitively. The higher the discount rate used in a net-present-value analysis, the lower the present value of all Exhibit 16–1 Net-Present-Value Method “We’re key members of the decision making team when it comes to sig- nificant capital expenditure decisions.” (16a) Ford Motor Company MOUNTAINVIEW CITY GOVERNMENT Purchase of Street Cleaner (r .10, n 5) Step 1 Time 0 Time 1 Time 2 Time 3 Time 4 Time 5 Acquisition cost $(50,470) 000,41$000,41$000,41$000,41$000,41$sgnivas tsoc launnA Step 2 Present value of annuity $14,000(3.791) Annuity discount factor for r .10 and n 5 from Table IV in Appendix A )074,05($eulav tneserP $53,074 Step 3 406,2$eulav tneserp teN Step 4 Accept proposal, since net present value is positive. hiL25664_ch16_678-731.indd 682hiL25664_ch16_678-731.indd 682 7/17/13 12:16 AM7/17/13 12:16 AM Final PDF to printer Chapter 16 Capital Expenditure Decisions 683 future cash flows will be. This is true because a higher discount rate means that it is even more important to have the money earlier instead of later. Thus, a discount rate higher than 10 percent would be required to drive the new street cleaner’s net present value down to zero. Finding the Internal Rate of Return How can we find this rate? One way is trial and error. We could experiment with different discount rates until we find the one that yields a zero net present value. We already know that a 10 percent discount rate yields a positive NPV. Let’s try 14 percent. Discounting the five-year, $14,000 cost-savings annuity at 14 percent yields a negative NPV of $(2,408). (3.433)($14,000) $50,470 $(2,408) Annuity discount factor for r .14 and n 5 from Table IV in Appendix A. What does this negative NPV at a 14 percent discount rate mean? We increased the discount rate too much. Therefore, the street cleaner’s internal rate of return must lie between 10 percent and 14 percent. Let’s try 12 percent: (3.605)($14,000) $50,470 0 Annuity discount factor for r .12 and n 5 from Table IV in Appendix A. That’s it. The new street cleaner’s internal rate of return is 12 percent. With a 12 percent discount rate, the investment proposal’s net present value is zero, since the street cleaner’s acquisition cost is equal to the present value of the cost savings. We could have found the internal rate of return more easily in this case, because the street cleaner’s cash flows exhibit a very special pattern. The cash inflows in years 1 through 5 are identical, as shown below. 543210emiT Cash flow $(50,470) $14,000 $14,000 $14,000 $14,000 $14,000 swolfni hsac lauqEwolftuo hsac laitinI )sgnivas tsoc-gnitarepo()tsoc noitisiuqca( When we have this special pattern of cash flows, the internal rate of return is deter- mined in two steps, as follows: 1. Divide the initial cash outflow by the equivalent annual cash inflows: $50,470 _______ $14,000 5 3.605 5 Annuity discount factor 2. In Table IV, find the discount rate associated with the annuity discount factor computed in step (1), given the appropriate number of years in the annuity. r 10% 12% 14% n = 5 3.791 3.605 3.433 From Table IV of Appendix A Decision Rule Now that we have determined the investment proposal’s internal rate of return to be 12 percent, how do we use this fact in making a decision? The deci- sion rule in the internal-rate-of-return method is to accept an investment proposal if hiL25664_ch16_678-731.indd 683hiL25664_ch16_678-731.indd 683 7/17/13 12:16 AM7/17/13 12:16 AM Final PDF to printer 684 Chapter 16 Capital Expenditure Decisions its internal rate of return is greater than the organization’s cost of capital (or hurdle rate). Thus, Mountainview’s controller should recommend that the new street cleaner be purchased. The internal rate of return on the proposal, 12 percent, exceeds the city’s hurdle rate, 10 percent. To summarize, the internal-rate-of-return method of discounted-cash-flow analysis includes the following three steps: 1. Prepare a table showing the cash flows during each year of the proposed invest- ment. This table will be identical to the cash-flow table prepared under the net- present-value method. (See Exhibit 16–1 .) 2. Compute the internal rate of return (IRR) for the proposed investment. This is accomplished by finding a discount rate that yields a zero net present value for the proposed investment. 3. If the IRR is equal to or greater than the hurdle rate (cost of acquiring invest- ment capital), accept the investment proposal. Otherwise, reject it. Recovery of Investment The reason for purchasing an asset is an expectation that it will provide benefits in the future. Thus, Mountainview may purchase the new street cleaner because of expected future operating-cost savings. For a capital investment pro- posal to be accepted, the expected future benefits must be sufficient for the purchaser to recover the investment and earn a return on the investment equal to or greater than the cost of acquiring capital. We can illustrate this point with Mountainview’s street-cleaner acquisition. Exhibit 16–2 examines the investment proposal’s cash flows from the perspective of recovering the investment and earning a return on the investment. Focus on the Year 1 column in the exhibit. The street cleaner costs $50,470, so this is the unrecovered invest- ment at the beginning of year 1. The operating-cost savings in year 1 are $14,000. Since the asset’s internal rate of return is 12 percent, it must earn $6,056 during the first year (12% 3 $50,470). Therefore, $6,056 of the $14,000 cost savings represents a return on the unrecovered investment. This leaves $7,944 as a recovery of the investment during year 1 ($14,000 2 $6,056). Subtracting the year 1 recovery of investment from the unre- covered investment at the beginning of the year leaves an unrecovered investment of $42,526 at year-end ($50,470 2 $7,944). “Our role is to be internal management consultants for the key decisions facing management.” (16b) Hewlett-Packard Exhibit 16–2 Recovery of Investment and Return on Investment MOUNTAINVIEW CITY GOVERNMENT Purchase of Street Cleaner (r .12, n 5) Year 1 Year 2 Year 3 Year 4 Year 5 1. Unrecovered investment at beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . $50,470 $42,526 $33,629 $23,664 $12,504 2. Cost savings during year . . . . . . . . . . . . . . . . . . . . 14,000 14,000 14,000 14,000 14,000 3. Return on unrecovered investment [12% amount in row (1)] . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,056 5,103 4,035 2,840 1,500 4. Recovery of investment during year [row (2) amount minus row (3) amount] . . . . . . . . . . . . . . . . . . . . . . 7,944 8,897 9,965 11,160 12,500 5. Unrecovered investment at end of year [row (1) amount minus row (4) amount] . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42,526 33,629 23,664 12,504 4* * We are left with an unrecovered investment of $4 because of accumulated rounding errors in the table. If we had carried out each number to cents, the table would have finished up with an unrecovered investment of zero. hiL25664_ch16_678-731.indd 684hiL25664_ch16_678-731.indd 684 7/17/13 12:16 AM7/17/13 12:16 AM Final PDF to printer Chapter 16 Capital Expenditure Decisions 685 Uneven Cash Flows A complication that often arises in finding a project’s internal rate of return is an uneven pattern of cash flows. In Mountainview’s proposed street-cleaner acquisition, the cost savings are $14,000 per year for all five years of the machine’s life. Suppose, instead, that the pattern of cost savings is as follows: Cost savings $14,000 $14,000 $12,000 $10,000 $8,000 Time 54321raeY Such an uneven cost-savings pattern is quite plausible, since the maintenance costs could rise in the machine’s latter years. When the cash-flow pattern is uneven, iteration must be used to find the internal rate of return. You can try various discount rates iteratively until you find the one that yields a zero net present value for the investment proposal. This sort of computationally intensive work is the kind of task for which computers are designed. Numerous computer software packages are available to find a project’s IRR almost instantaneously. Comparing the NPV and IRR Methods The decision to accept or reject an investment proposal can be made using either the net-present-value method or the internal-rate-of-return method. The different approaches used in the methods are summarized as follows: Learning Objective 16-2 Compare the net-present-value and internal-rate-of-return methods, and state the assump- tions underlying each method. Net-Present-Value Method 1. Compute the investment proposal’s net present value, using the organization’s hurdle rate as the discount rate. 2. Accept the investment proposal if its net present value is equal to or greater than zero; otherwise reject it. Internal-Rate-of-Return Method 1. Compute the investment proposal’s internal rate of return, which is the dis- count rate that yields a zero net present value for the project. 2. Accept the investment proposal if its internal rate of return is equal to or greater than the organization’s hurdle rate; otherwise reject it. Notice that the hurdle rate is used in each of the two methods. Advantages of Net-Present-Value Method The net-present-value method exhibits two potential advantages over the internal-rate-of-return method. First, if the investment analysis is carried out by hand, it is easier to compute a project’s NPV than its IRR. For example, if the cash flows are uneven across time, trial and error must be used to find the IRR. This advantage of the NPV approach is not as important, however, when a computer is used. A second potential advantage of the NPV method is that the analyst can adjust for risk considerations. For some investment proposals, the further into the future that a cash flow occurs, the less certain the analyst can be about the amount of the cash flow. Thus, the later a projected cash flow occurs, the riskier it may be. It is possible to adjust a net- present-value analysis for such risk factors by using a higher discount rate for later cash flows than earlier cash flows. It is not possible to include such a risk adjustment in the internal-rate-of-return method, because the analysis solves for only a single discount rate, the project’s IRR. Assumptions Underlying Discounted-Cash-Flow Analysis As is true of any decision model, discounted-cash-flow methods are based on assump- tions. Four assumptions underlie the NPV and IRR methods of investment analysis. hiL25664_ch16_678-731.indd 685hiL25664_ch16_678-731.indd 685 7/17/13 12:16 AM7/17/13 12:16 AM Final PDF to printer 686 Chapter 16 Capital Expenditure Decisions 1. In the present-value calculations used in the NPV and IRR methods, all cash flows are treated as though they occur at year-end. If the city of Mountainview were to acquire the new street cleaner, the $14,000 in annual operating-cost savings actu- ally would occur uniformly throughout each year. The additional computational complexity that would be required to reflect the exact timing of all cash flows would complicate an investment analysis considerably. The error introduced by the year-end cash-flow assumption generally is not large enough to cause any concern. 2. Discounted-cash-flow analyses treat the cash flows associated with an invest- ment project as though they were known with certainty. Although methods of capital budgeting under uncertainty have been developed, they are not used widely in practice. Most decision makers do not feel that the additional benefits in improved decisions are worth the additional complexity involved. As men- tioned above, however, risk adjustments can be made in an NPV analysis to partially account for uncertainty about the cash flows. 3. Both the NPV and IRR methods assume that each cash inflow is immediately reinvested in another project that earns a return for the organization. In the NPV method, each cash inflow is assumed to be reinvested at the same rate used to compute the project’s NPV, the organization’s hurdle rate. In the IRR method, each cash inflow is assumed to be reinvested at the same rate as the project’s internal rate of return. What does this reinvestment assumption mean in practice? In the case of Mountainview’s proposed new street cleaner, the city must instantly reinvest the money saved each year either in some interest-bearing investment or in some other capital project. 4. A discounted-cash-flow analysis assumes a perfect capital market. This implies that money can be borrowed or lent at an interest rate equal to the hurdle rate used in the analysis. In practice, these four assumptions rarely are satisfied. Nevertheless, discounted-cash- flow models provide an effective and widely used method of investment analysis. The improved decision making that would result from using more complicated models sel- dom is worth the additional cost of information and analysis. Choosing the Hurdle Rate The choice of a hurdle rate is a complex problem in finance. The hurdle rate is deter- mined by management based on the investment opportunity rate. This is the rate of return the organization can earn on its best alternative investments of equivalent risk. In general, the greater a project’s risk is, the higher the hurdle rate should be. Investment versus Financing Decisions In capital-expenditure decisions, the investment decision should be separated from the financing decision. The decision as to whether to invest in a project should be made first using a discounted-cash-flow approach with a hurdle rate based on the investment opportunity rate. If a project is accepted, then a separate analysis should be made as to the best way to finance the project. Cost of Capital How do organizations generate investment capital? Nonprofit orga- nizations, such as local, city, and state governments and charitable organizations, often acquire capital through special bond issues or borrowing from financial institutions. In such cases, the cost of capital is based on the interest rate paid on the debt. Another source of capital for both nonprofit and profit-oriented organizations is invested funds, such as a university’s endowment fund. In this case, the cost of using the capital for an investment project is the interest rate forgone on the original invest- ment. For example, suppose your university’s endowment earns interest at the rate of 10 percent. If the university uses a portion of these funds to buy new laboratory equipment, hiL25664_ch16_678-731.indd 686hiL25664_ch16_678-731.indd 686 7/17/13 12:16 AM7/17/13 12:16 AM Final PDF to printer Chapter 16 Capital Expenditure Decisions 687 the cost of capital is the 10 percent interest rate that is no longer earned on the funds removed from the endowment. Profit-oriented enterprises fund capital projects by borrowing, by issuing stock, or by using invested funds. In most cases, capital projects are funded by all of these sources. Then the cost of capital should be a combination of the costs of obtaining money from each of these sources. Depreciable Assets When a long-lived asset is purchased, its acquisition cost is allocated to the time peri- ods in the asset’s life through depreciation charges. However, we did not include any depreciation charges in our discounted-cash-flow analysis. Both the NPV and IRR meth- ods focus on cash flows, and periodic depreciation charges are not cash flows. Suppose that the controller for the city of Mountainview depreciates assets using the straight-line method. If the city purchases the new street cleaner for $50,470, the depreciation charges will be recorded as follows: Depreciation charges are not cash flowsAcquisition cost is a cash outflow Acquisition cost $50,470 Annual straight-line depreciation (D) Time D = $10,094 D = $10,094 D = $10,094 D = $10,094 D = $10,094 Year 1 Year 2 Year 3 Year 4 Year 5 The only cash flow in the diagram above is the $50,470 cash outflow incurred to acquire the street cleaner. The $10,094 annual depreciation charges are not cash flows. Thus, the acquisition cost is recorded as a cash flow in our investment analysis ( Exhibit 16–1 ), but the annual depreciation charges are not. Nonprofit versus Profit-Oriented Organizations Suppose our illustration had focused on a profit-seeking enterprise instead of the city of Mountainview. For example, if the street-cleaner acquisition is contemplated by a theme-park company, would this change our treatment of the annual depreciation charges for the street cleaner? The depre- ciation charges still are not cash flows. However, in a profit-seeking enterprise, deprecia- tion expense is deductible for income-tax purposes. Since tax payments are cash flows, the reduction in tax due to depreciation expense is a legitimate cash flow that should be included in an investment analysis. In Section 2 of this chapter, we will study the tax implications of depreciable assets in detail. For now, let’s return to our focus on the city of Mountainview. As a nonprofit enterprise, the city pays no income tax. Therefore, depreciation is irrelevant in our discounted-cash-flow analysis. Comparing Two Investment Projects We have developed all of the tools and concepts required to use discounted-cash- flow analysis in an investment decision. Now we can expand on our discussion using an illustration that combines the net-present-value method of investment analysis with the concepts of relevant costs and benefits studied in Chapter 14. The first step in any investment analysis is to determine the cash flows that are relevant to the analysis. Comparing Two Investment Projects Learning Objective 16-3 Use both the total-cost approach and the incremental- cost approach to evaluate an investment proposal. hiL25664_ch16_678-731.indd 687hiL25664_ch16_678-731.indd 687 7/17/13 12:16 AM7/17/13 12:16 AM Final PDF to printer 688 Chapter 16 Capital Expenditure Decisions The computing system used by the city of Mountainview is outdated. The city coun- cil has voted to purchase a new computing system to be funded through municipal bonds. The mayor has asked the city’s controller to make a recommendation as to which of two computing systems should be purchased. The two systems are equivalent in their ability to meet the city’s needs and in their ease of use. The mainframe system consists of one large mainframe computer with remote terminals and printers located throughout the city offices. The personal computer system consists of a much smaller mainframe computer, a few remote terminals, and a dozen personal computers, which will be networked to the small mainframe. Each system would last five years. The controller has decided to use a 12 percent hurdle rate for the analysis. Exhibit 16–3 presents data pertinent to the decision. Examine these data carefully. Most of the items are self-explanatory. Item (9) is the annual cost of a data-link service. This service enables Mountainview to participate in a nationwide computer network, which allows cities to exchange information on such issues as crime rates, demographic data, and economic data. Item (10) is the revenue the city will receive from two time- sharing customers. The Mountainview City School District and the county legislature each has agreed to pay the city in return for a limited amount of time on the city’s computer. Before we begin the steps of the net-present-value method, let’s examine the cash- flow data in Exhibit 16–3 to determine if any of the data can be ignored as irrelevant. Notice that items (1) and (9) do not differ between the two alternatives. Regardless of which new computing system is purchased, certain components of the old system can be sold now for $25,000. Moreover, the data-link service will cost $20,000 annually, regard- less of which system is acquired. If the only purpose of the NPV analysis is to determine Exhibit 16–3 Data for Extended Illustration of Net-Present-Value Analysis hiL25664_ch16_678-731.indd 688hiL25664_ch16_678-731.indd 688 7/17/13 12:16 AM7/17/13 12:16 AM Final PDF to printer Chapter 16 Capital Expenditure Decisions 689 Exhibit 16–4 Net-Present-Value Analysis: Total-Cost Approach MOUNTAINVIEW CITY GOVERNMENT Purchase of Computing System (r 5 .12, n 5 5) Item Number (from Exhibit 16–3) Time 0 Time 1 Time 2 Time 3 Time 4 Time 5 Mainframe System (2) Acquisition cost: computer ......................... $(400,000) (3) Acquisition cost: software .......................... (40,000) (4) System update .......................................... $ (40,000) (5) Salvage value ........................................... $ 50,000 (6), (7), (8) Operating costs ............................. $(335,000) $(335,000) (335,000) $(335,000) (335,000) (10) Time-sharing revenue ................................ 20,000 20,000 20,000 20,000 20,000 Total cash flow ........................................... $(440,000) $(315,000) $(315,000) $(355,000) $(315,000) $(265,000) 3 Discount factor .......................................... 3 1.000 3 .893 3 .797 3 .712 3 .636 3 .567 Present value ............................................ $(440,000) $(281,295) $(251,055) $(252,760) $(200,340) $(150,255) Net present value of costs Sum 5 $(1,575,705) Personal Computer System (2) Acquisition cost: computer ......................... $(300,000) (3) Acquisition cost: software .......................... (75,000) (4) System update .......................................... $ (60,000) (5) Salvage value ........................................... $ 30,000 (6), (7), (8) Operating costs ............................. $(235,000) $(235,000) (235,000) $(235,000) (235,000) (10) Time-sharing revenue ................................ –0– –0– –0– –0– –0– Total cash flow .......................................... $(375,000) $(235,000) $(235,000) $(295,000) $(235,000) $(205,000) 3 Discount factor ......................................... 3 1.000 3 .893 3 .797 3 .712 3 .636 3 .567 Present value ........................................... $(375,000) $(209,855) $(187,295) $(210,040) $(149,460) $(116,235) Net present value of costs ................................ Sum 5 $(1,247,885) Difference in NPV of costs (favors personal computer system) ................ $ (327,820) which computer system is the least-cost alternative, items (1) and (9) can be ignored as irrelevant, since they will affect both alternatives’ NPVs equally. Total-Cost Approach Exhibit 16–4 displays a net-present-value analysis of the two alternative computing systems. The exhibit uses the total-cost approach, in which all of the relevant costs of each computing system are included in the analysis. Then the net present value of the cost of the mainframe system is compared with that of the personal computer system. Since the NPV of the costs is lower with the personal computer system, that will be the controller’s recommendation to the Mountainview City Council. A decision such as Mountainview’s computing-system choice, in which the objective is to select the alternative with the lowest cost, is called a least-cost decision. Rather than maximizing the NPV of cash inflows minus cash outflows, the objective is to minimize the NPV of the costs to be incurred. Incremental-Cost Approach Exhibit 16–5 displays a different net-present-value analysis of the city’s two alternative computing systems. This exhibit uses the incremental- cost approach, in which the difference in the cost of each relevant item under the two alternative systems is included in the analysis. For example, the incremental computer acquisition cost is shown in Exhibit 16–5 as $(100,000). This is the amount by which the acquisition cost of the mainframe system exceeds that of the personal computer system. hiL25664_ch16_678-731.indd 689hiL25664_ch16_678-731.indd 689 7/17/13 12:16 AM7/17/13 12:16 AM Final PDF to printer 690 Chapter 16 Capital Expenditure Decisions Exhibit 16–5 Net-Present-Value Analysis: Incremental-Cost Approach “We make considerable use of discounted-cash-flow analysis when we’re con- sidering facility upgrades. We realize that we need to continually invest in our research facilities in order to do the kind of research that is needed.” (16c) Cornell University MOUNTAINVIEW CITY GOVERNMENT Purchase of Computing System (r 5 .12, n 5 5) Item Number (from Exhibit 16–3) Time 0 Time 1 Time 2 Time 3 Time 4 Time 5 Incremental Cost of Mainframe System over Personal Computer System (2) Acquisition cost: computer ................................. $(100,000) (3) Acquisition cost: software .................................. 35,000 (4) System update .................................................. $ 20,000 (5) Salvage value .................................................... $ 20,000 (6), (7), (8) Operating costs ..................................... $(100,000) $(100,000) (100,000) $(100,000) (100,000) (10) Time-sharing revenue ...................................... 20,000 20,000 20,000 20,000 20,000 Incremental cash flow ....................................... $ (65,000) $ (80,000) $ (80,000) $ (60,000) $ (80,000) $ (60,000) 3 Discount factor .................................................. 3 1.000 3 .893 3 .797 3 .712 3 .636 3 .567 Present value ................................................... $ (65,000) $ (71,440) $ (63,760) $ (42,720) $ (50,880) $ (34,020) Net present value of incremental costs (favors personal computer system) .......................... Sum 5 $(327,820) The result of this analysis is that the NPV of the costs of the mainframe system exceeds that of the personal computer system by $327,820. Notice that this is the same as the dif- ference in NPVs shown at the bottom of Exhibit 16–4 . The total-cost and incremental-cost approaches always will yield equivalent conclu- sions. Choosing between them is a matter of personal preference. Managerial Accountant’s Role To use discounted-cash-flow analysis in deciding about investment projects, managers need accurate cash-flow projections. This is where the managerial accountant plays a role. The accountant often is asked to predict cash flows related to operating-cost savings, additional working-capital requirements, or incremental costs and revenues. Such predic- tions are difficult in a world of uncertainty. The managerial accountant often draws upon historical accounting data to help in making cost predictions. Knowledge of market con- ditions, economic trends, and the likely reactions of competitors also can be important in projecting cash flows. Postaudit The discounted-cash-flow approach to evaluating investment proposals requires cash- flow projections. The desirability of a proposal depends heavily on those projections. If they are highly inaccurate, they may lead the organization to accept undesirable projects or to reject projects that should be pursued. Because of the importance of the capital- budgeting process, most organizations systematically follow up on projects to see how they turn out. This procedure is called a postaudit (or reappraisal ). In a postaudit, the managerial accountant gathers information about the actual cash flows generated by a project. Then the project’s actual net present value or internal rate of return is computed. Finally, the projections made for the project are compared with the actual results. If the project has not lived up to expectations, an investigation may be warranted to determine what went awry. Sometimes a postaudit will reveal shortcomings in the cash-flow projection process. In such cases, action may be taken to improve future cash-flow predic- tions. Two types of errors can occur in discounted-cash-flow analyses: undesirable projects Managerial Accountant’s Role hiL25664_ch16_678-731.indd 690hiL25664_ch16_678-731.indd 690 7/17/13 12:16 AM7/17/13 12:16 AM Final PDF to printer Chapter 16 Capital Expenditure Decisions 691 may be accepted, and desir- able projects may be rejected. The postaudit is a tool for fol- lowing up on accepted proj- ects. Thus, a postaudit helps to detect only the first kind of error, not the second. As in any performance- evaluation process, a postaudit should not be used punitively. The focus of a postaudit should provide information to the capital-budgeting staff, the project manager, and the management team. Real Option Analysis One way managerial accountants can assist the management team is by assessing the consequences of changes in an investment decision that may develop after the project has been approved. In long-term projects, there is often considerable uncertainty about the future cash flows, due to uncertainty about future economic, political, or cultural events. As a project unfolds, management may decide to alter the course of the project or even postpone it. Suppose, for example, that the city of Mountainview decides to build a new municipal water system that will take 5 years to build and is expected to last 75 years. The project involves collaboration with several private enterprises, other municipalities, and the state and federal governments. As the project develops and various uncertainties are resolved, it may be desirable to make changes in the water system or postpone certain parts of it. A capital-budgeting tool called real option analysis can be used to quantify and analyze the merits of such changes. Real option analysis is covered in advanced cost management and finance courses. Section 2: Income Taxes and Capital Budgeting When a business makes a profit, it usually must pay income taxes, just as individuals do. Since many of the cash flows associated with an investment proposal affect the compa- ny’s profit, they also affect the firm’s income-tax liability. The following equation shows the four types of items that appear on an income statement. Income 5 Revenue 2 Expenses 1 Gains 2 Losses Any aspect of an investment project that affects any of the items in this equation generally will affect the company’s income-tax payments. These income-tax payments are cash flows, and they must be considered in any discounted-cash-flow analysis. In some cases, tax considerations are so crucial in a capital-investment decision that they dominate all other aspects of the analysis. After-Tax Cash Flows The first step in a discounted-cash-flow analysis for a profit-seeking enterprise is to determine the after-tax cash flows associated with the investment projects under consid- eration. An after-tax cash flow is the cash flow expected after all tax implications have been taken into account. Each financial aspect of a project must be examined carefully to determine its potential tax impact. Section 2: Income Taxes and Capital Budgeting Capital-investment decisions go through an elaborate capital-budgeting process. This robotic arm packages candy at the chocolate factory of Lindt & Sprüngli in Zurich, Switzerland. Due to this equipment’s significant cost, the capital expenditure deci- sion was carefully analyzed. For what types of decisions would capital budgeting be used by the administration of the college you attend? Learning Objective 16-4 Determine the after-tax cash flows in an investment analysis. hiL25664_ch16_678-731.indd 691hiL25664_ch16_678-731.indd 691 7/17/13 12:16 AM7/17/13 12:16 AM Final PDF to printer 692 Chapter 16 Capital Expenditure Decisions To illustrate the tax implications of various types of financial items, we will focus on a retail business. High Country Department Stores, Inc. operates two department stores in the city of Mountainview. The firm has a large downtown store and a smaller branch store in the suburbs. The company is quite profitable, and management is considering several capital projects that will enhance the firm’s future profit potential. Before analyzing these projects, let’s pause to consider the tax issues the company is likely to face. For the pur- poses of our discussion, we will assume that High Country Department Stores’ income tax rate is 40 percent. Thus, if the company’s net income is $1,000,000, its income-tax payment will be $400,000 ($1,000,000 3 40%). Cash Revenue Suppose High Country’s management is considering the purchase of an additional delivery truck. The sales manager estimates that a new truck will allow the company to increase annual sales revenue by $110,000. Further suppose that this incre- mental sales revenue will be received in cash during the year of sale. Any credit sales will be paid in cash within a short time period. High Country’s additional annual sales revenue will result in an increase of $60,000 per year in cost of goods sold. Moreover, the additional merchandise sold will be paid for in cash during the same year as the related sales. Thus, the net incremental cash inflow resulting from the sales increase is $50,000 per year ($110,000 2 $60,000). What is High Country’s after-tax cash flow from the incremental sales revenue, net of cost of goods sold? As the following calculation shows, the firm’s incremental cash inflow from the additional sales is only $30,000. Incremental sales revenue, net of cost of goods sold (cash inflow) ................................................................... $50,000 Incremental income tax (cash outflow), $50,000 3 40% ............................................................................... (20,000) After-tax cash flow (net inflow after taxes) ..................................................................................................... $ 30,000 Although the incremental sales amounted to an additional net cash inflow of $50,000, the cash outflow for income taxes also increased by $20,000. Thus, the after-tax cash inflow from the incremental sales, net of cost of goods sold, is $30,000. A quick method for computing the after-tax cash inflow from incremental sales is the following: Incremental sales revenue, net of cost of goods sold 3 (1 2 Tax rate) 5 After-tax cash inflow $50,000 3 (1 2 .40) 5 $30,000 Cash Expenses What are the tax implications of cash expenses? Suppose the addition of the delivery truck under consideration by High Country’s management will involve hiring an additional employee, whose annual compensation and fringe benefits will amount to $30,000. As the following computation shows, the company’s incremental cash outflow is only $18,000. Incremental expense (cash outflow) .............................................................................................................. $(30,000) Reduction in income tax (reduced cash outflow), $30,000 3 40% ................................................................. 12,000 After-tax cash flow (net outflow after taxes) .................................................................................................. $(18,000) Although the incremental employee compensation is $30,000, this expense is tax- deductible. Thus, the firm’s income-tax payment will be reduced by $12,000. As a result, the after-tax cash outflow from the additional compensation is $18,000. A quick method for computing the after-tax cash outflow from an incremental cash expense is given in the following equation: Incremental cash expense 3 (1 2 Tax rate) 5 After-tax cash outflow $(30,000) 3 (1 2 .40) 5 $(18,000) HIGH COUNTRY DEPARTMENT STORES hiL25664_ch16_678-731.indd 692hiL25664_ch16_678-731.indd 692 7/17/13 12:17 AM7/17/13 12:17 AM Final PDF to printer Chapter 16 Capital Expenditure Decisions 693 Noncash Expenses Not all expenses represent cash outflows. The most common example of a noncash expense is depreciation expense. Suppose High Country Depart- ment Stores’ management is considering the purchase of a delivery truck that costs $40,000 and has no salvage value. We will discuss the specific methods of depreciation allowed under the tax law later in the chapter, but for now assume the truck will be depre- ciated as follows: Acquisition cost: $40,000 Depreciation: Depreciation: Depreciation: Depreciation: Depreciation: $5,000 $10,000 $10,000 $10,000 $5,000 Time 0 1 2 3 4 5 The only cash flow shown in the diagram above is the truck’s acquisition cost of $40,000 at time zero. The depreciation expense in each of the next five years is not a cash flow. However, depreciation is an expense on the income statement, and it reduces the firm’s income. For example, the $5,000 depreciation expense in year 1 will reduce High Country’s income by $5,000. As a result, the company’s year 1 income-tax payment will decline by $2,000 (40% 3 $5,000). The annual depreciation expense associated with the truck provides a reduction in income-tax expense equal to the firm’s tax rate times the depreciation deduction. This reduction in income taxes is called a depreciation tax shield. To summarize, depreciation is a noncash expense. Although depreciation is not a cash flow, it does cause a reduced cash outflow through the depreciation tax shield. wolf hsac a sIwolf hsac a ton sI $2,00040% Year 1 depreciation of $5,000 Depreciation or any other noncash expense Tax rate Reduced cash outflow for income taxes The following schedule shows High Country Department Stores’ depreciation tax shield over the depreciable life of the proposed delivery truck. Year Depreciation Expense Tax Rate Cash Flow: Reduced Tax Payment 1 ................................. $ 5,000 .......................... 40% ............................. $2,000 Depreciation tax shield 2 ................................. 10,000 ........................... 40 ................................ 4,000 3 ................................. 10,000 ........................... 40 ................................ 4,000 4 ................................. 10,000 ........................... 40 ................................ 4,000 5 ................................. 5,000 ........................... 40 ................................ 2,000 ⎫ ⎪ ⎪ ⎪ ⎬ ⎪ ⎪ ⎪ ⎭ The cash flows constituting the depreciation tax shield occur in five different years. Thus, in a discounted-cash-flow analysis, we still must discount these cash flows to find their present value. Cash Flows Not on the Income Statement Some cash flows do not appear on the income statement. They are not revenues, expenses, gains, or losses. A common example of such a cash flow is the purchase of an asset. If High Country Department Stores purchases the delivery truck, the $40,000 acquisition cost is a cash outflow but not an expense. A purchase is merely the exchange of one asset (cash) for another hiL25664_ch16_678-731.indd 693hiL25664_ch16_678-731.indd 693 7/17/13 12:17 AM7/17/13 12:17 AM Final PDF to printer 694 Chapter 16 Capital Expenditure Decisions (a delivery truck). The expense associated with the truck’s purchase is recognized through depreciation expense recorded throughout the asset’s depreciable life. Thus, the cash flow resulting from the purchase of an asset does not affect income and has no direct tax consequences. Net-Present-Value Analysis Now let’s complete our example by preparing a net- present-value analysis of the proposed delivery-truck acquisition. The company’s after- tax hurdle rate is 10 percent. Exhibit 16–6 displays the net-present-value analysis. Since the NPV is positive, the delivery truck should be purchased. Timing of Tax Deductions We have assumed in our analysis of High Country Depart- ment Stores’ delivery-truck purchase that the cash flows resulting from income taxes occur during the same year as the related before-tax cash flows. This assumption is realistic, as most businesses must make estimated tax payments throughout the tax year. They gener- ally cannot wait until the following year and pay their prior year’s taxes in one lump sum. Inflation Our discussion of discounted-cash-flow analysis has assumed no inflation. The additional complexity of inflation is discussed in Appendix B at the end of this chapter. Accelerated Depreciation The main concept underlying discounted-cash-flow analysis is the time value of money. We discount each cash flow to find its present value. Since money has a time value, it is advantageous for a business to take tax deductions as early as allowable under the tax law. Although federal and state income tax laws are changed periodically by the appropri- ate governmental legislative bodies, income-tax laws usually permit some form of accel- erated depreciation for tax purposes. An accelerated depreciation method is any method under which an asset is depreciated more quickly in the early part of its life than it would be by using straight-line depreciation. For example, suppose High Country Department Stores purchased a personal computer and peripheral devices for $10,000. The equip- ment’s useful life is four years with no salvage value. Exhibit 16–7 shows the pattern Exhibit 16–6 Net-Present-Value Analysis with After-Tax Cash Flows HIGH COUNTRY DEPARTMENT STORES HIGH COUNTRY DEPARTMENT STORES, INC. Purchase of Delivery Truck (r 5 .10, n 5 5) Time 0 Time 1 Time 2 Time 3 Time 4 Time 5 Acquisition cost ............................................................ $(40,000) After-tax cash flow from incremental sales revenue, net of cost of goods sold $50,000 3 (1 2 .40) ............................................... $30,000 $30,000 $30,000 $30,000 $30,000 After-tax cash flow from incremental compensation expense, $30,000 3 (1 2 .40) ............................................... (18,000) (18,000) (18,000) (18,000) (18,000) After-tax cash flow from depreciation tax shield, depreciation expense 3 .40 ...................................... 2,000 4,000 4,000 4,000 2,000 Total cash flow ...................................................... $(40,000) $14,000 $16,000 $16,000 $16,000 $14,000 3 Discount factor ...................................................... 3 1.000 3 .909 3 .826 3 .751 3 .683 3 .621 Present value ....................................................... $(40,000) $12,726 $13,216 $12,016 $10,928 $ 8,694 Net present value ......................................................... Sum 5 $17,580 hiL25664_ch16_678-731.indd 694hiL25664_ch16_678-731.indd 694 7/17/13 12:17 AM7/17/13 12:17 AM Final PDF to printer Chapter 16 Capital Expenditure Decisions 695 of depreciation deductions, the associated after-tax cash flows, and the present value of the depreciation tax shield under three different depreciation methods. Notice that both the double-declining-balance method and the sum-of-the-years’-digits method result in a greater present value for the depreciation tax shield than the straight-line method does. Thus, it usually is desirable for a business to use accelerated depreciation for tax pur- poses whenever the tax law permits. The current tax law does not require that the same depreciation method be used for both the tax purpose and the external-reporting purpose. Thus, management could use straight-line depreciation when preparing published finan- cial statements but use an accelerated method for tax purposes. Modified Accelerated Cost Recovery System (MACRS) Under U.S. tax laws, most depreciable assets acquired after December 31, 1980, have been depreciated for tax purposes in accordance with the Accelerated Cost Recovery System (ACRS). The Tax Reform Acts of 1986, 1989, and 1993 modified the ACRS depreciation program. Under the Modified Accelerated Cost Recovery System, or MACRS, every asset is placed in one of eight classes, depending on the asset’s expected useful life. These eight classes, along with examples of the assets included, are shown in columns (a) and (b) of Exhibit 16–8 . For each class, the Internal Revenue Code specifies the number of years over which the asset may be depreciated, and the depreciation method to be used. These specifications are shown in column (c) of Exhibit 16–8 . Notice that the number of years of depreciation specified by the tax code is not the same as an asset’s useful life. Thus, each asset’s useful life is used only to place the asset in its appropriate MACRS class. Then the tax code specifies the appropriate number of years of depreciation. 1 “It’s clear that we have an important role to play in the decision-making process. We bring a perspective that is different from the other functions.” (16d) Boeing Learning Objective 16-5 Use the Modified Accelerated Cost Recovery System to determine an asset’s depreciation schedule for tax purposes. 1 The U.S. tax law changes almost every year. Occasionally, changes are made in the assignment of assets to prop- erty classes and in the associated depreciation schedules. Moreover, the terminology frequently changes. The tax act of 1980 established the Accelerated Cost Recovery System, which then was referred to as ACRS. Since the tax act of 1986, the program has been referred to in various publications by a variety of names. Among these are the Modi- fied Accelerated Cost Recovery System (MACRS), the ACRS as modified, the CRS, or simply the ACRS. We will follow the common convention of referring to the current system as MACRS. Our discussion incorporates the latest tax law changes known as this book went to press. Regardless of what minor changes the tax laws may make in terminology or depreciation schedules, it is likely that the tax code will continue to allow depreciation by an accel- erated schedule similar to MACRS. Exhibit 16–7 Present Value of Depreciation Tax Shield: Alternative Depreciation Methods Depreciation Expense (Double- Declining- Balance*) Depreciation Tax Shield (Depreciation 3 40%) Depreciation Expense (Sum-of-the- Years’-Digits) Depreciation Tax Shield (Depreciation 3 40%) Depreciation Expense (Straight- Line) Depreciation Tax Shield (Depreciation 3 40%) $5,000 ........... $2,000 ......... $4,000 .......... $1,600 ........ $2,500 ........ $1,000 2,500 ........... 1,000 ......... 3,000 .......... 1,200 ........ 2,500 ........ 1,000 1,250 ........... 500 ......... 2,000 .......... 800 ........ 2,500 ........ 1,000 1,250 ........... 500 ......... 1,000 .......... 400 ........ 2,500 ........ 1,000 Present value of depreciation tax shield (10% discount rate) $3,361 $3,320 $3,170 * Steps in applying the double-declining-balance (DDB) method: To apply the double-declining-balance depreciation method, use the following steps: 1. Divide 100% by the number of years of depreciation to be taken. 2. Multiply the answer obtained in step (1) by 200%. 3. Compute the asset’s depreciation each year by applying the percentage obtained in step (2) to the asset’s undepreciated cost at the beginning of the year. 4. Switch to straight-line depreciation during the first year in which the straight-line amount, computed for the asset’s remaining life, is greater than the double-declining-balance amount. HIGH COUNTRY DEPARTMENT STORES hiL25664_ch16_678-731.indd 695hiL25664_ch16_678-731.indd 695 7/17/13 12:17 AM7/17/13 12:17 AM Final PDF to printer 696 Chapter 16 Capital Expenditure Decisions Depreciation Methods As Exhibit 16–8 indicates, assets in the 3-year, 5-year, 7-year, and 10-year MACRS property classes are depreciated using the double-declining-balance (DDB) method. Assets in the 15-year and 20-year MACRS property classes are depreci- ated using the 150%-declining-balance method. To apply this depreciation method, use the same steps as those listed in Exhibit 16–7 for the DDB method, except change 200% in step (2) to 150%. Assets in the 27.5-year and 39-year MACRS property classes are depreciated using the straight-line method. Half-Year Convention An asset may be purchased at any time during the tax year. MACRS assumes that, on average, assets will be placed in service halfway through the tax year. Thus, the tax code allows only a half-year’s depreciation during the tax year in which an asset is placed in service. The other half of the first year’s depreciation is picked up in the second tax year in which the asset is in service. The following diagram shows the pattern with which a five- year asset’s depreciation is recorded, for tax purposes, under MACRS. MACRS Depreciation Tables To assist taxpayers, the Internal Revenue Service has published tables of the MACRS depreciation percentages for each MACRS property class. The IRS tables use the depreciation method spec- ified in Exhibit 16–8 and incorporate the half-year convention. Exhibit 16–9 pro- vides a convenient table of the MACRS percentages, as computed by the IRS, for selected property classes. In the 5-year column, we see 20 percent for year 1. This results from the half-year convention, since 20 percent is half of the double-declining balance rate of 40 percent. The utility company that owns this truck uses an acceler- ated method of depreciation for its utility equipment. The truck is categorized in the five-year property class under the Modified Accelerated Cost Recovery System (MACRS). Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Time Asset’s Asset’s Asset’s Asset’s Asset’s first-year second-year third-year fourth-year fifth-year depreciation depreciation depreciation depreciation depreciation amount amount amount amount amount (a) Asset’s Useful Life* (b) Types of Assets in MACRS Class (c) MACRS Class and Depreciation Method Up to 4 years Industrial tools 3-year class; double-declining-balance Between 4 and 10 years Automobiles, trucks, office equipment, computers, research equipment 5-year class; double-declining-balance Between 10 and 16 years Most industrial equipment and machinery; office furniture 7-year class; double-declining-balance Between 16 and 20 years Equipment and machinery for specified purposes 10-year class; double-declining-balance Between 20 and 25 years Land improvements; some industrial machinery 15-year class; 150%-declining-balance 25 years or longer Specified real property, such as farm buildings 20-year class; 150%-declining-balance — Residential rental property 27.5-year class; straight-line — Nonresidential real property 39-year class; straight-line * In the tax law, an asset’s useful life is referred to as the Asset Depreciation Range (ADR) Midpoint Life. Exhibit 16–8 Modified Accelerated Cost Recovery System (as modi- fied by the Tax Reform Acts of 1986, 1989, and 1993) hiL25664_ch16_678-731.indd 696hiL25664_ch16_678-731.indd 696 7/17/13 12:17 AM7/17/13 12:17 AM Final PDF to printer Chapter 16 Capital Expenditure Decisions 697 No Salvage Values Under MACRS, an asset’s estimated salvage value is not sub- tracted in computing the asset’s depreciation basis. Thus, for an asset costing $10,000 with an estimated salvage value of $1,000, the full $10,000 cost is depreciated over the asset’s life. Optional Straight-Line Depreciation The tax law permits a business to depreciate any asset using the straight-line method instead of the method prescribed in Exhibit 16–8 . A business with a loss might prefer this approach for tax reasons. If the straight-line method is used, the business may depreciate the asset over either the MACRS life or the asset’s estimated useful life. Thus, businesses have considerable flexibility in choosing a depreciation schedule for tax purposes. Regardless of the depreciation method chosen, the half-year convention still must be followed. Income-Tax Complexities The U.S. tax code is a complex document with a multi- tude of provisions. It is not possible to cover all of these provisions in this text, so it is wise to consult a tax expert regarding the complexities that may apply in a particular investment decision. Since the tax code is changed frequently by Congress, a tax rule that applied last year may not apply this year. For example, the investment tax credit is one important tax-code provision that has been switched on and off repeatedly by Congress. During periods when the investment tax credit has been in effect, a com- pany has been allowed a substantial reduction in its income taxes when particular types of investments are made. The intent of the investment credit was to stimulate the economy by giving businesses an incentive to make new investments. The status of the investment tax credit is always subject to change. If there is a moral to the changing-tax-code story, it is this: When making an important investment decision, a manager should have a managerial accountant on one side and a tax accountant on the other. Gains and Losses on Disposal When a business sells an asset, there often is a gain or loss on the sale. Since gains and losses are included in income, the business’s income taxes generally are affected. Capital investment decisions frequently involve the disposal of assets, and sometimes gains or losses are recorded on those sales. Thus, the tax effects of gains and losses on disposal of assets can be an important feature of an investment decision. The book value of an asset is defined as the asset’s acquisition cost minus the accu- mulated depreciation on the asset. When an asset is sold for more than its current book value, a gain on disposal is recorded. The gain is defined as the difference between the “The tax issues can often drive a client’s business decision.” (16e) A. T. Kearney Learning Objective 16-6 Evaluate an investment proposal using a discounted-cash-flow analysis, giving full consideration to income-tax issues. Exhibit 16–9 Selected MACRS Depreciation Percentages as Computed by the IRS (incorporates half- year convention; also incorpo- rates recent modifications in the tax laws) MACRS Property Class Year 3-year 5-year 7-year 10-year 1 .................................................................... 33.33% 20.00% 14.29% 10.00% 2 .................................................................... 44.45 32.00 24.49 18.00 3 .................................................................... 14.81* 19.20 17.49 14.40 4 .................................................................... 7.41 11.52* 12.49 11.52 5 .................................................................... 11.52 8.93* 9.22 6 .................................................................... 5.76 8.92 7.37 7 .................................................................... 8.93 6.55* 8 .................................................................... 4.46 6.55 9 .................................................................... 6.56 10 ..................................................................... 6.55 11 ..................................................................... 3.28 * Denotes the year during which the depreciation method switches to the straight-line method. Source: IRS Publication 946, entitled “How to Depreciate Property.” hiL25664_ch16_678-731.indd 697hiL25664_ch16_678-731.indd 697 7/17/13 12:17 AM7/17/13 12:17 AM Final PDF to printer 698 Chapter 16 Capital Expenditure Decisions sales proceeds and the asset’s book value. A loss on disposal is recorded when an asset is sold for less than its current book value. The loss is equal to the difference between the asset’s current book value and the sales proceeds. To illustrate, suppose High Country Department Stores owns a forklift, which cost $10,000 and currently has accumulated depreciation of $6,000. The forklift’s book value is computed as follows: Book value 5 Acquisition cost 2 Accumulated depreciation $4,000 5 10,000 2 $6,000 Scenario I: Gain on Disposal Suppose High Country sells the forklift for $5,000. The gain on the sale is $1,000 ($5,000 proceeds minus $4,000 book value). If High Country’s income-tax rate is 40 percent, the following cash flows will occur at the time of the sale. Cash inflow: proceeds from sale .................................................................................................................... $5,000 Cash outflow: incremental income tax due to the gain, $1,000 3 40% ............................................................ (400) Net cash flow ................................................................................................................................................ $4,600 Although High Country sold the forklift for $5,000, the company’s net cash benefit is only $4,600. The firm will have to pay the other $400 in increased income taxes on the $1,000 gain. Scenario II: Loss on Disposal Now assume instead that High Country Department Stores sells the forklift for $3,200. The loss on the sale is $800 ($3,200 proceeds minus $4,000 book value). If High Country’s income-tax rate is 40 percent, the following cash flows will occur at the time of the sale. Cash inflow: proceeds from sale ................................................................................................................... $3,200 Reduced cash outflow: reduction in income tax due to the loss, $800 3 40% ................................................. 320 Total cash flow ............................................................................................................................................. $3,520 Although High Country sold the forklift for only $3,200, the company’s total benefit from the sale is $3,520. The extra $320 comes in the form of a reduction in income taxes due to the loss on the sale. Tax Rates on Gains and Losses Another complexity of the tax code that changes from time to time is that capital gains and losses may be taxed at different rates than ordi- nary income (i.e., revenue minus expenses). Thus, before preparing an NPV analysis, it is wise to check with a tax expert to obtain the proper income-tax rate to apply to a gain or loss on disposal. Investment in Working Capital Some investment proposals require additional outlays for working capital. Working capital, defined as the excess of current assets over current liabilities, often increases as the result of higher balances in accounts receivable or inventory necessary to sup- port a project. Such increases are uses of cash and should be included in a discounted- cash-flow analysis. To illustrate, suppose the city of Mountainview has offered High Country Department Stores a contract to sell special T-shirts and mementos com- memorating the city’s bicentennial. The contract covers the three-year period leading up to the bicentennial celebration. The cash flows associated with the proposal are displayed in panel A of Exhibit 16–10 . Notice that the sales proposal would require a $2,000 outlay for additional working capital throughout the three-year period. The increased working capital is largely due to a higher balance in merchandise Learning Objective 16-6 Evaluate an investment proposal using a discounted- cash-flow analysis, giving full consideration to income-tax issues. hiL25664_ch16_678-731.indd 698hiL25664_ch16_678-731.indd 698 7/17/13 12:17 AM7/17/13 12:17 AM Final PDF to printer Chapter 16 Capital Expenditure Decisions 699 inventory. Panel B of Exhibit 16–10 analyzes the contract proposal. Notice that the time 0 cash investment in working capital is included as a $2,000 cash outflow. Since the increase in working capital is not released until the end of year 3, that $2,000 inflow is discounted. The city’s proposal has a positive net present value, so it should be accepted. Notice that the presentation format used for the analysis in Exhibit 16–10 is different from the format we used previously. Instead of listing the cash flows for each item by year and then adding the columns, we have computed the present value of each financial item pertinent to the decision. The one-time cash flows at time zero then are added to the present value of the cost-savings annuity to determine the net present value. This alter- native presentation format will yield the same conclusion as the year-by-year, columnar approach. The choice of format is a matter of personal preference. Extended Illustration of Income-Tax Effects in Capital Budgeting Now we have covered all of the most important concepts for analyzing an investment proposal in a profit-seeking enterprise. A comprehensive illustration will help you solid- ify your understanding of these concepts. High Country Department Stores’ manage- ment is considering the installation of a new checkout system for its suburban store. The new computerized system would include new cash registers at each checkout station. HIGH COUNTRY DEPARTMENT STORES, INC. Contract Proposal for the City’s Bicentennial A. Data for Illustration Annual sales revenue from T-shirts and mementos .......................................................................................... $25,000 Annual expenses ............................................................................................................................................ (12,000) Annual contract fee to city .............................................................................................................................. (3,000) Investment in working capital (time 0) ............................................................................................................. (2,000) Release of working capital (end of year 3) ........................................................................................................ 2,000 Tax rate ......................................................................................................................................................... 40% After-tax hurdle rate ....................................................................................................................................... 10% B. Discounted-Cash-Flow Analysis Investment in working capital (time 0) ................................................................................... $ (2,000) Release of working capital: Working capital released (end of year 3) ............................................................................ $ 2,000 Discount factor (n 5 3, r 5 .10) ...................................................................................... 3 .751* Present value of working capital released .......................................................................... 1,502 Annual revenue and expenses: Sales revenue .................................................................................................................. $25,000 Expenses ......................................................................................................................... (12,000) Contract fee .................................................................................................................... (3,000) Before-tax annual income ................................................................................................. 10,000 3 (1 2 tax rate) .............................................................................................................. 3 .60 After-tax annual income ................................................................................................... 6,000 3 Annuity discount factor ............................................................................................... 3 2.487† Present value of after-tax annual income 14,922 Net present value of contract proposal .................................................................................. $14,424 * From Table III of Appendix A. † From Table IV of Appendix A. Exhibit 16–10 Investment in Working Capital HIGH COUNTRY DEPARTMENT STORES hiL25664_ch16_678-731.indd 699hiL25664_ch16_678-731.indd 699 7/17/13 12:17 AM7/17/13 12:17 AM Final PDF to printer 700 Chapter 16 Capital Expenditure Decisions In addition, the new checkout system would include an updated bar-code reading sys- tem. The new system will be faster and more accurate, and it will minimize the annoy- ance of the reader failing to recognize a product’s bar code. Among the advantages of the new system are accuracy in the checkout process, automatic updating of computer- ized inventory records, and the ability to gather data about customers’ buying patterns and trends. Exhibit 16–11 presents the data pertinent to the decision. Notice that the old equip- ment has been fully depreciated already. However, its useful life can be extended to six more years if an overhaul is done in year 2. The new equipment also has an expected use- ful life of six years, so its MACRS classification is the 5-year property class. Most of the data in Exhibit 16–11 are self-explanatory. The last two items in the exhibit under annual data relate to the new checkout system’s ability to gather data about customer demand patterns. The extra data analysis will cost $4,500 annually, but it is expected to generate another $40,000 in annual sales, net of cost of goods sold. A net-present-value analysis of the checkout equipment proposal is presented in Exhibit 16–12 . A total-cost approach is used. The present value of each financial item is computed for both alternatives; then these present values are added to determine each alternative’s net present value. An explanation of each line in the exhibit follows. (1) Line (1) in Exhibit 16–12 records the acquisition cost of the new checkout equipment. This cash flow has no tax impact and does not need to be discounted since it occurs at time 0. (2), (3) These one-time cash flows are required to retrain checkout personnel and retag merchandise to accommodate the new bar-code readers. Since these costs are expenses, we multiply by (1 2 .40). (4), (5) Since the old equipment has a current book value of zero, there is a $1,200 gain on the sale. The $1,200 proceeds are not taxed [line (4)], but the $1,200 gain on the sale is taxed [line (5)]. (6) The cost of updating the software in year 3 is an expense, so we multiply by (1 2 .40). HIGH COUNTRY DEPARTMENT STORES, INC. Computerized Checkout Equipment Decision Old checkout equipment: Remaining useful life, assuming overhaul in year 2 ................................................................................ 6 years Cost of overhaul in year 2 ..................................................................................................................... $3,500 Current book value (fully depreciated) .................................................................................................... –0– Current salvage value ........................................................................................................................... $1,200 Salvage value in six more years ............................................................................................................ –0– New checkout equipment: Useful (ADR midpoint) life ..................................................................................................................... 6 years MACRS property classification .............................................................................................................. 5-year class Acquisition cost of new equipment ........................................................................................................ $50,000 Update of software required in year 3 .................................................................................................... $4,000 Salvage value of new equipment in six years ......................................................................................... $1,000 Cost to retrain checkout personnel ........................................................................................................ $5,000 Cost to retag merchandise .................................................................................................................... $3,000 Annual data: Annual operating-cost savings .............................................................................................................. $15,000 Annual cost of computer-system operator .............................................................................................. $30,000 Annual cost of marketing-data analysis ................................................................................................. $4,500 Annual incremental sales resulting from marketing analysis, net of cost of goods sold .............................. $40,000 After-tax hurdle rate ................................................................................................................................. 10% Tax rate ................................................................................................................................................... 40% Exhibit 16–11 Data for Extended Illustration HIGH COUNTRY DEPARTMENT STORES Learning Objective 16-6 Evaluate an investment proposal using a discounted- cash-flow analysis, giving full consideration to income-tax issues. hiL25664_ch16_678-731.indd 700hiL25664_ch16_678-731.indd 700 7/17/13 12:17 AM7/17/13 12:17 AM Final PDF to printer Chapter 16 Capital Expenditure Decisions 701 (7), (8) The new equipment can be sold in year 6 for $1,000. Since it will be fully depreciated, there will be a $1,000 gain. The $1,000 proceeds are not taxed [line (7)], but the $1,000 gain is taxed [line (8)]. (9) The depreciation tax shield on the new equipment is computed using the MACRS depreciation schedule for the 5-year property class. The annual deprecia- tion deductions are not cash flows, but they do cause a reduction in income taxes. Each cash flow is then discounted using the appropriate discount factor from Table III in Appendix A. (10), (11), (12), (13) These items are annual cash flows. The flows are summed, and then the $20,500 annuity is multiplied by (1 2 .40) because each of the cash flows will be on the income statement. The after-tax cash-flow annuity of $12,300 is then discounted using the annuity discount factor for n 5 6 and r 5 .10. Exhibit 16–12 Net-Present-Value Analysis for Extended Illustration HIGH COUNTRY DEPARTMENT STORES, INC. Computerized Checkout Equipment Decision Year Amount Income- Tax Impact After-Tax Cash Flow Discount Factor (10%) Present Value of Cash Flow Purchase New Equipment (1) Acquisition cost of new equipment .................................. Time 0 $50,000 None $(50,000) 1.000 $(50,000) (2) Cost to retrain checkout personnel .................................. Time 0 5,000 (1 2 .40)* (3,000) 1.000 (3,000) (3) Cost to retag merchandise .............................................. Time 0 3,000 (1 2 .40) (1,800) 1.000 (1,800) (4) Proceeds from sale of old equipment ............................... Time 0 1,200 None 1,200 1.000 1,200 (5) Gain on sale of old equipment ......................................... Time 0 1,200 .40 (480) 1.000 (480) (6) Update of software ......................................................... Year 3 4,000 (1 2 .40) (2,400) .751 (1,802) (7) Salvage value of new equipment ..................................... Year 6 1,000 None 1,000 .564 564 (8) Gain on sale of new equipment ....................................... Year 6 1,000 .40 (400) .564 (226) (9) Depreciation tax shield: Year Cost MACRS Percentage (rounded) Depreciation Expense 1 $50,000 20.0% $10,000 ........................ 10,000 .40 4,000 .909 3,636 2 50,000 32.0% 16,000 ........................ 16,000 .40 6,400 .826 5,286 3 50,000 19.2% 9,600 ........................ 9,600 .40 3,840 .751 2,884 4 50,000 11.5% 5,750 ........................ 5,750 .40 2,300 .683 1,571 5 50,000 11.5% 5,750 ........................ 5,750 .40 2,300 .621 1,428 6 50,000 5.8% 2,900 ........................ 2,900 .40 1,160 .564 654 Total $50,000 Annual incremental costs and benefits (years 1 through 6): (10) Annual operating cost savings ........................................... $15,000 (11) Annual cost of computer operator ...................................... (30,000) Annuity discount factor for n 5 6, r 5 .10 (12) Annual cost of marketing analysis ..................................... (4,500) (13) Annual incremental sales revenue, net of cost of goods sold ................................................... 40,000 Total annual amount ................................................................ $20,500 $20,500 (1 2 .40) $12,300 4.355 53,567 (14) Net present value ................................................................. $13,482 Keep Old Equipment† (15) Cost of overhaul .............................................................. Year 2 $3,500 (1 2 .40) $(2,100) .826 $ (1,735) (16) Net present value ............................................................ $ (1,735) * High Country Department Stores’ tax rate is 40%. † There is no depreciation tax shield if the old equipment is kept, since it has been depreciated fully already. HIGH COUNTRY DEPARTMENT STORES hiL25664_ch16_678-731.indd 701hiL25664_ch16_678-731.indd 701 7/17/13 12:17 AM7/17/13 12:17 AM Final PDF to printer 702 Chapter 16 Capital Expenditure Decisions BIG PHARMA USES CAPITAL BUDGETING IN DEVELOPING NEW DRUGS Among the many large companies making extensive use of capital budgeting are the big pharmaceutical companies. It can take 10 years or more to develop a new drug. It takes huge outlays of cash to develop a drug, test it, and then shepherd it through the governmental approval process. Yet much of what the drug companies claim as the cost of a new drug is actually the opportunity cost of tying up these big dollar outlays for many years before any revenue stream begins. “The average drug developed by a major pharmaceutical company costs at least $4 billion, and it can be as much as $11 billion.” Estimates of the R&D spending per new drug for some of the biggest pharmaceuticals (in billions) are: “AstraZeneca, $11.790; GlaxoSmithKline, $8.170; Pfizer, $7.727; Eli Lilly, $4.577; and Merck, $4.209.” There are many costs included here. “A single clinical trial can cost $100 million at the high end.” And manufacturing costs are significant as well. “But the main expense is failure.” Most new drug ideas never make it to market. The uncertainties big pharmaceutical companies confront are a large part of the problem. First, only a small percentage of drugs under development ever make it as far as human trials. And only 1 in 10 of those makes it through to wide-scale testing. Then there’s the pricing uncertainty as well. How much will people pay for a new drug treatment? To take account of these uncertainties, many drug companies use simula- tion in conjunction with capital budgeting to decide whether to proceed with a drug’s development. A discounted-cash-flow analysis is run many times with differing assump- tions about the drug’s success, its development costs, and its eventual pricing. Then a probability distribution is generated for the drug’s NPV. Management can then make a decision about proceeding with development given the likelihood of a profitable drug.2 (14) The net present value of the new equipment is $13,482. (15) The only specific cash flow related to the alternative of keeping the old equip- ment is the $3,500 overhaul in year 2. This will be an expense, so we multiply by (1 2 .40). Then the after-tax cash flow is discounted. (16) The net present value of the alternative to keep the old equipment is $(1,735). Decision Rule The analysis indicates that High Country Department Stores should purchase the new checkout equipment. The NPV of the new equipment exceeds that of the old equipment. Ranking Investment Projects Suppose a company has several potential investment projects, all of which have positive net present values. If a project has a positive net present value, this means that the return projected for the project exceeds the company’s cost of capital. In this case, every project with a positive NPV should be accepted. In spite of the theoretical validity of this argu- ment, practice often does not reflect this viewpoint. In practice, managers often attempt to rank investment projects with positive net present values. Then only a limited number of the higher-ranking proposals are accepted. The reasons for this common practice are not clear. If a discount rate is used that accu- rately reflects the firm’s cost of capital, then any project with a positive NPV will earn a return greater than the cost of obtaining capital to fund it. One possible explanation for the practice of ranking investment projects is a limited supply of scarce resources, such as Ranking Investment Projects 2 Based on M. Herper, “The Truly Staggering Cost of Inventing New Drugs,” Forbes (online), February 10, 2012, p. 1; J. Carey and A. Barrett, “Drug Pricees: What’s Fair,” BusinessWeek, December 10, 2001, pp. 61–70; and the authors’ research. Learning Objective 16-7 Discuss the difficulty of ranking investment proposals, and use the profitability index. AstraZeneca, Pfizer, GlaxoSmithKline, Eli Lilly, and Merck M A P anagement ccounting ractice hiL25664_ch16_678-731.indd 702hiL25664_ch16_678-731.indd 702 7/17/13 12:17 AM7/17/13 12:17 AM Final PDF to printer Chapter 16 Capital Expenditure Decisions 703 managerial talent. Thus, a form of capital rationing takes place, not because of a limited sup- ply of investment capital, but because of limitations on other resources. A manager may feel that he or she simply cannot devote sufficient attention to all of the desirable projects. The solution, then, is to select only some of the positive-NPV proposals, which implies a ranking. Unfortunately, no valid method exists for ranking independent investment projects with positive net present values. To illustrate, suppose the management of High Country Department Stores has the following two investment opportunities: 1. Proposal A: Open a gift shop at the Mountainview Convention Center. High Country’s management believes the benefits of this proposal would last only six years. High Country’s management expects that after six years, the firm’s competitors will move into the Convention Center and eliminate High Coun- try’s current advantageous position. 2. Proposal B: Open a small gift shop at the Mountainview Airport. The airport gift concession would belong to High Country Department Stores for 10 years under a contract with the city. The predicted cash flows for these investment proposals are as follows: Cash Outflow After-Tax Cash Inflows Present Value of Inflows (10% Discount Rate) Net Present Value Internal Rate of ReturnInvestment Proposal Time 0 Years 1–6 Years 7–10 A (Convention Center) $ (54,450) $14,000 — $ 60,970 $6,520 14% B (Airport) (101,700) 18,000 $18,000 110,610 8,910 12% Both investment proposals have positive net present values. Suppose, however, that due to limited managerial time, High Country’s management has decided to pursue only one of the projects. Which proposal should be ranked higher? This is a difficult question to answer. Proposal B has a higher net present value, but it also requires a much larger initial investment. Proposal A exhibits a higher internal rate of return. However, proposal A’s return of 14 percent applies only to its six-year time horizon. If management accepts proposal A, what will happen in years 7 through 10? Will the facilities and equipment remain idle? Or could they be used profitably for some other purpose? These questions are left unanswered by the analysis above. The main reason that the NPV and IRR methods of analysis yield different rank- ings for these two proposals is that the projects have different lives. Without making an assumption about what will happen in years 7 through 10 if proposal A is accepted, the NPV and IRR methods simply are not capable of ranking the proposals in any sound manner. The only theoretically correct answer to the problem posed in this illustration is that both projects are desirable, and both should be accepted. Each proposal exhibits a positive NPV and an IRR greater than the hurdle rate of 10 percent. Profitability Index One criterion that managers sometimes apply in ranking invest- ment proposals is called the profitability index (or excess present value index ), which is defined as follows: Profitability index 5 Present value of cash flows, exclusive of initial investment _________________________ Initial investment The profitability indices for High Country’s two investment proposals are computed as follows: Investment Proposal Calculation Profitability Index Net Present Value Internal Rate of Return A Present value of inflows _________________ Initial investment 5 $60,970 _______ $54,450 5 1.12 $6,520 14% B Present value of inflows _________________ Initial investment 5 $110,610 ________ $101,700 5 1.09 $8,910 12% < < < hiL25664_ch16_678-731.indd 703hiL25664_ch16_678-731.indd 703 7/17/13 12:17 AM7/17/13 12:17 AM Final PDF to printer 704 Chapter 16 Capital Expenditure Decisions Although proposal A has a lower NPV than proposal B, proposal A exhibits a higher profitability index. Proposal A’s higher profitability index is due to its considerably lower initial investment than that required for proposal B. Is the profitability index a foolproof method for ranking investment proposals? Unfortunately, it too suffers from the same drawbacks as those associated with the NPV or IRR method. Both proposals exhibit a profitability index greater than 1.00, which merely reflects their positive NPVs. Thus, both projects are desirable. The unequal lives of the two proposals prevent the profit- ability index from indicating a theoretically correct ranking of the proposals. The relative desirability of proposals A and B simply depends on what will happen in years 7 through 10 if proposal A is selected. In summary, the problem of ranking investment projects with positive NPVs has not been solved in a satisfactory manner. This lack of resolution is due to an inconsistency inherent to the problem. The inconsistency is that if several projects have positive NPVs, they all are desirable. They all will earn a return greater than the cost of capital. If a manager chooses not to accept all projects with positive NPVs, then the required ranking ultimately must be made on the basis of subjective criteria. Section 3: Alternative Methods for Making Investment Decisions The best way to decide whether to accept an investment project is to use discounted-cash- flow analysis, as described in Sections 1 and 2 of this chapter. Both the net-present-value and the internal-rate-of-return methods will yield the correct accept-or-reject decision. The strength of these methods lies in the fact that they properly account for the time value of money. In spite of the conceptual superiority of discounted-cash-flow decision models, managers sometimes use other methods for making investment decisions. In some cases, these alternative methods are used in conjunction with a discounted-cash-flow analysis. Two of these alternative decision methods are described next. Our discussion is based on decisions faced by the management of High Country Department Stores. The firm operates two department stores in the city of Mountainview. Payback Method The payback period of an investment proposal is the amount of time it will take for the after-tax cash inflows from the project to accumulate to an amount that covers the origi- nal investment. The following formula defines an investment project’s payback period. Payback period 5 Initial investment _______________________ Annual after-tax cash inflow There is no adjustment in the payback method for the time value of money. A cash inflow in year 5 is treated the same as a cash inflow in year 1. To illustrate the payback method, suppose High Country Department Stores’ man- agement is considering the purchase of a new conveyor system for its warehouse. The two alternative machines under consideration have the following projected cash flows. Conveyor System Initial Investment After-Tax Cash Flows: Years 1 through 7 After-Tax Cash Flow When System Is Sold I ........................... $(20,000) ................... $4,000 ........................... –0– II .......................... (27,000) ................... 4,500 ........................... $14,000 The payback period for each conveyor system is computed below. Notice that after- tax cash flows are used in the payback method, just as they are in discounted-cash-flow methods of analysis. Section 3: Alternative Methods for Making Investment Decisions HIGH COUNTRY DEPARTMENT STORES Learning Objective 16-8 Use the payback method and accounting-rate-of-return method to evaluate capital investment projects. hiL25664_ch16_678-731.indd 704hiL25664_ch16_678-731.indd 704 7/17/13 12:17 AM7/17/13 12:17 AM Final PDF to printer Chapter 16 Capital Expenditure Decisions 705 Initial Investment Annual After-Tax Cash Inflow Conveyor System Payback Period I ................................ $20,000 _______ $4,000 ......................... 5 years II ............................... $27,000 _______ $4,500 ......................... 6 years According to the payback method, system I is more desirable than system II. System I will “pay back” its initial investment in five years, while system II requires six years. This conclusion is too simplistic, however, because it ignores the large salvage value associated with system II. Indeed, the NPV of system I is negative, while the NPV of system II is positive, as shown in the following analysis. Present Value of Cash Flows (10% Discount Factor) After-Tax Cash Flows System I System II Initial investment $(20,000) 3 1.000 5 $(20,000) $(27,000) 3 1.000 5 $(27,000) Years 1–7 4,000 3 4.868 5 19,472 4,500 3 4.868 5 21,906 Cash inflow from sale –0– 14,000 3 .513 5 7,182 Net present value $ (528) $ 2,088 The net-present-value analysis demonstrates that only system II can generate cash flows sufficient to cover the company’s cost of capital. The payback method makes it appear as though system I “pays back” its initial investment more quickly, but the method fails to consider the time value of money. Another shortcoming of the payback method is that it fails to consider an investment project’s profitability beyond the payback period. Suppose High Country Department Stores’ management has a third alternative for its warehouse conveyor system. System III requires an initial investment of only $12,000 and will generate after-tax cash inflows of $6,000 in years 1 and 2. Thus, System III’s payback period is two years, as computed below. System III payback period 5 $12,000 _______ $6,000 5 2 years Strict adherence to the payback method would rank system III above systems I and II, due to its shorter payback period. However, suppose we add another piece of infor- mation. System III’s useful life is only two years, and it has no salvage value after two years. It is true that system III will “pay back” its initial investment in only two years if we ignore the time value of money. But then what? System III provides no further benefits beyond year 2. In spite of system III’s short payback period, it is not a desirable investment proposal. The NPV of system III, $(1,584), is negative [$(1,584) 5 (1.736 3 $6,000) 2 $12,000]. Payback Period with Uneven Cash Flows The simple payback formula given on page 704 will not work if a project exhibits an uneven pattern of cash flows. Instead, the after-tax cash flows must be accumulated on a year-to-year basis until the accu- mulation equals the initial investment. Suppose High Country Department Stores’ management is considering the expansion of the downtown store’s parking facili- ties. Management expects that the additional parking will result in much greater sales initially. However, this benefit will gradually taper off, due to the reactions of com- petitors. The projected after-tax cash flows are shown in Exhibit 16–13 , which also presents the payback calculation for the parking lot proposal. The project’s payback period is five years. hiL25664_ch16_678-731.indd 705hiL25664_ch16_678-731.indd 705 7/17/13 12:17 AM7/17/13 12:17 AM Final PDF to printer 706 Chapter 16 Capital Expenditure Decisions Payback: Pro and Con In summary, the payback method of evaluating investment proposals has two serious drawbacks. First, the method fails to consider the time value of money. Second, it does not consider a project’s cash flows beyond the pay-back period. Despite these shortcomings, the payback method is used widely in practice, for two legit- imate reasons. First, the payback method provides a tool for roughly screening investment proposals. If a project does not meet some minimal criterion for the payback period, management may wish to reject the proposal regardless of potential large cash flows predicted well into the future. Second, a young firm may experience a shortage of cash. For such a com- pany, it may be crucial to select investment projects that recoup their initial investment quickly. A cash-poor firm may not be able to wait for the big payoff of a project with a long payback period. Even in these cases, it is wise not to rely on the payback method alone. If the payback method is used, it should be in conjunction with a discounted-cash- flow analysis. Accounting-Rate-of-Return Method Discounted-cash-flow methods of investment analysis focus on cash flows and incorpo- rate the time value of money. The accounting-rate-of-return method focuses on the incremental accounting income that results from a project. Accounting income is based on accrual accounting procedures. Revenue is recognized during the period of sale, not necessarily when the cash is received; expenses are recognized during the period they are incurred, not necessarily when they are paid in cash. The following formula is used to compute the accounting rate of return on an investment project. Accounting rate of return Average incremental revenue Average incremental expensses including depreciation and income taxes ( )) Initial investment ( () ) To illustrate the accounting-rate-of-return method, suppose High Country Depart- ment Stores’ management is considering the installation of a small lunch counter in its downtown store. The required equipment and furnishings cost $210,000 and are in the MACRS 7-year property class. The company has elected to use the optional straight- line depreciation method with the half-year convention. The Excel spreadsheet shown in Exhibit 16–14 displays management’s revenue and expense projections for the lunch Exhibit 16–13 Payback Period with Uneven Cash Flows HIGH COUNTRY DEPARTMENT STORES HIGH COUNTRY DEPARTMENT STORES, INC. Parking Lot Expansion After-Tax Cash Flows Year Type of Cash Flow Outflows Inflows Accumulated Cash Flows (excluding initial investment) 0 Initial investment $(200,000) — 1 Incremental sales* $60,000 $ 60,000 2 Incremental sales* 50,000 110,000 3 Incremental sales* 45,000 155,000 4 Incremental sales* 35,000 190,000 4 Repave parking lot (20,000) 170,000 Payback 5 Incremental sales* 30,000 200,000 period: 6 Incremental sales* 30,000 230,000 5 years 7 Incremental sales* 30,000 260,000 8 Incremental sales* 30,000 290,000 * Incremental sales, net of cost of goods sold. hiL25664_ch16_678-731.indd 706hiL25664_ch16_678-731.indd 706 7/17/13 12:17 AM7/17/13 12:17 AM Final PDF to printer Chapter 16 Capital Expenditure Decisions 707 counter. The total income projected over the project’s 10-year useful life is $174,000. Thus, the average annual income is $17,400. The accounting rate of return on the lunch- counter proposal is computed as follows: Accounting rate of return 5 $17,400 ________ $210,000 5 8.3% (rounded) To compute the lunch-counter project’s internal rate of return, let’s assume that each year’s sales revenue, cost of goods sold, operating expenses, and income taxes are cash flows in the same year that they are recorded under accrual accounting. Recall that the depreciation expense is not a cash flow. These assumptions imply the following cash- flow pattern for the project. Net After-Tax Cash Inflows Year Amount Year Amount Initial investment .......................... $(210,000) 1 ................................................. 36,000 6 ............................... $42,000 2 ................................................. 42,000 7 ............................... 42,000 3 ................................................. 42,000 8 ............................... 36,000 4 ................................................. 42,000 9 ............................... 30,000 5 ................................................. 42,000 10 ............................... 30,000 The internal rate of return on the lunch-counter proposal is approximately 13.5 per- cent. That is, if we compute the present value of the cash flows using a discount rate of 13.5 percent, we obtain approximately a zero NPV. 3 Notice that the project’s accounting rate of return, at 8.3 percent, is much lower than its IRR of 13.5 percent. 3 You can verify the IRR of 13.5% using Table III in Appendix A. You will need to interpolate to find the discount factors for 13.5%, which lie between the 12% and 14% discount factors. For example, .881 is the approximate discount factor for 13.5% and n 5 1 [.881 5 .877 1 (.25)(.893 2 .877)]. Alternatively, you can calculate the discount factor for 13.5% using the formula given in Table III. Exhibit 16–14 Accounting-Rate-of-Return Method HIGH COUNTRY DEPARTMENT STORES hiL25664_ch16_678-731.indd 707hiL25664_ch16_678-731.indd 707 7/17/13 12:17 AM7/17/13 12:17 AM Final PDF to printer 708 Chapter 16 Capital Expenditure Decisions Use of the Average Investment Some managers prefer to compute the accounting rate of return using the average amount invested in a project for the denominator, rather than the project’s full cost. The formula is modified as follows: Accounting rate of return using average inv( eesment Average incremental revenue ) 5 2 AAverage incemental expenses including depr( eeciation and income taxes Average i ) nnvestment ( () ) A project’s average investment is the average accounting book value over the proj- ect’s life. Refer again to High Country Department Stores’ lunch-counter data given in Exhibit 16–14 . The project’s book value at the beginning of each year is tabulated as follows: Year (a) Book Value at Beginning of Year MACRS Depreciation (b) Book Value at End of Year (a) 1 (b) _______ 2 Average Book Value During Year 1 ................. $210,000 ................... $15,000 ................ $195,000 ................ $202,500 2 ................. 195,000 ................... 30,000 ................ 165,000 ................ 180,000 3 ................. 165,000 ................... 30,000 ................ 135,000 ................ 150,000 4 ................. 135,000 ................... 30,000 ................ 105,000 ................ 120,000 5 ................. 105,000 ................... 30,000 ................ 75,000 ................ 90,000 6 ................. 75,000 ................... 30,000 ................ 45,000 ................ 60,000 7 ................. 45,000 ................... 30,000 ................ 15,000 ................ 30,000 8 ................. 15,000 ................... 15,000 ................ –0– ................ 7,500 9 ................. –0– ................... –0– ................ –0– ................ –0– 10 .................. –0– ................... –0– ................ –0– ................ –0– The average investment over the project’s useful life is the average of the amounts in the right-hand column, which is $84,000. Thus, the modified version of the project’s accounting rate of return is 20.7 percent. (The average annual income of $17,400 divided by the average investment of $84,000 equals 20.7 percent, rounded.) Notice that this modified version of the accounting rate of return yields a signifi- cantly higher return than the project’s internal rate of return, which we computed as 13.5 percent. As a general rule of thumb, the following relationships will be observed. Accounting rate of return (using initial investment) , Internal rate of return , Accounting rate of return (using average investment) Accounting Rate of Return: Pro and Con Like the payback method, the accounting- rate-of-return method is a simple way of screening investment proposals. Some managers use this method because they believe it parallels financial accounting statements, which also are based on accrual accounting. However, like the payback method, the accounting- rate-of-return method does not consider the time value of money. Inconsistent Terminology Many different terms for the accounting rate of return are used in practice. Among these terms are simple rate of return, rate of return on assets, and the unadjusted rate of return. Estimating Cash Flows: The Role of Activity-Based Costing The validity of any discounted-cash-flow analysis is dependent on the accuracy of the cash-flow estimates. Activity-based-costing (ABC) systems generally improve the ability of an analyst to estimate the cash flows associated with a proposed project. By separating Estimating Cash Flows: The Role of Activity-Based Costing hiL25664_ch16_678-731.indd 708hiL25664_ch16_678-731.indd 708 7/17/13 12:17 AM7/17/13 12:17 AM Final PDF to printer Chapter 16 Capital Expenditure Decisions 709 costs into activity cost pools and identifying a cost driver for each pool, the analyst can more accurately determine the levels of various costs that will be incurred if the project is implemented. Costs that are treated as fixed under a traditional, volume-based costing system often are seen to be variable, with respect to the appropriate cost driver, under an ABC system. 4 Accuracy in estimating cash flows is particularly important in evaluating a proposed investment in advanced manufacturing equipment. These decisions are complex, involv- ing many peripheral cash flows besides the actual purchase of the equipment. Flexible manufacturing systems (FMSs) generally require cash outlays for software, retraining of employees, realignment of the production line, and engineering. The benefits of such systems often are difficult to quantify also. Intangible benefits such as greater production flexibility are important considerations in making these investment decisions. In today’s manufacturing environment, it is crucial that companies make the best decisions possible regarding huge investments such as those in flexible manufacturing systems. Flawed decisions can spell disaster in today’s globally competitive arenas. Justification of Investments in Advanced Manufacturing Technology The manufacturing industry is changing dramatically as firms adopt a just-in-time (JIT) inventory management approach and move toward computer-integrated-manufacturing (CIM) systems. Many firms have found that JIT and CIM, coupled with a revised mana- gerial accounting system, have provided a competitive edge in the marketplace. In many cases, however, managers have been frustrated when an NPV analysis projects a negative net present value for a proposed investment in a CIM system. Managers often believe intuitively that such an investment is justified, but they are stymied when the NPV analy- sis points to rejection of the proposal. What is the problem here? Are managers overly optimistic about the advantages of CIM? Or is the NPV approach inappropriate for such an investment decision? Most likely neither of these conjectures is true. Managers often are right when their intuition tells them that the company would benefit from advanced manufacturing technology. And it is difficult to find fault with the NPV investment decision model. It is economically and mathematically sound. The problem lies in the difficulties of applying the NPV approach in a CIM investment decision. Some of these difficulties are listed here. 5 1. Hurdle rates that are too high. Sometimes managers have a tendency to set hurdle rates that are too high in a CIM investment analysis. They tend to forget that the purpose of discounting in the NPV model is to account for the time value of money. The appropriate hurdle rate for any investment decision is the investment opportunity rate for alternative investment projects of equivalent risk. In many cases managers tend to overstate this rate. 2. Time horizons that are too short. Another common mistake is to evaluate a CIM investment proposal with too short a time horizon. The acquisition cost of a CIM system can be enormous, and the benefits may be realized over a lengthy period of time. 3. Bias toward incremental projects. Most firms require that large investments be authorized by managers at higher levels than are required for smaller invest- ments. One result of this sensible practice is an incentive for lower-level Justification of Investments in Advanced Manufacturing Technology Learning Objective 16-9 Describe the impact of activity- based costing and advanced manufacturing technology on capital-budgeting decisions. 4 Activity-based-costing systems are covered extensively in Chapter 5. 