CHAPTER 1
THE MANAGER AND MANAGEMENT ACCOUNTING
See the front matter of this Solutions Manual for suggestions regarding your choices of
assignment material for each chapter.
Management accounting information is specifically provided for the internal usage of
organizations, and the preparation and presentation of management accounting reports are not
governed by standardized rules and regulation. Management accounting reports have no definite
time frame for preparation. Management accounting reports combine historical data with present
data for the purpose of influencing the future. Thus, it is considered futuristic in nature. The
objective of management accounting is to provide financial information to managers to enable
them to effectuate their planning, control and decision-making responsibilities.
Financial accounting reports focus on providing standardized information to external
users or those that do not have access to detailed private information of the entity. The users of
financial accounting reports comprise existing and potential shareholders; employees–both
within and outside the organization; financial and investment analysts; the government; the
company’s auditor; the public at large to mention a few. The preparation of financial accounting
statements is governed by rules and regulations commonly referred to as generally accepted
accounting principles (GAAP). These reports are usually presented to stakeholders on an annual
basis. Due to the historical nature of financial accounting reports, the degree of estimation and
approximation allowable in the course of writing the report is limited. The objective of financial
accounting reports is firstly to fulfil the doctrine of stewardship in accounting and secondly to
meet the statutory or regulatory requirement. It also provides information primarily to external
decision-makers (even employees might need it for their private decision-making) about
providing resources to the entity.
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Note: Financial accounting is regulated in some jurisdictions by the International Financial
Reporting Standard (IFRS) for private firms and the International Public Sector Accounting
Standards (IPSAS) in the government sector. There are also national accounting standards for
preparation of financial information. This therefore implies that management accounting reports
are influenced by guidelines or legislations. For example, IAS 2 outlines how inventories can be
valued, and what production costs should be included in inventory valuation.
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Financial accounting is governed by generally accepted accounting principles (GAAP).
Management accounting does not suffer such restrictions to these principles. The net effect is
that
 Management accounting allows managers to charge interest on owners’ capital to help
appraise a division’s performance, whereas such a charge is not permissible under GAAP.
 Financial accounting reports must be prepared in accordance with statutory requirements
(Companies Law, IFRS, IPSAS, GAAP, etc.), whereas no such legal requirements are there
for management accounting.
 Financial accounting reports focus more on historical information, whereas management
accounting places greater emphasis on reporting future costs and revenues.
 Management accounting reports are produced at intervals that are more frequent and are
less accurate as they are based on estimates.
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 Management accounting can include assets or liabilities (such as “brand names” developed
internally) not recognized under GAAP.
 Management accounting can use asset or liability measurement rules (such as present
values or resale prices) not permitted under GAAP.”
Note: Under the IFRS jurisdictions, the preparation of financial statements must comply with
both the format prescribed by the Standards and further disclosures required. This is not the case
with management accounting.
Management accounting information helps manager to develop, communicate, and
implement strategies by answering the following questions, which could contribute to an
effective formulation of the strategies:
 Who are our most important customers, and what critical capability do we have to be
competitive and deliver value to our customers?
 What are the bargaining power of our customers, and our suppliers?
 What substitute products exist in the marketplace, and how do they differ from our
products in terms of features, price, cost, and quality?
 Will adequate cash be available to fund the strategy, or will additional funds need to be
raised?
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Value chain analysis helps organizations to assess their competitive advantage by
determining the implications of all strategic activities to the organization. Cost accounting
provides the financial analysis of each of the strategic activities. Cost accounting provides the
financial estimates by undertaking the following analysis:
1. Internal cost analysis: this involves estimating the cost of each internal value chain
process, determining the financial implications and viability.
2. Vertical linkage analysis: this cost analysis estimates the sources of differentiation within
internal value-creating processes. Vertical linkages require obtaining information on
operating costs, revenues and assets for each process throughout the industry’s value
chain.
3. Internal differentiation analysis: this analysis requires the estimation of the effect of cost
supplies and other processes within the value chain and the business performance.
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Supply chain describes the flow of goods, services, and information from the initial
sources of materials and services to the delivery of products to consumers, regardless of whether
those activities occur in one organization or in multiple organizations.
Cost management is most effective when it integrates and coordinates activities across all
companies in the supply chain as well as across each business function in an individual
company’s value chain. Attempts are made to restructure all cost areas to be more cost-effective.
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Management accounting is concerned largely with looking at current issues and problems
and the future in terms of decision-making and forecasting. As management accounting outputs
are mainly for internal users, a confidential report is usually produced before the directors of the
company.
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Management accounting enables organizations in the following decision-making
activities: forecasting revenues and costs, planning activities, managing cost, identification of
sources and costs of funding, evaluation of investments, measurement and controlling
performance. Management accounting is therefore involved in managing the scorecard of the
firm.
Management accounting provides forward-looking information to help managers plan
and control operations as they lead the business. This includes managing the company’s plant,
equipment, and human resources.
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Management accountants can help improve quality and achieve timely product deliveries
by recording and reporting an organization’s current quality and timeliness levels and by
analyzing and evaluating the costs and benefits—both financial and nonfinancial—of new
quality initiatives, such as TQM, relieving bottleneck constraints, or providing faster customer
service.
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The five-step decision-making process is (1) identify the problem and uncertainties;
(2) obtain information; (3) make predictions about the future; (4) make decisions by choosing
among alternatives; and (5) implement the decision, evaluate performance, and learn.
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Planning decisions focus on selecting organization goals and strategies, predicting results
under various alternative ways of achieving those goals, deciding how to attain the desired goals,
and communicating the goals and how to attain them to the entire organization.
Control decisions focus on taking actions that implement the planning decisions, deciding
how to evaluate performance, and providing feedback and learning to help future decision
making.
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The three guidelines for management accountants are:
1. Employ a cost-benefit approach.
2. Recognize technical and behavioral considerations.
3. Apply the notion of “different costs for different purposes.”
Agree. Technical and basic analytical competences are necessary for preparing and
interpreting management accounting reports. However, these competencies are insufficient.
Management accountants are required to know:
a) how to work well in cross-functional teams and be an efficient business partner;
b) how to possess high integrity, and communicate clearly, openly and candidly;
c) how to lead and motivate people to change and be innovative;
d) how to promote fact-based analysis and make tough-minded, critical judgments without
being adversarial.
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The new controller could reply in one or more of the following ways:
a) Explain to the plant manager how he or she could benefit from activities and tasks
performed by accountants and the controller such as ‘reporting and interpreting relevant
data’ and highlight how the controller can influences the behavior of all employees and
helps line managers make better decisions.
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b) Demonstrate to the plant manager how accountants and the controller can help them with
Global Financial Planning/Budgeting and making correct decision/s when there is a
variation between budgeted costs and actual costs.
c) Demonstrate to the plant manager how accountants and the controller can help them in
identifying and analyzing problem situations and evaluating financial and nonfinancial
aspects of different alternatives, such capital budgeting, make or buy decisions, special
prices, outsourcing decisions, product-mixed decisions, etc.
d) Demonstrate to the plant manager that what accountants and the controller can do is not a
duplication of what accounting software and packages are capable of, and provide them
with a list of activities which need more in depth insights from accountants and the
controller such as customer satisfaction reporting, profitability reporting, performance
reporting and etc.
e) Explain that while the existing accounting software is able to provide information for the
smooth operation of current operational activities, the controller would be able to provide
information that would help the manager to become aware of and prepare for shifts in the
external environment, which would require changes in production processes.
1-13 The controller is the chief management accounting executive. The corporate controller
reports to the chief financial officer, a staff function. Companies also have business unit
controllers who support business unit managers or regional controllers who support regional
managers in major geographic regions.
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1. Setting professional ethical standards is important due to the following facts:
 They offer confidence in the employee-employer affiliation,
 Standards embody a locus point of reference for management accountants
confronted with ethical impasses;
 They allow for an assurance to the information users that the quality and integrity
of the information made available by the management accountants is without
doubt.
2. The five fundamental principles of ethics for professional management accountants as
advanced by the Chartered Institute of Management Accountants (CIMA) are:
There are five fundamental principles of ethics for professional management
accountants:
(a) Integrity — to be straightforward and honest in all professional and business
relationships
(b) Objectivity — not to compromise professional or business judgments because of
bias, conflict of interest or undue influence of others.
(c) Professional competence and due care to:
(i) Attain and maintain professional knowledge and skill at the level required to
ensure that a client or employing organization receives competent professional
service, based on current technical and professional standards and relevant
legislation; and
(ii) Act diligently and in accordance with applicable technical and professional
standards.
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(d) Confidentiality - to respect the confidentiality of information acquired as a result of
professional and business relationships.
(e) Professional behavior — to comply with relevant laws and regulations and avoid
any conduct that the professional accountant knows or should know might
discredit the profession.
When basic ethics is weak, suppliers might not improve the quality of their products or
lower the costs while at the same time win supply contracts by bribing executives. This situation
can lead to customers’ dissatisfaction when they receive low quality products at a high price.
When the quality of products is low, customers are discouraged to buy them, causing the market
to fail.
The price of products increases as a result of higher prices (which incorporate the bribes)
paid to suppliers while fewer products being produced and sold.
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Choice ‘c’ is correct. Preparation of financial statements and cash flow statement are not
the responsibilities of the management accountant. This is usually handled by the financial
accountant.
Choice ‘a’ Preparation of cost estimates, project planning, and analysis, Choice ‘b’
Budgetary controls and investigation, and Choice ‘d’ Performance evaluation and reporting are
all duties of the management accountant.
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(15 min.) Value chain and classification of costs, computer company.
Cost Item
a.
b.
c.
d.
e.
f.
g.
h.
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(15 min.)
Cost Item
a.
b.
c.
d.
e.
f.
g.
h.
Value Chain Business Function
Production
Distribution
Design of products and processes
Research and development
Customer service or marketing
Design of products and processes
(or research and development)
Marketing
Production
Value chain and classification of costs, pharmaceutical company.
Value Chain Business Function
Marketing
Design of products and processes
Customer service
Research and development
Marketing
Production
Marketing
Distribution
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(15 min.) Value chain and classification of costs, fast-food restaurant.
Cost Item
a.
b.
c.
d.
e.
f.
g.
h.
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Value Chain Business Function
Production
Distribution
Production
Production
Marketing
Marketing
Design of products and processes (or research and development)
Customer service
(10 min.) Key success factors.
Change in Operations/
Management Accounting
a.
b.
c.
d.
e.
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Key Success Factor
Innovation
Cost and efficiency and quality
Time and cost and efficiency
Innovation, sustainability, and cost and efficiency
Cost and efficiency
(10 min.) Key success factors.
Change in Operations/
Management Accounting
a.
Key Success Factor
Cost and efficiency, quality, and
sustainability
Cost and efficiency, time
Cost and efficiency
Efficiency, time and quality
Innovation, cost and efficiency, and
quality
b.
c.
d.
e.
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(10–15 min.) Planning and control decisions.
Action
a.
b.
c.
d.
e.
Decision
Planning
Control
Control
Planning
Planning
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(10–15 min.) Planning and control decisions.
Action
a.
b.
c.
d.
e.
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Decision
Planning
Planning
Control
Planning
Control
(10 mins.) Five-step decision-making process.
The five-step decision-making process includes:
a.
b.
c.
d.
e.
Identification of the problem and uncertainties.
Obtaining relevant information.
Make predictions about the future.
Make decisions by choosing among alternatives.
Implementation of decision, evaluation of performance and learning curve.
Identification of the problem and uncertainties: they have to identify where to obtain
the additional $15,000 from. What is the certainty that the bank will offer them the loan?
Are there other alternative sources of finance if the bank refuses to offer them the loan?
Obtaining relevant information: they have to obtain information on the number of
customers which justifies the expansion. Would this expansion increase demand or
require an increase in price?
Make predictions about the future: how many units will be produced following the
expansion? What will be the sales figure and demand? They will need to estimate the
breakeven units required to cover the costs of the expansion.
Make decisions by choosing among alternatives: based on the above analysis, they
have to decide whether to go ahead with the expansion or maintain the current level of
production.
Implementation of decision, evaluation of performance and learning curve: if the
loan is obtained and the expansion is carried out, they will compare and analyze the
actual sales with the breakeven. Where the actual sales vary from the breakeven,
investigation of the variances will be carried out to establish the cause and correct further
shortfalls.
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(15 min.) Five-step decision-making process, service firm.
Action
a.
b.
c.
d.
e.
f.
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Step in Decision-Making Process
Make decisions by choosing among alternatives.
Identify the problem and uncertainties through obtaining
information.
Obtain information and/or make predictions about the future.
Obtain information and/or make predictions about the future.
Make predictions about the future.
Obtain information.
(10–15 min.) Professional ethics and reporting division performance.
1. Wilson’s ethical responsibilities are well summarized in the IMA’s “Standards of Ethical
Conduct for Management Accountants” (Exhibit 1-7 of text). Areas of ethical responsibility
include the following:
 Competence
 Confidentiality
 Integrity
 Credibility
The ethical standards related to Wilson’s current dilemma are integrity, competence, and
credibility. Using the integrity standard, Wilson should carry out duties ethically and
communicate unfavorable as well as favorable information and exercise his professional
judgments and/or opinions. Competence requires Wilson to perform his professional duties in
accordance with relevant laws, regulations, and technical standards and provide decision support
information that is accurate. Credibility requires that Wilson report information fairly and
objectively and disclose deficiencies in internal controls in conformance with organizational
policy and/or applicable law. Wilson should refuse to include the $150,000 of defective
inventory. Both financial accounting and management accounting principles maintain that once
inventory is determined to be unfit for sale, it must be written off. It may be just a timing issue
but reporting the $150,000 of inventory as an asset would be misleading to the users of the
company’s financial statements.
2. Wilson should refuse to follow Leonard’s orders. If Leonard persists, the incident should be
reported to the corporate controller of Garman Enterprises. Wilson should support his line
management wholeheartedly without jeopardising his ethical conduct.
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(10–15 min.) Professional ethics and reporting division performance.
Gilpin’s ethical responsibilities are well summarized in the IMA’s “Standards of Ethical
Conduct for Management Accountants” (Exhibit 1-7 of text). Areas of ethical responsibility
include the following:
 Competence
 Confidentiality
 Integrity
 Credibility
1.
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The ethical standards related to Gilpin’s current dilemma are integrity, competence and
credibility. Using the integrity standard, Gilpin should carry out duties ethically, and
communicate unfavorable and favorable information, professional judgments as well as opinions.
Competence demands that Gilpin perform her professional duties in accordance with relevant
laws, regulations, and technical standards, providing accurate decision support information.
Credibility requires that Gilpin report information fairly, objectively, and disclose deficiencies in
internal controls in conformance with organizational policy and/or applicable law. Gilpin should
use her professional judgment to decide if reclassifying the costs of packing materials is
appropriate according to accounting principles. She should not take a decision solely on the basis
of avoiding overhead cost allocation.
2. Gilpin should discuss her concerns with Myers. Any overhead not allocated to Blakemore
would be allocated to other divisions of Eastern Glass and Window. Gilpin may want to consider
consulting the IMA for ethical guidance. Support for line management should be wholehearted,
but it should not entail unethical conduct.
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(15 min.) Planning and control decisions, Internet company.
1.
Planning decisions
a. Decision to raise monthly subscription fee from July
c. Decision to offer e-mail service to subscribers and upgrade content of online services
(later decision to inform subscribers and upgrade online services is an implementation
part of control)
e. Decision to decrease monthly subscription fee starting in November.
Control decisions
b. Decision to inform existing subscribers about the rate of increase—an implementation
part of control decisions
d. Dismissal of VP of Marketing—performance evaluation and feedback aspect of
control decisions
2.
Other planning decisions that may be made at PostNews.com: decision to raise or lower
advertising fees; decision to charge a fee from on-line retailers when customers click-through
from PostNews.com to the retailers’ websites.
Other control decisions that may be made at PostNews.com: evaluating how customers
like the new format for the weather information and evaluating whether the waiting time for
customers to access the website has been reduced.
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(20 min.) Strategic decisions and management accounting.
1. The strategies the companies are following in each case are:
a. Product differentiation strategy
b. Cost leadership strategy
c. Cost leadership strategy
d. Product differentiation strategy
2. Examples of information the management accountant can provide for each strategic decision
follow:
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a.
b.
c.
d.
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Market share of the close competitors in anti-ageing cream
Price of close competitive products
Costs of producing anti-ageing cream with natural ingredients
Total investments in the microprocessor
Cost advantages for the developed technology
Sensitivity of target bulk customers to change in price of microprocessor
Total investments for installing bio-metric system and sources of fund
Estimated monetary value for increase in productivity and efficiency
Effect of cost advantages on product pricing
Number of remote customers who are willing to take telemedicine service
Potential increased sales as a result of telemedicine service
Price charged by other companies who provide similar service
(20 min.) Strategic decisions and management accounting.
1. The strategies the companies are following in each case are:
a. Product differentiation strategy
b. Cost leadership or low-price strategy
c. Cost leadership or low-price strategy
d. Product differentiation strategy
2. Examples of information the management accountant can provide for each strategic decision
are as follows:
a. Cost to produce and sell special tetrazzini
Prices of tetrazzini sold by other competitors
The customers which the company may target to sell its special tetrazzini
Extra price the customers would be willing to pay considering the specialty of the
product
Yearly cash surplus after producing and selling special tetrazzini
b. Cost of producing the low-cost soap
Price of the homogenous products produced by the competitors
The present surplus production capacity of Vanford Soap
Market size of the low-cost soap in terms of sales volume
Estimated growth in the low-cost soap market in terms of sales volume and revenue
Sensitivity of target customers to price and quality
c. Cost of producing the drill machine as per the specification of the tender
The present surplus production capacity of Diato Inc.
Price of the homogenous products produced by the competitors who may compete for
the tender
Minimum order size to reach the break-even-point
Cash surplus that is going to be achieved by producing and selling 1,000 drill
machines
d. Cost to produce and sell the newly featured tablet
Present cash surplus of Smart Pixel to develop, produce, and sell the newly featured
tablet
Prices of tablets with standard features sold by other competitors
Price sensitivity of the target customers
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Present market size of tablets in terms of sales volume
Premium price the target customers will be willing to pay for the new features
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(10–15 min.) Management accounting guidelines.
a. Cost-benefit approach: managers continually face resource-allocation decisions, such as
decisions on the purchase of machinery, establishment of a new branch, or building of new
factory. The cost-benefit approach helps managers to weigh both the costs and expected
returns from such projects before making the decision.
b. Behavioral and technical considerations: Behavioral consideration impels managers to
discuss issues with their employees on any aspect of the organization. Such interaction creates
opportunity to understand both the needs of staff and the strategic focus of the organization.
Technical considerations enable managers to make wise economic decisions by providing
desired information in an appropriate format and at the required intervals.
c. Different costs for different purposes: Managers apply various ways in computing costs
depending on whether the costs evaluation is for external or internal use. For example, costs
that are inherent to a project may be written off or capitalized depending on the judgement of
the management in assessing the performance of the project.
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1.
2.
3.
4.
5.
6.
7.
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(15 min.) Management accounting guidelines.
Cost-benefit approach
Cost-benefit approach and/or behavioral and technical considerations (for example: how
the overall morale of employees will be impacted due to retrenchment, and whether the
machines will operate normally after the new start-up)
Different costs for different purposes
Cost-benefit approach or behavioral and technical considerations (for example: how
employees will react to more supervisory control)
Cost-benefit approach or behavioural and technical consideration (for example: how to
design the performance bonus to correctly improve productivity without sacrificing other
aspects)
Cost-benefit approach
Cost-benefit approach and/or behavioral and technical considerations (for example: how
employees will react to the production process)
(20 min.) The roles of chief financial officer (CFO) and controller
The roles of the CFO include:
Controllership – the CFO provides financial information for reports to managers and
shareholders and oversees the overall operations of the accounting system.
Tax – the CFO plans all tax liabilities and receipts of the business including value added tax
(VAT)
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Treasury – the CFO oversees banking, short and long-term financing, investments and cash
management of the business.
Risk management – the CFO manages the financial risk resulting from interest rate and exchange
rate changes, and the management of the derivatives.
Investor relations – the CFO communicates with stakeholders of the organization including the
shareholders, suppliers and investors.
Strategic planning – the CFO defines the financial strategy of the organization and allocates
resources to implement such strategies.
The roles of the controller (also known as chief accounting officer) include:
Globally financial planning
Budget preparation
Managing working capital
Profitability reporting
Subsidiary and liaison accounting
Figure 1: Flowchart indicating the roles and relationship between CFO and financial controller.
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(30 min.) Pharmaceutical company, budgeting, ethics.
1.
The overarching principles of the IMA Statement of Ethical Professional Practice are
Honesty, Fairness, Objectivity and Responsibility. The statement’s corresponding “Standards for
Ethical Behavior…” require management accountants to




Perform professional duties in accordance with relevant laws, regulations, and
technical standards.
Refrain from engaging in any conduct that would prejudice carrying out duties
ethically.
Communicate information fairly and objectively.
Provide all relevant information that could reasonably be expected to influence an
intended user’s understanding of the reports, analyses, or recommendations.
The idea of capitalizing some of the company’s R&D expenditures (item c) is a direct
violation of the IMA’s ethical standards above. This transaction would not be “in accordance
with relevant laws, regulations, and technical standards.” GAAP requires research and
development costs to be expensed as incurred. Even if Maddox believes his transaction is
justifiable, it violates the profession’s technical standards and would be unethical.
The other “year-end” actions occur in many organizations and fall into the “gray” to
“acceptable” area. Much depends on the circumstances surrounding each one, however, such as
the following:
a. Cut planned bonuses to the Amiven R&D team that would be paid in the third
quarter, knowing that doing so may result in lower productivity and increased
turnover of highly skilled staff. This solution is not a violation of ethical standards,
but this action may not be in the best interest of the company in the long run.
Reducing bonuses may help achieve the budget but losing highly skilled employees
would harm the company’s ability to develop new products in the future and hurt
long-run profits.
b. Sell off rights to the drug, Centrix. The company had not planned on doing this
because, under current market conditions, it would get less than fair value. It would,
however, result in a onetime gain that could offset the budget shortfall. Of course, all
future profits from Centrix would be lost. Again, this solution may solve the
company’s short-term budget crisis, but could result in the loss of future profits for
Pharmex in the long run. If this action does not create value for Pharmex, it would
result in taking an uneconomic action simply to manage accounting earnings in the
third quarter.
2.
While it is not uncommon for companies to sacrifice long-term profits for short-term
gains, it may not be in the best interest of the company’s shareholders. In the case of Pharmex,
the CFO is primarily concerned with “maximizing shareholder wealth” in the immediate future
(third quarter only) but not in the long term. Because this executive’s incentive pay and even
employment may be based on her ability to meet short-term targets, she may not be acting in the
best interest of the shareholders in the long run.
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Maddox definitely faces an ethical dilemma. It is not unethical on Maddox’s part to want
to please his new boss, nor is it unethical that Maddox wants to make a good impression on his
first days at his new job; however, Maddox must still act within the ethical standards required by
his profession. Taking illegal or unethical action by capitalizing R&D to satisfy the demands of
his new supervisor, Emily Alford, is unacceptable. Although not strictly unethical, I would
recommend that Maddox not agree to cut planned bonuses for the Amiven R&D team or sell off
the rights to Centrix. Each of these appears to sacrifice the overall economic interests of Pharmex
for short-run gain. Maddox should argue against doing this but not resign if Alford insists that
these actions be taken. If, however, Alford asks Maddox to capitalize R&D, he should raise this
issue with the chair of the audit committee after informing Alford that he is doing so. If the CFO
still insists on Maddox capitalizing R&D, he should resign rather than engage in unethical
behavior.
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(15-20 min.) Professional standards and management accountants.
The core professional standards governing management accountants include:
1. Competence- Each member:

Has a responsibility to maintain an appropriate level of professional expertise by
continually developing knowledge and skills.
 Performs professional duties in accordance with relevant laws, regulations, and
technical standards. Provide decision support information and recommendations
that are accurate, clear, concise and timely.
 Recognizes and communicates professional limitations or other constraints that
would preclude responsible judgement or successful performance of an entity.
2. Confidentiality - Each member:
 Has a responsibility to keep information confidential except when disclosure is
authorized or legally required.
 Informs all relevant parties regarding appropriate use of confidential information.
Monitor subordinates’ activities to ensure compliance.
 Refrains from using confidential information for unethical or illegal advantage.
3. Integrity: Each member:
 Has a responsibility to mitigate actual conflicts of interest, regularly communicate
with business associates to avoid apparent conflicts of interest.
 Advises all parties of any potential conflicts.
 Refrains from engaging in any conduct that would prejudice carrying out duties
ethically.
 Abstains from engaging in or supporting any activity that might discredit the
profession.
4. Credibility - Each member:
 Has a responsibility to communicate information fairly and objectively.
 Discloses all relevant information that could reasonably be expected to influence
an intended user’s understanding of the reports, analyses, or recommendations.
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
Discloses delays or deficiencies in information, timeliness, processing, or internal
controls in conformance with organization policy and applicable laws.
1-36 (30–40 min.)
Professional ethics and end-of-year actions.
1.
The possible motivations for Controller Sophie Gellar to modify the division’s year-end
earnings are as follows:
(i)
Job security and promotion: The company’s CFO is likely to reward her for
meeting the company’s performance expectations. Alternately, Gellar may be
penalized, perhaps to the extent of losing her job if the division’s performance
expectations are not met.
(ii)
Management incentives: Gellar’s bonus may be based on the division’s ability to
meet certain profit targets. If the House and Home division has already met its
profit target for the year, the Controller may personally benefit if new printing
equipment is sold off and replaced with the discarded equipment that no longer
meets current safety standards, or if operating income is manipulated by
questionable revenue and/or expense recognition.
2.
The overarching principles of the IMA Statement of Ethical Professional Practice are
Honesty, Fairness, Objectivity and Responsibility. The statement’s corresponding “Standards for
Ethical Conduct…” require management accountants to abide by the following principles:
● Perform professional duties in accordance with relevant laws, regulations, and technical
standards.
● Refrain from engaging in any conduct that would prejudice carrying out duties ethically.
● Communicate information fairly and objectively.
● Disclose all relevant information that could reasonably be expected to influence an
intended user’s understanding of the reports, analyses, or recommendations.
Several “year-end” actions are clearly are in conflict with the statement’s principles and required
standards and should be viewed as unacceptable.
(a)
Subscription revenue received in December in advance for magazines that will be
sent out in January or a later date is a liability. Depicting it as revenue falsely
represents next year’s revenue as this year’s revenue.
(b)
Revising the estimate for pension liability and expense would violate Generally
Accepted Accounting Principles unless the pension liability is currently
overstated. Recording this transaction would result in an overstatement of income
and could potentially mislead investors.
(c)
Booking advertising revenues that relate to February in December falsely
represents next year’s revenue as this year’s revenue.
The other “year-end” actions occur in many organizations and fall into the “gray” to
“acceptable” area. Much depends on the circumstances surrounding each one as witnessed
below:
(d)
Cancelling three of the division’s least profitable magazines, resulting in the
layoff of thirty employees. While employee layoffs may be necessary for the
business to survive, the layoff decision could result in economic hardship for
1-15
(e)
(f)
those employees who lose their jobs, as well as result in employee morale
problems for the rest of the division. Most companies would prefer to avoid
causing hardship for their existing employees due to layoffs unless necessary for
the survival of the business as a whole.
Selling the new printing equipment that was purchased in February and replacing
it with discarded equipment from one of the company’s other divisions. The
previously discarded equipment no longer meets current safety standards. Again,
while this method may result in a short-term solution for the Controller and the
Production Manager personally, this decision may harm the corporation
financially as a whole, not to mention the potential resulting injuries to production
workers from hazardous equipment. This method would be also be ethically
questionable and would likely violate the IMA’s ethical standards of integrity and
credibility.
Delaying maintenance on production equipment that was scheduled for October
until January. Performing regular scheduled maintenance is important for the safe
and efficient operation of production equipment. While a three-month delay may
not seem significant, delaying maintenance may put the production employees at
risk of physical harm, and put company at financial risk should the equipment
malfunction and cause injury. Furthermore, failure to keep a regular maintenance
schedule may void the warranties on the equipment. The Standards of Ethical
Behavior require management accountants to communicate information fairly and
objectively and to carry out duties ethically.
3.
Gellar should directly raise her concerns with the CFO, especially if the pressure from the
CFO is so great that the only course of action on the part of the Controller is to resort to unethical
behavior. If the CFO refuses to change his direction, the Controller should raise these issues with
the CEO, and then the Audit Committee and the Board of Directors, after informing the CFO that
she is doing the same. The Controller could also initiate a confidential discussion with an IMA
Ethics Counselor, other impartial advisers, or her own attorney. Under extreme circumstances,
the Controller may want to resign if the corporate culture of Phoenix Press is to reward
executives who take year-end actions that the Controller views as unethical and possibly illegal.
1-37
(40 min.) Ethical challenges, global company.
1.
The overarching principles of the IMA Statement of Ethical Professional Practice are
Honesty, Fairness, Objectivity, and Responsibility. The statement’s corresponding “Standards
for Ethical Conduct…” require management accountants to
 Perform professional duties in accordance with relevant laws, regulations, and technical
standards.
 Refrain from engaging in any conduct that would prejudice carrying out duties
ethically.
 Communicate information fairly and objectively.
 Disclose all relevant information that could reasonably be expected to influence an
intended user’s understanding of the reports, analyses, or recommendations.
1-16
Several of the suggestions made by Armstrong’s staff are clearly in conflict with the statement’s
principles and required standards and should be viewed as unacceptable.
a. Pay local officials to “certify” the ramin used by CI as sustainable. It is not certain
whether the ramin would indeed be sustainable or not. If the payment could be
considered a bribe, the company would be in violation of the Foreign Corrupt Practices
Act. Knowledge of such a violation of law would be considered a violation of
professional ethics.
b. Record executive year-end bonus compensation accrued for the current year when it is
paid in the next year after the December fiscal year-end. GAAP requires expenses to be
recorded (accrued) when incurred, not when paid (cash basis accounting). Therefore,
failure to record the executives’ year-end bonus would violate the IMA’s standards of
credibility and integrity.
c. Pressure current customers to take early delivery of goods before the end of the year so
that more revenue can be reported in this year’s financial statements. This tactic,
commonly known as channel stuffing, merely results in shifting future period revenues
into the current period. The overstatement of revenue in the current period may mislead
investors to believe that the company’s financial well-being is better than the actual
results achieved. This practice would violate the IMA’s standards of credibility and
integrity. Channel stuffing is frequently considered a fraudulent practice.
d. Recognize sales revenues on orders received but not shipped as of the end of the year.
GAAP requires income to be recorded (accrued) when the four criteria of revenue
recognition have been met:
1.
The company has completed a significant portion of the production and sales
effort.
2.
The amount of revenue can by objectively measured.
3.
The major portion of the costs has been incurred, and the remaining costs can be
reasonably estimated.
4.
The eventual collection of the cash is reasonably assured.
Because criteria 1 and 3 have not been met at the time the order is placed, the revenue should not
be recognized until after year-end. Therefore, recording next year’s revenue in the current year
would be a violation of GAAP and would be falsifying revenue. This would be a violation of the
IMA’s standards of credibility and integrity and considered fraudulent.
Three of the suggestions appear to be acceptable:
e. Reject the change in materials. Counter the bad publicity with an aggressive ad
campaign showing the consumer products as “made in the USA,” since manufacturing
takes place in North Carolina. This is an acceptable strategy. Consumers could then
weigh the employment benefits in the United States against the negative
environmental effects of the company’s actions.
f. Redesign upholstered furniture to replace ramin contained inside with less expensive
recycled plastic. Creative changes in product design using recycled materials will
allow CI to address sustainability concerns as well as protect company profits.
1-17
g.
Begin purchasing sustainable North American hardwoods and sell the Indonesian
lumber subsidiary. Initiate a “plant a tree” marketing program, by which the
company will plant a tree for every piece of furniture sold. While this solution would
increase cost of materials and the price CI must charge for its product, sales and profits
may not decline if consumers perceive the value of sustainability and corporate social
responsibility.
The other “year-end” actions occur in many organizations and fall into the “gray” to
“acceptable” area. Much depends on the circumstances surrounding each one, however, such as
the following:
h. Make deep cuts in pricing through the end of the year to generate additional revenue.
Again, this is only a short-term tactic to improve this year’s financial results. Investors
may be content in the short run, but in the long run, the company may see reduced
margins from these actions.
i. Sell-off production equipment prior to year-end. The sale would result in one-time
gains that could offset the company’s lagging profits. The owned equipment could be
replaced with leased equipment at a lower cost in the current year. While this course of
action does not necessarily violate the IMA’s code of ethical standards, it may be only a
short-term tactic to improve this year’s financial results. Armstrong will need to weigh
his options in the long term to make the most cost-effective decision for his company.
2.
It is possible that any of the “year-end” actions that fall into the “gray” area may be good
for investors, depending on the credible evidence that supports the management decision. For
example, replacing owned equipment with leased equipment may result in both short-term gains
for the company and long-term cost reduction. If so, this decision would be in the best interest of
the investors. If the decision only results in short-term gains, but higher costs in the long run,
then the decision may not be in the best long-term interest of the company’s investors and should
not be implemented solely to prop up short-term earnings.
Those decisions that clearly violate the IMA code of ethical standards (a, c, f, and i)
would never be in the best interest of the investor. These options would result in misleading
financial statements and could result in the demise of the company or even in criminal charges,
as was the case with companies such as Enron and WorldCom. If Armstrong asks the
management accountant to take any of the actions that are clearly unethical, he should raise this
issue with the chair of the Audit Committee after informing Armstrong that he is doing so. If
Armstrong still insists on the management accountant taking these actions, he should resign
rather than engage in unethical behavior.
1-18
CHAPTER 2
AN INTRODUCTION TO COST TERMS AND PURPOSES
2-1
When you think of a cost, you invariably think of it in the context of putting a price on a
particular ‘thing’. That ‘thing’ is called a cost object. Therefore, a cost object is anything for
which a cost measurement is desired. For example, an accounting textbook which cost you some
money to purchase, material purchased for use in the factory, an Apple phone which you
purchased from the shop, etc.
2-2
Direct costs of a cost object are those costs that are related to the particular cost object
and can be traced to it in an economically cost-effective manner. For example, in a computer
production company, the cost of the computer screen is directly traceable to the cost of the
computer.
Therefore, the computer screen is a direct cost when computing the manufacturing cost of
the computer. Direct costs make direct input in the production of the product. They must be
incurred if the product is to be produced.
Indirect costs of a cost object are related to the particular cost object but cannot be traced
to it in an economically cost-effective manner. For example, the salaries of security guards at a
computer production company. Though the security guards are securing the computer
production plant, they make no direct input into the manufacturing of the computer.
2-3
Managers believe that direct costs that are traced to a particular cost object are more
accurately assigned to that cost object than are indirect allocated costs. When costs are allocated,
managers are less certain whether the cost allocation base accurately measures the resources
demanded by a cost object. Managers prefer to use more accurate costs in their decisions.
2-4
Yes, it can. This is because everything for which you need to know the cost of is called a
cost object and a business department is one such item. For example, an organization’s supplies
and maintenance department is a cost object for the cost of the maintenance supplies and the
maintenance employees. At a later stage in the organization’s work process, the supplies and
maintenance department costs will be assigned to various products, which will also be regarded
as cost objects.
2-5
Fixed costs are costs that tend to remain the same in amount, regardless of level of
activity. They remain fixed during the relevant range of activity. Typical examples of costs that
are fixed include annual rent of business accommodation, salaries of supervision staff and
insurance. Variable costs are costs that increase or decrease in total as the volume of activity
increases or decreases. Examples of variable costs include raw materials and power for
machinery. It also includes labor where payment is made according to the level of output.
2-6
Variable and direct: Tires used to manufacture a particular kind of car
Variable and indirect: Electricity used in the plant where multiple products are manufactured
Fixed and direct: Depreciation for a machine that is only used for one product
Fixed and indirect: Salary for the company’s CEO
2-1
2-7
A cost driver is a variable, such as the level of activity or volume that causally affects
total costs over a given time span. A change in the cost driver results in a change in the level of
total costs. For example, the number of vehicles assembled is a driver of the costs of steering
wheels on a motor-vehicle assembly line.
2-8
Calculating a unit cost is essential in many cases, especially when managers want to take
a decision regarding the pricing of different cost objects as well as when they want to accept a
special order or prioritize a product mix. The unit cost calculation is vital during these cases
because the manager needs to be certain that they are making the right choice by accepting or
rejecting a special offer for a specific cost object.
2-9
A unit cost is computed by dividing some amount of total costs (the numerator) by the
related number of units (the denominator). In many cases, the numerator will include a fixed cost
that will not change despite changes in the denominator. It is erroneous in those cases to multiply
the unit cost by activity or volume change to predict changes in total costs at different activity or
volume levels.
2-10 Manufacturing-sector companies purchase materials and components and convert them
into various finished goods, for example automotive and textile companies.
Merchandising-sector companies purchase and then sell tangible products without
changing their basic form, for example retailing or distribution.
Service-sector companies provide services or intangible products to their customers, for
example, legal advice or audits.
2-11 Although all manufacturing costs are considered as inventoriable costs, they are not just
peculiar to the manufacturing firms. In the retail industry, for example, inventoriable costs
include the costs of purchasing goods that are for resale, costs of freight, insurance, and any
other handling costs. Inventoriable costs are first converted into work-in-process before the final
finished product, which is an asset in the balance sheet. Therefore, the service sector firms do not
have associated inventoriable costs.
Period costs are all costs in the income statement other than cost of goods sold. In the
manufacturing industry, all non-manufacturing costs including research and development
expenses are treated as period costs. In the retail industry, period costs include all costs shown in
the income statement except the cost of goods sold. Costs such as marketing and distribution
expenses, administration expenses and other operating expenses are considered as period costs.
In the service sector firms, all costs are treated as period costs.
2-12 Inventoriable costs are all costs of a product that are considered as assets in the balance
sheet when they are incurred and that become cost of goods sold when the product is sold. These
costs are included in work-in-process and finished goods inventory (they are “inventoried”) to
accumulate the costs of creating these assets.
Period costs are all costs in the income statement other than cost of goods sold. These
costs are treated as expenses of the accounting period in which they are incurred because they are
expected not to benefit future periods (because there is not sufficient evidence to conclude that
such benefit exists). Expensing these costs immediately best matches expenses to revenues.
2-2
2-13 Overtime premium is the wage rate paid to workers (for both direct labor and indirect
labor) in excess of their straight-time wage rates. Overtime premium is usually considered to be
part of indirect costs or overheads. This is because it is attributable to the general use of the
work done rather to any specific product. However, where overtime premium relates to a single
product, such circumstance will lead to overtime being treated as labor cost rather than overhead.
Idle time is a subclassification of indirect labor that represents wages paid for
unproductive time caused by lack of orders, machine breakdowns, material shortages, poor
scheduling, and the like. This is not related to any product and therefore considered an overhead,
and not a direct labor cost.
2-14 A product cost is the sum of the costs assigned to a product for a specific purpose.
Purposes for computing a product cost include:

pricing and product mix decisions,

contracting with government agencies, and

preparing financial statements for external reporting under GAAP.
2-15 The following three main features of cost accounting and cost management, which can be
used in wide range of applications include:
1. Calculating the cost of products, services and other cost objects – costing systems trace
direct costs and allocate indirect costs to products. For example, job costing and
activity-based costing are used to calculate total costs and unit costs of products and
services.
2. Obtaining information for planning and control, and performance evaluation – budget
is the most commonly used tool for planning and control. A budget forces managers to
look ahead, to translate a company’s strategy into plans, to coordinate and
communicate within the organization. It also provides a benchmark for evaluating the
company’s performance. Managers make efforts to meet their budget targets, thus
budgeting can affect the attitude of staff towards achieving the set target.
3. Analyzing the relevant information for making decisions – when designing strategies
and implementing them, managers must understand which revenues and costs to
consider and which ones to ignore. When making strategic decisions about which
products and how much to produce, managers must know how revenues and costs vary
with changes in output levels.
2-16 Choice “a” is incorrect. Variable costs are not fixed, they change in relation to the level
of activity. Fixed costs are fixed irrespective of the level of activity within the relevant range.
Choice “b” is also incorrect. Cost of materials and wages for factory workers are variable costs.
This is because these costs increase with the level of production. However, the fixed costs
remain the same at all levels of activity. Salaries paid to office staff do not vary with the level of
production. Note that costs are regarded as variable or fixed within a period or over a certain
range of activity.
Choice “c” is correct. Variable costs and fixed costs are only variable or fixed for a specific
activity and for a given time period. A cost may be variable in period one but fixed in period
two. For example, the cost of electricity used in the factory may vary on the level of production
2-3
activity in the factory. However, the company may decide to obtain a fixed bill contract that
allows it to pay a fixed amount irrespective of the level of production activity.
Choice “d” is incorrect. Reducing the level of activity can reduce the total variable cost whilst
for fixed cost, such reduction will not affect the total fixed costs.
2-17 Choice “2” is correct. Costs that maintain production capacity and do not vary regardless
of utilization are classified as fixed costs. In this instance, the salary costs of direct service staff
are required to maintain capacity based on the number of residents (doctors) and will be incurred
whether the facility is full or empty. The costs are fixed.
Choice “1” is incorrect. Direct labor costs mandated by statute do not vary with production, they
vary with the compliance requirement. Consequently, direct labor costs, in this instance, are
fixed, not variable.
Choice “3” is incorrect. Direct costs related to service provider salaries are considered to be
direct costs of the service, not overhead costs.
Choice “4” is incorrect. Comprehensive Care Nursing Home is a service company and does not
have any inventory and therefore no inventoriable costs.
2-18 Choice "3" is correct. The question asks what happens to variable and fixed costs when
cost driver activity changes (i.e., when the cost driver level increases or decreases). Statement I
says that, as the cost driver level increases, total fixed cost remains unchanged. Statement I is
correct. Total fixed cost will remain unchanged regardless of changes in the cost driver because
total fixed cost is unaffected by changes in the cost driver.
Statement II says that, as the cost driver level increases, unit fixed cost increases. This statement
is asking about unit fixed cost like the previous statement asked about total fixed cost. While
total fixed cost will remain unchanged regardless of changes in the cost driver, unit fixed cost
will not. If the cost driver level increases, total fixed cost will remain the same, but the total
number of units will increase, and unit fixed cost will decrease, not increase. Statement II is
incorrect.
Statement III says that as the cost driver level decreases, unit variable cost decreases. This
statement is asking about unit variable cost like the previous statement asked about unit fixed
cost. Unit variable cost will remain unchanged regardless of what happens to the cost driver.
Statement III is incorrect.
2-4
2-19 Choice “a” is incorrect because overtime premium and idle time are overhead costs. They
are not normally considered as cost of labor since they are not identifiable with specific
production process.
Choice “b” is incorrect because overtime is traceable to a single product, the overtime premium
can be treated as a labor cost.
Choice “c” is incorrect because idle time occurs when labor is not productively used. This may
be caused by breakdown of machine, unavailability of materials and other problems.
Choice “d” is correct as all the above options are accurate descriptions of overtime and idle time.
For example, overtime premium and idle time are both overhead costs. Overtime premium can
be classified as direct labor cost where the overtime related to a single product. However, all idle
time costs are treated as overheads.
2-20 Choice “4” is correct. The question seeks to analyze the flow of inventoriable and period
costs in an organization. Statement I is correct because both cost categories flow through the
income statement at a merchandising business. Statement II is also correct because
inventoriable costs are transformed to current assets in the balance sheet, e.g. work-in-process
and finished goods. Statement III is correct because period costs include all costs in the income
statement except the cost of goods sold.
2-5
2-21
(15 min)
Computing and interpreting manufacturing unit costs.
1. & 2.
Direct material cost
Direct manuf. labor costs
Manufacturing overhead costs
Total manuf. costs
Fixed costs allocated at a rate
of $15M ÷ $50M (direct mfg.
labor) equal to $0.30 per
dir. manuf. labor dollar
(0.30  $16; 26; 8)
Variable costs
Units produced (millions)
Manuf. cost per unit (Total manuf.
costs ÷ units produced)
Variable manuf. cost per unit
(Variable manuf. costs
 Units produced)
Supreme
$ 89.00
16.00
48.00
153.00
(in millions)
Deluxe
$ 57.00
26.00
78.00
161.00
4.80
$148.20
125
Regular
$60.00
8.00
24.00
92.00
Total
$206.00
50.00
150.00
406.00
7.80
$153.20
150
2.40
$89.60
140
15.00
$391.00
$1.2240
$1.0733
$0.6571
$1.1856
$1.0213
$0.6400
(in millions)
Deluxe
Regular
Total
$183.60
$203.93
$144.56
$532.09
$177.84
$194.05
$140.80
$512.69
Supreme
Based on total manuf. cost
per unit ($1.2240  150;
$1.0733  190; $0.6571  220)
Correct total manuf. costs based
on variable manuf. costs plus
fixed costs equal
Variable costs ($1.1856  150;
$1.0213  190; $0.64  220)
Fixed costs
Total costs
15.00
$527.69
The total manufacturing cost per unit in requirement 1 includes $15 million of indirect
manufacturing costs that are fixed irrespective of changes in the volume of output per month,
while the remaining variable indirect manufacturing costs change with the production volume.
Given the unit volume changes for August 2020, the use of total manufacturing cost per unit
from the past month at a different unit volume level (both in aggregate and at the individual
product level) will overestimate total costs of $532.09 million in August 2020 relative to the
correct total manufacturing costs of $527.69 million calculated using variable manufacturing cost
per unit times units produced plus the fixed costs of $15 million.
2-6
2-22
(15-20 min)
1. Classify each of the costs listed earlier as either direct or indirect costs.
Cost
Amount (£) Direct costs Indirect costs
(£)
(£)
Materials used in the product
100,000
100,000
Depreciation on factory machine
80,000
80,000
Factory insurance
6,000
6,000
Labor cost for factory workers
120,000
120,000
Factory repairs
10,000
10,000
Advertising expense
35,000
35,000
Distribution expenses
15,000
15,000
Sales commission
20,000
20,000
Secretary’s salary
25,000
25,000
2. Compute the total manufacturing cost.
Cost
Amount (£)
Direct materials:
Materials used in the product
100,000
Direct labor:
Labor cost for factory workers
120,000
Manufacturing overhead:
Depreciation on factory machine
80,000
Factory insurance
6,000
Factory repairs
10,000
Total manufacturing costs
316,000
Note: Advertising, sales commission, distribution and secretary’s salaries are not considered part of
the manufacturing costs. They are regarded as selling and administrative expenses.
2-7
2-23
(10-15 mins.)
1. For each cost item (A-I) from the records, identify the direct and indirect costs
Direct costs
Ink for the pens
Wages of factory staff
Plastics for pens
£’000
600
5,000
10,000
Indirect costs
Depreciation of factory machine
Salary of supervisors
Machine maintenance costs
Depreciation
of
delivery
vehicles
£’000
8,500
2,500
350
4,000
2. Compute Timi Company’s total indirect manufacturing cost.
Indirect costs
£’000
Depreciation of factory machine
8,500
Salary of supervisors
2,500
Machine maintenance costs
350
Total manufacturing overhead
11,350
Items excluded in (2) and the reason for excluding them are as follows: ink for the pens (direct
materials), wages for factory staff (direct labor cost), depreciation of delivery vehicles
(marketing cost), interest expense (financing cost), salary of general manager (administrative
cost), plastics for pens (direct material cost).
2-24
(15-20 min) Classification of costs, merchandising sector.
Cost object: t-shirts sold in apparel section of store
Cost variability: With respect to changes in the number of t-shirts sold
There may be some debate over classifications of individual items, especially with regard
to cost variability.
Cost Item
A
B
C
D
E
F
G
H
D or I
D
I
D
D
I
I
I
D
2-8
V or F
F
F
V
F
F
V
F
V
2-25
(15-20 min) Classification of costs, manufacturing sector.
Cost object: Type of chair assembled (Recliners or Rockers)
Cost variability: With respect to changes in the number of Recliners assembled
There may be some debate over classifications of individual items, especially with regard to cost
variability.
Cost Item
A
B
C
D
E
F
G
H
I
2-26
(20 min)
D or I
D
I
I
D
D
I
D
I
I
V or F
V
F
F
V
V
V
V
F
F
Variable costs, fixed costs, total costs.
1.
Minutes/month
Plan A ($/month)
Plan B ($/month)
Plan C ($/month)
0
0
15
22
50 100 150 200 240 300 327.5 350 400 450 510 540 600 650
5 10 15 20 24 30 32.75 35
40
45
51
54
60
65
15 15 15 15 15 19.80 22 23.80 27.80 31.80 36.60 39 43.80 47.80
22 22 22 22 22 22
22
22
22
22
22 23.50 26.50 29
60
Total Cost
50
40
Plan A
Plan B
Plan C
30
20
10
0
0
100
200
300
400
500
Number of long-distance minutes
2-9
600
2.
In each region, Ashton chooses the plan that has the lowest cost. From the graph (or from
calculations)*, we can see that if Ashton expects to use 0–150 minutes of long-distance each
month, she should buy Plan A; for 150–327.5 minutes, Plan B; and for more than 327.5 minutes,
Plan C. If Ashton plans to make 100 minutes of long-distance calls each month, she should
choose Plan A; for 240 minutes, choose Plan B; for 540 minutes, choose Plan C.
*Let x be the number of minutes when Plan A and Plan B have equal cost
$0.10x = $15
x = $15 ÷ $0.10 per minute = 150 minutes.
Let y be the number of minutes when Plan B and Plan C have equal cost
$15 + $0.08 (y – 240) = $22
$0.08 (y – 240) = $22 – $15 = $7
$7
 87.5
y – 240 =
$0.08
y = 87.5 + 240 = 327.5 minutes
2-27
(20 min.) Variable costs, fixed costs, relevant range.
1. The production capacity is 4,400 jawbreakers per month. Therefore, the current annual
relevant range of output is 0 to 4,400 jawbreakers × 12 months = 0 to 52,800 jawbreakers.
2. Current annual fixed manufacturing costs within the relevant range are $1,300 × 12 =
$15,600 for rent and other overhead costs, plus $9,500 ÷ 10 = $950 for depreciation, totalling
$16,550.
The variable costs, the materials, are 10 cents per jawbreaker, or $3,720 ($0.10 per
jawbreaker × 3,100 jawbreakers per month × 12 months) for the year.
3. If demand changes from 3,100 to 6,200 jawbreakers per month, or from 3,100 × 12 = 37,200
to 6,200 × 12 = 74,400 jawbreakers per year, Dotball will need a second machine. Assuming
Dotball buys a second machine identical to the first machine, it will increase capacity from
4,400 jawbreakers per month to 8,800. The annual relevant range will be between 4,400 × 12
= 52,800 and 8,800 × 12 = 105,600 jaw breakers.
Assume the second machine costs $9,500 and is depreciated using straight-line
depreciation over 10 years and zero residual value, just like the first machine. This will add
$950 of depreciation per year.
Fixed costs for next year will increase to $17,500 from $16,550 for the current year +
$950 (because rent and other fixed overhead costs will remain the same at $15,600). That is,
total fixed costs for next year equal $950 (depreciation on first machine) + $950
(depreciation on second machine) + $15,600 (rent and other fixed overhead costs).
The variable cost per jawbreaker next year will be 90% × $0.10 = $0.09. Total variable
costs equal $0.09 per jawbreaker × 74,400 jawbreakers = $6,696.
If Dotball decides not to increase capacity and meet only that amount of demand for
which it has available capacity (4,400 jaw breakers per month or 4,400 × 12 = 52,800 jaw
breakers per year), the variable cost per unit will be the same at $0.10 per jawbreaker.
Annual total variable manufacturing costs will increase to $0.10 × 4,400 jawbreakers per
2-10
month × 12 months = $5,280. Annual total fixed manufacturing costs will remain the same,
$16,550.
2-28
(10-15 min)
Cost behavior.
Variable Costs: Cost per unit is constant ($5)
10,000 units X $5 per unit = $50,000
20,000 units X $5 per unit = $100,000
50,000 units X $5 per unit = $250,000
Fixed Costs: Total cost is constant ($30,000)
10,000 units X $3 per unit = $30,000
$30,000/ 20,000 units = $1.50 per unit
$30,000/ 50,000 units = $0.60 per unit
2-29
(20 min)
Variable costs, fixed costs, relevant range.
1.
The production capacity is 5,000 jaw breakers per month. Therefore, the current annual
relevant range of output is 0 to 5,000 jaw breakers × 12 months = 0 to 60,000 jaw breakers.
2.
Current annual fixed manufacturing costs within the relevant range are $1,200 × 12 =
$14,400 for rent and other overhead costs, plus $6,500 ÷ 10 = $650 for depreciation, totaling
$15,050.
The variable costs, the materials, are 40 cents per jaw breaker, or $18,720 ($0.40 per jaw
breaker × 3,900 jaw breakers per month × 12 months) for the year.
3.
If demand changes from 3,900 to 7,800 jaw breakers per month, or from 3,900 × 12 =
46,800 to 7,800 × 12 = 93,600 jaw breakers per year, Gummy Land will need a second machine.
Assuming Gummy Land buys a second machine identical to the first machine, it will increase
capacity from 5,000 jaw breakers per month to 10,000. The annual relevant range will be
between 5,000 × 12 = 60,000 and 10,000 × 12 = 120,000 jaw breakers.
Assume the second machine costs $6,500 and is depreciated using straight-line
depreciation over 10 years and zero residual value, just like the first machine. This will add
$650 of depreciation per year.
Fixed costs for next year will increase to $15,700 from $15,050 for the current year + $650
(because rent and other fixed overhead costs will remain the same at $14,400). That is, total
fixed costs for next year equal $650 (depreciation on first machine) + $650 (depreciation on
second machine) + $14,400 (rent and other fixed overhead costs).
The variable cost per jaw breaker next year will be 90% × $0.40 = $0.36. Total variable
costs equal $0.36 per jaw breaker × 93,600 jaw breakers = $33,696.
If Gummy Land decides not to increase capacity and meet only that amount of demand for
which it has available capacity (5,000 jaw breakers per month or 5,000 × 12 = 60,000 jaw
breakers per year), the variable cost per unit will be the same at $0.40 per jaw breaker. Annual
total variable manufacturing costs will increase to $0.40 × 5,000 jaw breakers per month × 12
months = $24,000. Annual total fixed manufacturing costs will remain the same, $15,050.
2-11
2-30
1.
(20 min)
Cost drivers and value chain.
A. Perform market research on competing brands - design of products and processes
B. Design a prototype of the phone app and the security camera - design of products and
processes
C. Test the compatibility of the phone app and the security camera - design of products
and processes
D. Make necessary design changes to the prototype based on testing performed in C
above - design of products and processes
E. Manufacture the security cameras – production
F. Attend trade shows to make wholesalers aware of the camera - marketing
G. Process orders from the trade show orders and wholesalers - distribution
H. Deliver the security cameras to the wholesalers - distribution
I. Provide online assistance to the security camera users - customer service
J. Make additional design changes to the security camera based on customer feedback design of products and processes
2-12
2.
Value Chain
Category
Design of
products and
processes
Production
Marketing
Distribution
Customer
service
Activity
Perform market research on
competing brands
Cost Driver
Hours spent researching competing market
brands
Design a prototype of the
phone app and the security
camera
Engineering hours spent on initial product
design
Test the compatibility of the
phone app and the security
camera
Number of product tests conducted
Make necessary design changes
to the prototype based on
testing performed
Number of design changes
Make additional design
changes to the security
camera based on customer
feedback
Manufacture the security
cameras
Attend trade shows to make
wholesalers aware of the
camera
Number of design changes
Process orders from the trade
show orders and wholesalers
Number of security camera orders processed
Deliver the security cameras to
the wholesalers
Provide online assistance to the
security camera users
Number of deliveries made to wholesalers
2-13
Machine hours required to run the
production equipment
FTEs spent on attending trade shows
Customer-service hours
2-31
(20-25 mins.) Calculating unit cost
1. Prepare the cost of goods manufactured for the year 2019.
£
0
Beginning work in process inventory
Add: Direct materials used:
Beginning materials inventory
Purchases of direct materials
Available for use
Less: Ending materials inventory
Direct materials used
Direct labor
Manufacturing overhead:
Rent on plant
Utilities for plant
Plant janitorial services
£
10,000
33,000
43,000
(9,500)
33,500
25,000
8,000
1,100
300
9,400
Total manufacturing costs
Less: Ending work in process
Cost of goods manufactured
67,900
(3,500)
64,400
2. If the company produced 20,000 bottles of water in 2019, calculate the company’s unit
product cost for the year.
Unit product cost = Cost of goods manufactured ÷ total units produced
= £64,400 ÷ 20,000 = £3.22 per unit
2-32
1.
(20 min.)
Total costs and unit costs, service setting
Number of guests
Variable cost per guest
(£80 caterer charge –
£5 discount for ads)
Fixed Costs
0
£75
50
100
150
200
250
300
£75
£75
£75
£75
£75
£75
£14,000 £14,000 £14,000 £14,000 £14,000 £14,000 £14,000
Variable costs (number of
guests × variable cost per
0
3,750
7,500
11,250 15,000 18,750 22,500
guest)
Total costs (fixed +
£14,000 £17,750 £21,500 £25,250 £29,000 £32,750 £36,500
variable)
2-14
2.
Number of guests
0
50
100
150
200
250
300
Total costs
(fixed + variable)
£14,000 £17,750 £21,500 £25,250 £29,000 £32,750 £36,500
Costs per guest (total
costs ÷ number of guests)
£355
£215
£168.33 £145
£131
£121.67
As shown in the table above, for 150 attendees the total cost will be £25,250, and the cost per
attendee will be £168.33.
3.
As shown in the table in requirement 2, for 200 attendees, the total cost will be £29,000,
and the cost per attendee will be £145.
4.
TBE should charge customers based on the number of guests. As the number of guests
increase, TBE could offer price discounts because its fixed costs would be spread over a larger
number of guests.
Alternatively, TBE could charge a flat fee of £10,000 plus a margin for the music. The
catering costs would then vary less with the number of guests because only £4,000 of fixed costs
would be spread over the number of guests. For 100 guests, the fixed catering cost per guest
would be £40 (£4,000 ÷ 100 guests); for 200 guests, it would be £20 (£4,000 ÷ 200 guests).
TBE’s total cost would be £115 (variable cost per guest of £75 + fixed catering cost per guest of
£40) for 100 guests and £95 (variable cost per guest of £75 + fixed catering cost per guest of
£20) for 200 guests.
2-15
2-33
(15 – 20 mins.) Inventoriable versus period costs.
1. Identify the following as either an inventoriable product cost or a period cost:
Inventoriable costs
Depreciation on plant and equipment
Insurance on plant and building
Raw materials
Manufacturing overheads
Production staff wages
Period costs
Depreciation on delivery vans
Marketing manager’s salary
Electricity bill for the residential quarters
2. Compute the cost of goods manufactured:
£
Beginning work in process inventory
Add: Direct materials used
Direct labor
Manufacturing overhead
Total manufacturing costs incurred during the period
Total manufacturing costs
Less: Ending work in process
Cost of goods manufactured
2-34
£
12,000
24,000
9,000
17,000
50,000
62,000
(5,000)
57,000
(20-30 min) Inventoriable costs versus period costs.
1.
Manufacturing-sector companies purchase materials and components and convert them
into different finished goods.
Merchandising-sector companies purchase and then sell tangible products without
changing their basic form.
Service-sector companies provide services or intangible products to their customers—for
example, legal advice or audits.
Only manufacturing and merchandising companies have inventories of goods for sale.
2.
Inventoriable costs are all costs of a product that are regarded as an asset when they are
incurred and then become cost of goods sold when the product is sold. These costs for a
manufacturing company are included in work-in-process and finished goods inventory (they are
“inventoried”) to build up the costs of creating these assets.
Period costs are all costs in the income statement other than cost of goods sold. These
costs are treated as expenses of the period in which they are incurred because they are presumed
not to benefit future periods (or because there is not sufficient evidence to conclude that such
benefit exists). Expensing these costs immediately best matches expenses to revenues.
2-16
3.
A. Cost of lumber and plumbing supplies available at Home Depot - is an inventoriable cost
of a merchandising company. The cost becomes part of cost of goods sold when the
lumber and plumbing supplies are sold to customers.
B. Electricity used to provide lighting for assembly-line workers at an Apple manufacturing
plant – inventoriable cost of a manufacturing company. It is part of the manufacturing
overhead that is included in the manufacturing cost of a finished good.
C. Depreciation on store shelving in Home Depot – period cost of a merchandising
company. It is a cost that benefits the current period, and it is not traceable to goods
purchased for resale.
D. Mileage paid to nannies traveling to clients for Rent a Nanny - period cost of a service
company. Rent a Nanny has no inventory of goods for sale and, hence, no inventoriable
cost.
E. Wages for personnel responsible for quality testing of the Apple products during the
assembly process – inventoriable cost of a manufacturing company. It is usually part of
the manufacturing overhead that is included in the manufacturing cost of a finished good
(if quality testing is done for several products), but may be a direct cost, if quality testing
is done by personnel who work on a specific Apple product line such as the iPhone.
F. Salaries of Rent a Nanny marketing personnel planning local-newspaper advertising
campaigns – period cost of a service company. Rent a Nanny has no inventory of goods
for sale and, hence, no inventoriable cost.
G. Lunches provided to the nannies for Rent a Nanny - period cost of a service company.
Rent a Nanny has no inventory of goods for sale and, hence, no inventoriable cost.
H. Salaries of employees at Apple retail stores - period cost of a manufacturing company.
This is a distribution cost, not an inventoriable cost.
I. Shipping costs for Apple to transport products to retail stores - period cost of a
manufacturing company. This is a distribution cost, not an inventoriable cost.
2-17
2-35
(20 min.)
Cost of goods purchased, cost of goods sold, and income statement.
1a.
Purchases
Add freight-in
Huang Wong Ping Retail Outlet Stores
Schedule of Cost of Goods Purchased
For the Year Ended December 31, 2021
(in thousands)
$654,000
25,000
679,000
Deduct:
Purchase returns and allowances
Purchase discounts
$ 32,400
22,600
Cost of goods purchased
1b.
55,000
$624,000
Huang Wong Ping Retail Outlet Stores
Schedule of Cost of Goods Sold
For the Year Ended December 31, 2021
(in thousands)
Beginning merchandise inventory January 1, 2021
Cost of goods purchased (see above)
Cost of goods available for sale
Ending merchandise inventory December 31, 2021
Cost of goods sold
$ 115,800
624,000
739,800
124,200
$ 615,600
Huang Wong Ping Retail Outlet Stores
Income Statement
For the Year Ended December 31, 2021
(in thousands)
Revenues
$798,000
Cost of goods sold (see above)
615,600
Gross margin
182,400
Operating costs
Marketing and advertising costs
$54,300
Depreciation on Store Fixtures
10,420
Shipping of merchandise to customers
5,700
General and administrative costs
74,800
Total operating costs
145,220
Operating income
$ 37,180
2.
2-18
2-36
(20 min)
Cost of goods purchased, cost of goods sold, and income statement.
1a.
Mama Retail Outlet Stores
Schedule of Cost of Goods Purchased
For the Year Ended December 31, 2020
(in thousands)
Purchases
Add Freight—in
$521,000
21,000
542,000
Deduct:
Purchase returns and allowances
Purchase discounts
$25,000
22,000
Cost of goods purchased
1b.
$495,000
Mama Retail Outlet Stores
Schedule of Cost of Goods Sold
For the Year Ended December 31, 2020
(in thousands)
Beginning merchandise inventory 1/1/2020
Cost of goods purchased (see above)
Cost of goods available for sale
Ending merchandise inventory 12/31/2020
Cost of goods sold
2.
47,000
$94,000
495,000
589,000
101,000
$488,000
Mama Retail Outlet Stores
Income Statement
Year Ended December 31, 2020
(in thousands)
Revenues
Cost of goods sold (see above)
Gross margin
Operating costs
Marketing and advertising costs
Depreciation on store fixtures
Shipping of merchandise to customers
General and administrative costs
Total operating costs
Operating income
$690,000
488,000
202,000
$54,000
8,800
10,000
63,000
135,800
$ 66,200
2-19
2-37
(20 min)
Flow of inventoriable costs.
(All numbers below are in millions).
1.
Direct materials inventory 3/1/2020
Direct materials purchased
Direct materials available for production
Direct materials used
Direct materials inventory 3/31/2020
$
$
2.
Total manufacturing overhead costs
Subtract: Variable manufacturing overhead costs
Fixed manufacturing overhead costs for March 2020
3.
Total manufacturing costs incurred during March 2020
Subtract: Direct materials used (from requirement 1)
Total manufacturing overhead costs
Direct manufacturing labor costs for March 2020
4.
Work-in-process inventory 3/1/2020
Total manufacturing costs incurred during March 2020
Work-in-process available for production
Subtract: Cost of goods manufactured (moved into finished goods)
Work-in-process inventory 3/31/2020
5.
Finished goods inventory 3/1/2020
Cost of goods manufactured (moved from work in process)
Cost of finished goods available for sale in March 2020
6.
Cost of finished goods available for sale in March 2020
(from requirement 5)
Subtract: Cost of goods sold
Finished goods inventory 3/31/2020
2-20
$
$
90
345
435
(365)
70
485
(270)
215
$ 1,570
(365)
(485)
$
720
$
215
1,570
1,785
(1,640)
$
145
$
160
1,640
$ 1,800
$ 1,800
(1,740)
$
60
2-38
(30-40 min) Cost of goods manufactured, income statement, manufacturing
company.
1.
Peterson Company
Schedule of Cost of Goods Manufactured
Year Ended December 31, 2020
(in thousands)
Direct materials cost
Beginning inventory, January 1, 2020
$ 21,000
Purchases of direct materials
74,000
Cost of direct materials available for use
95,000
Ending inventory, December 31, 2020
23,000
Direct materials used
Direct manufacturing labor costs
Indirect manufacturing costs
Indirect manufacturing labor
17,000
Plant insurance
7,000
Depreciation—plant building & equipment
11,000
Repairs and maintenance—plant
3,000
Total indirect manufacturing costs
Manufacturing costs incurred during 2020
Add beginning work-in-process inventory, January 1, 2020
Total manufacturing costs to account for
Deduct ending work-in-process inventory, December 31, 2020
Cost of goods manufactured (to Income Statement)
2.
$ 72,000
22,000
38,000
132,000
26,000
158,000
25,000
$133,000
Peterson Company
Income Statement
Year Ended December 31, 2020
(in thousands)
Revenues
Cost of goods sold:
Beginning finished goods, January 1, 2020
Cost of goods manufactured
Cost of goods available for sale
Ending finished goods, December 31, 2020
Cost of goods sold
Gross margin
Operating costs:
Marketing, distribution, and customer-service costs
General and administrative costs
Total operating costs
Operating income
2-21
$310,000
$ 13,000
133,000
146,000
20,000
126,000
184,000
91,000
24,000
115,000
$ 69,000
2-39
(30-40 min) Cost of goods manufactured, income statement, manufacturing
company.
(30–40 min.)
Sales - Cost of Goods Sold (60% of Sales) = Gross Margin
If Cost of Goods Sold = 60% Sales, then Gross Margin = 40% of Sales
Gross Margin = $400,000
40% Sales = $400,000; Sales = $1,000,000 (= $400,000 / 40%)
Cost of Goods Sold = 60% Sales ($1,000,000) = $600,000
Cost of Goods Sold:
Finished Goods, 1/1
+ Cost of Goods Mfg
- Finished Goods, 12/31
= Cost of Goods Sold
$ 75,000
****
($ 50,000)
$600,000 (from above)
****Cost of Goods Mfg = $575,000 (Cost of Goods Sold $600,000 + Finished Goods, 12/31
$50,000 – Finished Goods $75,000)
Cost of Goods Mfg:
Raw Materials used
Direct Labor
Mfg Overhead
Total Mfg Costs
+ Work in Process, 1/1
- Work in Process, 12/31
Cost of Goods Mfg
$100,000
$ 25,000
( 60,000)
$575,000 (from COGS computation above)
Total Mfg Costs = $610,000 (Cost of Goods Mfg $575,000 + Work in Process, 12/31 $60,000 –
Work in Process, 1/1 $25,000)
Acct Rec
1/1
Acct Pay
120,000
credit 1,000,000
purchased
sales
1/1
collections
pymts
12/31 80,000
80,000
130,000
200,000
2-22
12/31
Raw Matl
Acct Rec Collections = $1,040,000 (Acct Rec, 1/1 $120,000 + Collections $1,000,000 – Acct
Rec, 12/31 $80,000)
Acct Pay, 1/1 = $150,000 (Acct Pay, 12/31 $200,000 – Raw Matl purchase $130,000 + Acct Pay
pymts $80,000)
Raw Matls
1/1
purchases
10,000
130,000
100,000
used
12/31
Raw Materials, 12/31 = $40,000 (Raw Matls, 1/1 $10,000 + Raw Matl purchased $130,000 –
Raw Matl used$100,000)
2-40
(25-30 min)
Income statement and schedule of cost of goods manufactured.
Howell Corporation
Income Statement for the Year Ended December 31, 2020
(in millions)
Revenues
Cost of goods sold
Beginning finished goods, Jan. 1, 2020
Cost of goods manufactured (below)
Cost of goods available for sale
Ending finished goods, Dec. 31, 2020
Gross margin
Marketing, distribution, and customer-service costs
Operating income
2-23
$950
$ 70
645
715
55
660
290
240
$ 50
Howell Corporation
Schedule of Cost of Goods Manufactured
for the Year Ended December 31, 2020
(in millions)
Direct materials costs
Beginning inventory, Jan. 1, 2020
Purchases of direct materials
Cost of direct materials available for use
Ending inventory, Dec. 31, 2020
Direct materials used
Direct manufacturing labor costs
Indirect manufacturing costs
Indirect manufacturing labor
Plant supplies used
Plant utilities
Depreciation––plant and equipment
Plant supervisory salaries
Miscellaneous plant overhead
Manufacturing costs incurred during 2020
Add beginning work-in-process inventory, Jan. 1, 2020
Total manufacturing costs to account for
Deduct ending work-in-process, Dec. 31, 2020
Cost of goods manufactured
2-24
$ 15
325
340
20
$320
100
60
10
30
80
5
35
220
640
10
650
5
$645
2-41
(15-20 min) Interpretation of statements (continuation of 2-40).
1.
The schedule in 2-40 can become a Schedule of Cost of Goods Manufactured and Sold
simply by including the beginning and ending finished goods inventory figures in the supporting
schedule, rather than directly in the body of the income statement. Note that the term cost of
goods manufactured refers to the cost of goods brought to completion (finished) during the
accounting period, whether they were started before or during the current accounting period.
Some of the manufacturing costs incurred are held back as costs of the ending work in process;
similarly, the costs of the beginning work in process inventory become a part of the cost of goods
manufactured for 2020.
2.
The sales manager’s salary would be charged as a marketing cost as incurred by both
manufacturing and merchandising companies. It is basically a period (operating) cost that
appears below the gross margin line on an income statement.
3.
An assembler’s wages would be assigned to the products worked on. Thus, the wages
cost would be charged to Work-in-Process and would not be expensed until the product is
transferred through Finished Goods Inventory to Cost of Goods Sold as the product is sold.
4.
The direct-indirect distinction can be resolved only with respect to a particular cost
object. For example, in defense contracting, the cost object may be defined as a contract. Then, a
plant supervisor working only on that contract will have his or her salary charged directly and
wholly to that single contract.
5.
Direct materials used = $320,000,000 ÷ 1,000,000 units = $320 per unit
Depreciation on plant equipment = $80,000,000 ÷ 1,000,000 units = $80 per unit
6.
Direct materials unit cost would be unchanged at $320 per unit. Depreciation cost per
unit would be $80,000,000 ÷ 1,200,000 = $66.67 per unit. Total direct materials costs would rise
by 20% to $384,000,000 ($320 per unit × 1,200,000 units), whereas total depreciation would be
unaffected at $80,000,000.
7. Unit costs are averages, and they must be interpreted with caution. The $320 direct materials
unit cost is valid for predicting total costs because direct materials is a variable cost; total direct
materials costs indeed change as output levels change. However, fixed costs like depreciation
must be interpreted quite differently from variable costs. A common error in cost analysis is to
regard all unit costs as one—as if all the total costs to which they are related are variable costs.
Changes in output levels (the denominator) will affect total variable costs, but not total fixed
costs. Graphs of the two costs may clarify this point; it is safer to think in terms of total costs
rather than in terms of unit costs.
2-25
2-42
(25-30 min) Income statement and schedule of cost of good manufactured.
Chan Corporation
Income Statement
for the Year Ended December 31, 2020
(in millions)
Revenues
Cost of goods sold
Beginning finished goods, Jan. 1, 2020
Cost of goods manufactured (below)
Cost of goods available for sale
Ending finished goods, Dec. 31, 2020
Gross margin
Marketing, distribution, and customer-service costs
Operating income (loss)
$352
$ 40
219
259
20
239
113
92
$ 21
Chan Corporation
Schedule of Cost of Goods Manufactured
for the Year Ended December 31, 2020
(in millions)
Direct material costs
Beginning inventory, Jan. 1, 2020
Direct materials purchased
Cost of direct materials available for use
Ending inventory, Dec. 31, 2020
Direct materials used
Direct manufacturing labor costs
Indirect manufacturing costs
Plant supplies used
Property taxes on plant
Plant utilities
Indirect manufacturing labor costs
Depreciation––plant and equipment
Miscellaneous manufacturing overhead costs
Manufacturing costs incurred during 2020
Add beginning work-in-process inventory, Jan. 1, 2020
Total manufacturing costs to account for
Deduct ending work-in-process inventory, Dec. 31, 2020
Cost of goods manufactured (to income statement)
2-26
$ 31
83
114
10
$104
48
3
7
9
24
5
12
60
212
15
227
8
$219
2-43
(15 -20 mins.)
1. Calculate Granolla’s overtime premium pay and total compensation for December 2019
Direct labor cost: 120 hours X £60 per hour =
£7,200
Overtime premium: 60 X £30 per hour =
Total compensation
£1,800
£9,000
2. What is Granola’s idle time cost for December 2019?
Direct labor cost: 114 hours X £60 per hour =
Idle time (overhead): 6 hours X £60 per hour =
Overtime premium (overhead): 60 hours X £30 =
Total earnings for 120 hours
£6,840
£ 360
£1,800
£9,000
3. Discuss the treatment of overtime premium and idle time on the product costs.
Though overtime premium and idle time are labor costs, but they are treated as overhead costs
here. However, where these costs are related to a single product, they may be classified as direct
costs.
2-44
(15 min)
Different meanings of product costs.
Purpose:
Purpose: Product
Mix
Purpose:
Government
Contract
Financial Statement
(using GAAP)
Direct material
Include
Include
Include
Direct manufacturing labor
Include
Include
Include
Manufacturing overhead
Include
Include
Include
Distribution costs
Include
Exclude*
Exclude
Include**
Exclude*
Exclude
R&D costs
Include
Exclude*
Exclude
Customer service
Include
Exclude*
Exclude
Type of Cost
Product design costs
* May change depending on the specifics of the contract.
** Assuming the product design costs have not already been incurred.
2-27
2-45
1.
2.
3.
(30-40 min) Missing records, computing inventory costs.
Finished goods inventory, 3/31/2020 = $190,000
Work-in-process inventory, 3/31/2020 = $30,000
Direct materials inventory, 3/31/2020 = $43,500
This problem is not as easy as it first appears. These answers are obtained by working from the
known figures to the unknowns in the schedule below. The basic relationships between
categories of costs are:
Manufacturing costs added during the period (given)
$400,000
Conversion costs (given)
$340,000
Direct materials used = Manufacturing costs added – Conversion costs
= $400,000 – $340,000 = $60,000
Cost of goods manufactured = Direct Materials Used × 5
= $60,000 × 5 = $300,000
Schedule of Computations
Direct materials inventory, 3/1/2020 (given)
Direct materials purchased (given)
Direct materials available for use
Direct materials inventory, 3/31/2020
Direct materials used
Conversion costs (given)
Manufacturing costs added during the period (given)
Add work in process inventory, 3/1/2020 (given)
Manufacturing costs to account for
Deduct work in process inventory, 3/31/2020
Cost of goods manufactured (5 × $60,000)
Add finished goods inventory, 3/1/2020
Cost of goods available for sale
Deduct finished goods inventory, 3/31/2020
Cost of goods sold (70% × $640,000)
2-28
3=
2=
1=
$ 13,500
90,000
103,500
43,500
60,000
340,000
400,000
30,000
430,000
130,000
300,000
190,000
490,000
42,000
$448,000
Some instructors may wish to place the key amounts in a Work in Process T-account. This
problem can be used to introduce students to the flow of costs through the general ledger
(amounts in thousands):
Direct Materials
Beg Inv 13.5
Purch.
90.0 DM
used 60
End Inv
2-46
43.5
(30 min.)
Work in Process
Beg Inv
30
DM used
COGM
(400–
60 300
300)
Conversio 340
n
To
account
430
for
Finished Goods
Beg Inv
190
300 COGS 415
Availabl
e for
sale
490
End Inv
End Inv
42
130
Cost of
Goods Sold
448
Comprehensive problem on unit costs, product costs.
1. If 2 pounds of direct materials are used to make each unit of finished product, 115,000 units ×
2 lbs., or 230,000 lbs. were used at £0.65 per pound of direct materials (£149,500 ÷ 230,000
lbs.). (The direct material costs of £149,500 are direct materials used, not purchased.) Therefore,
the ending inventory of direct materials is 2,300 lbs.  £0.65 = £1,495.
2.
Direct materials costs
Direct manufacturing labor costs
Plant energy costs
Indirect manufacturing labor costs
Other indirect manufacturing costs
Cost of goods manufactured
Manufacturing Costs for 115,000 units
Variable
Fixed
Total
£149,500
£
–
£149,500
34,500
–
34,500
6,000
–
6,000
12,000
17,000
29,000
7,000
27,000
34,000
£209,000
£44,000
£253,000
Average unit manufacturing cost: £253,000 ÷ 115,000 units
= £2.20 per unit
Finished goods inventory in units: = £15,400 (given)
£2.20 per unit
= 7,000 units
3.
Units sold in 2020
=
=
Selling price in 2020 =
=
Beginning inventory + Production – Ending inventory
0 + 115,000 –7,000 = 108,000 units
£540,000 ÷ 108,000
£5.00 per unit
2-29
4.
Office Essentials
Income Statement
Year Ended December 31, 2020
(in thousands)
Revenues (108,000 units sold × £5.00)
Cost of units sold:
Beginning finished goods, Jan. 1, 2020
Cost of goods manufactured
Cost of goods available for sale
Ending finished goods, Dec. 31, 2020
Gross margin
Operating costs:
Marketing, distribution, and customer-service costs
(£126,000 + £47,000)
Administrative costs
Operating income
£540,000
£
0
253,000
253,000
15,400
173,000
58,000
Note: Although not required, the full set of unit variable costs is:
Direct materials cost (£0.65 × 2 lbs.)
£1.300
Direct manufacturing labor cost (£34,500 ÷ 115,000)
0.300
Plant energy cost (£6,000 ÷ 115,000)
0.052
Indirect manufacturing labor cost (£12,000 ÷ 115,000) 0.104
Other indirect manufacturing cost (£7,000 ÷ 115,000)
0.061
Marketing, distribution, and customer-service costs
2-47
1.
£1.096
237,600
302,400
231,000
£ 71,400
= £1.817 per unit manufactured
per unit sold
(20-25 min.) Classification of costs; ethics.
Warehousing costs per unit =
per unit
If the $3,570,000 is treated as period costs, the entire amount would be expensed during
the year as incurred. If it is treated as a product cost, it would be “unitized” at $17 per unit and
expensed as each unit of the product is sold. Therefore, if only 190,000 of the 210,000 units are
sold, only $3,230,000 ($17 per unit × 190,000 units) of the $3,570,000 would be expensed in the
current period. The remaining $3,570,000 – $3,230,000 = $340,000 would be inventoried on the
balance sheet until a later period when the units are sold. The value of finished goods inventory
can also be calculated directly to be $340,000 ($17 per unit × 20,000 units).
2-30
2.
No. With respect to classifying costs as product or period costs, this determination is
made by GAAP. It is not something that can be justified by the plant manager or plant controller.
Even though these costs are in fact related to the product, they are not direct costs of
manufacturing the product. GAAP requires that research and development, as well as all costs
related to warehousing and distribution of goods, be classified as period costs and expensed in
the period they are incurred.
3.
Adalard Müller would improve his personal bonus and take-home pay by 8% × $340,000 =
$27,200.
4.
The controller should not reclassify costs as product costs just so the plant can reap shortterm benefits, including the increase in Müller’s personal year-end bonus. Research and
development costs, costs related to the shipping of finished goods, and costs related to
warehousing finished goods are all period costs under GAAP and must be treated as such.
Changing this classification on New Time’s financial statements would violate GAAP and would
likely be considered fraudulent. The idea of costs being classified as product costs versus period
costs is to properly reflect on the income statement those costs that are directly related to
manufacturing (costs incurred to transform one asset, direct materials into another asset, finished
goods) and to properly reflect on the balance sheet those costs that will provide a future benefit
(inventory). The controller should not be intimidated by Müller. Müller stands to personally
benefit from the reclassification of costs. The controller should insist that he must adhere to
GAAP so as not to submit fraudulent financial statements to corporate headquarters. If Müller
insists on the reclassification, the controller should raise the issue with the chief financial officer
after informing Müller that he is doing so. If, after taking all these steps, there is continued
pressure to modify the numbers, the controller should consider resigning from the company
rather than engage in unethical behavior.
2-31
2-48
(20–25 min.)
Finding unknown amounts.
Let G = given, I = inferred
Step 1:
Step 2:
Use gross margin formula
Revenues
Cost of goods sold
Gross margin
A
Case 1
$64,500
38,500
$26,000
Case 2
G
$57,600 G
I
33,400
G
G C $24,200 I
$14,500
5,200
10,400
30,100
4,600
34,700
2,300
32,400
G
$20,200
G
7,300
G D 9,800
I
37,300
G
2,800
I
40,100
G
5,500
I
34,600
G
G
I
I
G
I
G
I
6,600
32,400
39,000
500
38,500
G
I
I
I
I
G
I
I
G
G
Use schedule of cost of goods manufactured formula
Direct materials used
Direct manufacturing labor costs
Indirect manufacturing costs
Manufacturing costs incurred
Add beginning work in process, 1/1
Total manufacturing costs to account for
Deduct ending work in process, 12/31
Cost of goods manufactured
Step 3: Use cost of goods sold formula
Beginning finished goods inventory, 1/1
Cost of goods manufactured
Cost of goods available for sale
Ending finished goods inventory, 12/31
Cost of goods sold
B
5,100
34,600
39,700
6,300
33,400
For case 1, do steps 1, 2, and 3 in order.
For case 2, do steps 1, 3, and then 2.
Try It! 2-1
The following table shows the total costs of gasoline and insurance and the cost per mile if the
truck is driven (a) 25,000 miles and (b) 50,000 miles.
Number of Miles
Driven
(1)
25,000
50,000
Variable Gasoline
Costs
(2) = $0.25 × (1)
$6,250
12,500
Fixed Insurance
Costs
(3)
$5,500
5,500
2-32
Total Costs
(4) = (2) + (3)
$ 11,750
18,000
Cost per Mile
(5) = (4) ÷ (1)
$0.47
0.36
Try It! 2-2
We first calculate the cost of direct materials used and then total manufacturing costs incurred in
2020.
The cost of direct materials used is:
Beginning inventory of direct materials, January 1, 2020
+ Purchases of direct materials in 2020
− Ending inventory of direct materials, December 31, 2020
= Direct materials used in 2020
$10,000
90,000
2,000
$98,000
Total manufacturing costs incurred refers to all direct manufacturing costs and manufacturing
overhead costs incurred during 2020 for all goods worked on during the year. Carolyn
Corporation classifies its manufacturing costs into the three categories described earlier:
(i) Direct materials used in 2020
(ii) Direct manufacturing labor costs in 2020
(iii) Manufacturing overhead costs in 2020
Total manufacturing costs incurred in 2020
$ 98,000
32,000
39,000
$169,000
Try It! 2-3
(a) Cost of goods manufactured refers to the cost of goods brought to completion, whether they
were started before or during the current accounting period. Some of the manufacturing costs
incurred during 2020 are held back as the cost of the ending work-in-process inventory.
The cost of goods manufactured in 2020 for Carolyn Corporation is calculated as follows:
Beginning work-in-process inventory, January 1, 2020
$ 13,000
169,000
 Total manufacturing costs incurred in 2020
182,000
Total
manufacturing
costs
to
account
for