5This section is based on discussions in R. Kaplan, “Must CIM Be Justified by Faith Alone?” Harvard Business Review 64, no. 2 (March 1986), pp. 87–95; Callie Berliner and James A. Brimson, eds., Cost Management for Today’s Advanced Manufacturing (Boston: Harvard Business School Press, 1988), pp. 16–18, 36–38, 150; and Jean L. Noble, “A New Approach for Justifying Computer-Integrated Manufacturing,” Journal of Cost Management 3, no. 4 (Winter 1990), pp. 14–19. Learning Objective 16-9 Describe the impact of activity- based costing and advanced manufacturing technology on capital-budgeting decisions. hiL25664_ch16_678-731.indd 709hiL25664_ch16_678-731.indd 709 7/17/13 12:17 AM7/17/13 12:17 AM Final PDF to printer 710 Chapter 16 Capital Expenditure Decisions Focus on Ethics DYSFUNCTIONAL FOCUS ON EARLY CASH FLOWS The timing of cash flows in investment decisions can sometimes create behavioral incentives to make dysfunc- tional decisions. The following hypothetical scenario pres- ents such a situation. The Institute for Environmental Studies (IES) is a pri- vately funded, nonprofit scientific organization based in Montreal. The organization’s director of field research is scheduled to retire in two years, and the assistant direc- tor, Marie Fenwar, is hoping to be appointed to the post at that time. In her current position, Fenwar has significant administrative responsibilities, including the approval of research proposals and equipment acquisitions. Fenwar has developed a reputation for carefully scrutinizing every proposed project and keeping the institute’s field research branch within its budget. Fenwar has been so successful in her job that she has been quietly assured by several members of the IES board of directors that she is in line for her boss’s job. She knows, however, that her pros- pects depend on her continued success in keeping the field research branch in solid financial shape. IES recently signed a contract with the U.S. and Canadian governments to do a five-year study of the effects of global warming on the migration of water fowl. The contract fee is $500,000, payable in equal annual installments over the contract term. Fenwar is now con- sidering two alternative proposals for carrying out the study. Each proposal entails the purchase of equipment and the incurrence of various operating costs through- out the term of the contract. Fenwar’s normal procedure for project evaluation is to calculate each proposal’s NPV, using an 8 percent hurdle rate. The projected costs follow: Year Type of Cost Research Proposal I Research Proposal II Time 0 Equipment acquisition* $ 40,000 $70,000 Year 1 Operating costs 150,000 75,000 Year 2 Operating costs 120,000 75,000 Year 3 Operating costs 75,000 95,000 Year 4 Operating costs 40,000 95,000 Year 5 Operating costs 40,000 95,000 * The equipment will be obsolete at the end of the contract term. Fenwar calculated an NPV of $1,370 for Proposal I and $(14,375) for Proposal II. After completing her NPV analysis, however, Fenwar was tempted to ignore it. These thoughts ran through her mind as she drove to work: “If I approve Proposal I, the financial picture for the field research branch is going to pieces for the next two years. After a $40,000 initial investment in equipment, I’m going to show losses of $50,000 and $20,000 in the first two years. That’s not going to look very good when the board considers my promotion.” When she arrived at the office, Fenwar wrote a memo approving Proposal II. Which research proposal should Fenwar have accepted? Why? Comment on the ethical issues in this scenario. managers to request relatively small, incremental improvements in the manu- facturing process rather than a large, comprehensive improvement, such as a move to CIM. In many cases, a series of such incremental improvements will not bring about the benefits that could be attained with a full commitment to advanced manufacturing technology. 4. Greater uncertainty about operating cash flows. Managers often have greater uncertainty about the cash flows that will result when an advanced manufactur- ing system is implemented. This increased uncertainty is due to the complexity of the machinery and the firm’s inexperience with such advanced technology. 5. Exclusion of benefits that are difficult to quantify. The benefits to the firm from JIT and CIM systems are extensive. Some are easy to estimate, such as lower inventory levels, less floor space, and improved product quality. Others that can be even more significant are often difficult to quantify. Some of these benefits are as follows: a. Greater flexibility in the production process. A flexible manufacturing sys- tem cell often can produce runs of several distinct products in the same day. hiL25664_ch16_678-731.indd 710hiL25664_ch16_678-731.indd 710 7/17/13 12:17 AM7/17/13 12:17 AM Final PDF to printer Chapter 16 Capital Expenditure Decisions 711 Flexible manufacturing systems also allow engineering changes to be made more easily as products are adapted to changing customer preferences. b. Shorter cycle times and reduced lead times are possible with an FMS. This enables the firm to fill customer orders more quickly. c. Reduction of non-value-added costs often results when JIT and FMS systems are adopted. Part of the philosophy of these systems is to encour- age employees to seek out activities that can be made more efficient or eliminated. d. Reduced inventory levels result in savings on working capital investment, less storage space, and reduced obsolescence. e. Lower floor-space requirements in a flexible manufacturing system require less space than several stand-alone machines. f. Product quality becomes higher and more constant because of advanced manufacturing systems. Although it is difficult to quantify these benefits, few managers doubt their existence. Excluding them from an NPV analysis means they are being valued at zero. In many cases it would be preferable to make some estimate of these benefits, however crude it may be, than to ignore them. If a manager believes it is impossible to make such an estimate, then the investment criteria should be expanded to consider these intangible benefits along with a proposal’s NPV. Chapter Summary LO16-1 Use the net-present-value method and the internal-rate-of-return method to evaluate an investment proposal. Under the net-present-value method, an investment proposal should be accepted if its net present value is zero or positive. A project’s net present value is the present value of the proj- ect’s future cash flows, less its initial acquisition cost. In computing the present value of the cash flows, the discount rate is the organization’s cost of acquiring investment capital. Under the internal-rate-of- return method, an investment proposal should be accepted if its internal rate of return equals or exceeds the organization’s hurdle rate. A project’s internal rate of return is the discount rate required to make the project’s net present value equal to zero. LO16-2 Compare the net-present-value and internal-rate-of-return methods, and state the assumptions underlying each method. The net-present-value method is somewhat easier to apply. It also has the advantage of allowing the decision maker to adjust the discount rate upward for highly uncertain cash flows. Both the net-present-value method and the internal-rate-of-return method are based on important assumptions, including the following: (1) All cash flows are assumed to occur at year-end. (2) Cash flow amounts are assumed to be certain. (3) Cash flows are assumed to be reinvested immediately in another return-generating project. (4) A perfect capital market is assumed. LO16-3 Use both the total-cost approach and the incremental-cost approach to evaluate an invest- ment proposal. Under the total-cost approach, all projects’ cash flows are included in the analysis at their total amounts. Under the incremental-cost approach, the differences in each cash flow, between alternatives, are included in the analysis. LO16-4 Determine the after-tax cash flows in an investment analysis. For financial items that are both cash flows and on the income statement, the cash flow is multiplied by 1 minus the tax rate to compute the after-tax cash flow. For financial items that are not cash flows but are on the income statement, the cash flow is multiplied by the tax rate to compute the relevant after-tax cash flow. For financial items that are cash flows but are not on the income statement, the cash flow is multiplied by 1 to determine the after-tax cash flow. (In other words, for these items, the cash flow is already on an after-tax basis.) hiL25664_ch16_678-731.indd 711hiL25664_ch16_678-731.indd 711 7/17/13 12:17 AM7/17/13 12:17 AM Final PDF to printer 712 Chapter 16 Capital Expenditure Decisions LO16-5 Use the Modified Accelerated Cost Recovery System to determine an asset’s deprecia- tion schedule for tax purposes. This tax-law-based depreciation schedule, known as MACRS, places every asset in one of eight classes and then states the depreciation rate for each year in the asset’s depreciable life. LO16-6 Evaluate an investment proposal using a discounted-cash-flow analysis, giving full consideration to income-tax issues. For any organization subject to income taxes, the first step in a discounted-cash-flow analysis is to determine the after-tax cash flows related to the investment proposal under consideration. Then these after-tax cash flows are discounted in accordance with the net-present- value method or the internal-rate-of-return method. LO16-7 Discuss the difficulty of ranking investment proposals, and use the profitability index. No valid method exists for ranking independent investment projects with positive net present values. In theory, all projects with positive net present values should be accepted, because the returns expected for the projects exceed the company’s cost of capital. Nevertheless, in practice, managers often do attempt to rank investment projects. One commonly used criterion for such rankings is the profitability index, which is defined as follows: present value of a project’s cash flows, exclusive of the initial investment, divided by the project’s initial investment. LO16-8 Use the payback method and accounting-rate-of-return method to evaluate capital investment projects. A project’s payback period is its initial investment divided by the annual after- tax cash inflow. As explained in the chapter, for projects with uneven cash flows, the payback period requires a more complex calculation. A project’s accounting rate of return is computed as follows: (the project’s average incremental revenue minus its average incremental expenses, including depreciation and income taxes) divided by the project’s initial investment. Since these methods do not account for the time value of money, they are conceptually inferior to discounted-cash-flow methods. However, many organizations use these methods in conjunction with the NPV or IRR method. LO16-9 Describe the impact of activity-based costing and advanced manufacturing technology on capital-budgeting decisions. The validity of any discounted-cash-flow analysis depends on the accuracy of the cash-flow estimates. Activity-based costing systems generally improve the cost analyst’s ability to accurately estimate projects’ cash flows. Some observers argue that, for a variety of reasons, discounted-cash-flow analyses tend to underestimate the benefits of investing in advanced manufacturing technology. LO16-10 Explain the impact of inflation on a capital-budgeting analysis (Appendix B). Inflation (a decline in the purchasing power of a monetary unit) can be incorporated in a discounted-cash-flow analysis in either of two ways: (1) The cash flows are measured in nominal dollars, and the nominal interest rate is used to compute the nominal discount rate. (2) The cash flows are measured in real dol- lars, and the real interest rate is used to compute the real discount rate. Problem 1 Bay City’s Department of Public Works (DPW) is considering the replacement of some machinery. This machinery has zero book value but its current market value is $960. One possible alternative is to invest in new machinery, which has a cost of $46,800. This new machinery would produce estimated annual operating cash savings of $15,000. The estimated useful life of the new machinery is four years. The DPW uses straight-line depreciation. The new machinery has an estimated salvage value of $2,400 at the end of four years. The investment in the new machinery would require an additional investment in working capital of $3,600, which would be recovered after four years. If the DPW accepts this investment proposal, disposal of the old machinery and investment in the new equipment will take place on December 31, 20x4. The cash flows from the investment will occur during the calendar years 20x5 through 20x8. Required: Prepare a net-present-value analysis of the county DPW’s machinery replacement decision. The city has a 10 percent hurdle rate. Review Problems on Capital Expenditure Decisions hiL25664_ch16_678-731.indd 712hiL25664_ch16_678-731.indd 712 7/17/13 12:17 AM7/17/13 12:17 AM Final PDF to printer Chapter 16 Capital Expenditure Decisions 713 Problem 2 River City Pool Company recently purchased a truck for $40,000. The first year’s depreciation was $8,000. The truck driver’s salary in the first year of operation was $42,000. Required: Show how each of the amounts mentioned above should be converted to an after-tax amount. The company’s tax rate is 35 percent. Solutions to Review Problems Problem 1 Time 0 Time 1 Time 2 Time 3 Time 4 Acquisition cost ............................................ $(46,800) Investment in working capital ......................... (3,600) Recovery of working capital ........................... $ 3,600 Salvage value of old machinery ...................... 960 Salvage value of new machinery .................... 2,400 Annual operating cash savings ....................... $15,000 $15,000 $15,000 15,000 Total cash flow .............................................. $(49,440) $15,000 $15,000 $15,000 $21,000 Discount factor* ............................................ 3 1.000 3 .909 3 .826 3 .751 3 .683 Present value ................................................ $(49,440) $13,635 $12,390 $11,265 $14,343 Net present value Sum 5 $2,193 * The discount factors are from Table III in Appendix A (r 5 .10) Conclusion: The DPW’s proposed investment in new machinery has a positive net present value and should be accepted. Problem 2 a. Acquisition cost 5 $40,000 After-tax cash outflow 5 $(40,000) b. Depreciation expense 5 $8,000 After-tax cash flow 5 $8,000(.35) 5 $2,800 savings in cash outflow for taxes c. Salary expense 5 $42,000 After-tax cash outflow 5 ($42,000)(1 2 .35) 5 $(27,300) Key Terms For each term’s definition refer to the indicated page, or turn to the glossary at the end of the text. acceptance-or-rejection decision, 680 accounting-rate-of-return method, 706 after-tax cash flow, 691 capital-budgeting decision, 680 capital-rationing decision, 680 depreciation tax shield, 693 discounted-cash-flow analysis, 681 hurdle rate ( or minimum desired rate of return), 682 internal rate of return ( or time-adjusted rate of return), 682 investment opportunity rate, 686 Modified Accelerated Cost Recovery System (MACRS), 695 net present value, 682 nominal dollars, * 712 nominal interest rate, * 716 payback period, 704 postaudit ( or reappraisal), 690 profitability index ( or excess present value index), 703 real dollars, * 716 real interest rate, * 716 working capital, 698 *Terms appear in Appendix B. hiL25664_ch16_678-731.indd 713hiL25664_ch16_678-731.indd 713 7/17/13 12:17 AM7/17/13 12:17 AM Final PDF to printer 714 Chapter 16 Capital Expenditure Decisions APPENDIX A TO CHAPTER 16 Future Value and Present Value Tables Period 4% 6% 8% 10% 12% 14% 20% 1 1.040 1.060 1.080 1.100 1.120 1.140 1.200 2 1.082 1.124 1.166 1.210 1.254 1.300 1.440 3 1.125 1.191 1.260 1.331 1.405 1.482 1.728 4 1.170 1.263 1.361 1.464 1.574 1.689 2.074 5 1.217 1.338 1.469 1.611 1.762 1.925 2.488 6 1.265 1.419 1.587 1.772 1.974 2.195 2.986 7 1.316 1.504 1.714 1.949 2.211 2.502 3.583 8 1.369 1.594 1.851 2.144 2.476 2.853 4.300 9 1.423 1.690 1.999 2.359 2.773 3.252 5.160 10 1.480 1.791 2.159 2.594 3.106 3.707 6.192 11 1.540 1.898 2.332 2.853 3.479 4.226 7.430 12 1.601 2.012 2.518 3.139 3.896 4.818 8.916 13 1.665 2.133 2.720 3.452 4.364 5.492 10.699 14 1.732 2.261 2.937 3.798 4.887 6.261 12.839 15 1.801 2.397 3.172 4.177 5.474 7.138 15.407 20 2.191 3.207 4.661 6.728 9.646 13.743 38.338 30 3.243 5.744 10.063 17.450 29.960 50.950 237.380 40 4.801 10.286 21.725 45.260 93.051 188.880 1,469.800 Table I Future Value of $1.00(1 1 r ) n Table II Future Value of a Series of $1.00 Cash Flows (Ordinary Annuity) (1 1 r )n 1 r 2 Period 4% 6% 8% 10% 12% 14% 20% 1 1.000 1.000 1.000 1.000 1.000 1.000 1.000 2 2.040 2.060 2.080 2.100 2.120 2.140 2.220 3 3.122 3.184 3.246 3.310 3.374 3.440 3.640 4 4.247 4.375 4.506 4.641 4.779 4.921 5.368 5 5.416 5.637 5.867 6.105 6.353 6.610 7.442 6 6.633 6.975 7.336 7.716 8.115 8.536 9.930 7 7.898 8.394 8.923 9.487 10.089 10.730 12.916 8 9.214 9.898 10.637 11.436 12.300 13.233 16.499 9 10.583 11.491 12.488 13.580 14.776 16.085 20.799 10 12.006 13.181 14.487 15.938 17.549 19.337 25.959 11 13.486 14.972 16.646 18.531 20.655 23.045 32.150 12 15.026 16.870 18.977 21.385 24.133 27.271 39.580 13 16.627 18.882 21.495 24.523 28.029 32.089 48.497 14 18.292 21.015 24.215 27.976 32.393 37.581 59.196 15 20.024 23.276 27.152 31.773 37.280 43.842 72.035 20 29.778 36.778 45.762 57.276 75.052 91.025 186.690 30 56.085 79.058 113.283 164.496 241.330 356.790 1,181.900 40 95.026 154.762 259.057 442.597 767.090 1,342.000 7,343.900 hiL25664_ch16_678-731.indd 714hiL25664_ch16_678-731.indd 714 7/17/13 12:17 AM7/17/13 12:17 AM Final PDF to printer Chapter 16 Capital Expenditure Decisions 715 Table III Present Value of $1.00 1 (1 1 r )n Period 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% 24% 26% 28% 30% 32% 1 .962 .943 .926 .909 .893 .877 .862 .847 .833 .820 .806 .794 .781 .769 .758 2 .925 .890 .857 .826 .797 .769 .743 .718 .694 .672 .650 .630 .610 .592 .574 3 .889 .840 .794 .751 .712 .675 .641 .609 .579 .551 .524 .500 .477 .455 .435 4 .855 .792 .735 .683 .636 .592 .552 .516 .482 .451 .423 .397 .373 .350 .329 5 .822 .747 .681 .621 .567 .519 .476 .437 .402 .370 .341 .315 .291 .269 .250 6 .790 .705 .630 .564 .507 .456 .410 .370 .335 .303 .275 .250 .227 .207 .189 7 .760 .665 .583 .513 .452 .400 .354 .314 .279 .249 .222 .198 .178 .159 .143 8 .731 .627 .540 .467 .404 .351 .305 .266 .233 .204 .179 .157 .139 .123 .108 9 .703 .592 .500 .424 .361 .308 .263 .225 .194 .167 .144 .125 .108 .094 .082 10 .676 .558 .463 .386 .322 .270 .227 .191 .162 .137 .116 .099 .085 .073 .062 11 .650 .527 .429 .350 .287 .237 .195 .162 .135 .112 .094 .079 .066 .056 .047 12 .625 .497 .397 .319 .257 .208 .168 .137 .112 .092 .076 .062 .052 .043 .036 13 .601 .469 .368 .290 .229 .182 .145 .116 .093 .075 .061 .050 .040 .033 .027 14 .577 .442 .340 .263 .205 .160 .125 .099 .078 .062 .049 .039 .032 .025 .021 15 .555 .417 .315 .239 .183 .140 .108 .084 .065 .051 .040 .031 .025 .020 .016 20 .456 .312 .215 .149 .104 .073 .051 .037 .026 .019 .014 .010 .007 .005 .004 30 .308 .174 .099 .057 .033 .020 .012 .007 .004 .003 .002 .001 .001 — — 40 .208 .097 .046 .022 .011 .005 .003 .001 .001 — — — — — — Period 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% 24% 25% 26% 28% 30% 1 0.962 0.943 0.926 0.909 0.893 0.877 0.862 0.847 0.833 0.820 0.806 0.800 0.794 0.781 0.769 2 1.886 1.833 1.783 1.736 1.690 1.647 1.605 1.566 1.528 1.492 1.457 1.440 1.424 1.392 1.361 3 2.775 2.673 2.577 2.487 2.402 2.322 2.246 2.174 2.106 2.042 1.981 1.952 1.923 1.868 1.816 4 3.630 3.465 3.312 3.170 3.037 2.914 2.798 2.690 2.589 2.494 2.404 2.362 2.320 2.241 2.166 5 4.452 4.212 3.993 3.791 3.605 3.433 3.274 3.127 2.991 2.864 2.745 2.689 2.635 2.532 2.436 6 5.242 4.917 4.623 4.355 4.111 3.889 3.685 3.498 3.326 3.167 3.020 2.951 2.885 2.759 2.643 7 6.002 5.582 5.206 4.868 4.564 4.288 4.039 3.812 3.605 3.416 3.242 3.161 3.083 2.937 2.802 8 6.733 6.210 5.747 5.335 4.968 4.639 4.344 4.078 3.837 3.619 3.421 3.329 3.241 3.076 2.925 9 7.435 6.802 6.247 5.759 5.328 4.946 4.607 4.303 4.031 3.786 3.566 3.463 3.366 3.184 3.019 10 8.111 7.360 6.710 6.145 5.650 5.216 4.833 4.494 4.192 3.923 3.682 3.571 3.465 3.269 3.092 11 8.760 7.887 7.139 6.495 5.938 5.453 5.029 4.656 4.327 4.035 3.776 3.656 3.544 3.335 3.147 12 9.385 8.384 7.536 6.814 6.194 5.660 5.197 4.793 4.439 4.127 3.851 3.725 3.606 3.387 3.190 13 9.986 8.853 7.904 7.103 6.424 5.842 5.342 4.910 4.533 4.203 3.912 3.780 3.656 3.427 3.223 14 10.563 9.295 8.244 7.367 6.628 6.002 5.468 5.008 4.611 4.265 3.962 3.824 3.695 3.459 3.249 15 11.118 9.712 8.559 7.606 6.811 6.142 5.575 5.092 4.675 4.315 4.001 3.859 3.726 3.483 3.268 20 13.590 11.470 9.818 8.514 7.469 6.623 5.929 5.353 4.870 4.460 4.110 3.954 3.808 3.546 3.316 30 17.292 13.765 11.258 9.427 8.055 7.003 6.177 5.517 4.979 4.534 4.160 3.995 3.842 3.569 3.332 40 19.793 15.046 11.925 9.779 8.244 7.105 6.234 5.548 4.997 4.544 4.166 3.999 3.846 3.571 3.333 Table IV Present Value of Series of $1.00 Cash Flows 1 r (1 2 1(1 1 r n ) ) hiL25664_ch16_678-731.indd 715hiL25664_ch16_678-731.indd 715 7/17/13 12:17 AM7/17/13 12:17 AM Final PDF to printer 716 Chapter 16 Capital Expenditure Decisions APPENDIX B TO CHAPTER 16 Impact of Inflation Most countries have experienced inflation to some degree over the past 30 years. Inflation is defined as a decline in the general purchasing power of a monetary unit, such as a dollar, across time. Since capital- budgeting decisions involve cash flows over several time periods, it is worthwhile to examine the impact of inflation in capital-budgeting analyses. Inflation can be incorporated in a discounted-cash-flow analysis in either of two ways. Both approaches yield correct results, but the analyst must be careful to be consistent in applying either approach. The two approaches are distinguished by the use of either nominal or real interest rates and dollars. These terms are defined below. Interest Rates: Real or Nominal The real interest rate is the underlying interest rate, which includes compensation to investors for the time value of money and the risk of an investment. The nominal interest rate includes the real interest rate, plus an additional premium to compensate investors for inflation. Suppose the real interest rate is 10 percent, and inflation of 5 percent is projected. Then the nominal interest rate is determined as follows: 6 Real interest rate .............................................................................................................................................. .10 Inflation rate ..................................................................................................................................................... .05 Combined effect (.10 3 .05) ............................................................................................................................. .005 Nominal interest rate ......................................................................................................................................... .155 Dollars: Real or Nominal A cash flow measured in nominal dollars is the actual cash flow we observe. For example, a particular model of automobile cost $10,000 in year 1 but it cost $12,155 in year 5. Both the $10,000 cash flow in year 1 and $12,155 cash flow in year 5 are measured in nominal dollars. A cash flow measured in real dollars reflects an adjustment for the dollar’s purchasing power. The following table shows the relationship between nominal and real dollars, assuming an inflation rate of 5 percent. Year (a) Cash Flow in Nominal Dollars (b) Price Index (c) 5 (a) 4 (b) Cash Flow in Real Dollars Year 1 ........... $10,000 ........................ 1.0000 ............ $10,000 Year 2 ........... 10,500 ........................ (1.05)1 5 1.0500 ............ 10,000 Year 3 ........... 11,025 ........................ (1.05)2 5 1.1025 ............ 10,000 Year 4 ........... 11,576 ........................ (1.05)3 5 1.1576 ............ 10,000 Year 5 ........... 12,155 ........................ (1.05)4 5 1.2155 ............ 10,000 As the table shows, cash flows in nominal dollars must be deflated, which means dividing by the price index, to convert them to cash flows in real dollars. The real-dollar cash flows are expressed in year 1 dollars. Two Capital-Budgeting Approaches under Inflation A correct capital-budgeting analysis may be done using either of the following approaches. 1. Use cash flows measured in nominal dollars and a nominal interest rate to determine the nominal discount rate. 2. Use cash flows measured in real dollars and a real interest rate to determine the real discount rate. Learning Objective 16-10 Explain the impact of inflation on a capital-budgeting analysis. 6 An alternative way to compute the nominal interest rate is: (1.10 3 1.05) 2 1.00 5 .155. hiL25664_ch16_678-731.indd 716hiL25664_ch16_678-731.indd 716 7/17/13 12:17 AM7/17/13 12:17 AM Final PDF to printer Chapter 16 Capital Expenditure Decisions 717 To illustrate these two approaches, we will focus on an equipment-replacement decision faced by the management of High Country Department Stores. The company operates an appliance-repair service for the household appliances it sells. Management is considering the replacement of a sophisticated piece of testing equipment used in repairing TVs and VCRs. The new equipment costs $5,000 and will have no salvage value. Over its four-year life, the new equipment is expected to generate the cost savings and depreciation tax shield shown below. The cash flows in column (f) of the table are the total after-tax cash inflows, measured in nominal dollars. Measured in Nominal Dollars Year (a) Acquisition Cost (b) Cost Savings (c) After-Tax Cost Savings [(b) 3 (1 2 .40)] (d) MACRS Depreciation (3-year class) (e) Depreciation Tax Shield [(d) 3 .40] (f) Total After-Tax Cash Flow [(c) 1 (e)] Year 1 $(5,000) Year 2 $1,900 $1,140 $1,667 $667 $1,807 Year 3 2,000 1,200 2,223 889 2,089 Year 4 2,100 1,260 740 296 1,556 Year 5 2,500 1,500 370 148 1,648 Approach 1: Nominal Dollars and Nominal Discount Rate Under this capital- budgeting approach, we discount the nominal-dollar cash flows in the preceding table using the nominal discount rate of 15.5 percent. The net-present-value analysis is as follows: Year (a) Cash Flow in Nominal Dollars (b) Discount Factor for Nominal Discount Rate of 15.5% (c) 5 (a) 3 (b) Present Value Year 1 ........... $(5,000) ..................... 1.000 .......................... $(5,000) Year 2 ........... 1,807 ...................... .8658 [1/(1.155)]* .......................... 1,564 Year 3 ........... 2,089 ...................... .7496 [1/(1.155)2] .......................... 1,565 Year 4 ........... 1,556 ...................... .6490 [1/(1.155)3] .......................... 1,009 Year 5 ........... 1,648 ...................... .5619 [1/(1.155)4] .......................... 926 Net present value ............................................................................................................................ $ 64 * The 15.5% discount factors are computed using the formula in Table III of Appendix A. High Country’s management should purchase the new testing equipment, since its NPV is positive. Approach 2: Real Dollars and Real Discount Rate Under this capital-budgeting approach, we first convert the cash flows measured in nominal dollars to cash flows in real dollars, as follows: Year (a) After-Tax Cash Flow in Nominal Dollars (b) Price Index (c) 5 (a) 4 (b) After-Tax Cash Flow in Real Dollars* Year 1 .................... $(5,000) ..................................... 1.0000 ............................... $(5,000) Year 2 .................... 1,807 ...................................... 1.0500 ............................... 1,721 Year 3 .................... 2,089 ...................................... 1.1025 ............................... 1,895 Year 4 .................... 1,556 ...................................... 1.1576 ............................... 1,344 Year 5 .................... 1,648 ...................................... 1.2155 ............................... 1,356 * Real-dollar cash flows expressed in terms of year 1 dollars. HIGH COUNTRY DEPARTMENT STORES hiL25664_ch16_678-731.indd 717hiL25664_ch16_678-731.indd 717 7/17/13 12:17 AM7/17/13 12:17 AM Final PDF to printer 718 Chapter 16 Capital Expenditure Decisions Now we discount the after-tax cash flows, measured in real dollars, using the real discount rate of 10 percent. The net-present-value analysis is shown below. Year (a) Cash Flow in Real Dollars (b) Discount Factor for Real Discount Rate of 10% (c) 5 (a) 3 (b) Present Value Year 1 ............. $(5,000) .............................. 1.000 .................................... $(5,000) Year 2 ............. 1,721 ............................... .909 .................................... 1,564 Year 3 ............. 1,895 ............................... .826 .................................... 1,565 Year 4 ............. 1,344 ............................... .751 .................................... 1,009 Year 5 ............. 1,356 ............................... .683 .................................... 926 Net present value .............................................................................................................................. $ 64 Notice that the new testing equipment’s NPV is the same under both capital-budgeting approaches. Under both approaches, we conclude that High Country Department Stores should purchase the new equipment. Consistency Is the Key Either capital-budgeting approach will provide the correct conclusion, as long as it is applied consistently. Use either nominal dollars and a nominal discount rate or real dol- lars and a real discount rate. A common error in capital budgeting is to convert the after-tax cash flows to real dollars, but then use the nominal discount rate. This faulty analysis creates a bias against acceptance of worthwhile projects. To illustrate, suppose High Country’s management had made this error in its testing-equipment analysis. The following incorrect analysis is the result. Incorrect Analysis of Testing-Equipment Decision Inconsistency Year (a) Cash Flow in Real Dollars (b) Discount Factor for Nominal Discount Rate of 15.5% (c) 5 (a) 3 (b) Present Value Year 1 ...................... $(5,000) ......................... 1.0000 ............................ $(5,000) Year 2 ...................... 1,721 .......................... .8658 ............................ 1,490 Year 3 ...................... 1,895 .......................... .7496 ............................ 1,420 Year 4 ...................... 1,344 .......................... .6490 ............................ 872 Year 5 ...................... 1,356 .......................... .5619 ............................ 762 Net present value ................................................................................................................................ $ (456) This inconsistent and incorrect analysis will lead High Country’s management to the wrong conclusion. Review Questions Note: Review questions 1 through 10 relate to Section 1 of the chapter. Questions 11 through 18 relate to Section 2, and questions 19 through 22 relate to Section 3. Question 23 relates to Appendix B. 16–1. “Time is money!” is an old saying. Relate this state- ment to the evaluation of capital-investment projects. 16–2. Distinguish between the following two types of capital- budgeting decisions: acceptance-or-rejection decisions and capital-rationing decisions. 16–3. “The greater the discount rate, the greater the present value of a future cash flow.” True or false? Explain your answer. 16–4. Briefly explain the concept of discounted-cash-flow analysis. What are the two common methods of dis- counted-cash-flow analysis? 16–5. State the decision rule used to accept or reject an invest- ment proposal under each of these methods of analysis: (1) net-present-value method and (2) internal-rate-of- return method. 16–6. Explain the following terms: recovery of investment versus return on investment. 16–7. List and briefly explain two advantages that the net-present-value method has over the internal-rate- of-return method. 16–8. List and briefly explain four assumptions underlying discounted-cash-flow analysis. hiL25664_ch16_678-731.indd 718hiL25664_ch16_678-731.indd 718 7/17/13 12:17 AM7/17/13 12:17 AM Final PDF to printer Chapter 16 Capital Expenditure Decisions 719 16–9. Distinguish between the following approaches to discounted-cash-flow analysis: total-cost approach versus incremental-cost approach. 16–10. What is meant by a postaudit of an investment project? 16–11. Give an example of a noncash expense. What impact does such an expense have in a capital-budgeting analy- sis? Explain how to compute the after-tax impact of a noncash expense. 16–12. Explain how to compute the after-tax amount of a cash revenue or expense. 16–13. What is a depreciation tax shield? Explain the effect of a depreciation tax shield in a capital-budgeting analysis. 16–14. Give an example of a cash flow that is not on the income statement. How do you determine the after-tax amount of such a cash flow? 16–15. Why is accelerated depreciation advantageous to a business? 16–16. Explain how a gain or loss on disposal is handled in a capital-budgeting analysis. 16–17. Why may the net-present-value and internal-rate-of- return methods yield different rankings for investments with different lives? 16–18. Define the term profitability index. How is it used in ranking investment proposals? 16–19. What is meant by the term payback period? How is this criterion sometimes used in capital budgeting? 16–20. What are the two main drawbacks of the payback method? 16–21. How is an investment project’s accounting rate of return defined? Why do the accounting rate of return and inter- nal rate of return on a capital project generally differ? 16–22. Discuss the pros and cons of the accounting rate of return as an investment criterion. 16–23. (Appendix B) Briefly describe two correct methods of net-present-value analysis in an inflationary period. Exercises All applicable Exercises are available with McGraw-Hill’s Connect Accounting ®. Note: Several exercises on the basics of compound interest and the concept of present value are included in Appendix II, which appears at the end of the text. See page 766. Jefferson County’s Board of Representatives is considering the purchase of a site for a new sanitary landfill. The purchase price for the site is $234,000 and preparatory work will cost $88,080. The landfill would be usable for 10 years. The board hired a consultant, who estimated that the new landfill would cost the county $48,000 per year less to operate than the county’s current landfill. The current landfill also will last 10 more years. For a landfill project, Jefferson County can borrow money from the federal government at a subsidized rate. The county’s hurdle rate is only 6 percent for this project. Required: Compute the net present value of the new landfill. Should the board approve the project? Refer to the data given in the preceding e xercise. Required: Calculate the landfill project’s internal rate of return. Should the board approve the project? Refer to the data given in Exercise 1 6–24. Required: Prepare a display similar to Exhibit 16–2 to show the recovery of investment and return on investment for Jefferson County’s landfill project. The trustees of the Danube School of Art and Music, located in Tuttlingen, G ermany, are considering a major overhaul of the school’s audio system. With or without the overhaul, the system will be replaced in two years. If an overhaul is done now, the trustees expect to save the following repair costs during the next two years: year 1, €3,000; year 2, €5,000 . The overhaul will cost € 6,664 . (The euro is used in most European markets.) Required: Use trial and error to compute the internal rate of return on the proposed overhaul. ( Hint: The NPV of the overhaul is positive if an 8 percent discount rate is used, but the NPV is negative if a 16 percent rate is used.) Use the Internet to access the home page for the City of Chicago, www.cityofchicago.org. Use the Programs and Initiatives link to access information about various capital projects underway in the city government. When this text went to press, these initiatives included such categories as Environment, Housing, Technology, and Transportation. ■ Exercise 16–24 Net Present Value (Section 1) (LO 16-1) ■ Exercise 16–25 Internal Rate of Return (Section 1) (LO 16-1) ■ Exercise 16–26 Recovery of Investment (Section 1) (LO 16-1, 16-2) ■ Exercise 16–27 Internal Rate of Return; Uneven Cash Flows (Section 1) (LO 16-1, 16-2) ■ Exercise 16–28 Use of Internet; City Government; Capital Projects (Section 1) (LO 16-1) hiL25664_ch16_678-731.indd 719hiL25664_ch16_678-731.indd 719 7/17/13 12:17 AM7/17/13 12:17 AM Final PDF to printer 720 Chapter 16 Capital Expenditure Decisions Required: Read about one or more of these capital projects, and then discuss how the organization’s managers should go about making significant decisions about expenditures for major capital projects like the one you have explored. (If you prefer, complete a similar requirement for a different city of your choosing.) Toronto S hakespearean Theater’s board of directors is considering the replacement of the theater’s light- ing system. The old system requires two people to operate it, but the new system would require only a single operator. The new lighting system will cost $129,750 and save the theater $27,000 annually for the next eight years. Required: 1. Prepare a table showing the proposed lighting system’s net present value for each of the following discount rates: 8 percent, 10 percent, 12 percent, 14 percent, and 16 percent. Use the following headings in your table. Comment on the pattern in the net present value column. Discount Rate Annuity Discount Factor Annual Savings Present Value of Annual Savings Acquisition Cost Net Present Value 2. Build a spreadsheet: Construct an Excel spreadsheet to solve the preceding requirement. Show how the solution will change if the following information changes: the new lighting system will cost $131,000, and the annual savings amount to $27,500. Refer t o the data given in the preceding exercise. Suppose the Toronto Shakespearean Theater’s board is uncertain about the cost savings with the new lighting system. Required: How low could the new lighting system’s annual savings be and still justify acceptance of the proposal by the board of directors? Assume the theater’s hurdle rate is 12 percent. Portsmouth P rinting Corporation recently purchased a truck for $36,000. Under MACRS, the first year’s depreciation was $7,200. The truck driver’s salary in the first year of operation was $38,400. Required: Show how each of the amounts mentioned above should be converted to an after-tax amount. The company’s tax rate is 30 percent. For each of the f ollowing assets, indicate the MACRS property class and depreciation method. 1. A pharmaceutical company bought a new microscope to use in its Research and Development Division. 2. A midwestern farmer constructed a new barn to house beef cattle. 3. A steel fabrication company bought a machine, which is expected to be useful for 18 years. 4. The president of an insurance company authorized the purchase of a new desk for her office. 5. A pizza restaurant purchased a new delivery car. Trenton F abrication Company purchased industrial tools costing $110,000, which fall in the 3-year property class under MACRS. Required: 1. Prepare a schedule of depreciation deductions assuming: a. The firm uses the accelerated depreciation schedule specified by MACRS. b. The firm uses the optional straight-line depreciation method and the half-year convention. 2. Calculate the present value of the depreciation tax shield under each depreciation method listed in requirement (1). Trenton Fabrication Company’s after-tax hurdle rate is 12 percent, and the firm’s tax rate is 30 percent. In December of 20x4, M emphis Plastics sold a forklift for $9,255. The machine was purchased in 20x1 for $50,000. Since then $38,845 in depreciation has been recorded on the forklift. ■ Exercise 16–29 New Present Value with Different Discount Rates (Section 1) (LO 16-1) ■ Exercise 16–30 Sensitivity Analysis; NPV (Section 1) (LO 16-1) ■ Exercise 16–31 After-Tax Cash Flows (Section 2) (LO 16-4) ■ Exercise 16–32 Using the Modified Acceler- ated Cost Recovery System (Section 2) (LO 16-5) ■ Exercise 16–33 Depreciation Tax Shield (Section 2) (LO 16-5) ■ Exercise 16–34 Gain or Loss on Disposal; Taxes (Section 2) (LO 16-4) hiL25664_ch16_678-731.indd 720hiL25664_ch16_678-731.indd 720 7/17/13 12:17 AM7/17/13 12:17 AM Final PDF to printer Chapter 16 Capital Expenditure Decisions 721 Required: 1. What was the forklift’s book value at the time of sale? 2. Compute the gain or loss on the sale. 3. Determine the after-tax cash flow at the time the forklift was sold. The firm’s tax rate is 45 percent. The owner of Cape Cod Confectionary is considering the purchase of a new s emiautomatic candy machine. The machine will cost $30,000 and last 10 years. The machine is expected to have no salvage value at the end of its useful life. The owner projects that the new candy machine will generate $4,800 in after-tax savings each year during its life (including the depreciation tax shield). Required: Compute the profitability index on the proposed candy machine, assuming an after-tax hurdle rate of: ( a ) 8 percent, ( b ) 10 percent, and ( c ) 12 percent. The management of Iroquois National Bank is considering an investment in automatic teller m achines. The machines would cost $124,200 and have a useful life of seven years. The bank’s controller has esti- mated that the automatic teller machines will save the bank $27,000 after taxes during each year of their life (including the depreciation tax shield). The machines will have no salvage value. Required: 1. Compute the payback period for the proposed investment. 2. Compute the net present value of the proposed investment assuming an after-tax hurdle rate of: ( a ) 10 percent, ( b ) 12 percent, and ( c ) 14 percent. 3. What can you conclude from your answers to requirements (1) and (2) about the limitations of the payback method? 4. Build a spreadsheet: Construct an Excel spreadsheet to solve requirements (1) and (2) above. Show how the solution will change if the following information changes: the machines would cost $134,400, and the annual savings amount to $28,000. Yankay Specialty Metals Corporation is reviewing an investment proposal. The initial cost as well a s the estimate of the book value of the investment at the end of each year, the net after-tax cash flows for each year, and the net income for each year are presented in the following schedule. The salvage value of the investment at the end of each year is equal to its book value. There would be no salvage value at the end of the investment’s life. Year Initial Cost and Book Value Annual Net After-Tax Cash Flows Annual Net Income 0 $105,000 1 70,000 $50,000 $15,000 2 42,000 45,000 17,000 3 21,000 40,000 19,000 4 7,000 35,000 21,000 5 0 30,000 23,000 Management uses a 16 percent after-tax target rate of return for new investment proposals. Required: For requirement (1) only assume that the cash flows in years 1 through 5 occur uniformly throughout each year. 1. Compute the project’s payback period. 2. Calculate the accounting rate of return on the investment proposal. Base your calculation on the initial cost of the investment. 3. Compute the proposal’s net present value. (CMA, adapted) The state’s secretary of education is considering the purchase of a new c omputer for $150,000. A cost study indicates that the new computer should save the Department of Education $45,000, measured in real dollars, during each of the next eight years. ■ Exercise 16–35 Profitability Index; Taxes (Sections I, II, and III) (LO 16-7) ■ Exercise 16–36 Payback Period; Even Cash Flows (Section 3) (LO 16-1, 16-8) ■ Exercise 16–37 Payback, Accounting Rate of Return; Net Present Value; Taxes (Sections 1, 2, and 3) (LO 16-1, 16-8) ■ Exercise 16–38 Inflation and Capital Budgeting (Appendix B) (LO 16-10) hiL25664_ch16_678-731.indd 721hiL25664_ch16_678-731.indd 721 7/17/13 12:17 AM7/17/13 12:17 AM Final PDF to printer 722 Chapter 16 Capital Expenditure Decisions The real interest rate is 20 percent and the inflation rate is 10 percent. As a governmental agency, the Department of Education pays no taxes. Required: 1. Prepare a schedule of cash flows measured in real dollars. Include the initial acquisition and the cost savings for each of the next eight years. 2. Using cash flows measured in real dollars, compute the net present value of the proposed computer. Use a real discount rate equal to the real interest rate. Refer to the data in t h e preceding exercise. Required: 1. Compute the nominal interest rate. 2. Prepare a schedule of cash flows measured in nominal dollars. 3. Using cash flows measured in nominal dollars, compute the net present value of the proposed computer. Use a nominal discount rate equal to the nominal interest rate. ■ Exercise 16–39 Inflation and Capital Budgeting (Appendix B) (LO 16-10) Problems Community C hallenges, a nonprofit organization for physically and mentally challenged people, manu- factures a variety of products in four plants located in California. The company is currently purchasing an electronic igniter from an outside supplier for $62 per unit. Because of supplier reliability problems, the company is considering producing the igniters internally in a currently idle manufacturing plant. Annual volume over the next five years is expected to total 400,000 units at variable manufacturing costs of $60 per unit. Management must hire a factory supervisor and assistant for a total annual salary and fringe benefit package of $95,000. In addition, the company must acquire $60,000 of new equipment. The equipment has a five-year service life and a $12,000 salvage value, and will be depreciated by the straight-line method. Repairs and maintenance are expected to average $4,500 per year in years 3–5, and the equipment will be sold at the end of its life. Required: 1. Should discounted cash flows be used in this outsourcing decision? Why? 2. Ignoring your answer to requirement (1), use the net-present-value method (total-cost approach) and a 14 percent hurdle rate to determine whether management should manufacture or outsource the igniters. 3. Suppose management is able to negotiate a lower purchase price from its supplier. At what purchase price would management be financially indifferent between manufacturing and outsourcing the igniters? Medical Arts H ospital’s board of trustees is considering the addition of a comprehensive medical test- ing laboratory. In the past, the hospital has sent all blood and tissue specimens to Diagnostic Testing Services, an independent testing service. The hospital’s current contract with the testing service is due to expire, and the testing service has offered a new 10-year contract. Under the terms of the new contract, Medical Arts Hospital would pay Diagnostic Testing Services a flat fee of $80,000 per year plus $20 per specimen tested. Since Medical Arts Hospital does not have its own comprehensive testing lab, the hospital staff is forced to refer some types of cases to a nearby metropolitan hospital. If Medical Arts Hospital had its own lab, these cases could be handled in-house. Medical Arts Hospital’s administrator estimates that the hospital loses $100,000 per year in contribution margin on the cases that currently must be referred elsewhere. The proposed new lab would not require construction of a new building, since it would occupy space currently used by the hospital for storage. However, the hospital then would be forced to rent stor- age space in a nearby medical building at a cost of $30,000 per year. The equipment for the lab would cost $625,000 initially. Additional equipment costing $300,000 would be purchased after four years. ■ Problem 16–40 Net Present Value; Outsourcing (Section 1) (LO 16-1, 16-3) 2. Outsource, net present value: $(85,138,400) ■ Problem 16–41 Net Present Value; Total-Cost Approach (Section 1) (LO 16-1, 16-3) Contract with Diagnostic Testing Services, NPV: $(3,277,580) All applicable Problems are available with McGraw-Hill’s Connect Accounting ®. Ex hiL25664_ch16_678-731.indd 722hiL25664_ch16_678-731.indd 722 7/17/13 12:17 AM7/17/13 12:17 AM Final PDF to printer Chapter 16 Capital Expenditure Decisions 723 Due to the rapid technological improvement of medical testing equipment, the equipment would have negligible salvage value after 10 years. Staffing the lab would require two supervisors and four techni- cians. Annual compensation costs would run $40,000 each for the supervisors and $30,000 each for the lab technicians. Fixed operating costs in the lab would be $50,000 per year, and variable costs would amount to $10 per medical test. Medical Arts Hospital requires 20,000 tests per year. The capacity of the lab would be 25,000 tests per year. Medical Arts Hospital’s administrator believes that physicians in private practice would utilize the lab’s excess capacity by sending their own tests to Medical Arts Hospital. The administrator has projected a charge of $20 per test for physicians in private practice. Medical Arts Hospital’s hurdle rate is 12 percent. Required: Use the total-cost approach to prepare a net-present-value analysis of the proposed testing laboratory. Refer to the data in the preceding problem regarding Medical Arts H ospital. Required: Use the incremental-cost approach to prepare a net-present-value analysis of Medical Arts Hospital’s proposed new medical testing laboratory. San Joaquin Community Hospital is a nonprofit hospital operated by the county. T he hospital’s admin- istrator is considering a proposal to open a new outpatient clinic in the nearby city of San Marco. The administrator has made the following estimates pertinent to the proposal. 1. Construction of the clinic building will cost $780,000 in two equal installments of $390,000, to be paid at the end of 20x0 and 20x1. The clinic will open on January 2, 20x2. All staffing and operat- ing costs begin in 20x2. 2. Equipment for the clinic will cost $150,000, to be paid in December of 20x1. 3. Staffing of the clinic will cost $800,000 per year. 4. Other operating costs at the clinic will be $200,000 per year. 5. Opening the clinic is expected to increase charitable contributions to the hospital by $250,000 per year. 6. The clinic is expected to reduce costs at San Joaquin Community Hospital. Annual cost savings at the hospital are projected to be $1,000,000. 7. A major refurbishment of the clinic is expected to be necessary toward the end of 20x5. This work will cost $180,000. 8. Due to shifting medical needs in the county, the administrator doubts the clinic will be needed after 20x9. 9. The clinic building and equipment could be sold for $290,000 at the end of 20x9. 10. The hospital’s hurdle rate is 12 percent. Required: 1. Compute the cash flows for each year relevant to the analysis. 2. Prepare a table of cash flows, by year, similar to Exhibit 16–4 . 3. Compute the net present value of the proposed outpatient clinic. 4. Should the administrator recommend to the hospital’s trustees that the clinic be built? Why? 5. Build a spreadsheet: Construct an Excel spreadsheet to solve requirements. (1), (2), and (3) above. Show how the solution will change if the following information changes: staffing will cost $790,000 per year, and the increased charitable contributions will be $265,000. Special People Industries (SPI) is a nonprofit organization w hich employs only people with physical or mental disabilities. One of the organization’s activities is to make cookies for its snack food store. Sev- eral years ago, Special People Industries purchased a special cookie-cutting machine. As of December 31, 20x0, this machine will have been used for three years. Management is considering the purchase of a newer, more efficient machine. If purchased, the new machine would be acquired on December 31, 20x0. Management expects to sell 300,000 dozen cookies in each of the next six years. The selling price of the cookies is expected to average $1.15 per dozen. Special People Industries has two options: continue to operate the old machine, or sell the old machine and purchase the new machine. No trade-in was offered by the seller of the new machine. The following information has been assembled to help management decide which option is more desirable. ■ Problem 16–42 Net Present Value; Incremen- tal-Cost Approach (Section 1) (LO 16-1, 16-3) ■ Problem 16–43 Net-Present-Value Analysis; Hospital (Section 1) (LO 16-1, 16-3) 3. NPV: $239,410 ■ Problem 16–44 Net Present Value; Qualitative Issues (Section 1) (LO 16-1, 16-3) 1. Old machine, net present value: $(494,605) hiL25664_ch16_678-731.indd 723hiL25664_ch16_678-731.indd 723 7/17/13 12:17 AM7/17/13 12:17 AM Final PDF to printer 724 Chapter 16 Capital Expenditure Decisions Old Machine New Machine Original cost of machine at acquisition .................................................................. $80,000 $120,000 Remaining useful life as of December 31, 20x0 ..................................................... 6 years 6 years Expected annual cash operating expenses: Variable cost per dozen .................................................................................... $.38 $.29 Total fixed costs ............................................................................................... $21,000 $ 11,000 Estimated cash value of machines: December 31, 20x0 ...................................................................................... $40,000 $120,000 December 31, 20x6 ...................................................................................... $ 7,000 $ 20,000 Assume that all operating revenues and expenses occur at the end of the year. Required: 1. Use the net-present-value method to determine whether Special People Industries should retain the old machine or acquire the new machine. The organization’s hurdle rate is 16 percent. 2. Independent of your answer to requirement (1), suppose the quantitative differences are so slight between the two alternatives that management is indifferent between the two proposals. Write a memo to the president of SPI, which identifies and discusses any nonquantitative factors that man- agement should consider. (CMA, adapted) Adams C ounty’s Board of Representatives is considering the construction of a longer runway at the county airport. Currently, the airport can handle only private aircraft and small commuter jets. A new, long runway would enable the airport to handle the midsize jets used on many domestic flights. Data pertinent to the board’s decision appear below. Cost of acquiring additional land for runway .................................................................................................... $ 70,000 Cost of runway construction............................................................................................................................ 200,000 Cost of extending perimeter fence .................................................................................................................. 29,840 Cost of runway lights ..................................................................................................................................... 39,600 Annual cost of maintaining new runway .......................................................................................................... 28,000 Annual incremental revenue from landing fees ................................................................................................ 40,000 In addition to the preceding data, two other facts are relevant to the decision. First, a longer run- way will require a new snowplow, which will cost $100,000. The old snowplow could be sold now for $10,000. The new, larger plow will cost $12,000 more in annual operating costs. Second, the County Board of Representatives believes that the proposed long runway, and the major jet service it will bring to the county, will increase economic activity in the community. The board projects that the increased economic activity will result in $64,000 per year in additional tax revenue for the county. In analyzing the runway proposal, the board has decided to use a 10-year time horizon. The coun- ty’s hurdle rate for capital projects is 12 percent. Required: 1. Compute the initial cost of the investment in the long runway. 2. Compute the annual net cost or benefit from the runway. 3. Determine the IRR on the proposed long runway. Should it be built? Refer to the d ata given in the preceding problem. Required: 1. Prepare a net-present-value analysis of the proposed long runway. 2. Should the County Board of Representatives approve the runway? 3. Which of the data used in the analysis are likely to be most uncertain? Least uncertain? Why? ■ Problem 16–45 Internal Rate of Return; Even Cash Flows (Section 1) (LO 16-1, 16-3) 1. Initial cost of investment: $(429,440) ■ Problem 16–46 Net Present Value (Section 1) (LO 16-1, 16-3) 1. Present value of annual benefits: $361,600 hiL25664_ch16_678-731.indd 724hiL25664_ch16_678-731.indd 724 7/17/13 12:17 AM7/17/13 12:17 AM Final PDF to printer Chapter 16 Capital Expenditure Decisions 725 Refer to the data given in Problem 16–45. T he County Board of Representatives believes that if the county conducts a promotional effort costing $20,000 per year, the proposed long runway will result in substantially greater economic development than was projected originally. However, the board is uncer- tain about the actual increase in county tax revenue that will result. Required: Suppose the board builds the long runway and conducts the promotional campaign. What would the increase in the county’s annual tax revenue need to be in order for the proposed runway’s internal rate of return to equal the county’s hurdle rate of 12 percent? Flotilla Beam, the owner of the Bay City Boatyard, recently had a brilliant idea. T here is a shortage of boat slips in the harbor during the summer. Beam’s idea is to develop a system of “dry slips.” A dry slip is a large storage rack in a warehouse on which a boat is stored. When the boat owner requests, a forklift is used to remove the boat from the dry slip and place the boat in the water. The entire operation requires one hour when a launch reservation is made in advance. The boatyard already has a vacant warehouse, which could be used for this purpose. However, Beam’s idea will require the following capital invest- ment by the boatyard. • Storage racks: cost, $200,000; useful life, 18 years; MACRS class, 10-year property. • Forklift: cost, $120,000; useful life, six years; MACRS class, 5-year property. Bay City Boatyard’s tax rate is 35 percent, and its after-tax hurdle rate is 14 percent. Required: For each of the boatyard’s proposed capital investments: 1. Prepare a schedule of the annual depreciation expenses for tax purposes. 2. Compute the present value of the depreciation tax shield. MicroTest Technology, Inc., is a high-technology company that manufactures s ophisticated testing instruments for evaluating microcircuits. These instruments sell for $3,500 each and cost $2,450 each to manufacture. An essential component of the company’s manufacturing process is a sealed vacuum chamber where the interior approaches a pure vacuum. The technology of the vacuum pumps that the firm uses to prepare its chamber for sealing has been changing rapidly. On January 2, 20x0, MicroTest bought the latest in electronic high-speed vacuum pumps, a machine that allowed the company to evacuate a chamber for sealing in only six hours. The company paid $400,000 for the pump. Recently, the manufacturer of the pump approached MicroTest with a new pump that would reduce the evacu- ation time to two hours. MicroTest’s management is considering the acquisition of this new pump and has asked Melanie Harris, the controller, to evaluate the financial impact of replacing the exist- ing pump with the new model. Harris has gathered the following information prior to preparing her analysis. • The new pump would be installed on December 31, 20x2, and placed in service on January 1, 20x3. The cost of the pump is $608,000, and the costs for installing, testing, and debugging the new pump will be $12,000. For depreciation purposes, these costs will be considered part of the cost of the equipment. The pump would be assigned to the 3-year MACRS class for depreciation and is expected to have a salvage value of $80,000 when sold at the end of four years. • The old pump will be fully depreciated at the time the new pump is placed in service. If the new pump is purchased, arrangements will be made to sell the old pump for $50,000, the estimated salvage value on December 31, 20x2. • At the current rate of production, the new pump’s greater efficiency will result in annual cash savings of $125,000. • MicroTest is able to sell all of the testing instruments it can produce. Because of the increased speed of the new pump, output is expected to be 30 units greater in 20x3 than in 20x2. In 20x4 and 20x5, production will be 50 units greater than in 20x2. The production in 20x6 will exceed 20x2 production by 70 units. For all additional units produced, the manufacturing costs would be reduced by $150 per unit. • MicroTest is subject to a 40 percent tax rate. For evaluating capital investment proposals, MicroTest’s management uses a 16 percent after-tax discount rate. ■ Problem 16–47 Internal Rate of Return; Sensitivity Analysis (Section 1) (LO 16-1, 16-3) Initial cost of investment: $429,440 Total annual costs: $60,000 ■ Problem 16–48 MACRS Depreciation; Present Value of Tax Shield (Section 2) (LO 16-4, 16-5) Present value of depreciation tax shield, storage racks: $39,748 ■ Problem 16–49 Net Present Value; Taxes (Section 2) (LO 16-3, 16-4, 16-6) 1. Depreciation tax shield, 20x3: $82,658 hiL25664_ch16_678-731.indd 725hiL25664_ch16_678-731.indd 725 7/17/13 12:17 AM7/17/13 12:17 AM Final PDF to printer 726 Chapter 16 Capital Expenditure Decisions Required: 1. Determine whether or not MicroTest should purchase the new pump by calculating the net present value of the investment. 2. Describe the factors, other than the net present value, that MicroTest should consider before making the pump replacement decision. (CMA, adapted) LifeLine Corporation manufactures fire extinguishers. One part used in all types of f ire extinguishers is a unique pressure fitting that requires specialized machine tools that need to be replaced. LifeLine’s production manager has concluded that the only alternative to replacing these machine tools is to buy the pressure fitting from Milwaukee Pipe and Fitting Company. LifeLine could buy the fitting for $20 if a minimum order of 70,000 fittings is placed annually. LifeLine has used an average of 80,000 fittings over the past three years. The production manager believes this volume will remain constant for five more years. Cost records indicate that unit manufacturing costs for the last several years have been as follows: Direct material .................................................................................................................................................. $ 4.10 Direct labor ...................................................................................................................................................... 3.70 Variable overhead ............................................................................................................................................ 1.70 Fixed overhead* ............................................................................................................................................... 4.50 Total unit cost .............................................................................................................................................. $14.00 * Depreciation accounts for two-thirds of the fixed overhead. The balance is for other fixed-overhead costs of the factory that require cash expenditures. If the specialized tools are purchased, they will cost $2,500,000 and will have a disposal value of $100,000 after their expected life of five years. Straight-line depreciation is used for book purposes, but MACRS is used for tax purposes. The specialized tools are considered 3-year property for MACRS purposes. The company has a 40 percent tax rate, and management requires a 12 percent after-tax return on investment. The sales representative for the manufacturer of the new tools stated, “The new tools will allow direct labor and variable overhead to be reduced by $1.60 per unit.” Data from another manufacturer using identical tools and experiencing similar operating conditions, except that annual production gen- erally averages 110,000 units, confirm the direct-labor and variable-overhead savings. However, the manufacturer indicated that it experienced an increase in direct-material cost to $4.50 per unit due to the higher quality of material that had to be used with the new tools. Required: 1. Prepare a net-present-value analysis covering the life of the new specialized tools to determine whether management should replace the old tools or purchase the pressure fittings. Include all tax implications. 2. Identify any additional factors management should consider before a decision is made to replace the tools or purchase the pressure fittings. (CMA, adapted) Weisinger C orporation’s management is considering the replacement of an old machine. It is fully depreciated but it can be used by the corporation through 20x5. If management decides to replace the old machine, James Company has offered to purchase it for $60,000 on the replacement date. The old machine would have no salvage value in 20x5. If the replacement occurs, a new machine would be acquired from Hillcrest Industries on December 31, 20x1. The purchase price of $1,000,000 for the new machine would be paid in cash at the time of replacement. Due to the increased efficiency of the new machine, estimated annual cash savings of $300,000 would be generated through 20x5, the end of its expected useful life. The new machine is not expected to have any salvage value at the end of 20x5. Weisinger’s management requires all investments to earn a 12 percent after-tax return. The company’s tax rate is 40 percent. The new machine would be classified as three-year property for MACRS purposes. Required: 1. Compute the net present value of the machine replacement investment. 2. Between which of the following two percentages is the internal rate of return on the machine replacement: 4 percent, 6 percent, 8 percent, 10 percent, 12 percent, and 14 percent? ■ Problem 16–50 After-Tax Cash Flows; NPV (Section 2) (LO 16-3, 16-4, 16-6) 1. Total incremental costs: $664,000 1. Annual cost savings, present value: $2,024,568 ■ Problem 16–51 Net Present Value; Internal Rate of Return; Payback; Sensitivity Analysis; Taxes (Sections 2, 3) (LO 16-3, 16-4, 16-6, 16-8) 1. Total after-tax cash flow, 20x1: $(964,000) 3. Total after-tax cash inflow (years 20x2, 20x3, 20x4): $910,360 hiL25664_ch16_678-731.indd 726hiL25664_ch16_678-731.indd 726 7/17/13 12:17 AM7/17/13 12:17 AM Final PDF to printer Chapter 16 Capital Expenditure Decisions 727 3. Between what two whole numbers of years is the machine replacement’s payback period? 4. How much would the salvage value of the new machine have to be on December 31, 20x5, in order to turn the machine replacement into an acceptable investment? (CMA, adapted) The owner of Zivanov’s Pancake House is considering an expansion of the business. H e has identified two alternatives, as follows: • Build a new restaurant near the mall. • Buy and renovate an old building downtown for the new restaurant. The projected cash flows from these two alternatives are shown below. The owner of the restaurant uses a 10 percent after-tax discount rate. Investment Proposal Cash Outflow: Time 0 Net After-Tax Cash Inflows* Years 1–10 Years 11–20 Mall restaurant .................................. $400,000 ........................ $50,000 ..................... $50,000 Downtown restaurant ......................... 200,000 ........................ 35,800 ..................... — * Includes after-tax cash flows from all sources, including incremental revenue, incremental expenses, and depreciation tax shield. Required: 1. Compute the net present value of each alternative restaurant site. 2. Compute the profitability index for each alternative. 3. How do the two sites rank in terms of ( a ) NPV and ( b ) the profitability index? 4. Comment on the difficulty of ranking the owner’s two options for the new restaurant site. Refer to the data given in the preceding problem. The owner of Zivanov’s Pancake House will c onsider capital projects only if they have a payback period of six years or less. The owner also favors projects that exhibit an accounting rate of return of at least 15 percent. The owner bases a project’s accounting rate of return on the initial investment in the project. Required: 1. Compute the payback period for each of the proposed restaurant sites. 2. Compute the accounting rate of return for each proposed site. Assume the average annual incre- mental income is $50,000 for the mall restaurant and $35,800 for the downtown restaurant. 3. If the owner of the restaurant sticks to his criteria, which site will he choose? 4. Comment on the pros and cons of the restaurant owner’s investment criteria. The Golden Triangle Theater is a nonprofit enterprise in downtown Pittsburgh. The board of d irectors is considering an expansion of the theater’s seating capacity, which will entail significant renovations to the existing facilities. The board has been promised by the city government that in five years the city will build a new building for the theater, so the proposed expansion is only a temporary solution to the theater’s strained seating capacity. The seating expansion project will cost $120,000. The following table lists the incremental ticket revenue, the incremental operating expenses, the depreciation expense, and the incremental operating income over the five-year life of the investment expected as a result of the theater expansion. The theater’s revenue and operating expenses are in cash. Thus, depreciation is the only noncash expense. As a nonprofit enterprise, the theater company is not subject to income taxes. Year Incremental Revenue Incremental Operating Expenses Net Incremental Cash Flow Annual Straight-Line Depreciation 1 $70,000 $30,000 $40,000 $24,000 2 72,000 32,000 40,000 24,000 3 74,000 34,000 40,000 24,000 4 76,000 38,000 38,000 24,000 5 78,000 41,000 37,000 24,000 ■ Problem 16–52 Ranking Investment Propos- als; NPV versus Profitability Index; Taxes (Section 2) (LO 16-4, 16-6, 16-7) 1. Mall restaurant, net present value: $25,700 2. Downtown restaurant, profitability index: 1.10 (rounded) ■ Problem 16–53 Payback; Accounting Rate of Return (Section 3) (LO 16-8) 2. ARR, mall restaurant: 12.5% ■ Problem 16–54 Payback; Accounting Rate of Return; Ethics (Section 3) (LO 16-8) 2. Accounting rate of return (ARR) using initial investment: .125 hiL25664_ch16_678-731.indd 727hiL25664_ch16_678-731.indd 727 7/17/13 12:17 AM7/17/13 12:17 AM Final PDF to printer 728 Chapter 16 Capital Expenditure Decisions Required: 1. Compute the payback period for the proposed expansion of the theater’s seating capacity. 2. Compute the project’s accounting rate of return using the project’s initial investment. 3. Compute the project’s accounting rate of return using the project’s average investment. 4. Explain why many managerial accountants believe that discounted-cash-flow methods of evaluat- ing investment proposals are superior to the payback and accounting-rate-of-return methods. 5. Suppose the chairperson of the theater’s board, who was formerly a managerial accountant, has calculated the seating expansion project’s internal rate of return to be lower than the project’s accounting rate of return. Moreover, the theater’s cost of acquiring expansion capital is above the expansion project’s internal rate of return but below its accounting rate of return. As a champion of the theater, and a strong proponent of the expansion, the board chairperson has decided to present only the project’s accounting rate of return to the board for its approval of the project. Is this ethi- cal on the part of the board’s chairperson? Explain. Vallejo C ablevision Company provides television cable service to two counties in Southern California. The firm’s management is considering the construction of a new satellite dish in December of 20x0. The new antenna would improve reception and the service provided to customers. The dish antenna and associated equipment will cost $200,000 to purchase and install. The company’s old equipment, which is fully depreciated, can be sold now for $20,000. The company president expects the firm’s improved capabilities to result in additional revenue of $80,000 per year during the dish’s useful life of seven years. The incremental operating expenses associated with the new equipment are projected to be $10,000 per year. These incremental revenues and expenses are in real dollars. The new satellite dish will be depreciated under the MACRS depreciation schedule for the 5-year property class. The company’s tax rate is 40 percent. Vallejo Cablevision’s president expects the real rate of interest in the economy to remain stable at 10 percent. She expects the inflation rate, currently running at 20 percent, to remain unchanged. Required: 1. Prepare a schedule of cash flows projected over the next eight years (20x0 through 20x7), mea- sured in nominal dollars. The schedule should include the initial costs of purchase and installation, the after-tax incremental revenue and expenses, and the depreciation tax shield. Remember to express the incremental revenues and expenses in nominal dollars. 2. Compute the nominal interest rate. 3. Prepare a net-present-value analysis of the proposed new satellite dish. Use cash flows measured in nominal dollars and a nominal discount rate equal to the nominal interest rate. Refer to the d ata given in the preceding problem for Vallejo Cablevision Company. Required: 1. Compute the price index for each year from 20x1 through 20x7, using 1.0000 as the index for 20x0. 2. Prepare a schedule of after-tax cash flows measured in real dollars. 3. Compute the net present value of the proposed new satellite dish using cash flows measured in real dollars. Use a real discount rate equal to the real interest rate. ■ Problem 16–55 Inflation; NPV; Nominal Dollars (Appendix B) (LO 16-4, 16-6, 16-10) 1. Time 0 cash outflow: $(188,000) 3. Net present value: $56,204 ■ Problem 16–56 Inflation; NPV; Real Dollars (Appendix B) (LO 16-4, 16-6, 16-10) Time 0 cash outflow: $(188,000) The board o f education for the Blue Ridge School District is considering the acquisition of several minibuses for use in transporting students to school. Five of the school district’s bus routes are under- populated, with the result that the full-size buses on those routes are not fully utilized. After a careful study, the board has decided that it is not feasible to consolidate these routes into fewer routes served by full-size buses. The area in which the students live is too large for that approach, since some students’ bus ride to school would exceed the state maximum of 45 minutes. The plan under consideration by the board is to replace five full-size buses with eight minibuses, each of which would cover a much shorter route than a full-size bus. The bus drivers in this rural school district are part-time employees whose compensation costs the school district $18,000 per year for each driver. In addition to the drivers’ compensation, the annual costs of operating and maintaining a full-size bus amount to $50,000. In contrast, the board projects that a minibus will cost only $20,000 annually to operate and maintain. A minibus driver earns the same wages as a full-size bus driver. The school district ■ Case 16–57 Decision Problem with Suboptions; NPV; IRR; Ethics (Section 1) (LO 16-1, 16-2, 16-3) 4. Present value of incre- mental annual cash flows: $129,780 Acquisition cost of minibuses: $(216,000) Cases hiL25664_ch16_678-731.indd 728hiL25664_ch16_678-731.indd 728 7/17/13 12:17 AM7/17/13 12:17 AM Final PDF to printer Chapter 16 Capital Expenditure Decisions 729 controller has estimated that it will cost the district $15,250, initially, to redesign its bus routes, inform the public, install caution signs in certain hazardous locations, and retrain its drivers. A minibus costs $27,000, whereas a full-size bus costs $90,000. The school district uses straight- line depreciation for all of its long-lived assets. The board has two options regarding the five full-size buses. First, the buses could be sold now for $15,000 each. Second, the buses could be kept in reserve to use for field trips and out-of-town athletic events and to use as backup vehicles when buses break down. Currently, the board charters buses from a private company for these purposes. The annual cost of chartering buses amounts to $30,000. The school district controller has estimated that this cost could be cut to $5,000 per year if the five buses were kept in reserve. The five full-size buses have five years of useful life remaining, either as regularly scheduled buses or as reserve buses. The useful life of a new minibus is projected to be five years also. Blue Ridge School District uses a hurdle rate of 12 percent on all capital projects. Required: 1. Think about the decision problem faced by the board of education. What are the board’s two main alternatives? 2. One of these main alternatives has two options embedded within it. What are those two options? 3. Before proceeding, check the hint given at the end of the chapter, which explains and diagrams the school board’s alternatives. Suppose the board of education chooses to buy the minibuses. Prepare a net-present-value analysis of the two options for the five full-size buses. Should these buses be sold now or kept in reserve? 4. From your answer to requirement (3), you know the best option for the board to choose regarding the full-size buses if the minibuses are purchased. Now you can ignore the other option. Prepare a net-present-value analysis of the school board’s two main alternatives: (a) continue to use the full- size buses on regular routes, or (b) purchase the minibuses. Should the minibuses be purchased? 5. Compute the internal rate of return on the proposed minibus acquisition. 6. What information given in this case was irrelevant to the school board’s decision problem? Explain why the information was irrelevant. 7. Independent of requirements (1) through (6), suppose the NPV analysis favors keeping the full- size buses. Michael Jeffries, the business manager for the Blue Ridge School District, was pre- pared to recommend that the board not purchase the minibuses. Before doing so, however, Jeffries ran into a long-time friend at the racquet club. Peter Reynolds was the vice president for sales at a local automobile dealership from which the minibuses would have been purchased. Jeffries broke the bad news about his impending recommendation about the minibuses to his friend. The two talked for some time about the pros and cons of the minibus alternative. Finally, Reynolds said, “Michael, you and I go back a long time. I know you’re not paid all that well at the school district. Our top financial person is retiring next year. How would you like to come to work for the dealership?” “That’s pretty tempting, Peter. Let me think it over,” was Jeffries’ response. “Sure, Michael, take all the time you want. In the meantime, how about rethinking that minibus decision? It’s no big deal to you, and I could sure use the business.” “But Peter, I told you what the figures say about that,” responded Jeffries. “Come on, Michael. What are friends for?” Discuss the ethical issues in this situation. What should Michael Jeffries do? Instant Dinners, Inc. (IDI), is an established manufacturer of microwavable frozen foods. L eland Forrest is a member of the planning and analysis staff. Forrest has been asked by Bill Rolland, chief financial officer of IDI, to prepare a net-present-value analysis for a proposed capital equipment expenditure that should improve the profitability of the western plant. This analysis will be given to the board of directors for approval. Several years ago, as director of planning and analysis at IDI, Rolland was instrumental in convincing the board to open the western plant. However, recent competitive pressures have forced all of IDI’s manufacturing divisions to consider alternatives to improve their market position. To Rolland’s dismay, the western plant may be sold in the near future unless significant improvement in cost control and production efficiency are achieved. Western’s production manager, an old friend of Rolland, has submitted a proposal for the acquisi- tion of an automated-material-handling system. Rolland is anxious to have this proposal approved as it will ensure the continuation of the western plant and preserve his friend’s position. The plan calls for the replacement of a number of forklift trucks and operators with a computer-controlled conveyor belt ■ Case 16–58 Capital-Budgeting Analysis of Automated-Material-Handling System; Taxes; Ethical Issues (Section 2) (LO 16-3, 16-4, 16-6) 1. Net present value: $(235,280) Ex hiL25664_ch16_678-731.indd 729hiL25664_ch16_678-731.indd 729 7/17/13 12:17 AM7/17/13 12:17 AM Final PDF to printer 730 Chapter 16 Capital Expenditure Decisions system that feeds directly into the refrigeration units. This automation would eliminate the need for a number of material handlers and increase the output capacity of the plant. Rolland has given this pro- posal to Forrest and instructed him to use the following information to prepare his analysis. Automated-Material-Handling System Projections Projected useful life .................................................................................................................................. 10 years Purchase and installation of equipment ..................................................................................................... $4,500,000 Increased working capital needed* ............................................................................................................ 1,000,000 Increased annual operating costs (exclusive of depreciation) ....................................................................... 200,000 Equipment repairs to maintain production efficiency (end of year 5) .............................................................. 800,000 Increase in annual sales revenue ............................................................................................................... 700,000 Reduction in annual manufacturing costs ................................................................................................... 500,000 Reduction in annual maintenance costs ...................................................................................................... 300,000 Estimated salvage value of conveyor belt system ........................................................................................ 850,000 * The working capital will be released at the end of the 10-year useful life of the conveyor belt system. The forklift trucks have a net book value of $500,000 with a remaining useful life of five years and no salvage value for depreciation purposes. If the conveyor belt system is purchased now, these trucks will be sold for $100,000. IDI has a 40 percent tax rate, has chosen the straight-line depreciation method for both book and tax purposes, and uses a 12 percent discount rate. For the purpose of analysis, all tax effects and cash flows from the equipment acquisition and disposal are considered to occur at the time of the transaction while those from operations are considered to occur at the end of each year. When Forrest completed his initial analysis, the proposed project appeared quite healthy. However, after investigating equipment similar to that proposed, Forrest discovered that the estimated salvage value of $850,000 was very optimistic. Information previously provided by several vendors estimates this value to be only $100,000. Forrest also discovered that industry trade publications considered eight years to be the maximum life of similar conveyor belt systems. As a result, Forrest prepared a second analysis based on this new information. When Rolland saw the second analysis, he told Forrest to dis- card this revised material, warned him not to discuss the new estimates with anyone at IDI, and ordered him not to present any of this information to the board of directors. Required: 1. Prepare a net-present-value analysis of the purchase and installation of the material-handling system using the revised estimates obtained by Leland Forrest. (For this problem, ignore the half-year convention. Assume annual straight-line depreciation of $562,500, which is $4,500,000 4 8.) 2. Explain how Leland Forrest, a management accountant, should evaluate Bill Rolland’s directives to repress the revised analysis. Take into consideration the specific ethical standards of compe- tence, confidentiality, integrity, and objectivity discussed in Chapter 1. 3. Identify some steps Leland Forrest could take to resolve this situation. (CMA, adapted) hiL25664_ch16_678-731.indd 730hiL25664_ch16_678-731.indd 730 7/17/13 12:17 AM7/17/13 12:17 AM Final PDF to printer This page intentionally left blank 17 THIS CHAPTER’S FOCUS COMPANY is Riverside Clinic, an outpatient medi- cal facility in Louisville, Kentucky. The clinic has two direct-patient-care depart- ments: Orthopedics and Internal Medicine. In these two departments, patients are treated by medical professionals. Riverside Clinic also has three service departments, which are not directly involved in patient care. The clinic’s Patient Records, Human Resources, and Administration and Accounting departments are necessary for the clinic to function, but they operate in a support role to the two direct-patient-care departments. In this chapter, we explore several methods for allocating the costs of the clinic’s service departments to the direct-patient-care departments. FOCUS COMPANY >>>
Allocation of Support
Activity Costs and
Joint Costs
RIVERSIDE
CLINIC
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In contrast to the health care services setting of Riverside Clinic, we
explore a different type of allocation issue in the context of International
Chocolate Company. This company uses a joint production process to
turn cocoa beans into cocoa butter and cocoa powder. The cocoa powder can be processed
further into instant cocoa mix. A joint production process results in two or more products,
which are called joint products. We will discuss several different methods that International
Chocolate Company could use to allocate the costs of its joint production process to its two
joint products.
<<< IN CONTRAST hiL25664_ch17_732-759.indd 733hiL25664_ch17_732-759.indd 733 7/17/13 12:18 AM7/17/13 12:18 AM Final PDF to printer 734 In earlier chapters, we studied cost allocation and explored its role in an organization’s overall managerial accounting system. We also examined several purposes of cost alloca- tion. The goal of cost allocation is to ensure that all costs incurred by the organization ultimately are assigned to its products or services. This is important for several purposes, including cost-based pricing and bidding, cost reimbursements from outside parties such as insurance companies, valuation of inventory, and determination of cost of goods sold. In addition, the allocation of all costs to departments serves to make departmental manag- ers aware of the costs incurred to produce services their departments use. This chapter is divided into two sections, each of which explores a particular cost- allocation topic in greater detail. The two sections, which may be studied separately, cover the following topics: • Service department cost allocation 1 • Joint product cost allocation 2 Section 1: Service Department Cost Allocation A service department is a unit in an organization that is not involved directly in produc- ing the organization’s goods or services. However, a service department does provide a service that enables the organization’s production process to take place. For example, the Maintenance Department in an automobile plant does not make automobiles, but if it did not exist, the production process would stop when the manufacturing machines broke down. Thus, the Maintenance Department is crucial to the production operation even though the repair personnel do not work directly on the plant’s products. Section 1: Service Department Cost Allocation Learning Objective 17-1 Allocate service department costs using the direct method and the step-down method. 17-1 Allocate service department costs using the direct method and the step-down method. 17-2 Use the dual approach to service department cost allocation. 17-3 Explain the difference between two-stage cost allocation with departmental overhead rates and activity-based costing (ABC). 17-4 Allocate joint costs among joint products using each of the following techniques: physical-units method, relative-sales-value method, and net-realizable-value method. 17-5 Describe the purposes for which joint cost allocation is useful and those for which it is not. 17-6 Allocate service department costs using the reciprocal-services method (appendix). After completing this chapter, you should be able to: 1 The section on service department cost allocation is written as a module, which can be studied separately from the rest of the chapter. This material may be studied after the completion of Chapter 3, which covers basic issues in product costing. 2 The section on joint cost allocation is written as a module, which can be studied separately from the rest of the chapter. This material may be studied after the completion of Chapter 3. hiL25664_ch17_732-759.indd 734hiL25664_ch17_732-759.indd 734 7/17/13 12:18 AM7/17/13 12:18 AM Final PDF to printer Chapter 17 Allocation of Support Activity Costs and Joint Costs 735 Service departments are important in nonmanufacturing organizations also. For example, a hospital’s Human Resources Department is responsible for staffing the hospi- tal with physicians, nurses, lab technicians, and other employees. The Human Resources Department never serves the patients, yet without it the hospital would have no staff to provide medical care. A service department such as the Maintenance Department or the Human Resources Department must exist in order for an organization to carry out its primary function. Therefore, the cost of running a service department is part of the cost incurred by the organization in producing goods or services. In order to determine the cost of those goods or services, all service department costs must be allocated to the production depart- ments in which the goods or services are produced. For this reason, the costs incurred in an automobile plant’s Maintenance Department are allocated to all of the production departments that have machinery. The costs incurred in a hospital’s Human Resources Department are allocated to all of the departments that have personnel. Direct-patient- care departments, such as Surgery and Physical Therapy, are allocated their share of the Human Resources Department’s costs. To see how service department cost allocation fits into the overall picture of product and service costing, it may be helpful to review Exhibit 3–12 on page 103. The exhibit shows three types of allocation processes, as follows: 1. Cost distribution. Costs in various cost pools are distributed to all departments, including both service and production departments. 2. Service department cost allocation. Service department costs are allocated to production departments. 3. Cost application. Costs are assigned to the goods or services produced by the organization. It is the second type of allocation process listed above that we are focusing on now. The context for our discussion is Riverside Clinic, an outpatient medical facility in Lou- isville, Kentucky. The clinic is organized into three service departments and two direct-patient-care departments. Exhibit 17–1 displays a simple organization chart for Riverside Clinic. Since the clinic is not a manufacturing organization, we refer to direct-patient-care departments instead of production departments. These two departments, Orthopedics and Internal Medicine, directly provide the health care that is the clinic’s primary objective. Thus, the clinic’s direct-patient-care departments are like the production departments in a manufacturing firm. Notice that the Human Resources Department and the Administration and Account- ing Department provide services to each other. When this situation occurs, the two ser- vice departments exhibit reciprocal services. Exhibit 17–2 provides some of the details for our illustration of service department cost allocation. Panel A shows the proportion of each service department’s output that is consumed by each of the departments using its services. Panel B shows the allocation RIVERSIDE CLINIC “Support, or service, department costs are becoming a greater and greater percentage of our cost structure.”(17a) Chrysler Exhibit 17–1 Organization Chart for Riverside Clinic * RIVERSIDE CLINIC Service departments Patient Records Department Human Resources Department Administration and Accounting Department Direct-patient-care departments Orthopedics Department Internal Medicine Department * The arrows in the organization chart depict the provision of service by the three service departments. For example, the Human Resources Department serves the Patient Records Department, but not vice versa. hiL25664_ch17_732-759.indd 735hiL25664_ch17_732-759.indd 735 7/17/13 12:18 AM7/17/13 12:18 AM Final PDF to printer 736 Chapter 17 Allocation of Support Activity Costs and Joint Costs bases, which are used to determine the proportions shown in panel A. Further explanation of the information in Exhibit 17–2 follows. Patient Records The service output of the Patient Records Department is consumed only by the Orthopedics and Internal Medicine Departments. Annual patient load is the allocation base used to determine that 30 percent of the Patient Records Department’s services were consumed by Orthopedics and 70 percent by Internal Medicine. Human Resources The Human Resources Department serves each of the clinic’s other departments, including the other two service departments and the two direct- patient-care departments. The allocation base used to determine the proportions of the Human Resources Department’s output consumed by the four using departments is the number of employees in the using departments. For example, 5 percent of the clinic’s employees (excluding those in the Human Resources Department) work in the Patient Records Department. Administration and Accounting This service department provides services only to the Human Resources Department, the Orthopedics Department, and the Internal Medi- cine Department. A variety of services are provided, such as computer support, patient billing, and general administration. Since greater amounts of these services are pro- vided to the larger departments, departmental size is the allocation base used to deter- mine the proportion of service output consumed by each department. Since the space devoted to each department is a convenient measure of departmental size, square footage A. Percentage of Service Output Consumed by Using Departments Provider of Service User of Service
Patient
Records
Human
Resources
Administration
and Accounting
Patient Records …………………………….. — 5% —
Service departments Human Resources ………………………….. — — 5%
Administration and Accounting ………….. — 20% —
Direct-patient-care
departments
Orthopedics ………………………………….. 30% 25% 35%
Internal Medicine …………………………… 70% 50% 60%
B. Allocation Bases
esaB noitacollAtnemtrapeD ecivreS
Patient Records ………………………………………………………………………………………………………… Annual patient load
Human Resources ……………………………………………………………………………………………………… Number of employees
Administration and Accounting …………………………………………………………………………………….. Size of department
(measured in square
feet of space)
C. Service Department Costs
Service Department
Variable
Cost
Fixed
Cost
Total Cost to
Be Allocated
Patient Records ……………………………………………………………………. $24,000 $ 76,000 $100,000
Human Resources …………………………………………………………………. 15,000 45,000 60,000
Administration and Accounting …………………………………………………. 47,500 142,500 190,000
Total …………………………………………………………………………………… $86,500 $263,500 $350,000
Exhibit 17–2
Provision of Services by
Service Departments in 20×1:
Riverside Clinic
RIVERSIDE
CLINIC
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Chapter 17 Allocation of Support Activity Costs and Joint Costs 737
is the measure used in Exhibit 17–2 . For example, 5 percent of the clinic’s space (exclud-
ing that occupied by Administration and Accounting and Patient Records) is devoted to
the Human Resources Department.
Panel C of Exhibit 17–2 shows the total budgeted cost of each service department
that is to be allocated among the using departments.
There are two widely used methods of service department cost allocation, the direct
method and the step-down method. These methods are discussed and illustrated next,
using the data for Riverside Clinic.
Direct Method
Under the direct method , each service department’s costs are allocated among only the
direct-patient-care departments that consume part of the service department’s output.
This method ignores the fact that some service departments provide services to other
service departments. Thus, even though Riverside Clinic’s Human Resources Department
provides services to two other service departments, none of its costs are allocated to those
departments. Exhibit 17–3 presents Riverside Clinic’s service department cost alloca-
tions under the direct method.
Notice that the proportion of each service department’s costs to be allocated to each
direct-patient-care department is determined by the relative proportion of the service
department’s output consumed by each direct-patient-care department. For example, a
glance at Exhibit 17–2 shows that the Human Resources Department provides 25 per-
cent of its services to Orthopedics and 50 percent to Internal Medicine. Summing these
two percentages yields 75 percent. Thus, 25/75 is the fraction of the Human Resources
Department’s cost allocated to Orthopedics and 50/75 is the fraction allocated to Internal
Medicine.
Step-Down Method
As stated above, the direct method ignores the provision of services by one service
department to another service department. This shortcoming is overcome partially by the
step-down method of service department cost allocation. Under this method, the mana-
gerial accountant first chooses a sequence in which to allocate the service departments’
costs. A common way to select the first service department in the sequence is to choose
the one that serves the largest number of other service departments. The service depart-
ments are ordered in this manner, with the last service department being the one that
serves the smallest number of other service departments. 3 Then the managerial accountant
Direct-Patient-Care Departments Using Services
Orthopedics Internal Medicine
Provider of Service Cost to Be Allocated Proportion Amount Proportion Amount
Patient Records . …………………….. $100,000 3/10 $ 30,000 7/10 $ 70,000
Human Resources …………………… 60,000 25/75 20,000 50/75 40,000
Administration and Accounting …… 190,000 35/95 70,000 60/95 120,000
Total …………………………………….. $350,000 $120,000 $230,000
Grand total $350,000
⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩
Exhibit 17–3
Direct Method of Service
Department Cost Allocation:
Riverside Clinic
RIVERSIDE
CLINIC
3 A tie occurs when two or more service departments serve the same number of other service departments. Then the
sequence among the tied service departments usually is an arbitrary choice.
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738 Chapter 17 Allocation of Support Activity Costs and Joint Costs
allocates each service department’s costs among the direct-patient-care departments and
all of the other service departments that follow it in the sequence. Note that the ultimate
cost allocations assigned to the direct-patient-care departments will differ depending on
the sequence chosen.
The step-down method is best explained by way of an illustration. Riverside Clinic’s
Human Resources Department serves two other service departments: Patient Records,
and Administration and Accounting. The Administration and Accounting Department
serves only one other service department: Human Resources. Finally, the Patient Records
Department serves no other service departments. Thus, Riverside Clinic’s service depart-
ment sequence is as follows:
(1)
Human
Resources
(2)
Administration
and Accounting
(3)
Patient
Records
In accordance with this sequence, each service department’s costs are allocated to the
other departments as follows:

Cost Allocated from This Service Department To These Departments
Human Resources ……………………………………………………………………………………………… Administration and Accounting
Patient Records
Orthopedics
Internal Medicine
Administration and Accounting ……………………………………………………………………………… Orthopedics
Internal Medicine
Patient Records ………………………………………………………………………………………………… Orthopedics
Internal Medicine
Notice that even though Administration and Accounting serves Human Resources,
there is no cost allocation in that direction. This results from the placement of Human
Resources before Administration and Accounting in the allocation sequence. Moreover,
no costs are allocated from Patient Records to either of the other service departments,
because Patient Records does not serve those departments.
Exhibit 17–4 presents the results of applying the step-down method at Riverside
Clinic. First, the Human Resources Department’s $60,000 in cost is allocated among the
four departments using its services. Second, the cost of the Administration and Account-
ing Department is allocated. The total cost to be allocated is the department’s original
$190,000 plus the $12,000 allocated from the Human Resources Department. The new
total of $202,000 is allocated to the Orthopedics and Internal Medicine Departments
according to the relative proportions in which these two departments use the services
of the Administration and Accounting Department. Finally, the Patient Records Depart-
ment’s cost is allocated.
Reciprocal-Services Method
The direct method and the step-down method both ignore the fact that the Administration
and Accounting Department serves the Human Resources Department. Neither of these
methods allocates any of the costs incurred in Administration and Accounting back to
Human Resources.
Review the relationships between the service departments depicted in Exhibit 17–1 .
Notice that the Administration and Accounting Department and the Human Resources
“Allocating service depart-
ment costs to the academic
units serves a variety of
purposes. For one thing,
it makes the [academic]
units aware that their activi-
ties result in those costs
being incurred behind the
scenes.” (17b)
Cornell University
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Chapter 17 Allocation of Support Activity Costs and Joint Costs 739
Department serve each other. This mutual provision of service is called recipro-
cal service. A more accurate method of service department cost allocation, called the
reciprocal-services method , fully accounts for the mutual provision of services. This
method, which is more complex than the direct and step-down methods, is covered in the
appendix at the end of this chapter.
Fixed versus Variable Costs
In our allocation of Riverside Clinic’s service department costs, we did not distinguish
between fixed and variable costs. Under some circumstances, this simple approach
can result in an unfair cost allocation among the using departments. To illustrate, we
will use the data about Riverside Clinic’s fixed and variable costs given in panel C of
Exhibit 17–2 . Consider the cost data for the Patient Records Department, which serves
only the Orthopedics and Internal Medicine departments. Under the direct method of
service department cost allocation, the Patient Records Department’s costs were allo-
cated as follows:
Patient Records Orthopedics
Cost Allocation for 20×1: Direct Method
($100,000)(3/10) = $30,000
Internal Medicine
($100,000)(7/10) = $70,000
Variable cost
Fixed cost
Total cost
$ 24,000
76,000
$100,000
. . . . . . . . . . . .
. . . . . . . . . . . .
. . . . . . . . . . . ..
..
The allocation base used in this cost allocation is the annual patient load in the
Orthopedics and Internal Medicine departments. Let’s assume the following patient loads
in 20×1, the year for which the cost allocation has been done.
Service Department Direct-Patient-Care Department
Human
Resources
Administration
and Accounting Patient Records Orthopedics
Internal
Medicine
Costs prior to allocation …………………………… $60,000 $190,000 $100,000
Allocation of Human Resources
Department costs ………………………………… $60,000 12,000 (20/100)† 3,000 (5/100) $ 15,000 (25/100) $ 30,000 (50/100)
Allocation of Administration and
)59/06( *975,721)59/53( *124,47 000,202$…………………………………………… stsoc tnemtrapeD gnitnuoccA
Allocation of Patient Records
Department costs ……………………………………………………………………………………………. $103,000 30,900 (30/100) 72,100 (70/100)
Total cost allocated to
each department …………………………………………………………………………………………………………………………… $120,321 $229,679
Total cost allocated
to direct-patient-care departments ……………………………………………………………………………………………………………………. $350,000
*Rounded.
† Fractions in parentheses are relative proportions of service department’s output consumed by departments to which costs are allocated.
Exhibit 17–4
Step-Down Method of Service
Department Cost Allocation:
Riverside Clinic
RIVERSIDE
CLINIC
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740 Chapter 17 Allocation of Support Activity Costs and Joint Costs