6,000
 Ending work-in-process inventory, December 31, 2020
$176,000
 Cost of goods manufactured in 2020
(b) The cost of goods sold is the cost of finished goods inventory sold to customers during the
current accounting period. Cost of goods sold is an expense that is matched against revenues.
The cost of goods sold in 2020 for Carolyn Corporation is calculated as follows:
Beginning inventory of finished goods, January 1, 2020
$ 13,000
176,000
 Cost of goods manufactured in 2020
16,000
Ending
inventory
of
finished
goods,
December
31,
2020

$173,000
 Cost of goods sold in 2020
2-33
CHAPTER 3
COST–VOLUME–PROFIT ANALYSIS
NOTATION USED IN CHAPTER 3 SOLUTIONS
SP:
VCU:
CMU:
FC:
TOI:
Selling price
Variable cost per unit
Contribution margin per unit
Fixed costs
Target operating income
3-1
Cost–volume–profit (CVP) analysis studies the impact on future profit of changes in
fixed costs, variable costs, volume, sales mix, and selling price. It explores the relationship that
exists between costs, revenue, output levels and resulting profit, and is more relevant where the
proposed changes in the levels of activity are relatively small.
3-2
1.
2.
3.
4.
The assumptions underlying the CVP analysis outlined in Chapter 3 are
Changes in the level of revenues and costs arise only because of changes in the number
of product (or service) units sold.
Total costs can be separated into a fixed component that does not vary with the units sold
and a variable component that changes with the number of units sold.
When represented graphically, the behaviors of total revenues and total costs are linear
(represented as a straight line) in relation to number of units sold within a relevant range
and time period.
The selling price, variable cost per unit, and total fixed costs are known and constant.
3-3
Operating income is total revenues from operations for the accounting period minus cost
of goods sold and operating costs (excluding income taxes):
Costs of goods sold and operating
Operating income = Total revenues from operations – costs (excluding income taxes)
Net income is operating income plus nonoperating revenues (such as interest revenue)
minus nonoperating costs (such as interest cost) minus income taxes. Chapter 3 assumes
nonoperating revenues and nonoperating costs are zero. Thus, Chapter 3 computes net income
as:
Net income = Operating income – Income taxes
3-4
Contribution margin represents the difference between the total revenues and total
variable costs. It indicates why the operating income changes as the number of units sold
changes. It can be expressed per unit (contribution margin per unit) or as a total (contribution
margin). The ratio of contribution margin to revenue is called contribution margin ratio (also
called contribution margin percentage). It is designed to measure the level of contribution
derivable from a specified amount of sales.
3-5
Three methods to express CVP relationships are the equation method, the contribution
margin method, and the graph method. The first two methods are most useful for analyzing
3-1
operating income at a few specific levels of sales. The graph method is useful for visualizing the
effect of sales on operating income over a wide range of quantities sold.
3-6
Breakeven point refers to the quantity of output sold at which total revenues equal total
costs. This is illustrated in the graph below. It is the level of activity at which there is neither
profit nor loss. It can be estimated by using a breakeven chart or by calculation. The breakeven
chart indicates approximate profit or loss at different levels of sales volume within a limited
range. The BEP tells managers how much they must to sell to avoid a loss.
TOTAL REVENUE
BEP
$
TOTAL COSTS
Q
BEP graph showing the point where the total revenue is equals the total cost.
3-7
CVP analysis is based on a simple assumption that focuses only on two factors: revenue
and cost. It assumes that the relationship between revenue and cost is linear. CVP analysis is
applicable within a relevant range of activity and it is assumed that productivity and efficiency of
operations will remain constant. CVP analysis also assumes that costs can be accurately divided
into fixed and variable categories and selling price and variable cost per unit remain constant
while these assumptions may not be true. CVP is limited in terms of the details and the amount
of information that it can provide, especially in a multi-product operation.
3-8
An increase in the income tax rate does not affect the breakeven point. Operating income
at the breakeven point is zero, and no income taxes are paid at this point.
3-9
Sensitivity analysis is a “what-if” technique that managers use to examine how an
outcome will change if the original predicted data are not achieved or if an underlying
assumption changes. The advent of the electronic spreadsheet has greatly increased the ability to
explore the effect of alternative assumptions at minimal cost. CVP is one of the most widely
used software applications in the management accounting area.
3-10 CVP analysis is more focused on the short run because the variables cannot be influenced
(fixed costs, selling price, and variable costs per unit). So, the only variable that can be altered is
the production and sales volume.
3-11 Yes. You can use the assumption of a constant sales mix of the products. You cannot
calculate the BEP in products, but you can calculate the BEP in dollars revenue.
3-2
3-12 Operating leverage describes the effects that fixed costs have on changes in operating
income as changes occur in units sold, and hence, in contribution margin. Knowing the degree of
operating leverage at a given level of sales helps managers calculate the effect of fluctuations in
sales on operating incomes.
3-13 CVP analysis is always performed within a relevant range of activity and for a specified
time horizon. What we consider to be a fixed cost in CVP analysis can be true when we are
focusing on a specific short horizon, but it may not be true when sufficient time is provided. In
other words, a fixed cost in a short horizon can be considered as unfixed in a long-term horizon.
Furthermore, there are some costs that are semi-fixed and some that are semi-variable, depending
on the relevant range of activities.
So, the time periods and the relevant range of activities are two main bases for sort costs
into the fixed and variable categories.
3-14
Breakeven analysis assumes the following:
• Selling price, variable cost per unit and fixed costs are all known and constant
• Profits are calculated on a variable costing only
• Cost and revenue behave in a linear fashion
3-15 The gross margin focuses on full cost, but the contribution margin focuses only on
variable cost to measures how much a company is making for its products above the costs of
acquiring or producing them. The contribution margin is the main focus of CVP analysis.
3-16 Choice "c" is correct. The number of boxes needed to be sold is calculated as follows:
Selling Price per box: $20 per box
Contribution % = 60%
Contribution margin per box: 60% × $20 = $12 per box
Fixed costs: $25,000
Income after tax: $15,000
Tax rate: 25%
Operating income before tax: $15,000 ÷ (1 – 0.25) = $15,000 ÷ 0.75 = $20,000
Total fixed costs $25,000 + target operating income, $20,000 = $45,000
Boxes necessary to produce target operating income: $45,000 / $12 per box = 3,750 boxes
Choice "a" is incorrect. The contribution margin of 60% means that variable costs are 40% of the
sale price, not 60% of the sales price.
Choice "b" is incorrect. The contribution margin needs to cover the fixed costs of $25,000 and
the operating income before tax of $20,000. Fixed costs are not subject to the income tax rate in
the calculation.
Choice "d" is incorrect. Net income of $15,000 is after deducting the income tax expense.
Operating income before tax of $20,000 must be generated in order to produce net income of
$15,000.
3-17
Choice “d” is correct. All the statements are correct.
Choice “a” is correct as contribution margin measures the difference in the operating profit
compared with the units sold.
3-3
Choice “b” is also correct as the contribution margin explains the revenue available from sales
from which the profit is derived after deducting the fixed costs.
Choice “c” is thus correct. The gross margin indicates the cost of sales compared to the actual
sales.
3-18
Choice “c” is correct. The contribution margin percentage per plate of fried rice is calculated as
[contribution margin per unit ÷ selling price x 100 = £2 ÷ £6 = 33.33%]. This means that Cheng
Hi Fried Rice Restaurant earns 33.33% for each plate of fried rice sold which contributes
towards the recovery of the fixed cost.
Choice “a” is incorrect. The contribution margin per unit has been calculated instead of the ratio.
Students should pay attention to what exactly is required in the question.
Choice “b” is incorrect. The ratio has been obtained by dividing the contribution margin per unit
by the variable cost per unit.
Choice “d” is incorrect as the variable costs to selling price ratio has been computed.
3-19
Choice “a” is correct. Step 1: First convert the net income to operating income = net income =
[1-tax rate]
£75,000 = £100,000
[1 – 0.25]
Step 2: Derive the new selling price. Sales volume (selling price – variable cost per unit) – fixed
costs = operating income. [50,000 (Selling price - £4) - £60,000 = £100,000]. Therefore, the
new selling price =£4 + £360,000 = £7.20 which is a percentage increase of 20%.
50,000
Choice “b” is incorrect. The operating income has been derived without considering the variable
costs of £200,000. This means that the new selling price becomes £3.2 which is a percentage
reduction of 46.67%.
Choice “c” is incorrect. The operating income has been derived without considering the fixed
costs of £60,000. This means that the new selling price remains at £6.00 which is a percentage
change of 0%.
Choice “d” is incorrect. The operating income has been equated to £75,000 instead of £100,000.
This means that the new selling price becomes £6.7 which is a percentage increase of 12%.
3-20
The correct Choice is “d”. [BEP in units = Fixed Costs ÷ contribution margin per unit = £60,000
£2
= 30,000 plates of fried rice.
This means that Cheng Hi Fried Rice Restaurant will break even if it sells 30,000 plates of fried
rice. The equivalent BEP in value can be calculated by multiplying the 30,000 plates by selling
price of £6, which is £180,000. Another approach of deriving the BEP in value is by dividing the
fixed cost of £60,000 by the contribution sales ratio.
Choice “a” is incorrect, though the BEP in units is correctly calculated but the value equivalent is
wrong. The BEP in value should be the BEP (units) multiplied by the selling price per unit.
Choice “b” is wrong because the BEP in value has been used instead of the units and the BEP in
value has been wrongly computed.
Choice “c” is also wrong as the BEP in units has been calculated as fixed cost divided by selling
price.
3-4
3-21
(10 min.) CVP computations.
Revenue
s
Variable
Costs
a.
$4,250
$1,700
b.
8,000
c.
d.
3-22
Fixed
Costs
Total
Costs
Operating
Income
Contribution
Margin
Operating
Income %
Contribution
Margin %
5,000
$1,27
5
1,000
$2,97
5
6,000
$1,275
$2,550
30.00%
60.00%
2,000
3,000
25.00%
37.50%
6600
3500
900
4400
2200
3,100
33.33%
46.97%
7,400
2,400
1800
4,200
3,200
5,000
43.24%
67.57%
(10–15 min.) CVP computations.
1a.
Contribution margin
($80 per unit × 40% × 540,000 units)
$ 17,280,000
1b.
Sales ($80 per unit × 540,000 units)
Contribution margin (from above)
Variable costs
$43,200,000
17,280,000
$25,920,000
1c.
Contribution margin (from above)
Fixed costs
Operating income
$17,280,000
2,100,000
$15,180,000
2a.
Sales (from above)
Variable costs ($25,920,000 × 80%)
Contribution margin
$43,200,000
20,736,000
$22,464,000
2b.
Contribution margin (from above)
Fixed costs ($2,100,000 + 3,800,000)
Operating income
$22,464,000
5,900,000
$16,564,000
3.
If the production manager’s proposal is accepted, the operating income is expected to
increase by $1,384,000 ($16,564,000 − $15,180,000).
The management would consider other factors before making the final decision. It is
likely that product quality will improve as a result of the modernized production process.
However, due to increased automation, many workers will probably have to be laid off.
Simplex’s management will have to consider the impact of such an action on employee
morale. In addition, the proposal increases the company’s fixed costs dramatically. This will
increase the company’s operating leverage and risk.
3-5
3-23
(35–40 min.) CVP analysis, changing revenues and costs.
1a.
SP
VCU
CMU
FC
= 10% × $1,300 = $130 per ticket
= $34 per ticket
= $130 – $34 = $96 per ticket
= $36,000 a month
Q
1b.
Q
2a.
SP
VCU
CMU
FC
tickets
tickets
= $130 per ticket
= $30 per ticket
= $130 – $30 = $100 per ticket
= $36,000 a month
Q
2b.
Q
3a.
SP
VCU
CMU
FC
tickets
tickets
= $46 per ticket
= $30 per ticket
= $46 – $30 = $16 per ticket
= $36,000 a month
Q
3b.
tickets
Q
tickets
The reduced commission sizably increases the breakeven point and the number of tickets
required to yield a target operating income of $12,000:
Breakeven point
Attain OI of $12,000
4a.
10%
Commission
(Requirement 2)
360
480
Fixed
Commission of $46
2,250
3,000
The $8 delivery fee can be treated as either an extra source of revenue (as done below) or
as a cost offset. Either approach increases CMU $8:
SP
= $54 ($46 + $8) per ticket
VCU = $30 per ticket
3-6
CMU = $54 – $30 = $24 per ticket
FC
= $36,000 a month
Q
4b.
Q
tickets
tickets
(refer to Equation 4)
The $8 delivery fee results in a higher contribution margin, which reduces both the breakeven
point and the tickets sold to attain operating income of $12,000.
3-7
3-24
Orig
.
1.
2.
(20 min.) CVP exercises.
Revenues
Variable
Costs
$12,500,000 G $9,750,000
Contribution
Margin
Fixed Costs
G $2,750,000
$2,240,000
G
2,240,000
2,240,000
$ 510,000
12,500,000
12,500,000
9,337,500
10,162,500
3,162,500
2,337,500
3.
12,500,000
9,750,000
2,750,000
2,464,000
c
286,000
4.
5.
6.
7.
8.
12,500,000
14,000,000 e
11,000,000 g
13,500,000 i
12,500,000
9,750,000
10,920,000
8,580,000
10,530,000
9,165,000
2,750,000
3,080,000
2,420,000
2,970,000
3,335,000
2,016,000
2,240,000
2,240,000
2,419,200
2,374,400
d
734,000
840,000
180,000
550,800
960,600
f
h
j
l
a
b
Budgeted
Operating
Income
922,500
97,500
k
m
Gstands for given.
a$2,750,000 × 1.15; b$2,750,000 × 0.85; c$2,240,000 × 1.10; d$2,240,000 × 0.90; e$12,500,000
× 1.12; f$9,750,000 × 1.12; g$12,500,000 × 0.88; h$9,750,000 × 0.88; i$12,500,000 × 1.08;
j$9,750,000 × 1.08; k$2,240,000 × 1.08; l$9,750,000 × 0.94; m$2,240,000 × 1.06
9. Alternative 8, an 6% decrease in variable costs holding revenues constant with a 6% increase
in fixed costs, yields the highest budgeted operating income because it has decreased variables
costs and consequently made a highest increase in the contribution margin which has contributed
in the highest increase in operating income after nullifying the effect of increase in fixed
costs.without increasing fixed costs.
3-25
(20 min.) CVP exercises.
1a.
[Units sold (Selling price – Variable costs)] – Fixed costs
[300,000 ($12.50 – $7.00)] – $880,000
1b.
Fixed costs ÷ Contribution margin per unit = Breakeven units
$880,000 ÷ [($12.50 – $7.00)] = 160,000 units
Breakeven units × Selling price = Breakeven revenues
160,000 units × $12.50 per unit = $2,000,000
or,
Contribution margin ratio
= Operating income
= $770,000
Fixed costs ÷ Contribution margin ratio = Breakeven revenues
$880,000 ÷ 0.44 = $2,000,000
3-8
2.
3.
4.
5.
6.
300,000 ($12.50 – $7.00 × 110%)) – $880,000
[300,000 (1.02) ($12.50 – $7.00)] – ($880,000 + 250,000)]
[300,000 (1.25) ($11.25 – $7. 70)] – [$880,000 (0.9)]
$880,000 (1.2) ÷ ($12.50 – $7.00)
($880,000 + $30,000) ÷ ($14.00 – $7.00)
3-26
=
=
=
=
=
$560,000
$2,813,000
$539,250
192,000 units
130,000 units
(10 min.) CVP analysis, income taxes.
1. Monthly fixed costs = $52,800 + $75,200 + $18,400 =
Contribution margin per unit = $5,000 – $4,200 – $5,000 × .04 =
Breakeven units per month
refrigerators
2. Tax rate
Target net income
Target operating income
30%
$63,000
Quantity required to be sold
3-27
1.
units
(20–25 min.) CVP analysis, income taxes.
Variable cost percentage is $3.80  $9.50 = 40%
Let R = Revenues needed to obtain target net income
R – 0.40R – $456,000 =
0.60R = $456,000 + $228,000
R = $684,000  0.60
R = $1,140,000
or,
Proof:
$146,400
$600
Revenues
Variable costs (at 40%)
Contribution margin
Fixed costs
Operating income
Income taxes (at 30%)
Net income
$1,140,000
456,000
684,000
456,000
228,000
68,400
$ 159,600
3-9
2.a.
Customers needed to break even:
Contribution margin per customer = $9.50 – $3.80 = $5.70
Breakeven number of customers = Fixed costs  Contribution margin per customer
= $456,000  $5.70 per customer
= 80,000 customers
2.b.
Customers needed to earn net income of $159,600:
Total revenues  Sales check per customer
$1,140,000  $9.50 = 120,000 customers
3.
Using the shortcut approach:
Change in net income
New net income
Unit
 Change in 





=  number of    contribution   1  Tax rate 
 customers 
 margin 




= (145,000 – 120,000)  $5.70  (1 – 0.30)
= $142,500  0.7 = $99,750
= $99,750 + $159,600 = $259,350
Alternatively, with 145,000 customers,
Operating income = Number of customers  Selling price per customer
– Number of customers  Variable cost per customer – Fixed costs
= 145,000  $9.50 – 145,000  $3.80 – $456,000 = $370,500
Net income
= Operating income × (1 – Tax rate) = $370,500 × 0.70 = $259,350
The alternative approach is:
Revenues, 145,000  $9.50
Variable costs at 40%
Contribution margin
Fixed costs
Operating income
Income tax at 30%
Net income
$1,377,500
551,000
826,500
456,000
370,500
111,150
$ 259,350
3-10
3-28
(10-15 mins.) CVP analysis, sensitivity analysis.
1)
SP = £3,500; or $6,300 @ 1.80 = £3,500.
VCU = £3,000
CMU = £500 per unit.
FC
= £10 million
Breakeven units
units
Operating income = (CMU × Q) − FC (refer to Equation 2 of Contribution margin
method)
CMU = £500
Q
= 25,000
Operating income = (£500 × 25,000 units) − £10million = £2.5million
2)
3)
Lets assume that the selling price per unit is ‘£z’
CMU = £z − £3,000
Using the Contribution margin method (Equation 2),
Operating income = (CMU × Q) − FC
We can derive the selling price as:
£2.5million = (£z − £3,000) × 25,000 − £7million
£2.5million = 25,000z − £75million − £7million
£84.5million = 25,000z
Therefore: z = £3,380
This represents a 3.4% price reduction.
4)
Quantity of superbikes required to be sold
units
To earn the target operating income of £5million, the company needs to sell 30,000
superbikes.
Proof:
Revenue, £3,500 per unit x 30,000 units
Variable costs, £3,000 per unit x 30,000 units
Contribution margin
Fixed costs
Operating income
Income taxes, £5,000,000 x 0.25
Net income
3-11
£105,000,000
90,000,000
15,000,000
10,000,000
5,000,000
1,250,000
£3,750,000
3-29
1.
(10 min.) CVP analysis, margin of safety.
Breakeven point revenues
Contribution margin percentage
2.
Contribution margin percentage =
Selling price  Variable cost per unit
Selling price
SP  $30
0.25 =
SP
0.25 SP = SP – $30
0.75 SP = $30
SP = $40
3. Breakeven sales in units = Breakeven revenues ÷ Selling price = $3,200,000 ÷ $40 = 80,000
units
Margin of safety in units = Sales in units – Breakeven sales in units = 105,000 – 80,000 =
25,000 units
Revenue (105,000 units  $40)
$4,200,000
Breakeven revenues
3,200,000
Margin of safety
$1,000,000
4. The risk of making a loss is high. If due to adverse situations, sales decrease by 25,000 units
÷ 105,000 units i.e. by 23.81% or more, Ariba will make a loss. The most likely reasons for
this risk are increased competition, entry of substitute products, sudden drop in demand due
to economic condition, or bad management.
3-12
3-30
(25 min.) Choosing most profitable production volume.
1.
Denote fixed costs by F.
Selling price × Units sold – Variable cost per unit × Units sold – Fixed costs = Operating income
$50 × 6,000 – $30 × 6,000 – F = $ 20,000
$300,000 − $180,000 – F = $ 20,000
$120,000 – F = $ 20,000
F = $100,000
Under the alternative choice, Blanchard’s operating income is:
$60 ×3,500 + $40×2,000 − $30×5,500 − $100,000 = $210,000 + $80,000 − $165,000 − $100,000
= $ 25,000
Blanchard should choose the second alternative because the operating income of $25,000 is
greater than the operating income of $20,000 under first alternative.
2.
Selling price × Units sold – Variable cost per unit × Units sold – Fixed costs = Operating income
(a) If Centa sells 2,500 units, its operating income will be
$300 × 2,500 – $75 × 2,500 – $250,000 = $ 750,000 – $187,500 – $250,000 = $312,500
(b) If Centa sells 5,000 units, its operating income will be
$200 × 5,000 – $50 × 5,000 – $350,000 = $1,000,000 – $250,000 – $350,000 = $400,000
(c) If Centa sells 8,000 units, its operating income will be
$175 × 8,000 – $30 × 8,000 – $800,000 = $1,400,000 – $240,000 – $800,000 = $360,000
Centa Corporation should plan to produce and sell 5,000 units because this level of production
and sales maximizes operating income.
3-31
(25 min.) Operating leverage.
1a.
Let Q denote the quantity of carpets sold
Breakeven point under Option 1
$1,500Q  $900Q  (0.25  $1,500Q) =
0
225Q =
0
Q =
0
Breakeven point under Option 2
$1,500Q  $900Q
=
$30,000
$600Q
=
$30,000
Q
=
$30,000  $600 = 50 carpets
1b.
3-13
2.
Operating income under Option 1 = $225Q
Operating income under Option 2 = $600Q  $30,000
Find Q such that $225Q = $600Q  $30,000
$375Q = $30,000
Q = $30,000 $375 = 80 carpets
Revenue = $1,500 × 80 carpets = $120,000
For Q = 80 carpets, operating income under both Option 1 ($225 × 80) and Option 2
($600 × 80  $30,000) = $18,000
For Q > 80, say, 81 carpets,
Option 1 gives operating income = $225  81 = $18,225
Option 2 gives operating income = ($600  81)  $30,000 = $18,600
Broadpull Rugs will prefer Option 2.
For Q < 80, say, 79 carpets,
Option 1 gives operating income = $225  79 = $17,775
Option 2 gives operating income = ($600  79)  $30,000 = $17,400
Broadpull Rugs will prefer Option 1.
3.
Degree of operating leverage
Option 1
Contribution margin per unit = $1,500 – $900 – 0.25  $1,500 = $225
Degree of operating leverage
Option 2
Contribution margin per unit = $1,500 – $900 = $600
Degree of operating leverage
(rounded)
4.
The calculations in requirement 3 indicate that when sales are 80 units, a percentage change
in sales and contribution margin will result in 2.67 times that percentage change in operating
income for Option 2, but the same percentage change in operating income for Option 1 (because
there are no fixed costs in Option 1). The degree of operating leverage at a given level of sales
helps managers calculate the effect of fluctuations in sales on operating incomes.
3-14
3-32 (15 min.)
Country
CVP analysis, international cost structure differences.
(1)
(2)
(3)
Italy
$200 $ 6,386,000 $70
Spain
200
5,043,000
61
Singapore 200 12,240,000
84
(4)
(5) = (1)
– (3)
– (4)
$27 $103.00
16 123.00
14 102.00
(6) =
(2)  (5)
62,000
41,000
120,000
(7) =
[80,000  (5)]–
(6)  (1)
(2)
$12,400,000 $1,854,000
8,200,000
4,797,000
24,000,000 (4,080,000)
Requirement 1
Requirement 1
Requirement 2
Spain has the lowest breakeven point because it has both the lowest fixed costs ($5,043,000) and the lowest variable cost per unit
($77.00). Hence, for a given selling price, Spain will always have a higher operating income (or a lower operating loss) than Italy or
Singapore.
The Singapore breakeven point is 120,000 units. Hence, with sales of only 80,000 units, it has an
operating loss of $4,080,000.
3-15
3-33
(30 min.) Sales mix, new and upgrade customers.
1.
SP
VCU
CMU
New
Customers
$195
65
$130
Upgrade
Customers
$115
35
$ 80
The 60%/40% sales mix implies that, in each bundle, 3 units are sold to new customers and 2
units are sold to upgrade customers.
Contribution margin of the bundle = 3  $130 + 2  $80 = $390 + $160 = $550
$16,500,000
Breakeven point in bundles =
= 30,000 bundles
$550
Breakeven point in units is:
Sales to new customers:
30,000 bundles  3 units per bundle
90,000 units
Sales to upgrade customers: 30,000 bundles  2 units per bundle
60,000 units
Total number of units to breakeven (rounded)
150,000 units
Alternatively,
Let S = Number of units sold to upgrade customers
1.5S = Number of units sold to new customers
Revenues – Variable costs – Fixed costs = Operating income
[$195 (1.5S) + $115S] – [$65 (1.5S) + $35S] – $16,500,000 = OI
$407.5S – $132.5S – $16,500,000 = OI
Breakeven point is 150,000 units when OI = $0 because
$275S
S
1.5S
BEP
= $16,500,000
= 60,000 units sold to upgrade customers
= 90,000 units sold to new customers
= 150,000 units
Check
Revenues ($195  90,000) + ($115  60,000)
Variable costs ($65  90,000) + ($35  60,000)
Contribution margin
Fixed costs
Operating income
3-16
$24,450,000
7,950,000
16,500,000
16,500,000
$
0
2.
When 170,000 units are sold, mix is:
Units sold to new customers (60%  170,000)
Units sold to upgrade customers (40%  170,000)
Revenues ($195  102,000) + ($115  68,000)
Variable costs ($65  102,000) + ($35  68,000)
Contribution margin
Fixed costs
Operating income
3a.
102,000
68,000
$27,710,000
9,010,000
18,700,000
16,500,000
$ 2,200,000
At New 40%/Upgrade 60% mix, each bundle contains 2 units sold to new customers and 3
units sold to upgrade customers.
Contribution margin of the bundle = 2  $130 + 3  $80 = $260 + $240 = $500
$16,500,000
Breakeven point in bundles =
= 33,000 bundles
$500
Breakeven point in units is:
Sales to new customers:
33,000 bundles × 2 unit per bundle
66,000 units
Sales to upgrade customers:
33,000 bundles × 3 unit per bundle
99,000 units
Total number of units to breakeven
165,000 units
Alternatively,
Let S = Number of units sold to new customers
then 1.5S = Number of units sold to upgrade customers
[$195S + $115 (1.5S)] – [$65S + $35 (1.5S)] – $16,500,000 = OI
367.5S – 117.5S = $16,500,000
250S
= $16,500,000
S
=
66,000 units sold to new customers
1.5S =
99,000 units sold to upgrade customers
BEP
=
165,000 units
Check
Revenues ($195  66,000) + ($115  99,000)
$24,255,000
Variable costs ($65  66,000) + ($35  99,000)
7,755,000
Contribution margin
16,500,000
Fixed costs
16,500,000
Operating income
$
0
3b.
At New 80%/ Upgrade 20% mix, each bundle contains 4 units sold to new customers and 1
unit sold to upgrade customers.
Contribution margin of the bundle = 4  $130 + 1  $80 = $520 + $80 = $600
$16,500,000
Breakeven point in bundles =
= 27,500 bundles
$600
Breakeven point in units is:
Sales to new customers:
27,500 bundles  4 units per bundle
110,000 units
Sales to upgrade customers:
27,500 bundles  1 unit per bundle
27,500 units
Total number of units to breakeven
137,500 units
3-17
Alternatively,
Let S = Number of units sold to upgrade customers
then 4S = Number of units sold to new customers
[$195 (4S) + $115S] – [$65 (4S) + $35S] – $16,500,000 = OI
895S – 295S = $16,500,000
600S
= $16,500,000
S
=
27,500 units sold to upgrade customers
4S
=
110,000 units sold to new customers
137,500 units
Check
Revenues ($195  110,000) + ($115  27,500)
Variable costs ($65  110,000) + ($35  27,500)
Contribution margin
Fixed costs
Operating income
$24,612,500
8,112,500
16,500,000
16,500,000
$
0
3c. As Chartz increases its percentage of new customers, which have a higher contribution
margin per unit than upgrade customers, the number of units required to break even decreases:
Requirement 3(a)
Requirement 1
Requirement 3(b)
New
Customers
40%
60
80
3-18
Upgrade
Customers
60%
40
20
Breakeven
Point
165,000
150,000
137,500
3-34
(15–25 min.) Sales mix, three products.
1.
Sales of A, B, and C are in ratio 40,000:120,000:80,000
For every 1 unit of A, 3 (120,000 ÷ 40,000) units of B are sold, and 2 (80,000 ÷ 40,000)
units of C are sold.
Contribution margin of the bundle = (1  $7) + (3  $5) + (2  $4) = $7 + $15 + $8 = $30
Breakeven point (in bundles)
bundles
Breakeven point in units is:
Product A:
18,400 bundles × 1 unit per bundle
18,400 units
Product B:
18,400 bundles × 3 units per bundle
55,200 units
Product C:
18,400 bundles × 2 units per bundle
36,800 units
Total number of units to breakeven
110,400 units
Alternatively,
Let Q = Number of units of A to break even
3Q = Number of units of B to break even
2Q = Number of units of C to break even
Contribution margin – Fixed costs = Zero operating income
$7Q + $5(3Q) + $4(2Q) – $552,000
$30Q
Q
3Q
2Q
Total
2.
=
=
=
=
=
=
0
$552,000
18,400 ($552,000 ÷ $30) units of A
55,200 units of B
36,800 units of C
110,400 units
Calculate sales mix at 220,000 total units:
A: 1/6 (or 40,000/240,000)  220,000 = 0.167; 0.167  220,000 = 36,740 units
B: 3/6 (or 120,000/240,000)  220,000 = 0.5; 0.5  220,000 = 110,000 units
C: 2/6 (or 80,000/240,000)  220,000 = 0.333; 0.333  220,000 = 73,260 units
Contribution margin:
A:
36,740  $7 $257,180
B:
110,000  $5 550,000
C:
73,260  $4
293,040
Contribution margin
$1,100,220
Fixed costs
552,000
Operating income
$548,220
3.
Contribution margin
A:
40,000  $7
B: 100,000  $5
C: 100,000  $4
Contribution margin
Fixed costs
Operating income
$628,000
$280,000
500,000
400,000
$1,180,000
552,000
3-19
Sales of A, B, and C are in ratio 40,000 : 100,000 : 100,000. So for every 1 unit of A, 2.5
(1,000,000 ÷ 40,000) units of B and 2.5 (100,000 ÷ 40,000) units of C are sold, that is, for every
2 units of A, 5 units of B and 5 units
Contribution margin of the bundle = (2  $7) + (5  $5) + (5  $4) = $14 + $25 + $20 = $59
Breakeven point in bundles = 552,000 / $59 = 9,356 bundles (rounded)
Breakeven point in units is:
Product A:
9,356 bundles  2 units per bundle
Product B:
9,356 bundles  5 units per bundle
Product C:
9,356 bundles  5 units per bundle
Total number of units to breakeven
Alternatively,
Let 2Q =
5Q =
5Q =
18,712 units
46,780 units
46,780 units
112,272 units
Number of units of A to break even
Number of units of B to break even
Number of units of C to break even
Contribution margin – Fixed costs
=
Breakeven point
$7(2Q) + $5(5Q) + $4(5Q) – $552,000
$59Q
2Q
5Q
5Q
Total
=
=
=
=
=
=
0
$552,000
18,712 [($552,000 ÷ $59)  2] units of A
46,780 units of B
46,780 units of C
112,272 units
Breakeven point increases because the new mix contains less of the higher contribution margin
per unit, product B, and more of the lower contribution margin per unit, product C.
4. No, it is not always better to choose the sales mix with the lowest breakeven point because this
calculation ignores the demand for the various products. The company should look to and sell as
much of each of the three products as it can to maximize operating income even if this means
that this sales mix results in a higher breakeven point.
3-20
3-35
i.
(15-20 mins.) CVP analysis, decision making
Sales
Manufacturing costs
Total
Fixed costs
Variable costs
Variable cost per unit
Selling and Administration
Total
Fixed costs
Commission (3%)
Variable costs
ii. Variable cost per unit
2,000,000
6,000,000kr
2,400,000kr
3,600,000kr
1.8kr (3,600,000kr/2,000,000)
3,100,000kr
2,300,000kr
300,000kr
500,000kr
25p (500,000kr/2,000,000)
Evaluation of order
Incremental costs
Manufacturing
150,000 x 1.8kr
=
270,000kr
Sales
150,000 x 0.25kr
=
37,500kr
Clips
150,000 x 0 .2kr
=
30,000kr
Incremental costs
=
337,500kr
Incremental revenue
660,000kr
2). Incremental contribution
322,500kr
3). Acceptance of the order will increase the contribution by 322,500kr, so the operating income
(profits) will rise from 900,000kr to 1,222,500kr (an increase of 35.8%).
4) Although the president is correct that the acceptance of the order may trigger a chain reaction
from competitors and may also encourage other customers to request special discounts. However,
the order has a positive contribution and hence adds to the operating income of the business.
Therefore, the rejection of the order will be a bad decision as contribution of 322,500kr will be lost.
Orders with positive contributions should be considered.
3-21
3-36 (20 min.)
Contribution margin, gross margin and margin of safety.
1.
Roma Skincare
Operating Income Statement, June 2020
Units sold
Revenues
Variable costs
Variable manufacturing costs
Variable marketing costs
Total variable costs
Contribution margin
Fixed costs
Fixed manufacturing costs
Fixed marketing & administration costs
Total fixed costs
Operating income
2.
15,000
$120,000
$60,000
6,000
66,000
54,000
$22,000
14,000
36,000
$18,000
Contribution Margin per Unit
per unit
Breakeven Quantity
units
Selling Price
per unit
Breakeven revenues = 10,000 units × $8 per unit = $80,000
Alternatively,
Contribution Margin Percentage
Breakeven Revenue
3.
4.
Margin of safety (in units) = Units sold – Breakeven quantity
= 15,000 units – 10,000 units = 5,000 units
Units Sold
Revenue (units sold × selling price = 12,000 × $8)
Contribution Margin (revenue × CM percentage = $96,000 × 45%)
12,000
$96,000
$43,200
Fixed Costs
Operating Income
Taxes (30% × $7,200)
Net Income
36,000
7,200
2,160
$5,040
3-22
3-37 (30 min.) Uncertainty and expected costs.
1. Monthly Number of
Orders
400,000
600,000
800,000
Monthly Number of
Orders
400,000
600,000
800,000
Cost of Current System
$2,500,000 + $62(400,000) =
$2,500,000 + $62(600,000) =
$2,500,000 + $62(800,000) =
$27,300,000
$39,700,000
$52,100,000
Cost of Partially Automated System
$7,200,000 + $50(400,000) =
$7,200,000 + $50(600,000) =
$7,200,000 + $50(800,000) =
Monthly Number of
Cost of Partially Automated System
Orders
400,000
$11,400,000 + $30(400,000) =
600,000
$11,400,000 + $30(600,000) =
800,000
$11,400,000 + $30(800,000) =
2. Current System Expected Cost:
$27,300,000 ×
0.35
=
$9,555,000
39,700,000 ×
0.40
=
15,880,000
52,100,000 ×
0.25
=
13,025,000
$38,460,000
Partially Automated System Expected Cost:
$27,200,000 ×
0.35
=
37,200,000 ×
0.40
=
47,200,000 ×
0.25
=
Fully Automated System Expected Cost:
$23,400,000 ×
0.35
=
29,400,000 ×
0.40
=
35,400,000 ×
0.25
=
$27,200,000
$37,200,000
$47,200,000
$23,400,000
$29,400,000
$35,400,000
$9,520,000
14,880,000
11,800,000
$36,200,000
$8,190,000
11,760,000
8,850,000
$28,800,000
3. Futuremart should consider the impact of the different systems on its relationship with
suppliers. The interface with Futuremart’s system may require that suppliers also update their
systems. This could cause some suppliers to raise the cost of their merchandise. It could force
other suppliers to drop out of Futuremart’s supply chain because the cost of the system change
would be prohibitive. Futuremart may also want to consider other factors such as the reliability
of different systems and the effect on employee morale if employees have to be laid off as it
automates its systems.
3-23
3-38 (15-20 mins) CVP analysis, Service firms
1.
FC = £1,590
CMU = SP – VC = £2.00
Contribution margin percentage
2.
We can rearrange Equation 3 to derive the BEP.
Breakeven output level
units
Breakeven revenue
Alternative:
Breakeven revenues = Breakeven number of units x Selling price
= 795 units × £2.50 = £1,987.50
Operating income = (Contribution margin per unit x Quantity of unit sold) – Fixed costs
The contribution margin per unit = £2.00, quantity = 20,000 units and fixed costs = £1,590
Therefore, operating income = (£2.00 × 20,000) − £1,590 = £40,000 − £1,590 = £38,410
3.
4.
If the rental cost increases by £288, the fixed costs = £1,590 + £288 = £1,878
Breakeven output level
units
Breakeven revenue
Alternative:
Breakeven revenues
5.
= Breakeven number of units × Selling price
= 939 units × £2.50 = £2,347.50
Fixed costs = £1,590
Variable cost per unit = £0.50 + £0.10 = £0.60
Contribution margin per unit = SP – VC = £2.50 - £0.60 = £1.90
Contribution margin % = £1.90 ÷ £2.50 = 0.76 = 76%
i.
New breakeven units
units
New breakeven revenue
The additional £0.10 paid to the manufacturer for each unit sold is a variable cost and therefore
increases the variable costs to £0.60.
ii.
3-39
Operating income = (Contribution margin per unit × Quantity of unit sold) – Fixed
costs
= (£1.90 × 20,000) − £1,590 = £36,410.
(15-20 mins.) CVP analysis, medical sector.
1. Contribution margin ratio = Total fees – Total variable cost
Total fees
Contribution margin per unit
3-24
2. BEP in in-patient days = Total Fixed Costs
=
Contribution margin per unit
BEP in in-patient fees = Total Fixed Costs
Contribution margin ratio
=
¥252,000
¥9
= 28,000 days
¥252,000
0.18
= ¥1,400,000
3. Margin of safety at full capacity
Full capacity in-Patient days – BEP in-patient days × 100
Full capacity in-Patient days
Note: Full capacity = 80 beds × 365 days = 29,200 in-patient days
29,200 – 28,000 × 100 = 1200 ×100 = 4.11%
29,200
29,200
4. Contribution margin per unit
BEP in in-patient days if direct salaries were increased:
5. BEP in in-patient days if fixed patient service overheads were increased:
3-25
3-40
(30 mins.) CVP analysis, sensitivity analysis, and margin of safety
1) Variable cost of a chair (VCU) = €15 + €8 + €7 = €30
2) Breakeven output
3) Operating income
=
=
Contribution margin – Fixed costs (refer to Equation 2)
(€20 × 200) − €3,000 = €4,000 − €3,000 = €1,000
4) Quantity of chairs required to be sold = Fixed Costs + Target operating income
Contribution margin per unit
Refer to Equation 4.
The company will have to produce and sell 350 chairs to achieve the TOI of €4,000.
New information:
SP
= €48,
VCU = (€15 × 1.2) + €8 + €7 = €18 + €8 + €7 = €33
FC = €4,000
5) Breakeven output =
Fixed Costs
=
€4,000
= 267 chairs
Contribution margin per unit
€15
6) Operating income
= Contribution margin – Fixed costs
= [(€48 - €33) x 350 chairs] − €4,000 = €1,250
7) Margin of safety in units
= Sales in units – Breakeven sales in units
= 350 – 267 = 83 units
Margin of safety percentage = (Sales in units – Breakeven sales in units) × 100
Sales in units
= (350 – 267) × 100 = 83 × 100
267
267
8) Desired output
= 31.1%
= Fixed Cost + Target operating income
Contribution margin per unit
= €4,000 + €4,000
€15
= 533 chairs
3-26
3-41
(30–40 min.) CVP analysis, income taxes.
1.
Revenues – Variable costs – Fixed costs =
Target net income
1  Tax rate
Let X = Net income for 2020
22,000($35.00) – 22,000($18.50) – $214,500 =
$770,000 – $407,000 – $214,500 =
X
1  0.40
X
0.60
$462,000 – $244,200 – $128,700 = X
X = $89,100
Alternatively,
Operating income = Revenues – Variable costs – Fixed costs
= $770,000 – $407,000 – $214,500 = $148,500
Income taxes = 0.40 × $148,500 = $59,400
Net income = Operating income – Income taxes
= $148,500 – $59,400 = $89,100
2.
Let Q = Number of units to break even
$35.00Q – $18.50Q – $214,500 = 0
Q = $214,500  $16.50 = 13,000 units
3.
Let X = Net income for 2021
25,000($35.00) – 25,000($18.50) – ($214,500 + $16,500)
=
$875,000 – $462,500 – $231,000
=
$181,500
=
X
1  0.40
X
0.60
X
0.60
X = $108,900
4.
Let Q = Number of units to break even with new fixed costs of $146,250
$35.00Q – $18.50Q – $231,000
Q = $231,000  $16.50
Breakeven revenues = 14,000  $35.00
5.
= 0
= 14,000 units
= $490,000
Let S = Required sales units to equal 2020 net income
$35.00S – $18.50S – $231,000 =
$89,100
0.60
$16.50S = $379,500
S = 23,000 units
Revenues = 23,000 units  $35 = $805,000
6.
Let A = Amount spent for advertising in 2021
$875,000 – $462,500 – ($214,500 + A) =
$108,450
0.60
$875,000 – $462,500 – $214,500 – A = $180,750
$875,000 – $857,750 = A
A = $17,250
3-27
3-42 (25 min.) CVP, sensitivity analysis.
[NOTE: In some versions of the print book, the question contains a mix of currency
symbols ($ and €). This is incorrect and the correct currency symbol for the question is €.]
Contribution margin per unit = €25 – €15 = €10
Fixed costs = €174,000
Units sold = Total sales ÷ Selling price = €750,000 ÷ €25 per pair = 30,000 units
Variable costs per unit = €5 +€4 + €6 = €15
1. variable manufacturing costs per unit decrease by 25%; Fixed costs increase by 20%
Sales revenues: 30,000 × €25
€750,000
Variable costs: 30,000 × (€15 – €4 × 0.25)
420,000
Contribution margin: 30,000 × €11
330,000
Fixed costs €174,000 ×1.20
208,800
Operating income
€121,200
2. Increase advertising (fixed costs) by €30,000; Increase sales 20%
Sales revenues: 30,000 × 1.20 × €25.00
€900,000
Variable costs: 30,000 × 1.20 × €15.00
540,000
Contribution margin
360,000
Fixed costs: (€174,000 + €30,000)
204,000
Operating income
€ 156,000
3. Increase selling price by €5; Sales decrease 20%; Increase Raw-material costs by €3
Sales revenues: 30,000 × (1 –0.2) × (€25 + €5) €720,000
Variable costs: 30,000 × (1 –0.2) × (€15 + €3) 432,000
Contribution margin: 30,000 × (1 –0.2) × €12 288,000
Fixed costs
174,000
Operating income
€ 114,000
4. Double fixed costs; Increase sales by 60%
Sales revenues: 30,000 × 1.60 × €25
Variable costs: 30,000 × 1.60 × €15
Contribution margin: 30,000 × 1.60 × €10
Fixed costs €174,000 × 2
Operating income
€1,200,000
720,000
480,000
348,000
€132,000
Alternative 2 yields the highest operating income. Choosing alternative 2 will give
Mundial Nails a 23.81% [(€156,000 – €126,000)/€126,000 = 23.81%] increase in
operating income, which is less than the company’s 25% targeted increase. Alternative 4
also generates more operating income for Mundial Nails, but it too does not meet
Mundial Nails’ target of 25% increase in operating income. Alternatives 1 and 3 result in
lower operating income than under Mundial Nails’ current cost structure. There is no
reason, however, for Mundial Nails to think of these alternatives as being mutually
exclusive. For example, Mundial Nails can combine actions 1 and 2, automate the
machining process and spend for a new advertising campaign and by this process
increase sales by 20% and decrease variable manufacturing costs per unit by 25% while
increasing fixed costs by 20% and spending €30,000 for the new advertisement
3-28
campaign. This will result in a 24.76% [(€157,200 – €126,000)/€126,000 = 24.76%]
increase in operating income as follows:
Sales revenue: 30,000 × 1.20 × €25
Variable costs: 30,000 × 1.20 × (€15 – €4 × 0.25)
Contribution margin: 30,000 × 1.20 × €11
Fixed costs: €174,000 × 1.20 + €30,000
Operating income
€900,000
504,000
396,000
238,800
€157,200
The point of this problem is that managers always need to consider broader rather than
narrower alternatives to meet ambitious future or stretch goals.
3-43
(20–30 min.) CVP analysis, shoe stores.
1. CMU (SP – VCU = $40 – $31)
a. Breakeven units (FC÷CMU = $171,000÷$9 per unit)
b. Breakeven revenues
(Breakeven units × SP = 19,000 units×$40 per unit)
$
2. Pairs sold
Revenues, 15,000 × $40
Total cost of shoes, 15,000 × $29
Total sales commissions, 15,000 × $2
Total variable costs
Contribution margin
Fixed costs
Operating income (loss)
15,000
$600,000
435,000
30,000
465,000
135,000
171,000
$ (36,000)
3. Unit variable data (per pair of shoes)
Selling price
Cost of shoes
Sales commissions
Variable cost per unit
Annual fixed costs
Rent
Salaries, $96,000 + $19,190
Advertising
Depreciation
Other fixed costs
Total fixed costs
9.00
19,000
$760,000
$
40.00
29.00
0
29.00
$
$
25,000
115,190
35,000
6,000
9,000
$ 190,190
CMU, $40 – $29
a. Breakeven units, $190,190 ÷ $11 per unit
b. Breakeven revenues, 17,290 units × $40 per unit
3-29
$
11
17,290
$691,600
4. Unit variable data (per pair of shoes)
Selling price
Cost of shoes
Sales commissions
Variable cost per unit
Total fixed costs
$
40.00
29.00
3.50
$ 32.50
$171,000
CMU, $40 – $32.5
a. Break even units = $171,000 ÷ $7.50 per unit
b. Break even revenues = 22,800 units × $40 per unit
5. Pairs sold
Revenues (25,000 pairs × $40 per pair)
Total cost of shoes (25,000 pairs × $29 per pair)
Sales commissions on first 19,000 pairs (19,000 pairs × $2 per pair)
Sales commissions on additional 6,000 pairs
[6,000 pairs × ($2 + $1.50 per pair)]
Total variable costs
Contribution margin
Fixed costs
Operating income
$
7.50
22,800
$912,000
25,000
$1,000,000
725,000
38,000
21,000
784,000
216,000
171,000
$ 45,000
Alternative approach:
Breakeven point in units = 19,000 pairs
Store manager and store supervisor receive commission of $1.50 ($1+$0.50) on 6,000 (25,000 –
19,000) pairs.
Contribution margin per pair beyond breakeven point of 19,000 pairs =
$7.50 ($40 – $31 – $1.50) per pair.
Operating income = 6,000 pairs × $7.50 contribution margin per pair = $45,000.
3-30
3-44 (30 min.) CVP analysis, shoe stores (continuation of 3-43).
1. For an expected volume of 25,000 pairs, the owner would be inclined to choose the higherfixed-salaries-only plan because income would be much higher by $30,810 compared to the
salary-plus-commission plan.
Operating income for salary plan = $11 × 25,000 – $190,190 = $84,810
Operating income under commission pan = $9 × 25,000 – $171,000 = $54,000
However, it is likely that sales volume itself is determined by the nature of the compensation
plan. The salary-plus-commission plan provides a greater motivation to the salespeople, and it
may well be that for the same amount of money paid to salespeople, the salary-plus-commission
plan generates a higher volume of sales than the fixed-salary plan.
2.
Let TQ = Target number of units
For the salary-only plan,
$40TQ – $29TQ – $190,190
$11TQ
TQ
TQ
For the salary-plus-commission plan,
$40TQ – $31TQ – $171,000
$9TQ
TQ
TQ
= $99,000
= $289,190
= $289,190 ÷ $11
= 26,290 units
= $99,000
= $270,000
= $270,000 ÷ $9
= 30,000 units
The decision regarding the salary-plus-commission plan depends heavily on predictions
of demand. For instance, the salary-only plan offers the same operating income at 26,290 units as
the commission plan offers at 30,000 units.
3.
LadyStyle
Operating Income Statement, 2020
Revenues (20,000 pairs × $40) + (5,000 pairs × $35)
Cost of shoes, 25,000 pairs × $29
Commissions = Revenues × 5% = $975,000 × 0.05
Contribution margin
Fixed costs
Operating income
3-31
$975,000
725,000
48,750
201,250
171,000
$
30,250
3-45
(40 min.) Alternative cost structures, uncertainty, and sensitivity analysis.
1. Contribution margin per
page assuming current
fixed leasing agreement
Fixed costs = $1,500
Breakeven point
= $0.20 – $0.08 – $0.07 = $0.05 per page
pages
New commission-based agreement
Contribution margin per page
assuming $10 per 500 page
commission agreement
= $0.20 – $0.02a – $0.08 – $0.07 = $0.03 per page
Fixed costs = $0
Breakeven point
pages
(i.e., Sunshine makes a profit no matter how few pages it sells)
a
$10 ÷ 500 pages = $0.02 per page
2. Let x denote the number of pages Sunshine must sell for it to be indifferent between the
fixed leasing agreement and commission-based agreement.
To calculate x we solve the following equation.
$0.20x – $0.08x – $0.07x – $1,500 = $0.20x – $0.02x – $0.08x – $.07x
$0.05x – $1,500 = $0.03x
$0.02x = $1,500
x = $1,500 ÷ $0.02 = 75,000 pages
For sales between 0 to 75,000 pages, Sunshine prefers the commission-based agreement
because in this range, $0.03x > $0.05x – $1,500. For sales greater than 75,000 pages,
Sunshine prefers the fixed leasing agreement because in this range, $0.05x – $1,500 >
$0.03x.
3-32
3. Fixed leasing agreement
Pages
Sold
(1)
Revenue
(2)
30,000
30,000 × $0.20 = $6,000
45,000
45,000 × $0.20 = $9,000
60,000
60,000 × $0.20 = $12,000
75,000
75,000 × $0.20 = $15,000
90,000
90,000 × $0.20 = $18,000
Expected value of fixed leasing agreement
Variable Costs
(3)
Fixed
Costs
(4)
30,000 × $0.15 = $4,500
45,000 × $0.15 = $6,750
60,000 × $0.15 = $9,000
75,000 × $0.15 = $11,250
90,000 × $0.15 = $13,500
$1,500
$1,500
$1,500
$1,500
$1,500
Operating Income
(Loss)
(5) = (2) – (3) – (4)
Probability
(6)
$ 0
$ 750
$1,500
$2,250
$3,000
0.20
0.20
0.20
0.20
0.20
Expected
Operating
Income
(7) = (5)×(6)
$ 0
150
300
450
600
$1,500
Commission-based leasing agreement:
Pages Sold
Revenue
Variable Costs
(1)
(2)
(3)
30,000
30,000 × $0.20 = $6,000
30,000×$0.17 = $5100
45,000
45,000 × $0.20 = $9,000
45,000×$0.17=$,7,650
60,000
60,000 × $0.20 = $12,000
60,000×$0.17 = $10,200
75,000
75,000 × $0.20 = $15,000
75,000×$0.17=$12,750
90,000
90,000 × $0.20 = $18,000
90,000×$0.17=$15,300
Expected value of commission-based agreement
Operating
Income
(4) = (2) – (3)
$900
$1,350
$1,800
$2,250
$2,700
Probability
(5)
0.20
0.20
0.20
0.20
0.20
Expected
Operating Income
(6)=(4) × (5)
$ 180
270
360
450
540
$1,800
Sunshine should choose the commission-based agreement because the expected value is higher than under the fixed cost leasing
agreement. The range of sales is not high enough (i.e. >75,000) to make the fixed leasing agreement more attractive.
3-33
3-46 (20-30 min.) CVP, alternative cost structures.
1. Variable cost per unit = $10
Contribution margin per unit = Selling price –Variable cost per unit
= $30 – $10 = $20
Fixed Costs:
Manager’s salary ($60,000 × 1.18 × 0.4) ÷12
$2,360 per month
Rent
900 per month
Hourly employee wages (3 × 160 hours × $12)
5,760 per month
Total fixed costs
$9,020 per month
Breakeven point
= Fixed costs ÷ Contribution margin per unit
= $9,020 ÷ $20 = 451 hats (per month)
2. Target number of hats
3. Contribution margin per unit
Fixed costs
hats
= Selling price – Variable cost per computer
= $30 – (0.20 × $30) – $10 = $14
= Manager’s salary + Rent
= $2,360 + $900 = $3,260
Target number of hats
hats
4. Let x be the number of hats for which TopHats is indifferent between paying a monthly rental
fee for the retail space and paying a 5% commission on sales. TopHats will be indifferent
when the operating incomes under the two alternatives are equal.
$30x − $10x – $9,020 = $30x – $10x − $30 (0.05)x − $8,120
$20x – $9,020 = $18.50x − $8,120
$1.50 x = $900
x = 600 hats
For sales between 0 and 600 hats, TopHats prefers to pay the 5% commission because in this
range, $18.50x − $8,120 > $20x – $9,020. For sales greater than 600 hats, the company prefers
to pay the monthly fixed rent of $900 because $20x – $9,020> $18.50x − $8,120.
3-34
3-47
(30 min.)
CVP analysis, income taxes, sensitivity.
1a.
To breakeven, Carlisle Engine Company must sell 1,600 units. This amount represents
the point where revenues equal total costs.
Let Q denote the quantity of engines sold.
Revenue
=
Variable costs + Fixed costs
$4,000Q
=
$1000Q + $4,800,000
$3,000Q
=
$4,800,000
Q
=
1,600 units
Breakeven can also be calculated using contribution margin per unit.
Contribution margin per unit = Selling price – Variable cost per unit = $4,000 – $1,000 = $3,000
Breakeven
= Fixed Costs  Contribution margin per unit
= $4,800,000  $3,000
= 1,600 units
1b.
To achieve its net income objective, Carlisle Engine Company must sell 2,100 units.
This amount represents the point where revenues equal total costs plus the corresponding
operating income objective to achieve net income of $1,200,000.
Revenue = Variable costs + Fixed costs + [Net income ÷ (1 – Tax rate)]
$4,000Q = $1,000Q + $4,800,000 + [$1,200,000  (1  0.20)]
$4,000Q = $1,000Q + $4,800,000 + $1,500,000
Q = 2,100 units
2.
None of the alternatives will help Carlisle Engineering achieve its net income objective
of $1,200,000. Alternative b, where variable costs are reduced by $300 and selling price is
reduced by $400 resulting in 1,750 additional units being sold through the end of the year, yields
the highest net income of $1,180,000. Carlisle’s managers should examine how to modify
Alternative b to further increase net income. For example, could variable costs be decreased by
more than $300 per unit or selling prices decreased by less than $400? Calculations for the three
alternatives are shown below.
Alternative a
Revenues
=
($4,000  400) + ($3,400a  2,100) = $8,740,000
Variable costs =
$1,000  2,500b = $2,500,000
Operating income
=
$8,740,000 $2,500,000  $4,800,000 = $1,440,000
Net income =
$1,440,000  (1  0.20) = $1,152,000
a
$4,000 – ($4,000 × 0.15) ; b400 units + 2,100 units.
3-35
Alternative b
Revenues
=
($4,000  400) + ($3,600a  1,750) = $7,900,000
Variable costs =
($1,000  400) + (700b  1,750) = $1,625,000
Operating income
=
$7,900,000  $1,625,000  $4,800,000 = $1,475,000
Net income =
$1,475,000  (1  0.20) = $1,180,000
a
$4,000 – 400 ; b$1,000 – $300.
Alternative c
Revenues
=
($4,000  400) + ($2,800a  2,200) = $7,760,000
Variable costs =
$1,000  2,600b = $2,600,000
Operating income
=
$7,760,000 $2,600,000  $4,320,000c = 840,000
Net income =
$840,000  (1  0.20) = $672,000
a
$4,000 – ($4,000 0.30); b400 units + 2,200nits; c$4,800,000 – ($4,800,000  0.10)
3-48
(30 min.) Choosing between compensation plans, operating leverage.
1. We can recast AgroPharm’s income statement to emphasize contribution margin, and then use
it to compute the required CVP parameters.
AgroPharm Corporation
Income Statement for the Year Ended December 31, 2020
Revenues
Variable Costs
Cost of goods sold −
variable
Marketing commissions
Contribution margin
Fixed costs
Cost of goods sold − fixed
Marketing fixed
Operating income
Using Sales Agents
Using Own Sales Force
$45,000,000
$45,000,000
$15,750,000
8,100,000
$15,750,000
23,850,000
$21,150,000
$5,425,000
5,250,000
5,400,000
21,150,000
$23,850,000
$5,425,000
10,675,000
$10,475,000
Contribution margin percentage
($21,150,000-:-$45,000,000;
$23,850,000÷$45,000,000)
47.00%
Breakeven revenues
($10,675,000 ÷ 0.47;
3-36
7,950,000
13,375,000
$10,475,000
53.00%
$13,375,000 ÷ 0.53)
$22,712,766
Degree of operating leverage
($21,150,000 ÷ $10,475,000;
$23,850,000 ÷ $10,475,000)
$25,235,849
2.02
2.28
2. The calculations indicate that at sales of $45,000,000, a percentage change in sales and
contribution margin will result in 2.02 times that percentage change in operating income if
AgroPharm continues to use sales agents and 2.28 times that percentage change in operating
income if AgroPharm employs its own sales staff. The higher contribution margin per dollar of
sales and higher fixed costs gives AgroPharm more operating leverage, that is, greater benefits
(increases in operating income) if revenues increase but greater risks (decreases in operating
income) if revenues decrease. AgroPharm also needs to consider the skill levels and incentives
under the two alternatives. Sales agents have more incentive compensation and, hence, may be
more motivated to increase sales. On the other hand, AgroPharm’s own sales force may be more
knowledgeable and skilled in selling the company’s products. That is, the sales volume itself will
be affected by who sells and by the nature of the compensation plan.
3. Variable costs of marketing
= 14% of Revenues
Fixed marketing cost = $7,950,000
Variable
Fixed
Variable
Fixed
Operating income = Revenues 