Department Patient Load Proportion of Total
Orthopedics …………………………………………… 30,000 ………………………………………….. (30,000/100,000) 5 3/10
Internal Medicine ……………………………………. 70,000 ………………………………………….. (70,000/100,000) 5 7/10
Total …………………………………………………….. 100,000 …………………………………………..
Now suppose the projections for 20×2 are as follows:

Department Projected Patient Load Projected Proportion of Total
Orthopedics …………………………………… 30,000 ……………………………………… (30,000/80,000) 5 3/8
Internal Medicine ……………………………. 50,000 ……………………………………… (50,000/80,000) 5 5/8
Total …………………………………………….. 80,000

Department Budgeted Variable Cost Budgeted Fixed Cost Budgeted Total Cost
Patient Records ………….. $19,200 ……………………… $76,000 ……………………….. $95,200
The projections for 20×2 include a stable patient load in the Orthopedics Department but
a decline in the patient load of the Internal Medicine Department. Since the projected
total patient load is lower for 20×2, the projected variable cost in the Patient Records
Department is lower also.
What will be the effect of these changes on the 20×2 allocation of the Patient Records
Department’s costs? Using the direct method, we obtain the following allocation.
Patient Records Orthopedics
Cost Allocation for 20×2: Direct Method
($95,200)(3/8) = $35,700
Internal Medicine
($95,200)(5/8) = $59,500
Variable cost
Fixed cost
Total cost
$ 19,200
76,000
$ 95,200
. . . . . . . . . . . .
. . . . . . . . . . . .
. . . . . . . . . . . ..
..
Compare the costs allocated to the two direct-patient-care departments in 20×1
and 20×2. Notice that the cost allocated to the Orthopedics Department increased by
$5,700 (from $30,000 to $35,700), even though Orthopedics’ patient load is projected to
remain constant. What has happened here? The projected decline in the Internal Medicine
Department’s volume resulted in lower budgeted variable costs for the Patient Records
Department, but the budgeted fixed costs did not change. At the same time, the lower
projected patient load in Internal Medicine resulted in a higher proportion of the total
projected patient load for Orthopedics (from 3/10 in 20×1 up to 3/8 in 20×2). As the fol-
lowing analysis shows, this results in an increased allocation of fixed costs to the Ortho-
pedics Department in 20×2.
20×1 20×2
Fixed cost in Patient Records Department ……………………………………………………………… $76,000 $76,000
Orthopedics Department’s proportion of total patient load …………………………………………. 3/10 3/8
Orthopedics Department’s allocation of fixed cost …………………………………………………… $22,800 $28,500
Difference 5 $5,700
⎧ ⎪ ⎪ ⎨ ⎪ ⎪ ⎩
This difference of $5,700 is equal to the increase in the Orthopedics Department’s total
cost allocation from the Patient Records Department in 20×2.
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Chapter 17 Allocation of Support Activity Costs and Joint Costs 741
To summarize, the projected decline in Internal Medicine’s 20×2 patient load will
result in an increased cost allocation from the Patient Records Department to the Ortho-
pedics Department in 20×2. The cause of this increased allocation is our failure to distin-
guish between fixed and variable costs in the allocation process.
Dual Cost Allocation
The problem illustrated in the preceding section can be resolved by allocating fixed and
variable costs separately. This approach, called dual cost allocation , works with either
the direct method or the step-down method of allocation. Under dual cost allocation,
variable costs are allocated on the basis of short-run usage of the service department’s
output; fixed costs are allocated on the basis of long-run average usage of the service
department’s output. The rationale for this approach is that fixed costs are capacity-
producing costs. When service departments are established, their size and scale usually
are determined by the projected long-run needs of the using departments.
To illustrate dual cost allocation for Riverside Clinic, we need estimates of the long-
run average usage of each service department’s output by each using department. These
estimates are given in Exhibit 17–5 .
Learning Objective 17-2
Use the dual approach to
service department cost
allocation.
COST REIMBURSEMENT IN THE HEALTH CARE INDUSTRY
Medicare uses a system called relative value units (RVUs) to set payment rates for phy-
sicians. “RVUs are supposed to measure how much time and physical effort a doctor
requires to perform different clinical endeavors. Medicare assigns each clinical procedure
a different RVU and then multiplies this figure by a fixed amount of money to arrive at how
much it will pay a doctor for a given task. A routine office visit has an RVU of about 1.68.
Setting a finger fracture rates a 3.48.” There is much argument in the press about the
effectiveness of this system in managing health care costs. One observer argues, “This
system misses all the intangible factors that help gauge the quality and efficiency of the
health care being delivered.” 4
Additionally, there is much uncertainty in the minds of many as to how Medicare
payments will be affected by the U.S. Patient Protection and Affordable Care Act enacted
in 2010. And, of course, many observers argue that the entire Medicare system is in jeop-
ardy of running out of money as the baby boom generation retires and adds to the ranks
of Medicare recipients. Most observers agree that the entire U.S. health care system is in
need of reform as costs continue to explode.
Medicare
anagement
ccounting
ractice
M
A
P
4 Scott Gottlieb, “The Doctor Won’t See You Now. He’s Clocked Out,” The Wall Street Journal, March 15, 2013,
p. A13; and the authors’ research.
Exhibit 17–5
Provision of Services by
Service Departments:
Long-Run Average Usage,
Riverside Clinic
RIVERSIDE
CLINIC
Provider of Service
User of Service
Patient
Records
Human
Resources
Administration
and Accounting
Patient Records ………………………………. — 10% —
Service departments Human Resources ……………………………. — — 10%
Administration and Accounting ……………. — 10% —
Direct-patient-care
departments
Orthopedics ……………………………………. 40% 20% 45%
Internal Medicine …………………………….. 60% 60% 45%
⎧
⎨
⎩
⎧
⎨
⎩
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742 Chapter 17 Allocation of Support Activity Costs and Joint Costs
To combine the dual-allocation approach with either the direct method or the step-down
method, we simply apply the allocation method twice, as follows:

Costs to Be Allocated Basis for Allocation Allocation Method
Variable costs in 20×1 Short-run usage in 20×1 Direct Step-down
(Exhibit 17–2, panel C) (Exhibit 17–2, panel A) method method
OR
Fixed costs in 20×1 Long-run average usage Direct Step-down
(Exhibit 17–2, panel C) (Exhibit 17–5) method method
After both of these allocation procedures have been completed, the resulting vari-
able- and fixed-cost allocations for each direct-patient-care department are summed.
Exhibit 17–6 presents the allocation computations when the dual approach is combined
with the direct method. Compare the final direct allocations with those in Exhibit 17–3 ,
where the dual approach was not used. Notice that the final allocations are different.
Exhibit 17–7 presents the computations for the step-down method. Compare the final
step-down allocations with those in Exhibit 17–4 , where the dual approach was not used.
Again, the final allocations are different.
A Behavioral Problem Dual cost allocation prevents a change in the short-run activ-
ity of one using department from affecting the cost allocated to another using department.
However, the approach sometimes presents a problem of its own. In order to implement
the technique, we need accurate projections of the long-run average usage of each service
department’s output by each using department. This is the information in Exhibit 17–5 .
Typically, these estimates come from the managers of the departments that consume the
services. The problem is that the higher a manager’s estimate of the department’s long-run
average usage is, the greater will be the department’s allocation of fixed service depart-
ment costs. This creates an incentive for using-department managers to understate their
expected long-run service needs. Ultimately, such understatements can result in building
service facilities that are too small.
How can we prevent this behavioral problem? First, we can rely on the profession-
alism and integrity of the managers who provide the estimates. Second, we can reward
managers through promotions and pay raises for making accurate estimates of their
departments’ service needs.
“Our clients are realizing to
an ever-greater extent that
they have to understand
and manage their support
service costs.” (17c)
American Management
Systems
Exhibit 17–6
Dual Allocation Combined
with Direct Method: Riverside
Clinic
RIVERSIDE
CLINIC
Direct-Patient-Care Department Using Services
Orthopedics Internal Medicine
Provider of Service Cost to Be Allocated Proportion Amount Proportion Amount
I. Variable Costs
Patient Records ………………………….. $ 24,000 3/10 $ 7,200 7/10 $ 16,800
Human Resources ……………………….. 15,000 25/75 5,000 50/75 10,000
Administration and Accounting ……….. 47,500 35/95 17,500 60/95 30,000
Total variable cost ……………………….. $ 86,500 $ 29,700 $ 56,800
II. Fixed Costs
Patient Records ………………………….. $ 76,000 4/10 $ 30,400 6/10 $ 45,600
Human Resources ……………………….. 45,000 20/80 11,250 60/80 33,750
Administration and Accounting ……….. 142,500 45/90 71,250 45/90 71,250
Total fixed cost ……………………………. $263,500 $112,900 $150,600
Total cost (variable 1 fixed) …………… $350,000 $142,600 $207,400
Grand total 5 $350,000
⎧ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎩
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Chapter 17 Allocation of Support Activity Costs and Joint Costs 743
Allocate Budgeted Costs
When service department costs are allocated to production departments, such as the direct-
patient-care departments of Riverside Clinic, budgeted service department costs should be
used. If actual costs are allocated instead, any operating inefficiencies in the service depart-
ments are passed along to the using departments. This reduces the incentive for service depart-
ment managers to control the costs in their departments. The proper approach is as follows:
1. Compare budgeted and actual service department costs and compute any variances.
2. Use these variances to help control costs in the service departments.
3. Close out the service department cost variances against the period’s income.
4. Allocate the service departments’ budgeted costs to the departments that
directly produce goods or services.
Today’s Advanced Manufacturing Environment
In traditional manufacturing environments, service department costs are allocated to pro-
duction departments to ensure that all manufacturing costs are assigned to products. For
example, the costs incurred in a machine-maintenance department typically are allocated
to the other service departments and the production departments that use maintenance
services. Service department cost allocation continues to be used in the new manufactur-
ing environment, characterized by JIT inventory management and CIM systems. How-
ever, the extent of such allocations is diminished in advanced manufacturing systems,
because more costs are directly traceable to product lines. In a flexible manufacturing
system, almost all operations are performed in the FMS cell. Even machine maintenance
Today’s Advanced Manufacturing Environment
Exhibit 17–7
Dual Allocation Combined
with Step-Down Method:
Riverside Clinic
RIVERSIDE
CLINIC
Service Department Direct-Patient-Care Department
Human
Resources
Administration
and Accounting
Patient
Records Orthopedics
Internal
Medicine
I. Variable Costs
Variable cost prior to allocation ……………… $15,000 $ 47,500 $24,000
Allocation of Human Resources
Department costs …………………………… $15,000 3,000 (20/100)† 750 (5/100) $ 3,750 (25/100) $ 7,500 (50/100)
Allocation of Administration
and Accounting Department costs ………. $ 50,500 18,605* (35/95) 31,895* (60/95)
Allocation of Patient Records
Department costs …………………………… $24,750 7,425 (30/100) 17,325 (70/100)
Total variable cost allocated
to each department …………………………. $ 29,780 $ 56,720
II. Fixed Costs
Fixed cost prior to allocation …………………. $45,000 $142,500 $76,000
Allocation of Human Resources
Department costs …………………………… $45,000 4,500 (10/100) 4,500 (10/100) $ 9,000 (20/100) $ 27,000 (60/100)
Allocation of Administration and
Accounting Department costs ……………. $147,000 73,500 (45/90) 73,500 (45/90)
Allocation of Patient Records
Department costs …………………………… $ 80,500 32,200 (40/100) 48,300 (60/100)
Total fixed cost allocated
to each department …………………………. $ 114,700 $ 148,800
Total cost allocated to each
department (variable 1 fixed) ……………. $ 144,480 $ 205,520
Grand total 5 $350,000
* Rounded
† Fractions in parentheses are relative proportions of service department’s output consumed by departments to which costs are allocated. Variable costs allocated on basis of short-run
proportions. Fixed costs allocated on basis of long-run average proportions.
⎧ ⎪ ⎪ ⎨ ⎪ ⎪ ⎩
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744 Chapter 17 Allocation of Support Activity Costs and Joint Costs
is done largely by the FMS cell operators rather than a separate maintenance department.
Inspection often is performed by FMS cell operators, eliminating the need for a separate
inspection department. In short, as more and more costs become directly traceable to
products, the need for allocation of indirect costs declines.
The Rise of Activity-Based Costing
Service department cost allocation is one type of allocation procedure used in two-stage allo-
cation with departmental overhead rates. (See Exhibit 3–12 on page 103.) Under this approach,
costs first are distributed to departments; then they are allocated from service departments to
production departments. Finally, they are assigned from production departments to products
or services. Departments play a key role as intermediate cost objects under this approach.
In an activity-based costing (ABC) system, on the other hand, the key role is played by
activities, not departments. (See Exhibit 5–4 on page 169.) First, the costs of various activi-
ties are assigned to activity cost pools; then these costs are assigned to products or services.
The breakdown of costs by activity in an ABC system is much finer than a breakdown
by departments. For example, under the service department cost allocation approach, the
Purchasing Department might be one of the service departments identified. However, under
ABC, the various activities engaged in by purchasing personnel would be separately identi-
fied. Activities such as part specification, vendor identification, vendor selection, price nego-
tiation, ordering, expediting, receiving, inspection, and invoice paying might be identified
separately under ABC. Then the costs of each of these activities would be assigned to prod-
ucts or services on the basis of the appropriate cost drivers. The ABC approach generally
will provide a much more accurate cost for each of the organization’s products or services. 5
Section 2: Joint Product Cost Allocation
A joint production process results in two or more products, which are termed joint
products . The cost of the input and the joint production process is called a joint product
cost. The point in the production process where the individual products become sepa-
rately identifiable is called the split-off point . To illustrate, International Chocolate
Company produces cocoa powder and cocoa butter by processing cocoa beans in the joint
production process depicted in Exhibit 17–8 .
As the diagram shows, cocoa beans are processed in 1-ton batches. The beans cost $500
and the joint process costs $600, for a total joint cost of $1,100. The process results in 1,500
pounds of cocoa butter and 500 pounds of cocoa powder. Each of these two joint products can
be sold at the split-off point or processed further. Cocoa butter can be separately processed
into a sun screen, and cocoa powder can be separately processed into instant cocoa mix.
Learning Objective 17-3
Explain the difference between
two-stage cost allocation with
departmental overhead rates
and activity-based costing
(ABC).
Section 2: Joint Product Cost Allocation
Learning Objective 17-4
Allocate joint costs among
joint products using each
of the following techniques:
physical-units method, relative-
sales-value method, and
net-realizable-value method.
5 Activity-based costing is covered extensively in Chapter 5.
Milk processing provides an
example of joint product cost
allocation in the agriculture
industry. The cost of producing
raw milk must be allocated
among such joint products
as heavy cream, light cream,
whole milk, 2 percent milk,
and skim milk.
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Chapter 17 Allocation of Support Activity Costs and Joint Costs 745
Allocating Joint Costs
For product-costing purposes, a joint product cost usually is allocated to the joint products
that result from the joint production process. Such allocation is necessary for inventory
valuation and income determination, among other reasons. 6 As we discussed in Chapter
14, however, joint cost allocation is not useful for making substantive economic decisions
about the joint process or the joint products. For example, Chapter 14 shows that joint
cost allocation is not useful in deciding whether to process a joint product further. (See
pages 000–000.) There are three commonly used methods for allocating joint product
costs. Each of these is explained next.
Physical-Units Method The physical-units method allocates joint product costs on
the basis of some physical characteristic of the joint products at the split-off point. Panel
A of Exhibit 17–9 illustrates this allocation method for International Chocolate Company
using the weight of the joint products as the allocation basis.
Learning Objective 17-5
Describe the purposes for
which joint cost allocation is
useful and those for which it
is not.
Exhibit 17–8
Joint Processing of Cocoa
Beans: International
Chocolate Company
Cocoa beans
costing $500
per 1-ton batch
Total joint cost:
$1,100 per 1-ton batch
Split-off point
Joint production
process costing
$600 per ton
Cocoa butter
sales value:
$750 for
1,500 pounds
Cocoa powder
sales value:
$500 for
500 pounds
Separable
process
costing
$800
Instant cocoa mix
sales value:
$2,000 for
500 pounds
Cocoa
Beans
Separable
process
costing
$1,560
Sun screen
sales value:
$3,000 for
1,500
pounds
6 The purposes of product costing are covered in Chapter 3.
A. Physical-Units Method
Joint Cost Joint Products Weight at Split-off Point
Relative
Proportion
Allocation of
Joint Cost
$1,100
Cocoa butter …………………………………………. 1,500 pounds ……………….. 3/4 ……….. $ 825
Cocoa powder ………………………………………. 500 pounds ……………….. 1/4 ……….. 275
Total joint cost allocated …………………………………………………………………………………………….. $1,100
B. Relative-Sales-Value Method
Joint Cost Joint Products
Sales Value at
Split-off Point
Relative
Proportion
Allocation of
Joint Cost
$1,100
Cocoa butter ……………………………………………. $750 ……………………. 3/5 ……………. $ 660
Cocoa powder …………………………………………. 500 ……………………. 2/5 ……………. 440
Total joint cost allocated ……………………………………………………………………………………………. $1,100
⎧
⎨
⎩
⎧
⎨
⎩
(continued)
Exhibit 17–9
Methods for Allocating Joint
Product Costs
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746 Chapter 17 Allocation of Support Activity Costs and Joint Costs
*Sales value of
final product
2
Separable cost
of processing
5
Net realizable
value †Calculation of relative proportions:
$3,000 2 $1,560 5 $1,440 $1,440 1 $1,200 5 $2,640
2,000 2 800 5 1,200 1,440 4 2,640 5 6/11
1,200 4 2,640 5 5/11
C. Net-Realizable-Value Method
Joint Cost Joint Products
Sales Value
of Final
Product
Separable
Cost of
Processing
Net
Realizable
Value
Relative
Proportion
Allocation
of Joint
Cost
Sun screen ……………….. $3,000 ………. $1,560 ………. $1,440* ………. 6/11† . ……. $ 600
$1,100 Instant cocoa mix ……….. 2,000 ………. 800 ………. 1,200* ………. 5/11† …….. 500
Total joint cost allocated ……………………………………………………………………………………………. $1,100
⎧
⎨
⎩
Exhibit 17–9
Methods for Allocating Joint
Product Costs
(concluded)
Relative-Sales-Value Method The relative-sales-value method is based on the rela-
tive sales value of each joint product at the split-off point. In the International Chocolate
Company illustration, these joint products are cocoa butter and cocoa powder. This
method is illustrated in Exhibit 17–9 (panel B).
Net-Realizable-Value Method Under the net-realizable-value method , the rela-
tive value of the final products is used to allocate the joint cost. International Chocolate
Company’s final products are sun screen and instant cocoa mix. The net realizable value
JOINT COST ALLOCATION IN THE PETROLEUM INDUSTRY
One of the most complicated problems in joint cost allocation routinely occurs in the
petroleum industry. When an oil company, such as ExxonMobil, drills a successful oil well,
the well almost always produces natural gas in addition to crude oil. Moreover, the crude
oil produced by a typical oil well is of various grades. Lighter crude oils suitable for pro-
duction of such products as gasoline are generally near the top of an oil reservoir, while
the heavier crudes are near the bottom. The heavier crude oils are used to make such
products as fuel oil for heating homes and businesses and for the generation of electricity.
All of these products obtained from a successful oil well are joint products: the vari-
ous grades of crude oil and the natural gas. Most of these products will require further
processing before they will be salable products such as gasoline, diesel fuel, or home
heating oil. Thus, substantial separable costs will be incurred in processing the joint prod-
ucts in addition to the joint costs incurred in the oil field operations. Millions of dollars of
joint costs are incurred in the development of an off-shore oil field. The costs of locating
the oil field, building the drilling platforms, and the drilling itself are all joint costs. Then
there are the costs of crewing the oil rigs and the ongoing costs of bringing oil and natural
gas to the surface.
Oil companies such as ExxonMobil typically use the net realizable value of the prod-
ucts manufactured as the basis for allocating the joint production costs. The full costs
of the company’s various products then become the basis for pricing and product-mix
decisions.
The next time you pump gas for your automobile, think about the salaries of the
helicopter pilots who bring food and other supplies to the many off-shore oil platforms.
Those costs comprise a part of the joint cost allocated to the gasoline you obtain from
the pump.
ExxonMobil
anagement
ccounting
ractice
M
A
P
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Chapter 17 Allocation of Support Activity Costs and Joint Costs 747
of each final product is its sales value less any separable costs incurred after the split-off
point. The joint cost is allocated according to the relative magnitudes of the final prod-
ucts’ net realizable values. Panel C of Exhibit 17–9 illustrates this allocation method.
Notice how different the cost allocations are under the three methods, particularly the
physical-units method. Since the physical-units approach is not based on the economic
characteristics of the joint products, it is the least preferred of the three methods.
By-Products A joint product with minimal value relative to the other joint products is
termed a by-product . For example, whey is a by-product in the production of cheese. A
common practice in accounting is to subtract a by-product’s net realizable value from the
cost of the joint process. Then the remaining joint cost is allocated among the major joint
products.
An alternative procedure is to inventory the by-product at its sales value at the split-
off point. Then the by-product’s sales value is deducted from the production cost of the
main products.
“Joint costing problems
crop up more often than you
might think. They’re among
the thornier [cost manage-
ment] issues our clients
have to deal with.” (17d)
A. T. Kearney
Chapter Summary
LO17-1 Allocate service department costs using the direct method and the step-down method.
Under the direct method, the costs of each service department are allocated directly to each production
department in proportion to each production department’s usage of each service department’s output.
Under the step-down method, the service departments are first ranked by the number of other service
departments that each one serves. Then the costs of each service department in the ranked sequence
are allocated among all of the remaining service departments in the sequence together with all of the
production departments.
LO17-2 Use the dual approach to service department cost allocation. Either the direct or the step-
down method may be combined with the dual-allocation approach, in which variable and fixed costs are
allocated separately.
LO17-3 Explain the difference between two-stage cost allocation with departmental overhead
rates and activity-based costing (ABC). Two-stage allocation with departmental overhead rates
involves the following three steps: (1) All overhead costs are allocated among all service and produc-
tion departments. (2) Service-department costs are allocated to production departments. (3) Produc-
tion department costs are applied to products or services. In contrast, two-stage allocation under ABC
involves the following two steps: (1) Resource costs are assigned to activity cost pools. (2) The costs in
these activity cost pools are assigned to cost objects (e.g., products or services) using appropriate cost
drivers.
LO17-4 Allocate joint costs among joint products using each of the following techniques: physical
units method, relative-sales-value method, and net-realizable-value method. In the physical-units
method, the joint cost is allocated to the joint products in proportion to some physical characteristic of
the joint products, such as weight or volume. In the relative-sales-value method, the joint cost is allo-
cated to the joint products in proportion to the joint products’ sales values at the split-off point In the
net-realizable-value method, the joint cost is allocated to the joint products in proportion to the joint
products’ net realizable values.
LO17-5 Describe the purposes for which joint cost allocation is useful and those for which it is
not. Joint cost allocation is useful for product-costing purposes, but the allocated costs should not affect
substantive economic decisions.
LO17-6 Allocate service department costs using the reciprocal-services method (appendix). Under
the reciprocal-services method, simultaneous equations are specified to show how each service and
production department uses the services of the various service departments. When these equations
are solved simultaneously, the result is the amount of service department cost to be allocated to each
production department. Unlike the direct and step-down methods, the reciprocal-services method fully
accounts for all reciprocal services among service departments.
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748 Chapter 17 Allocation of Support Activity Costs and Joint Costs
Review Problem on Service Department Cost Allocation
Renaissance School of Music and Art provides classes for school-age children. The students are enrolled
in two departments: Music Education and Art Education. The school also has two service departments:
Administration and Human Resources (A & HR) and Maintenance (M). The budgeted costs in the two
service departments are as follows:

Administration and Human Resources ……………………………………………………………………………………………… $342,000
Maintenance ………………………………………………………………………………………………………………………………. 171,000
The usage of the service department’s output for the year is as follows:

Provider of Service
User of Service
Administration &
Human Resources Maintenance
Administration & Human Resources …………………………………………………………. — 5%
Maintenance ……………………………………………………………………………………….. 10% —
Music Education ………………………………………………………………………………….. 40% 40%
Art Education ………………………………………………………………………………………. 50% 55%
Required: Allocate the two services departments’ costs to the Music Education and Art Education
departments using each of the following allocation methods.
1. Direct method.
2. Step-down method (Since each service department serves one other service department, allocate
the cost of A & HR first.)
Solution to Review Problem
1. Cost allocation using direct method:
Departments Using Services
Music Education Art Education
Provider of Service
Cost to Be
Allocated Proportion Amount Proportion Amount
A & HR ………………………….. $342,000 (4/9) $152,000 (5/9) $190,000
M* ……………………………….. 171,000 (8/19) 72,000 (11/19) 99,000
Total ……………………………… $513,000 $224,000 $289,000
*(8/19) 5 [40/(40 1 55)]; (11/19) 5 [55/(40 1 55)].
2. Cost allocation using step-down method:
Service Departments Departments Using Services
A&HR M Music Education Art Education
Costs prior to allocation ………………………….. $342,000 $171,000
Allocation of A & HR
costs* ………………………………………………. $342,000 34,200 (10%) $136,800 (40%) $171,000 (50%)
Allocation of M
costs* ………………………………………………. $205,200 86,400 (8/19) 118,800 (11/19)
Total costs allocated to
each department ………………………………… $223,200 $289,800
Total cost allocated to
academic departments …………………………. $513,000
*(8/19) 5 [40/(40 1 55)]; (11/19) 5 [55/(40 1 55)].
⎧ ⎪ ⎨ ⎪ ⎩

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Chapter 17 Allocation of Support Activity Costs and Joint Costs 749
APPENDIX TO CHAPTER 17
Key Terms
For each term’s definition, refer to the indicated page or turn to the glossary at the end of the text.
by-product, 747
direct method, 737
dual cost allocation, 741
joint production process, 744
joint products, 744
net realizable value, 746
net-realizable-value
method, 746
physical-units
method, 745
reciprocal-services
method, 739
relative-sales-value
method, 746
service department, 734
split-off point, 744
step-down method, 737
Reciprocal-Services Method
The reciprocal-services method of service department cost allocation fully accounts for the mutual pro-
vision of services among all the service departments. The relationships between Riverside Clinic’s three
service departments are portrayed in the following diagram.
Patient Records
(Department R)
Human Resources
(Department H)
Administration and Accounting
(Department A)
The first step in the technique is to specify a set of equations that express the relationships between
the departments. The following equations, which express these relationships for Riverside Clinic, are
based on the data in Exhibit 17–2 on page 736.
R 5 100,000 1 .05H (1)
H 5 60,000 1 .05A (2)
A 5 190,000 1 .20H (3)
where R denotes the total cost of the Patient Records Department
H denotes the total cost of the Human Resources Department
A denotes the total cost of the Administration and Accounting Department
Equation (1) says that the total cost of operating the Patient Records Department ( R ) is
$100,000 plus 5 percent of the total cost of operating the Human Resources Department ( H ). The
$100,000 comes from Exhibit 17–2 (panel C) and is the total cost traceable to the Patient Records
Department. We add to this amount 5 percent of the total cost of operating the Human Resources
Department. Why? Because Exhibit 17–2 (panel A) tells us that the Patient Records Department
used 5 percent of the Human Resources Department’s services. Similar explanations underlie equa-
tions (2) and (3).
The second step in the reciprocal-services method is to solve the simultaneous equations. 7 Let’s
begin by substituting the expression for A from equation (3) into equation (2), and solving for H as
follows:
H 5 60,000 1 .05(190,000 1 .20H)
5 60,000 1 9,500 1 .01H
.99H 5 69,500
H 5 70,202 (rounded)
RIVERSIDE
CLINIC
Learning Objective 17-6
Allocate service department
costs using the reciprocal
services method.
7 Simultaneous equations are more quickly solved by computers than by people. Numerous software packages are
available for this purpose.
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750 Chapter 17 Allocation of Support Activity Costs and Joint Costs
Then we substitute the value for H we just obtained into equation (3), and solve for A as follows:
A 5 190,000 1 .20H
5 190,000 1 (.20)(70,202)
5 204,040 (rounded)
Now we can solve for R by substituting the value for H into equation (1) as follows:
R 5 100,000 1 .05H
5 100,000 1 (.05)(70,202)
5 103,510 (rounded)
Thus, we have determined that H 5 70,202, A 5 204,040, and R 5 103,510.
The final step in the reciprocal-services method is to allocate the total cost of operating each service
department ( R, H, and A ) to the various departments that use its services. For example, we will allocate the
total cost of operating the Human Resources Department ( H ) among all four of Riverside Clinic’s other
departments, because they all use services from Human Resources. This allocation is made in proportion
to the use of Human Resources’s services by the other departments, as given in Exhibit 17–2 (panel A).
The allocations are shown in Exhibit 17–10 . Focus on the second row of numbers, which refers to
the Human Resources Department. The $70,202 shown in parentheses in the Human Resources column
is that department’s total cost, as computed using the simultaneous equations. This $70,202 total cost is
allocated as follows:
• 20 percent (or $14,040) to Administration and Accounting, because that department uses
20 percent of the Human Resources Department’s services
• 5 percent (or $3,510) to Patient Records, because that department uses 5 percent of the Human
Resources Department’s services
• 25 percent (or $17,551) to Orthopedics, because that department uses 25 percent of the Human
Resources Department’s services
• 50 percent (or $35,101) to Internal Medicine, because that department uses 50 percent of the
Human Resources Department’s services.
A similar explanation underlies the Administration and Accounting row and the Patient Records row in
Exhibit 17–10 .
The total costs allocated to Riverside Clinic’s two direct-patient-care departments are as follows:
$120,018 to Orthopedics and $229,982 to Internal Medicine. Notice that these two amounts add up to
$350,000, which is the total of the original traceable costs for the three service departments. Thus, all
service department costs have been fully allocated.
The reciprocal-services method is more accurate than the direct and step-down methods, because
it fully accounts for reciprocal services. To make the reciprocal-services method even more accurate, it
can be combined with the dual-allocation approach. In this approach, variable and fixed costs are allo-
cated separately. This method is explored in Problem 17–34.
Service Department Direct-Patient-Care Department
Human
Resources
Administration
and Accounting
Patient
Records Orthopedics
Internal
Medicine
Traceable costs ………………………………….. $60,000 $190,000 $100,000
Allocation of Human Resources
Department costs …………………………… (70,202) 14,040* (.20) 3,510* (.05) $ 17,551*(.25) $ 35,101 (.50)
Allocation of Administration and
Accounting Department costs ……………. 10,202 (.05)† (204,040) –0– (0) 71,414 (.35) 122,424 (.60)
Allocation of Patient Records
Department costs …………………………… –0– (0) –0– (0) (103,510) 31,053 (.30) 72,457 (.70)
Total cost allocated to each
direct-patient-care department …………………………………………………………………………………………………………….. $120,018 $229,982
Total costs allocated …………………………………………………………………………………………………………………………………………….. $350,000
*Rounded.
†Percentages in parentheses are relative proportions of a service department’s output consumed by departments to which costs are allocated (from Exhibit 17–2, panel A).
⎧ ⎪ ⎪ ⎨ ⎪ ⎪ ⎩
RIVERSIDE
CLINIC
Exhibit 17–10
Reciprocal-Services Method
of Service Department Cost
Allocation: Riverside Clinic
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Chapter 17 Allocation of Support Activity Costs and Joint Costs 751
17–1. Distinguish between a service department and a pro-
duction department. Give an example of the counter-
part of a manufacturer’s “production” department
in a bank.
17–2. Define the term reciprocal services.
17–3. Explain briefly the main differences between the direct,
step-down, and reciprocal-services methods of service
department cost allocation.
17–4. How does the managerial accountant determine the
department sequence in the step-down method? How
are ties handled?
17–5. Why does the dual-allocation approach improve the
resulting cost allocation?
17–6. What potential behavioral problem can result when the
dual approach is used?
17–7. Should actual or budgeted service department costs be
allocated? Why?
17–8. Explain the difference between two-stage allocation
with departmental overhead rates and activity-based
costing. Which approach generally results in more
accurate product costs?
17–9. Define the following terms: joint production process,
joint costs, joint products, split-off point, separable
costs, and by-product.
17–10. Briefly explain how to use the physical-units method of
joint cost allocation.
17–11. Describe the relative-sales-value method of joint cost
allocation.
17–12. Define the term net realizable value, and explain how
this concept can be used to allocate joint costs.
17–13. Are joint cost allocations useful? If they are, for what
purpose?
17–14. For what purpose should the managerial accountant be
careful to not use joint cost allocations?
Review Questions
Exercises
Aurora National Bank has two service departments, the Human Resources (HR) D epartment and the Com-
puting Department. The bank has two other departments that directly service customers, the Deposit Depart-
ment and the Loan Department. The usage of the two service departments’ output for the year is as follows:

Provider of Service
User of Service Human Resources Computing
Human Resources (HR) ………………………………………………………………………………….. — 15%
Computing ………………………………………………………………………………………………….. 10% —
Deposit ………………………………………………………………………………………………………. 60% 50%
Loan …………………………………………………………………………………………………………. 30% 35%
The budgeted costs in the two service departments for the year are as follows:

Human Resources ………………………………………………………………………………………………………………….. $459,000
Computing ……………………………………………………………………………………………………………………………. 688,500
Required: Use the direct method to allocate the budgeted costs of the Human Resources and Comput-
ing departments to the Deposit and Loan departments.
Refer to the data given in the preceding e xercise.
Required: Use the step-down method to allocate the budgeted costs of the Human Resources and
Computing departments to the Deposit and Loan departments. Aurora National Bank allocates the costs
of the Human Resources Department first.
Visit the website of one of the following organizations, or a different organization of y our choosing.
Allstate www.allstate.com
Gallo Winery www.gallo.com
Mayo Clinic www.mayo.edu
Sheraton Hotels www.sheraton.com
Walt Disney Studios www.disney.com
Required: Read about the organization’s activities and operations. Then list three activities that you think
the organization would need that would likely be established as service departments. For what purposes would
it be relevant to allocate those service department costs to nonservice departments within the organization?
■ Exercise 17–15
Direct Method of Service
Department Cost Allocation;
Bank
(LO 17-1)
■ Exercise 17–16
Step-Down Method of Service
Department Cost Allocation;
Bank
(LO 17-1)
■ Exercise 17–17
Service Department Cost
Allocation; Use of Internet
(LO 17-1)
All applicable Exercises are available with McGraw-Hill’s Connect Accounting ®.
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752 Chapter 17 Allocation of Support Activity Costs and Joint Costs
Bay S tate Community College enrolls students in two departments, Liberal Arts and Sciences. The col-
lege also has two service departments, the Library and the Computing Services Department. The usage
of these two service departments’ output for the year is as follows:

Provider of Service
User of Service Library Computing Services
Library ……………………………………………………………………………………………… — 20%
Computing Services …………………………………………………………………………….. — —
Liberal Arts ………………………………………………………………………………………… 60% 30%
Sciences …………………………………………………………………………………………… 40% 50%
The budgeted costs in the two service departments for the year are as follows:

Library …………………………………………………………………………………………………………………………………. $900,000
Computing Services ………………………………………………………………………………………………………………… 360,000
Required:
1. Use the direct method to allocate the budgeted costs of the Library and Computing Services
Department to the college’s Liberal Arts and Sciences departments.
2. Build a spreadsheet: Construct an Excel spreadsheet to solve the preceding requirement. Show
how the solution will change if the following information changes: the budgeted costs of the
Library and Computing Services are $890,000 and $340,000, respectively.
Refer to the d ata given in the preceding exercise.
Required:
1. Use the step-down method to allocate Bay State Community College’s service department costs to
the Liberal Arts and Sciences departments.
2. Build a spreadsheet: Construct an Excel spreadsheet to solve the preceding requirement. Show
how the solution will change if the following information changes: the budgeted costs of the
Library and Computing Services are $890,000 and $340,000, respectively.
Breakfasttime C ereal Company manufactures two breakfast cereals in a joint process. Cost and quantity
information is as follows:

Joint Cost Cereal Quantity at Split-Off Point Sales Price per Kilogram
$90,000
Yummies ………………………….. 12,000 kilograms …………………………… $6.00
Crummies …………………………. 8,000 kilograms …………………………… 7.50
Required: Use the physical-units method to allocate the company’s joint production cost between
Yummies and Crummies.
Refer to the d ata given in the preceding exercise.
Required: Use the relative-sales-value method to allocate Breakfasttime Cereal Company’s joint pro-
duction cost between Yummies and Crummies.
Refer to the data given i n Exercise 17–20. Breakfasttime Cereal Company has an opportunity to process
its Crummies further into a mulch for ornamental shrubs. The additional processing operation costs
$1.50 per kilogram, and the mulch will sell for $10.50 per kilogram.
Required:
1. Should Breakfasttime’s management decide to process Crummies into the mulch? Why?
2. Suppose the company does process Crummies into the mulch. Use the net-realizable-value method
to allocate the joint production cost between the mulch and the Yummies.
■ Exercise 17–18
Direct Method of Service
Department Cost Allocation;
College
(LO 17-1)
■ Exercise 17–19
Step-Down Method of Service
Department Cost Allocation;
College
(LO 17-1)
■ Exercise 17–20
Physical-Units Method; Joint
Cost Allocation
(LO 17-4)
■ Exercise 17–21
Relative-Sales-Value Method;
Joint Cost Allocation
(LO 17- 4)
■ Exercise 17–22
Net-Realizable-Value Method;
Joint Cost Allocation
(LO 17-4)
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Chapter 17 Allocation of Support Activity Costs and Joint Costs 753
Refer to the data given in Exercise 17–15 for Aurora National B ank.
Required: Use the reciprocal-services method to allocate the budgeted costs of the Human Resources
and Computing Departments to the Deposit and Loan Departments.
■ Exercise 17–23
Reciprocal-Services Method;
Bank (Appendix)
(LO 17-6)
Problems
Glass Creations Company is developing departmental overhead rates based o n direct-labor hours for
its two production departments, Etching and Finishing. The Etching Department employs 20 people
and the Finishing Department employs 80 people. Each person in these two departments works 2,000
hours per year. The production-related overhead costs for the Etching Department are budgeted at
$400,000, and the Finishing Department costs are budgeted at $640,000. Two service departments,
Maintenance and Computing, directly support the two production departments. These service depart-
ments have budgeted costs of $96,000 and $500,000, respectively. The production departments’ over-
head rates cannot be determined until the service departments’ costs are allocated. The following
schedule reflects the use of the Maintenance Department’s and Computing Department’s output by
the various departments.

Using Department
Service Department Maintenance Computing Etching Finishing
Maintenance (maintenance hours) ………………. 0 1,000 1,000 8,000
Computing (minutes) …………………………………. 240,000 0 840,000 120,000
Required:
1. Use the direct method to allocate service department costs. Calculate the overhead rates per
direct-labor hour for the Etching Department and the Finishing Department.
2. Use the step-down method to allocate service department costs. Allocate the Computing Depart-
ment’s costs first. Calculate the overhead rates per direct-labor hour for the Etching Department
and the Finishing Department.
(CMA, adapted)
Jacksonville Instrument Company manufactures gauges for construction machinery. T he company has
two production departments: Machining and Finishing. There are three service departments: Human
Resources (HR), Maintenance, and Design. The budgeted costs in Jacksonville Instrument Company’s
service departments during the year are as follows:

HR Maintenance Design
Variable …………………………………………………………………. $ 50,000 $ 80,000 $ 50,000
Fixed …………………………………………………………………….. 200,000 150,000 300,000
Total …………………………………………………………………….. $250,000 $230,000 $350,000
The usage of these service departments’ output during the year just completed is as follows:

Provision of Service Output (in hours of service)
Provider of Service
User of Service HR Maintenance Design
HR …………………………………………………………………………. — — —
Maintenance ……………………………………………………………. 500 — —
Design ……………………………………………………………………. 500 500 —
Machining ……………………………………………………………….. 4,000 3,500 4,500
Finishing …………………………………………………………………. 5,000 4,000 1,500
Total ……………………………………………………………………….. 10,000 8,000 6,000
■ Problem 17–24
Service Department Cost
Allocation; Overhead Rates
(LO 17-1, 17-3)
1. Service department
costs allocated to Etching:
$448,167
2. Service department
costs allocated to Etching:
$371,778
Ex
■ Problem 17–25
Direct and Step-Down
Methods of Service
Department Cost Allocation
(LO 17-1)
1. Total cost allocated to
Finishing: $349,056
3. Total cost allocated to
Finishing: $340,664
All applicable Problems are available with McGraw-Hill’s Connect Accounting ®.
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754 Chapter 17 Allocation of Support Activity Costs and Joint Costs
Required:
1. Use the direct method to allocate Jacksonville Instrument Company’s service department costs to
its production departments.
2. Determine the proper sequence to use in allocating the firm’s service department costs by the
step-down method.
3. Use the step-down method to allocate the company’s service department costs.
4. Build a spreadsheet: Construct an Excel spreadsheet to solve requirements (1) and (3) above.
Show how the solution will change if the following information changes: the budgeted vari-
able costs in the three departments are $60,000, $70,000, and $55,000, for Human Resources,
Maintenance, and Design, respectively.
Refer to the data g iven in the preceding problem. When Jacksonville Instrument Company established
its service departments, the following long-run needs were anticipated.

Long-Run Service Needs (in hours of service)
Provider of Service
User of Service HR Maintenance Design
HR ……………………………………………………………………………. — — —
Maintenance ……………………………………………………………….. 500 — —
Design ………………………………………………………………………. 1,000 800 —
Machining …………………………………………………………………… 3,500 4,800 4,800
Finishing ……………………………………………………………………. 5,000 2,400 1,200
Total ………………………………………………………………………….. 10,000 8,000 6,000
Required: Use the dual approach in conjunction with each of the following methods to allocate Jack-
sonville Instrument Company’s service department costs: (1) direct method, and (2) step-down method.
Travelcraft, Inc., m anufactures a complete line of fiberglass suitcases and attaché cases. The firm has
three manufacturing departments: Molding, Component, and Assembly. There are also two service
departments: Power and Maintenance.
The sides of the cases are manufactured in the Molding Department. The frames, hinges, and locks
are manufactured in the Component Department. The cases are completed in the Assembly Department.
Varying amounts of materials, time, and effort are required for each of the cases. The Power Department
and Maintenance Department provide services to the three manufacturing departments.
Travelcraft has always used a plantwide overhead rate. Direct-labor hours are used to assign over-
head to products. The predetermined overhead rate is calculated by dividing the company’s total estimated
overhead by the total estimated direct-labor hours to be worked in the three manufacturing departments.
Karen Mason, director of cost management, has recommended that Travelcraft use departmental over-
head rates. The planned operating costs and expected levels of activity for the coming year have been devel-
oped by Mason and are presented by department in the following schedules. (All numbers are in thousands.)

Manufacturing Departments
Molding Component Assembly
Department activity measures:
Direct-labor hours ……………………………………………………………. 500 2,000 1,500
Machine hours ……………………………………………………………….. 875 125 -0-
Departmental costs:
Direct material ………………………………………………………………… $24,800 $ 60,000 $ 2,500
Direct labor ……………………………………………………………………. 7,000 40,000 24,000
Variable overhead ……………………………………………………………. 7,000 20,000 33,000
Fixed overhead ……………………………………………………………….. 35,000 12,400 12,200
Total departmental costs …………………………………………………… $73,800 $132,400 $71,700
■ Problem 17–26
Dual Allocation of Service
Department Costs
(LO 17-1, 17-2)
1. Total variable cost allocated
to Finishing: $82,945
2. Total variable cost allocated
to Finishing: $80,664
■ Problem 17–27
Service Department Cost
Allocation; Plantwide versus
Departmental Overhead
Rates; Cost Drivers
(LO 17-1, 17-2, 17-3)
1. Total manufacturing
department overhead:
$119,600
Total estimated overhead,
service departments:
$164,400
(continues)
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Chapter 17 Allocation of Support Activity Costs and Joint Costs 755
Use of service departments:
Maintenance:
Estimated usage in labor hours
for the coming year ……………………………………………….. 90 25 10
Power (in kilowatt-hours):
Estimated usage for the coming year ……………………………….. 360 320 120
Maximum allotted capacity ……………………………………………. 500 350 150

Service Departments
Power Maintenance
Departmental activity measures:
Maximum capacity …………………………………………………………………… 1,000 kilowatt-hours Adjustable
Estimated usage for the coming year …………………………………………… 800 kilowatt-hours 125 hours
Departmental costs:
Materials and supplies ……………………………………………………………… $10,000 $3,000
Variable labor …………………………………………………………………………. 2,800 4,500
Fixed overhead ……………………………………………………………………….. 24,000 500
Total service department costs ……………………………………………………. $36,800 $8,000
Required:
1. Calculate the plantwide overhead rate for Travelcraft, Inc., for the coming year using the same
method as used in the past.
2. Karen Mason has been asked to develop departmental overhead rates for comparison with the
plantwide rate. The following steps are to be followed in developing the departmental rates.
a. The Maintenance Department costs should be allocated to the three manufacturing depart-
ments using the direct method.
b. The Power Department costs should be allocated to the three manufacturing departments using
dual cost allocation combined with the direct method. Fixed costs are to be allocated accord-
ing to maximum allotted capacity, and variable costs are to be allocated according to planned
usage for the coming year.
c. Calculate departmental overhead rates for the three manufacturing departments using a
machine-hour cost driver for the Molding Department and a direct-labor-hour cost driver
for the Component and Assembly departments.
3. As Karen Mason’s assistant, draft a memo for her to send to Travelcraft’s president recommend-
ing whether the company should use a plantwide rate or departmental rates to assign overhead to
products.
(CMA, adapted)
Le Monde C ompany is a manufacturer of chemicals for various purposes. One of the processes used
by Le Monde produces HTP–3, a chemical used in hot tubs and swimming pools; PST–4, a chemical
used in pesticides; and RJ–5, a product that is sold to fertilizer manufacturers. Le Monde uses the net-
realizable-value method to allocate joint production costs. The ratio of output quantities to input quan-
tities of direct material used in the joint process remains consistent from month to month. Le Monde
Company uses FIFO (first-in, first-out) in valuing its finished-goods inventories.
Data regarding operations for the month of October are as follows. During this month, Le Monde
incurred joint production costs of $1,360,000 in the manufacture of HTP–3, PST–4, and RJ–5.

HTP–3 PST–4 RJ–5
Finished goods inventory in gallons (October 1) ………………………… 18,000 52,000 3,000
October sales in gallons ……………………………………………………… 650,000 325,000 150,000
October production in gallons ………………………………………………. 700,000 350,000 170,000
Additional processing costs …………………………………………………. $699,200 $652,800 $48,000
Final sales value per gallon ………………………………………………….. $ 3.20 $ 4.80 $ 4.00
■ Problem 17–28
Joint Costs; Allocation and
Production Decisions
(LO 17-4, 17-5)
1. Allocation of joint cost,
HTP-3: $654,840
2. October production cost
per gallon, HTP-3: $1.93
October 31 inventory, HTP-3:
$131,240
3. Incremental sales value:
$1.76 per gallon
Manufacturing Departments
Molding Component Assembly
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756 Chapter 17 Allocation of Support Activity Costs and Joint Costs
Required:
1. Determine Le Monde Company’s allocation of joint production costs for the month of October.
(Carry calculation of relative proportions to four decimal places.)
2. Determine the dollar values of the finished-goods inventories for HTP–3, PST–4, and RJ–5 as of
October 31. (Round the cost per gallon to the nearest cent.)
3. Suppose Le Monde Company has a new opportunity to sell PST–4 at the split-off point for $3.04
per gallon. Prepare an analysis showing whether the company should sell PST–4 at the split-off
point or continue to process this product further.
(CMA, adapted)
Gleed Company manufactures products Alpha, Beta, and Gamma from a joint process. Production,
sales, and cost data for July follow.

Alpha Beta Gamma Total
Units produced ……………………………………………………….. 4,000 2,000 1,000 7,000
Joint cost allocation …………………………………………………. $46,800 ? ? $ 78,000
Sales value at split-off ………………………………………………. ? ? $19,500 $130,000
Additional costs if processed further …………………………….. $ 9,100 $ 6,500 $ 3,900 $ 19,500
Sales value if processed further ………………………………….. $91,000 $32,500 $26,000 $149,500
Required:
1. Assuming that joint costs are allocated using the relative-sales-value method, what were the joint
costs allocated to products Beta and Gamma?
2. Assuming that joint costs are allocated using the relative-sales-value method, what was the sales
value at split-off for product Alpha?
3. Use the net-realizable-value method to allocate the joint production costs to the three
products.
(CPA, adapted)
Allegheny River S awmill manufactures two lumber products from a joint milling process. The two prod-
ucts developed are mine support braces (MSB) and unseasoned commercial building lumber (CBL). A
standard production run incurs joint costs of $750,000 and results in 60,000 units of MSB and 90,000
units of CBL. Each MSB sells for $5, and each unit of CBL sells for $10.
Required:
1. Calculate the amount of joint cost allocated to commercial building lumber (CBL) on a physical-
units basis.
2. Calculate the amount of joint cost allocated to the mine support braces (MSB) on a relative-sales-
value basis.
3. Assume the commercial building lumber is not marketable at split-off but must be further planed
and sized at a cost of $1,000,000 per production run. During this process, 10,000 units are
unavoidably lost; these spoiled units have no value. The remaining units of commercial building
lumber are saleable at $25.00 per unit. The mine support braces, although saleable immediately
at the split-off point, are coated with a tarlike preservative that costs $250,000 per production run.
The braces are then sold for $12.50 each. Using the net-realizable-value basis, compute the com-
pleted cost assigned to each unit of commercial building lumber.
4. If Allegheny River Sawmill chose not to process the mine support braces beyond the split-
off point, the contribution from the joint milling process would increase or decrease by what
amount?
5. Did you use the joint cost allocation results in answering requirement (4)? If so, how? Why did
you use or not use the allocation results?
(CMA, adapted)
■ Problem 17–29
Joint Cost Allocation; Missing
Data
(LO 17-4)
1. Gamma’s joint cost
allocation: $11,700
2. Alpha’s sales value at
split-off: $78,000
■ Problem 17–30
Joint Costs
(LO 17-4, 17-5)
1. Allocation of joint cost,
MSB: $300,000
3. Allocation of joint cost,
MSB: $250,000
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Chapter 17 Allocation of Support Activity Costs and Joint Costs 757
Wyalusing Chemicals uses a joint process to produce MJ-4, a chemical used in the m anufacture of
paints and varnishes; HD-10, a chemical used in household cleaning products; and FT-5, a by-product
that is sold to fertilizer manufacturers. Joint production costs are allocated to the main products on the
basis of net realizable value. The by-product is inventoried at its net realizable value, and this value is
used to reduce the joint production cost before allocation to the main products.
During the month of November, Wyalusing incurred joint production costs of $3,136,000. Data
regarding Wyalusing’s November operations are as follows:

MJ-4 HD-10 FT-5
November production in gallons ……………………………………………….. 600,000 320,000 85,000
Sales value per gallon at split-off ……………………………………………… None $6.00 $1.80*
Separable processing cost ………………………………………………………. $1,440,000 $1,840,000 None
Final sales value per gallon ………………………………………………………. $8.00 $12.75 None
Finished-goods inventory in gallons on
November 30 (all produced during November) …………………………. 9,000 26,000 1,500
* Disposal costs of $.20 per gallon will be incurred in order to sell the by-product
Required:
1. Define the terms joint costs and split-off point.
2. Determine the dollar values of Wyalusing Chemicals’ finished-goods inventories on November 30
for MJ-4 and HD-10.
3. Wyalusing Chemicals has an opportunity to sell HD-10 for its sales value at the split-off point.
Determine if management should sell HD-10 at the split-off point or continue to process it further.
(CPA, adapted)
Chemco, Inc., manufactures two products out of a joint process: Compod and U ltrasene. The joint costs
incurred are $750,000 for a standard production run that generates 120,000 gallons of Compod and 80,000
gallons of Ultrasene. Compod sells for $6.00 per gallon while Ultrasene sells for $9.75 per gallon.
Required:
1. If there are no additional processing costs incurred after the split-off point, calculate the amount of
joint cost of each production run allocated to Compod on a physical-units basis.
2. If there are no additional processing costs incurred after the split-off point, calculate the amount of
joint cost of each production run allocated to Ultrasene on a relative-sales-value basis.
3. Suppose the following additional processing costs are required beyond the split-off point in order
to obtain Compod and Ultrasene: $.30 per gallon for Compod and $3.30 per gallon for Ultrasene.
a. Calculate the amount of joint cost of each production run allocated to Ultrasene on a physical-
units basis.
b. Calculate the amount of joint cost of each production run allocated to Compod on a
net- realizable-value basis.
4. Assuming the same data as in requirement (3), suppose Compod can be processed further into a
product called Compodalene, at an additional cost of $1.20 per gallon. Compodalene will be sold
for $7.80 per gallon by independent distributors. The distributors’ commission will be 10% of the
sales price. Should Chemco sell Compod or Compodalene?
5. Independent of your answer to requirement (4), suppose Christine Dalton, the assistant con-
troller, has completed an analysis showing that Compod should not be processed further into
Compodalene. Before presenting her analysis to top management, however, she got a visit from
Jack Turner, Chemco’s director of research. Turner was upset upon learning that Compodalene, a
product he had personally developed, would not be manufactured.
Turner: “The company’s making a big mistake if it passes up this opportunity. Compodalene will
be a big seller and get us into new markets.”
Dalton: “But the analysis shows that we’d be losing money on every gallon of Compod that we
process further.”
■ Problem 17–31
Joint Products; Sell or
Process Further
(LO 17-4, 17-5)
2. Joint cost allocation, MJ-4:
$1,800,000
3. Incremental sales value per
gallon: $6.75
■ Problem 17–32
Joint Costs; Allocation and
Production Decisions; Ethics
(LO 17-4, 17-5)
1. Allocation of joint cost,
Compod: $450,000
3. Allocation of joint cost,
Compod: $427,500
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758 Chapter 17 Allocation of Support Activity Costs and Joint Costs
Turner: “I know, Christine, but that’s a temporary problem. Eventually, we’ll bring down the cost
of making Compodalene.”
Dalton: “Can you find me some estimates on the cost reduction you expect?”
Turner: “I don’t have a crystal ball, Christine. Look, if you could just fudge the numbers a little
bit to help me get approval to produce some Compodalene, I can get this product off the
ground. I know the cost reduction will come.”
Comment on the ethical issues in this scenario. What should Christine Dalton do?
6. Assume the same data as given in requirements (3) and (4). The industrial chemical industry
has experienced a downturn, which has left Chemco with idle capacity. Suppose Chemco can
sell only half of the Compod made in each production run, but the remainder could be sold as
Compodalene. Should Chemco process the remaining Compod into Compodalene?
(CMA, adapted)
Refer to the data g iven in Problem 17–24 for Glass Creations Company.
Required:
1. Use the reciprocal-services method to allocate service department costs. Calculate the overhead
rates per direct-labor hour for the Etching Department and the Finishing Department.
2. Which of the three methods of service department cost allocation results in the most accurate
overhead rates? Why?
Refer to the data f or Riverside Clinic given in Exhibits 17–2 and 17–5 .
Required: Use the reciprocal-services method in combination with the dual-allocation approach
to allocate Riverside’s service department costs. Hint: You will need to apply the reciprocal-services
method twice. First, allocate the three service departments’ variable costs using the short-run usage
proportions in Exhibit 17–2 (panel A). Second, allocate the three service departments’ fixed costs using
the long-run average usage proportions in Exhibit 17–5 . Finally, add the variable costs and fixed costs
allocated to each direct-patient-care department.
■ Problem 17–33
Reciprocal-Services Method
(Appendix)
(LO 17-6)
“Total” cost of Computing
Department: $520,000
Ex
■ Problem 17–34
Reciprocal-Services Method;
Dual Allocation (Appendix)
(LO 17-2, 17-6)
1. “Total” variable cost of HR:
$17,551 (rounded)
2. “Total” fixed cost of HR:
$59,848 (rounded)
Cases
Tropics Fruit Company, based on Oahu, grows, processes, cans, and sells three main pineapple products:
sliced, crushed, and juice. T he outside skin is cut off in the Cutting Department and processed as animal
feed. The feed is treated as a by-product. The company’s production process is as follows:
• Pineapples first are processed in the Cutting Department. The pineapples are washed, and the
outside skin is cut away. Then the pineapples are cored and trimmed for slicing. The three main
products (sliced, crushed, juice) and the by-product (animal feed) are recognizable after process-
ing in the Cutting Department. Each product then is transferred to a separate department for final
processing.
• The trimmed pineapples are sent to the Slicing Department, where the pineapples are sliced and
canned. Any juice generated during the slicing operation is packed in the cans with the slices.
• The pieces of pineapple trimmed from the fruit are diced and canned in the Crushing Department.
Again, the juice generated during this operation is packed in the can with the crushed pineapple.
• The core and surplus pineapple generated from the Cutting Department are pulverized into a liquid
in the Juicing Department. There is an evaporation loss equal to 8 percent of the weight of the good
output produced in this department which occurs as the juices are heated.
• The outside skin is chopped into animal feed in the Feed Department.
Tropics Fruit Company uses the net-realizable-value method to assign the costs of the joint process
to its main products. The net realizable value of the by-product is subtracted from the joint cost before
the allocation.
■ Case 17–35
Joint Cost Allocation;
By-Product
(LO 17-4)
1. Juice, net pounds:
135,000
2. Slices, net realizable value:
$208,000
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Chapter 17 Allocation of Support Activity Costs and Joint Costs 759
A total of 540,000 pounds were entered into the Cutting Department during June. The following
schedule shows the costs incurred in each department, the proportion by weight transferred to the four
final processing departments, and the selling price of each end product.

Processing Data and Costs for June
Department
Costs
Incurred
Proportion of
Product by Weight
Transferred to Departments
Selling Price
per Pound of
Final Product
Cutting …………………………… $240,000 ……………………………….. — ……………………………………. None
Slicing ……………………………… 18,800 ……………………………….. 35% ……………………………………. $1.20
Crushing …………………………. 42,320 ……………………………….. 28 ……………………………………. 1.10
Juicing ……………………………. 13,000 ……………………………….. 27 ……………………………………. .60
Animal feed ……………………… 2,800 ……………………………….. 10 …………………………………….. .20
Total …………………………… $316,920 ……………………………….. 100%
Required: Compute each of the following amounts.
1. The number of pounds of pineapple that result as output for pineapple slices, crushed pineapple,
pineapple juice, and animal feed.
2. The net realizable value at the split-off point of the three main products.
3. The amount of the cost of the Cutting Department allocated to each of the three main products.
(CMA, adapted)
Edmonton Chemical Company manufactures two industrial chemical products in a j oint process. In
May, 10,000 gallons of input costing $180,000 were processed at a cost of $450,000. The joint process
resulted in 8,000 pounds of Resoline and 2,000 pounds of Krypto. Resoline sells for $75 per pound,
and Krypto sells for $150 per pound. Management generally processes each of these chemicals further
in separable processes to produce more refined chemical products. Resoline is processed separately at
a cost of $15 per pound. The resulting product, Resolite, sells for $105 per pound. Krypto is processed
separately at a cost of $45 per pound. The resulting product, Kryptite, sells for $285 per pound.
Required:
1. Draw a diagram similar to Exhibit 17–8 to depict Edmonton Chemical Company’s joint production
process.
2. Allocate the company’s joint production costs for May using:
a. The physical-units method.
b. The relative-sales-value method.
c. The net-realizable-value method.
3. Edmonton’s management is considering an opportunity to process Kryptite further into a new
product called Omega. The separable processing will cost $120 per pound. Packaging costs for
Omega are projected to be $18 per pound, and the anticipated sales price is $390 per pound.
Should Kryptite be processed further into Omega? Why?
4. In answering requirement (3), did you use your joint cost allocation from requirement (2)? If so,
how did you use it?
5. Build a spreadsheet: Construct an Excel spreadsheet to solve requirements (2) and (3) above.
Show how the solution will change if the following information changes: the joint processing cost
is $460,000, and the sales price of Omega is $375 per pound.

■ Case 17–36
Comprehensive Case on Joint
Cost Allocation
(LO 17-4, 17-5)
1. Resolite, sales value:
$840,000
2(a). Allocation of joint cost,
Resoline: $504,000
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760
The Sarbanes-Oxley Act (often abbreviated as SOX) was enacted by the U.S. Congress in
2002 in the aftermath of several corporate accounting scandals. Accounting problems at
Enron and Worldcom, and other debacles, resulted in a precipitous drop in the investing
public’s confidence in companies’ published financial statements. SOX was enacted to
bring about reform in companies’ financial reporting processes, as well as the internal and
external auditing of the financial reporting process. Under SOX, a company’s top execu-
tives, including the CEO (chief executive officer) and the CFO (chief financial officer),
can be held criminally responsible if their firm’s financial statements prove to be fraudu-
lent or materially misstate the firm’s financial condition.
The SOX act runs 66 pages long and consists of 11 major parts (called titles), each of
which is organized into several sections. SOX is a very complicated piece of legislation,
and most of it relates primarily to corporate governance, financial accounting, auditing,
and the penalties that the courts can invoke for violations of the law. 1 Three sections
of SOX are germane to management accounting, because they address aspects of inter-
nal controls over financial reporting. Before covering these three sections of SOX, let’s
digress for a brief discussion of internal controls.
Appendix I
The Sarbanes-Oxley Act,
Internal Controls, and
Management Accounting
I-1 Understand and discuss the concept of internal controls over financial reporting.
I-2 Understand and discuss the role of the PCAOB and the implications of
Sarbanes-Oxley Sections 302 and 404.
After completing this appendix, you should be able to:
1The entire Sarbanes-Oxley Act is available at http://news.findlaw.com/hdocs/docs/gwbush/sarbanesoxley072302 .
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Appendix I The Sarbanes-Oxley Act, Internal Controls, and Management Accounting 761
Internal Controls over Financial Reporting
Internal control may be “broadly defined as a process, established by an entity’s board
of directors, management, and other personnel, designed to provide reasonable assurance
regarding the achievement of objectives in the following categories:
• Effectiveness and efficiency of operations.
• Reliability of financial reporting.
• Compliance with applicable laws and regulations.” 2
The second bullet point above refers to internal controls over financial reporting.
This refers to the broad set of policies, processes, and procedures that enable both the
organization’s management and interested outside parties to have confidence in the orga-
nization’s financial reports. These reports include the financial statements in the organiza-
tion’s annual report, the 10K filed with the SEC (Securities and Exchange Commission),
tax returns filed with tax authorities, and other public financial disclosures. Even a mod-
erately large company has thousands of procedures that can properly be viewed as inter-
nal controls. “They include a range of activities as diverse as approvals, authorizations,
verifications, reconciliations, reviews of operating performance, security of assets, and
separation of duties.” 3 A few examples follow.
• Physical control over raw-material, work-in-process, and finished-goods inven-
tories to prevent loss due to theft.
• Maintenance of adequate cost records to justify inventory valuations.
• Limitations on who is authorized to make purchases of various types and value.
• Requirement that two individuals sign checks to reduce the possibility of fraudu-
lent expenditures.
This list could go on and on. Moreover, in the age of computerized accounting systems,
many internal control procedures are automated. When you make a purchase from a major
retailer, for example, the sale is entered into a computerized cash register by the sales-
person. All sales are then accumulated across time by the retailer’s accounting software
system, and the result is a sales revenue figure on the firm’s income statement. Suppose,
though, that there was a glitch in the company’s accounting software such that this sales
accumulation process was not accurate. Among the retailer’s internal controls would be
safeguards to ensure that the software is working properly and doing what it is supposed
to do. 4 Other important software controls include limits on who in the organization has
the authority to access computer programs and data.
To summarize, a large company’s internal controls over financial reporting comprise
a vast array of policies and procedures involving potentially hundreds of individuals.
Since accounting information is used by both managers inside the company and inter-
ested parties outside the organization, internal controls are crucial to the integrity of both
managerial and financial accounting. Now let’s turn our attention to the three sections of
the Sarbanes-Oxley Act that address internal controls.
Learning Objective I-1
Understand and discuss the
concept of internal controls
over financial reporting.
2Internal Controls—Integrated Framework: Executive Summary (New York: AICPA, Committee of Sponsoring
Organizations of the Treadway Commission, or COSO, 2005), p. 1.
3Ibid., p. 2.
4There are many anecdotes of software glitches that resulted in flawed financial information or other mistakes. In
one such incident, a company’s billing software was incorrectly designed to express amounts in cents, rather than
dollars, resulting in the company sending out bills for, say 10,000 dollars rather than the correct amount of
100 dollars (which is equivalent to 10,000 cents).
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762 Appendix I The Sarbanes-Oxley Act, Internal Controls, and Management Accounting
Public Company Accounting Oversight Board
Title I, Section 101 of SOX established the Public Company Accounting Oversight
Board (PCAOB) . With five full-time board members operating under the auspices of
the SEC, the PCAOB’s mission is to “oversee and investigate the audits and auditors
of public companies, and sanction both firms and individuals for violations of laws,
rules, and regulations.” 5 The PCAOB’s Auditing Standard No. 5, entitled An Audit of
Internal Control Over Financial Reporting That Is Integrated With an Audit of Financial
Statements, details the board’s requirements for auditors as they assess and attest to a
client’s internal control system.
SOX Sections 302 and 404
The SOX sections most relevant to managerial accounting are sections 302 and 404.
SOX 302 Entitled Corporate Responsibility for Financial Reports, SOX section 302
requires the signing officers of a company’s financial reports to establish, maintain, and
periodically evaluate the effectiveness of the company’s internal controls over financial
reporting. The following is an excerpt from SOX section 302, part (a).
(4) The signing officers:
(A) are responsible for establishing and maintaining internal controls;
(B) have designed such internal controls to ensure that material information relating to
the issuer [of the financial reports] and its consolidated subsidiaries is made known
to such officers by others within those entities . . .;
(C) have evaluated the effectiveness of the issuer’s internal controls as of a date within
90 days prior to the report;
(D) have presented in the report their conclusions about the effectiveness of their
internal controls based on their evaluation as of that date. 6
Section 302 goes on to require that the signing officers must disclose to the company’s
auditors any material weaknesses or changes in the company’s internal control system.
SOX 404 Entitled Management Assessment of Internal Controls, SOX section 404
requires a company to include in its annual report an internal control report. SOX section
404, part (a) states that the internal control report shall:
(1) state the responsibility of management for establishing and maintaining an adequate
internal control structure and procedures for financial reporting; and
(2) contain an assessment, as of the end of the most recent fiscal year of the issuer, of the
effectiveness of the internal control structure and procedures of the issuer for financial
reporting. 7
Implications of SOX Sections 302 and 404
SOX section 302(a)(4)(C), excerpted earlier in this appendix, is “one of the most seri-
ous and onerous requirements imposed by SOX. The CEO and CFO are expected to be
able to demonstrate that there is a reliable process in place to evaluate, at least quarterly,
the internal controls in place to ensure the reliability of the data being produced.” 8 SOX
Learning Objective I-2
Understand and discuss the
role of the PCAOB and the
implications of Sarbanes-Oxley
Sections 302 and 404.
5“How the Sarbanes-Oxley Act of 2002 Impacts the Accounting Profession” (New York: AICPA), p. 1, available at
http://www.aicpa.org/info/Sarbanes-Oxley2002.asp.
6Excerpt from the Sarbanes-Oxley Act, p. 33, available at http://files.findlaw.com/news.findlaw.com/hdocs/docs/
gwbush/sarbanesoxley072302 [bracketed clarification added].
7Ibid., p. 45.
8T. J. Leech, “Sarbanes-Oxley Sections 302 and 404: A White Paper Proposing Practical, Cost Effective Compliance
Strategies,” CARDdecisions, April 2003, p. 1, available at http://www.sec.gov/rules/proposed/s74002/card941503 .
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Appendix I The Sarbanes-Oxley Act, Internal Controls, and Management Accounting 763
section 404 then adds the requirement that the company’s annual report include a report
assessing the company’s internal controls over financial reporting.
To summarize, SOX sections 302 and 404 go hand in hand. Section 302 essentially
requires that management establish, maintain, and periodically assess the company’s
internal controls over financial reporting. Section 404 then requires that management
include in the company’s annual report a separate report that assesses those internal con-
trols. Moreover, the company’s auditors are required to attest as to the effectiveness of the
internal controls.
Since its enactment, SOX sections 302 and 404 have caused a firestorm of contro-
versy in business and accounting. Managers of many companies have complained about
the onerous requirements imposed by sections 302 and 404 for detailed reporting on
internal controls, as well as the extensive documentation required to back up the internal
control reports. Others defend sections 302 and 404 as necessary reforms in the wake of
Enron and other corporate scandals.
The concept of controlling substantial risk exposure may well be the key to mak-
ing SOX sections 302 and 404 more effective. It is probably not reasonable to require
companies to report on the minutia of their internal controls over financial reporting.
If management maintains, assesses, and reports on the internal control areas where the
greatest risk of fraud or material misstatement occurs, that may be enough to achieve the
objectives of SOX.
The first decade of the SOX legislation was characterized by controversy, Congres-
sional hearings, and court rulings. In recent years, however, some of the controversy
has died down as small businesses have been absolved of the most onerous reporting
requirements. Most observers believe the law will remain in some form, at least for the
foreseeable future. As the pros and cons of SOX continue to be debated, one perspective
holds that “the impact of Sarbanes-Oxley isn’t necessarily found in the collective impact
of its substantive provisions. Rather, it is found in the profound way the law has reshaped
attitudes toward corporate governance. The need for fundamental change in boardroom
behavior was a message that transcended the text of the Sarbanes-Oxley law. The old
ways weren’t working. That idea lit the corporate responsibility movement,”9 resulting in
greater fiduciary responsibility to shareholders and to corporate ethical behavior in gen-
eral. And, as another observer put it, “SOX has been successful in increasing corporate
focus on a strong ethical culture in publicly-owned companies.”10
9M. W. Peregrine, “The Law Changed Corporate America,” The New York Times, July 25, 2012. See also K. Drawbaugh
and D. Aubin, “A Decade On, Is Sarbanes-Oxley Working,” Reuters, July 30, 2012.
10C. Verschoor, “Has SOX Been Successful?” Strategic Finance, September 2012, p. 17.
Key Terms
For each term’s definition, refer to the indicated page or turn to the glossary at the end of the text.
internal control, 761 Public Company Account-
ing Oversight Board
(PCAOB), 762
SOX 302, 762 SOX 404, 762
Review Questions
I–1. Briefly describe the overall intent of the Sarbanes-
Oxley Act of 2002.
I–2. Explain the nature and importance of internal controls
over financial reporting.
I–3. What is the PCAOB? Describe its mission.
I–4. What does SOX section 302 require of management?
I–5. What does SOX section 404 require of management?
I–6. Why did some managers complain about the require-
ments imposed by SOX sections 302 and 404?
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764 Appendix I The Sarbanes-Oxley Act, Internal Controls, and Management Accounting
Exercises
Can you describe any internal controls you observed in a job you have held? Alternatively, what kinds of
internal controls do you think are in place at your college?
Can the CEO of a large company really be expected to know what is going on at all levels in the organi-
zation? In various court cases, CEOs have argued that they could not be held accountable for the actions
of others in their companies. As a group, stage an in-class debate about this issue.
Go online and use Google or another search engine to find several current news articles about SOX.
Read three of these articles, and then summarize them for your classmates.
As a group, stage an in-class debate about the future of the Sarbanes-Oxley Act. At least three positions
can be staked out: leave SOX as is, repeal SOX, and modify SOX.
What does it mean to say that the concept of risk exposure may be the key to making SOX sections 302
and 404 more effective?
Read Exercise 13–31 on page 574. Instead of answering the requirements listed in the exercise, discuss
the implications of SOX sections 302 and 404 for the company’s internal control issues.
Read Problem 9–41 on pages 397 and 398. Instead of answering the requirements listed in the problem,
discuss the implications of SOX sections 302 and 404 regarding John Winslow’s contemplated actions.
■ Exercise I–8
Need for Internal Controls;
Accountability
(LO I-1)
■ Exercise I–9
Implications of
Sarbanes-Oxley
(LO I-2)
■ Exercise I–10
Implications of
Sarbanes-Oxley
(LO I-2)
■ Exercise I–11
Implications of
Sarbanes-Oxley
(LO I-2)
■ Exercise I–12
Internal Controls and
Sarbanes-Oxley
(LO I-1, I-2)
■ Exercise I–13
Internal Controls and
Sarbanes-Oxley
(LO I-1, I-2)
■ Exercise I–7
Internal Controls
(LO I-1)
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766
Before we can study the methods used to make capital-budgeting decisions, we must
examine the basic tools used in those methods. The fundamental concept in a capital-
budgeting decision analysis is the time value of money. Would you rather receive a $100
gift check from a relative today, or would you rather receive a letter promising the
$100 in a year? Most of us would rather have the cash now. There are two possible rea-
sons for this attitude. First, if we receive the money today, we can spend it on that new
sweater now instead of waiting a year. Second, as an alternative strategy, we can invest
the $100 received today at 10 percent interest. Then, at the end of one year, we will have
$110. Thus, there is a time value associated with money. A $100 cash flow today is not
the same as a $100 cash flow in 1 year, 2 years, or 10 years.
Compound Interest Suppose you invest $100 today (time 0) at 10 percent interest for
one year. How much will you have after one year? The answer is $110, as the following
analysis shows.
Appendix II
Compound Interest
and the Concept of
Present Value
II-1 Explain the importance of the time value of money in capital-budgeting decisions.
II-2 Compute the future value and present value of cash flows occurring over several
time periods.
After completing this appendix, you should be able to:
Learning Objective II-1
Explain the importance of
the time value of money in
capital-budgeting decisions.
001$001$ (.10)($100) $110
Time
Time 0 Year 1 Time 1
⎫⎪⎪⎪⎪⎪⎪⎪⎪⎪⎪⎪⎪⎪⎪⎪⎬⎪⎪⎪⎪⎪⎪⎪⎪⎪⎪⎪⎪⎪⎪⎪⎭
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Appendix II Compound Interest and the Concept of Present Value 767
The $110 at time 1 (end of one year) is composed of two parts, as shown below.
Principal, time 0 amount ……………………………………………………………………………………………………………………….. $100
Interest earned during year 1 (.10 × $100) ……………………………………………………………………………………………….. 10
Amount at time 1 …………………………………………………………………………………………………………………………………. $110
Thus, the $110 at time 1 consists of the $100 at time 0, called the principal, plus the $10
of interest earned during the year.
Now suppose you leave your $110 invested during the second year. How much will
you have at the end of two years? As the following analysis shows, the answer is $121.
We can break down the $121 at time 2 into two parts as follows:
Amount at time 1 ………………………………………………………………………………………………………………………………….. $110
Interest earned during year 2 (.10 × $110) ………………………………………………………………………………………………… 11
Amount at time 2 ………………………………………………………………………………………………………………………………….. $121
Notice that you earned more interest in year 2 ($11) than you earned in year 1 ($10).
Why? During year 2, you earned 10 percent interest on the original principal of $100 and
you earned 10 percent interest on the year 1 interest of $10. Interest earned on prior peri-
ods’ interest is called compound interest. Exhibit II–1 shows how your invested funds
grow over the five-year period of the investment. As the exhibit shows, the future value
of your initial $100 investment is $161.05 after five years.
As the number of years in an investment increases, it becomes more cumber-
some to compute the future value of the investment using the method in Exhibit II–1 .
$100 $100 (.10)($100) $110 $110 (.10)($110) $121
Time
Time 0 Year 1 Time 1 Year 2 Time 2
⎫⎪⎪⎪⎪⎪⎪⎪⎪⎪⎬⎪⎪⎪⎪⎪⎪⎪⎪⎪⎭ ⎫⎪⎪⎪⎪⎪⎪⎪⎪⎪⎬⎪⎪⎪⎪⎪⎪⎪⎪⎪⎭
Learning Objective II-2
Compute the future value and
present value of cash flows
occurring over several time
periods.
Time 0
Year 1
Time 1
Year 2
Time 2
Year 3
Time 3
Year 4
Time 4
Year 5
Time 5
Principal, time 0 amount
Interest earned during year 1 (.10 × $100)
Amount at time 1
Interest earned during year 2 (.10 × $110)
Amount at time 2
Interest earned during year 3 (.10 × $121)
Amount at time 3
Interest earned during year 4 (.10 × $133.10)
Amount at time 4
Interest earned during year 5 (.10 × $146.41)
Amount at time 5
$100.00
10.00
$110.00
11.00
$121.00
12.10
$133.10
13.31
$146.41
14.64
$161.05
Time
Exhibit II–1
Compound Interest
and Future Value
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768 Appendix II Compound Interest and the Concept of Present Value
Fortunately, the simple formula shown below may be used to compute the future value of
any investment.
F n 5 P(1 1 r )
n (1)
where P denotes principal
r denotes interest rate per year
n denotes number of years
Using formula (1) to compute the future value after five years of your $100 investment,
we have the following computation.
F n 5 P(1 1 r )
n
5 $100(1 1 .10 ) 5
5 $100(1.6105) 5 $161.05
The value of (1 1 r ) n is called the accumulation factor. The values of (1 1 r ) n , for vari-
ous combinations of r and n, are tabulated in Table I of Appendix A to Chapter 16, which
appears on page 714.
Use formula (1) and the tabulated values in Table I to compute the future value after
10 years of an $800 investment that earns interest at the rate of 12 percent per year. 1
Present Value In the discussion above, we computed the future value of an investment
when the original principal is known. Now consider a slightly different problem. Suppose
you know how much money you want to accumulate at the end of a five-year investment.
Your problem is to determine how much your initial investment needs to be in order to accu-
mulate the desired amount in five years. To solve this problem, we start with formula (1):
F n 5 P(1 1 r )
n
Now divide each side of the preceding equation by (1 1 r ) n
P F
r
n n
1
1( )
⎞
⎟
⎠
⎞
⎟
⎠
(2)
In formula (2), P denotes what is commonly referred to as the present value of the cash
flow F n , which occurs after n years when the interest rate is r.
Let’s try out formula (2) on your investment problem, which we analyzed in Exhibit II–1 .
Suppose you did not know the value of the initial investment required if you want to accumu-
late $161.05 at the end of five years in an investment that earns 10 percent per year. We can
determine the present value of the investment as follows:
P F
r
n n
1
1
161 05
1
1 10
1
5
( )
$ .
( . )
$ 661 05 6209 100. (. ) $
⎞
⎟
⎠
⎞
⎟
⎠
⎞
⎟
⎠
⎞
⎟
⎠
1Using formula (1): F 5 $800(1 1 .12)10. From Table I, (1 1 .12)10 5 3.106. (Note that the values in Table I are
rounded.) Thus, the future value of the investment is ($800)(3.106) 5 $2,484.80. Compound interest will more than
triple the original $800 investment in 10 years.
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Appendix II Compound Interest and the Concept of Present Value 769
Thus, as we knew already, you must invest $100 now in order to accumulate $161.05
after five years in an investment earning 10 percent per year. The present value of $100
and the future value of $161.05 at time 5 are economically equivalent, given that the
annual interest rate is 10 percent. If you are planning to invest the $100 received now,
then you should be indifferent between receiving the present value of $100 now or receiv-
ing the future value of $161.05 at the end of five years.
When we used formula (2) to compute the present value of the $161.05 cash flow
at time 5, we used a process called discounting. The interest rate used when we discount
a future cash flow to compute its present value is called the discount rate. The value of
1/(1 1 r ) n , which appears in formula (2), is called the discount factor. Discount factors, for
various combinations of r and n, are tabulated in Table III of Appendix A to Chapter 16.
Suppose you want to accumulate $18,000 to buy a car in four years, and you can
earn interest at the rate of 8 percent per year on an investment you make now. How
much do you need to invest now? Use formula (2) and the discount factors in Table III of
Appendix A to Chapter 16 (p. 715) to compute the present value of the required $18,000
amount needed at the end of four years. 2
Present Value of a Cash-Flow Series The present-value problem we just solved
involved only a single future cash flow. Now consider a slightly different problem.
Suppose you just won $5,000 in the state lottery. You want to spend some of the cash
now, but you have decided to save enough to rent a beach condominium during spring
break of each of the next three years. You would like to deposit enough in a bank account
now so that you can withdraw $1,000 from the account at the end of each of the next three
years. The money in the bank account will earn 8 percent per year. The question, then, is
how much do you need to deposit? Another way of asking the same question is, what is
the present value of a series of three $1,000 cash flows at the end of each of the next three
years, given that the discount rate is 8 percent?
Present
Value
? $1,000 $1,000 $1,000
Time
0 1 2 3
2Using formula (2): P 5 $18,000 3 [1/(1 1 .08)4]. From Table III, 1/(1 1 .08)4 5 .735. (Note that the values in
Table III are rounded.) Thus, the present value of the required $18,000 amount is ($18,000)(.735) 5 $13,230. An
investment of $13,230 made now, earning annual interest at 8 percent, will accumulate to $18,000 at the end of four
years.
One way to figure out the answer to the question is to compute the present value of
each of the three $1,000 cash flows and add the three present-value amounts. We can use
formula (2) for these calculations, as shown in panel A of Exhibit II–2. Notice that the
present value of each of the $1,000 cash flows is different, because the timing of the cash
flows is different. The earlier the cash flow will occur, the higher is its present value.
Examine panel A of Exhibit II–2 carefully. We obtained the $2,577 total present
value by adding three present-value amounts. Each of these amounts is the result of mul-
tiplying $1,000 by a discount factor. Notice that we can obtain the same final result by
adding the three discount factors first, and then multiplying by $1,000. This approach is
taken in panel B of Exhibit II–2. The sum of the three discount factors is called an annu-
ity discount factor, because a series of equivalent cash flows is called an annuity. Annuity
discount factors for various combinations of r and n are tabulated in Table IV of Appen-
dix A to Chapter 16 (p. 715).
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770 Appendix II Compound Interest and the Concept of Present Value
Now let’s verify that $2,577 is the right amount to finance your three spring-break
vacations. Exhibit II–3 shows how your bank account will change over the three-year
period as you earn interest and then withdraw $1,000 each year.
Future Value of a Cash-Flow Series To complete our discussion of present-value
and future-value concepts, let’s consider the series of $1,000 condo rental payments from
Exhibit II–2
Present Value of a Series of
Cash Flows
A. Present Value of Cash-Flow Series Using Three Independent Present-Value Calculations
Present-value formula [formula (2)]:
Present value of time 1 cash flow: $ 925.90
Present value of time 2 cash flow: $ 857.30
Present value of time 3 cash flow: $ 793.80
Total: present value of series of three cash flows $2,577.00
Sum of Three Discount Factors
is the Annuity Discount Factor
B. Present Value of Cash-Flow Series Using the Annuity Discount Factor
Present value of series of three cash flows $1,000(2.5770) $2,577.00
P F
rn n
1
1( )
⎛
⎝
⎜
⎞
⎠
⎟
$ ,
( . )
$ , (. )1000
1
1 08
1000 9259
1
⎛
⎝
⎜
⎞
⎠
⎟
$ ,
( . )
$ , (. )1000
1
1 08
1000 8573
2
⎛
⎝
⎜
⎞
⎠
⎟
$ ,
( . )
$ , (. )1000
1
1 08
1000 7938
3
⎛
⎝
⎜
⎞
⎠
⎟
Time 0 Deposit $2,577 ………………………………………………………………………………. $2,577.00
Earn interest of $2,577(.08) ………………………………………………………………. 206.16*
Year 1
Accumulation at time 1 …………………………………………………………………….. $2,783.16
Time 1 Withdrawal to cover time 1 beach trip ………………………………………………….. 1,000.00
Amount remaining to earn interest in year 2 ………………………………………….. $1,783.16
Year 2 Earn interest of $1,783.16(.08) ………………………………………………………….. 142.65*
Accumulation at time 2 …………………………………………………………………….. $1,925.81
Time 2 Withdrawal to cover time 2 beach trip ………………………………………………….. 1,000.00
Amount remaining to earn interest in year 3 ………………………………………….. $ 925.81*
Year 3 Earn interest of $925.81(.08) …………………………………………………………….. 74.06
Accumulation at time 3 …………………………………………………………………….. $ 999.87†
Time 3 Withdrawal to cover time 3 beach trip ………………………………………………….. $ 999.87†
Time
*Rounded
†This amount does not equal $1,000 exactly because of rounding error in the computation of each year’s interest.
Exhibit II–3
Verification of Present-Value
Calculation for Cash-Flow
Series
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Appendix II Compound Interest and the Concept of Present Value 771
the condo owner’s perspective. Suppose the owner invests each $1,000 rental payment
in a bank account that pays 8 percent interest per year. How much will the condo owner
accumulate at the end of the three-year period? An equivalent question is, What is the
future value of the three-year series of $1,000 cash flows, given an annual interest rate of
8 percent? Exhibit II–4 answers the question in two ways. In panel A of the exhibit, three
separate future-value calculations are made using formula (1). Notice that the $1,000
cash flow at time 1 is multiplied by (1.08) 2 , since it has two years to earn interest. The
$1,000 cash flow at time 2 has only one year to earn interest, and the time 3 cash flow has
no time to earn interest.
In panel B of the exhibit, the three-year annuity accumulation factor is used. This
factor is the sum of the three accumulation factors used in panel A of the exhibit. The
annuity accumulation factors for various combinations of r and n are tabulated in Table II
of Appendix A to Chapter 16 (p. 714).
Using the Tables Correctly When using the tables in Appendix A to Chapter 16
(pp. 714,715) to solve future-value and present-value problems, be sure to select the cor-
rect table. Table I is used to find the future value of a single cash flow, and Table III is
used to find the present value of a single cash flow. Table II is used in finding the future
value of a series of identical cash flows; Table IV is used in finding the present value of
a series of identical cash flows. Be careful not to confuse future value with present value
or to confuse a single cash flow with a series of identical cash flows.
If you have a calculator that will exponentiate (raise a number to a power), you can
forget the tables altogether. Just use the pertinent formula and compute the appropriate
factor yourself.
Exhibit II–4
Future Value of a Series of
Cash Flows
A. Future Value of Cash-Flow Series Using Three Independent Future-Value Calculations
Future-value formula [formula (1)]: Fn 5 P (1 1 r )
n
Future value of time 1 cash flow: $1,000(1 1 .08)2 5 $1,000(1.1664) 5 $1,166.40
Future value of time 2 cash flow: $1,000(1 1 .08)1 5 $1,000(1.0800) 5 $1,080.00
Future value of time 3 cash flow: $1,000 5 $1,000(1.0000) 5 $1,000.00
Total: future value of series of three cash flows $3,246.40
Sum of Three Accumulation Factors
is the Annuity Accumulation Factor
B. Future Value of Cash-Flow Series Using the Annuity Accumulation Factor
Future value of series of three cash flows 5 $1,000(3.2464) 5 $3,246.40
Key Terms
For each term’s definition, refer to the indicated page or turn to the glossary at the end of the text.
accumulation factor, 768
annuity, 769
compound interest, 767
discount rate, 769
future value, 767
present value, 768
principal, 767
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772 Appendix II Compound Interest and the Concept of Present Value
Review Questions
II–1. What is meant by the term compound interest?
II–2. Explain in words the following future-value formula:
F n 5 P (1 1 r )
n .
II–3. Define the term present value.
II–4. “The greater the discount rate, the greater the present
value of a future cash flow.” True or false? Explain your
answer.
II–5. “If the interest rate is 10 percent, a present value of
$100 and a future value of $161.10 at the end of five
years are economically equivalent. ” Explain.
II–6. What is an annuity?
All applicable Exercises are available with McGraw Hill’s Connect Accounting ® . Exercises
Answer each of the following independent questions. Ignore personal income taxes.
1. Suppose you invest $2,500 in an account bearing interest at the rate of 14 percent per year. What
will be the future value of your investment in six years?
2. Your best friend won the state lottery and has offered to give you $10,000 in five years, after he
has made his first million dollars. You figure that if you had the money today, you could invest it at
12 percent annual interest. What is the present value of your friend’s future gift?
3. In four years, you would like to buy a small cabin in the mountains. You estimate that the property
will cost you $52,500 when you are ready to buy. How much money would you need to invest
each year in an account bearing interest at the rate of 6 percent per year in order to accumulate the
$52,500 purchase price?
4. You have estimated that your educational expenses over the next three years will be $13,000
per year. How much money do you need in your account now in order to withdraw the required
amount each year? Your account bears interest at 10 percent per year.
Refer to the answers given for the preceding exercise.
Required:
1. Refer to requirement (1) of the preceding exercise. Prepare a display similar to Exhibit II–1
to show how your accumulation grows each year to equal $5,487.50 after six years.
2. Refer to requirement (4) of the preceding exercise. Prepare a display similar to Exhibit II–3
to verify that $32,331 is the amount you need to fund your educational expenses.
You plan to retire at age 40 after a highly successful but short career. You would like to accumulate
enough money by age 40 to withdraw $225,000 per year for 40 years. You plan to pay into your account
15 equal installments beginning when you are 25 and ending when you are 39. Your account bears
interest of 12 percent per year.
Required:
1. How much do you need to accumulate in your account by the time you retire?
2. How much do you need to pay into your account in each of the 15 equal installments?
3. Is this a future-value problem or a present-value problem? Explain.
■ Exercise II–8
Continuation of Preceding
Exercise
(LO II-1, II-2)
■ Exercise II–9
Future Value and Present
Value
(LO II-1, II-2)
■ Exercise II–7
Future Value and Present
Value
(LO II-1, II-2)
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774
A key decision in manufacturing, retail and some service industry firms is how much
inventory to keep on hand. Moreover, inventory policy is a key part of the budgeting
process. This Appendix covers two alternative approaches to inventory management.
Section 1 covers the traditional approach, known as the economic order quantity decision
model. Section 2 covers a more contemporary approach, known as the just-in-time inven-
tory management system.
Section 1: Economic Order Quantity
Inventory decisions involve a delicate balance between three classes of costs: ordering
costs, holding costs, and shortage costs. Examples of costs in each of these categories
are given in Exhibit III–1. The following illustration emphasizes the benefits of a sound
inventory policy.
Cozycamp.com, a camping equipment manufacturer, has recently expanded its
product line into winter sports equipment. The company’s newest product is a fiberglass
snowboard. One of the raw materials is a special resin used to bind the fiberglass in the
molding phase of production. The production manager, Hi Mogul, uses an economic
order quantity (EOQ) decision model to determine the size and frequency with which
resin is ordered. The EOQ model is a mathematical tool for determining the order quan-
tity that minimizes the costs of ordering and holding inventory.
Resin is purchased in 50-gallon drums, and 9,600 drums are used each year. Each
drum costs $400. The controller estimates that the cost of placing and receiving a typical
resin order is $225. The controller’s estimate of the annual cost of carrying resin in inven-
tory is $3 per drum.
Tabular Approach Suppose Mogul orders 800 drums of resin in each order placed
during the year. The total annual cost of ordering and holding resin in inventory is calcu-
lated as follows:
cozycamp.com
Appendix III
Inventory Management
III-1 Calculate the economic order quantity (EOQ) using the EOQ decision model.
III-2 Understand the differences between the economic-order-quantity and just-in-time
approaches to inventory management.
After completing this appendix, you should be able to:
Learning Objective III-1
Calculate the economic order
quantity (EOQ) using the EOQ
decision model.
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Appendix III Inventory Management 775
Notice that the $3,900 cost does not include the purchase cost of the resin at $400 per
drum. We are focusing only on the costs of ordering and holding resin inventory.
Can Mogul do any better than $3,900 for the annual cost of his resin inventory pol-
icy? Exhibit III–2, which tabulates the inventory costs for various order quantities, indi-
cates that Mogul can lower the costs of ordering and holding resin inventory. Of the five
order quantities listed, the 1,200-drum order quantity yields the lowest total annual cost.
Unfortunately, this tabular method for finding the least-cost order quantity is cumber-
some. Moreover, it does not necessarily result in the optimal order quantity. It is possible
that some order quantity other than those listed in Exhibit III–2 is the least-cost order
quantity.
Equation Approach The total annual cost of ordering and holding inventory is given
by the following equation.
Total annual cost 5 ( Annual requirement _________________ Order quantity ) ( Cost per order )
1 ( Order quantity ____________ 2 ) ( Annual holding cost per unit )

Annual requirement
_________________
Quantity per order
5
9,600
_____
800
5 12 5 Number of orders
Annual ordering cost 5 12 orders 3 $225 per order 5 $2,700
Average quantity in inventory 5
Quantity per order
_______________
2
5 800 ____
2
5 400 drums
Annual holding cost 5 (Average quantity in inventory) 3 (Annual carrying cost per drum)
5 400 3 $3 5 $1,200
Total annual cost
of inventory policy
5 Ordering cost 1 Holding cost 5 $2,700 1 $1,200 5 $3,900
Ordering Costs
Clerical costs of preparing purchase orders
Time spent finding suppliers and expediting orders
Transportation costs
Receiving costs (e.g., unloading and inspection)
Holding Costs
Costs of storage space (e.g., warehouse depreciation)
Security
Insurance
Forgone interest on working capital tied up in inventory
Deterioration, theft, spoilage, or obsolescence
Shortage Costs
Disrupted production when raw materials are unavailable:
Idle workers
Extra machinery setups
Lost sales resulting in dissatisfied customers
Loss of quantity discounts on purchases
Exhibit III–1
Inventory Ordering, Holding,
and Shortage Costs
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776 Appendix III Inventory Management
The following formula for the least-cost order quantity, called the economic order
quantity (or EOQ), has been developed using calculus.
Economic order quantity 5 √
_________________________________

(2)(Annual requirement)(Cost per order)
_________________________________
(Annual holding cost per unit)

The EOQ formula in Cozycamp.com’s problem yields the following EOQ for resin.
EOQ 5 √
_____________