 marketing  marketing
manuf. costs manuf. costs
costs
costs
Denote the revenues required to earn $10,475,000 of operating income by R, then
R  0.35R  $5,425,000  0.14R  $7,950,000 = $10,475,000
R  0.35R  0.14R = $5,425,000 + $7,950,000 + $10,475,000
0.51R = $23,850,000
R = $$23,850,000  0.51 = $46,764,706
3-37
3-49
(15–25 min.) Sales mix, three products.
1. Sales of A, B, and C are in ratio 40,000 : 200,000 : 160,000. So for every 1 unit of A, 5
(200,000 ÷ 40,000) units of B are sold, and 4 (160,000 ÷ 40,000) units of C are sold.
Contribution margin of the bundle = 1  $7 + 5  $5 + 4  $4 = $7 + $25 + $16 = $48
Breakeven point in bundles =
$1,020,000
= 21,250 bundles
$48
Breakeven point in units is:
Product A:
21,250 bundles × 1 unit per bundle
Product B:
21,250 bundles × 5 units per bundle
Product C:
21,250 bundles × 4 units per bundle
Total number of units to breakeven
21,250 units
106,250 units
85,000 units
212,500 units
Alternatively,
Let Q = Number of units of A to break even
5Q = Number of units of B to break even
4Q = Number of units of C to break even
Contribution margin – Fixed costs = Zero operating income
$7Q + $5(5Q) + $4(4Q) – $1,020,000 =
$48Q =
Q =
5Q =
4Q =
Total =
2. Contribution margin:
A:
40,000  $7
B:
200,000  $5
C:
160,000  $4
Contribution margin
Fixed costs
Operating income
3. Contribution margin
A: 40,000  $7
B: 160,000  $5
C: 200,000  $4
Contribution margin
Fixed costs
Operating income
0
$1,020,000
21,250 ($1,020,000 ÷ $48) units of A
106,250 units of B
85,000 units of C
212,500 units
$ 280,000
1,000,000
640,000
$1,920,000
1,020,000
$ 900,000
$ 280,000
800,000
800,000
$1,880,000
1,020,000
$ 860,000
Sales of A, B, and C are in ratio 40,000 : 160,000 : 200,000. So for every 1 unit of A, 4
(160,000 ÷ 40,000) units of B and 5 (200,000 ÷ 40,000) units of C are sold.
3-38
Contribution margin of the bundle = 1  $7 + 4  $5 + 5  $4 = $7 + $20 + $20 = $47
Breakeven point in bundles =
$1,020,000
= 21,703 bundles (rounded up)
$47
Breakeven point in units is:
Product A:
21,703 bundles × 1 unit per bundle
Product B:
21,703 bundles × 4 units per bundle
Product C:
21,703 bundles × 5 units per bundle
Total number of units to breakeven
Alternatively,
Let Q
4Q
5Q
=
=
=
21,703 units
86,812 units
108,515 units
217,030 units
Number of units of A to break even
Number of units of B to break even
Number of units of C to break even
Contribution margin – Fixed costs
=
Breakeven point
$7Q + $5(4Q) + $4(5Q) – $1,020,000 = 0
$47Q = $1,020,000
Q =
21,703 ($1,020,000 ÷ $47) units of A
(rounded up)
4Q =
86,812 units of B
5Q =
108,515 units of C
Total
=
217,030 units
Breakeven point increases because the new mix contains less of the higher contribution
margin per unit, product B, and more of the lower contribution margin per unit, product C.
3-39
3-50 ( 40 min.) Multi-product CVP and decision making.
1. Faucet filter:
Selling price
Variable cost per unit
Contribution margin per unit
$150
90
$60
Pitcher-cum-filter:
Selling price
Variable cost per unit
Contribution margin per unit
$160
80
$ 80
Each bundle contains two faucet models and three pitcher models.
So contribution margin of a bundle = 2 × $60 + 3 × $80 = $360
Breakeven point
bundles
Breakeven point in units of faucet models and pitcher models is:
Faucet models: 3,500 bundles × 2 units per bundle = 7,000 units
Pitcher models: 3,500 bundles × 3 units per bundle = 10,500 units
Total number of units to breakeven
= 17,500 units
Breakeven point in dollars for faucet models and pitcher models is:
Faucet models: 7,000 units × $150 per unit = $1,050,000
Pitcher models: 10,500 units × $160 per unit = 1,680,000
Breakeven revenue
= $2,730,000
Alternative
Weighted CMU
Breakeven point
Faucet filter
units
units
Pitcher-cum-filter
units
Breakeven point
Faucet filter: 7,000 units × $150 per unit = $1,050,000
Pitcher-cum-filter: 10,500 units × $160 per unit = $1,680,000
2. Faucet filter:
Selling price
Variable cost per unit
Contribution margin per unit
Pitcher-cum-filter:
Selling price
Variable cost per unit
Contribution margin per unit
$150
85
$ 65
$160
70
$ 90
3-40
Each bundle contains two faucet models and three pitcher models.
So contribution margin of a bundle = 2 × $65 + 3 × $90 = $400
Breakeven point
bundles
Breakeven point in units of faucet models and pitcher models is:
Faucet models: 3,750 bundles × 2 units per bundle = 7,500 units
Pitcher models: 3,750 bundles × 3 units per bundle = 11,250 units
Total number of units to breakeven
= 18,750 units
Breakeven point in dollars for faucet models and pitcher models is:
Faucet models: 7,500 bundles × $150 per unit = $ 1,125,000
Pitcher models: 11,250 bundles × $160 per unit = $ 1,800,000
Breakeven revenues
= $ 2,925,000
Alternative
Weighted CMU
Breakeven point
Faucet filter
units
units
Pitcher-cum-filter
units
Breakeven point in dollars:
Faucet filter: 7,500 units × $150 per unit
= $1,125,000
Pitcher-cum-filter: 11,250 units × $160 per unit = $1,800,000
3. Let x be the number of bundles for Romi Filters to be indifferent between the old and
new production equipment.
Operating income using old equipment = $360x – $1,260,000
Operating income using new equipment = $400x – $1,260,000 – $240,000
At point of indifference:
$360x – $1,260,000= $400x – $1,500,000
$400x – $360x = $1,500,000 – $1,260,000
$40x = $240,000
x = $240,000 ÷ $40 = 6,000 bundles
Faucet models: 6,000 bundles × 2 units per bundle = 12,000 units
Pitcher models: 6,000 bundles × 3 units per bundle = 18,000 units
Total number of units is
= 30,000 units
Let x be the number of bundles;
3-41
When total sales are less than 30,000 units (6,000 bundles)
$360x - $1,260,000 > $400x - $1,500,000
Romi Filters is better off with the old equipment.
When total sales are greater than 30,000 units (6,000 bundles)
$400x - $1,500,000 >$360x - $1,260,000
Romi Filters is better off buying the new equipment.
At total sales of 28,000 units (5,600 bundles), Romi Filters should keep the old
production equipment.
Proof
$360 × 5,600 – $1,260,000 = $756,000 > $400 × 5,600 – $1,500,000 = $740,000.
3-51
(30 mins.) Sales mix, two products and sensitivity analysis
1)
CPU =
£10 - £4 - £1.9
Contribution margin percentage
2)
We can rearrange Equation 3 to derive the BEP as:
Breakeven output
= £4.1
= 41%
units
Breakeven revenue
Note: 15,000 units sold at £10 per unit = £150,000
3)
Contribution margin ratio
= 41%
Total fixed costs
= £55,000 + £6,500 = £61,500
With revenues of £200,000 the contribution margin = 41% of £200,000 = £82,000
Operating income = CMU – FC (refer to Equation 2)
= £82,000 − £61,500 = £20,500
4)
Predicted change in unit sales from a price change (15% of 20,000) = 3,000
Predicted change in sales from the increase in advertising (5% of 20,000) = 1,000
Total change in sales
4,000
New sales total
24,000
Increase in Fixed costs
£10,000
New price
£9.5 (£10 − 5% of £10)
CMU = £9.5 - £4 - £1.9 = £3.6
Contribution margin on 24,000 sales = £3.6 x 24,000 = £86,400
Operating income = Contribution margin - Fixed costs
= £86,400 - £71,500 (£55,000 + £6,500 + £10,000) = £14,900.
(Rearranging Equation 2)
Clearly operating income has fallen from £20,500 when sales was 20,000 units at £10 per
unit, to £14,900 when sales is 24,000 units at £9.50 per unit.
3-42
5)
Deluxe
Deluxe price
Variable costs
Contribution
=
=
=
Standard
Standard price
VC of standard
Contribution
£15
£8
£7
Contribution margin
=
Breakeven Revenue
=
= £10
= £5.9
= £4.1
(3 x £4.1) + (1 x £7) = £4.825
4
4
£61,500
=
£12,746.11
£ 4.825
75% (3/4) are for the standard model = 0.75 x 12,747 = 9,560 units
25% (1/4) are for the deluxe model = 0.25 x 12,747 = 3,187 units
3-52
(20 min.) Gross margin and contribution margin.
1.
Ticket sales ($30  attendees)
Variable cost of magic show ($20a  600 attendees)
$12,000
b
Variable printing, invitations and paperwork ($1.5  600)
900
Contribution margin
5,100
Fixed cost of magic show
8,000
Fixed cost of printing, invitations and paperwork
900
Operating profit (loss)
a
$18,000
8,900
$ (3,800)
($20,000  60%)/600 attendees = $20/attendee
($1,800  50%)/600 attendees = $1.50/attendee
b
2.
Ticket sales ($30  600 attendees  180%)
$32,400
Variable cost of magic show ($20  1,080 attendees)
$21,600
Variable printing, invitations and paperwork ($1.50  1,080) 1,620
Contribution margin
9,180
Fixed cost of magic show
8,000
Fixed cost of printing, invitations and paperwork
900
Operating profit (loss)
3-43
23,220
8,900
$ 280
3-53
(30 min.)
Ethics, CVP analysis.
1.
Contribution margin percentage =
=
=
Breakeven revenues
=
=
2.
If variable costs are 55% of revenues, contribution margin percentage equals 45%
(100%  55%)
Breakeven revenues
=
=
3.
Revenues  Variable costs
Revenues
$5, 000, 000  $3, 250, 000
$5,000,000
$1,750,000
= 35%
$5,000,000
Fixed costs
Contributi on margin percentage
$1,890,000
= $5,400,000
0.35
Fixed costs
Contributi on margin percentage
$1,890,000
= $4,200,000
0.45
Revenues
Variable costs (0.55  $5,000,000)
Fixed costs
Operating income
$5,000,000
2,750,000
1,890,000
$ 360,000
4.
Incorrect reporting of environmental costs with the goal of continuing operations is
unethical. In assessing the situation, the specific “Standards of Ethical Conduct for Management
Accountants” (described in Exhibit 1-7) that the management accountant should consider are
listed below.
Competence
Clear reports using relevant and reliable information should be prepared. Preparing reports on
the basis of incorrect environmental costs to make the company’s performance look better than it
is violates competence standards. It is unethical for DiNunzo not to report environmental costs to
make the plant’s performance look good.
Integrity
The management accountant has a responsibility to avoid actual or apparent conflicts of interest
and advise all appropriate parties of any potential conflict. DiNunzo may be tempted to report
lower environmental costs to please Kirby and Gibbs and save the jobs of his colleagues. This
action, however, violates the responsibility for integrity. The Standards of Ethical Conduct
require the management accountant to communicate favorable as well as unfavorable
information.
3-44
Credibility
The management accountant’s Standards of Ethical Conduct require that information should be
fairly and objectively communicated and that all relevant information should be disclosed. From
a management accountant’s standpoint, underreporting environmental costs to make
performance look good would violate the standard of objectivity.
DiNunzo should indicate to Gibbs that estimates of environmental costs and liabilities should be
included in the analysis. If Gibbs still insists on modifying the numbers and reporting lower
environmental costs, DiNunzo should raise the matter with Kirby or one of Gibbs’s superiors. If
after taking all these steps, there is continued pressure to understate environmental costs,
DiNunzo should consider resigning from the company and not engage in unethical behavior.
3-54
(35 min.) Deciding where to produce.
Los Barrios
$200.00
Selling price
Variable cost per unit
Manufacturing
$80.00
Marketing and distribution
20.00
Contribution margin per unit (CMU)
Fixed costs per unit
Manufacturing
35.00
Marketing and distribution
30.00
Operating income per unit
CMU of normal production (as shown above)
CMU of overtime production
($100 - $5; $90 - $10)
3-45
Ascó
$200.00
$85.00
100.00 25.00
$100.00
65.00
$35.00
$100.00
95.00
27.00
24.00
110.00
$90.00
51.00
$39.00
$90.00
80.00
1.
Annual fixed costs = Fixed cost per unit ×
Daily production rate × Normal annual
capacity
($65  500 units  240 days;
$51  400 units  240 days)
Breakeven volume = FC  CMU of normal
production ($7,800,000  $100;
$4,896,000  90)
Los Barrios
$7,800,000
Ascó
$4,896,000
78,000 units
2.
Units produced and sold
120,000
Normal annual volume (units)
(500 × 240; 400 × 240)
120,000
Units over normal volume (needing
overtime)
0
CM from normal production units (normal
annual volume  CMU normal production)
(120,000 × $100; 96,000 × $90)
$12,000,000
CM from overtime production units
(0; 24,000  $80)
0
Total contribution margin
$12,000,000
Total fixed costs
7,800,000
Operating income
$4,200,000
Total operating income
$9,864,000
54,400 units
120,000
96,000
24,000
$8,640,000
1,920,000
10,560,000
4,896,000
$5,664,000
3.
The optimal production plan is to produce 150,000 units at the Los Barrios plant and
90,000 units at the Ascó plant. The full capacity of the Los Barrios plant, 150,000 units (500
units × 300 days), should be used because the contribution from these units is higher at all levels
of production than is the contribution from units produced at the Ascó plant.
Operating income at optimum production level:
Los Barrios: 120,000 × $100
Los Barrios: 30,000 × ($100 – $5)
Ascó: 90,000 × $90
Total contribution margin
Deduct total fixed costs
Operating income
$ 12,000,000
2,850,000
8,100,000
22,950,000
12,696,000
$ 10,254,000
The contribution margin is higher when 150,000 units are produced at the Los Barrios plant and
90,000 units at the Ascó plant. As a result, operating income will also be higher in this case
because total fixed costs for the division remain unchanged regardless of the quantity produced
at each plant.
3-46
Try It 3-1 Solution
Equation Method:
 Selling   Quantity of   Variable cost   Quantity of   Fixed Operating





 
price
units
sold
per
unit
units
sold
costs
income










Operating income =
($700 × 4,000) – ($600 × 4,000) – $160,000 = $2,800,000 − $2,400,000 − $160,000 = $240,000
Contribution Method:
Rearranging the equation above,
 Selling Variable cost   Quantity of   Fixed Operating




 
per unit   units sold   costs
income
 price
 Contribution margin Quantity of  Fixed Operating




per unit
units sold  costs
income

Contribution margin per unit = Selling price – Variable cost per unit = $700 – $600 = $100
Operating income = $100 × 4,000 – $160,000 = $240,000
3-47
Try It 3-2 Solution
(a) Recall the equation method (equation 1):
 Selling Quantity of   Variable cost Quantity of   Fixed Operating





 
price
units
sold
per
unit
units
sold
costs
income






Setting operating income equal to $0 and denoting quantity of output units that must be sold by
Q, the breakeven number of units is
 $700  Q    $600  Q   $160, 000  $0
$100  Q  $160, 000
Q  $160, 000  $100 per unit  1, 600 units
Recall the contribution margin method (equation 2):
 Contribution Quantity of 


  Fixed costs  Operating income
 margin per unit units sold 
At the breakeven point, operating income is by definition $0, and so,
Contribution margin per unit  Breakeven quantity of units  Fixed costs (Equation 3)
Rearranging equation 3 and entering the data,
Breakeven
Fixed costs
$160, 000


 1, 600 units
number of units Contribution margin per unit $100 per unit
Breakeven revenues  Breakeven number of units  Selling price
 1, 600 units  $700 per unit  $1,120, 000
(b)
 Selling   Quantity of   Variable cost   Quantity of   Fixed Operating





 
income
 price   units sold   per unit   units sold   costs
(Equation 1)
We denote by Q the unknown quantity of units Best Windows must sell to earn an operating
income of $180,000. Selling price is $700, variable cost per package is $600, fixed costs are
$160,000, and target operating income is $180,000. Substituting these values into equation 1, we
have
 $700  Q    $600  Q   $160, 000  $180, 000
$100  Q  $160, 000  $180, 000  $340, 000
Q  $340, 000  $100 per unit  3, 400 units
Alternatively, we could use equation 2,
3-48
 Contribution margin Quantity of  Fixed Operating




per unit
units sold  costs
income

(Equation 2)
Given a target operating income ($180,000 in this case), we can rearrange terms to get equation
4.
Quantity of units Fixed costs  Target operating income

required to be sold
Contribution margin per unit
Quantity of units $160, 000  $180, 000

 3, 400 units
required to be sold
$100 per unit
Revenues to earn an operating income of $180,000 is
Revenues = Number of units required to be sold × Selling price
3,400 units × $700 = $2,380,000
3-49
(Equation 4)
Try It 3-3 Solution
Target
Target

 

Target net income  
 Tax rate 

 operating income   operating income

Target net income  (Target operating income)  (1  Tax rate)
Target net income $63, 000
Target operating income 

 $90, 000
1  Tax rate
1  0.30
In other words, to earn a target net income of $63,000, Best Windows’s target operating income
is $90,000.
Proof:
Target operating income
$90,000
Tax at 30% (0.30  $90,000)
27,000
Target net income
$63,000
The key step is to take the target net income number and convert it into the corresponding target
operating income number. We can then use equation 1 to determine the target operating income
and substitute numbers from our Best Windows example.
 Selling Quantity of   Variable cost Quantity of   Fixed Operating



(Equation 1)


 
units sold   per unit
units sold   costs
income
 price
 $700  Q    $600  Q   $160, 000  $90, 000
$100  Q  $250, 000
Q  $250, 000  $100 per unit  2,500 units
Alternatively, we can calculate the number of units Best Windows must sell by using the
contribution margin method and equation 4:
Quantity of units Fixed costs  Target operating income

required to be sold
Contribution margin per unit
$160, 000  $90, 000

 2,500 units
$100 per unit
(Equation 4)
Revenues to earn net income of $63,000 or equivalently operating income of $90,000 is
Revenues = Number of units required to be sold × Selling price
2,500 units × $700 = $1,750,000
3-50
Try It 3-4 Solution
Budgeted Breakeven

 $2,800, 000  $1,120, 000  $1, 680, 000
revenues
revenues
Margin of
Budgeted
Breakeven


 4, 000  1, 600  2, 400 units
safety (in units) sales (units) sales (units)
Margin of safety 
The margin of safety indicates that sales would have to decrease by 2,400 units and revenues by
$1,680,000 before the breakeven point is reached.
Sometimes margin of safety is expressed as a percentage:
Margin of safety percentage 
In our example, margin of safety percentage 
Margin of safety in dollars
Budgeted  or actual  revenues
$1, 680, 000
 60%
$2,800, 000
This result means that revenues would have to decrease substantially, by 60%, to reach the
breakeven revenues.
The high margin of safety gives management of Best Windows confidence that the company is
unlikely to suffer a loss.
3-51
Try It 3-5 Solution
At any given level of sales,
Degree of
Contribution margin

operating leverage
Operating income
The following table shows the degree of operating leverage at sales of 3,400 units for the two
options.
Option 1
Option 2
No Commission
5% Commission
1. Selling price
$
700
$
700
2. Variable cost ($600; $600 + 0.03 × $700)
$
600
$
621
3. Contribution margin per unit
$
100
$
79
4. Contribution margin (row 3  3,400 units)
$340,000
$268,600
5. Fixed costs
$160,000
$ 93,000
6. Operating income (from Exhibit 3-5)
$180,000
$175,600
7. Degree of operating leverage (row 4 
row 6)
$340, 000
 1.89
$180, 000
$268, 600
 1.53
$175, 600
These results indicate that, when sales are 3,400 units, a 1% change in sales and contribution
margin will result in 1.89% change in operating income for Option 1. For Option 2, a 1% change
in sales and contribution margin will result in only a 1.53% change in operating income. The
degree of operating leverage at a given level of sales helps managers calculate the effect of sales
fluctuations on operating income. Option 1 with no commission has higher fixed costs and a
higher breakeven point ($160,000 ÷ $100 = 1,600 units) compared to option 2 ($93,000 ÷ $79 =
1,178 units). However, the higher operating leverage of Option 1 means that it generates higher
operating income per dollar of sales revenue compared to Option 2. Of course, the sales revenue
generated is not independent of sales compensation. Many managers believe that paying sales
people a commission would provide stronger incentives to sell and so achieve higher sales.
3-52
Try It 3-6 Solution
We assume that the budgeted sales mix (3,000 units of Chad Windows sold for every 1,500 units
of Musk Windows sold, that is, a ratio of 2:1) will not change at different levels of total unit
sales. That is, we think of Best Windows selling a bundle of 2 units of Chad Windows and 1 unit
of Musk Windows. (Note that this does not mean that Best Windows physically bundles the two
products together into one big package.)
Each bundle yields a contribution margin of $650, calculated as follows:
Number of Units of
Chad Windows and
Musk Windows in
Each Bundle
Contribution Margin
per Unit for Chad
Windows and Musk
Windows
Contribution
Margin of the
Bundle
Chad Windows
2
$100
$200
Musk Windows
1
50
50
Total
$250
To compute the breakeven point, we calculate the number of bundles Best needs to sell.
Breakeven
Fixed costs
$160, 000
point in 

 640 bundles
Contribution margin per bundle $250 per bundle
bundles
The breakeven point in units of Chad Windows and Musk Windows is as follows:
Chad Windows: 640 bundles  2 units per bundle
1,280 units
Musk Windows: 640 bundles  1 units per bundle
640 units
Total number of windows to break even
1,920 units
The breakeven point in dollars for Chad Windows and Musk Windows is as follows:
Chad Windows: 1,280 units  $700 per unit
$ 896,000
Musk Windows: 640 units  $300 per unit
192,000
Breakeven revenues
$1,088,000
3-53
When there are multiple products, it is often convenient to use the contribution margin
percentage. Under this approach, Best also calculates the revenues from selling a bundle of 2
units of Chad Windows and 1 unit of Musk Windows:
Number of Units of
Chad Windows and
Musk Windows in Each
Bundle
Selling Price for Chad
Windows and Musk
Windows
Chad Windows
2
$700
$1,400
Musk Windows
1
300
300
Revenue of the
Bundle
Total
$1,700
Contribution
margin
Contribution margin of the bundle
$250


 0.1470588, or 14.70588%
percentage for
Revenue of the bundle
$1, 700
the bundle
Breakeven
Fixed costs
$160,000


 $1,088,000
revenues Contribution margin % for the bundle 0.1470588
Number of bundles
Breakeven revenues
$1, 088, 000
required to be sold 

 640 bundles
Revenue per bundle $1, 700 per bundle
to break even
The breakeven point in units and dollars for Chad Windows and Musk Windows are as follows:
Chad Windows: 640 bundles × 2 units per bundle = 1,280 units × $700 = $ 896,000
Musk Windows: 640 bundles × 1 unit per bundle =
Total breakeven revenues
640 units × $300 =
192,000
$1,088,000
3-54
CHAPTER 4
JOB COSTING
4-1
Cost pool––a grouping of individual indirect cost items.
Cost tracing––the assigning of direct costs to the chosen cost object.
Cost allocation––the assigning of indirect costs to the chosen cost object.
Cost-allocation base––a factor that links in a systematic way an indirect cost or group of
indirect costs to cost objects.
4-2
In a job-costing system, costs are assigned to a distinct unit, batch, or lot of a product or
service. In a process-costing system, the cost of a product or service is obtained by using broad
averages to assign costs to masses of identical or similar units.
4-3
An advertising campaign for Pepsi is likely to be very specific to that individual client.
Job costing enables all the specific aspects of each job to be identified. In contrast, the
processing of checking account deposits is similar for many customers. Here, process costing can
be used to compute the cost of each checking account deposit.
4-4
By tracing the cost of direct cost and allocating the cost of indirect cost to a cost object as
follows: After identifying the cost object, you can trace the cost of direct cost to it. Then you can
select necessary cost-allocation base(s) for all relevant indirect costs, calculate the overhead
rate(s) for each cost-allocation base(s), and allocate indirect costs associated with each costallocation base(s) to the chosen cost object/job. And finally calculate the total cost of the job by
adding all direct traced and all indirect costs allocated to the cost object/job.
4-5
Job costing allocates costs to products and services that are readily identified by
individual units or batches (e.g. aircraft, pieces of furniture, special-purpose machinery,
construction, printing, and manufacturing tailor-made or unique goods). Each unit or batch
receives varying degrees of attention and skill. In a job costing environment, each job uses
different amounts of resources. Each product or service is unique and therefore job costing is
used to estimate the cost for the product or service.
Process costing is used when the products or services are similar and identical. For example, the
service of postal service for all mails posted in the district is the same and therefore follows a
similar process. Process costing deals with great masses of like units and broad averages of unit
costs.
4-6
Three major source documents used in job-costing systems are (1) job cost record or job
cost sheet, a document that records and accumulates all costs assigned to a specific job, starting
when work begins; (2) materials requisition record, a document that contains information about
the cost of direct materials used on a specific job and in a specific department; and (3) labor-time
sheet, a document that contains information about the amount of labor time used for a specific
job in a specific department.
4-7
Information technology provides managers with up-to-date, quick and accurate job
costing information, and making it quicker and easier for them to manage and control the costs
and to make necessary decision(s) if needed.
4-1
4-8
An annual period eliminates the influence of seasonal patterns in calculating overhead
cost rates and reduces the effect of variations in output levels as one single average overhead rate
is calculated for the whole period.
4-9
Normal costing is a costing system that traces direct costs to a cost object by using the
actual direct-cost rates by the actual quantities of the direct-cost inputs. The normal costing
system allocates indirect costs based on the budgeted indirect-cost rates by the actual quantities
of the cost-allocation bases. On the other hand, actual costing system uses the actual indirect-cost
rates calculated annually at the end of the year.
4-10 Job-costing information can be used to determine the profitability of individual jobs, to
assist with determining the minimum price for a job in bidding situation, and to help in
prioritizing jobs based on the costs and profits when there are limited resources.
4-11 The statement is false. Both “actual costing” and “normal costing” systems are similar
only in determining the direct costs of jobs/cost objects, but they are different in terms of
determining overhead or indirect cost of jobs. In other words, they both use actual direct-cost
rates x actual quantities of direct-cost inputs only for determining the direct cost of a job but
normal costing uses “budgeted indirect-cost rates” × actual quantities of cost-allocation bases for
calculating the indirect cost of a job while actual costing uses ‘actual indirect-cost rates’ x actual
quantities of cost-allocation bases for calculating the indirect cost of a job.
4-12 Direct material’s costs and direct labor’s costs are traced, and indirect costs are allocated
to ‘work-in-process’ account. After completing the job, the total cost of the job is transferred
from the ‘work-in-process’ account to the ‘finished goods’ account. And finally, when the sales
occur, the total costs of the job are transferred from the ‘finished goods’ account to the ‘goods
sold’ account.
4-13 A company’s indirect costs are hardly the exact amount incurred. This is because indirect
costs are based on estimates made up to 12 months before actual costs are incurred. Therefore,
when the amounts are reconciled, an adjustment will need to be carried out and can actually
reveal that the costs have been under- or over-allocated.
4-14 A company might use budgeted costs rather than actual costs to compute direct labor
rates because it may be difficult to trace direct labor costs to jobs as they are completed (for
example, because bonuses are only known at the end of the year).
4-15 Modern technology of electronic data interchange (EDI) is helpful to managers because it
ensures that a purchase order is transmitted quickly and accurately to suppliers with minimum
paperwork and costs.
4-2
4-16 Choice ‘a’ is a correct statement. Both direct materials and direct manufacturing labor are
traceable to the job in flow of costs in job costing system.
Choice ‘b’ is a correct statement. The direct materials and direct manufacturing labor become
part of work-in-process inventory on the balance sheet which is an asset.
Choice ‘c’ is a correct statement. Direct manufacturing labors transforms direct materials into
work-in-process inventory and are considered inventoriable costs. Inventoriable costs are all
manufacturing costs that are transformed to assets in the balance sheet.
Choice ‘d’ is incorrect. Marketing and customer service costs are period costs and are therefore
not transformed to create assets in the balance sheet.
Therefore, the correct answer is ‘d’.
4-17 Choice ‘d’ is correct. Manufacturing costs includes are the costs incurred both direct
[direct material $80,000 + direct manufacturing labor $40,000] and indirect costs [indirect
materials $120,000 + indirect manufacturing labor $50,000] and manufacturing overhead
including depreciation [ $100,000 +$10,000].
Choice ‘a’ is incorrect. Only the indirect materials of $120,000 + indirect manufacturing labor of
$50,000 have been included. These are only part of the manufacturing costs.
Choice ‘b’ is incorrect. Only the direct materials of $80,000+ direct labor $40,000 have been
included. Both are part of the manufacturing costs.
Choice ‘c’ is incorrect. Only the direct materials of $80,000 + direct manufacturing labor of
$40,000 + manufacturing overhead $100,000 have been included. These are only part of the
manufacturing costs.
4-18 Choice ‘d’ is correct. Job costing is used in: Audit service, Advertising service,
Consulting service, Legal services, and Movie production services. Process costing is used in:
Oil refining services, Beverage production, Mail and postal delivery service, and Check clearing
service at a bank counter.
Choice ‘a’ is incorrect. Job costing does not include mail and postal delivery service and
beverage production. Process costing does not also include consulting service and legal services.
Choice ‘b’ is incorrect. Process costing does not include consulting service and advertising
service.
Choice ‘c’ is incorrect. Job costing does not include mail and postal delivery service. Process
costing does not include consulting service, advertising service, and legal services.
4-3
4-19 Choice ‘a’ is correct. £1,350 is under-allocated overhead.
£20,000
This is computed as £18,850 − ( 800 ) × 700 actual direct labor hours
£18,850 − £17,500 = £ 1,350 underallocated overhead.
Choice ‘b’ is incorrect. The underallocation of overhead has been computed by subtracting the
actual from the budgeted overheads £20,000 - £18,850 = £1,150
Choice ‘c’ is incorrect. The overallocation has been computed as £18,850 − (
800 actual direct labor hours = £21,543
£18,850
700
Choice ‘d’ is incorrect. The overallocation has been computed as £18,850 − (
actual direct labor hours = £4,007
)×
£20,000
700
) × 800
4-20 Choice ‘a’ is correct. The manufacturing costs of Job #506 has been calculated by adding
up the direct manufacturing labor (£60,000) + manufacturing overheads (£22,733) + direct
materials costs (£6,000). The manufacturing overhead is calculated as:
[£22,000 x 6,200 actual direct labor hours / 6,000 budgeted direct labor hours] = £22,733
Choice ‘b’ is incorrect. The manufacturing costs of Job #506 has been calculated by adding up
the direct manufacturing labor (£60,000) + manufacturing overheads (£22,000) + direct materials
costs (£6,000).
Choice ‘c’ is incorrect. The manufacturing costs of Job #506 has been calculated by adding up
the direct manufacturing labor (£60,000) + manufacturing overheads (£22,000).
Choice ‘d’ is incorrect. The manufacturing costs of Job #506 has been calculated by adding up
the direct manufacturing labor (£60,000) + manufacturing overheads (£22,000) - direct materials
costs (£6,000).
4-4
4-21
(10 minutes) Job costing, process costing.
Job costing
Building a space satellite
A play in a theatre
Making a film
A film in a cinema
School meals for kids
Newspaper printing
Textile production
A picture framer
A private hospital
Process costing
Manufacturing computer memory chips
Egg production
A sugar refiner
Coal mining business
Cement manufacturer
4-5
4-22
(20 min)
Actual costing, normal costing, accounting for manufacturing
overhead.
Budgeted Manufacturing Overhead Costs
1. Budgeted Manufacturing Overhead Rate = Budgeted Direct Manufacturing Labor Costs
$3,294,000
= $1,830,000 = 1.80 𝑜𝑟 180%
Actual Manufacturing Overhead Costs
Actual Manufacturing Overhead Rate = Actual Direct Manufacturing Labor Costs
$3,780,000
= $2,250,000 = 1.68 𝑜𝑟 168%
2.
Costs of Job 635 under actual and normal costing follow:
Actual
Costing
$ 73,500
51,000
Direct materials
Direct manufacturing labor costs
Manufacturing overhead costs
$51,000  1.68; $51,000  1.80
85,680
Total manufacturing costs of Job 635 $210,180
3.
Normal
Costing
$ 73,500
51,000
91,800
$216,300
Total manufacturing overhead allocated under normal costing
= Actual manufacturing labor costs × Budgeted overhead rate
= $2,250,000 × 1.80
= $4,050,000
Overallocated manufacturing overhead
= Manufacturing overhead allocated – Actual manufacturing overhead costs
= $4,050,000  $3,780,000
= $270,000
There is no under- or over-allocated overhead under actual costing because overhead is
allocated under actual costing by multiplying actual manufacturing labor costs and the
actual manufacturing overhead rate. This, of course, equals the actual manufacturing
overhead costs. All actual overhead costs are allocated to products. Hence, there is no
under- or over-allocated overhead.
4.
Managers at Carolin Chemicals might prefer to use normal costing because it enables them
to use the budgeted manufacturing overhead rate determined at the beginning of the year to
estimate the cost of a job as soon as the job is completed. Managers may want to know job costs
for ongoing uses, including pricing jobs, monitoring and managing costs, evaluating the success
of the job, learning about what did and did not work, bidding on new jobs, and preparing interim
financial statements. Under actual costing, managers would only determine the cost of a job at
the end of the year when they know actual manufacturing overhead costs.
4-6
4-23
(20-30 min)
Job costing, normal and actual costing.
1.
Budgeted Indirect Cost Rate = Budgeted Direct Labor Hours
Budgeted Indirect Costs
=
Actual Indirect Cost Rate =
$5,100,000
150,000
= $34 per direct labor hour
Actual Indirect Costs (Assembly Support)
Actual Direct Labor Hours
$5,355,000
= 153,000 hours = $35 per direct labor hour
These rates differ because both the numerator and the denominator in the two
calculations are different—one based on budgeted numbers and the other based on actual
numbers.
2a.
Steel Wheels Magic Wheels
Normal costing
Direct costs
Direct materials
Direct labor
$78,290
$25,445
103,735
Indirect costs
Manufacturing support ($34 × 840; $34 × 960) 28,560
Total costs
$132,295
2b. Actual costing
Direct costs
Direct materials
Direct labor
Indirect costs
Manufacturing support ($35 × 840; $35 × 960)
Total costs
4-7
$94,650
$32,752
127,402
32,640
$160,042
$78,290
25,445
103,735
$94,650
32,752
127,402
29,400
$133,135
33,600
$161,002
3.
Normal costing enables Caldwell to report a job cost as soon as the job is completed,
assuming that both the direct materials and direct labor costs are known at the time of
use. Once the 840 direct labor-hours are known for the Steel Wheels (Jan–May 2020),
Caldwell can compute the $132,295 cost figure using normal costing. Caldwell can use
this information to manage the costs of the Steel Wheels job as well as to bid on similar
jobs later in the year. In contrast, Caldwell has to wait until the December 2020 year-end
to compute the $133,135 cost of the Steel Wheels using actual costing.
The following overview diagram summarizes Caldwell Toy’s job-costing system:
INDIRECT
COST
POOL

Manufacturing
Assembly
support
Support
COST
ALLOCATION
BASE

Direct
Labor-Hours
COST OBJECT:
RESIDENTIAL
HOME

DIRECT
COSTS

Indirect Costs
Direct Costs
Direct
Manufacturing
Labor
Direct
Materials
4-8
4-24
(10 min) Budgeted manufacturing overhead rate, allocated manufacturing overhead.
1.
Budgeted manufacturing overhead rate =
Budgeted Manufacturing Overhead
Budgeted Machine Hours
=
$4,600,000
184,000
=
$25 per machine-hour
2.
Manufacturing overhead allocated
= Actual Machine Hours × Budgeted Manufacturing Overhead Rate
= 180,000 × $25 = $4,500,000
3.
Because manufacturing overhead allocated is less than the actual manufacturing overhead
costs, Gammaro calculates under-allocated manufacturing overhead as follows:
Manufacturing overhead allocated
Actual manufacturing overhead costs
Under-allocated manufacturing overhead
4-9
$4,500,000
4,830,000
$ 330,000
4-25
(20-30 min)
Job costing, accounting for manufacturing overhead, budgeted rates.
1. An overview of the product costing system is
INDIRECT
COST
POOL
COST
ALLOCATION
BASE


Machining Department
Manufacturing Overhead
Finishing Department
Manufacturing Overhead
Machine-Hours
in Machining Dept.

Direct Manufacturing
Labor Costs
in Finishing Dept.
Indirect Costs
COST OBJECT:
PRODUCT
Direct Costs

DIRECT
COST
Direct
Manufacturing
Labor
Direct
Materials
Budgeted manufacturing overhead divided by allocation base:
Machining Department overhead =
$1,800,000
50,000
$3,600,000
= $36 per machine-hour
Assembly Department overhead= $2,000,000 = 180% of direct manuf. labor costs
2.
Machining department overhead allocated, 2,000 hours  $36
Assembly department overhead allocated, 180%  $15,000
Total manufacturing overhead allocated to Job 494
3.
Actual manufacturing overhead
Manufacturing overhead allocated,
$36  55,000 machine-hours
180%  $2,200,000
Underallocated (Overallocated)
Machining Dept.
$2,100,000
1,980,000
—
$ 120,000
4-10
$72,000
27,000
$99,000
Assembly Dept.
$ 3,700,000
—
3,960,000
$ (260,000)
4-26
(20-25 min)
Job costing, consulting firm.
1.
Budgeted indirect-cost rate for client support can be calculated as follows:
Budgeted indirect-cost rate = $22,170,000 ÷ $15,000,000 = 147.80% of professional labor costs
INDIRECT
COST
POOL

Consulting
Consulting
Support
Support
Client
Support
COST
ALLOCATION
BASE
COST OBJECT:
JOB FOR
CONSULTING
CLIENT
DIRECT
COSTS
2.

Professional
Professional
Labor
LaborCosts
Costs

Indirect Costs
Direct Costs

Professional
Labor
At the budgeted revenues of $42,000,000, Global Enterprize’s operating income of
$4,830,000 equals 11.50% of revenues.
Markup rate = $42,000,000 ÷ $15,000,000 = 280% of direct professional labor costs
3.
Budgeted costs
Direct costs:
Director, $175  8
$ 1,400
Partner, $80  20
1,600
Associate, $40  75
3,000
Assistant, $25  180
4,500
Indirect costs:
Consulting support, 147.80%  $10,500
Total costs
4-11
$10,500
15,519
$26,019
As calculated in requirement 2, the bid price to earn an 11.50% income-to-revenue margin is
280% of direct professional costs. Therefore, Global Enterprize should bid 2.8  $10,500 =
$29,400 for the Horizon Telecommunications job.
Bid price to earn target operating income-to-revenue margin of 11.50% can also be calculated as
follows:
Let R = revenue to earn target income
R – 0.115R = $26,019
0.885R = $26,019
R = $29,019 ÷ 0.885 = $29,400
Or
Direct costs
$10,500
Indirect costs
15,519
Operating income (0.115  $29,400) 3,381
Bid price
$29,400
4-12
4-27
(15-20 min)
Time period used to compute indirect cost rates.
1.
(1) Pools sold
(2) Direct manufacturing
labor hours (1  Row 1)
(3) Fixed manufacturing
overhead costs
(4) Budgeted fixed
manufacturing overhead rate
per direct manufacturing
labor hour ($12,250  Row
2)
Quarter
1
565
2
490
3
245
4
100
Annual
1,400
565
490
245
100
1,400
$12,250
$12,250
$12,250
$12,250
$49,000
$21.68
$25
$50
$122.50
$35
Direct material costs ($14  490 pools; 245 pools)
Direct manufacturing labor costs
($20  490 hours; 245 hours)
Variable manufacturing overhead costs
($15  490 hours; 245 hours)
Fixed manufacturing overhead costs
($25  490 hours; $50 × 245 hours)
Total manufacturing costs
Divided by pools manufactured each quarter
Manufacturing cost per pool
4-13
Budgeted Costs Based on
Quarterly Manufacturing
Overhead Rate
2nd
3rd
Quarter
Quarter
$ 6,860
$ 3,430
9,800
4,900
7,350
3,675
12,250
$36,260
÷ 490
$ 74.00
12,250
$24,255
÷ 245
$ 99.00
2.
Direct material costs ($14  490 pools; 245 pools)
Direct manufacturing labor costs
($20  490 hours; 245 hours)
Variable manufacturing overhead costs
($15  490 hours; 245 hours)
Fixed manufacturing overhead costs
($35  490 hours; 245 hours)
Total manufacturing costs
Divided by pools manufactured each quarter
Manufacturing cost per pool
Budgeted Costs Based on
Annual Manufacturing
Overhead Rate
2nd
3rd
Quarter
Quarter
$ 6,860
$ 3,430
9,800
4,900
7,350
3,675
17,150
$41,160
 490
$ 84.00
8,575
$20,580
 245
$84.00
2nd
Quarter
3rd
Quarter
$96.20
$128.70
$109.20
$109.20
3.
Prices based on quarterly budgeted manufacturing
overhead rates calculated in requirement 1
($74.00  130%; $99.00  130%)
Price based on annual budgeted manufacturing
overhead rates calculated in requirement 2
($84.00  130%; $84.00  130%)
Socha might be seeing large fluctuations in the prices of its pools because Plunge is determining
budgeted manufacturing overhead rates on a quarterly rather than an annual basis. Plunge
should use the budgeted annual manufacturing overhead rate because capacity decisions are
based on longer annual periods rather than quarterly periods. Prices should not vary based on
quarterly fluctuations in production. Plunge could vary prices based on market conditions and
demand for its pools. In this case, Plunge would charge higher prices in quarter 2 when demand
for its pools is high. Pricing based on quarterly budgets would cause Plunge to do the
opposite—to decrease rather than increase prices!
4-14
4-28
(10-15 min)
Accounting for manufacturing overhead.
1.
Budgeted manufacturing overhead rate= 200,000 labor hours = $22 per direct labor-hour
2.
Work-in-Process Control
4,664,000
Manufacturing Overhead Allocated
4,664,000
(212,000 direct labor-hours  $22 per direct labor-hour = $4,664,000)
$4,400,000
3.
$4,650,000– $4,664,000 = $14,000 overallocated, an insignificant amount of difference
compared to manufacturing overhead costs allocated $14,000 ÷ $4,664,000 = 0.3%. If the
quantities of work-in-process and finished goods inventories are small, the difference between
proration and write off to Cost of Goods Sold account would be very small compared to net
income.
Manufacturing Overhead Allocated
4,664,000
Manufacturing Department Overhead Control
4,650,000
Cost of Goods Sold
14,000
4-15
4-29
(20 minutes) Track the flow of costs in a job costing system.
Cutting department: estimated overhead absorption = $56,000 = $3.50 per machine hour
16,000
Assembly department: estimated overhead absorption = $48,000 = $3.00 per labor hour
16,000
Painting and finishing department: estimated overhead absorption = $32,000
16,000
= $2.00 per unit
Manufacturing cost of stapling machine:
Direct materials
Labor:
Cutting: 10 minutes @ $6 per hour
$1.00
Assembly: 1 hour 30 minutes @$6 per hour
$9.00
Painting and finishing: 20 minutes @ $4.50 per hour $1.50
Production overhead:
Cutting
Assembly
Painting and finishing
$3.50
$3.00
$2.00
Total manufacturing costs per unit
Total manufacturing cost of 16,000 units @ $35.50 = $568,000
4-16
$15.50
$11.50
$8.50
$35.50
4-30
(35 min)
Journal entries, T-accounts, and source documents.
1.
(1) Direct Materials Control
125,000
Accounts Payable Control
Source Document: Purchase Invoice, Receiving Report
Subsidiary Ledger: Direct Materials Record, Accounts Payable
125,000
(2) Work in Process Controla
121,700
Direct Materials Control
121,700
Source Document: Material Requisition Records, Job Cost Record
Subsidiary Ledger: Direct Materials Record, Work-in-Process Inventory Records by Jobs
(3) Work in Process Control
88,000
Manufacturing Overhead Control
54,700
Wages Payable Control
142,700
Source Document: Labor Time Sheets, Job Cost Records
Subsidiary Ledger: Manufacturing Overhead Records, Employee Labor Records, Work-inProcess Inventory Records by Jobs
(4) Manufacturing Overhead Control
141,600
Salaries Payable Control (Maintenance)
26,000
Accounts Payable Control (Miscellaneous)
9,600
Accumulated Depreciation Control (Depreciation)
36,000
Rent Payable Control (Rent)
70,000
Source Document: Depreciation Schedule, Rent Schedule, Maintenance wages due, Invoices
for miscellaneous factory overhead items
Subsidiary Ledger: Manufacturing Overhead Records
(5) Work in Process Control
220,000
Manufacturing Overhead Allocated
($88,000 × $2.50)
Source Document: Labor Time Sheets, Job Cost Record
Subsidiary Ledger: Work-in-Process Inventory Records by Jobs
220,000
(6) Finished Goods Controlb
411,900
Work in Process Control
411,900
Source Document: Job Cost Record, Completed Job Cost Record
Subsidiary Ledger: Work-in-Process Inventory Records by Jobs, Finished Goods Inventory
Records by Jobs
(7) Cost of Goods Soldc
445,900
Finished Goods Control
Source Document: Sales Invoice, Completed Job Cost Records
Subsidiary Ledger: Finished Goods Inventory Records by Jobs
4-17
445,900
(8)
Administrative Expenses
7,300
Advertising Expenses
92,000
Salary Expenses (Sales Commissions)
36,000
Salaries Payable Control
36,000
Accounts Payable Control
92,000
Accumulated Depreciation, Office Equipment
7,300
Source Document: Depreciation Schedule, Marketing Payroll Request, Invoice for
Advertising, Sales Commission Schedule.
Subsidiary Ledger: Employee Salary Records, Administration Cost Records, Marketing Cost
Records, Commissions Cost Records.
(9) Manufacturing Overhead Allocated
Manufacturing Overhead Control
($54,700 + $141,600)
Cost of Goods Sold
Source Document: Prior Journal Entries
a
220,000
196,300
23,700
Materials used = Beginning direct materials inventory + Purchases – Ending direct
materials inventory
= $9,700 + $125,000 - $13,000 = $121,700
b
Cost of
goods manufactured = Beginning WIP inventory + Manufacturing cost – Ending WIP
inventory
= $6,200 + ($121,700 + $88,000 + $220,000) - $24,000 = $411,900
c
Cost of goods sold = Beginning finished goods inventory + Cost of goods manufactured
– Ending finished goods inventory
= $66,000 + $411,900 -$32,000 = $445,900
4-18
1.
T-accounts
Bal. 1/1/2020
(1) Accounts Payable Control
(Purchases)
Bal. 12/31/2020
Bal. 1/1/2020
(2) Materials Control
(Direct materials used)
(3) Wages Payable Control
(Direct manuf. labor)
(5) Manuf. Overhead
Allocated
Bal. 12/31/2020
Bal. 1/1/2020
(6) WIP Control
(Cost of goods manuf.)
Bal. 12/31/2020
(7) Finished Goods Control
(Goods sold)
Bal.
Direct Materials Control
9,700 (2) Work-in-Process Control
(Materials used)
125,000
13,000
Work-in-Process Control
6,200 (6) Finished Goods Control
(Cost of goods
121,700
manufactured)
411,900
88,000
220,000
24,000
Finished Goods Control
66,000 (7) Cost of Goods Sold
445,900
411,900
32,000
Cost of Goods Sold
(9) Manufacturing Overhead
445,900
Allocated (Adjust for
overallocation)
422,200
Manufacturing Overhead Control
(3) Wages Payable Control
(9) To close
(Indirect manuf. labor)
54,700
(4) Salaries Payable Control
(Maintenance)
26,000
(4) Accounts Payable Control
(Miscellaneous)
9,600
(4) Accum. Deprn. Control
(Depreciation)
36,000
(4) Rent Payable Control
(Rent)
70,000
Bal.
0
(9) To close
121,700
Manufacturing Overhead Allocated
196,300 (5) Work-in-Process Control
(Manuf. overhead
allocated)
Bal.
4-19
23,700
196,300
196,300
0
4-31
(45 min)
Job costing, journal entries.
Some instructors may wish to assign Problem 4-30. It demonstrates the relationships of journal
entries, general ledger, subsidiary ledgers, and source documents.
1.
2.
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
(10a)
(10b)
An overview of the product-costing system is
INDIRECT
COST
POOL