(2)(9,600)(225)
_____________
3
5 1,200
Graphical Approach Another method for solving the EOQ problem is the graphical
method, which is presented in Exhibit III–3. Notice that the ordering-cost line slants
down to the right. This indicates a decline in these costs as the order size increases and
the order frequency decreases. However, as the order size increases, so does the average
inventory on hand. This results in an increase in holding costs, as indicated by the posi-
tive slope of the holding-cost line. The EOQ falls at 1,200 units, where the best balance is
struck between these two costs. Total costs are minimized at $3,600.
Timing of Orders The EOQ model helps management decide how much to order
at a time. Another important decision is when to order. This decision depends on the
lead time, which is the length of time it takes for the material to be received after an
order is placed. Suppose the lead time for resin is one month. Since Cozycamp.com uses
9,600 drums of resin per year, and the production rate is constant throughout the year,
this implies that 800 drums are used each month. Production manager Mogul should
order resin, in the economic order quantity of 1,200 drums, when the inventory falls to
800 drums. By the time the new order arrives, one month later, the 800 drums in inven-
tory will have been used in production. Exhibit III–4 depicts this pattern of ordering and
using inventory. By placing an order early enough to avoid a stockout, management takes
into account the potential costs of shortages.
Safety Stock Our example assumed that the usage of resin is constant at 800 drums
per month. Suppose instead that monthly usage fluctuates between 600 and 1,000 drums.
Although average monthly usage still is 800 drums, there is the potential for an excess
usage of 200 drums in any particular month. In light of this uncertainty, management
may wish to keep a safety stock of resin equal to the potential excess monthly usage of
200 drums. With a safety stock of 200 drums, the reorder point is 1,000 drums.
Thus, Mogul should order the EOQ of 1,200 drums whenever resin inventory falls to
1,000 drums. During the one-month lead time, another 600 to 1,000 drums of resin will
be consumed in production. Although a safety stock will increase inventory holding costs,
it will minimize the potential costs caused by shortages.
Order size ……………………………………………………………. 800 960 1,200 1,600 2,400
Number of orders (9,600 4 order size) ………………………. 12 10 8 6 4
Ordering costs ($225 3 number of orders) …………………. $2,700 $2,250 $1,800 $1,350 $ 900
Average inventory (order size 4 2) ……………………………. 400 480 600 800 1,200
Holding costs ($3 3 average inventory)………………………. $1,200 $1,440 $1,800 $2,400 $3,600
Total annual cost (ordering cost 1 holding cost) …………… $3,900 $3,690 $3,600 $3,750 $4,500
Minimum
Exhibit III–2
Tabulation of Inventory Order-
ing and Holding Costs
cozycamp.com
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Appendix III Inventory Management 777
Exhibit III–3
Graphical Solution to
Economic Order Quantity
Decision
cozycamp.com
Inventory level (drums)
Time
1,200
800
400
Order
received
Usage of resin
1 month
lead time
Reorder point:
when inventory
equals 800 drums,
order EOQ of
1,200 drums
Exhibit III–4
Ordering, Lead Time, and
Usage of inventory.
cozycamp.com
Total annual cost
400 800 1,200 1,600 2,000 2,400
Order
quantity
$1,000
$2,000
$3,000
$4,000
$5,000
$6,000
Economic order
quantity (EOQ)
Minimum
cost
Holding cost
Ordering cost
Total annual cost
Section 2: Just-in-Time Inventory Management
In traditional manufacturing settings, inventories of raw materials and parts, partially
completed components, and finished goods were kept as a buffer against the possibility
of running out of a needed item. However, large buffer inventories consume valuable
resources and generate hidden costs. Consequently, many companies have changed their
approach to production and inventory management. These manufacturers have adopted
a strategy for controlling the flow of manufacturing in a multistage production process.
In a just-in-time (JIT) production and inventory management system, raw materials
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778 Appendix III Inventory Management
Demand for raw
materials and parts is
signaled when there is
a need in stage I for
more inputs.
Demand for production
activity in stage I is
signaled when there is
a need in stage II for
more inputs.
Demand for production
activity in stage II is
signaled when there is
a need in stage III for
more inputs.
Demand for finished
goods is signaled when
sales activity warrants
more finished units.
This triggers
manufacturing activity
in the final stage of
production (stage III).
SalesProduction Stage IIIProduction Stage IIProduction Stage IPurchasing
Denotes flow of materials, parts, partially finished goods, and finished goods.
Denotes a signal that more goods are needed at the next stage of production
Exhibit III–5
Just-in-Time (JIT) Production
and Inventory Management
System
and parts are purchased or produced just in time to be used at each stage of the production
process. This approach to inventory and production management brings considerable cost
savings from reduced inventory levels.
The key to the JIT system is the “pull” approach to controlling manufacturing. To
visualize this approach, look at Exhibit III–5, which displays a simple diagram of a mul-
tistage production process. The flow of manufacturing activity is depicted by the solid
arrows running across the page from one stage of production to the next. However, the
signal that triggers more production activity in each stage comes from the next stage of
production. These signals, depicted by the dashed-line arrows, run from right to left.
We begin with sales at the right-hand side of the exhibit. When sales activity warrants
more production of finished goods, the goods are “pulled” from production stage III by
sending a signal that more goods are needed. Similarly, when production employees in
stage III need more inputs, they send a signal back to stage II. This triggers production
activity in stage II. Working our way back to the beginning of the process, purchases of
raw materials and parts are triggered by a signal that they are needed in stage I. This pull
system of production management, which characterizes the JIT approach, results in a
smooth flow of production and significantly reduced inventory levels. The result is con-
siderable cost savings for the manufacturer.
JIT Implications for EOQ The EOQ model minimizes the total cost of ordering and
holding purchased inventory. Thus, this inventory management approach seeks to balance
the cost of ordering against the cost of storing inventory. Under the JIT philosophy, the
goal is to keep all inventories as low as possible. Any inventory holding costs are seen as
inefficient and wasteful. Moreover, under JIT purchasing, ordering costs are minimized
by reducing the number of vendors, negotiating long-term supply agreements, making
less frequent payments, and eliminating inspections. The implication of the JIT philoso-
phy is that inventories should be minimized by more frequent deliveries in smaller quan-
tities. This result can be demonstrated using the EOQ formula, as shown in Exhibit III–6.
As the cost of holding inventory increases, the EOQ decreases. Moreover, as the cost of
placing an order declines, the EOQ decreases.
The economics underlying the EOQ model support the JIT viewpoint that inven-
tory should be purchased or produced in small quantities, and inventories should be kept
to the absolute minimum. However, the basic philosophies of JIT and EOQ are quite
Learning Objective III-2
Understand the differences
between the economic-order-
quantity and just-in-time
approaches to inventory
management.
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Appendix III Inventory Management 779
different. The EOQ approach takes the view that some inventory is necessary, and the
goal is to optimize the order quantity in order to balance the cost of ordering against the
cost of holding inventory. In contrast, the JIT philosophy argues that holding costs tend
to be higher than may be apparent because of the inefficiency and waste of storing inven-
tory. Thus, inventory should be minimized, or even eliminated completely, if possible.
Moreover, under the JIT approach, orders typically will vary in size, depending on needs.
The EOQ model, in contrast, results in a constant order quantity.
Key Terms
For each term’s definition refer to the indicated page, or turn to the glossary at the end of the text.
economic order quantity (EOQ), 774 just-in-time (JIT) production and
inventory management system, 777
lead time, 776
Review Questions
III–1. Define and give examples of inventory ordering,
holding, and shortage costs.
Exercises All applicable Exercises are available with McGraw-Hill’s Connect Accounting ® .
For each of the following independent cases, use the equation method to compute the economic order
quantity.
■ Exercise III–3
Economic Order Quantity
(LO III-1)
Case A Case B Case C
Annual requirement (in units) ………………………………………………. 13,230 1,681 560
Cost per order …………………………………………………………………. $250 $40 $10
Annual holding cost per unit ……………………………………………….. 6 20 7
Andrew and Fulton, Inc., uses 780 tons of a chemical bonding agent each year. Monthly demand fluctu-
ates between 50 and 80 tons. The lead time for each order is one month, and the economic order quantity
is 130 tons.
Required:
1. Determine the safety stock appropriate for the chemical bonding agent.
2. At what order point, in terms of tons remaining in inventory, should Andrew and Fulton, Inc.,
order the bonding agent?
Ordering Costs per Order
Holding Costs per Unit $225 $150 $100 $50
$3 1,200* 980 800 566 EOQ declines
4 1,039 849 693 490
5 930 759 620 438
6 849 693 566 400
EOQ
declines
*The annual requirement is assumed to be 9,600 units for each case in this table. This was the annual requirement for drums of resin in the
Cozycamp.com illustration. (Several of the EOQs in the table are rounded.)
Exhibit III–6
Economic Order Quantity
with Different Ordering and
Holding Costs
cozycamp.com
III–2. Explain the differences in the basic philosophies underly-
ing the JIT and EOQ approaches to inventory management.
■ Exercise III–4
Lead Time and Safety Stock
(LO III-1)
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780 Appendix III Inventory Management
Fiber Technology, Inc., manufactures glass fibers used in the communications industry. The company’s
materials and parts manager is currently revising the inventory policy for XL-20, one of the chemicals
used in the production process. The chemical is purchased in 10-pound canisters for $95 each. The firm
uses 4,800 canisters per year. The controller estimates that it costs $150 to place and receive a typical
order of XL-20. The annual cost of storing XL-20 is $4 per canister.
Required:
1. Write the formula for the total annual cost of ordering and storing XL-20.
2. Use the EOQ formula to determine the optimal order quantity.
3. What is the total annual cost of ordering and storing XL-20 at the economic order quantity?
4. How many orders will be placed per year?
5. Fiber Technology’s controller, Jay Turnbull, recently attended a seminar on JIT purchasing. After-
ward he analyzed the cost of storing XL-20, including the costs of wasted space and inefficiency.
He was shocked when he concluded that the real annual holding cost was $19.20 per canister.
Turnbull then met with Doug Kaplan, Fiber Technology’s purchasing manager. Together they
contacted Reno Industries, the supplier of XL-20, about a JIT purchasing arrangement. After some
discussion and negotiation, Kaplan concluded that the cost of placing an order for XL-20 could be
reduced to just $20. Using these new cost estimates, Turnbull computed the new EOQ for XL-20.
a. Use the equation approach to compute the new EOQ.
b. How many orders will be placed per year?
Refer to the original data given in the preceding exercise for Fiber Technology, Inc.
Required:
1. Prepare a table showing the total annual cost of ordering and storing XL-20 for each of the
following order quantities: 400, 600, and 800 canisters.
2. What are the weaknesses in the tabular approach?
Refer to the original data given in Exercise III–5 for Fiber Technology, Inc.
Required: Prepare a graphical analysis of the economic order quantity decision for XL-20.
Refer to the original data given in Exercise III–5 for Fiber Technology, Inc. The lead time required to
receive an order of XL-20 is one month.
Required:
1. Assuming stable usage of XL-20 each month, determine the reorder point for XL-20.
2. Draw a graph showing the usage, lead time, and reorder point for XL-20.
3. Suppose that monthly usage of XL-20 fluctuates between 300 and 500 canisters, although annual
demand remains constant at 4,800 canisters. What level of safety stock should the materials and
parts manager keep on hand for XL-20? What is the new reorder point for the chemical?
■ Exercise III–5
Economic Order Quantity
Equation Approach; JIT
Purchasing
(LO III-1, III-2)
■ Exercise III–6
Economic Order Quantity;
Tabular Approach
(LO III-1)
■ Exercise III–7
Economic Order Quantity;
Graphical Approach
(LO III-1)
■ Exercise III–8
Economic Order Quantity;
Lead Time and Safety Stock
(LO III-1)
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781
References for “In Their Own Words”
Chapter One
(1a)* Gary Siegel and James E. Sorensen, principal investigators for
the Gary Siegel Organization, Counting More, Counting Less:
Transformations in the Management Accounting Profession
(Montvale, NJ: Institute of Management Accountants, 1999).
(1b) Ibid.
(1c) Ibid.
(1d) Ibid.
(1e) Ibid.
(1f) Ibid.
(1g) Ibid.
(1h) Matthew Quinn, “CFO Journal: For CFOs, a Move Past
Finance,” Wall Street Journal, July 31, 2012.
(1i) Ibid.
(1j) Ibid. (1a)
(1k) Matthew Quinn and Alix Stuart, “Not Just Bean Counters,”
Wall Street Journal, July 31, 2012.
(1l) Ibid. (1h)
Chapter Two
(2a) Gary Siegel and James E. Sorensen, principal investigators for
the Gary Siegel Organization, Counting More, Counting Less:
Transformations in the Management Accounting Profession
(Montvale, NJ: Institute of Management Accountants, 1999).
(2b) Gary Siegel, project director, The Practice Analysis of Manage-
ment Accounting (Montvale, NJ: Institute of Management
Accountants, 1996) pp. 17, 18.
(2c) Ibid., p. 14.
(2d) Ibid., p. 19.
(2e) Activity-Based Management: Part I, a management education
video (Boston: President and Fellows of Harvard College, 1993).
(2f) Gary Siegel, project director, The Practice Analysis of
Management Accounting (Montvale, NJ: Institute of Manage-
ment Accountants, 1996), p. 18.
(2g) Interview with a Delta Air Lines accountant conducted during
research by the author.
(2h) Gary Siegel and James E. Sorensen, principal investigators for
the Gary Siegel Organization, Counting More, Counting Less:
Transformations in the Management Accounting Profession
(Montvale, NJ: Institute of Management Accountants, 1999).
Chapter Three
(3a) The Management Accounting Video, a management education
video (New York: McGraw-Hill, 1997). Note: Since this video
was made, MiCRUS was sold to Phillips.
(3b) Gary Siegel and James E. Sorensen, principal investigators for
the Gary Siegel Organization, Counting More, Counting Less:
Transformations in the Management Accounting Profession
(Montvale, NJ: Institute of Management Accountants, 1999).
(3c) The Management Accounting Video, a management education
video (New York: McGraw-Hill, 1997). Note: Since this video
was made, MiCRUS was sold to Phillips.
(3d) Interview with a DaimlerChrysler accountant conducted during
research by the author.
(3e) Interview with an accountant for The Walt Disney Company con-
ducted during research by the author.
(3f) Interview with a DaimlerChrysler accountant conducted during
research by the author.
(3g) Gary Siegel, project director, The Practice Analysis of Manage-
ment Accounting (Montvale, NJ: Institute of Management
Accountants, 1996), p. 17.
(3h) Interview with a Cornell University accountant conducted during
research by the author.
(3i) The Management Accounting Video, a management education
video (New York: McGraw-Hill, 1997).
Chapter Four
(4a) Steve Player and Carol Cobble, Cornerstones of Decision
Making: Profiles of Enterprise ABM (Greensboro, NC: Oakhill
Press, 1999), p. 161.
(4b) Ibid., p. 12.
(4c) Ibid., p. 168.
Chapter Five
(5a) Activity-Based Management: Part I, a management education
video (Boston: The President and Fellows of Harvard College,
1993).
(5b) Joyce R. Ochs and Kenneth L. Parkinson, “Moving to Activity-
Based Cost Analysis,” Business Finance 5, no. 11 (November
1999), p. 101.
(5c) Steve Player and Carol Cobble, Cornerstones of Decision
Making: Profiles of Enterprise ABM (Greensboro, NC: Oakhill
Press, 1999), p. 167.
(5d) Steve Player and Carol Cobble, Cornerstones of Decision
Making: Profiles of Enterprise ABM (Greensboro, NC: Oakhill
Press, 1999), p. 119.
(5e) Tad Leahy, “The A to Z of ABC Dictionaries,” Business
Finance 5, no. 12 (December 1999), p. 82.
(5f) Steve Player and Carol Cobble, Cornerstones of Decision
Making: Profiles of Enterprise ABM (Greensboro, NC: Oakhill
Press, 1999), p. 151.
(5g) Ibid., p. 226.
(5h) Scott Smith, in Steve Player and Carol Cobble, Cornerstones of
Decision Making: Profiles of Enterprise ABM (Greensboro,
NC: Oakhill Press, 1999), p. 187.
(5i) The Management Accounting Video, a management education
video (New York: McGraw-Hill, 1997).
Chapter Six
(6a) Paulo Salgado, Margarida Bajanca, and Nuno Belo, in Steve
Player and Carol Cobble, Cornerstones of Decision Making:
Profiles of Enterprise ABM (Greensboro, NC: Oakhill Press,
1999), p. 172.
(6b) Steve Player and Carol Cobble, Cornerstones of Decision
Making: Profiles of Enterprise ABM (Greensboro, NC: Oakhill
Press, 1999), p. 214.
(6c) Interview with a Ford Motor Company accountant conducted
during research by the author.
* The references are organized by chapter. Thus, reference (1a) relates to the first quote in Chapter 1, and so forth.
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782 References for “In Their Own Words”
(10b) The Management Accounting Video, a management education
video (New York: McGraw-Hill, 1997).
(10c) African Performance Specialists, “Purchasing Efficiency
Improvement Project,” APS NewsLetter, October 2008, http://
www.africanwizard.co.za/files/purchasing_efficiency_oct_08.
pdf.
(10d) Ibid. (10b)
(10e) Rockwell Collins, “Engineer of the Year Awards,” Horizons
Online 15, Issue 2 (2010).
(10f) David Johnsen and Parvez Sopariwala, “Standard Costing Is
Alive and Well at Parker Brass,” Management Accounting
Quarterly 1, no. 2 (Winter 2000), p. 13.
Chapter Eleven
(11a) Gary Siegel and James E. Sorensen, principal investigators for
the Gary Siegel Organization, Counting More, Counting Less:
Transformations in the Management Accounting Profession
(Montvale, NJ: Institute of Management Accountants, 1999).
(11b) Interview with an A. T. Kearney consultant conducted during
research by the author.
(11c) Steve Player and Carol Cobble, Cornerstones of Decision
Making: Profiles of Enterprise ABM (Greensboro, NC: Oakhill
Press, 1999), p. 79.
(11d) Cynthia Beier Greeson and Mehmet C. Kocakulah, “Implement-
ing an ABC Pilot at Whirlpool,” Journal of Cost Management 11,
no. 2 (March/April 1997), pp. 16–21.
(11e) Interview with an A. T. Kearney consultant conducted during
research by the author.
Chapter Twelve
(12a) Interview with Chrysler accountant conducted during research
by the author.
(12b) Gary Siegel and James E. Sorensen, principal investigators for
the Gary Siegel Organization, Counting More, Counting Less:
Transformations in the Management Accounting Profession
(Montvale, NJ: Institute of Management Accountants, 1999).
(12c) Ibid.
(12d) Company presentation at www.univarcorp.com/040506/
UKUnivarAGM-1.ppt (May 2004).
(12e) Ibid. (12b)
(12f) The Management Accounting Video, a management education
video (New York: McGraw-Hill, 1997).
(12g) Mark Green, Jeanine Garrity, Andra Gumbus, and Bridget Lyons,
“Pitney Bowes Calls for New Metrics,” Strategic
Finance 83, no. 11 (May 2002), p. 34.
(12h) Quoted in Palladium Group, “Strategy Management,” http://
www.thepalladiumgroup.com/Solutions/strategy/Pages/overview
.aspx (February 16, 2013).
Chapter Thirteen
(13a) Gary Siegel and James E. Sorensen, principal investigators for
the Gary Siegel Organization, Counting More, Counting Less:
Transformations in the Management Accounting Profession
(Montvale, NJ: Institute of Management Accountants, 1999).
(13b) Thomas P. Kunes, “Environmental Cost Management,” Strategic
Finance, February 2001, p. 83.
(13c) Current Practices, Perceptions and Trends: Transfer Pricing—
1997 Global Survey (Chicago: Ernst & Young, 1997), p. 1.
(13d) Ibid., p. 4.
(13e) Ibid., p. 11.
(13f) Ibid., p. 11.
(6d) Steve Player and Carol Cobble, Cornerstones of Decision
Making: Profiles of Enterprise ABM (Greensboro, NC: Oakhill
Press, 1999), p. 78.
(6e) Interview with a Cornell University administrator conducted
during research by the author.
Chapter Seven
(7a) Gary Siegel and James E. Sorensen, principal investigators for
the Gary Siegel Organization, Counting More, Counting Less:
Transformations in the Management Accounting Profession
(Montvale, NJ: Institute of Management Accountants, 1999).
(7b) Interview with a Cornell University accountant conducted during
research by the author.
(7c) Interview with a Delta Air Lines accountant conducted during
research by the author.
(7d) Gary Siegel and James E. Sorensen, principal investigators
for the Gary Siegel Organization, Counting More, Counting
Less: Transformations in the Management Accounting Profession
(Montvale, NJ: Institute of Management Accountants, 1999).
(7e) Steve Player and Carol Cobble, Cornerstones of Decision
Making: Profiles of Enterprise ABM (Greensboro, NC: Oakhill
Press, 1999), p. 78.
Chapter Eight
(8a) Timothy Aeppel, “Firms Race to Regain Control Over Invento-
ries,” Wall Street Journal, February 9, 2009.
(8b) ASQ website, http://asq.org/learn-about-quality/cost-of-quality/
overview/overview.html (2012).
(8c) Michael Arndt, “Quality Isn’t Just for Widgets,” BusinessWeek,
July 22, 2002, p. 72.
(8d) Marc J Epstein, Adriana Rejc Buhovac, and Kristi Yuthas, “Man-
aging Social, Environmental and Financial Performance Simul-
taneously: What Can We Learn from Corporate Best Practices,”
IMA Research Foundation Report Series (2009).
(8e) Richard Anderson, “Puma First to Publish Environmental Impact
Costs,” BBC News, May 16, 2011.
Chapter Nine
(9a) Matthew Quinn, “CFO Journal: For CFOs, a Move Past
Finance,” Wall Street Journal, July 31, 2012.
(9b) The Management Accounting Video, a management education
video (New York: McGraw-Hill, 1997). Best Foods introduced
several well-known brands, such as Skippy peanut butter,
Hellman’s mayonnaise, and Thomas’ English Muffins. Best
Foods has since been acquired by Unilever.
(9c) Steve Player, “FP&A Talent in High Demand,”
bigfatfinanceblog.com (February 23, 2010).
(9d) Anne Stuart, “The Importance of Accurate Forecasting: A CFO’s
Perspective,” Sales Performance Journal, March 2006.
(9e) Jay Collins, “Advanced Use of ABM: Using ABC for Target
Costing, Activity-Based Budgeting, and Benchmarking,” in
Activity-Based Management: Arthur Andersen’s Lessons from
the ABM Battlefield, ed. Steve Player and David E. Keys
(New York: John Wiley & Sons, 1999), p. 153.
(9f) Steve Hornyak, “Budgeting Made Easy,” Management Account-
ing 80, no. 4 (October 1998), pp. 18–23.
(9g) “A Survey of Corporate IT: Let It Rise,” The Economist,
October 23, 2008.
Chapter Ten
(10a) Bill Gates, “My Plan to Fix the World’s Biggest Problems,”
Wall Street Journal, January 26-27, 2013, pp. C1–C2.
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References for “In Their Own Words” 783
(15g) Presentation by Honda of America, The Second Annual
International Conference on Target Costing, sponsored by the
Consortium for Advanced Manufacturing—International, Arthur
Andersen, Ernst & Young, and the University of Akron
(Washington, DC: CAM-I, 1998).
(15h) Ibid.
Chapter Sixteen
(16a) Interview with a Ford Motor Company accountant conducted
during research by the author.
(16b) Interview with a Hewlett-Packard accountant conducted during
research by the author.
(16c) Interview with a Cornell University accountant conducted during
research by the author.
(16d) Interview with a Boeing Company accountant conducted during
research by the author.
(16e) Interview with an A. T. Kearney consultant conducted during
research by the author.
Chapter Seventeen
(17a) Interview with a Chrysler accountant conducted during research
by the author.
(17b) Interview with a Cornell University accountant conducted during
research by the author.
(17c) Interview with an American Management Systems consultant
conducted during research by the author.
(17d) Interview with an A. T. Kearney consultant conducted during
research by the author.
Chapter Fourteen
(14a) Gary Siegel and James E. Sorensen, principal investigators for
the Gary Siegel Organization, Counting More, Counting Less:
Transformations in the Management Accounting Profession
(Montvale, NJ: Institute of Management Accountants, 1999).
(14b) Ibid.
(14c) Ibid.
(14d) Ibid.
(14e) Ibid.
Chapter Fifteen
(15a) Gary Siegel and James E. Sorensen, principal investigators for
the Gary Siegel Organization, Counting More, Counting Less:
Transformations in the Management Accounting Profession
(Montvale, NJ: Institute of Management Accountants, 1999).
(15b) Ibid.
(15c) Steve Player and Carol Cobble, Cornerstones of Decision
Making: Profiles of Enterprise ABM (Greensboro, NC: Oakhill
Press, 1999), p. 80.
(15d) Ibid.
(15e) Presentation by U.S. Navy Acquisition Center, The Second
Annual International Conference on Target Costing, sponsored
by the Consortium for Advanced Manufacturing—International,
Arthur Andersen, Ernst & Young, and the University of Akron
(Washington, DC: CAM-I, 1998).
(15f) Presentation by Eastman Kodak Company, The Second Annual
International Conference on Target Costing, sponsored by the
Consortium for Advanced Manufacturing—International, Arthur
Andersen, Ernst & Young, and the University of Akron
(Washington, DC: CAM-I, 1998).
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784
Glossary
absorption costing (or full costing ) A method of product cost-
ing in which both variable and fixed manufacturing overhead are
included in the product costs that flow through the manufacturing
accounts (i.e., Work-in-Process Inventory, Finished-Goods Inven-
tory, and Cost of Goods Sold). 319, 565
Accelerated Cost Recovery System (ACRS) The depreciation
schedule specified by the United States tax code. Since it has been
modified by recent tax law changes, the system also is called the
Modified Accelerated Cost Recovery System (MACRS). 695
acceptance-or-rejection decision A decision as to whether or not
a particular capital investment proposal should be accepted. 680
account-classification method (also called account analysis)
A cost-estimation method involving a careful examination of the
ledger accounts for the purpose of classifying each cost as vari-
able, fixed, or semivariable. 236
accounting rate of return A percentage formed by taking a
project’s average incremental revenue minus its average incre-
mental expenses (including depreciation and income taxes) and
dividing by the project’s initial investment. 706
accumulation factor The value of (1 1 r ) n , in a future value
calculation, where r denotes the interest rate per year and n
denotes the number of years. 768
accurate information Precise and correct data. 590
activity A measure of an organization’s output of goods or
services. 47
activity accounting The collection of financial or opera-
tional performance information about significant activities in an
enterprise. 23
activity analysis The detailed identification and description of
the activities conducted in an enterprise. 182
activity base ( or cost driver) A measure of an organization’s
activity that is used as a basis for specifying cost behavior. The
activity base also is used to compute a predetermined overhead
rate. The current trend is to refer to the activity base as a volume-
based cost driver. 88
activity-based budgeting (ABB) The process of developing a
master budget using information obtained from an activity-based
costing (ABC) analysis. 360
activity-based costing (ABC) system A two-stage procedure
used to assign overhead costs to products or services produced.
In the first stage, significant activities are identified, and over-
head costs are assigned to activity cost pools in accordance with
the way resources are consumed by the activities. In the second
stage, the overhead costs are allocated from each activity cost
pool to each product line in proportion to the amount of the cost
driver consumed by the product line. 23, 168
activity-based flexible budget A flexible budget based on
several cost drivers rather than on a single, volume-based cost
driver. 468
activity-based management (ABM) Using an activity-based cost-
ing system to improve the operations of an organization. 23, 182
activity-based responsibility accounting A system for mea-
suring the performance of an organization’s people and subunits,
which focuses not only on the cost of performing activities but on
the activities themselves. 508
activity cost pool A grouping of overhead costs assigned to
various similar activities identified in an activity-based costing
system. 168
activity dictionary A complete listing of the activities included
in an organization’s ABC analysis. 181
actual costing A product-costing system in which actual
directmaterial, direct-labor, and actual manufacturing-overhead
costs are added to Work-in-Process Inventory. 100
actual manufacturing overhead The actual costs incurred during
an accounting period for manufacturing overhead. Includes actual
indirect material, indirect labor, and other manufacturing costs. 94
actual overhead rate The rate at which overhead costs are
actually incurred during an accounting period. Calculated as
follows: actual manufacturing overhead 4 actual cost driver (or
activity base). Supp *
after-tax cash flow The cash flow expected after all tax impli-
cations have been taken into account. 691
after-tax net income An organization’s net income after its
income-tax expense is subtracted. 296
aggregate ( or total) productivity Total output divided by total
input. 514
allocation base A measure of activity, physical characteristic,
or economic characteristic that is associated with the responsibil-
ity centers that are the cost objects in an allocation process. 506
annuity A series of equivalent cash flows. 506, 769
applied manufacturing overhead The amount of manufacturing-
overhead costs added to Work-in-Process Inventory during an
accounting period. 93
appraisal costs Costs of determining whether defective prod-
ucts exist. 326
attention-directing function The function of managerial
accounting information in pointing out to managers issues that
need their attention. 7
average cost per unit The total cost of producing a particular
quantity of product divided by the number of units produced. 55
average revenue curve See demand curve.
avoidable expenses Expenses that will no longer be incurred if
a particular action is taken. 601
balanced scorecard A model of business performance evalu-
ation that includes several types of financial and nonfinancial
performance measures, typically comprising the following per-
spectives: financial, customer, internal business process, and
learning and growth. 9, 515
*Supp refers to Supplement. Several terms defi ned in this glossary appear in the various supplements to the text, rather than in the text itself.
See page xxii for a list of supplements to this textbook.
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Glossary 785
overhead costs to be incurred and shows the cost of the goods to
be sold during a budget period. 375
budgeted statement of cash flows A budget schedule provid-
ing information about the expected sources and uses of cash for
operating activities, investing activities, and financing activities
during a particular period of time. 370
by-product A joint product with very little value relative to the
other joint products. 747
CAD/CAM system See computer-aided design and com-
puter-aided manufacturing.
capacity The upper limit on the amount of goods or services
that an organization can produce in a specified period of time. 20
capital budget A long-term budget that shows planned acquisi-
tion and disposal of capital assets, such as land, buildings, and
equipment. 354
capital-budgeting decision A decision involving cash flows
beyond the current year. 680
capital-intensive A production process accomplished largely
by machinery. Supp
capital-rationing decision A decision in which management
chooses which of several investment proposals to accept to make
the best use of limited investment funds. 680
capital turnover Sales revenue divided by invested capital. 547
cash bonus See pay for performance.
cash budget Details the expected cash receipts and disburse-
ments during a budget period. 368
cash disbursements budget A schedule detailing expected
cash payments during a budget period. 368
cash equivalents Short-term, highly liquid investments that are
treated as equivalent to cash in the preparation of a statement of
cash flows. Supp
cash provided by ( or used by) operations The difference
between the cash receipts and cash disbursements that are related
to operating activities. Supp
cash receipts budget A schedule detailing the expected cash
collections during the budget period. 366
cellular manufacturing The organization of a production
facility into FMS cells. Supp
Certified Management Accountant (CMA) An accoun-
tant who has earned professional certification in managerial
accounting. 24
chief financial officer (CFO) The executive responsible for all
accounting and finance functions in an organization. 15
coefficient of determination A statistical measure of goodness
of fit; a measure of how closely a regression line fits the data on
which it is based. 249
committed cost A cost that results from an organization’s own-
ership or use of facilities and its basic organization structure. 235
common costs Costs incurred to benefit more than one organi-
zational segment. 509
common-size financial statements Financial statements pre-
pared in terms of percentages of a base amount. Supp
comparative financial statements Financial statements show-
ing the results of two or more successive years. Supp
batch-level activity An activity that must be accomplished for
each batch of products rather than for each unit. 169
batch manufacturing High-volume production of several
product lines that differ in some important ways but are nearly
identical in others. 146
before-tax income An organization’s income before its income
tax expense is subtracted. 296
benchmarking ( or competitive benchmarking) The con-
tinual search for the most effective method of accomplishing a
task, by comparing existing methods and performance levels with
those of other organizations or with other subunits within the
same organization. 514
best practices The most effective methods of accomplishing
various tasks in a particular industry, often discovered through
benchmarking. Supp
bill of activities (for a product or service) A complete list-
ing of the activities required for that product or service to be
produced. 181
bill of materials A list of all the materials needed to manufac-
ture a product or product component. 86
break-even point The volume of activity at which an organiza-
tion’s revenues and expenses are equal. May be measured either
in units or in sales dollars. 270
budget A detailed plan, expressed in quantitative terms, that
specifies how resources will be acquired and used during a speci-
fied period of time. 353
budget administration The procedures used to prepare a bud-
get, secure its approval, and disseminate it to the people who
need to know its contents. Supp
budget committee A group of top-management personnel who
advise the budget director during the preparation of the budget. 379
budget director ( or chief budget officer) The individual desig-
nated to be in charge of preparing an organization’s budget. 378
budget manual A set of written instructions that specify who
will provide budgetary data, when and in what form the data
will be provided, how the master budget will be prepared and
approved, and who should receive the various schedules consti-
tuting the budget. 379
budget period The time period covered by a budget. Supp
budgetary slack The difference between the budgetary pro-
jection provided by an individual and his or her best estimate of
the item being projected. (For example, the difference between
a supervisor’s expected departmental utility cost and his or her
budgetary projection for utilities.) 381
budgeted balance sheet Shows the expected end-of-period
balances for the company’s assets, liabilities, and owners’
equity. 370, 376
budgeted financial statements ( or pro forma financial state-
ments) A set of planned financial statements showing what an
organization’s overall financial condition is expected to be at the
end of the budget period if planned operations are carried out. 354
budgeted income statement Shows the expected revenue and
expenses for a budget period, assuming that planned operations
are carried out. 369
budgeted schedule of cost of goods manufactured and
sold Details the direct material, direct labor, and manufacturing
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786 Glossary
cost allocation The process of assigning costs in a cost pool
to the appropriate cost objects. See also cost distribution. 506
cost behavior The relationship between cost and activity. 226
cost center A responsibility center whose manager is account-
able for its costs. 500
cost distribution ( sometimes called cost allocation) The first
step in assigning manufacturing-overhead costs. Overhead costs
are assigned to all departmental overhead centers. 102 , 506
cost driver A characteristic of an activity or event that results in
the incurrence of costs by that activity or event. 20, 47, 178
cost estimation The process of determining how a particular
cost behaves. 226
cost hierarchy The classification of activities into levels, such
as unit-level, batch-level, product-sustaining level, and facility-
level activities. 169
cost management system (CMS) A management planning and
controlling system that measures the cost of significant activities,
identifies non-value-added costs, and identifies activities that will
improve organizational performance. 23
cost objects Responsibility centers, products, or services to
which costs are assigned. 51, 506
cost of capital The cost of acquiring resources for an organiza-
tion, either through debt or through the issuance of stock. Supp
cost of goods manufactured The total cost of direct mate-
rial, direct labor, and manufacturing overhead transferred from
Work-in-Process Inventory to Finished-Goods Inventory during
an accounting period. 44, 97
cost of goods sold The expense measured by the cost of the
finished goods sold during a period of time. 37
cost-plus pricing A pricing approach in which the price is
equal to cost plus a markup. 648
cost pool A collection of costs to be assigned to a set of cost
objects. 506
cost prediction Forecast of cost at a particular level of
activity. 226
cost structure The relative proportions of an organization’s
fixed and variable costs. 287
cost variance The difference between actual and standard
cost. 411
cost variance analysis The process of systematically compar-
ing expected costs (standards) against actual costs, analyzing the
differences, and explaining significant deviations. 416
cost-volume-profit (CVP) analysis A study of the relation-
ships between sales volume, expenses, revenue, and profit. 268
cost-volume-profit (CVP) graph A graphical expression of
the relationships between sales volume, expenses, revenue, and
profit. 272
cross-elasticity The extent to which a change in a product’s
price affects the demand for substitute products. 647
curvilinear cost A cost with a curved line for its graph. 232
customer-acceptance measures The extent to which a firm’s
customers perceive its product to be of high quality. 513
customer-profitability analysis Using the concepts of activity-
based costing to determine the activities, costs, and profit associ-
ated with serving particular customers. 185, 511
competitive benchmarking See benchmarking.
competitive bidding A situation where two or more companies
submit bids (prices) for a product, service, or project to a poten-
tial buyer. 659
compound interest The interest earned on prior periods’
interest. 767
comptroller See controller.
computer-aided design (CAD) system Computer software
used by engineers in the design of a product. Supp
computer-integrated manufacturing (CIM) system The
most advanced form of automated manufacturing, in which vir-
tually all parts of the production process are accomplished by
computer-controlled machines and automated material-handling
equipment. Supp
computer-numerically-controlled (CNC) machines Stand-
alone machines controlled by a computer via a numerical,
machine- readable code. Supp
constraints Algebraic expressions of limitations faced by a
firm, such as those limiting its productive resources. 616
consumption ratio The proportion of an activity consumed by
a particular product. 177
continual (or continuous) improvement The constant effort
to eliminate waste, reduce response time, simplify the design of
both products and processes, and improve quality and customer
service. 331
contribution income statement An income statement on
which fixed and variable expenses are separated. 285
contribution margin Sales revenue minus variable expenses.
The amount of sales revenue, which is left to cover fixed expenses
and profit after paying variable expenses. Supp
contribution margin per unit The difference between the unit
sales price and the unit variable expense. The amount that each
unit contributes to covering fixed expenses and profit. Supp
contribution-margin ratio The unit contribution margin divided
by the sales price per unit. Also may be expressed in percentage
form; then it is called the contribution-margin percentage. 271
controllability The extent to which managers are able to con-
trol or influence a cost or cost variance. 424
controllable cost A cost that is subject to the control or sub-
stantial influence of a particular individual. 51
controller The top managerial and financial accountant in an
organization. Supervises the accounting department and assists
management at all levels in interpreting and using managerial-
accounting information. 15
controlling Ensuring that an organization operates in the
intended manner and achieves its goals. Supp
conversion costs Direct-labor cost plus production-overhead
cost or, more generally, the costs of the resources needed to convert
purchased inputs into a marketable product or service. 43, 364
cost The sacrifice made, usually measured by the resources
given up, to achieve a particular purpose. 36
Cost Accounting Standards Board (CASB) A federal agency
chartered by Congress in 1970 to develop cost-accounting stan-
dards for large government contractors. Supp
cost accounting system Part of the core accounting system that
accumulates data about the costs of producing goods and services
for use in both managerial and financial accounting. 11
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Glossary 787
direct-material purchase price variance The difference
between the standard price and the actual price paid for direct
material purchased, multiplied by the actual quantity of material
purchased. 418
direct-material quantity variance The difference between
actual and standard quantity of materials allowed, given actual
output, multiplied by the standard price. 417
direct method (of preparing the statement of cash flows) A
method of preparing the operating activities section of a state-
ment of cash flows. A cash-basis income statement is constructed
in which operating cash disbursements are subtracted from oper-
ating cash receipts. Supp
direct method (of service department cost allocation) A
method of service department cost allocation in which ser-
vice department costs are allocated directly to the production
departments. 737
discount rate The interest rate used in computing the present
value of a cash flow. 769
discounted-cash-flow analysis An analysis of an investment
proposal that takes into account the time value of money. 681
discretionary cost A cost that results from a discretionary man-
agement decision to spend a particular amount of money. 235
distribution cost The cost of storing and transporting finished
goods for sale. Supp
dual cost allocation An approach to service department cost
allocation in which variable costs are allocated in proportion to
short-term usage and fixed costs are allocated in proportion to
long-term usage. 741
e-budgeting An electronic and enterprisewide budgeting process
in which employees throughout the organization can submit and
retrieve budget information electronically via the Internet. 379
economic order quantity (EOQ) The order size that mini-
mizes inventory ordering and holding costs. 774
economic value added (EVA) An investment center’s after-tax
operating income minus the investment center’s total assets (net
of its current liabilities) times the company’s weighted-average
cost of capital. 551
electronic data interchange (EDI) The direct exchange
between organizations of data via a computer-to-computer
interface. Supp
engineered cost A cost that results from a definitive physical
relationship with the activity measure. 235
engineering method A cost-estimation method in which
a detailed study is made of the process that results in cost
incurrence. 243
environmental cost management The strategic implemen-
tation of systems for identifying, measuring, controlling, and
reducing environmental costs. 333
environmental costs Costs incurred in dealing with environ-
mental issues. 332
equivalent unit A measure of the amount of production effort
applied to a physical unit of production. For example, a physi-
cal unit that is 50 percent completed represents one-half of an
equivalent unit. 137
estimated manufacturing overhead The amount of manufactur-
ing-overhead cost expected for a specified period of time. Used as the
numerator in computing the predetermined overhead rate. Supp
customer-profitability profile A graphical portrayal of a com-
pany’s customer profitability analysis. 188
cycle time See throughput time. 61, 513
decentralization A form of organization in which subunit man-
agers are given authority to make substantive decisions. Supp
decision making Choosing between alternatives. Supp
decision variables The variables in a linear program about
which a decision is made. 616
delivery cycle time The average time between the receipt of a
customer order and delivery of the goods. 513
demand curve A graph of the relationship between sales price
and the quantity of units sold. 644
departmental overhead center Any department to which
overhead costs are assigned via overhead cost distribution. 102
departmental overhead rate An overhead rate calculated for a
single production department. 102
departmental production report The key document in a pro-
cess-costing system. This report summarizes the physical flow of
units, equivalent units of production, cost per equivalent unit, and
analysis of total departmental costs. 138
dependent variable A variable whose value depends on other
variables, called independent variables. 241
depreciation tax shield The reduction in a firm’s income-tax
expense due to the depreciation expense associated with a depre-
ciable asset. 693
differential cost The difference in a cost item under two deci-
sion alternatives. 54, 594
direct cost A cost that can be traced to a particular department
or other subunit of an organization. 51
direct-exchange ( or noncash) transaction A significant
investing or financing transaction involving accounts other than
cash, such as a transaction where land is obtained in exchange for
the issuance of capital stock. Supp
directing operational activities Running an organization on a
day-to-day basis. Supp
direct-labor budget A schedule showing the number of hours
and cost of direct labor to be used in production of services or
goods during a budget period. 364
direct-labor cost The cost of salaries, wages, and fringe ben-
efits for personnel when they are working directly on the produc-
tion of goods or services. 42
direct-labor efficiency variance The difference between
actual and standard hours of direct labor multiplied by the stan-
dard hourly labor rate. 419
direct-labor rate variance The difference between actual and
standard hourly labor rate multiplied by the actual hours of direct
labor used. 419
direct material Raw material that is physically incorporated in
the finished product. 42
direct-material budget A schedule showing the number of
units and the cost of material to be purchased during a budget
period. 373
direct-material price variance The difference between actual
and standard price of direct material used in production, multi-
plied by the actual quantity of material used. 417
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788 Glossary
future value The amount to which invested funds accumulate
over a specified period of time. 767
gain-sharing plan An incentive system that specifies a formula
by which the cost savings from productivity gains achieved by a
company are shared with the workers who helped accomplish the
improvements. 514
goal congruence A meshing of objectives, where managers
throughout an organization strive to achieve the goals set by top
management. 500, 545
goodness of fit The closeness with which a regression line fits
the data upon which it is based. 241
grade The extent of a product’s capability in performing its
intended purpose, viewed in relation to other products with the
same functional use. 326
gross margin Sales revenue minus cost of goods sold. 285
high-low method A cost estimation method in which a cost
line is fit using exactly two data points—the high and low activity
levels. 239
homogeneous cost pool A grouping of overhead costs in which
each cost component is consumed in roughly the same proportion
by each product line. Supp
horizontal analysis An analysis of the year-to-year change in
each financial statement item. Supp
hurdle rate The minimum desired rate of return used in a dis-
counted-cash-flow analysis. 682
hybrid product-costing system A system that incorporates
features from two or more alternative product-costing systems,
such as job-order and process costing. 146
idle time Unproductive time spent by employees due to fac-
tors beyond their control, such as power outages and machine
breakdowns. 43
imperfect competition A market in which a single producer or
group of producers can affect the market price. 563
incentive compensation See pay for performance.
incremental cost The increase in cost from one alternative to
another. 54
independent variable The variable upon which an estimate is
based in least-squares regression analysis. 241
indirect cost A cost that cannot be traced to a particular
department. 51
indirect labor All costs of compensating employees who do
not work directly on the firm’s product but who are necessary for
production to occur. 43
indirect-labor budget A schedule showing the amount and
cost of indirect labor to be used during a budget period. Supp
indirect materials Materials that either are required for the
production process to occur but do not become an integral part
of the finished product, or are consumed in production but are
insignificant in cost. 42
indirect method ( or reconciliation method) A method of
preparing the operating activities section of a statement of cash
flows, in which the analyst begins with net income. Then adjust-
ments are made to convert from an accrual-basis income state-
ment to a cash-basis income statement. Supp
information overload The provision of so much information
that, due to human limitations in processing information, manag-
ers cannot effectively use it. 592
expected value The sum of the possible values for a random
variable, each weighted by its probability. 608
expense The consumption of assets for the purpose of generat-
ing revenue. 37
experience curve A graph (or other mathematical representa-
tion) that shows how a broad set of costs decline as cumulative
production output increases. 243
external failure costs Costs incurred because defective prod-
ucts have been sold. 326
facility- ( or general-operations-) level activity An activity
that is required for an entire production process to occur. 169
favorable variance Sometimes abbreviated F, a cost variance
is designated as favorable when spending on that element of
cost is lower than the spending anticipated during the planning
process. 416
feasible region The possible values for decision variables that
are not ruled out by constraints. 616
FIFO (first-in, first-out) method A method of process cost-
ing in which the cost assigned to the beginning work-in-process
inventory is not added to current-period production costs. The
cost per equivalent unit calculated under FIFO relates to the cur-
rent period only. Supp
financial accounting The use of accounting information for
reporting to parties outside the organization. 10
financial leverage The concept that a relatively small increase
in income can provide a proportionately much larger increase in
return to the common stockholders. Supp
financial planning and analysis (FP&A) system A coordi-
nated set of tools that helps managers assess the company’s future
and know if they are reaching their performance goals; includes
subsystems for (1) planning, (2) measuring and recording results,
and (3) evaluating performance. 352
financial planning model A set of mathematical relation-
ships that express the interactions among the various operational,
financial, and environmental events that determine the overall
results of an organization’s activities. 378
financing activities Transactions involving a company’s debt
or equity capital. Supp
financing budget A schedule that outlines how an organiza-
tion will acquire financial resources during the budget period (for
example, through borrowing or sale of capital stock). 354
finished goods Completed products awaiting sale. 41
fixed cost A cost that does not change in total as activity
changes. 48, 229
fixed-overhead budget variance The difference between
actual and budgeted fixed overhead. 465
fixed-overhead volume variance The difference between bud-
geted and applied fixed overhead. 465
flexible budget A budget that is valid for a range of activity. 455
flexible manufacturing system (FMS) A series of manufac-
turing machines, controlled and integrated by a computer, which
is designed to perform a series of manufacturing operations
automatically. Supp
FMS cell A group of machines and personnel within a flexible
manufacturing system (FMS). Supp
full ( or absorption) cost A product’s variable cost plus an allo-
cated portion of fixed overhead. 319, 565
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Glossary 789
labor-intensive A production process accomplished largely by
manual labor. Supp
lag indicators Measures of the final, usually financial, out-
comes of earlier management decisions. 518
lead indicators Performance measures that identify future non-
financial and financial outcomes to guide management decision
making. 518
lead time The time required to receive inventory after it has
been ordered. 776
learning curve A graphical expression of the decline in
the average labor time required per unit as cumulative output
increases. 243
least-squares regression method A cost estimation method in
which the cost line is fit to the data by statistical analysis. The
method minimizes the sum of the squared deviations between the
cost line and the data points. 240
line positions Positions held by managers who are directly
involved in providing the goods or services that constitute an
organization’s primary goals. 14
make-or-buy ( or outsourcing) decision A decision as to
whether a product or service should be produced in-house or pur-
chased from an outside supplier. 598
management by exception A managerial technique in which
only significant deviations from expected performance are
investigated. 411
management by objectives (MBO) The process of designat-
ing the objectives of each subunit in an organization and plan-
ning for the achievement of these objectives. Managers at all
levels participate in setting goals, which they then will strive to
achieve. 545
managerial accountants Specialists in using the tools of
managerial accounting to help the organization and its managers
operate effectively. 5
managerial accounting The process of identifying, measuring,
analyzing, interpreting, and communicating information in pur-
suit of an organization’s goals. 4
manufacturing The process of converting raw materials into
finished products. Supp
manufacturing costs Costs incurred in a manufacturing pro-
cess, which consist of direct material, direct labor, and manufac-
turing overhead. Supp
manufacturing cycle efficiency (MCE) The ratio of process
time to the sum of processing time, inspection time, waiting time,
and move time. 514
manufacturing cycle time The total amount of production
time (or throughput time) required per unit. 514
manufacturing overhead All manufacturing costs other than
direct-material and direct-labor costs. 42
manufacturing-overhead budget Shows the cost of overhead
expected to be incurred in the manufacturing process during the
budget period. 88
manufacturing-overhead variance The difference between
actual overhead cost and the amount specified in the flexible
budget. Supp
marginal cost The extra cost incurred in producing one addi-
tional unit of output. 54
in-process quality controls Procedures designed to assess
product quality before production is completed. 513
inspection time The time spent on quality inspections of raw
materials, partially completed products, or finished goods. Supp
internal auditor An accountant who reviews the accounting
procedures, records, and reports in both the controller’s and trea-
surer’s areas of responsibility. 16
internal control system A process designed to provide reason-
able assurance regarding the achievement of objectives in the
following categories: effectiveness and efficiency of operations,
reliability of financial reporting, and compliance with applicable
laws and regulations. 569, 761
internal failure costs Costs of correcting defects found prior to
product sale. 326
internal rate of return The discount rate required for an
investment’s net present value to be zero; also known as the time-
adjusted rate of return. 682
inventoriable cost Cost incurred to purchase or manufacture
goods. See also product cost. 38
inventoriable goods Goods that can be stored before sale,
such as durable goods, mining products, and some agricultural
products. Supp
inventory budgets Schedules that detail the amount and cost of
finished-goods, work-in-process, and direct-material inventories
expected at the end of a budget period. Supp
investing activities Transactions involving the extension or
collection of loans, acquisition or disposal of investments, and
purchase or sale of productive, long-lived assets. Supp
investment center A responsibility center whose manager is
accountable for its profit and for the capital invested to generate
that profit. 501, 544
investment opportunity rate The rate of return an organiza-
tion can earn on its best alternative investments that are of equiva-
lent risk. 686
ISO 9000 standards International quality-control standards
issued by the International Standards Organization. Supp
job-cost record A document that records the costs of direct
material, direct labor, and manufacturing overhead for a particu-
lar production job or batch. The job-cost record is a subsidiary
ledger account for the Work-in-Process Inventory account in the
general ledger. 84
job-order costing system A product-costing system in which
costs are assigned to batches or job orders of production. Used
by firms that produce relatively small numbers of dissimilar
products. 83
joint cost The cost incurred in a joint production process before
the joint products become identifiable as separate products. 604
joint production process A production process that results in
two or more joint products. 603, 744
joint products The outputs of a joint production process. 744
just-in-time (JIT) production and inventory management
system A comprehensive inventory and manufacturing control
system in which no materials are purchased and no products are
manufactured until they are needed. 777
kaizen costing The process of cost reduction during the man-
ufacturing phase of a product. Refers to continual and gradual
improvement through small betterment activities. 185
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790 Glossary
normal costing A product-costing system in which actual
direct-materials, actual direct-labor, and applied manufacturing-
overhead costs are added to Work-in-Process Inventory. 98
normalized overhead rate An overhead rate calculated over a
relatively long time period. Supp
objective function An algebraic expression of the firm’s
goal. 616
off-line quality control Activities during the product design
and engineering phases that will improve the manufacturabil-
ity of the product, reduce production costs, and ensure high
quality. Supp
oligopolistic market ( or oligopoly) A market with a small
number of sellers competing among themselves. 647
operating activities All activities that are not investing or
financing activities. Generally speaking, operating activities
include all cash transactions that are involved in the determina-
tion of net income. Supp
operating expenses The costs incurred to produce and sell
services, such as transportation, repair, financial, or medical
services. 40
operating income Profits from operations, excluding non-
operating items such as interest income, interest expense, and
taxes. 39, 188
operating leverage The extent to which an organization uses
fixed costs in its cost structure. The greater the proportion of
fixed costs, the greater the operating leverage. 288
operating leverage factor A measure of operating leverage
at a particular sales volume. Computed by dividing an organiza-
tion’s total contribution margin by its net income. 288
operation costing A hybrid of job-order and process cost-
ing. Direct material is accumulated by batch of products using
job-order costing methods. Conversion costs are accumulated
by department and assigned to product units by process-costing
methods. 146
operational budgets A set of budgets that specify how opera-
tions will be carried out to produce an organization’s services or
goods. 356
opportunity cost The potential benefit given up when the choice
of one action precludes selection of a different action. 53, 595
organizational culture The mindset of employees, including
their shared beliefs, values, and goals. Supp
outlier A data point that falls far away from the other points in
a scatter diagram and is not representative of the data. 238
out-of-pocket costs Costs incurred that require the expenditure
of cash or other assets. 53
outsourcing ( or make-or-buy) decision A decision as to
whether a product or service should be produced in-house or pur-
chased from an outside supplier. 598
overapplied overhead The amount by which the period’s
applied manufacturing overhead exceeds actual manufacturing
overhead. 96
overhead application ( or absorption) The third step in assign-
ing manufacturing-overhead costs. All costs associated with each
production department are assigned to the product units on which
a department has worked. 87
marginal cost curve A graph of the relationship between the
change in total cost and the quantity produced and sold. 644
marginal revenue curve A graph of the relationship between
the change in total revenue and the quantity sold. 644
marketing cost The cost incurred in selling goods or services.
Includes order-getting costs and order-filling or distribution
costs. Supp
mass customization A manufacturing environment in which
many standardized components are combined to produce custom-
made products to customer order. 41
master budget ( or profit plan) A comprehensive set of bud-
gets that covers all phases of an organization’s operations for a
specified period of time. 354
material-requirements planning (MRP) An operations-
management tool that assists managers in scheduling production
in each stage of a complex manufacturing process. Supp
material requisition form A document used by the production
department supervisor to request the release of raw materials for
production. 85
merchandise cost The cost of acquiring goods for resale.
Includes purchasing and transportation costs. Supp
merchandising The business of acquiring finished goods for
resale, either in a wholesale or a retail operation. Supp
merit pay See pay for performance.
mixed cost See semivariable cost.
Modified Accelerated Cost Recovery System (MACRS) The
depreciation schedule specified by the United States tax code, as
modified by recent changes in the tax laws. 695
move time The time spent moving raw materials, subassem-
blies, or finished products from one production operation to
another. Supp
multiple regression A statistical method in which a linear
(straight-line) relationship is estimated between a dependent vari-
able and two or more independent variables. 242
multistage cost allocation The three-step process in which
costs are assigned to products or services: (1) cost distribution (or
allocation), (2) service department cost allocation, and (3) cost
application. Supp
net present value The present value of a project’s future cash
flows less the cost of the initial investment. 682
net realizable value A joint product’s final sales value less any
separable costs incurred after the split-off point. 746
net-realizable-value method A method in which joint costs
are allocated to the joint products in proportion to the net realiz-
able value of each joint product. 746
nominal dollars The measure used for an actual cash flow that
is observed. 712
nominal interest rate The real interest rate plus an additional
premium to compensate investors for inflation. 716
non-value-added activities Operations that are either (1) un-
necessary and dispensable or (2) necessary, but inefficient and
improvable. 182
non-value-added costs The costs of activities that can be elim-
inated without deterioration of product quality, performance, or
perceived value. 23, 182
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Glossary 791
practical ( or attainable) standard The cost expected under
normal operating conditions. 413
predatory pricing An illegal practice in which the price of a
product is set low temporarily to broaden demand. Then the prod-
uct’s supply is restricted and the price is raised. 662
predetermined overhead rate The rate used to apply manu-
facturing overhead to Work-in-Process Inventory, calculated as:
estimated manufacturing overhead cost 4 estimated amount of
cost driver (or activity base). 88
present value The economic value now of a cash flow that will
occur in the future. 682, 768
prevention costs Costs of preventing defective products. 326
price discrimination The illegal practice of quoting different
prices for the same product or service to different buyers, when
the price differences are not justified by cost differences. 662
price elasticity The impact of price changes on sales
volume. 647
price takers Firms whose products or services are determined
totally by the market. 642
prime costs The costs of direct material and direct labor. 43
principal The amount originally invested, not including any
interest earned. 767
process A set of linked activities. 184
process-costing system A product-costing system in which
production costs are averaged over a large number of product
units. Used by firms that produce large numbers of nearly identi-
cal products. 84, 134
process time The amount of time during which a product is
actually undergoing conversion activity. Supp
process value analysis (PVA) Another term for activity anal-
ysis, which is the detailed identification and description of the
activities conducted in an enterprise. 184
product cost Cost associated with goods for sale until the time
period during which the products are sold, at which time the costs
become expenses. See also inventoriable cost. 37
product-costing system The process of accumulating the costs
of a production process and assigning them to the products that
constitute the organization’s output. 80
product life-cycle costing The accumulation of costs that
occur over the entire life cycle of a product. Supp
production budget A schedule showing the number of units of ser-
vices or goods that are to be produced during a budget period. 372
production department A department in which work is done
directly on a firm’s products. Supp
production-overhead budget Shows the cost of overhead
expected to be incurred in the production process (either manu-
facturing or nonmanufacturing) during the budget period. 365
product-sustaining-level activity An activity that is needed to
support an entire product line but is not always performed every
time a new unit or batch of products is produced. 169
profit center A responsibility center whose manager is
accountable for its profit. 500
profit plan ( or master budget) A comprehensive set of bud-
gets that cover all phases of an organization’s operations during a
specified period of time. 354
overhead budget A schedule showing the cost of overhead
expected to be incurred in the production of services or goods
during a budget period. Supp
overhead cost performance report A report showing the
actual and flexible-budget cost levels for each overhead item,
together with variable-overhead spending and efficiency vari-
ances and fixed-overhead budget variances. 467
overtime premium The extra compensation paid to an
employee who works beyond the normal period of time. 43
padding the budget The process of building budgetary slack
into a budget by overestimating expenses and underestimating
revenue. 381
partial ( or component) productivity Total output (in dollars)
divided by the cost of a particular input. 514
participative budgeting The process of involving people
throughout an organization in the budgeting process. 381
pay for performance A one-time cash payment to an invest-
ment-center manager as a reward for meeting a predetermined
criterion on a specified performance measure. 556
payback period The amount of time required for a project’s
after-tax cash inflows to accumulate to an amount that covers the
initial investment. 704
penetration pricing Setting a low initial price for a new prod-
uct in order to penetrate the market deeply and gain a large and
broad market share. 653
percentage of completion The extent to which a physical unit
of production has been finished with respect to direct material or
conversion activity. Supp
perfect competition A market in which the price does not
depend on the quantity sold by any one producer. 563
perfection ( or ideal) standard The cost expected under per-
fect or ideal operating conditions. 513
performance report A report showing the budgeted and actual
amounts, and the variances between these amounts, of key finan-
cial results for a person or subunit. 504
period costs Costs that are expensed during the time period in
which they are incurred. 38
physical unit An actual item of production, fully or partially
completed. Supp
physical-units method A method in which joint costs are
allocated to the joint products in proportion to their physical
quantities. 745
planning Developing a detailed financial and operational
description of anticipated operations. Supp
plantwide overhead rate An overhead rate calculated by aver-
aging manufacturing-overhead costs for the entire production
facility. 102
pool rate The cost per unit of the cost driver for a particular
activity cost pool. 171
postaudit ( or reappraisal) A systematic follow-up of a cap-
ital-budgeting decision to see how the project turned out. 690
practical capacity The upper limit on the amount of goods or
services that an organization can produce in a specified period of
time, allowing for normal occurrences such as machine down-
time and employee fatigue or illness. 20
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792 Glossary
responsibility accounting Tools and concepts used by mana-
gerial accountants to measure the performance of an organiza-
tion’s people and subunits. 500
responsibility center A subunit in an organization whose
manager is held accountable for specified financial results of its
activities. 500
return on investment (ROI) Income divided by invested
capital. 546
return-on-investment pricing A cost-plus pricing method in
which the markup is determined by the amount necessary for the
company to earn a target rate of return on investment. 650
revenue center A responsibility center whose manager is
accountable for its revenue. 500
rolling budget ( also revolving or continuous budget) A bud-
get that is continually updated by adding another incremental time
period and dropping the most recently completed period. 354
safety margin Difference between budgeted sales revenue and
break-even sales revenue. 277
safety stock Extra inventory consumed during periods of
above-average usage in a setting with fluctuating demand. Supp
sales budget A schedule that shows the expected sales of ser-
vices or goods during a budget period, expressed in both mon-
etary terms and units. 362
sales forecasting The process of predicting sales of services or
goods. The initial step in preparing a master budget. 355
sales margin Income divided by sales revenue. 547
sales mix Relative proportion of sales of each of an organiza-
tion’s multiple products. 282
sales-price variance The difference between actual and expected
unit sales price multiplied by the actual quantity of units sold. 478
sales-volume variance The difference between actual sales
volume and budgeted sales volume multiplied by the budgeted
unit contribution margin. 478
scatter diagram A set of plotted cost observations at various
activity levels. 237
schedule of cost of goods manufactured A detailed schedule
showing the manufacturing costs incurred during an accounting
period and the change in work-in-process inventory. 44, 97
schedule of cost of goods sold A detailed schedule showing
the cost of goods sold and the change in finished-goods inventory
during an accounting period. 44, 97
segmented income statement A financial statement show-
ing the income for an organization and its major segments
(subunits). 509
selling costs Costs of obtaining and filling sales orders, such as
advertising costs, compensation of sales personnel, and product
promotion costs. Supp
selling, general, and administrative (SG&A) expense bud-
get A schedule showing the planned amounts of selling, gen-
eral, and administrative expenses during a budget period. 366
semivariable ( or mixed) cost A cost with both a fixed and a
variable component. 231
sensitivity analysis A technique for determining what would
happen in a decision analysis if a key prediction or assumption
proves to be wrong. 284, 607
profit-volume graph A graphical expression of the relation-
ship between profit and sales volume. 275
profitability index ( or excess present value index) The pres-
ent value of a project’s future cash flows (exclusive of the initial
investment), divided by the initial investment. 703
project costing The process of assigning costs to projects,
cases, contracts, programs, or missions in nonmanufacturing
organizations. Supp
proration The process of allocating underapplied or overap-
plied overhead to Work-in-Process Inventory, Finished-Goods
Inventory, and Cost of Goods Sold. 96
Public Company Accounting Oversight Board (PCAOB) An
organization operating under the auspices of the SEC, whose
mission is to oversee and investigate the audits and auditors of
public companies, and sanction both firms and individuals for
violations of laws, rules, and regulations. 762
purchases budget A schedule showing the company’s plan for
the resources they will need to acquire from outside the organiza-
tion in order to produce the goods and services they plan to sell
during the budget period. 363
qualitative characteristics Factors in a decision analysis that
cannot be expressed easily in numerical terms. 589
quality of conformance The extent to which a product meets
the specifications of its design. 326
quality of design The extent to which a product is designed to
perform well in its intended use. 326
quick assets Cash, marketable securities, accounts receivable,
and current notes receivable. Excludes inventories and prepaid
expenses, which are current assets but not quick assets. Supp
raw material Material entered into a manufacturing process. 41
real dollars A measure that reflects an adjustment for the pur-
chasing power of a monetary unit. 716
real interest rate The underlying interest rate in the economy,
which includes compensation to an investor for the time value of
money and the risk of an investment. 716
reciprocal-services method A method of service department
cost allocation that accounts for the mutual provision of recipro-
cal services among all service departments. 739
reengineering The complete redesign of a process, with
an emphasis on finding creative new ways to accomplish an
objective. Supp
regression line A line fit to a set of data points using least-
squares regression. 240
relative-sales-value method A method in which joint costs are
allocated to the joint products in proportion to their total sales
values at the split-off point. 604, 746
relevant information Data that are pertinent to a decision. 590
relevant range The range of activity within which manage-
ment expects the organization to operate. 233
research and development (R&D) costs Costs incurred to
develop and test new products or services. Supp
residual income Profit minus an imputed interest charge, which
is equal to the invested capital times an imputed interest rate. 549
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Glossary 793
standard direct-material quantity The total amount of mate-
rial normally required to produce a finished product, including
allowances for normal waste and inefficiency. 415
standard quantity allowed The standard quantity per unit of
output multiplied by the number of units of actual output. 418
statement of cash flows A major financial statement that shows
the change in an organization’s total cash and cash equivalents
and explains that change in terms of the organization’s operating,
investing, and financing activities during a period. Supp
static budget A budget that is valid for only one planned activ-
ity level. 455
statistical control chart A plot of cost variances across time,
with a comparison to a statistically determined critical value. 425
step-down method A method of service department cost allo-
cation in which service department costs are allocated first to ser-
vice departments and then to production departments. 737
step-fixed cost A cost that remains fixed over wide ranges of
activity, but jumps to a different amount for activity levels outside
that range. 229
step-variable cost A cost that is nearly variable, but increases
in small steps instead of continuously. 228
storage time The time during which raw materials or finished
products are stored in stock. Supp
storyboarding A procedure used to develop a detailed process
flowchart, which visually represents activities and the relation-
ships among the activities. 180
strategic cost analysis A broad-based managerial-accounting
analysis that supports strategic management decisions. Supp
strategic cost management Overall recognition of the
cost relationships among the activities in the value chain, and
the process of managing those cost relationships to a firm’s
advantage. 20
summary cash budget A combination of the cash receipts and
cash disbursements budgets. Supp
sunk costs Costs that were incurred in the past and cannot be
altered by any current or future decision. 53, 592
supply chain The flow of all goods, services, and information
into and out of an organization. 86
sustainable development Business activity that produces the
goods and services needed in the present without limiting the
ability of future generations to meet their needs. 332
target cost The projected long-run product cost that will enable
a firm to enter and remain in the market for the product and com-
pete successfully with the firm’s competitors. 652
target costing The design of a product, and the processes used
to produce it, so that ultimately the product can be manufactured
at a cost that will enable a firm to make a profit when the product
is sold at an estimated market-driven price. This estimated price
is called the target price, the desired profit margin is called the
target profit, and the cost at which the product must be manufac-
tured is called the target cost. 653
target profit ( or income) The profit level set as management’s
objective. 276
task analysis Setting standards by analyzing the production
process. 412
separable processing cost Cost incurred on a joint product
after the split-off point of a joint production process. 605
sequential production process A manufacturing operation in
which partially completed products pass in sequence through two
or more production departments. Supp
service department cost allocation The second step in assign-
ing manufacturing-overhead costs. All costs associated with a
service department are assigned to the departments that use the
services it produces. 102
service ( or support) departments Subunits in an organization
that are not involved directly in producing the organization’s out-
put of goods or services. 43, 102, 734
service-industry firm A firm engaged in production of a ser-
vice that is consumed as it is produced, such as air transportation
service or medical service. Supp
shareholder value analysis Calculation of the residual
income associated with a major product line, with the objective
of determining how the product line affects a firm’s value to its
shareholders. 551
simple regression A regression analysis based on a single inde-
pendent variable. 242
Six Sigma An analytical method that aims at achieving near
perfect results in a production process. 328
skimming pricing Setting a high initial price for a new product
in order to reap short-run profits. Over time, the price is reduced
gradually. 653
source document A document that is used as the basis for an
accounting entry. Examples include material requisition forms
and direct-labor time tickets. 86
SOX 302 A section of the Sarbanes-Oxley Act that requires
the signing officers of a company’s financial reports to establish,
maintain, and periodically evaluate the effectiveness of the com-
pany’s internal controls over financial reporting. 762
SOX 404 A section of the Sarbanes-Oxley Act that requires
a company to include in its annual report an internal control
report. 762
split-off point The point in a joint production process at
which the joint products become identifiable as separate prod-
ucts. 604, 744
staff positions Positions held by managers who are only
indirectly involved in producing an organization’s product or
service. 15
standard cost A predetermined cost for the production of
goods or services that serves as a benchmark against which to
compare the actual cost. 410
standard-costing system A cost-control and product-costing
system in which cost variances are computed and production
costs are entered into work-in-process inventory at their standard
amounts. 428
standard direct-labor quantity The number of labor hours
normally needed to manufacture one unit of product. 415
standard direct-labor rate Total hourly cost of compensation,
including fringe benefits. 415
standard direct-material price The total delivered cost, after
subtracting any purchase discounts taken. 415
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794 Glossary
unit contribution margin Sales price minus the unit variable
cost. 282, 477
unit-level activity An activity that must be done for each unit
of production. 169
value analysis See value engineering.
value chain An organization’s set of linked, value-creating
activities, ranging from securing basic raw materials and energy
to the ultimate delivery of products and services. 18
value engineering ( or value analysis) A cost-reduction and
process improvement technique that utilizes information col-
lected about a product’s design and production processes and
then examines various attributes of the design and processes to
identify candidates for improvement efforts. 657
variable cost A cost that changes in total in direct proportion to
a change in an organization’s activity. 47, 227
variable costing ( or direct costing) A method of product cost-
ing in which only variable manufacturing overhead is included
as a product cost that flows through the manufacturing accounts
(i.e., Work-in-Process Inventory, Finished-Goods Inventory, and
Cost of Goods Sold). Fixed manufacturing overhead is treated as
a period cost. 319
variable-overhead efficiency variance The difference between
actual and standard hours of an activity base (e.g., machine hours)
multiplied by the standard variable-overhead rate. 462
variable-overhead spending variance The difference between
actual variable-overhead cost and the product of the standard
variable-overhead rate and actual hours of an activity base (e.g.,
machine hours). 462
variance See cost variance.
variance analysis See cost variance analysis.
velocity The number of units produced in a given time
period. 514
vertical analysis An analysis of the relationships among vari-
ous financial items on a particular financial statement. Generally
presented in terms of common-size financial statements. Supp
visual-fit method A method of cost estimation in which a cost
line is drawn through a scatter diagram according to the visual
perception of the analyst. 237
volume-based cost driver ( or activity base) A cost driver that
is closely associated with production volume, such as direct-labor
hours or machine hours. 88
volume-based ( or throughput-based) costing system A prod-
uct-costing system in which costs are assigned to products on the
basis of a single activity base related to volume (e.g., direct-labor
hours or machine hours). 167
waiting time The time during which partially completed prod-
ucts wait for the next phase of production. Supp
weighted-average cost of capital (WACC) A weighted aver-
age of the after-tax cost of debt capital and the cost of equity
capital. 551
weighted-average method A method of process costing in
which the cost assigned to beginning work-in-process inven-
tory is added to the current-period production costs. The cost per
equivalent unit calculated under this process-costing method is a
theoretical capacity The upper limit on production of goods
or services, during a specified period of time, if everything works
perfectly (i.e., no employees miss time for illness, no machines
break down, there are no unexpected interruptions such as power
outages or severe storms, and so forth). Supp
throughput time The average amount of time required to con-
vert raw materials into finished goods ready to be shipped to
customers. 101
time and material pricing A cost-plus pricing approach that
includes components for labor cost and material cost, plus mark-
ups on either or both of these cost components. 658
time record A document that records the amount of time an
employee spends on each production job. 87
timely information Data that are available in time for use in a
decision analysis. 591
total contribution margin Total sales revenue less total vari-
able expenses. 270, 279, 477
total cost curve Graphs the relationship between total cost and
total quantity produced and sold. 644
total quality management (TQM) The broad set of manage-
ment and control processes designed to focus an entire organiza-
tion and all of its employees on providing products or services that
do the best possible job of satisfying the customer. 328
total revenue curve Graphs the relationship between total
sales revenue and quantity sold. 642
transfer price The price at which products or services are
transferred between two divisions in an organization. 544
transferred-in costs Costs assigned to partially completed
products that are transferred into one production department from
a prior department. 135
treasurer An accountant in a staff position who is responsible
for managing an organization’s relationships with investors and
creditors and maintaining custody of the organization’s cash,
investments, and other assets. 16
trend analysis A comparison across time of three or more obser-
vations of a particular financial item, such as net income. Supp
two-dimensional ABC model A combination of the cost
assignment view of the role of activity-based costing with its pro-
cess analysis and evaluation role. Two-dimensional ABC is one
way of depicting activity-based management. 182
two-stage cost allocation A two-step procedure for assigning
overhead costs to products or services produced. In the first stage,
all production costs are assigned to the production departments.
In the second stage, the costs that have been assigned to each
production department are applied to the products or services
produced in those departments. 102
unavoidable expenses Expenses that will continue to be
incurred even if a subunit or activity is eliminated. 601
underapplied overhead The amount by which the period’s
actual manufacturing overhead exceeds applied manufacturing
overhead. 95
unfavorable variance Sometimes abbreviated U, a cost vari-
ance is designated as unfavorable when spending on that element
of cost is higher than the spending anticipated during the planning
process. 416
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Glossary 795
work in process Partially completed products that are not yet
ready for sale. 41
working capital Current assets minus current liabilities. 698
weighted average of the costs in the beginning work in process
and the costs of the current period. 138
weighted-average unit contribution margin Average of a
firm’s several products’ unit contribution margins, weighted by
the relative sales proportion of each product. 282
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Photo Credits
Front Matter
Page xxvii left: © Eye Ubiquitous/SuperStock; xxvii right: © Brand X Pic-
tures; xxviii: © Alaska Stock LLC/Alamy; xxix top: © Orlin Wagner/AP
Images; xxix bottom: © Burke Triolo Productions/Getty Images; xxx left: ©
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Images; xxxiii right: © Brand X Pictures/PunchStock; xxxiv left: © Brand
X Pictures/PunchStock; xxxiv right: © Ingram Publishing/SuperStock; xxxv
left: © Ingram Publishing; xxxv right: Photo by Gary Kramer, USDA Natural
Resources Conservation Service; xxxvi: © Comstock/Alamy.
Chapter One
Page 2 top: © Eye Ubiquitous/SuperStock; 2 bottom left: © David Suther-
land/Alamy; 2 bottom right: © Margaret M. Savino/Alamy; 3 left: © Mark
Scheuern/Alamy; 3 right: © AFP/Getty Images; 11 left: © Purestock/Super-
Stock; 11 right: © Royalty-Free/Corbis; 17 top left: © Digital Vision/Punch-
Stock; 17 top right: © Comstock Images/Getty Images; 17 bottom left: © The
McGraw-Hill Companies, Inc./Andrew Resek, photographer; 17 bottom right:
© Stockbyte/Getty Images; 19 top left: Photo by Scott Bauer, USDA-ARS; 19
top middle: © Juan Silva/Getty Images; 19 top right: © Thinkstock/Corbis; 19
bottom left: © NetPhotos/Alamy; 19 bottom middle: © Bloomberg via Getty
Images; 19 bottom right: © Yellow Dog Productions.
Chapter Two
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right: © PhotoAlto/Odilon Dimier/Getty Images; 35 left: © ZUMA Wire Service/
Alamy; 35 right © Clerkenwell/Getty Images; 41 top: © Universal Pictures/Uni-
media Images, Inc./Newscom; 41 top middle: © Bloomberg via Getty Images;
41 bottom middle: © Bill Pugliano/Getty Images; 41 bottom: © Royalty-Free/
Corbis; 47: © Joe Raedle/Getty Images; 56: © Hill Street Studios/Getty Images.
Chapter Three
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Corbis; 78 bottom right: © Raymond Forbes/SuperStock; 79 left: © image-
broker/Alamy; 79 right: © Lew Robertson/Getty Images; 83 left: © Creatas
Images/Jupiterimages; 83 middle: © The McGraw-Hill Companies, Inc./
Christopher Kerrigan, photographer; 83 right: © Radius Images/Getty Images;
92: © Dan Abramson/Stock Boston.
Chapter Four
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PunchStock; 132 bottom left: © Purestock/SuperStock; 133 left: © Purestock/
SuperStock; 133 right: © Dynamic Graphics Group/Creatas/Alamy; 138 left:
© Royalty-Free/Corbis; 140 right: © Eric Martin, photographer/Iconotec.
Chapter Five
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Stockbtye/PunchStock; 164 bottom right: © Royalty-Free/Corbis; 165 left:
© Comstock Images/JupiterImages; 165 right: © Ryan McVay/Getty Images; 174
left: © Alistair Berg/Digital Vision/Getty Images; 174 right: © Pixtal/AGE Fotos-
tock; 181 left: © ColorBlind Images/Getty Images; 181 right: © Ronald W. Hilton.
Chapter Six
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son/AP Images; 224 bottom right: © Brand X Pictures/PunchStock; 225 left:
© John Raoux/AP Images; 225 right: © Stock Trek/Getty Images; 235: ©
Chamussy/SIPA/Newscom.
Chapter Seven
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Image Works; 266 bottom right: © Ingram Publishing; 267 left: © PhotoDisc/
Getty Images; 267 right: © JupiterImages/Brand X/Corbis; 270 left: © Jack
Hollingsworth/Getty Images; 270 right: © Bloomberg via Getty Images; 282:
© Royalty-Free/Corbis; 289: © DesignPics; 292: © Lonnie Duka/Getty Images.
Chapter Eight
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Grill/Getty Images; 316 bottom right: © Shalom Ormsby/Getty Images; 317
left: © UpperCut Images/Alamy; 317 right: © KidStock/Getty Images; 320: ©
Ryan Pyle/Corbis; 327: © ZUMA Press, Inc./Alamy; 332: © Creatas Images/
Jupiterimages.
Chapter Nine
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E. Platt; 351 left: © Jordan Siemens/Getty Images; 351 right: © Amana Images
RF/Getty Images; 354: © Glow Images; 356: © Jack Kurtz/The Image Works;
380: © The McGraw-Hill Companies, Inc./Barry Barker, photographer.
Chapter Ten
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PhotoSpin, Inc/Alamy; 408 bottom right: © Vegar Abelsnes Photography/Getty
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Chapter Eleven
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Getty Images; 452 bottom right: © Roy McMahon/Corbis; 453 left: © Niko
Guido/Getty Images; 453 right: © Lawrence Manning/Corbis; 460 left:
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Images; 471: © Image Source/Getty Images.
Chapter Twelve
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Pics/Peter French/Newscom; 498 bottom right: © Melba Photo Agency/
PunchStock ; 499 left: © Robert Nicholas/Getty Images; 499 right: © Duncan
Smith/Corbis; 501 top left: © Jim West/The Image Images; 501 top right: ©
BananaStock/Iconotec; 501 bottom left: © Brand X Pictures/PunchStock; 501
bottom right: © McGraw-Hill Companies, Inc./Dave Moyer, photographer;
516: © Chuck Burton/AP Images; 522: © Digital Vision/PunchStock.
Chapter Thirteen
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Koebe/Corbis; 543 left: © Fuse/Getty Images; 543 right: © Image100/Super-
Stock; 549: © Royalty-Free/Corbis; 559: © Jim West/Alamy; 568: © Dennis
Macdonald/Getty Images.
Chapter Fourteen
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Free/Corbis; 586 bottom right: © Blend Images/Masterfile; 587 left: © Bloom-
berg via Getty Images; 587 right: © Maximilian Stock Ltd/Getty Images; 600
left: © PhotoLink/Getty Images; 600 right: © Royalty-Free/Corbis.
Chapter Fifteen
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son/Getty Images; 642 bottom right: © Royalty-Free/Corbis; 639 left:
© Ingram Publishing/SuperStock; 639 right: © Dennis MacDonald/
PhotoEdit; 642: © Mary Altaffer/AP Images.
Chapter Sixteen
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Service; 678 bottom left: © Frank Siteman/Getty Images; 678 bottom right:
© Alexey Stiop/Alamy; 679 left: © Eileen Bach/Getty Images; 679 right:
© Digital Vision/Getty Images; 691: © Erik Tham/Corbis; 696: © Walt Jen-
nings/FEMA.
Chapter Seventeen
Page 732 top: © Comstock/Alamy; 732 bottom left: © Fuse/Getty Images;
732 bottom right: © DreamPictures/Pam Ostrow/Blend Images; 733 left: ©
PhotoLink/Getty Images; 733 right: © PhotoAlto/PunchStock; 744: © Jason
Lugo/Getty Images.
796
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797
GoDaddy.com, 12
Goldman Sachs, 12
Goodwill Industries International, 357
Google, 166
Greater Miami Opera Association, 46
Greyhound, 55
GTE Supply, 183
Halliburton, 522
Hewlett-Packard, 7, 47n, 178, 430, 454, 684
Home Depot, 235
Honda of America Manufacturing, Inc., 656,
658
Honeywell, 106
IBM, 16, 353, 513
IKEA, 519
Immigration and Naturalization Service, 178
Indianapolis, IN, City of, 178, 188
Intel Corporation, 16, 52, 600
Internal Revenue Service (IRS), 178, 325, 567
Isuzu Motors, Ltd., 657
ITT Automotive, 41, 42
J.Crew, 12
JetBlue, 281
J.M. Weston, 235
John Deere and Company, 47n, 178
John Deere Health Care, Inc., 136, 137,
143, 180
Johnson & Johnson, 166, 178
JPMorgan Chase Bank, 40, 187, 519
Kaiser Permanente, 291
Kawasaki, 320
Kestrel Management Services, 547
K’Nex Brands, 599
KPMG, 58, 336
Levi Strauss, 58
Lincoln Electric, 234
Lindt & Sprüngli, 691
Los Angeles, CA, City of, 81
M. D. Ander-son Cancer Center, 12
Macy’s, 20
Magic Kingdom, 6, 20, 51
Mall of America, 15
Marriot Hotels, 12
Massachusetts General Hospital, 47, 268, 269
Mayo Clinic, 470
McDonald’s Corporation, 10, 380, 501
McDonnell-Douglas Corporation, 107
McKinsey & Company, 103
Medicare, 81, 741
Merck, 702
Meritor, 177
Microsoft Corporation, 519
Micrus, 81, 83, 106, 513
Midas, Inc, 35, 56–57, 58
Motorola, 58, 330, 519
CIGNA Property and Casualty Division, 519
Cirrus Logic, 513
Cisco Systems, Inc., 245
Citigroup, 519
Coca-Cola, 166, 178, 552
Cole Muffler, 46
Columbia Sportswear, 519
Cornell University, 105, 235, 270, 379, 470,
471n, 568, 690, 738
Corning Inc., 322
Coursera, 8
Cummins Engine, 600
Dana Commercial Credit Corporation, 180
Days Inn, 454
Deepwater Horizon, 332
Delta Air Lines, 51, 271, 353
Deutsche Post AE, 179
DHL, 178, 179
Disney/ABC Television Group, 16
Disney Ambassador Hotel, 16
Disney Consumer Products, 14
Disneyland Paris, 16
Disney’s Animal Kingdom, 6, 7, 9, 12, 15
Disney’s Hollywood Studios, 6
Disney Store, 15
Dole, 81
Duke Children’s Hospital, 519
Eastman Kodak Company, 655
Economist (magazine), 379
edX, 8
Eli Lilly, 702
Elkay Manufacturing, 358
Enron, 25, 760
Enterprise Rent-a-Car, 58
ePartners Inc., 356
Epcot, 6, 51
Ernst & Young, 560, 562, 566, 567
ESPN, 14, 15, 16
E-Trade Financial, 25
Expedia, 289
ExxonMobil, 36–37, 519, 746
Facebook, 8, 10
Fannie Mae, 519
Farmer’s Insurance, 245
FedEx, 166, 178, 188, 413, 603
Florida, State of, 268
Ford Motor Company, 12, 22, 42, 233, 682
Fruehauf, 15
Gallo Winery, 600
GEICO Insurance Company, 470
General Dynamics Corp., 245
General Electric Company, 15, 51, 330, 358,
544, 599
General Motors Corporation, 15, 47, 353, 454,
519, 544, 559
Genworth, 178
GlaxoSmithKline, 106, 702
Page numbers followed by n refer to footnotes.
Index of Companies and Organizations
A. T. Kearney, 470, 697, 747
ABB, 430
Abbott Laboratories, 55, 269, 277, 456, 503,
546, 591
Accenture, 227
Adirondack Outfitters, Inc., 78, 84–102
Aetna, 454
Airbus, 244
Air France, 188
Alamo, 52
Allstate Insurance Company, 47, 58, 413, 544
Amazon.com Inc., 18, 289, 356, 520–521,
652, 654
AMC Entertainment, 18
American Airlines, 12, 178, 188, 281, 413
American Express, 166, 178, 188
American Management Systems, 742
American Red Cross, 12, 46
Anheuser-Busch, 519
Ann Taylor, 519
Apple Computer, 20, 519
Arianespace, 103
Arthur Anderson, 58
ASQ, 326, 328
AstraZeneca, 702
AT&T, 178
AT&T Paradyne, 360
Bank of America, 46, 166, 188, 519
Bank One Corp., 187
Baskin-Robbins, 454
Best Buy, 652
Best Foods, 353, 413, 426
Bill and Melinda Gates Foundation, 411
Blue Cross/Blue Shield, 178
Blue Cross/Blue Shield of North Carolina, 235,
291, 469, 650, 652
Boeing, 7, 14, 16, 44, 102, 107, 244, 593, 596,
657, 695
Boise Cascade, 178
Bosch Chassis Systems, 430
Boston Consulting Group (BCG), 243
BP, 332
Braas Company, 179
British Navy, 178
BSH Bosch und Siemens, 460
Budget Rent-a-Car, 454
Burger King, 40, 413
California Department of Taxation, 178
Cambridge Hospital Community Health Care
Network, 188
Caterpillar, 5, 6, 12, 36, 37, 38, 39, 40–41, 88,
166, 178, 330, 506, 519, 589, 597, 603,
642, 648, 657
CenturyLink, 9, 40, 81
Charlotte, NC, City of, 519
Chase Manhattan Bank, 454, 600
Chicago, IL, City of, 353
Chicago Bulls, 46
Chrysler, 43, 94, 101, 178, 502, 519, 657, 735
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798 Index of Companies and Organizations
Unilever, 88, 353, 413, 426
Union Pacific, 188
United Airlines, 46, 81, 268, 281, 413, 454
U.S. Department of Defense, 12, 106, 519
U.S. Marine Corps, 88
U.S. Naval Supply Center, 188
U.S. Navy Acquisition Center, 655
U.S. Postal Service, 178, 188
United Way, 269
Univar N.V., 508
University of Texas, 12
UPS (United Parcel Service), 88, 516, 519
US Airways, 52
Vereeniging Refractories, 418
Verizon, 20, 183
Veterans Affairs Department, 178
Wal-Mart Stores, Inc., 8, 36, 38, 40, 88, 105,
106, 234, 245, 355, 655
The Walt Disney Company, 2–18, 16, 98, 180
Walt Disney’s Imagineering Division, 6
Walt Disney Studios, 16, 18
Walt Disney World, 51
Walt Disney World Resort, 15
Warner Lambert, 186
Washington State, 519
WellsFargo, 81, 226
Westin Hotels, 46
Whirlpool, 454, 469
Whole Foods Market, Inc., 3, 5n, 18–22
WorldCom, Inc., 57–58, 760
Xerox Corporation, 328
Yamanouchi Pharmaceutical, 600
Yoplait, 325
Zappos.com, 512
Ramada Inn, 48
Renault Group, SA, 22
Rockwater, 522
Rockwell Collins, 428
Rockwell Express, 178
Rockwell International, 177
Royal Bank of Canada, 552
Royal Dutch Shell, 42
San Francisco General Hospital, 18
Sheraton Hotels, 40, 353
Shiloh Industries, Inc., 188
Siemens, 552
Singer, 15
Southwest Airlines, 4, 36, 38, 39, 40, 166,
235, 281
Stanford University, 269
Starbucks, 234, 245
State Farm, 413
Statoil, 358
Stern Stewart & Company, 546
Stihl, Inc., 469
Subway, 52
Summit Bancorp, 188
Swissair, 88
Taco Bell, 234, 245
Target, 52, 106, 652
TELUS, 178, 188
Tesco, 519
Texas Instruments, 37, 429
Thomasville, 106
Toronto Dominion Bank, 178, 378
Toyota, 51, 55
Transco, 229
U-Haul, 234, 245
Ulster Bank, 516
Nabisco, 226
NASA, 103
National City Bank, 330
Nationwide Mutual Insurance, 40
Naval Supply Center, U.S., 188
Navistar International Corporation, 181
Navy Acquisition Center, U.S., 655
NBC, 268
Nestlé, 234
Netflix, 18
New York Police Department, 4
New York Transit Authority, 48
New York Yankees, 268
Nike, 58
Nissan Motor Co., 22
Northwestern Mutual, 519
NXP Semiconductor, 81, 83, 106, 513
Owens & Minor, 188
Parker Hannifin Corporation, 421, 429
Pennsylvania Blue Shield, 189
Pennzoil, 178
Perrier, 325
Pfizer, 166, 178, 186, 519, 702
Philadelphia Children’s Hospital, 103
Phillips Electronics, 519
Pitney Bowes, 516
Pizza Hut, 48
Portugal Telecom, 227
Princeton University, 55
Pringles, 325
Procter & Gamble, 332, 655
Prudential Insurance Company, 353
Puma, 333
Quantas, 4
Qwest, 9, 40, 81, 510
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799
Abatement costs, 334
ABB. See Activity-based budgeting (ABB)
ABC. See Activity-based costing (ABC)
systems
ABM. See Activity-based management (ABM)
Absorption cost, cost-based transfer prices
and, 565
Absorption costing, 318–319
cost-volume-profit analysis and, 323–324
evaluation of, 324–325
income reconciliation under, 321–323
income statements and, 320–321
by Internal Revenue Service, 325
variable costing compared with, 319
Absorption-cost pricing, product costs and, 649
Accelerated cost recovery system (ACRS), 695
Accelerated depreciation, discounted-cash-
flow analysis and, 694–697
Accept-or-reject decisions, 596–598, 680
capacity and, 597–598
competitive bidding and, 661
Account analysis, 236–237
Account-classification method of cost
estimation, 236–237
Accounting-rate-of-return method, 706–708
Accounting systems, 11
Accumulation factor, 768
Accuracy of information, 590–591
ACRS. See Accelerated cost recovery system
(ACRS)
Activities
batch-level, 169, 170
definition of, 47
facility-level, 169, 170
non-value-added. See Non-value-added
activities
product-sustaining-level, 169, 170
unit-level, 169, 170
Activity accounting, 23, 51
Activity analysis, 182
Activity base, 88
Activity-based budgeting (ABB), 359–360
Activity-based costing (ABC) systems, 23,
164–181
activity dictionary and, 181
in advanced manufacturing systems,
291–294
bill of activities and, 181–182
cost drivers in, 178–180
data collection for, 180–181
ethical issues surrounding, 192–193
interpreting product costs and, 173–175
multidisciplinary activity-based costing
project teams and, 181
outsourcing decision and, 610–611
overhead assignment and, 102
product-cost distortion and, 656–657
product cost distortion by volume-based
systems and, 175–178, 179
service department cost allocation and, 744
in service industry, 188–192
stage one of, 169–170
stage two of, 170–173
target costing and, 656–657
two-dimensional, 182, 183
Activity-based flexible budgets, 468–470
Activity-based management (ABM), 23,
182–188
customer-profitability analysis and, 185–188
identifying non-value-added activities and
costs and, 182–185
two-dimensional, 182, 183
Activity-based responsibility accounting,
507–508
Activity cost pools, 168
Activity dictionaries, 181
Activity measures for flexible budgets,
456–457
criteria for choosing, 460–461
Actual cost(s), standard costs versus, transfer
pricing and, 566
Actual costing
overhead application and, 100–101
in process-costing systems, 145
Actual manufacturing-overhead, 94
Add-or-drop decisions, 601–603
Administrative costs, 38
Advanced manufacturing environment. See
also Just-in-time (JIT) production and
inventory management system
cost-volume-profit analysis and activity-
based costing systems and, 291–294
labor-intensive production processes versus,
290
service department cost allocation in, 743–744
standard costing in, 429–431
Aeppel, Timothy, 88n
Aerospace industry, cost overruns at Boeing
and, 107
Affordable Care Act, 291
After-tax cash flows, 691–694
After-tax net income, 296–298
Aggregate productivity, 514
AICPA. See American Institute of Certified
Public Accountants (AICPA)
Airlines
break-even load factors and, 281
costs of running, 52
Allocation bases, 506–507
American Accounting Association, 24
American Institute of Certified Public
Accountants (AICPA), 23
Annual reports, cost-volume-profit information
in, 281
Ansari, Shahid L., 654n, 657n
Ansberry, C., 234n
Ante, S., 330n
Antitrust laws, pricing and, 661
Antos, John, 360n
Applied manufacturing overhead, in job-order
costing system, 93
Appraisal costs, 326
Arndt, M., 330n, 603n
Assembly manufacturing, costs and, 42
Assets
allocating to investment centers, 555
definition of, under absorption and variable
costing, 324
depreciable, in discounted-cash-flow
analysis, 687
Attainable standards, 413
Attention-directing function, 7
Aubin, D., 763n
Auditors, internal, 16
Auto industry, unused capacity in, 22
Average cost(s), 55
Average cost per unit, 55
Average revenue curve, profit-maximizing
pricing and, 644, 645
Avoidable expenses, 601
Balanced scorecard, 9–10, 515–522
lead and lag indicators and, 518–519
linking to organizational strategy, 519–522
Balance sheet
budgeted, master budget and, 370, 376–377
costs on, 40–41
Ball, Steve, 326n
Banham, Russ, 358n
Bar codes, 106
Barr, Alistair, 8n
Barrett, A., 702n
Barrett, Devlin, 58n
Bartley, Jon, 336n
Batch-level activities, 169, 170
Batch manufacturing
operation costing for, 146–149
product costing in, 83. See also Job-order
costing systems
Before-tax income, 296
Bell, Jan E., 654n, 657n
Benchmarking, 514
Benefits
of information, 55, 647–648
irrelevant, 595
relevant, 592–596
Berliner, Callie, 709n
Berzon, A., 234n
Big pharma, capital-budgeting decisions by, 702
Bills of activities, 181
Bills of materials, 86, 181
Blame, responsibility accounting and, 508
Blumenstein, Rebecca, 58n
Böer, German, 333n
Bonsack, Robert A., 429n
Bonuses, cash, 556
Book value
of equipment, 592–594
gross versus net, measuring invested capital
and, 554–555
Borkowski, Susan C., 336n
Index of Subjects
Page numbers followed by n refer to footnotes.
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Index of Subjects 800
Chief performance analyst, 16
Chiu, Joanne, 179n
CIM. See Computer-integrated manufacturing
(CIM)
CIMA. See Chartered Institute of Management
Accountants (CIMA)
Clayton Act, 661
Clean Air Act, 332
Cloud solutions, 379–380
CMA. See Certified Management Accountant
(CMA) program
Cobble, C., 179n
Coefficient of determination, 249
Cokins, Gary, 326n
Collins, Jay, 471n
Collins, Jonathan, 106n
Columnar flexible budgets, 457
Committed costs, 235
Common costs, 509–510
Common-size income statement, 287n
Communication, facilitating, as budgeting
purpose, 353
Competition, pricing decisions and, 641
Competitive bidding, 659–661
Component productivity, 514
Compound interest, 766–768
Comprehensive Environmental Response,
Compensation and Liability
(“ Superfund”) Act, 332
Comptrollers, 15–16
Computer-integrated manufacturing (CIM),
656
Computerized planning models, cost-volume-
profit analysis and, 284
Conformance, quality of, 326
Conlin, M., 234n
Conlin, Michelle, 245n
Constraints, 616
Consumption ratio, 177
Continuous budget, 354
Contribution income statement, cost-volume-
profit relationships and, 285–287
Contribution margin
total, 270, 279, 477
unit, 477
Contribution-margin approach
to break-even point computation, 270–271
to target profit, 276
Contribution-margin percentage, 271
Contribution-margin ratio, 271
Controllability
of cost variances, 424, 426
responsibility accounting and, 508
Controllable costs, 51–52
in service industry, 57
Controllers, 15–16
Controlling
assisting managers in, 7
as managerial accounting role, 6
Conversion costs, 43, 136, 364
in operation costing, 146
in process-costing systems, 145
Cooper, Robin, 360n, 657n
Cooray, S., 657n
Coordination, facilitating, as budgeting
purpose, 353
Corruption, prevention of, 569
theoretical, 20
unused, in auto industry, 22
utilization of, fixed-overhead variances
and, 466–467
Capital
cost of, capital-expenditure decisions
and, 686–687
invested, measuring, 553–555
working, 698–699
Capital budget, 354
Capital-budgeting decisions, 678–712
accept-or-reject, 680
accounting-rate-of-return method for,
706–708
activity-based costing and, 708–709
advanced manufacturing technology
and, 709–711
by big pharma, 702
capital-rationing, 680–681
discounted-cash-flow analysis for. See
Discounted-cash-flow analysis
income taxes and. See Income taxes
inflation and, 716–718
investment versus financing and, 686
payback method for, 704–706
project focus and, 681
ranking investment projects and, 702–704
Capital-rationing decisions, 680–681
Capital turnover, 547
Carey, J., 702n
Carlivati, Peter, 330n
Carpenter, F. W., 106n
CASB. See Cost Accounting Standards Board
(CASB)
Cash bonuses, 556
Cash budgets, 358–359, 368–369
Cash disbursements budgets, 358, 367–369
Cash flows. See also Discounted-cash-flow
analysis
early focus on, 710
estimating, activity-based costing and,
708–709
not on income statement, discounted-cash-
flow analysis and, 693–694
uneven, internal-rate-of-return method
and, 685
Cash receipts budgets, 357–358, 366–369
Cause-and-effect diagrams, 328, 329
CEO. See Chief executive officer (CEO)
Certification, 24
Certified Management Accountant (CMA)
program, 24
Certified Management Accountants of
Canada, 24
Certified public accountants (CPAs), 23
CFO. See Chief financial officer (CFO)
CGMA. See Chartered Global Management
Accountant (CGMA) certification
Chartered Global Management Accountant
(CGMA) certification, 24n
Chartered Institute of Management Accoun-
tants (CIMA), 24
Chazan, G., 556n
Chen, Clement C., 330n
Chief budget officers, 378–379
Chief executive officer (CEO), 14
Chief financial officer (CFO), 15–16
Bottleneck machinery, 512
Bottleneck operations, 512, 607
Brady, D., 556n
Break-even load factor, 281
Break-even point
cost-volume-profit analysis and, 270–272
implications of, 274–275
operating leverage and, 289–290
Brem, L., 189n
Brimson, James A., 182n, 360n, 709n
Brinker, Barry J., 326n
Budget(s), 410
administration of, 378–380
allocation bases based on, 506–507
behavioral impact of, 380–382
capital, 354
cash, 358–359, 368–369
cash disbursements, 358, 367–369
cash receipts, 357–358, 366–369
definition of, 353
direct labor, 363–365
direct-material, 373–375
financing, 354, 357–359, 366–369
flexible. See Flexible budgets
master. See Master budget
operational, 356–357
padding, 381, 382
as planning tools, 353, 358
production, 372–373
production overhead, 365–366
purchases, 363
revolving (continuous), 354
rolling, 354
sales, 362–363
selling, general and administrative expense,
365–366
static, 455
Budgetary slack, 381
Budget committees, 379
Budget directors, 378–379
Budgeted balance sheet, 370, 376–377
Budgeted costs, service department cost
allocation and, 743
Budgeted financial statements, 354, 359,
369–370, 376–377
Budgeted income statement, 369
Budgeted schedule of cost of goods
manufactured and sold, 375
Budgeted statement of cash flows, 370
Budgeting
activity-based, 359–360
capital. See Capital-budgeting decisions
international aspects of, 380
participative, 381–382
purposes of, 353
Budget manuals, 379
Busco, Cristiano, 336n
Bustillo, M., 8n
By-products, joint product cost allocation and,
747
Campanella, Jack, 326n
Capacity, 20–22
accept-or-reject decisions and, 597–598
excess, transfer pricing and, 561, 562
practical, 20
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801 Index of subjects
standard. See Standard-costing systems
target. See Target costing
throughput-based, 167–168
variable (direct). See Variable costing
Cost management
German systems for, 469
product costing in, 80
product costing versus, 463
strategic, 20
Cost management and control team, 50–52
Cost management systems, 23
Cost objects, 51, 102n, 506
Cost of goods manufactured, 44, 97, 98
schedule of, 44, 97, 98, 375
Cost of goods sold, 37, 56
schedule of, 44, 97, 99, 375
Cost of Goods Sold account, 81, 82
Cost-plus pricing, 648–652
absorption-cost pricing formulas for,
649–650
markup determination and, 650–651
price wars and, 652
variable-cost pricing formulas for, 649–650
Cost pools, 506
activity, 168
machine-related, 170–172
Cost predictions, 226
Cost reimbursement, in health-care industry, 741
Cost standards
cost variance and. See Cost variances
methods for setting, 412
participants in setting, 412
perfection (ideal), 413
practical (attainable), 413
service organization use of, 413
Cost structure, cost-volume-profit analysis
and, 287–288, 290
Cost tear-down, 658
Cost variances, 411, 414–425
controllability of, 424
costs and benefits of investigating, 424
direct-labor standards and, 415
direct-labor variances and, 419–421
direct-material standards and, 414–415
direct-material variances and, 417–419
favorable, 416, 424
interaction among, 427
multiple types of direct material or direct
labor and, 421–422
overhead. See Overhead cost variances
production loss and, 422
recurring, 423
size of, 3
standard costs given actual output
and, 415–416
statistical approach to, 425
trends in, 423–424
unfavorable variances, 416
Cost-volume-profit (CVP) analysis, 266–295
under absorption and variable costing,
323–324
activity-based costing and advanced
manufacturing systems and, 291–294
assumptions underlying, 284
break-even point and, 270–272
changes in fixed expenses and, 277–278
Cost Accounting Standards Board (CASB), 97
Cost accounting system, 11
Cost allocation, 102, 506. See also Cost drivers
allocation bases for, 506–507
of joint product costs. See Joint product cost
allocation
of service department costs. See Service
department cost allocation
two-stage, 102n, 102–103
Cost-based pricing, market forces versus,
641–642
Cost-based transfer prices, 565–566
Cost behavior, 226, 227–236
of committed costs, 235
of curvilinear costs, 232–233
of discretionary costs, 235
of engineered costs, 235
of fixed costs, 229, 230
learning effects on, 243–245
in merchandising firms, 236
predicting posts using patterns of, 233, 235
projected, cost-volume-profit analysis and,
269
of semivariable costs, 231–232
of step-fixed costs, 229–231
of step-variable costs, 228–229
of variable costs, 227–228
Cost centers, 500, 503
Cost cutting, ethics of, 522
Cost distribution. See Cost allocation
Cost drivers, 20, 47. See also Cost allocation
in activity-based costing, 178–180
activity measures for flexible budgets
and, 461
for overhead application, 101
pool rate and, 171
in process-costing systems, 145
in service industry, 56
Cost estimation, 226, 236–243
account-classification method of (account
analysis), 236–237
data collection problems and, 242–243
engineering method of, 243
high-low method of, 239
least-squares regression method of, 240–242
multiple regression method of, 242
visual-fit method of, 237–238
Cost flows
in job-order and process-costing systems,
134–136, 137
in manufacturing firms, 81–83
Cost hierarchies, 169
Costing
absorption (full). See Absorption costing
activity-based. See Activity-based costing
(ABC) systems
actual, 100–101, 145
hybrid product-costing systems and,
146–149
job-order. See Job-order costing systems
normal, 98, 145
operation, for batch manufacturing, 146–149
price-led, 654
process. See Process-costing systems
product. See Job-order costing systems;
Process-costing systems; Product-
costing systems
Cost(s)
abatement, 334
administrative, 38
appraisal, 326
average, in service industry, 57
average, per unit, 55
capacity, 20–22
of capital, capital-expenditure decisions
and, 686–687
committed, 235
common, 509–510
controllable, 51–52, 57
conversion. See Conversion costs
curvilinear, behavior of, 232–233
customer-related, 186
definition of, 36–38
differential, 54, 57, 594
direct. See Direct entries
discretionary, 235
engineered, 235
environmental. See Environmental cost(s)
on financial statements, 38–41
fixed. See Fixed costs
health-care. See Health-care costs
incremental, 54
indirect. See Indirect entries
of information, 55, 647–648
inventoriable. See Product cost(s)
of investigating cost variances, 424
irrelevant, 595
life-cycle, target costing and, 655
manufacturing. See Manufacturing costs
manufacturing-overhead. See
Manufacturing-overhead costs
marginal, 54–55, 57
non-value-added. See Non-value-added costs
opportunity. See Opportunity costs
out-of-pocket, 53, 57
overhead. See Overhead cost(s)
period, 38, 56
predicting using cost behavior patterns,
233, 235
prevention, 326
pricing decisions and, 641–642
prime, 43
product. See Product cost(s)
production, in service industry firms and
nonprofit organizations, 44, 46
quality, 326
relevant, 592–596
remediation, 334
research and development, 38
of running airlines, 52
selling, 38
semivariable, behavior of, 231–232
in service industry, 56–58
standard. See Standard cost(s)
step-fixed, behavior of, 229–231
step-variable, behavior of, 228–229
sunk, 53–54, 57, 592–594
target, 653
total. See Total cost entries
transferred-in, 135
uncontrollable, 51–52, 57
unit, in weighted-average method of process
costing, 142
variable. See Variable cost(s)
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Index of Subjects 802
Direct-material purchase price variance,
418–419
Direct-material quantity, standard, 415
Direct-material quantity variance, 417, 418
controllability of, 426
Direct method for service department cost
allocation, 737
Discounted-cash-flow analysis, 681–702
assumptions underlying, 685–686
hurdle rate and, 686–687
illustration of, 687–690
income taxes and. See Income taxes
incremental-cost approach to, 689–690
internal-rate-of-return method for, 682–685
managerial accountant’s role in, 690–691
net-present-value method for, 682, 685
real option analysis and, 691
total-cost approach to, 689
Discount rate, 769
Discretionary costs, 235
Disposal, gains and losses on, discounted-cash-
flow analysis and, 697–698
Distress market prices, transfer prices based
on, 564
Drawbaugh, K., 763n
Dual cost allocation, of service department
costs, 741–743
Duties, import, transfer pricing and, 567–568
Dynamic tear-down, 658
Dzinkowski, Ramona, 333n
E-budgeting, 379
Ecoefficiency, 332
E-commerce
operating leverage and, 289
pricing and, 654
Econometric models, 356
Economic order quantity (EOQ), 774–777
equation approach to, 775–776
graphical approach to, 776, 777
just-in-time production and inventory man-
agement system and, 778–779
safety stock and, 776
tabular approach to, 774–775