Manufacturing
Overhead
COST
ALLOCATION
BASE

Machine-Hours
COST OBJECT
PRODUCT

DIRECT
COSTS

Indirect Costs
Direct Costs
Direct
Materials
Direct
Manuf. Labor
Amounts in millions.
Materials Control
Accounts Payable Control
Work-in-Process Control
Materials Control
Manufacturing Overhead Control
Materials Control
Work-in-Process Control
Wages Payable Control
Manufacturing Overhead Control
Wages Payable Control
Manufacturing Overhead Control
Accumulated Depreciation
Manufacturing Overhead Control
Various liabilities
Work-in-Process Control
Manufacturing Overhead Allocated
Finished Goods Control
Work-in-Process Control
Cost of Goods Sold
Finished Goods Control
Accounts Receivable Control (or Cash )
Revenues
4-20
154
154
147
147
19
19
90
90
32
32
26
26
14
14
84
84
295
295
293
293
400
400
The posting of entries to T-accounts is as follows:
Bal
(1)
Bal.
Materials Control
13 (2)
154 (3)
1
Bal.
(9)
Bal.
Finished Goods Control
7 (10a)
295
9
(3)
(5)
(6)
(7)
147
19
Bal.
(2)
(4)
(8)
Bal.
Work-in-Process Control
4 (9)
147
90
84
30
293
(10a)
(11)
Bal.
Cost of Goods Sold
293
7
300
Manufacturing Overhead Control
19 (11)
91
32
26
14
(10b)
Accounts Payable Control
(1)
154
Accumulated Depreciation
(6)
28
295
Manufacturing Overhead Allocated
(11)
84 (8)
84
Accounts Receivable Control
410
Wages Payable Control
(4)
(5)
96
34
Various Liabilities
(7)
13
Revenues
(10b)
410
The ending balance of Work-in-Process Control is $30 million.
3.
(11) Manufacturing Overhead Allocated
84
Cost of Goods Sold
7
Manufacturing Department Overhead Control
91
Entry posted to T-accounts in Requirement 2.
4. Gross margin = Revenues  Cost of goods sold = $400  $300 = $100.
Docks Transport’s gross margin of 25% ($100 ÷ $400) is relatively small, indicating
Docks Transport did fine but not particularly well in 2020. (Gross margins below 30%
are generally considered small.) A company manufacturing prestige manufactured homes
should have higher gross margins.
4-21
4-32
(15 min)
Job costing, unit cost, ending work in progress.
1.
Direct manufacturing labor rate per hour
Manufacturing overhead cost allocated
per manufacturing labor-hour
Direct manufacturing labor costs
Direct
manufacturing
labor-hours
($273,000 ÷ $26; $208,000 ÷ $26)
Manufacturing overhead cost allocated
(10,500 × $20; 8,000 × $20)
Job Costs May 2020
Direct materials
Direct manufacturing labor
Manufacturing overhead allocated
Total costs
$26
$20
Job M1
$273,000
Job M2
$208,000
10,500
8,000
$210,000
$160,000
Job M1
$ 78,000
273,000
210,000
$561,000
Job M2
$ 51,000
208,000
160,000
$419,000
2.
Number of pipes produced for Job M1
Cost per pipe ($561,000 ÷ 1,100)
1,100
$510
3.
Finished Goods Control
Work-in-Process Control
561,000
561,000
4. Global Pipes began May 2020 with no work-in-process inventory. During May, it started and finished
M1. It also started M2, which is still in work-in-process inventory at the end of May. M2’s manufacturing
costs up to this point, $419,000, remains a debit balance in the work-in-process inventory account at the end
of May 2020.
4-22
4-33
1.
(20-30 min)
Job costing; actual, normal, and variation from normal costing.
Actual direct cost rate for professional labor
$735,000
Actual indirect cost rate =
17,500 hours
Budgeted direct cost rate
$990,000
for professional labor
=
18,000 hours
$774,000
Budgeted indirect cost rate =
18,000 hours
Direct-Cost Rate
Indirect-Cost Rate
= $58 per professional labor-hour
= $42 per professional labor-hour
= $55 per professional labor-hour
= $43 per professional labor-hour
(a)
(b)
Actual
Normal
Costing
Costing
$58
$58
(Actual rate)
(Actual rate)
$42
$43
(Actual rate) (Budgeted rate)
(c)
Variation of
Normal Costing
$55
(Budgeted rate)
$43
(Budgeted rate)
2.
Chico & Partners should choose a job-costing system based on the direct cost information
available to them. If Chico knows direct costs as the jobs are being done, I would recommend
Chico use normal costing over actual costing by calculating a budgeted indirect cost rate to cost
jobs. Normal costing enables Chico to use the budgeted indirect cost rate calculated at the
beginning of the year to estimate the cost of a job as soon as the job is completed. Chico can use
knowledge of job costs for ongoing uses, including pricing jobs, monitoring and managing costs,
evaluating the success of the job, learning about what did and did not work, bidding on new jobs,
and preparing interim financial statements. Under actual costing, Chico would only determine
the cost of a job at the end of the year when actual indirect costs are known. To be useful, of
course, the budgeted indirect cost rate and the allocated costs need to reasonably approximate the
actual indirect cost rate and the actual costs.
If Chico does not know direct costs as the jobs are being completed, I would recommend that
Chico use the variation of normal costing that calculates a budgeted direct cost rate. This would
allow Chico to estimate costs on a more-timely basis and gain all the benefits discussed earlier in
the context of indirect costs. To be useful, of course, the budgeted direct cost rate needs to
reasonably approximate the actual direct cost rate. This is the case here since the budgeted rate of
$55 per professional labor-hour is a reasonable approximation of the actual rate of $58 per
professional labor-hour.
4-23
3.
Direct Costs
Indirect Costs
Total Job Costs
(a)
(b)
(c)
Actual
Normal
Variation of
Costing
Costing
Normal Costing
$58  180 = $10,440 $58  180 = $10,440 $55  180 = $9,900
$42  180 = 7,560 $43  180 = 7,740 $43  180 = 7,740
$18,000
$18,180
$17,640
All three costing systems use the actual professional labor time of 180 hours. The budgeted 160 hours
for the Pierre Enterprises audit job is not used in job costing. However, Chico may have used the 160
hour number in bidding for the audit.
The actual costing figure of $18,000 is less than the normal costing figure of $18,180 because the
actual indirect-cost rate ($42) is less than the budgeted indirect-cost rate ($43). The normal costing
figure of $18,180 exceeds the variation of normal costing (based on budgeted rates for direct costs)
figure of $17,640 because the actual direct-cost rate ($58) exceeds the budgeted direct-cost rate ($55).
Although not required, the following overview diagram summarizes Chico’s job-costing system:
INDIRECT
COST
POOL
COST
ALLOCATION
BASE
COST OBJECT:
JOB FOR
AUDITING
PIERRE
& CO.
Audit
Support
Professional
Labor-Hours
Indirect Costs
Direct Costs
DIRECT
COST
Professional
Labor
4-24
4-34
1.
(20-30 min)
Job costing; actual, normal, and variation from normal costing.
$260,000
= $26 per direct labor-hour
10,000
$200,000
Actual indirect cost rate
=
= $20 per direct labor-hour
10,000
$280,000
Budgeted direct labor-hour rate =
= $28 per direct labor-hour
10,000
$180,000
Budgeted indirect cost rate
=
= $18 per direct labor-hour
10,000
Actual direct-labor hour rate
Direct-Cost Rate
Indirect-Cost Rate
=
(a)
(b)
Actual
Normal
Costing
Costing
$26
$26
(Actual rate)
(Actual rate)
$20
$18
(Actual rate) (Budgeted rate)
(c)
Variation of
Normal Costing
$28
(Budgeted rate)
$18
(Budgeted rate)
2.
Clayton Solutions should choose a job-costing system based on the direct cost
information available to them. If Clayton Solutions knows direct costs as the jobs are being done,
I would recommend Clayton Solutions use normal costing over actual costing by calculating a
budgeted indirect cost rate to cost jobs. Normal costing enables Clayton Solutions to use the
budgeted indirect cost rate calculated at the beginning of the year to estimate the cost of a job as
soon as the job is completed. Clayton Solutions can use knowledge of job costs for ongoing uses,
including pricing jobs, monitoring and managing costs, evaluating the success of the job,
learning about what did and did not work, bidding on new jobs, and preparing interim financial
statements. Under actual costing, Clayton Solutions would only determine the cost of a job at the
end of the year when actual indirect costs are known. To be useful, of course, the budgeted
indirect cost rate and the allocated costs need to reasonably approximate the actual indirect cost
rate and the actual costs, which is the case here.
If Clayton Solutions does not know direct costs as the jobs are being completed, I would
recommend that Clayton Solutions use the variation of normal costing that calculates a budgeted
direct cost rate. This would allow Clayton Solutions to estimate costs on a more-timely basis and
gain all the benefits discussed earlier in the context of indirect costs. However, if Clayton
Solutions does use the variation of normal costing, it needs to continue to do a good job of
estimating the budgeted direct cost rate. Currently, the budgeted direct cost rate ($28) is close to
the actual rate of $26 per direct labor-hour.
4-25
3.
Direct Costs
Indirect Costs
Total Job Costs
(a)
Actual
Costing
$26  80 = $2,080
$20  80 = 1,600
$3,680
(b)
Normal
Costing
$26  80 = $2,080
$18  80 = 1,440
$3,520
(c)
Variation of
Normal Costing
$28  80 = $2,240
$18  80 = 1,440
$3,680
All three costing systems use the actual direct labor-hours of 80 hours. The budgeted 95 hours
for the Greenville Day School job is not used in job costing. However, Clayton Solutions may
have used the budgeted number of hours in bidding for the job.
4-26
4-35
(30 min)
Proration of overhead.
1. Budgeted manufacturing
overhead rate
Budgeted manufacturing overhead cost
= Budgeted direct manufacturing labor cost
=
$110,000
= 50% of direct manufacturing labor cost
$220,000
2. Overhead allocated = 50% × Actual direct manufacturing labor cost
= 50% × $230,000 = $115,000
Underallocated
manufacturing
overhead
Actual
Allocated plant
=
manufacturing
–
overhead costs
overhead costs
= $117,000 – $115,000 = $2,000
Underallocated manufacturing overhead = $2,000
3a. All underallocated manufacturing overhead is written off to cost of goods sold.
Both work-in-process (WIP) and finished goods inventory remain unchanged.
Account
WIP
Finished Goods
Cost of Goods Sold
Total
Dec. 31, 2020
Balance
(Before Proration)
(1)
$ 41,500
232,400
556,100
$830,000
Proration of $2,000
Underallocated
Manuf. Overhead
(2)
$
0
0
2,000
$2,000
Dec. 31, 2020
Balance
(After Proration)
(3) = (1) + (2)
$ 41,500
232,400
558,100
$832,000
3b. Underallocated manufacturing overhead prorated based on ending balances:
Account
WIP
Finished Goods
Cost of Goods Sold
Total
Dec. 31, 2020
Account Balance
(Before
Proration)
(1)
$ 41,500
232,400
556,100
$830,000
Account
Balance as a
Percent of Total
(2) = (1) ÷ $830,000
0.05
0.28
0.67
1.00
4-27
Proration of $2,000
Underallocated
Manuf. Overhead
(3) = (2)× $2,000
0.05 × $2,000 = $ 100
0.28 × $2,000 =
560
0.67 × $2,000 = 1,340
$2,000
Dec. 31, 2020
Account Balance
(After Proration)
(4) = (1) + (3)
$ 41,600
232,960
557,440
$832,000
3c. Underallocated manufacturing overhead prorated based on 2020 overhead in ending
balances:
Account
WIP
Finished
Goods
Cost of
Goods
Sold
Total
a,b,c
Dec. 31, 2020
Account
Balance
(Before
Proration)
(1)
$ 41,500
Allocated
Manuf.
Overhead in
Dec. 31, 2020
Balance
(Before
Proration)
(2)
$ 11,500a
Allocated Manuf.
Overhead in
Dec. 31, 2020
Balance as a
Percent of Total
(3) = (2) ÷
$115,000
0.10
Dec. 31, 2020
Account
Proration of $3,000
Balance
Underallocated
(After
Manuf. Overhead
Proration)
(5) = (1) + (4)
(4) = (3)× $3,000
0.10 × $2,000 = $ 200
$ 41,700
232,400
33,350b
0.29
0.29 × $2,000 =
556,100
$830,000
70,150c
$115,000
0.61
1.00
0.61 × $2,000 =
580
232,980
1,220
557,320
$832,000
$2,000
Overhead allocated = Direct manuf. labor cost×50% = $23,000; $66,700; $140,300×50%
4. Writing off all of the underallocated manufacturing overhead to Cost of Goods Sold (COGS)
is usually warranted when COGS is large relative to Work-in-Process and Finished Goods
Inventory and the underallocated manufacturing overhead is immaterial. Both these conditions
apply in this case. ROW should write off the $2,000 underallocated manufacturing overhead to
Cost of Goods Sold Account.
4-28
4-36
(20-30 min)
Job costing, accounting for manufacturing overhead, budgeted rates.
1. An overview of the job-costing system is:
INDIRECT
COST
POOL
COST
ALLOCATION
BASE


Machining Department
Manufacturing Overhead
Machine-Hours
in Machining Dept.


2.
Direct Manufacturing
Labor Costs
in Finishing Dept.
Indirect Costs
COST
COSTOBJECT:
OBJECT:
PRODUCT
JOB
DIRECT
COST
Finishing Department
Manufacturing Overhead
Direct Costs
Direct
Materials
Direct
Manufacturing
Labor
Budgeted manufacturing overhead divided by allocation base:
$9,065,000
a. Technology Department = 185,000 machine−hours = $49 per machine-hour
b. Finishing Department =
$8,181,000
4,050,000
= 202% of direct manufacturing labor costs
3.
Technology Department overhead, $49  140 machine-hours$6,860
Finishing Department overhead, 202% of $1,250
2,525
Total manufacturing overhead allocated
$9,385
4.
Total costs of Job 431:
Direct costs:
Direct materials––Technology Department
––Finishing Department
Direct manufacturing labor —Technology Department
—Finishing Department
Indirect costs:
Technology Department overhead, $49  140
Finishing Department overhead, 202% of $1,250
Total costs
$13,000
5,000
900
1,250
$ 6,860
2,525
$20,150
9,385
$29,535
The per-unit product cost of Job 431 is $29,535 ÷ 300 units = $98.45 per unit
The point of this part is (a) to get the definitions straight and (b) to underscore that
overhead is allocated by multiplying the actual amount of the allocation base by the
budgeted rate.
4-29
5.
Technology
$10,000,000
Manufacturing overhead incurred (actual)
Manufacturing overhead allocated
200,000 hours  $49
9,800,000
202% of $4,100,000
Underallocated manufacturing overhead
$ 200,000
Overallocated manufacturing overhead
Total overallocated overhead = $300,000 – $200,000 = $100,000
Finishing
$7,982,000
8,282,000
$ 300,000
6.
A homogeneous cost pool is one where all costs have the same or a similar cause-andeffect or benefits-received relationship with the cost-allocation base. Daewoong likely assumes
that all its manufacturing overhead cost items are not homogeneous. Specifically, those in the
Technology Department have a cause-and-effect relationship with machine-hours, while those in
the Finishing Department have a cause-and-effect relationship with direct manufacturing labor
costs. Daewoong believes that the benefits of using two cost pools (more accurate product costs
and better ability to manage costs) exceed the costs of implementing a more complex system.
4-30
4-37
(15-20 min)
Service industry, job costing, law firm.
1.
INDIRECT
COST
POOL
COST
ALLOCATION
BASE
COST OBJECT:
JOB FOR
CLIENT
DIRECT
COST

Legal
Support

Professional
Labor-Hours

Indirect Costs
Direct Costs
}
Professional
Labor
2.
Budgeted professional
Budgeted direct labor compensation per professional
labor-hour direct cost rate = Budgeted direct labor-hours per professional
=
$97,500
1,500 hours
= $65 per professional labor-hour
Note that the budgeted professional labor-hour direct-cost rate can also be calculated by
dividing total budgeted professional labor costs of $2,925,000 ($97,500 per professional  30
professionals) by total budgeted professional labor-hours of 45,000 (1,500 hours per professional 
30 professionals), $2,925,000  45,000 = $65 per professional labor-hour.
3.
Budgeted indirect
cost rate
=
=
Budgeted total costs in indirect cost pool
Budgeted total professional labor-hours
$2,475,000
1,500 hours per professional × 30 professionals
$2,475,000
= 45,000 hours
= $55 per professional labor-hour
4.
4.
Richardson
Direct costs:
Professional labor, $65  120; $65  160
Indirect costs:
Legal support, $55  120; $55  160
4-31
Punch
$ 7,800
$10,400
6,600
$14,400
8,800
$19,200
4-38
(25-30 min) Service industry, job costing, two direct- and indirect-cost categories,
law firm (continuation of 4-37).
Although not required, the following overview diagram is helpful to understand Kidman’s jobcosting system.
INDIRECT
COST
POOL
COST
ALLOCATION
BASE

General
Support
Secretarial
Support

Professional
Labor-Hours
Partner
Labor-Hours
COST OBJECT:
JOB FOR
CLIENT

DIRECT
COST
}
Indirect Costs
Direct Costs
Professional
Partner Labor
1.
Budgeted compensation per professional
Divided by budgeted hours of billable
time per professional
Budgeted direct-cost rate
Professional
Associate Labor
Professional
Partner Labor
$ 210,000
Professional
Associate Labor
$75,000
÷1,500
$140 per hour*
÷1,500
$50 per hour†
Total budgeted partner labor costs
$210,000 × 5 $1,050,000
= 1,500 × 5 = 𝟕,𝟓𝟎𝟎
Total budgeted partner labor - hours
Total budgeted associate labor costs
$75,000 × 25 $1,875,000
†
Can also be calculated as
= 1,500 × 25 = 𝟑𝟕,𝟓𝟎𝟎
Total budgeted associate labor - hours
*Can also be calculated as
2.
Budgeted total costs
Divided by budgeted quantity of allocation base
Budgeted indirect cost rate
4-32
General
Secretarial
Support
Support
$2,025,000
$450,000
÷ 45,000 hours ÷ 7,500 hours
$45 per hour
$60 per hour
= $140
= $50
3.
Richardson
Direct costs:
Professional partners,
$140  48 hr.; $140  32 hr.
Professional associates,
$50  72 hr.; $50  128 hr.
Direct costs
Indirect costs:
General support,
$45  120 hr.; $45  160 hr.
Secretarial support,
$60  48 hr.; $60  32 hr.
Indirect costs
Total costs
Punch
$6,720
$4,480
3,600
6,400
$10,320
5,400
7,200
2,880
1,920
8,280
$18,600
4.
Single direct – Single indirect
(from Problem 4-37)
Multiple direct – Multiple indirect
(from requirement 3 of Problem 4-38)
Difference
$10,880
9,120
$20,000
Richardson
Punch
$14,400
$19,200
18,600
$ 4,200
undercosted
20,000
$ 800
undercosted
The Richardson and Punch jobs differ in their use of resources. The Richardson job has a
mix of 40% partners and 60% associates, while Punch has a mix of 20% partners and 80%
associates. Thus, the Richardson job is a relatively high user of the more costly partner-related
resources (both direct partner costs and indirect partner secretarial support). The Punch job, on
the other hand, has a mix of partner and associate-related hours (1:4) that is only slightly higher
than the mix of partner and associate hours for the firm as a whole (1:5). The refined-costing
system in Problem 4-38 increases the reported cost in Problem 4-37 for the Richardson job by
29.17% (from $14,400 to $18,600) and the Punch job by a much smaller 4.17% (from $19,200 to
$20,000).
5.
I would recommend that Kidman & Associates use the job costing system in this problem
with two direct- and two indirect- cost categories.
Kidman & Associates should use multiple categories of direct costs (partner labor and
professional labor) because the costs of the different categories of labor are very different and
different jobs use these direct labor resources in different proportions. The system with only one
direct cost would be accurate only if all jobs used partner-labor and professional-labor in the
same proportion, which is clearly not the case. Using a single direct-cost category would
undercost (overcost) jobs that have a high (low) proportion of partner-labor.
Kidman should use multiple indirect cost pools because partners use additional secretarial
support resources that professionals do not use. With a single indirect cost pool as in problem 437, jobs that use proportionately greater (fewer) partner labor-hours are not assigned the extra
(lower) costs of supporting these partners and are undercosted (overcosted).
The job costing system in this problem more accurately represents the costs incurred on
different jobs and therefore helps managers make better decisions.
4-33
4-39
(20-25 min)
Proration of overhead.
1. Budgeted manufacturing overhead rate is $4,800,000 ÷ 80,000 hours = $60 per machine-hour.
2. Manufacturing overhead
underallocated
= Manufacturing overhead incurred –
Manufacturing overhead allocated
= $4,900,000 – $4,500,000*
= $400,000
*$60  75,000 actual machine-hours = $4,500,000
a.
Write-off to Cost of Goods Sold
Account
(1)
Work in Process
Finished Goods
Cost of Goods Sold
Total
Write-off
of $400,000
Underallocated
Manufacturing
Overhead
(3)
Dec. 31, 2020
Account
Balance
(Before Proration)
(2)
$
750,000
1,250,000
8,000,000
$10,000,000
$
0
0
400,000
$400,000
Dec. 31, 2020
Account
Balance
(After Proration)
(4) = (2) + (3)
$
750,000
1,250,000
8,400,000
$10,400,000
b.
Proration based on ending balances (before proration) in Work in Process, Finished
Goods, and Cost of Goods Sold.
Account
(1)
Work in Process
Finished Goods
Cost of Goods Sold
Total
Proration of $400,000
Dec. 31, 2020
Underallocated
Account Balance
Manufacturing
(Before Proration)
Overhead
(2)
(3)
$ 750,000 ( 7.5%) 0.075  $400,000 = $ 30,000
1,250,000 (12.5%) 0.125  $400,000 =
50,000
8,000,000 (80.0%) 0.800  $400,000 = 320,000
$10,000,000 100.0%
$400,000
Dec. 31, 2020
Account
Balance
(After Proration)
(4) = (2) + (3)
$ 780,000
1,300,000
8,320,000
$10,400,000
c.
Proration based on the allocated overhead amount (before proration) in the ending
balances of Work in Process, Finished Goods, and Cost of Goods Sold.
Dec. 31, 2020 Allocated Overhead
Dec. 31, 2020
Account
Included in
Account
Balance
Dec. 31, 2020
Proration of $400,000
Balance
(Before
Account Balance
Underallocated
(After
Account
Proration)
(Before Proration) Manufacturing Overhead
Proration)
(1)
(2)
(3)
(4)
(5)
(6) = (2) + (5)
a
Work in Process
$ 750,000 $ 240,000
(5.33%) 0.0533$400,000 = $ 21,320
$ 771,320
Finished Goods
1,250,000
660,000
Cost of Goods Sold
8,000,000
3,600,000
$10,000,000
$4,500,000
Total
a
b
c
(14.67%) 0.1467$400,000 =
58,680
1,308,680
(80.00%) 0.8000$400,000 = 320,000
8,320,000
100.00%
b
c
$60  4,000 machine-hours; $60  11,000 machine-hours; $60  60,000 machine-hours
4-34
$400,000
$10,400,000
3.
Alternative (c) is theoretically preferred over (a) and (b) because the underallocated amount
and the balances in work-in-process and finished goods inventories are material. Alternative (c)
yields the same ending balances in work in process, finished goods, and cost of goods sold that
would have been reported had actual indirect cost rates been used.
Chapter 4 also discusses an adjusted allocation rate approach that results in the same
ending balances as in alternative (c). This approach operates via a restatement of the indirect costs
allocated to all the individual jobs worked on during the year using the actual indirect cost rate.
4-35
4-40
(20-25 min.) Track the flow of costs in a job costing system and ledger entries.
a. Compute the total manufacturing overhead costs for Job #369
Job #369
$
Direct materials used
355,000
Direct labor costs
169,000
Overheads:
Indirect materials
17,000
Indirect labor
28,000
Factory insurance
10,000
Factory maintenance
7,000
Factory cleaning
6,000
Depreciation of equipment
5,000
Under-allocated overheads
13,000
Total manufacturing overheads
604,000
b. Show the relevant ledger entries to allocate manufacturing overhead cost to work in process
inventory.
1st April Purchases
1st April Balance
Materials inventory
420,000
Direct material used
355,000
17,000
Indirect materials used 17,000
Manufacturing overhead
4 April Indirect materials
17,000 Manufacturing overhead allocated 60,000
Indirect labor
28,000
Factory insurance
10,000
Factory maintenance
7,000
Factory cleaning
6,000
Depreciation of equipment
5,000 Under-allocated overheads
13,000
Total
73,000
73,000
th
Work in process inventory
Direct materials
355,000
Direct labor
169,000
Manufacturing overhead allocated 60,000
Wages incurred
Manufacturing wages
197,000
Direct labor
169,000
Indirect labor 28,000
197,000
Total
197,000
4-36
4-41
1.
(15 min.)
Proration of overhead with two indirect cost pools.
Fabrication department:
Overhead allocated = $20 per machine-hour × 2,000 machine-hours = $40,000
Finishing department:
Overhead allocated = $16 per direct labor-hour × 1,200 direct labor-hours = $19,200
2.
Under- or overallocated overhead in each department and in total follows:
Fabrication department:
$49,500 actual overhead – $40,000 allocated = $9,500 underallocated
Finishing department:
$22,200 actual overhead – $19,200 allocated = $3,000 underallocated
Total underallocated overhead = $9,500 + $3,000 = $12,500
3. Underallocated overhead prorated based on ending balances
Account
Balance
(Before
Proration)
Account
(1)
Work in Process $ 50,000
Finished Goods 150,000
Cost of Goods
Sold
300,000
Total
$500,000
Account
Balance
as a Percent
of Total
(2) = (1) ÷
$500,000
0.10
0.30
Proration of $12,500
Underallocated Overhead
(3) = (2) × 12,500
0.10 × $12,500 = $ 1,250
0.30 × $12,500 =
3,750
0.60 × $12,500 =
0.60
1.00
Account
Balance
(After
Proration)
(4) = (1) + (3)
$ 51,250
153,750
7,500
307,500
$12,500 $512,500
Because Premier Golf Carts is disposing of underallocated costs based on the ending
balance in Work in Process, Finished Goods, and Cost of Goods Sold accounts, it does not have
to allocate the underallocated overhead from each department separately. Had Premier Golf Carts
disposed of the underallocated overhead based on the overhead allocated in the ending balances in
each of the three accounts, it would have to dispose of the underallocated overhead in the
Fabrication Department and the underallocated overhead in the Finishing Department separately.
4.
The ending balance in Cost of Goods Sold would be $312,500 instead of $307,500 if the
entire $12,500 amount of underallocated overhead was written off to Cost of Goods Sold account.
Cost of Goods Sold would increase by 1.6% ($312,500 – $307,500) ÷ $307,500. Because this is
an insignificant amount, it would be reasonable to use the simpler method of charging off to Cost
of Goods Sold.
4-37
4-42 (30-35 min)
1.
2.
a.
Proration of overhead.
Budgeted Manufacturing Overhead ÷ Budgeted Direct Labor Cost = Budgeted OH Rate
$1,210,000 ÷ $550,000 = 220% of Direct Labor Cost
$562,200 Direct Labor Cost × 220% = $1,236,840 Manufacturing OH Allocated
$1,236,840 Manufacturing OH Allocated - $1,200,500 Actual = $36,340 Overallocated
Write-off to Cost of Goods Sold:
Account
(1)
Cost of Goods Sold
Finished Goods
Work-in-Process
Total
Write-off
of $36,340
Overallocated
Manufacturing
Overhead
(3)
Dec. 31, 2020
Account
Balance
(Before Proration)
(2)
$2,100,000
600,000
300,000
$3,000,000
$36,340
0
0
$36,340
Dec. 31, 2020
Account
Balance
(After Proration)
(4) = (2) - (3)
$2,063,660
600,000
300,000
$2,963,660
b.
Proration based on ending balances (before proration) in Work in Process, Finished
Goods, and Cost of Goods Sold:
Account
(1)
Cost of Goods Sold
Finished Goods
Work-in-Process
Total
Proration of $36,340
Dec. 31, 2020
Overallocated
Account Balance
Manufacturing
(Before Proration)
Overhead
(2)
(3)
$2,100,000 (70.0%) 0.70  $36,340 = $ 25,438
600,000 (20.0%) 0.20  $36,340 =
7,268
300,000 (10.0%) 0.10  $36,340 =
3,634
$3,000,000 100.0%
$ 36,340
4-38
Dec. 31, 2020
Account
Balance
(After Proration)
(4) = (2) - (3)
$ 2,074,562
592,732
296,366
$2,963,660
c.
Proration based on the allocated overhead amount (before proration) in the ending
balances of Work in Process, Finished Goods, and Cost of Goods Sold:
Account
(1)
Cost of Goods
Sold
Dec.31,2020
Account
Balance
(Before
Proration)
(2)
$2,100,000
Allocated Overhead
Included in
Dec. 31, 2020
Account Balance
(Before Proration)
(3)
(4)
$841,051 (68.0%)
Proration of $36,340
Overallocated
Manufacturing
Overhead
(5)
0.68  $36,340 =$24,711
Dec. 31, 2020
Account
Balance
(After
Proration)
(6) = (2) - (5)
$ 2,075,289
Finished
Goods
600,000
272,105 (22.0%)
0.22  $36,340 = 7,995
592,005
Work-inProcess
300,000
123,684 (10.00%)
0.10  $36,340 = 3,634
296,366
Total
$3,000,000
$1,236,840 100.00%
$36,340
$2,963,660
3.
Alternative (c) is theoretically preferred over (a) and (b) because the overallocated amount
and the balances in work-in-process and finished goods inventories are material. Alternative (c)
yields the same ending balances in work in process, finished goods, and cost of goods sold that
would have been reported had actual indirect cost rates been used.
Chapter 4 also discusses an adjusted allocation rate approach that results in the same
ending balances as in alternative (c). This approach operates via a restatement of the indirect costs
allocated to all the individual jobs worked on during the year using the actual indirect cost rate.
4-39
4-43
(40-45 min)
Overview of general ledger relationships.
NOTE: In some print versions of the textbook, the second column heading appears as “Ending
Balance 12/31.” The second column heading in the problem should be “Ending Balance 12/30”
and not “Ending Balance 12/31.”
1. Adjusting entry for 12/31 payroll.
(a) Work-in-Process Control
Manufacturing Department Overhead Control
Wages Payable Control
To recognize payroll costs
(b) Work-in-Process Control
Manufacturing Overhead Allocated
To allocate manufacturing overhead at 110% 
$4,300 = $4,730 on $4,300 of direct manufacturing
labor incurred on 12/31
4,300
1,400
5,700
4,730
4,730
Note: Students tend to forget entry (b) entirely. Stress that a budgeted overhead allocation
rate is used consistently throughout the year. This point is a major feature of this problem.
2. a-e An effective approach to this problem is to draw T-accounts and insert all the known
figures. Then, working with T-account relationships, solve for the unknown figures. Entries (a)
and (b) are posted into the T-accounts that follow.
Materials Control
Beginning balance 12/1
Purchases
Balance 12/30
a
$2,100 + $66,300 – $8,500 = $59,900
2,100
66,300
8,500
(a)
59,900a
Materials requisitioned
Direct materials requisitioned into work in process during December equals $59,900
because no materials are requisitioned on December 31.
Work-in-Process Control
Beginning balance 12/1
6,700
Direct materials
$59,900
Direct manf. labor
84,000b
Manf. overhead
allocated
92,400b
236,300
234,000 Cost of goods manufactured
Balance 12/30
9,000
(a) Direct manuf. labor 12/31 payroll
4,300
(b) Manuf. overhead allocated 12/31
4,730c
Ending balance 12/31
18,030
b
Direct manufacturing labor and manufacturing overhead allocated are unknown.
Let x = Direct manufacturing labor up to 12/30 payroll
Manufacturing overhead allocated up to 12/30 payroll = 1.10x
4-40
Use the T-account equation and solve for x:
$6,700 + $59,900 + x + 1.10x – $234,000 = $9,000
2.10x = $9,000 – $6,700 – $59,900 + $234,000
2.10x = $176,400
x = $176,400 / 2.10 = $84,000
Direct manufacturing labor up to 12/30 payroll = $84,000
Manufacturing overhead allocated up to 12/30 = 1.10 × $84,000 = $92,400
Total direct manufacturing labor for December = $84,000 + $4,300 (direct manufacturing labor
for 12/31 calculated in requirement 1) = $88,300
Total manufacturing overhead allocated for December = $92,400 + $4,730 c = $97,130
$4,300  110% = $4,730, manufacturing overhead allocated on $4,300 of direct manufacturing
labor incurred on 12/31.
c
(b)
(c)
(d)
Total direct manufacturing labor for December = $88,300.
Total manufacturing overhead allocated (recorded) in work in process equals $97,130.
Ending balance in work-in-process inventory on December 31 equals $9,000 + $4,300
(direct manufacturing labor added on 12/31, requirement 1) + $4,730 (manufacturing
overhead allocated on 12/31, requirement 1) = $18,030.
An alternative approach to solving requirements 2b, 2c, and 2d is to calculate the work-in-process
inventory on December 31, recognizing that because no new units were started or completed, no
direct materials were added and the direct manufacturing labor and manufacturing overhead
allocated on December 31 were added to the work-in-process inventory balance of December 30.
Work-in-process
inventory
on 12/31
=
Work-in-process
inventory on
12/30
+
Direct
manufacturing
+
labor incurred
on 12/31
Manufacturing
overhead
allocated on
12/31
= $9,000 + $4,300 + $4,730
= $18,030
We can now use the T-account equation for work-in-process inventory account from 12/1 to
12/31, as follows.
Let x = Direct manufacturing labor for December
Then 1.10x = Manufacturing overhead allocated for December
Work-inprocess
+
inventory
on 12/1
Direct
Direct
Manufacturing
Work-inCost of goods
materials
manufacturing
overhead
process
+
+
– manufactured =
added in
labor added in
allocated in
inventory on
in December
December
December
December
12/31
$6,700 + $59,900 + x + 1.10x – $234,000 = $18,030
2.10x = $18,030 – $6,700 – $59,900 + $234,000
2.10x = $185,430
x = $185,430 / 2.10 = $88,300
Total direct manufacturing labor for December = $88,300
Total manufacturing overhead allocated in December = 1.10  $88,300 = $97,130
4-41
Finished Goods Control
Beginning balance 12/1
4,400
Cost of goods manufactured
234,000
219,000c Cost of goods sold
Balance 12/31
19,400
c
$4,400 + $234,000 – $19,400 = $219,000
(e)
Cost of goods sold for December before adjustments for under- or overallocated overhead
equals $219,000:
Cost of goods sold
Cost of Goods Sold
219,000
1,730
(c) Closing entry
Manufacturing Department Overhead Control
Balance through 12/30
94,000
(a) Indirect manufacturing
labor 12/31
1,400
95,400 (c) Closing entry
(c) Closing entry
Manufacturing Overhead Allocated
97,130
92,400
Balance through 12/30
4,730
(b) Manufacturing overhead
allocated, 12/31
Wages Payable Control
1,400
(a) 12/31 payroll
3. Closing entries:
(c) Manufacturing Overhead Allocated
97,130
Manufacturing Department Overhead Control
95,400
Cost of Goods Sold
1,730
To close manufacturing overhead accounts and overallocated overhead to cost of goods
sold.
4-42
4-44
(25 min)
Allocation and proration of overhead.
1. Compute the over or under allocation of manufacturing overheads
Budgeted manufacturing overhead rate
= Budgeted manufacturing overhead costs = £792, 000 = £18 per unit
Budgeted units of production
44,000
Over-allocation of manufacturing overheads
= (actual production – budgeted production) x manufacturing overhead rate per unit
= (48, 800 – 44, 000) x £18 per unit = £ 86, 400
2. Compute the total manufacturing costs
£
Direct material costs
36.00
Direct labor costs
8.00
Variable manufacturing overheads
6.00
Variable manufacturing costs
50.00
Fixed manufacturing overhead costs
18.00
Total manufacturing costs per unit
68.00
Total manufacturing costs = £68 x 48,800 = £3,318,400
3. Show how the over-or-under allocation of the manufacturing overheads affects the income of
Kitchen Wood Ltd.
£
Revenue (40,800 x £100)
Total manufacturing costs (48,800 x £68)
Closing inventory (8,000 x £68)
Cost of sales
Gross profit
Sales commission (£4,080,000 x 10%)
Administrative overheads
Selling costs
£
4,080,000
3,318,400
544,000
2,774,400
1,305,600
408,000
208,000
112,000
Add: Over-allocated overheads
Operating income
4-43
728,000
577,600
86,400
664,000
4-45
(25-30 min)
Job costing, ethics.
1. Overhead overallocated = Manufacturing overhead allocated – Manufacturing overhead incurred
= $1,424,000a − $1,250,000 = $174,000 overallocated
a
$890,000 x 1.6 = $1,424,000
2.
a. If the overallocated overhead is closed out to cost of goods sold, COGS decreases by $174,000:
$2,950,000 − $174,000 = $2,776,000
Revenue
$5,580,000
COGS
2,776,000
Selling and admin. expenses 2,790,000
Net operating income
$ 14,000
b. If the overallocated overhead is prorated to work in process control, finished goods control,
and cost of goods sold based on ending balances before proration, cost of goods sold will be
adjusted as follows:
Account
Ending Balance
Balance
Before Proration as a Percent
12/31/2020
of Total
(1)
(2)=(1)/3,494,000
WIP Control
Fin. Goods Control
Cost of Goods Sold
$ 244,000
300,000
2,950,000
7.0%
8.6%
84.4%
$3,494,000
100%
×
×
×
Proration of
$174,000 of
Overallocated
Manufacturing
Overhead
(4) = (3)×$108,000
Overallocated
Manufacturing
Overhead
(3)
$174,000
174,000
174,000
=
=
=
$ 12,180
14,964
146,856
$174,000
$174,000 overallocated overhead × 84.4% = $146,856 is subtracted from COGS
$2,950,000 − $146,856 = $2,803,144
Revenue
$5,580,000
COGS
2,803,144
Selling and admin. expenses 2,790,000
Net operating loss
$ (13,144)
3. Manufacturing overhead costs were overallocated in this case. In 2a the overallocation is
adjusted by subtracting the entire overallocated amount of $174,000 from COGS. The inventory
in the work in process and finished goods accounts is still allocated too much overhead, which is
not adjusted for. When this inventory is sold in the next periods COGS will be higher and net
operating income lower, compared to the approach in 2b.
4-44
4.
While technically the $27,144 difference in adjusted cost of goods sold may have been
immaterial, the difference caused Baker Brothers to report a profit in the first instance, and a loss
in the second. Recall that the company is under pressure to report a profit in 2020 because it is
preparing for an acquisition by a private equity firm. The circumstances cause the amount to be
material.
Further, Bledsoe may have been planning for this all along, when she increased the overhead
allocation rate for 2020. The ethical issue is that she may have planned for an overallocation of
overhead so that she would have the option of reducing cost of goods sold at the end of the year in
order to increase earnings. Such an intentional manipulation would be a violation of the
credibility principle of the IMA Statement of Ethical Professional Practice: “Each practitioner has
a responsibility to…communicate information fairly and objectively.”
4-45
4-46
(20-25 min.) Track the flow of costs in a job costing system and ledger entries.
a. Show the journal entries for each transaction
1.
2.
3
4.
5.
6.
7.
8.
9.
10.
11.
Dr
Cr
Dr
Cr
Dr
Cr
Dr
Cr
Cr
Cr
Dr
Dr
Dr
Cr
Dr
Dr
Cr
Dr
Cr
Dr
Cr
Dr
Cr
Cr
Dr
Cr
Dr
Stores ledger control account
Creditors control account
Purchase of materials
Work in process account
Stores ledger control account
Conversion of raw material to WIP inventory
Factory overhead control account
Stores ledger control account
Issuing of indirect material
Wages control account
Tax payable
Social insurance contribution
Wages accrued
Gross pay, tax deduction and other authorized deductions
Tax payable
Social insurance contribution
Wages accrued
Cash/ bank
Payment of tax, wages and social insurance contribution
Work in process control account
Factory overhead control account
Wages control account
Wages control allocated to job and overhead
Factory overhead control account
Social insurance contribution account
Social insurance contribution account charged to the
factory overhead
Social insurance contribution account
Cash/ bank
Payment of social insurance contribution
Factory overhead control account
Expense creditors control account
Provision of depreciation account
Creditors and depreciation charged to factory overheads
Work in process control account
Factory overhead control account
Factory overhead charged to WIP account
Non-manufacturing overheads account
4-46
$
182,000
$
182,000
165,000
165,000
10,000
10,000
185,000
60,000
20,000
105,000
60,000
20,000
105,000
185,000
145,000
40,000
185,000
25,000
25,000
25,000
25,000
71,000
41,000
30,000
140,000
140,000
40,000
Cr
12.
13.
14.
15.
16.
Dr
Cr
Dr
Cr
Dr
Cr
Dr
Cr
Dr
Cr
Expense creditors control account
Creditors accounts charged to non-manufacturing
overheads
Expense creditors control account
Cash/bank
Payment towards expense creditors
Profit and loss account
Non-manufacturing overheads account
Non-manufacturing overheads charged to profit and loss
account
Finished goods inventory account
Work in process control account
Transfer of WIP to finished inventory
Debtors control account
Revenues account
Sales of goods to customers
Costs of sales account
Finished goods inventory
Finished goods charged to the cost of sales account
40,000
81000
81000
40,000
40,000
300,000
300,000
400,000
400,000
240,000
b. Show the T-account (ledger) of the major transactions
Stores ledger control account
Creditor account
182,000
Work in process account
Factory overhead account
Balance c/d
182,000
Balance b/d
7,000
240,000
165,000
10,000
7,000
182,000
Wages control account
Wages accrued account
105,000 Work in process account
145,000
Tax payable account
60,000 Factory overheads account
40,000
Social insurance contribution account 20,000
185,000
185,000
Factory overheads control account
Stores ledger control account
10,000
Work in process control account 140,000
Wages control account
40,000
Balance – under-allocation of
overhead transferred to
profit and loss account
6,000
Social insurance contribution account 25,000
Expenses creditors account
4 1,000
Provision for depreciation account
30,000
146,000
146,000
4-47
Work in process control account
Stores ledger control account
165000 Finished goods control account
Wages control account
145000 Balance
Factory overhead control account
140000
450000
Finished goods control account
Work in process control account
300000 Cost of sales account
Balance
300000
Profit and loss account
Cost of sales account
240000 Revenue account
Non-manufacturing overhead
account
40000
Factory overhead control
6000
(under allocation of overhead)
Profit
114000
400000
4-48
300000
150000
450000
240000
60000
300000
400000
400000
Try It! 4-1
The solution assumes that Huckvale Corporation allocates manufacturing overhead costs in its
normal costing system based on direct manufacturing labor-hours.
Budgeted indirect
Budgeted annual manufacturing overhead costs

cost rate
Budgeted annual quantity of the cost-allocation base
Budgeted indirect
cost rate
$1,160,000
=
29,000 hours
= $40 per direct manufacturing labor hour
Total manufacturing costs of the 32 Pioneer Drive job equals:
Direct manufacturing costs
Direct materials
Direct manufacturing labor ($18 per direct
manufacturing labor hour × 180 direct manufacturing
labor-hours)
Manufacturing overhead costs
($40 per direct manufacturing labor-hour × 180 hours)
Total manufacturing costs of 32 Pioneer Drive job
4-49
$3,600
3,240
$ 6,840
7,200
$14,040
Try It! 4-2
The solution assumes that Huckvale Corporation allocates manufacturing overhead costs in its
costing system based on direct manufacturing labor-hours. Although Huckvale uses a normalcosting system to manage costs throughout the year, the problem asks you to calculate actual
costs using actual costing at the end of the year. The point of the problem is to illustrate that
companies that use normal costing also use actual costing at the end of the year to evaluate how
well their normal costing systems are working. As the chapter discussion indicates, companies
rarely use actual costing as their main costing system.
Actual manufacturing
overhead rate
=
Actual annual manufacturing overhead costs
Actual annual quantity of the cost-allocation base
=
$1,260,000
28,000 direct manufacturing labor-hours
= $45 per direct manufacturing labor-hour
Manufacturing overhead costs
allocated to 32 Pioneer Drive job
=
=
Actual manufacturing
overhead rate
$45 per direct manuf.
labor-hour
´
´
Actual quantity of direct
manufacturing labor-hours
180 direct manufacturing
labor-hours
= $8,100
The cost of the job under actual costing is:
Direct manufacturing costs
Direct materials
Direct manufacturing labor ($20 per direct
manufacturing labor hour × 160 direct manufacturing
labor-hours)
Manufacturing overhead costs
($45 per direct manufacturing labor-hour × 180 hours)
Total manufacturing costs of 32 Pioneer Drive job
4-50
$3,600
3,240
$ 6,840
8,100
$14,940
Try It! 4-3
The solution assumes that Huckvale Corporation allocates manufacturing overhead costs in its
normal costing system based on direct manufacturing labor-hours.
Budgeted indirect
Budgeted manufacturing overhead costs

cost rate
Budgeted annual quantity of the cost-allocation base
Budgeted indirect
cost rate
$1,160,000
=
29,000 hours
= $40 per direct manufacturing labor hour
(a) Usage of direct materials, $20,000, and indirect materials, $2,000 during April 2020
Work-in-Process Control
20,000
Manufacturing Overhead Control
2,000
Materials Control
22,000
(b) Manufacturing payroll for April 2020: direct labor, $50,000 paid in cash
Work-in-Process Control
50,000
Cash Control
50,000
(c) Other manufacturing overhead costs incurred during April 2020, $76,000, consisting of
■ Supervision and engineering salaries, $49,000 (paid in cash);
■ Plant utilities and repairs $7,000 (paid in cash); and
■ Plant depreciation, $20,000
Manufacturing Overhead Control
76,000
Cash Control
56,000
Accumulated Depreciation Control
20,000
(d) Allocation of manufacturing overhead to jobs = Budgeted manufacturing overhead rate ×
Actual direct manufacturing labor-hours = $40 × 3,000 = $120,000
Work-in-Process Control
120,000
Manufacturing Overhead Allocated
120,000
(e) The sum of all individual jobs completed and transferred to finished goods in April 2020 is
$230,000
Finished Goods Control
230,000
Work-in-Process Control
230,000
(f) Cost of goods sold in April 2020, $225,000
Cost of Goods Sold
225,000
Finished Goods Control
225,000
4-51
Try It! 4-4
Budgeted indirect
Budgeted manufacturing overhead costs