timing of orders and, 776, 777
Economic value added (EVA), 551–552
pay for performance based on, 552
EDI. See Electronic data interchange (EDI)
Edwards, C., 330n
Eichenwald, Kurt, 58n
Eig, J., 234n
Electronic data interchange (EDI), 105
Electronic spreadsheets
cost-volume-profit analysis using, 284
least-squares regression using, 248–249
EMS. See Environmental Management System
(EMS)
Engineered costs, 235
Engineering method of cost estimation, 243
Enterprise-hosted model of financial planning
and analysis, 379
Environmental cost(s), 332–336
ISO 14000 standards and, 335–336
management of, 333–335
private versus social, 332–333
visible versus hidden, 333–335
Environmental cost management, 333–335
managerial performance evaluation and, 611
outsourcing decisions and, 598–601
pitfalls in, 612
providing information for, 7
quantitative versus qualitative analysis
and, 589–590
sell-or-process further decisions and,
603–605
short-versus long-run decisions and, 612
steps in, 589
uncertainty and, 607–608
unique versus repetitive decisions and,
591–592
Decision variables, 616
DeFreitas, D., 88n
Delivery cycle time, 513
Delivery in today’s production environment
and, 513–514
Demand, pricing decisions and, 641
Demand curve, profit-maximizing pricing and,
644, 645
Departmental overhead centers, 102
Departmental overhead rates, 101–102
Departmental production reports, 138,
143–144
Dependent variable, 241
Depreciable assets in discounted-cash-flow
analysis, 687
Depreciation
accelerated, discounted-cash-flow analysis
and, 694–697
straight-line, modified accelerated cost
recovery system and, 697
Depreciation cash shields, 693
Design
of process, focus on, target costing and, 655
of products, focus on, target costing and, 655
quality of, 326
Differential costs, 54, 594
in service industry, 57
Direct cost(s), 51, 56–57
in service industry, 56–57
Direct costing. See Variable costing
Directing operational activities
assisting managers in, 7
as managerial accounting role, 6
Direct-labor budget, 363–365
Direct-labor cost, 42, 87
in job-order costing, 87, 92
limitation as cost driver, 101
multiple types of, 421–422
as variable cost, 245
as variable versus fixed cost, 234
Direct-labor efficiency variance, 419, 420–421
controllability of, 426
Direct-labor quantity, standard, 415
Direct-labor rate, standard, 415
Direct-labor rate variance, 419, 420
controllability of, 426
Direct-material budget, 373–375
Direct-material cost, 42
in job-order costing, 85–86, 91
multiple types of, 421–422
in operation costing, 146
Direct-material price, standard, 415
Direct-material price variance, 417, 418–419
controllability of, 426
changes in unit contribution margin and,
278–279
computerized planning model and electronic
spreadsheet role and, 284
contribution-margin approach to, 270–271,
276
cost behavior and, 269
cost structure and operating leverage
and, 287–291
equation approach to, 271–272, 276–277
illustration of, 269
income statement and, 285–287
income taxes and, 296–298
independent changes in key variables
and, 280–281
information in annual reports and, 281
with multiple products, 282–284
predicting profit given expected volume
and, 279–280
projected expenses and revenue and, 269
safety margin and, 277
target profit and, 276–277
Cost-volume-profit (CVP) graph, 272–275, 277
alternative format for, 274, 275
interpreting, 273–275
Cox, W., 88n
Coy, P., 234n, 245n
CPAs. See Certified public accountants (CPAs)
Crockett, R., 330n
Cross-elasticity, 647
Cross-functional deployment of managerial
accountants, 16
Cross-functional teams, target costing and, 655
Crum, R., 289n
Curtin, Margaret, 333n
Curvilinear costs, behavior of, 232–233
Customer-acceptance measures, 513
Customer focus, target costing and, 654
Customer-profitability analysis, 185–188,
511–512
at Bank One Corp., 187
illustration of, 185–188
Customer-profitability profiles, 188
Customer-related costs, 186
CVP. See Cost-volume-profit (CVP) analysis;
Cost-volume-profit (CVP) graph
Cycle time, 101
Data collection
for activity-based costing systems, 180–181
cost estimation and, 242–243
Davila, Antonio, 516n
Decision making, 589–608
accept-or-reject decisions and. See Accept-
or-reject decisions
add-or-drop decisions and, 601–603
capital budgeting and. See Capital-budgeting
decisions
delegation of, investment centers and,
544–552
dysfunctional, 565–566
identification of relevant costs and benefits
and, 592–596
incentives for, 611
information for, 590–592
limited resources and, 605–607
managerial accountant’s role in, 6, 588–591
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803 Index of subjects
GRI. See Global Reporting Initiative (GRI)
Groom, D. J., 140n
Gross book value, measuring invested capital
and, 554–555
Gross margin, 285
Gujarathi, M., 567n
Hagerty, J., 603n
Hagerty, J. R., 599n
Hamilton, David P., 654n
Hatch, Toby, 517n, 519n
Hayes, R., 41n
Hayes-Wheelwright production process matrix,
41n
Health-care costs
explosion of, 50
operating leverage and, 291
reimbursement of, 741
Herbst, M., 234n, 245n
Herper, M., 702n
Hidden environmental costs, 333–335
Hidden quality costs, 326
High-low method of cost estimation, 239
Historical data, analysis of, for cost standard
setting, 412
Hodowanitz, John, 25n
Hof, R. D., 289n
Holmes, Stanley, 107n
Hoyt, Louis, 333n
Hurdle rate
in discounted-cash-flow analysis, 686–687
in net-present-value method, 682
Hybrid product-costing systems, 146–149
Ideal standards, 413
Idle time, 43
IMA. See Institute of Management
Accountants (IMA)
Image, public, pricing decisions and, 642
Imperfect competition, general transfer-pricing
rule and, 563
Import duties, transfer pricing and, 567–568
Improvement targets, in today’s production
environment, 514
Incentive(s)
for decision makers, 611
gain-sharing plans as, 514–515
to overproduce inventory, 336–337
performance evaluation and, 568–569
providing, as budgeting purpose, 353
Incentive compensation, 556
Income
before-tax, 296
investment-center, measuring, 556–557
net, after-tax, 296–298
residual, 548–551
target, 276–277
Income reconciliation, under absorption
and variable costing, 321–323
Income statement
absorption-costing, 320–321
budgeted, master budget and, 369
cash flows not on, discounted-cash-flow
analysis and, 693–694
common-size, 287n
contribution, cost-volume-profit
relationships and, 285–287
Financing planning models, 378
Finished goods inventory, 41
Finished-Goods Inventory account, 81, 82
Fink, R., 88n
First-in, first-out (FIFO) process-costing
method, 139
Fishbone diagrams, 328, 329
Fishman, C., 599n
Fixed costs, 48–50, 234
allocated, decision making and, 612
behavior of, 229, 230
in service industry, 56
unitized, decision making and, 612
variable costs versus, service department
cost allocation and, 739–741
Fixed expenses, changes in, cost-volume-profit
analysis and, 277–278
Fixed manufacturing overhead, absorption
versus variable costing and, 319
Fixed-overhead budget variance, 465
Fixed-overhead volume variance, 465–466
Flexible budgets, 455–459
activity-based, 468–470
activity measure and, 456–457
advantages of, 455–456
columnar, 457
formula, 457–459
overhead cost variances and, 461–462
in service industry, 470–472
Foreign Corrupt Practices Act of 1977, 569
Formula flexible budgets, 457–459
Foust, D., 603n
Fowler, G. A., 8n
FP&A. See Financial planning and analysis
(FP&A) systems
France, Mike, 107n
Fraud, prevention of, 569
Frigo, Mark L., 336n
Fukuda, J., 657n
Full cost, cost-based transfer prices and, 565
Full costing. See Absorption costing
Future value, 767
of cash-flow series, 770–771
Future value tables, 714
Gain-sharing plans, 514–515
Gains on disposal, discounted-cash-flow
analysis and, 697–698
Gaiser, Bernd, 469n
Gates, Bill, 411
General transfer-pricing rule, 560–563
Ghosn, Carlos, 22
Gillette, J., 88n
Global Reporting Initiative (GRI), 335, 336
Goal congruence, 500
obtaining, 545
transfer pricing and, 559–560, 561–563
Goizueta, Roberto, 552
Goldratt, Eliyahu M., 513n
Golvin, Geoff, 291n
Goodness of fit, 241–242, 249
Gottlieb, Scott, 741n
Govindarajan, V., 655n
Graphical approach
to economic order quantity, 776, 777
to linear programming, 616–618
Greenwood, J., 552n
Environmental Management System (EMS), 335
Environmental Protection Agency (EPA), 332
EOQ. See Economic order quantity (EOQ)
EPA. See Environmental Protection
Agency (EPA)
Equation approach
to break-even point computation, 271–272
to cost-volume-profit analysis, 271–272,
276–277
to economic order quantity, 775–776
to target profit, 276–277
Equivalent units, 136–138
in weighted-average method of process
costing, 141–142
Ethics, 24–26
activity-based costing and, 192–193
of cost cutting, 522
cost overruns at Boeing and, 107
direct labor as variable cost and, 245
misstated standards and, 472–473
WorldCom and, 57–58
EVA. See Economic value added (EVA)
Excess capacity, transfer pricing and, 561, 562
Excess present value index, 703–704
Expected value, 608
uncertainty and, 608
Expenses
avoidable and unavoidable, 601
cash, after-tax cash flows and, 692
definition of, 37
fixed, changes in, cost-volume-profit
analysis and, 277–278
noncash, after-tax cash flows and, 693
operating, in service industry, 56
projected, cost-volume-profit analysis and, 269
Experience curve, cost behavior and, 243–244
Extensible Markup Language (XML), 106
External failure costs, 326
External reporting, under absorption and
variable costing, 324
Facility-level activities, 169, 170
Failure costs, internal and external, 326
Favorable variances, 416
Feasible region, 616
Ferreira, L., 472n
FIFO. See First-in, first-out (FIFO) process-
costing method
Financial accounting
definition of, 10
managerial accounting versus, 10–12
product costing in, 80
Financial Executives Institute, 24
Financial misrepresentation, prevention of, 569
Financial planning and analysis
enterprise-hosted model of, 379
provider-hosted model of, 379–380
Financial planning and analysis (FP&A)
systems, 352–354, 410. See also Budget(s);
Budgeting; Flexible budgets; Master budget
e-budgeting and, 379–380
Financial statements. See also Balance sheet;
Income statement; Schedule of cost
of goods manufactured; Schedule of cost
of goods sold
budgeted (pro forma). See Budgeted
financial statements
Financing budgets, 354, 357–359, 366–369
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Index of Subjects 804
relative-sales-value method for, 746
Joint production processes, 603–605, 744
Jones, Keith T., 330n
Joshi, Satish, 333n, 334n
Journal entries
posting to ledger, 98
under standard costing, 475–476
Joy, J., 567n
Just-in-time (JIT) production and inventory
management system, 777–779
under absorption and variable costing, 325
economic order quantity and, 778–779
move toward, 292–294
perishable products and, 476
Kaiser, Henry F., 291
Kaplan, R., 709n
Kaplan, Robert S., 9n, 50n, 360n, 429n, 516n,
517n, 519n, 522n
Kato, Y., 657n
Kaye, Kate, 654n
Keenan, Faith, 88n
Keys, David E., 471n
Khan, Zafar U., 326n
Kiernan, Kaitlyn, 8n
Kirn, Steven P., 520n
Klein, Norman, 516n
Kranhold, Kathryn, 333n
Krell, E., 567n
Krishnan, Ranjani, 333n, 334n
Krumwiede, Kip R., 469n
Labor
direct, as variable cost. See Direct labor
entries
indirect, 43, 92
Labor-intensive production processes, advanced
manufacturing systems versus, 290
Lag indicators, balanced scorecard and,
518–519
Landers, Peter, 600n
Latour, A., 58n
Lave, Lester, 333n, 334n
Lavelle, Louis, 552n
Law(s)
Affordable Care Act, 291
antitrust, pricing and, 661
Clean Air Act, 332
Comprehensive Environmental Response,
Compensation and Liability
(“Superfund”) Act, 332
Foreign Corrupt Practices Act of 1977, 569
Sarbanes-Oxley Act of 2002 (SOX). See
Sarbanes-Oxley Act of 2002 (SOX)
Tax Reform Acts of 1986, 1989, and 1993,
695
Lawson, Raef, 517n, 519n
Lead indicators, balanced scorecard and,
518–519
Lead time, EOQ model and, 776, 777
Leahy, T., 552n
Learning curve, cost behavior and, 243–245
Least-squares regression, using Microsoft
Excel, 248–249
Least-squares regression method of cost
estimation, 240–242
Le Carre, John, 654
Interviews, for activity-based costing data col-
lection, 180
Inventoriable costs. See Product cost(s)
Inventory
finished goods, 41
on hand, cost of, 594
incentive to overproduce, 336–337
income reconciliation under absorption and
variable costing and, 321–323
just-in-time. See Just-in-time (JIT) produc-
tion and inventory management system
raw-material, 41
in today’s production environment, 512
work-in-process, 41
Inventory management, 774–779
direct-material budget and, 374–375
economic order quantity and, 774–777
just-in-time, 777–779
Invested capital, measuring, 553–555
Investment
recovery of, internal-rate-of-return method
and, 684
return on. See Return on investment (ROI);
Return-on-investment pricing
in working capital, 698–699
Investment centers, 501, 502, 544–557
adaptation of management control systems
and, 545
allocating assets to, 555
delegation of decision making and, 544–552
economic value added and, 551–552
goal congruence and, 545
inflation and, 557
invested capital and, 553–555
measuring income of, 556–557
performance measurement in, 546
residual income and, 548–551
return on investment and, 546–548
Investment opportunity rate, hurdle rate and,
686
Investment projects, ranking, 702–704
Ishikawa diagrams, 328, 329
ISO. See International Organization for
Standardization (ISO)
Iwabuchi, Y., 657n
Jargon, J., 234n
JIT. See Just-in-time (JIT) production and
inventory management system
Job-cost records, 84–85
Job-order costing systems, 83, 84–98
cost accumulation in, 84–89, 90
event sequence in, 89, 90
illustration of, 89, 91–98, 99, 100
in nonmanufacturing organizations, 103–105
process-costing systems compared with,
134–136, 137
Job-shop operations, product costing in, 83.
See also Job-order costing systems
Johnsen, David, 421n
Johnson, H. Thomas, 429n
Joint product(s), 744
Joint product cost allocation, 744–747
by-products and, 747
net-realizable-value method for, 746–747
in petroleum industry, 746
physical-units method for, 745–746
costs on, 38–40
segmented, 509–510, 511
traditional, cost-volume-profit relationships
and, 286–287, 285
variable-costing, 321
Income taxes
accelerated depreciation and, 694–697
after-tax cash flows and, 691–694
cost-volume-profit analysis and, 296–298
gains and losses on disposal and, 697–698
illustration of effects in capital budgeting,
699–702
investment in working capital and, 698–699
Modified accelerated cost recovery system
and, 695–697
transfer pricing and, 566–567
Incremental cost(s), 54
Incremental-cost approach, to discounted cost-
flow analysis, 689–690
Independent variable, 241
Indirect costs, 51
in service industry, 57
Indirect labor, 43
in job-order costing system, 92
Indirect material, 42
in job-order costing system, 91
Inflation
capital-budgeting decisions and, 716–718
discounted-cash-flow analysis and, 694
historical-cost versus current-value
accounting and, 557
Information
accuracy of, 590–591
costs and benefits of, 55, 647–648
relevant, 590, 591
responsibility accounting and, 508
timeliness of, 591
Information overload, 55, 592
Innovation in today’s production environment
and, 514
In-process quality controls, 513
Insourcing, 599
Institute of Certified Management Accountants
in Australia, 24
Institute of Internal Auditors, 24
Institute of Management Accountants (IMA), 24
Statement of Ethical Professional Practice
of, 26
Interest, compound, 766–768
Interest rates, real and nominal, 716
Internal auditors, 16
Internal audit staff, 569
Internal controls, Sarbanes-Oxley Act of 2002
and, 761
Internal control systems, 569
Internal failure costs, 326
Internal rate of return, finding, 683
Internal-rate-of-return method
for capital-budgeting decisions, 682–685
net-present-value method compared with,
685
International Organization for Standardization
(ISO)
ISO 9000 standards and, 330–331
ISO 14000 standards and, 335–336
Internet. See also E-commerce
monetizing users of, 8
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805 Index of subjects
Material tear-down, 658
Mattioli, Dana, 652n
MBO. See Management by objectives (MBO)
McCartney, Scott, 52n
MCE. See Manufacturing cycle efficiency (MCE)
Merchandising firms
cost behavior in, 236
operational budgets of, 356–357
Merchant, K., 472n
Merit pay, 556
Michaels, D., 107n
Microsoft Excel, least-squares regression
using, 248–249
Milani, K., 567n
Minimum desired rate of return. See Hurdle rate
Mintz, S. L., 177n
Modified accelerated cost recovery system
(MACRS), discounted-cash-flow analysis
and, 695–697
Monetizing Internet users, 8
Moore, R., 189n
Motivating
as managerial accounting role, 8–9
responsibility accounting and, 508–509
MRP. See Material requirements planning
(MRP)
Mullaney, T. J., 289n
Multidisciplinary activity-based costing project
teams, 181
Multiple products, cost-volume-profit analysis
with, 282–284
Multiple regression method of cost
estimation, 242
Narayanan, V. G., 189n
Naughton, Keith, 22n
Negotiated transfer prices, 564–565
Net book value, measuring invested capital
and, 554–555
Net income, after-tax, 296–298
Net present value (NPV), capital-budgeting
decisions and, 682
Net-present-value analysis
discounted-cash-flow analysis and, 694
internal-rate-of-return method compared
with, 685
Net realizable value, 746–747
Net-realizable-value method for joint product
cost allocation, 746–747
New products, strategic pricing of, 653
Noble, Jean L., 709n
Nominal dollars, 716
Nominal interest rate, 716
Nonfinancial information, in segment perfor-
mance evaluation, 558
Nonmanufacturing organizations. See also
Merchandising firms; Nonprofit organiza-
tions; Service industry firms
job-order costing in, 103–105
Nonprofit organizations
depreciable assets in discounted-cash-flow
analysis and, 687
operational budgets of, 357
performance evaluation in, 558–559
product costing in, 81
production costs in, 44, 46
Non-value-added activities
eliminating, to relax constraints, 607
identifying using ABM, 182–184
Manufacturing firms
changing technology in, 105–106
cost flows in, 81–83
costs and, 41–43
decisions involving limited resources in,
605–607
joint products and, 603–605
master budget for, 371–377
operational budgets of, 356
operational performance measures in today’s
production environment and, 512–515
product costing in, 80–81
uncertainty and, 607–608
Manufacturing-overhead costs, 42, 87–89
actual, in job-order costing system, 94
application of, in job-order costing system, 93
cost variances and. See Overhead cost
variances
incurrence of, in job-order costing system,
92–93
non-unit-level, 176–177
Manufacturing technology, activity measures
for flexible budgets and, 460
Marginal cost(s), 54–55
in service industry, 57
Marginal cost curve, profit-maximizing pricing
and, 644, 645
Marginal revenue curve, profit-maximizing
pricing and, 644, 645
Market(s), oligopolistic, 647
Market forces, cost-based pricing versus,
641–642
Market price, external, transfer pricing based
on, 563–564
Markup. See also Cost-plus pricing
determining, 650–651
Master budget, 354–359
assumptions and predictions underlying,
377–378
budgeted balance sheet and, 376–377
budgeted financial statements and, 359,
369–370
budgeted schedule of cost of goods
manufactured and sold and, 375
development of, 360–371
direct labor budget and, 363–365
direct-material budget and, 373–375
financing budgets and, 357–359, 366–369
financing planning models and, 378
key features of, 370–371
for manufacturing firms, 371–377
operational budgets and, 356–357
production budget and, 372–373
production overhead and selling, general and
administrative expense budgets and,
365–366
purchased budget and, 363
sales budget and, 362–363
sales forecasting and, 355–356
sales of services or goods and, 354–355
Material
purchase of, in job-order costing system, 91
raw, 42
Material costs. See Direct-material cost;
Indirect material
Material requirements planning (MRP), 86
Material requisition form, 85–86
Ledger, posting journal entries to, 98
Leech, T. J., 762n
Legal issues. See also Law(s); Sarbanes-Oxley
Act of 2002 (SOX)
antitrust laws and pricing as, 661
pricing decisions and, 642
Leone, Emilia L., 336n
Leverage, operating. See Operating leverage
Lewin, Tamar, 8n
Life-cycle costs, target costing and, 655
Linear programming, 616–618
graphical solution for, 616–618
multiple scarce resources and, 606
simplex algorithm and, 618
Line positions, 14–15
Losses
on disposal, discounted-cash-flow analysis
and, 697–698
production, standard costs and, 422
Lublin, J., 552n
Lublin, Joann, 25n
Machine-related cost pools, 170–172
Machinery
bottleneck, 512
in today’s production environment and, 512
MACRS. See Modified accelerated cost
recovery system (MACRS)
Maher, Michael W., 336n
Make-or-buy decisions, 598–600
conventional analysis of, 609–610
Management Accounting Quarterly, 24
Management by exception, 411, 504
Management by objectives (MBO), 545
Managerial accountants
definition of, 5
in discounted cash-flow analysis, 690–691
location in organization, 12–16
professional certification of, 24
professional organizations and, 23–24
role in decision making, 588–591
Managerial accounting
activities of, 5–6
balanced scorecard and, 9–10
as business partnership with management, 5
capacity and capacity costs and, 20–22
cost management systems and, 23
definition of, 4
financial accounting versus, 10–12
objectives of, 7–9
operational context of, 17–23
organization type and, 12
product costing in, 80
value chain and, 18–20
Managerial control systems, adaptation of, 545
Managerial performance evaluation, 611
Managing constraints. See Theory of con-
straints (TOC)
Manufacturing, just-in-time. See Just-in-time
(JIT) production and inventory manage-
ment system
Manufacturing costs, 41–43. See also Direct-
labor entries; Direct-material entries;
Manufacturing-overhead costs
flows of, 44–46
Manufacturing cycle efficiency (MCE), 514
Manufacturing cycle time, 514
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Index of Subjects 806
computerized planning models for, cost-
volume-profit analysis and, 284
enterprise-hosted model of financial
planning and analysis and, 379
financing planning models for, 378
as managerial accounting role, 6
master budget and. See Master budget
material requirements, 86
providing information for, 7
Plantwide overhead rate, 102
Player, S., 179n
Player, Steve, 358n, 471n
Political issues, pricing decisions and, 642
Pool rate, 171
Porter, Michael E., 50n
Postappraisals, 690–691
Postaudits, 690–691
Posting journal entries to ledger, 98
Practical capacity, 20
Practical standards, 413
Predatory pricing, 661
Predetermined overhead application rate, in
operation costing, 146
Predetermined overhead rate, 87–89
Premium, overtime, 43
Present value, 768–770
of cash-flow series, 769–770
Present value tables, 715
Prevention costs, 326
Price(s)
direct-material. See Direct-material price
entries
market, external, transfer pricing based on,
563–564
profit-maximizing, 644, 646–647
sales, changes in, cost-volume-profit
analysis and, 278–279
transfer, 544, 565–566
Price discrimination, 661
Price elasticity, profit-maximizing pricing
and, 647
Price-led costing, 654
Price takers, 642
Price wars, 652
Pricing, 638–663
under absorption and variable costing, 324
antitrust laws and, 662
competitive bidding and, 659–661
cost-plus. See Cost-plus pricing
dynamic, by e-tailers, 654
major influences on, 640–642
penetration, 653
profit-maximizing. See Profit-maximizing
pricing
return-on-investment, 650–651
skimming, 653
strategic, of new products, 653
target costing and. See Target costing
time and material, 658–659
Prime costs, 43
Principal, 767
Private environmental costs, 332–335
visible versus hidden, 333–335
Process-costing systems, 84, 134–146
actual versus normal costing and, 145
cost drivers for overhead application
and, 145
Overhead cost variances, 461–467
disposition of, product costing and, 476
fixed, 465–467
flexible budget and, 461–462
graphing, 463–464
managerial interpretation of, 464
variable, 462–465
Overhead rates
departmental, 101–102
plantwide, 102
predetermined, 87–89
Overtime premium, 43
Overtime to relax constraints, 607
Padding the budget, 381, 382
Paper trails for activity-based costing data
collection, 180
Parallel processing to relax constraints, 607
Pareto diagrams, 328, 329
Partial productivity, 514
Participative budgeting, 381–382
Pasztor, Andy, 107n
Payback method, 704–706
Payback period, 704
with uneven cash flows, 705–706
Pay for performance, 556
based on economic value added, 552
PCAOB. See Public Company Accounting
Oversight Board (PCAOB)
Pearson, David, 22n
Penetration pricing, 653
Peregrine, M. W., 763n
Perfect competition, general transfer-pricing
rule and, 563
Perfection standards, 413
Performance evaluation
alternative measures for, 557–558
as budgeting purpose, 353
in investment centers, 546
managerial, 611
nonfinancial information for, 558
in nonprofit organizations, 558–559
risk aversion and incentives and, 568–569
Performance measures, operational, in today’s
production environment, 512–515
Performance reports, 504–508
activity-based flexible budgets and,
469–470
activity-based responsibility accounting and,
507–508
budgets, variance analysis, and
responsibility accounting and, 506
cost allocation and, 506–507
Period costs, 38
in service industry, 56
Perishable products, just-in-time production
and, 476
Petroleum industry, joint product cost
allocation in, 746
Pharmaceutical industry, capital-budgeting
decisions by, 702
Physical-units method for joint product cost
allocation, 745–746
Pisano, G., 41n
Planning. See also Financial planning and
analysis (FP&A) systems
budgets as tools for, 353, 358
Non-value-added costs, 23, 51
identifying using ABM, 184–185
Norkiewicz, Angela, 189n
Normal costing
overhead application and, 98
in process-costing systems, 145
Norton, David P., 9n, 516n, 517n, 519n, 522n
NPV. See Net present value (NPV)
Objective function, 616
Observable quality costs, 326, 327, 328
Okano, H., 657n
Oligopolistic markets, 647
Operating expenses, 40
in service industry, 56
Operating leverage
cost-volume-profit analysis and, 288–291
health-care costs and, 291
Web companies and, 289
Operating leverage factor, 288
Operation(s), controlling, as budgeting pur-
pose, 353
Operational budgets, 356–357
Operation costing, for batch manufacturing,
146–149
Opportunity costs, 53, 595–596
allocated, 612
in service industry, 57
Organization(s), location of managerial
accountants in, 12–16
Organizational strategy, linking balanced
scorecard to, 519–522
Organization charts, 14–16
Ostrower, J., 107n
Outliers, 238
Out-of-pocket costs, 53
in service industry, 57
Output, actual, standard costs and, 415–416
Outsourcing, 52–55
activity-based costing analysis of decision
for, 610–611
average cost per unit and, 55
conventional analysis of decision for,
609–610
decision making about, 598–600
differential costs and, 54
effects of decision to outsource and, 613
marginal costs and, 54–55
opportunity costs and, 53
to relax constraints, 607
reversal of, 599
sunk costs and, 53–54
Overapplied overhead, in job-order costing
system, 95–97
Overhead application (overhead absorption),
87, 98, 100–102
actual and normal costing and, 98, 100
cost drivers for, 101, 145
departmental overhead rates and, 101–102
in standard-costing systems, 459–460
Overhead budgets, 454–457
flexible, 455–459
Overhead cost(s)
manufacturing. See Manufacturing-overhead
costs; Overhead cost variances
variable, management of, 465
Overhead cost performance report, 467–468
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807 Index of subjects
Remediation costs, 334
Repetitive decisions, 592
Reports
annual, cost-volume-profit information in, 281
external reporting under absorption and vari-
able costing and, 324
overhead cost performance, 467–468
performance. See Performance reports
production, departmental, 138, 143–144
segmented reporting and. See Segmented
reporting
Research and development costs, 38
Residual income, 548–551
Resource(s), limited, decisions involving,
605–607
Resource allocation, as budgeting purpose, 353
Responsibility accounting, 50, 500–509
activity-based, 507–508
behavioral effects of, 508–509
illustration of, 501–503
performance evaluation and. See Perfor-
mance evaluation
performance reports and, 504–508
responsibility centers and, 500–501
Responsibility centers, 500–501, 544. See also
Investment centers
Retraining to relax constraints, 607
Return, rate of. See Rate of return
Return on investment (ROI), 546–548
factors underlying, 547–548
improving, 548
Return-on-investment pricing, 650–651
Revenue
cash, after-tax cash flows and, 692
projected, cost-volume-profit analysis and,
269
Revenue centers, 500
Revolving budget, 354
RFID. See Radio frequency identification
(RFID) systems
Riccaboni, Angelo, 336n
Richardson, T., 58n
Risk aversion, performance evaluation and,
568–569
Robinson-Patman Act, 661
ROI. See Return on investment (ROI)
Rolling budget, 354
Romero, Simon, 58n
Rowley, I., 22n
Rucci, Anthony J., 520n
Russolillo, Steven, 8n
SaaS solutions, 379–380
Safety margin, 277
operating leverage and, 289–290
Safety stock, 776
Sales
of goods, in job-order costing system, 95
master budget and, 354–355
Sales budget, 362–363
Sales forecasting, master budget and, 355–356
Sales margin, 547
Sales mix, 282
Sales price, changes in, cost-volume-profit
analysis and, 278–279
Sales-price variance, 478
Sales variances, 477–478
quantity and, 644, 646–647
total cost and marginal cost curves and,
644, 645
total revenue, demand, and marginal revenue
curves and, 642–644
Profit-oriented organizations, depreciable assets
in discounted-cash-flow analysis and, 687
Profit plan. See Master budget
Profit-volume graph, 275, 277
Pro forma financial statements. See Budgeted
financial statements
Program accounting, 107
Provider-hosted model of financial planning
and analysis, 379–380
Public Company Accounting Oversight Board
(PCAOB), 25
Public image, pricing decisions and, 642
Purchases budget, 363
Purchasing, link with production, 374
Qualitative characteristics, 589–590
Quality, 325–331
costs of, 326
of design, 326
identifying quality control problems and,
328–329
ISO 9000 standards for, 330–331
optimal, changing views of, 326–330
of products, 325–326
sacrificing to cut standard costs, 431
Six Sigma program and, 328, 330
in today’s production environment and, 513
total quality management and, 328
zero-defect perspective on, 327–328
Quality audit programs, 513
Quality of conformance, 326
Quantitative characteristics, 589–590
Quantity. See also Economic order quantity
(EOQ)
profit-maximizing, 644, 646–647
Quinn, Richard T., 520n
Radio frequency identification (RFID)
systems, 106
Radnofsky, L., 234n
Rate of return
accounting, 706–708
internal (time-adjusted). See Internal rate of
return; Internal-rate-of-return method
minimum desired. See Hurdle rate
Raw material, 42
in today’s production environment and, 512
Raw-material inventory, 41
Real dollars, 716
Real interest rate, 716
Real option analysis, 691
Reciprocal-services method for service depart-
ment cost allocation, 738–739, 749–750
Regression line, 240
Relative-sales-value method, 604, 746
Relevant costs
activity-based costing of outsourcing
decision and, 610–611
conventional outsourcing analysis and,
609–610
Relevant information, 590, 591
Relevant range, 233
equivalent units and, 136–138
illustration of, 138–144
job-order costing systems compared with,
134–136, 137
subsequent production departments and,
145–146
in wine industry, 140
Process design, focus on, target costing and,
655
Processing costs, separable, 605
Product(s)
by-products and, 747
grade of, 325–326
joint. See Joint entries
new, strategic pricing of, 653
perishable, just-in-time production and, 476
quality of, 325–326
Product cost(s), 37
absorption-cost pricing and, 649–650
activity-based costing, interpreting, 173–175
cost-plus pricing and, 648–649
at Internal Revenue Service, 325
markup determination and, 650–651
in service industry, 56
variable-cost pricing and, 650
Product cost distortion
activity-based costing and, 656–657
by volume-based costing systems, 175–178,
179
Product-costing systems, 80–81
cost management versus, 463
hybrid, 146–149
job-order. See Job-order costing systems
in manufacturing firms, 80–81
in nonmanufacturing firms, 81
process costing. See Process-costing systems
standard costs and, 475–476
Product design, focus on, target costing and,
655
Production
link with purchasing, 374
loss in, standard costs and, 422
Production budget, 372–373
Production costs, in service industry firms and
nonprofit organizations, 44, 46
Production jobs, completion of, in job-order
costing system, 95
Production overhead budget, 365–366
Production processes, joint, 744
Productivity
aggregate (total), 514
partial (component), 514
in today’s production environment and, 514
Product-sustaining-level activities, 169, 170
Professional certification, 24
Profit. See also Cost-volume-profit (CVP)
analysis
controlling, as budgeting purpose, 353
predicting, given expected volume, 279–280
target, 276–277
Profitability index, 703–704
Profit centers, 500, 503, 544n
Profit-maximizing pricing, 642–648
costs and benefits of information and,
647–648
limitations of, 647
price elasticity and, 647
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Index of Subjects 808
Stratton, William, 517n, 519n
Subsequent production departments, in
process-costing systems, 145–146
Sukurai, Michiharu, 429n
Sunk costs, 53–54
decision making and, 592–594, 612
in service industry, 57
“Superfund” Act, 332
Suppliers, standard costing and, 430
Supply chain management, 86
Support departments, 43
Sustainability Reporting Framework, 335, 336
Sustainable development, 332. See also Envi-
ronmental cost(s)
Swedberg, Claire, 106n
Tanaka, T., 655n
Tani, T., 657n
Target cost(s), 653
Target costing, 652–658
activity-based costing and, 656–657
key principles of, 654–655
value engineering and, 657–658
Target profit, 276–277
Task analysis, 412
Tax(es). See Income taxes
Tax Reform Acts of 1986, 1989, and 1993, 695
Tear-down methods, 658
Theoretical capacity, 20
Theory of constraints (TOC), 512, 607
Throughput-based costing systems. See
Volume-based costing systems
Throughput time, 101
Thurm, S., 552n
Time-adjusted rate of return, 682
Time and material pricing, 658–659
Time and motion studies, 243
Timeliness of information, 591
Time periods, income reconciliation under
absorption and variable costing and, 323
Time records, 87
Tita, B., 603n
TOC. See Theory of constraints (TOC)
Tonner, Andrew, 8n
Total contribution margin, 270, 279, 477
Total-cost approach to discounted cost-flow
analysis, 689
Total cost curve, profit-maximizing pricing
and, 644, 645
Total cost in weighted-average method of
process costing, 142–143
Total productivity, 514
Total quality control (TQC), 292–294
Total quality management (TQM), 328
Total revenue curve, profit-maximizing pricing
and, 642–644
TQM. See Total quality management (TQM)
Transfer prices, 544
cost-based, 565–566
Transfer pricing, 559–568
based on external market price, 563–564
cost-based transfer prices and, 565–566
general transfer-pricing rule and, 560–563
goal congruence and, 559–560, 561–563
income taxes and, 566–567
international perspective on, 566–568
negotiated transfer prices and, 564–565
SG&A. See Selling, general and administrative
expense (SG&A) budget
Shank, J., 655n
Shareholder value analysis, 551
Sherman Act, 661
Shimizu, N., 657n
Siegel, Gary, 5n
Simons, Robert L., 516n
Simple regression, 242
Simplex algorithm, 618
Six Sigma program, 328, 330
Skimming pricing, 653
Smith, Carl S., 469n
Smith, Debra A., 107
Social environmental costs, 332–333
Solieri, Steven A., 25n
Soloway, Lewis J., 182n
Sopariwala, Parvez, 421n
Soueo, Anne, 107n
Source documents, 86
SOX. See Sarbanes-Oxley Act of 2002 (SOX)
Split-off point, 604, 744
Spreadsheets, electronic. See Electronic
spreadsheets
Staff positions, 15
Stambaugh, C. T., 106n
Standard cost(s), 410–411
actual costs versus, transfer pricing and, 566
actual output and, 415–416
advantages of, 428–429
cost variance and. See Cost variances
cutting by sacrificing quality, 431
at Parker Hannifin, 421
product costing and, 427–428
Standard-costing systems, 428
advantages of, 428–429
behavioral impact of, 425–426
journal entries under, 475–476
misstated standards and, 472–473
overhead application in, 459–460
suppliers and, 430
in today’s manufacturing environment,
429–431
Standard direct-labor quantity, 415
Standard direct-labor rate, 415
Standard direct-material price, 415
Standard direct-material quantity, 415
Standard quantity allowed, 418
Stanley, Bruce, 517n
Statement of cash flows, budgeted, master
budget and, 370
Statement of Ethical Professional Practice
(IMA), 26
Static budgets, 455
Static tear-down, 658
Statistical control charts, 425
Step-down method for service department cost
allocation, 737–738, 739
Step-fixed costs, behavior of, 229–231
Step-variable costs, behavior of, 228–229
Stohr, Greg, 25n
Storyboarding, for activity-based costing data
collection, 180–181
Straight-line depreciation, modified acceler-
ated cost recovery system and, 697
Strategic cost management, 20
Strategic Finance, 24
Sales-volume variance, 478
Salvage values, modified accelerated cost
recovery system and, 697
Sandberg, Jared, 58n
Sarbanes-Oxley Act of 2002 (SOX), 25, 569n,
760–763
internal controls and, 761
Public Company Accounting Oversight
Board and, 762
Sections 302 and 404 of, 762–763
Scannell, Kara, 25n
Scatter diagrams, 237
Schedule of cost of goods manufactured, 44,
97, 98
budgeted, master budget and, 375
Schedule of cost of goods sold, 44, 97, 99
budgeted, master budget and, 375
Schmeisser, Wilhelm, 519n
Scrap in today’s production environment and, 512
Seannell, K., 552n
Sechler, B., 603n
Segmented income statements, 509–510, 511
Segmented reporting, 509–512
contribution format and, 510, 511
customer-profitability analysis and activity-
based costing and, 511–512
key features of, 511
segments versus segment managers and,
510–511
Selling, general and administrative expense
(SG&A) budget, 365–366
Selling and administrative costs, in job-order
costing system, 94–95
Selling costs, 38
Sell-or-process further decisions, 603–605
Semivariable costs, behavior of, 231–232
Sensitivity analysis, 284, 607–608, 618
Separable processing costs, 605
Service department(s), 43, 102
Service department cost allocation, 102,
734–743
activity-based costing and, 744
in advanced manufacturing environment,
743–744
of budgeted costs, 743
direct method for, 737
dual, 741–743
fixed versus variable costs and, 739–741
reciprocal-services method for, 738–739,
749–750
step-down method for, 737–738, 739
Service industry firms
activity-based costing in, 188–192
costs in, 56–58
cost standard use by, 413
differential costs in, 57
direct costs in, 56–57
flexible budgeting in, 470–472
marginal costs in, 57
operational budgets of, 357
out-of-pocket cost in, 57
period costs in, 56
product costing in, 81
production costs in, 44, 46
sunk costs in, 57
transfer pricing in, 568
uncontrollable costs in, 57
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809 Index of subjects
WACC. See Weighted-average cost of capital
(WACC)
Webb, Alex, 22n
Web companies. See E-commerce
Weighted-average cost of capital (WACC),
551–552
Weighted-average method of process costing,
138–139, 141–144
Weighted-average unit contribution margin, 282
Welch, D., 22n
Welch, Jack, 330, 358
Welch, Suzy, 358n
Welsh, Mary Jeanne, 336n
Wentzel, Kristin, 336n
Wheelwright, S., 41n
Wine industry, process costing in, 140
Work centers, 43
Working capital, 698–699
Work-in-process inventory, 41
Work-in-Process Inventory account, 81, 82
Worthy, Ford S., 177n
Wrappe, S. C., 567n
Wright, P. T., 243
XML. See Extensible Markup Language (XML)
Young, S., 58n
Young, Shawn, 58n
Yuan, L., 58n
Zaino, Jennifer, 106n
Zero defect level, 327–328
Value added, economic, 551–552
pay for performance based on, 552
Value chain, 18–20
Value-chain orientation, target costing
and, 655
Value engineering (VE), 657–658
Variable cost(s), 47–48, 234
behavior of, 227–228
cost-based transfer prices and, 565
direct labor as, 245
fixed costs versus, service department cost
allocation and, 739–741
in service industry, 56
Variable costing, 319
absorption costing compared with, 319
cost-volume-profit analysis and, 323–324
evaluation of, 324–325
income reconciliation under, 321–323
income statements and, 321
Variable-cost pricing, product costs and, 649
Variable-overhead efficiency variance, 462,
463–464
Variable-overhead spending variance, 462–465
Varmazis, Maria, 430n
VE. See Value engineering (VE)
Velocity, 514
Verschoor, C., 763n
Visible environmental costs, 333–335
Visual-fit method of cost estimation, 237–238
Volume-based cost drivers, 88
Volume-based costing systems, 167–168
product cost distortion by, 175–178, 179
in service industry, 568
standard versus actual costs and, 566
undermining of divisional autonomy by, 566
Transferred-in costs, 135
Treasurers, 16
Turney, Peter B. B., 182n
Two-dimensional activity-based costing model,
182, 183
Two-stage allocation, 102n
Two-stage cost allocation, 102–103
Unauthorized action, prevention of, 569
Unavoidable expenses, 601
Uncontrollable costs, 51–52
in service industry, 57
Underapplied overhead, in job-order costing
system, 95–97
Unfavorable variances, 416
Unique decisions, 591–592
Unit contribution margin, 477
changes in, cost-volume-profit analysis and,
278–279
weighted-average, 282
Unit costs
outsourcing decisions and, 600–601
in weighted-average method of process
costing, 142
Unit-level activities, 169, 170
Unit variable expenses, changes in,
cost- volume-profit analysis and, 278
Upton, D., 41n
Utility cost pools, 506
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Cover
Title
Copyright
Contents
1 The Changing Role of Managerial Accounting in a Dynamic Business Environment
Managerial Accounting as a Career
Professional Organizations
Professional Certification
Managerial Accounting: A Business Partnership with Management
Managing Resources, Activities, and People
Decision Making
Planning
Directing Operational Activities
Controlling
How Managerial Accounting Adds Value to the Organization
Objectives of Managerial Accounting Activity
M.A.P. Using Managerial Accounting to Monetize the Internet
The Balanced Scorecard
Managerial versus Financial Accounting
Managerial Accounting in Different Types of Organizations
Where Do We Find Managerial Accountants in an Organization?
Organization Chart
Cross-Functional Deployment
Physical Location
The Operational Context of Managerial Accounting
Managerial Accounting and the Value Chain
Capacity and Capacity Costs
M.A.P. Managing the Costs of Unused Capacity in the Auto Industry: A Global Challenge
Cost Management Systems
Managerial Accounting and the Ethical Climate of Business
Focus on Ethics: IMA Statement of Ethical Professional Practice
Chapter Summary
Key Terms
Review Questions
Exercises
Problems
Cases
2 Basic Cost Management Concepts
What Do We Mean by a Cost?
Product Costs, Period Costs, and Expenses
Costs on Financial Statements
Income Statement
Balance Sheet
Manufacturing Operations and Manufacturing Costs
Assembly Manufacturing
Manufacturing Costs
Manufacturing Cost Flows
Production Costs in Service Industry Firms and Nonprofit Organizations
Basic Cost Management Concepts: Different Costs for Different Purposes
The Cost Driver Team
Variable and Fixed Costs
M.A.P. Understanding Exploding Health Care Costs
The Cost Management and Control Team
M.A.P. How Airlines Spend your Airfare
The Outsourcing Action Team
Costs and Benefits of Information
Costs in the Service Industry
Focus on Ethics: Was WorldCom’s Controller Just Following Orders?
Chapter Summary
Review Problems on Cost Classifications
Key Terms
Review Questions
Exercises
Problems
Cases
3 Product Costing and Cost Accumulation in a Batch Production Environment
Product and Service Costing
Product Costing in Nonmanufacturing Firms
Flow of Costs in Manufacturing Firms
Types of Product-Costing Systems
Job-Order Costing Systems
Process-Costing Systems
Summary of Alternative Product-Costing Systems
Accumulating Costs in a Job-Order Costing System
Job-Cost Record
Direct-Material Costs
Direct-Labor Costs
Manufacturing-Overhead Costs
M.A.P. Supply Chain Management
Summary of Event Sequence in Job-Order Costing
Illustration of Job-Order Costing
Purchase of Material
Use of Direct Material
Use of Indirect Material
Use of Direct Labor
Use of Indirect Labor
Incurrence of Manufacturing-Overhead Costs
Application of Manufacturing Overhead
Summary of Overhead Accounting
Selling and Administrative Costs
Completion of a Production Job
Sale of Goods
Underapplied and Overapplied Overhead
Schedule of Cost of Goods Manufactured
Schedule of Cost of Goods Sold
Posting Journal Entries to the Ledger
Further Aspects of Overhead Application
Actual and Normal Costing
Choosing the Cost Driver for Overhead Application
Departmental Overhead Rates
Two-Stage Cost Allocation
Project Costing: Job-Order Costing in Nonmanufacturing Organizations
Changing Technology in Manufacturing Operations
EDI and XML
Use of Bar Codes and RFID Systems
M.A.P. Radio Frequency Identification Systems (RFID)
Focus on Ethics: Did Boeing Exploit Accounting Rules to Conceal Cost Overruns and Production Snafus?
Chapter Summary
Review Problem on Job-Order Costing
Key Terms
Review Questions
Exercises
Problems
Cases
4 Process Costing and Hybrid Product-Costing Systems
Comparison of Job-Order Costing and Process Costing
Flow of Costs
Differences Between Job-Order and Process Costing
Equivalent Units: A Key Concept
Equivalent Units
Illustration of Process Costing
Basic Data for Illustration
M.A.P. New York Wine Industry
Weighted-Average Method of Process Costing Other Issues in Process Costing
Actual versus Normal Costing
Other Cost Drivers for Overhead Application
Subsequent Production Departments
Hybrid Product-Costing Systems
Operation Costing for Batch Manufacturing Processes
Chapter Summary
Review Problem on Process Costing
Key Terms
Review Questions
Exercises
Problems
Case
5 Activity-Based Costing and Management
Traditional, Volume-Based Product-Costing System
Trouble in Denver
Activity-Based Costing System
ABC Stage One
ABC Stage Two
Interpreting the ABC Product Costs
The Punch Line
Why Traditional, Volume-Based Systems Distort Product Costs
M.A.P. Cost Distortion at Rockwell International
Activity-Based Costing: Some Key Issues
Cost Drivers
M.A.P. Cost Distortion at DHL Express
Collecting ABC Data
Activity Dictionary and Bill of Activities
Activity-Based Management
Two-Dimensional ABC
Using ABM to Identify Non-Value-Added Activities and Costs
Customer-Profitability Analysis
Illustration of Customer-Profitability Analysis
M.A.P. Customer Profitability Analysis at Bank One Corp.
Activity-Based Costing in the Service Industry
Activity-Based Costing at Delaware Medical Center
Interpreting the Primary Care Unit’s ABC Information
Focus on Ethics: Ethical Issues Surrounding Activity-Based Costing
Chapter Summary
Review Problems on Cost Drivers and Product-Cost Distortion
Key Terms
Review Questions
Exercises
Problems
Cases
6 Activity Analysis, Cost Behavior, and Cost Estimation
Cost Behavior Patterns
Variable Costs
Step-Variable Costs
Fixed Costs
Step-Fixed Costs
Semivariable Cost
Curvilinear Cost
Using Cost Behavior Patterns to Predict Costs
M.A.P. Is Direct Labor a Variable or a Fixed Cost?
Engineered, Committed, and Discretionary Costs
Cost Behavior in Other Industries
Cost Estimation
Account-Classification Method
Visual-Fit Method
High-Low Method
Least-Squares Regression Method
Multiple Regression
Data Collection Problems
Engineering Method of Cost Estimation
Effect of Learning on Cost Behavior
Focus on Ethics: Cisco Systems, Walmart, Taco Bell, Starbucks, U-Haul, General Dynamics, and Farmer’s Insurance: Is Direct Labor a Variable Cost?
Chapter Summary
Review Problems on Cost Behavior and Estimation
Key Terms
Appendix to Chapter 6: Least-Squares Regression Using Microsoft® Excel
Review Questions
Exercises
Problems
Cases
7 Cost-Volume-Profit Analysis
Illustration of Cost-Volume-Profit Analysis
Projected Expenses and Revenue
The Break-Even Point
Contribution-Margin Approach
Equation Approach
Graphing Cost-Volume-Profit Relationships
Interpreting the CVP Graph
Alternative Format for the CVP Graph
Profit-Volume Graph
Target Profit
Contribution-Margin Approach
Equation Approach
Graphical Approach
Applying CVP Analysis
Safety Margin
Changes in Fixed Expenses
Changes in the Unit Contribution Margin
Predicting Profit Given Expected Volume
Interdependent Changes in Key Variables
CVP Information in Published Annual Reports
M.A.P. Airlines Keep a Close Eye on Break-Even Load Factors
CVP Analysis with Multiple Products
Assumptions Underlying CVP Analysis
Role of Computerized Planning Models and Electronic Spreadsheets
CVP Relationships and the Income Statement
Traditional Income Statement
Contribution Income Statement
Comparison of Traditional and Contribution Income Statements
Cost Structure and Operating Leverage
Operating Leverage
M.A.P. Operating Leverage Helps Web Companies to be Profitable
Cost Structure and Operating Leverage: A Cost-Benefit Issue
M.A.P. Health-Care Costs and Operating Leverage
CVP Analysis, Activity-Based Costing, and Advanced Manufacturing Systems
A Move Toward JIT and Flexible Manufacturing
Chapter Summary
Review Problem on Cost-Volume-Profit Analysis
Key Terms
Appendix to Chapter 7: Effect of Income Taxes
Review Questions
Exercises
Problems
Cases
8 Variable Costing and the Costs of Quality and Sustainability
Section 1: Absorption and Variable Costing
Fixed Manufacturing Overhead: The Key
Illustration of Absorption and Variable Costing
Absorption-Costing Income Statements
Variable-Costing Income Statements
Reconciling Income under Absorption and Variable Costing
Cost-Volume-Profit Analysis
Evaluation of Absorption and Variable Costing
M.A.P. IRS: Unique Product Packaging is an Inventoriable Cost
Section 2: Costs of Assuring Quality
Measuring and Reporting Quality Costs
Changing Views of Optimal Product Quality
M.A.P. Six Sigma for Quality Management and Cost Reduction
ISO 9000 Standards
Section 3: Costs of Environmental Sustainability
Classifying Environmental Costs
Managing Private Environmental Costs
ISO 14000 Standards and the GRI Sustainability Reporting Framework
Focus on Ethics: Incentive to Overproduce Inventory
Chapter Summary
Review Problem on Absorption and Variable Costing
Key Terms
Review Questions
Exercises
Problems
Cases
9 Financial Planning and Analysis: The Master Budget
Financial Planning and Analysis (FP&A) Systems
Purposes of Budgeting
Types of Budgets
The Master Budget: A Planning Tool
Sales of Services or Goods
Sales Forecasting
Operational Budgets
Financing Budgets
M.A.P. The Budget: Valuable Planning Tool or Costly Waste of Time?
Budgeted Financial Statements
Activity-Based Budgeting
Developing the Master Budget
Sales Budget
Purchases Budget
Direct Labor Budget
Production Overhead and SG&A Budgets
Financing Budgets
Budgeted Financial Statements
Summary: Key Features of a Master Budget
Extending the Master Budget for a Manufacturing Firm
Production Budget
Direct-Material Budget
Budgeted Schedule of Cost of Goods Manufactured and Sold
Budgeted Balance Sheet
Assumptions and Predictions Underlying the Master Budget
Financial Planning Models
Budget Administration
M.A.P. Budget Administration at Cornell University
International Aspects of Budgeting
Behavioral Impact of Budgets
Budgetary Slack: Padding the Budget
Participative Budgeting
Focus on Ethics: Is Padding the Budget Unethical?
Chapter Summary
Review Problem on Preparing Master Budget Schedules
Key Terms
Review Questions
Exercises
Problems
Cases
10 Standard Costing and Analysis of Direct Costs
Managing Costs
Management by Exception
Setting Standards
Methods for Setting Standards
Participation in Setting Standards
Perfection versus Practical Standards: A Behavioral Issue
Use of Standards by Service Organizations
Cost Variance Analysis
Direct-Material Standards
Direct-Labor Standards
Standard Costs Given Actual Output
Analysis of Cost Variances
Direct-Material Variances
Direct-Labor Variances
M.A.P. Parker Hannifin Corporation’s Brass Products Division
Multiple Types of Direct Material or Direct Labor
Allowing for Production Loss
Significance of Cost Variances
A Statistical Approach
Behavioral Impact of Standard Costing
Controllability of Variances
Interaction among Variances
Standard Costs and Product Costing
Evaluation of Standard Costing Systems
Advantages of Standard Costing
Criticisms of Standard Costing in Today’s Manufacturing Environment
M.A.P. Working with Suppliers to Manage Costs
Focus on Ethics: Sacrificing Quality to Cut Standard Costs
Chapter Summary
Review Problem on Standard Costing and Analysis of Direct Costs
Key Terms
Appendix to Chapter 10: Use of Standard Costs for Product Costing
Review Questions
Exercises
Problems
Cases
11 Flexible Budgeting and Analysis of Overhead Costs
Overhead Budgets
Flexible Budgets
Advantages of Flexible Budgets
The Activity Measure
Flexible Overhead Budget Illustrated
Formula Flexible Budget
Overhead Application in a Standard-Costing System
Choice of Activity Measure
Criteria for Choosing the Activity Measure
Cost Management Using Overhead Cost Variances
Variable Overhead
Fixed Overhead
Overhead Cost Performance Report
Activity-Based Flexible Budget
M.A.P. Cost Management Systems in Germany
Flexible Budgeting in the Service Industry
Focus on Ethics: Misstated Standards Affect Accuracy of Reports
Chapter Summary
Review Problem on Flexible Budgeting and Analysis of Overhead Costs
Key Terms
Appendix A to Chapter 11: Standard Costs and Product Costing
Appendix B to Chapter 11: Sales Variances
Review Questions
Exercises
Problems
Cases
12 Responsibility Accounting, Operational Performance Measures, and the Balanced Scorecard
Responsibility Centers
Illustration of Responsibility Accounting
Performance Reports
Budgets, Variance Analysis, and Responsibility Accounting
Cost Allocation
Cost Allocation Bases
Allocation Bases Based on Budgets
Activity-Based Responsibility Accounting
Behavioral Effects of Responsibility Accounting
Information versus Blame
Controllability
Motivating Desired Behavior
Segmented Reporting
Segments versus Segment Managers
Key Features of Segmented Reporting
Customer-Profitability Analysis and Activity-Based Costing
Operational Performance Measures in Today’s Production Environment
Gain-Sharing Plans
The Balanced Scorecard
M.A.P. The Balanced Scorecard
Lead and Lag Measures: The Key to the Balanced Scorecard
Linking the Balanced Scorecard to Organizational Strategy
M.A.P. Linking The Balanced Scorecard to Organizational Strategy
Focus on Ethics: Short-Sighted View of Cost Cutting
Chapter Summary
Review Problems on Responsibility Accounting and Operational Performance Measures
Key Terms
Review Questions
Exercises
Problems
Cases
13 Investment Centers and Transfer Pricing
Delegation of Decision Making
Obtaining Goal Congruence: A Behavioral Challenge
Adaptation of Management Control Systems
Measuring Performance in Investment Centers
Return on Investment
Residual Income
Economic Value Added
M.A.P. Pay for Performance Based on Eva
Measuring Income and Invested Capital
Invested Capital
Measuring Investment-Center Income
Inflation: Historical-Cost versus Current-Value Accounting
Other Issues in Segment Performance Evaluation
Alternatives to ROI, Residual Income, and Economic Value Added (EVA)
Importance of Nonfinancial Information
Measuring Performance in Nonprofit Organizations
Transfer Pricing
Goal Congruence
General Transfer-Pricing Rule
Transfers Based on the External Market Price
Negotiated Transfer Prices
Cost-Based Transfer Prices
Standard versus Actual Costs
Undermining Divisional Autonomy
An International Perspective
M.A.P. Transfer Pricing and Tax Issues
Transfer Pricing in the Service Industry
Behavioral Issues: Risk Aversion and Incentives
Goal Congruence and Internal Control Systems
Chapter Summary
Review Problems on Investment Centers and Transfer Pricing
Key Terms
Review Questions
Exercises
Problems
Cases
14 Decision Making: Relevant Costs and Benefits
The Managerial Accountant’s Role in Decision Making
Steps in the Decision-Making Process
Quantitative versus Qualitative Analysis
Obtaining Information: Relevance, Accuracy, and Timeliness
Relevant Information
Unique versus Repetitive Decisions
Importance of Identifying Relevant Costs and Benefits
Identifying Relevant Costs and Benefits
Sunk Costs
Irrelevant Future Costs and Benefits
Opportunity Costs
Summary
Analysis of Special Decisions
Accept or Reject a Special Offer
Outsource a Product or Service
M.A.P. Insourcing Makes a Come-Back
Add or Drop a Service, Product, or Department
M.A.P. Adding a Service
Special Decisions in Manufacturing Firms
Joint Products: Sell or Process Further
Decisions Involving Limited Resources
Uncertainty
Activity-Based Costing and Today’s Advanced Manufacturing Environment
Conventional Outsourcing (Make-or-Buy) Analysis
Activity-Based Costing Analysis of the Outsourcing Decision
Other Issues in Decision Making
Incentives for Decision Makers
Short-Run versus Long-Run Decisions
Pitfalls to Avoid
Focus on Ethics: Effects of Decision to Close a Department and Outsource
Chapter Summary
Review Problem on Relevant Costs
Key Terms
Appendix to Chapter 14: Linear Programming
Review Questions
Exercises
Problems
Cases
15 Target Costing and Cost Analysis for Pricing Decisions
Major Influences on Pricing Decisions
Customer Demand
Actions of Competitors
Costs
Political, Legal, and Image-Related Issues
Economic Profit-Maximizing Pricing
Total Revenue, Demand, and Marginal Revenue Curves
Total Cost and Marginal Cost Curves
Profit-Maximizing Price and Quantity
Price Elasticity
Limitations of the Profit-Maximizing Model
Costs and Benefits of Information
Role of Accounting Product Costs in Pricing
Cost-Plus Pricing
Absorption-Cost Pricing Formulas
Variable-Cost Pricing Formulas
Determining the Markup
M.A.P. Real Time Price Wars
Cost-Plus Pricing: Summary and Evaluation
Strategic Pricing of New Products
Target Costing
M.A.P. Dynamic Pricing on the Internet by “E-Tailers”
A Strategic Profit and Cost Management Process
Activity-Based Costing and Target Costing
Product-Cost Distortion and Pricing: The Role of Activity-Based Costing
Value Engineering and Target Costing
Time and Material Pricing
Competitive Bidding
Effect of Antitrust Laws on Pricing
Chapter Summary
Review Problem on Cost-Plus Pricing
Key Terms
Review Questions
Exercises
Problems
Cases
16 Capital Expenditure Decisions
Section 1: Discounted-Cash-Flow Analysis
Net-Present-Value Method
Internal-Rate-of-Return Method
Comparing the NPV and IRR Methods
Assumptions Underlying Discounted-Cash-Flow Analysis
Choosing the Hurdle Rate
Depreciable Assets
Comparing Two Investment Projects
Managerial Accountant’s Role
Postaudit
Real Option Analysis
Section 2: Income Taxes and Capital Budgeting
After-Tax Cash Flows
Accelerated Depreciation
Modified Accelerated Cost Recovery System (MACRS)
Gains and Losses on Disposal
Investment in Working Capital
Extended Illustration of Income-Tax Effects in Capital Budgeting
M.A.P. Big Pharma Uses Capital Budgeting in Developing New Drugs
Ranking Investment Projects
Section 3: Alternative Methods for Making Investment Decisions
Payback Method
Accounting-Rate-of-Return Method
Estimating Cash Flows: The Role of Activity-Based Costing
Justification of Investments in Advanced Manufacturing Technology
Focus on Ethics: Dysfunctional Focus on Early Cash Flows
Chapter Summary
Review Problems on Capital Expenditure Decisions
Key Terms
Appendix A to Chapter 16: Future Value and Present Value Tables
Appendix B to Chapter 16: Impact of Inflation
Review Questions
Exercises
Problems
Cases
17 Allocation of Support Activity Costs and Joint Costs
Section 1: Service Department Cost Allocation
Direct Method
Step-Down Method
Reciprocal-Services Method
Fixed versus Variable Costs
M.A.P. Cost Reimbursement in the Health Care Industry
Dual Cost Allocation
Allocate Budgeted Costs
Today’s Advanced Manufacturing Environment
The Rise of Activity-Based Costing
Section 2: Joint Product Cost Allocation
Allocating Joint Costs
M.A.P. Joint Cost Allocation in the Petroleum Industry
Chapter Summary
Review Problem on Service Department Cost Allocation
Key Terms
Appendix to Chapter 17: Reciprocal-Services Method
Review Questions
Exercises
Problems
Cases
Appendix I: The Sarbanes-Oxley Act, Internal Controls, and Management Accounting
Appendix II: Compound Interest and the Concept of Present Value
Appendix III: Inventory Management
References for “In Their Own Words”
Glossary
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Photo Credits
Index of Companies and Organizations
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Index of Subjects
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