cost rate
Budgeted annual quantity of the cost-allocation base
Budgeted indirect
cost rate
$1,160,000
=
29,000 hours
= $40 per direct manufacturing labor hour
Manufacturing overhead allocated during the year =
Budgeted indirect cost rate × Actual direct manufacturing labor-hours = $40 × 28,000 =
$1,120,000
Underallocated manufacturing overhead = Actual manufacturing overhead costs – Allocated
manufacturing overhead costs = $1,260,000 − $1,120,000 = $140,000.
Account
Work-inprocess control
Finished goods
control
Cost of goods
sold
Total
Account
Balance
(Before
Proration)
(1)
$
Manufacturing
Overhead in
Each Account
Balance
Allocated in the
Current Year
(Before
Proration)
(2)
Manufacturing
Overhead in
Each Account
Balance
Allocated in the
Current Year as
Percent of Total
(3)=(2)÷$960,000
Proration of $62,000
of Underallocated
Manufacturing
Overhead
(4)=(3)×$62,000
45,000
$ 29,000
2.5%
0.025 × $140,000 = $ 3,500
65,000
63,800
5.5%
0.055 × $140,000 =
1,067,200
1,600,000
$1,710,000
$1,160,000
4-52
Account
Balance
(After
Proration)
(5)=(1)+(4)
$
48,500
7,700
72,700
92.0%
0.92 × $140,000 = 128,800
1,728,800
100.0%
$140,000
$1,850,000
CHAPTER 5
ACTIVITY-BASED COSTING AND ACTIVITY-BASED MANAGEMENT
5-1
Broad averaging (or “peanut-butter costing”) describes a costing approach that uses broad
averages for assigning (or spreading, as in spreading peanut butter) the cost of resources uniformly
to cost objects when the individual products or services, in fact, use those resources in non-uniform
ways.
Broad averaging, by ignoring the variation in the consumption of resources by different
cost objects, can lead to inaccurate and misleading cost data, which in turn can negatively impact
the marketing and operating decisions made based on that information.
5-2
Undercosting products will lead to underpricing and may even lead to sales that actually
result in losses because the sales may bring in less revenue than the cost of resources they use.
Overcosting products will lead to overpricing causing those products to lose market share to
competitors producing similar products.
5-3
Costing system refinement means making changes to a simple costing system that reduces
the use of broad averages for assigning the cost of resources to cost objects and provides better
measurement of the costs of overhead resources used by different cost objects. Three guidelines
for refinement are:
1.
Classify as many of the total costs as direct costs as is economically feasible.
2.
Expand the number of indirect cost pools until each of these pools is more homogenous.
3.
Use the cause-and-effect criterion, when possible, to identify the cost-allocation base for
each indirect-cost pool.
5-4
Individual activities are the fundamental cost objects in activity-based costing. Activitybased costing first uses resource drivers to assign the costs of resources to individual activities and
then it uses activity drivers to assign the cost of these activities to products or services (as final
cost objects).
5-5
A cost hierarchy can lead to a more accurate costing system by focusing on the levels of
cause-and-effect relationships between various activity cost pools on the one hand and final cost
objects on the other hand. It categorizes various activity cost pools into four individual levels on
the basis of the different types of cost drivers, cost-allocation bases, or the different degrees of
difficulty in determining cause-and-effect relationships. These four levels of a cost hierarchy (from
the highest to the lowest cause-and-effect relationship to cost objects) are: output unit-level costs,
batch-level costs, product-sustaining costs or service-sustaining costs, and facility-sustaining
costs.
5-1
5-6
Out of four levels of hierarchy costs in activity-based costing, only ‘output unit-level costs’
is used in simple costing systems. In other words, there are three additional levels of hierarchy
costs in activity-based-costing systems which are not used in simple costing systems as follows:
batch-level costs, product-sustaining costs or service-sustaining costs, and facility-sustaining
costs. These three additional levels of hierarchy costs are important because not all cost-allocation
bases are unit level. Some are batch-level costs, some are product-sustaining costs and some are
facility-sustaining costs which have no direct link with the cost objects.
5-7
1.
2.
3.
4.
5.
6.
7.
The steps involved are:
Identifying the products that are the chosen cost objects.
Identifying the direct costs of the products.
Selecting the cost-allocation bases to use for allocating indirect or overhead costs to the
products.
Identifying the indirect costs associated with each cost-allocation base.
Computing the rate per unit of each cost-allocation base.
Computing the indirect costs allocated to the products.
Computing the total cost of the products by adding all direct and indirect costs assigned to
the products.
5-8
Managers must be sensitive to the following behavioral issues in implementing ABC
system:
1.
Gaining support of top management and creating a sense of urgency for the ABC effort.
2.
Creating a guiding coalition of managers throughout the value chain for the ABC effort.
3.
Educating and training employees in ABC as a basis for employee empowerment.
4.
Seeking small short-run success as proof that the ABC implementation is yielding results.
5.
Recognizing that ABC information is not perfect because it balances the need for better
Information against the costs of creating a complex system that few managers and
employees can understand.
5-9
No. It depends on several factors such as the variety and number of activities, cost
allocation bases, and cost objects/products. For example: if a company produces one single product
then the product cost under both simple costing systems and activity-based-costing can be the
same. Or, when different products use resources from different activities in the same proportions
as with simple costing systems.
5-10 “Tell-tale” signs that indicate when ABC systems are likely to provide the most benefits
are as follows:
1.
Significant amounts of indirect costs are allocated using only one or two cost pools.
2.
All or most indirect costs are identified as output-unit-level costs (i.e., few indirect costs
are described as batch-level, product-sustaining, or facility-sustaining costs).
3.
Products make diverse demands on resources because of differences in volume, process
steps, batch size, or complexity.
4.
Products that a company is well suited to make and sell show small profits, whereas
products that a company is less suited to produce and sell show large profits.
5.
Operations staff has significant disagreements with the accounting staff about the costs of
manufacturing and marketing products and services.
5-2
5-11 The main limitations of ABC systems are the difficulties of the measurement to implement
it. The ABC systems require managers to estimate costs of activity pools and to identify and
measure cost drivers for these pools to serve as cost-allocation bases. Even basic ABC systems
require several calculations to determine costs of product or services. Such measurements are
costly, and the activity-based rate also need to be updated regularly. Occasionally, managers are
also forced to use allocation bases for which data are readily available rather than allocation bases
they would have liked to use.
5-12 ABC systems can be used equally for product costing and service costing as well as for
strategic decisions in manufacturing and service companies. ABC systems are more suited to
service companies because a vast majority of their cost structure is composed of indirect costs.
5-13 No. The additional costs and resources needed may not exceed the benefits gained by
having more accurate and detailed information provided by the ABC system. Thus, cost benefit
analysis is always needed to make sure that expected benefits exceed expected costs to replace
simple costing.
5-14 The main factors for determining the number of indirect-cost pools are the homogeneity of
cost pools as well as the similarity in proportions at which different products/services use cost
pools. The higher the homogeneity of cost pools, and the similarity of proportions of using
different activities by products/services, the lower the number of required indirect-cost pools.
5-15
It can be argued that the adoption of ABC may result in reduction of the total
manufacturing costs of the company. ABC can help with cost reduction and process improvement
decisions by identifying individual activities and their relevant costs. This can help managers to
eliminate non-added value activities, reduce costs and improve the overall process. So, it is not
always true that total manufacturing cost remains the same if a company decides to adopt ABC as
eliminating non-added value activities can reduce the production costs. It can also be argued that
by adopting the ABC system, the manager will be in a better position to make improved decisions
in terms of pricing and product-mixed decisions. ABC could help to identify products that may be
currently under-costed, and are being actually sold for losses, where the losses are masked by sales
of very profitable product lines.
5-3
5-16 Choice ‘3’ is correct. It is wrong to assume that department costing systems always
properly recognize the drivers of costs within departments. The other options are correct:
emphasizing activities leads to more-focused and homogenous costs pools, and activities that aid
in identifying cost-allocation bases for activities that have a better cause-and-effect relationship
with the costs in activity-cost pools. It is also true that some companies have evolved their costing
systems from using a single indirect cost rate system to using separate indirect cost rates for each
department. It is correct that ABC systems, with their focus on specific activities, are a further
refinement of department costing systems.
Choices ‘1’, ‘2’, and ‘4’ are incorrect. It is wrong to assume that department costing systems
always properly recognize the drivers of costs within departments. The other options are however
correct: emphasizing activities leads to more-focused and homogenous costs pools, and activities
that aid in identifying cost-allocation bases for activities that have a better cause-and-effect
relationship with the costs in activity-cost pools.
5-17 Choice ‘4’ is correct. All the options are true and likely to yield positive results in ABC
systems.
Choice ‘1’ is correct. If there is only one product or if all products consume resources similarly,
then broad-based averages from traditional systems are sufficient.
Choice ‘2’ is correct. Operations that are varied and complex require ABC, otherwise, just a few
indirect-cost pools would suffice.
Choice ‘3’ is correct. ABC is increasing in popularity because changes in business are decreasing
implementation costs while increasing the relative benefits. Managers may need to re-evaluate the
cost system if costs/prices appear to be out of line with those of the competitors.
5-18
1.
(20 min.) Cost hierarchy.
a. Indirect manufacturing labor costs of $950,000 support direct manufacturing labor and
are output unit-level costs. Direct manufacturing labor generally increases with output
units and so will the indirect costs to support it.
b. Batch-level costs are costs of activities that are related to a group of units of a product
rather than each individual unit of a product. Purchase order-related costs (including
costs of receiving materials and paying suppliers) of $675,000 relate to a group of units
of product and are batch-level costs.
c. Cost of indirect materials of $180,000 generally changes with labor hours or machine
hours which are unit-level costs. Therefore, indirect material costs are output unit-level
costs.
d. Setup costs of $450,000 are batch-level costs because they relate to a group of units of
product produced after the machines are set up.
e. Costs of designing processes, drawing process charts, and making engineering changes
for individual products, $315,000, are product sustaining because they relate to the
costs of activities undertaken to support individual products regardless of the number
of units or batches in which the product is produced.
5-4
f. Machine-related overhead costs (depreciation and maintenance) of $975,500 are output
unit-level costs because they change with the number of units produced.
g. Plant management, plant rent, and insurance costs of $578,000 are facility-sustaining
costs because the costs of these activities cannot be traced to individual products or
services but support the organization as a whole.
2.
3.
5-19
The complex karaoke machine made in many batches will use significantly more batchlevel overhead resources compared to the simple karaoke machine that is made in a few
batches. In addition, the complex karaoke machine will use more product-sustaining
overhead resources because it is complex. Since each karaoke machine requires the same
number of machine-hours, both the simple and the complex karaoke machine will be
allocated the same amount of overhead costs per karaoke machine if SharpPitch uses only
machine-hours to allocate overhead costs to karaoke machines. As a result, the complex
karaoke machine will be undercosted (it consumes a relatively high level of resources but
is reported to have a relatively low cost) and the simple karaoke machine will be
overcosted (it consumes a relatively low level of resources but is reported to have a
relatively high cost).
Using the cost hierarchy to calculate activity-based costs can help SharpPitch to identify
both the costs of individual activities and the cost of activities demanded by individual
products. SharpPitch can use this information to manage its business in several ways:
a. Pricing and product mix decisions. Knowing the resources needed to manufacture and
sell different types of karaoke machines can help SharpPitch to price the different
karaoke machines and also identify which karaoke machines are more profitable. It can
then emphasize its more profitable products.
b. SharpPitch can use information about the costs of different activities to improve
processes and reduce costs of the different activities. SharpPitch could have a target of
reducing costs of activities (setups, order processing, etc.) by, say, 2% and constantly
seek to eliminate activities and costs (such as engineering changes) that its customers
perceive as not adding value.
c. SharpPitch management can identify and evaluate new designs to improve performance
by analyzing how product and process designs affect activities and costs.
d. SharpPitch can use its ABC systems and cost hierarchy information to plan and manage
activities. What activities should be performed in the period and at what cost?
(25 min.) ABC, cost hierarchy, service.
Output unit-level costs
a. Direct-labor costs, $276,000
b. Equipment-related costs (rent, maintenance, energy, and so on), $495,000
These costs are output unit-level costs because they are incurred on each unit of materials
tested, that is, for every hour of testing.
Batch-level costs
c. Setup costs, $630,000
These costs are batch-level costs because they are incurred each time a batch of materials
5-5
is set up for either HT or ST, regardless of the number of hours for which the tests are
subsequently run.
Service-sustaining costs
d. Costs of designing tests, $399,000
These costs are service-sustaining costs because they are incurred to design the HT and ST
tests, regardless of the number of batches tested or the number of hours of test time.
5-6
2.
Direct labor costs (given)
Heat Testing (HT)
Total
Per Hour
(1)
(2) = (1) ÷ 50,000
$204,000
$4.08
Stress Testing (ST)
Total
Per Hour
(3)
(4) = (3) ÷ 40,000
$72,000
$1.80
Equipment-related costs
$5.50 per hour* × 275,000
50,000 hours
$5.50 per hour* ×
40,000 hours
Setup costs
$30 per setup-hour† × 450,000
15,000 setup-hours
5.50
220,000
5.50
180,000
4.50
9.00
$30 per setup-hour† ×
6,000 setup-hours
Costs of designing tests
$66.50 per hour** × 266,000
4,000 hours
$66.50 per hour** ×
2,000 hours
Total costs
$1,195,000.00
5.32
3.33
133,000
$605,000.00 $15.13
$23.90
5-7
*$495,000  (50,000 + 40,000) hours = $5.50 per test-hour
†
$630,000  (15,000 + 6,000) setup hours = $30 per setup-hour
**$399,000  (4,000 + 2,000) hours = $66.50 per hour
At a cost per test-hour of $20, the simple costing system undercosts heat testing ($23.90) and
overcosts stress testing ($15.13). The reason is that heat testing uses direct labor, setup, and design
resources per hour more intensively than stress testing. Heat tests are more complex, take longer
to set up, and are more difficult to design. The simple costing system assumes that testing costs
per hour are the same for heat testing and stress testing.
3. The ABC system better captures the resources needed for heat testing and stress testing because
it identifies all the various activities undertaken when performing the tests and recognizes the
levels of the cost hierarchy at which costs vary. Hence, the ABC system generates more accurate
product costs.
CoreTech’s management can use the information from the ABC system to make better pricing and
product mix decisions. For example, it might decide to increase the prices charged for the costlier
heat testing and consider reducing prices on the less costly stress testing. CoreTech should watch
if competitors are underbidding CoreTech in stress testing and causing it to lose business.
CoreTech can also use ABC information to reduce costs by eliminating processes and activities
that do not add value, identifying and evaluating new methods to do testing that reduce the
activities needed to do the tests, reducing the costs of doing various activities, and planning and
managing activities.
5-8
5-20
(15 min.)
Alternative allocation bases for a professional services firm.
1.
Client
(1)
SAN ANTONIO
DOMINION
Walliston
Boutin
Abbington
AMSTERDAM
ENTERPRISES
Walliston
Boutin
Abbington
Direct Professional Time
Rate per Number
Hour
of Hours
Total
(2)
(3)
(4) = (2)  (3)
Support Services
Rate
(5)
Amount
Billed to
Total
Client
(6) = (4)  (5) (7) = (4) + (6)
$640
220
100
26
5
39
$16,640
1,100
3,900
30%
30
30
$4,992
330
1,170
$21,632
1,430
5,070
$28,132
$640
220
100
4
14
52
$2,560
3,080
5,200
30%
30
30
$ 768
924
1,560
$ 3,328
4,004
6,760
$14,092
2.
Client
(1)
SAN ANTONIO
DOMINION
Walliston
Boutin
Abbington
AMSTERDAM
ENTERPRISES
Walliston
Boutin
Abbington
Direct Professional Time
Support Services
Rate
per
Number
Rate per
Hour of Hours
Total
Hour
Total
(2)
(3)
(5)
(4) = (2)  (3)
(6) = (3)  (5)
Amount
Billed to
Client
(7) = (4) + (6)
$640
220
100
26
5
39
$16,640
1,100
3,900
$75
75
75
$1,950
375
2,925
$18,590
1,475
6,825
$26,890
$640
220
100
4
14
52
$2,560
3,080
5,200
$75
75
75
$ 300
1,050
3,900
$ 2,860
4,130
9,100
$16,090
San Antonio Dominion
Amsterdam Enterprises
Requirement 1
$28,132
14,092
$42,224
5-9
Requirement 2
$26,890
16,090
$42,980
Both clients use 70 hours of professional labor time. However, San Antonio Dominion uses a
higher proportion of Walliston’s time (26 hours), which is more costly. This attracts the highest
support-services charge when allocated on the basis of direct professional labor costs.
3.
Assume that the Walliston Group uses a cause-and-effect criterion when choosing the
allocation base for support services. You could use several pieces of evidence to determine whether
professional labor costs or hours is the driver of support-service costs:
a. Interviews with personnel. For example, staff in the major cost categories in support
services could be interviewed to determine whether Walliston requires more support
per hour than, say, Abbington. The professional labor costs allocation base implies that
an hour of Walliston’s time requires 6.40 ($640 ÷ $100) times more support-service
dollars than does an hour of Abbington’s time.
b. Analysis of tasks undertaken for selected clients. For example, if computer-related costs
are a sizable part of support costs, you could determine if there was a systematic
relationship between the percentage involvement of professionals with high billing
rates on cases and the computer resources consumed for those cases.
5-10
5-21
(20 min.) Plantwide, department, and ABC indirect cost rates.
1.
Actual plantwide variable
MOH rate based on machine
hours, $308,600 ÷ 4,000
$77.15 per machine hour
United
Motors
Variable manufacturing overhead, allocated based
on machine hours
($77.15 × 120; $77.15 × 2,800; $77.15 × 1,080)
$9,258
Holden
Motors
Leland
Auto
Total
$216,020 $83,322 $308,600
2.
Department
Design
Production
Engineering
MOH
in Total
2020
Driver Units
$39,000
390
29,600
370
240,000
4,000
Rate
$100
$ 80
$ 60
per CAD-design hour
per engineering hour
per machine hour
United
Motors
Holden
Motors
Design-related overhead, allocated on CADdesign hours
(110 × $100; 200 × $100; 80 × $100)
$11,000
Production-related overhead, allocated on
engineering hours
(70 × $80; 60 × $80; 240 × $80)
5,600
Engineering-related overhead, allocated on
machine hours
(120 × $60; 2,800 × $60; 1,080 × $60)
7,200
Total
$23,800
Leland
Auto
Total
$ 20,000 $ 8,000 $ 39,000
4,800
19,200
29,600
168,000 64,800
$92,00
$192,800 0
240,000
$308,60
0
3.
United
Motors
a. Department rates
(Requirement 2) $23,800
b. Plantwide rate
(Requirement 1) $ 9,258
Ratio of (a) ÷ (b)
2.57
Holden
Motors
Leland
Auto
$192,800
$92,000
$216,020
0.89
$83,322
1.10
The manufacturing overhead allocated to United Motors increases by 157% under the department
rates, the overhead allocated to Holden decreases by about 11%, and the overhead allocated to
Leland increases by about 10%.
The three contracts differ sizably in the way they use the resources of the three departments.
5-11
The percentage of total driver units in each department used by the companies is:
Department
Design
Engineering
Production
Cost
Driver
CAD-design hours
Engineering hours
Machine hours
United
Motors
28%
19
3
Holden
Motors
51%
16
70
Leland
Auto
21%
65
27
The United Motors contract uses only 3% of total machines hours in 2020 yet uses 28% of
CAD design-hours and 19% of engineering hours. The result is that the plantwide rate, based on
machine hours, will greatly underestimate the cost of resources used on the United Motors
contract. This explains the 157% increase in indirect costs assigned to the United Motors contract
when department rates are used. The Leland Auto contract also uses far fewer machine-hours than
engineering-hours and is also undercosted.
In contrast, the Holden Motors contract uses less of design (51%) and engineering (16%)
than of machine-hours (70%). Hence, the use of department rates will report lower indirect costs
for Holden Motors than does a plantwide rate.
Holden Motors was probably complaining under the use of the simple system because its
contract was being overcosted relative to its consumption of MOH resources. United and Leland,
on the other hand, were having their contracts undercosted and underpriced by the simple system.
Assuming that AP is an efficient and competitive supplier, if the new department-based rates are
used to price contracts, United and Leland will be unhappy. AP should explain to United and
Leland how the calculation was done, and point out United’s high use of design and engineering
resources and Leland’s high use of engineering resources relative to production machine hours.
Discuss ways of reducing the consumption of those resources, if possible, and show willingness
to partner with them to do so. If the price rise is going to be steep, perhaps offer to phase in the
new prices.
4.
Other than for pricing, AP can also use the information from the department-based system
to examine and streamline its own operations so that there is maximum value-added from all
indirect resources. It might set targets over time to reduce both the consumption of each indirect
resource and the unit costs of the resources. The department-based system gives AP more
opportunities for targeted cost management.
5.
It would not be worthwhile to further refine the cost system into an ABC system if (1) a
single activity accounts for a sizable proportion of the department’s costs or (2) significant costs
are incurred on different activities within a department, but each activity has the same cost driver
or (3) there wasn’t much variation among contracts in the consumption of activities within a
department. If, for example, most activities within the design department were, in fact, driven by
CAD-design hours, then the more refined system would be costlier and no more accurate than the
department-based cost system. Even if there was sufficient variation, considering the relative sizes
of the three department cost pools, it may only be cost-effective to further analyze the engineering
cost pool, which consumes 78% ($240,000 ÷ $308,600) of the manufacturing overhead.
5-12
5-22
(50 min.) Plantwide, department, and activity-cost rates.
1.
Trophies
Direct materials
Forming
$26,000
Assembly
5,200
Total
31,200
Direct manufacturing labor
Forming
31,200
Assembly
15,600
Total
Total direct costs
Budgeted Overhead Rate =
cost
Direct materials
Direct labor
Total direct cost
Allocated overhead*
Total costs
Plaques
Total
$22,500
18,750
41,250
18,000
21,000
46,800
39,000
$78,000
$80,250
$158,250
$24,000+$20,772+$46,000+$21,920
$158,250
Trophies
$ 31,200
46,800
78,000
55,544
$133,544
Plaques
$ 41,250
39,000
80,250
57,148
$137,398
$112,692
= $158,250 = $0.712 per dollar of direct
Total
$ 72,450
85,800
158,250
112,692
$270,942
*Allocated overhead = Total direct cost  Budgeted overhead rate (0.712114).
2. Forming Department
Budgeted Forming Dept. Overhead Costs
Budgeted Overhead Rate= Budgeted Forming Dept. DirectManufacturing Labor Costs
$24,000 + $20,772
$31,200 + $18,000
$44,772
= $49,200 = $0.91 per Forming Dept direct manufacturing labor dollar
=
Assembly Department
Budgeted Assembly Dept. Overhead Costs
$46,000+$21,920
Budgeted Overhead Rate= Budgeted Assembly Dept. Direct Costs = $5,200+$18,750+$15,600+$21,000
=
Direct materials
Direct labor
Total direct cost
Allocated overhead
Forming Dept.a
$67,920
$60,550
= $1.122 per Assembly Department direct cost dollar
Trophies
$ 31,200
46,800
78,000
Plaques
$ 41,250
39,000
80,250
Total
$ 72,450
85,800
158,250
28,392
16,380
44,772
5-13
Assembly Dept.b
Total costs
23,332
$129,724
44,588
$141,218
67,920
$270,942
Trophies
Plaques
Total
$31,200
$18,000
$49,200
$28,392
$16,380
$44,772
Total direct costs
($5,200 + $15,600; $18,750 + $21,000)
$20,800
$39,750
$60,550
Allocated overhead
(1.121718  $20,800; $39,750)
$23,332
$44,588
$67,920
a
Forming Dept.
Direct manufacturing labor costs
Allocated overhead
(0.91 × $31,200; $18,000)
b
Assembly Dept.
3.
Forming Department
$24,000
Budgeted Set-up Rate = 156 batches = $153.846 per batch
$20,772
Budgeted Supervision Rate = $49,200 = $0.422195 per direct manufacturing-labor dollar
Assembly Department
$46,000
Budgeted Set-up Rate= 146 batches = $315.069 per batch
$21,920
Budgeted Supervision Rate= $36,600 = $0.598907 per direct manufacturing labor dollar
Assembly Department
Budgeted general overhead rate =
$42,000
= $1.20 per direct manuf.-labor dollar
$35,000
Trophies
Plaques
Total
Direct material costs
Direct labor costs
Total direct costs
$ 31,200
46,800
78,000
$ 41,250
39,000
80,250
$ 72,450
85,800
158,250
Forming Dept. overhead
Set up
$153.84615  40; 116
Supervision
0.422195 × $31,200; $18,000
6,154
17,846
24,000
13,172
7,600
20,772
Assembly Department overhead
5-14
Set up
$315.06849 × 43; 103
Supervision
0.598907 × $15,600; $21,000
Total costs
13,548
32,452
46,000
9,343
12,577
21,920
$120,217
$150,725
$270,942
4.
As Triumph uses more refined cost pools, the costs of trophies decrease, and costs of
plaques increases. This is because plaques use a higher proportion of cost drivers (batches of set
ups and direct manufacturing labor costs) than trophies, whereas the direct costs (the allocation
base used in the simple costing system) are slightly smaller for plaques compared to trophies. This
results in plaques being undercosted and trophies overcosted in the simple costing system.
Department costing systems increase the costs of plaques relative to trophies because the
forming department costs are allocated based on direct manufacturing labor costs in the forming
department and plaques use more direct manufacturing labor in this department compared to
trophies.
Disaggregated information can improve decisions by allowing managers to see the details
that help them understand how different aspects of cost influence total cost per unit. Managers can
also understand the drivers of different cost categories and use this information for pricing and
product-mix decisions, cost reduction and process-improvement decisions, design decisions, and
to plan and manage activities. However, too much detail can overload managers who don’t
understand the data or what it means. Also, managers looking at per-unit data may be misled when
considering costs that aren’t unit-level costs.
5-15
5-23 (20 min.) ABC, single production process costing, benefits and costs of ABC.
All costs are in ₦.
1.
Compute the budgeted cost of the Transformer toys using ABC.
The first step is to calculate the cost driver rates for the cost activity pools.
Activity pools
Material orders
Packaging and
handling
Budgeted
overheads (₦)
12,500
25,500
Machine set-ups 10,100
Service costs
25,400
Quality control
checks
Machine costs
14,800
40,200
Cost drivers
Number of
orders
Number of
packaging and
handling
Number of setups
Service hours
Number of
checks
Number of
machine hours
Budgeted
volume
6,200
3,750
800
6,500
3,600
4,000
Cost driver
rate*
12,500 = 2.02
6,200
25,500 = 6.80
3,750
10,100 = 12.63
800
25,400 = 3.91
6,500
14,800 = 4.11
3,600
40,200 = 10.05
4,000
*Cost driver rates are rounded to 2 decimal places.
The next step will be to compute the manufacturing costs:
Transformer Toys
Direct costs:
Direct materials costs
Direct labor costs
Variable overheads
Manufacturing overheads
Material orders
90 x ₦2.02 =
Toy handling
62 x ₦6.80 =
Machine set-ups
34 x ₦12.63 =
Service time (hours)
500 x ₦3.91 =
Quality control checks
100 x ₦4.11 =
Machine hours
2000 x ₦10.05 =
Total Manufacturing Costs
₦
100,000.00
50,000.00
125,000.00
181.80
421.60
429.42
1,955.00
411.00
20,100.00
₦298,498.82
2. What are the main reasons why managers at John Bradshaw & Bros Ltd. would
consider implementing ABC system?
Managers use ABC system for the following reasons:
1. The system provides useful financial measures such as cost driver rates and non-financial
measures such as service time, quality control check etc.
5-16
2. It provides a more realistic product costs especially where overheads form significant portion
of the manufacturing costs.
3. The system recognizes the complexity of modern production system by the use of multiple
cost drivers.
4. The system is flexible and can trace costs of processes, customers, responsibilities as well as
the cost of manufacturing the product.
3. What are the problems that John Bradshaw & Bros Ltd. may face from an activitybased costing system?
The followings are some of the problems that the company may face with ABC system.
1. ABC is complex particularly where there are numerous cost pools and cost drivers.
2. It can be expensive to run. The cost of setting up the system can also be time consuming.
3. The choice of cost drivers can be a very arbitrary decision. Thus managers can easily select
what cost drivers to use.
4. It is often difficult to attribute costs to a single activity as some costs may support several
activities in the production process.
5-17
5-24
(20 mins.) Department costing, service company
Note: The cost driver for engineering is number of engineering-hours, not number of engineers.
This change does not, however, affect the solution itself.
1.
Using the simple costing system, total overhead costs are equally allocated to projects.
There were 3 projects in 2020, so the overhead cost per project is
Overhead cost per project in 2020 = $4,011,780 ÷ 3 = $1,337,260 per project
2
Rates per unit cost driver:
Activity
Design
Engineering
Construction
Cost Driver
Design department hours
Rate
$1,500,000 ÷ (1,000 + 5,000 + 4,000)
= $150 per design-hour
Engineering department hours $500,030 ÷ (2,000 + 2,000 + 2,200)
= $80.65 per engineering-hour
Labor-hours
$2,011,750 ÷ (20,800 + 21,500 + 19,600)
= $32.50 per labor-hour
Overhead cost allocated to each project using department overhead cost rates:
Design: $150 × 1,000; 5,000; 4,000
Engineering: $80.65 × 2,000; 2,000;
2,200
Construction: $32.50 × 20,800;
21,500; 19,600
Total overhead costs
Sanders
$150,000
161,300
Hanley
$ 750,000
161,300
Stanley
$ 600,000
177,430
676,000
698,750
637,000
$987,300
$1,610,050
$1,414,430
3.
a. Department rates
(Requirement 2)
b. Plantwide rate
(Requirement 1)
Ratio of (a) ÷ (b)
Sanders
Hanley
Stanley
$ 987,300
$1,610,050
$1,414,430
$1,337,260
0.74
$1,337,260
1.20
$1,337,260
1.06
The overhead allocated to Sanders decreases by 26% under the department rates, the overhead
allocated to Hanley increases by about 20%, and the overhead allocated to Stanley increases by
about 6%.
The three projects differ sizably in the way they use the resources of the three departments.
The percentage of total driver units in each department used by the companies is:
The percentage of total driver units in each department used by the companies is:
5-18
Department
Design
Engineering
Construction
Cost
Driver
Design-hours
Engineering-hours
Labor-hours
Sanders
10%
32
33
Hanley
50%
32
35
Stanley
40%
36
32
The Sanders project uses only 10% of design-hours in 2020 and uses 32% of engineeringhours and 33% of construction hours. The result is that the overhead rate, based on allocating costs
equally to all projects (33%), will greatly overestimate the cost of resources used on the Sanders
project, which uses very few design-hours. This explains the 26% decrease in indirect costs
assigned to the Sanders project when department rates are used.
In contrast, the Hanley and Stanley projects use more of design (50% and 40%,
respectively). Hence, the use of department rates will report higher indirect costs for Hanley and
Stanley than does a single overhead rate.
Sanders was probably complaining about the costs resulting from using the simple system
because its project was being overcosted relative to its consumption of overhead resources. Hanley
and Stanley, on the other hand, were having their projects undercosted and underpriced by the
simple system. If the new department-based rates are used to price projects, Hanley and Stanley
will be unhappy. CKM should explain to Hanley and Stanley how the calculations were done and
point out their high use of design resources. CKM should discuss ways of reducing the
consumption of design resources, if possible, and show willingness to partner with them to do so.
CKM could even offer to phase in the new prices.
4.
It would not be worthwhile to further refine the cost system into an ABC system if (1) a
single activity accounts for a sizable proportion of the department’s costs or (2) significant costs
are incurred on different activities within a department, but each activity has the same cost driver
or (3) there wasn’t much variation among contracts in the consumption of activities within a
department. If, for example, most activities within the design department were, in fact, driven by
design-hours, then the more refined system would be more costly and no more accurate than the
department-based cost system.
5-19
5-25
(30 min.)
Activity-based costing, service company.
1.
Total indirect costs = $1,008,000 + $781,200 + $27,360 + $42,000 + $259,200
+ $309,120 = $2,426,880
Total machine-hours = (2,400  10) + (1,200  10) = 36,000
Indirect cost rate per machine-hour = $2,426,880  36,000
= $67.413 per machine-hour
Simple Costing System
Cost of supplies per job
Direct labor cost per job
Indirect cost allocated to each job
(10 machine hours  $67.413 per machine hour)
Total costs
5-20
Standard
Job
$210.00
170.00
674.13
$1,054.13
Special
Job
$310.00
220.00
674.13
$1,204.13
2. Activity-based costing system
Quantity of Cost Driver
Consumed during 2020
(see column (1))
Activity
(1)
Machine operations
(2,400 jobs  10
mach. hrs. per job;
1,200 jobs  10
mach. hrs. per job)
Setups (6  2,400; 9
 1,200)
Purchase orders
(given)
Design
Marketing
Cost Driver
Standard
Job
Total Cost
of Activity
(given)
Special
Job
Allocation
Rate
(6) = (5)  ((3) + (4)), or
given
$ 28.00 per machine
hour
(2)
Machine hours
(3)
24,000
(4)
12,000
(5)
$1,008,000
Setup hours
14,400
10,800
$781,200
$
31.00 per setup hour
330
430
$27,360
$
36.00 per purchase
order
$42,000
$259,200
$
No. of purchase
orders
$4,080,000
$2,400,000
1
0.04 per dollar of
sales
2
2
Administration
$408,000
$264,000
$309,120
$0.46 per dollar of
direct manuf.
labor cost
1
Revenue from standard jobs, $1,700 × 2,400 = $4,080,000; Revenue from special jobs, $2,000 × 1,200 = $2,400,000
2
Percentage of
revenue
Dir. labor costs
1
Direct labor costs of standard jobs, $170 × 2,400 jobs = $408,000; Direct labor costs of special jobs, $220 × 1,200 jobs = $264,000
5-21
Total Costs
Standard
Special
Job
Job
$ 504,000 $ 372,000
408,000
264,000
Cost of supplies ($210  2,400; $310  1,200)
Direct labor costs ($170  2,400; $220  1,200)
Indirect costs allocated:
Machine operations ($28 per mach. hr.  24,000; 12,000)
672,000
336,000
Setups ($31 per setup hr.  14,400; 10,800)
446,400
334,800
Purchase orders ($36 per order  330; 430)
11,880
15,480
Design
7,000
35,000
Marketing (0.04  $4,080,000; 0.04  $2,400,000)
163,200
96,000
Administration (0.46  $408,000; $264,000)
187,680
121,440
Total costs
$2,400,160 $1,574,720
Cost of each job ($2,400,160  2,400; $133,071  200)
$1,000.07 $1,312.27
3.
Cost per job
Simple Costing System
Activity-based Costing System
Difference (Simple – ABC)
Standard
Job
$1,054.13
$1,000.07
$ 54.06
Special
Job
$1,204.13
$1,312.27
$(108.14)
Relative to the ABC system, the simple costing system overcosts standard jobs and undercosts
special jobs. Both types of jobs need 10 machine hours per job, so in the simple system, they are
each allocated $674.13 in indirect costs. But, the ABC study reveals that each standard job
consumes less of the indirect resources such as setups, purchase orders, and design costs than a
special job, and this is reflected in the lower indirect costs allocated to the standard jobs and higher
indirect costs allocated to special jobs in the ABC system.
4.
Aniline can use the information revealed by the ABC system to change its pricing based
on the ABC costs. Under the simple system, Aniline was making a gross margin of 38% on each
standard job ([$1,700 – $1,054.13]  $1,700) and 40% on each special job ([$2,000 – $1,204.13]
 $2,000). But, the ABC system reveals that it is actually making a gross margin of about 41%
([$1,700 – $1,000.07]  $1,700) on each standard job and about 34% ([$2,000 – $1,312.27] 
$2,000) on each special job. Depending on the market competitiveness, Aniline may either want
to reprice the different types of jobs, or it may choose to market standard jobs more aggressively
than before.
Aniline can also use the ABC information to improve its own operations. It could examine
each of the indirect cost categories and analyze whether it would be possible to deliver the same
level of service, but consume fewer indirect resources, or find a way to reduce the per-unit-costdriver cost of some of those indirect resources.
5-22
5-26
(30 min.)
Activity-based costing, manufacturing.
1.
Simple costing system:
Total indirect costs = $95,000 + $45,000 + $25,000 + $60,000 + $8,000 + 3% x [($125  3,200)
+ ($200  1,800)]
= $255,800
Total machine-hours = 5,500 + 4,500 = 10,000
Indirect cost rate per machine-hour = $255,800  10,000
= $25.58 per machine-hour
Simple Costing System
Direct materialsa
Direct manufacturing laborb
Indirect cost allocated to each job
($25.58 × 5,500; 4,500 machine hours)
Interior
$ 96,000
76,800
Exterior
$ 81,000
64,800
140,690
115,110
Total costs
$313,490
$260,910
$
$ 144.95
Total cost per unit
($313,490  3,200; $260,910  1,800)
a
b
2.
97.97
$30 × 3,200 units; $45  1,800 units
$16 × 1.5 × 3,200 units; $16  2.25  1,800 units
Activity-based costing system
Total
Cost of
Activity
(2)
Cost
Driver
Quantity
(4)
Allocation Rate
(5) = (2)  (4)
per production
c
$95,000
Production runs
125
$760.00 run
$45,000
Material moves
per material
240d
$187.50 move
$25,000
Machine setups
200e
$125.00 per setup
$60,000
Machine hours
per machine
10,000
$ 6.00 hour
Inspection
$ 8,000
Inspections
400f
$ 20.00 per inspection
Marketing
Percentage of
$ 0.03 per dollar of
revenues
sales
c
d
e
f
40 + 85 = 125; 72 + 168 = 240; 45 + 155 = 200; 250 + 150 = 400
Activity
(1)
Product
scheduling
Material
handling
Machine setup
Assembly
Cost Driver
(3)
5-23
ABC System
Direct materials
Direct manufacturing labor
Indirect costs allocated:
Production scheduling ($760 per run  40; 85)
Material handling ($187.50 per move  72; 168)
Machine setup ($125 per setup  45; 155)
Assembly ($6 per MH × 5,500; 4,500)
Inspection ($20 per inspection × 250; 150)
Marketing (0.03  $125  3,200; 0.03  $200  1,800)
Total costs
Interior
$ 96,000
76,800
Exterior
$ 81,000
64,800
30,400
13,500
5,625
33,000
5,000
12,000
$272,325
64,600
31,500
19,375
27,000
3,000
10,800
$302,075
$ 85.10
$ 167.82
Total cost per unit
($272,325 ÷ 3,200 units; $302,075 ÷ 1,800 units)
3.
Cost per unit
Simple Costing System
Activity-based Costing System
Difference (Simple – ABC)
Interior
$97.97
$85.10
$12.87
Exterior
$144.95
$167.82
$ (22.87)
Relative to the ABC system, the simple costing system overcosts interior doors and undercosts
exterior doors. Interior doors require 1.72 machine-hours per unit (5,500 hours ÷ 3,200 units) while
exterior doors require 2.5 machine-hours per unit (4,500 hours ÷ 1,800 units). In the simple-costing
system, overhead costs are allocated to the interior and exterior doors on the basis of the machinehours used by each type of door. The ABC study reveals that the ratio of the cost of production
runs, material moves, and setups for each exterior door versus each interior door is even higher
than the ratio of 2.5 to 1.72 machine-hours for each exterior relative to each interior door. This
higher ratio results in higher indirect costs allocated to exterior doors relative to interior doors in
the ABC system.
4.
Decorative Doors, Inc. can use the information revealed by the ABC system to change its
pricing based on the ABC costs. Under the simple system, Decorative Doors was making an
operating margin of 21.6% on each interior door ([$125 – $97.97]  $125) and 27.5% on each
exterior door ([$200 – $144.95]  $200). But, the ABC system reveals that it is actually making
an operating margin of about 32% ([$125 – $85.10]  $125) on each interior door and about 16%
([$200 – $167.82]  $200) on each exterior door. Decorative Doors, Inc., should consider
decreasing the price of its interior doors to be more competitive. Decorative Doors should also
consider increasing the price of its exterior doors, depending on the competition it faces in this
market.
Decorative Doors can also use the ABC information to improve its own operations. It could
examine each of the indirect cost categories and analyze whether it would be possible to deliver
the same level of service, but consume fewer indirect resources, or find a way to reduce the perunit-cost-driver cost of some of those indirect resources. Making these operational improvements
can help Decorative Doors to reduce costs, become more competitive, and reduce prices to gain
further market share while increasing its profits.
5-24
5-27
(20-25 min.) ABC, simple costing systems.
1. Compute the unit cost for each cable using direct labor hours to apply the
manufacturing overheads.
€233,000
Overhead rate = 8,500 = €27.41
Direct material
Direct labor (70 hours per cable)
Variable overhead cost
Manufacturing overheads
(assigned based on 70 DLH per
cable x €27.41)
Total costs
Number of units
Cost per unit
Industrial cable
€950
€820
€500
Household cable
€1,200
€700
€250
€1,918.70
€1,918.70
4,188.70
200
4,188.70 = €20.94
200
4,068.70
120
4,068.70 = €33.91
120
2. Compute the unit cost for each job using the ABC system.
Activity pool rates
i.
Set-ups
ii.
Placement costs
iii.
Machine costs
iv.
Customer service
€50,000 = €125
400
€50,000 = €9.43
5,300
€100,000 = €5
20,000
€33,000 = €1.32
25,000
The next step is to use the activity pool rates to compute the overheads and total manufacturing
costs.
Industrial cable (€)
Household cable (€)
Direct material
950.00
1,200.00
Direct labor (70 hours per cable)
820.00
700.00
Variable overhead cost
500.00
250.00
Manufacturing overheads:
Set-up costs
1 x €125 = 125.00 2 x €125
= 250.00
Placement costs
8 x €9.43 = 75.44 12 x 9.43 = 113.16
Machine costs
25 x €5 = 125.00 45 x €5
= 225.00
Customer service costs
33 x €1.32 = 43.56 56 x €1.32 = 73.92
Total manufacturing costs
€2,639.00
€2,812.08
Number of units produced
200
120
Cost per unit
€13.20
€23.43
5-25
3. What is the advantage of using a simple and ABC systems by Caleb Enterprises Ltd’s
management?
The ABC system ensures that costs are assigned in proportion to the activities utilizing the service.
In a production setting with multiple and varied overhead amounts, ABC allows for equitable
apportionment of overheads to ensure that the cost of product reflects all utilized costs. The simple
cost approach is most useful in a production environment where the overhead is identifiable to a
particular source. Thus, in the case of Caleb Enterprises Ltd, the use of ABC appears more
efficient in the product costing.
5-26
5-28
(15–20 min.) ABC, wholesale, customer profitability.
1.
Gross sales
Sales returns
Net sales
Cost of goods sold (80%)
Gross margin
Customer-related costs:
Regular orders
$20 × 40; 150; 50; 70
Rush orders
$100 × 10; 50; 10; 30
Returned items
$10 × 100; 26; 60; 40
Catalogs and customer
support
Customer related costs
Contribution (loss) margin
Contribution (loss) margin
as percentage of gross
sales
Chain
2
$30,000
5,000
25,000
20,000
5,000
1
$50,000
10,000
40,000
32,000
8,000
3
$100,000
7,000
93,000
74,400
18,600
4
$70,000
6,000
64,000
51,200
12,800
800
3,000
1,000
1,400
1,000
5,000
1,000
3,000
1,000
1,000
260
1,000
600
1,000
400
1,000
3,800
$4,200
8.4%
9,260
$(4,260)
(14.2%)
3,600
$15,000
15.0%
5,800
$7,000
10.0%
2.
The analysis indicates that customers’ profitability (loss) contribution varies widely from
(14.2%) to 15.0%. Immediate attention to Chain 2 is required which is currently showing a loss
contribution. The chain has a disproportionate number of both regular orders and rush orders.
Ramirez should work with the management of Chain 2 to find ways to reduce the number of orders
while maintaining or increasing the sales volume. If this is not possible, Ramirez should consider
dropping Chain 2 if it can save the customer-related costs.
Chain 1 has a disproportionate number of the items returned as well as sale returns. The
causes of these should be investigated so that the profitability contribution of Chain 1 could be
improved.
5-27
5-29
(50 min.)
Activity-based costing.
1. Overhead allocation using a simple job-costing system, where overhead is allocated based on
machine hours.
Overhead allocation rate = $226,800  10,500 machine-hours = $21.60 per machine-hour
Overhead allocateda
a
2.
Job 215
Job 325
$ 864
$1,296
$21.60 per machine-hour × 40 hours; 60 hours
Overhead allocation using an activity-based job-costing system:
Purchasing
Material handling
Machine maintenance
Product inspection
Packaging
Budgeted
Overhea
d
(1)
$ 35,000
$ 43,750
$ 118,650
$ 9,450
$ 19,950
$ 226,800
Budgeted
Activity
Activity Driver Driver
(2)
(3)
Purchase orders 2,000
processed
Material moves
5,000
Machine hours 10,500
Inspections
1,200
Units produced
3,800
Overhead allocated
Purchasing ($17.50  25; 8 orders)
Material handling ($8.75  10; 4 moves)
Machine maintenance ($11.30  40; 60 hours)
Product inspection ($7.875  9; 3 inspections)
Packaging ($5.25  15; 6 units)
Total
Activity Rate
(4) = (1)  (3)
$17.50
$ 8.75
$11.30
$ 7.875
$ 5.25
Job 215
Job 325
$ 437.50
87.50
452.00
70.88
78.75
$1,126.63
$140.00
35.00
678.00
23.63
31.50
$908.13
3.
The manufacturing manager likely would find the ABC job-costing system more useful in
cost management. Unlike direct manufacturing labor costs, the five indirect cost pools are
systematically linked to the activity areas at the plant. The result is more accurate product costing.
The manufacturing manager can seek to reduce both the level of activity (fewer purchase orders,
less material handling) and the cost of each activity (such as the cost per inspection).
Marketing managers can use ABC information to bid for jobs more competitively because
ABC provides managers with a more accurate reflection of the resources used for and the costs of
each job.
5-28
5-30
(30 min.) ABC, product-costing at banks, cross-subsidization.
1.
Lindell
Revenues
Spread revenue on annual basis
(3% ; $1,500, $800, $26,600)
Monthly fee charges
($25 ; 0, 12, 0)
Total revenues
Costs
Deposit/withdrawal with teller
$2.75 ; 46; 53; 5
Deposit/withdrawal with ATM
$0.75  14; 25; 12
Deposit/withdrawal on prearranged basis
$0.60  0; 16; 55
Bank checks written
$8.50  10; 3; 4
Foreign currency drafts
$12.25  7; 2; 7
Inquiries
$1.80  8; 14; 5
Total costs
Operating income (loss)
Welker
Colston Total
$45.00
$24.00
0
45.00
300
324.00
0
798.00
300
1,167
126.50
145.75
13.75
286.00
10.50
18.75
9.00
38.25
0
9.60
33.00
42.60
85.00
25.50
34.00
144.50
85.75
24.50
85.75
196.00
14.40
25.20
$322.15 $249.30
($277.15) $74.70
$798.00 $867.00
9.00
48.60
$184.50 $755.95
$613.50 $411.05
The assumption that the Lindell and Colston accounts exceed $1,000 every month and the
Welker account is less than $1,000 each month means the monthly charges apply only to Welker.
One student with a banking background noted that in this solution 100% of the spread is
attributed to the “depositor side of the bank.” He noted that often the spread is divided between
the “depositor side” and the “lending side” of the bank.
2.
Cross-subsidization across individual Star Accounts occurs when profits made on some
accounts are offset by losses on other accounts. The aggregate profitability on the three customers
is $411.05. The Colston account is highly profitable, $613.50, while the Lindell account is sizably
unprofitable. The Welker account shows a small profit but only because of the $300 monthly fees.
It is unlikely that Welker will keep paying these high fees and that LB would want Welker to pay
such high fees from a customer relationship standpoint.
The The facts also suggest that the customers do not use the bank services uniformly. For
example, Lindell and Welker have a lot of transactions with the teller and also inquire about their
account balances more often than Colston. This suggests cross-subsidization. LB should be very
5-29
concerned about the cross-subsidization. Competition likely would “understand” that high-balance
low-activity type accounts (such as Colston) are highly profitable. Offering free services to these
customers is not likely to retain these accounts if other banks offer higher interest rates.
Competition likely will reduce the interest rate spread LB can earn on the high-balance low-activity
accounts they are able to retain.
3.
Possible changes LB could make are:
a. Offer higher interest rates on high-balance accounts to increase LB’s competitiveness
in attracting and retaining these accounts.
b. Introduce charges for individual services. The ABC study reports the cost of each
service. LB has to decide if it wants to price each service at cost, below cost, or above
cost. If it prices above cost, it may use advertising and other means to encourage
additional use of those services by customers. Of course, in determining its pricing
strategy, LB would need to consider how other competing banks are pricing their
products and services.
5-30
5-31 (15 min.) Job costing with single direct-cost category, single indirect-cost pool, law
firm.
1.
Pricing decisions at Bradley Associates are heavily influenced by reported cost numbers.
Suppose Bradley is bidding against another firm for a client with a job similar to that of Campa
Coal. If the costing system overstates the costs of these jobs, Bradley may bid too high and fail to
land the client. If the costing system understates the costs of these jobs, Bradley may bid low, land
the client, and then lose money in handling the case.
2.
Campa
Coal
Direct professional labor
$80  150; $80  100
Indirect costs allocated
$100  150; $100  100
Total costs
St. Edith’s
Glass
Total
$12,000
$ 8,000
$20,000
15,000
$27,000
10,000
$18,000
25,000
$45,000
5-31
5-32 20–25 min.) Job costing with multiple direct-cost categories, single indirect-cost pool,
law firm (continuation of 5-31).
1.
Indirect costs = $10,000
Total professional labor-hours = 250 hours (150 hours on Campa Coal +
100 hours on St. Edith’s Glass)
Indirect cost allocated per professional labor-hour (revised) = $10,000 ÷ 250 = $40 per hour
2.
Campa Coal
Direct costs:
Direct professional labor
$80150; $80100
Research support labor
Computer time
Travel and allowances
Telephones/faxes
Photocopying
Total direct costs
Indirect costs allocated
$40150; $40100
Total costs to be billed
St. Edith’s
Glass
Total
$12,000
1,800
400
700
250
300
15,450
$8,000
3,850
1,600
4,200
1,200
700
19,550
$20,000
5,650
2,000
4,900
1,450
1,000
35,000
6,000
$21,450
4,000
$23,550
10,000
$45,000
3.
Problem 5-31
Problem 5-32
Campa Coal
$27,000
21,450
St. Edith’s Glass
$18,000
23,550
Total
$45,000
45,000
The Problem 5-32 approach directly traces $15,000 of general support costs to the individual jobs.
In Problem 5-31, these costs are allocated on the basis of direct professional labor-hours. The
averaging assumption implicit in the Problem 5-31 approach appears incorrect—for example, the
St. Edith’s Glass job has travel costs six times higher than the Campa Coal case despite having
lower direct professional labor-hours.
5-32
5-33 (30 min.) Job costing with multiple direct-cost categories, multiple indirect-cost
pools, law firm (continuation of 5-31 and 5-32).
1.
Campa Coal
Direct costs:
Partner professional labor
$100 × 50; $100 × 75
Associate professional labor
$60 × 100; $60 × 25
Research support labor
Computer time
Travel and allowances
Telephones/faxes
Photocopying
Total direct costs
Indirect costs allocated:
Indirect costs for partners
$48 × 50; $48 × 75
Indirect costs for associates
$32 × 100; $32 × 25
Total indirect costs
Total costs to be billed
Comparison
Single direct cost/
Single indirect cost pool
Multiple direct costs/
Single indirect cost pool
Multiple direct costs/
Multiple indirect cost pools
St. Edith’s
Glass
Total
$5,000
$7,500
$12,500
6,000
1,800
400
700
250
300
14,450
1,500
3,850
1,600
4,200
1,200
700
20,550
7,500
5,650
2,000
4,900
1,450
1,000
35,000
2,400
3,600
6,000
3,200
5,600
$20,050
800
4,400
$24,950
4,000
10,000
$45,000
Campa Coal
St. Edith’s Glass
Total
$27,000
$18,000
$45,000
$21,450
$23,550
$45,000
$20,050
$24,950
$45,000
The higher the percentage of costs directly traced to each case, and the greater the number of
homogeneous indirect cost pools linked to the cost drivers of indirect costs, the more accurate the
product cost of each individual case.
The Campa and St. Edith’s cases differ in how they use “resource areas” of Bradley Associates:
Campa
St. Edith’s
Coal
Glass
Partner professional labor
40.0%
60.0%
Associate professional labor
80.0
20.0
Research support labor
31.9
68.1
Computer time
20.0
80.0
Travel and allowances
14.3
85.7
Telephones/faxes
17.2
82.8
Photocopying
30.0
70.0
5-33
The Campa Coal case makes relatively low use of the higher-cost partners but relatively higher
use of the lower-cost associates than does St. Edith’s Glass. As a result, it also uses less of the
higher indirect costs required to support partners compared to associates. The Campa Coal case
also makes relatively lower use of the support labor, computer time, travel, phones/faxes, and
photocopying resource areas than does the St. Edith’s Glass case.
2
The specific areas where the multiple direct/multiple indirect (MD/MI) approach can
provide better information for decisions at Bradley Associates include the following:
Pricing and product (case) emphasis decisions. In a bidding situation using single
direct/single indirect (SD/SI) or multiple direct/single indirect (MD/SI) data, Bradley may win
bids for legal cases on which it will subsequently lose money. It may also not win bids on which
it would make money with a lower-priced bid.
From a strategic viewpoint, SD/SI or MD/SI exposes Bradley Associates to cherry-picking
by competitors. Other law firms may focus exclusively on Campa Coal-type cases and take sizable
amounts of “profitable” business from Bradley Associates. MD/MI reduces the likelihood of
Bradley Associates losing cases on which it would have made money.
Client relationships. MD/MI provides a better “road map” for clients to understand how
costs are accumulated at Bradley Associates. Bradley can use this road map when meeting with
clients to plan the work to be done on a case before it commences. Clients can negotiate ways to
get a lower-cost case from Bradley, given the information in MD/MI—for example, (a) use a
higher proportion of associate labor time and a lower proportion of a partner time, and (b) use fax
machines more and air travel less. If clients are informed in advance how costs will be
accumulated, there is less likelihood of disputes about bills submitted to them after the work is
done.
Cost control. The MD/MI approach better highlights the individual cost areas at Bradley
Associates than does the SD/SI or MD/SI approaches:
MD/MI
SD/SI
MD/SI
Number of direct cost categories
7
1
7
Number of indirect cost categories
2
1
1
Total
9
2
8
MD/MI is likely to promote better cost-control practices than SD/SI or MD/SI, as the nine cost
categories in MD/MI give Bradley a better handle on how to effectively manage different
categories of both direct and indirect costs..
5-34
5-34 (30 min.) First stage allocation, time-driven activity-based costing, manufacturing
sector.
1.
Wages and salaries
Depreciation
Rent
Other overhead
Total
Direct Manuf.
Labor Support
$210,000
$14,400
$32,000
$70,000
$326,400
Order
Processing
$180,000
$10,800
$38,400
$70,000
$299,200
Design
Support
$150,000
$10,800
$19,200
$112,000
$292,000
Other
Total
$60,000
$600,000
$36,000
$72,000
$38,400
$128,000
$28,000
$280,000
$162,400 $1,080,000
Cost
Allocation Base
Allocation Rate
$326,400
32,000 DMLHs
$10.20/DMLH
Order Processing
Design Support
$299,200
Other
$162,400
440 orders
2,500 custom designs
hours
32,000 DMLHs
$680/order
$116.80/custom design
hour
$5.075/DMLH
Direct Manuf. Labor Support
$292,000
2.
Direct materials
Direct manuf. labor (100 hrs. × $25/hr.)
$5,500.00
2,500.00
Direct manuf. labor support (100 dir. manuf. lbr-hrs. × $10.20/hr.)
Order processing (1 order × $680/order)
1,020.00
680.00
Design support
Complex design (4 parts × 13 hours × $116.80/custom design-hour)
Simple design (2 parts × 8 hours × $116.80/custom design-hour)
Other overhead (100 dir. manuf. lbr-hrs. × $5.075/hr.)
6,073.60
1,868.80
507.50
Total overhead costs
$18,149.90
3. Because only some of the orders that Marshall’s Devices receives require custom designs
(complex design and simple design), it is important that the costs generated by custom designs
are not allocated to non-custom orders. Activity-based costing allows Marshall’s Devices to only
assign resources used by orders to the orders. Similarly, order processing costs of $680/order are
assigned to each order, regardless of the size of the order. Activity-based costing leads to more
accurate costing of orders. This, in turn, leads to more competitive pricing. If Marshall’s Devices
allocated all overhead costs to orders on the basis of direct manufacturing labor hours, they would
tend to overprice larger, non-custom orders and underprice smaller, custom orders. They would
5-35
likely lose bids on the overpriced orders and win the underpriced orders, but then lose money on
the bids they won because the actual costs would be much greater than the estimated costs. The
underpriced bids have small direct manufacturing labor hours relative to the resources needed to
support custom designs and order processing costs for small orders.
4. When designing its activity-based costing system, Marshall uses time-driven activity-based
costing (TDABC) system for its design department which carry out complex designs and simple
designs. Complex designs require more design hours than simple designs. Complex designs
require 13 design hours in comparison to 8 design hours required for simple designs. TDABC
systems allow Marshall to charge its customers based on the accurate number of custom design
hours required depending upon the complexity of a particular order. Hence, the orders which are
more complex in nature requiring more design hours are charged more whereas the orders which
are not complex in nature requiring less design hours are not charged excessively.
If Marshall would have used the number of customer designs rather than the number of custom
design-hours to allocate costs to different customer orders (complex and simple), the cost of Order
277100 would have been different. If the costs of design support department are allocated based
on number of custom designs (ignoring complexity of a particular order), allocation rate per
custom design will be $1,168 ($292,000 ÷ 250 custom designs).
The cost of Order 277100 shall be determined as below:
Direct materials
$5,500.00
Direct manuf. labor (100 hrs. × $25/hr.)
2,500.00
Direct manuf. labor support (100 dir. manuf. lbr-hrs. × $10.20/hr.)
1,020.00
Order processing (1 order × $680/order)
680.00
Design support (6 custom designs × $1,168/custom design)
7,008.00
Other overhead (100 dir. manuf. lbr-hrs. × $5.075/hr.)
507.50
Total overhead costs
$17,215.50
If the cost of Order 277100 is determined taking number of designs as a cost driver, the cost of
this order is $17,125.50. Whereas the cost of Order 277100 becomes $18,149.90 if the number of
designs hours are taken as a cost driver. Under this circumstance, number of custom design hours
as a cost driver is better than number of designs as a cost driver. Because the later cost driver
ignores the complexity of a particular order and allows all the orders whether requiring more or
less design hours to be charged as same. If Mashall uses number of designs as cost driver, it will
overprice the orders requiring simple design and underprice the orders requiring complex designs.
5-36
5-35
(30 min.) First stage allocation, time-driven activity-based costing, service sector.
1.
Wages and salaries
Depreciation
Supplies
Other overhead
Total
Estimating Jobs
Lawn Care
Landscape Design
Estimating
Jobs
$18,000
7,200
0
43,200
$68,400
Cost
$ 68,400
$562,800
$118,800
Lawn Care
$252,000
46,800
120,000
144,000
$562,800
Landscape
Design
$ 54,000
7,200
0
57,600
$118,800
Allocation Base
250 estimates
10,000 DLHs
500 design hours
Other
$36,000
10,800
0
43,200
$90,000
Total
$360,000
72,000
120,000
288,000
$840,000
Allocation Rate
$273.60/estimate
$ 56.28/DLH
$237.60/design hour
Other costs are facility-sustaining costs and not allocated to jobs when estimating total costs of a
job. The mark up is set sufficiently high so that the price and revenue earned can cover these costs.
2.
Estimating jobs (1 estimate  $273.60/estimate.)
Lawn care (250 DLHs  $56.28/DLH)
Landscape design (40 design hours  $237.60/design hour)
Total costs
Markup
Bid price
$ 273.60
14,070.00
9,504.00
$23,847.60

150%
$35,771.40
1.
If LawnCare USA had used the number of landscape designs rather than the number of
landscape design-hours to allocate costs to different jobs, it would have calculated the landscape
design allocation rate as follows:
Total number of landscape designs = 30
Landscape-design allocation rate = $118,800 ÷ 30 landscape designs = $3,960 per landscape design
Sunset Office Park required a single landscape design so it would be allocated $3,960 of landscape
design costs.
Allocating costs on the basis of the number of landscape designs ignores the fact that some
complex designs take much longer than simple designs and so will place greater demands on
design support resources. The Sunset Office Park design is one of 30 designs budgeted to be done
by LawnCare USA (which accounts for 3.33% (1÷30) of landscape design costs). However, based
on landscape design-hours, the Sunset Office Park job is much more complex than the average
design and accounts for 8% (40 ÷ 500 budgeted design hours). As a result design support costs
allocated to the Sunset Office park job ($3,960) is lower if LawnCare USA uses the number of
5-37
landscape designs as the allocation base compared to the $9,504 allocated when LawnCare USA
uses time-driven activity-based costing (TDABC) that uses landscape-design hours and takes into
account that complex landscape designs require more hours and hence more landscape design
resources. I would recommend that LawnCare USA uses TDABC and landscape-design hours to
allocate design support resources to jobs. The main advantage of this approach is that it helps
distinguish the costs and demands placed on resources by complex landscape designs relative to
simple landscape designs.
2.
Because the landscape design and estimating costs are only incurred once for the entire job,
bidding on 2 years of service may allow LawnCare USA to be more competitive on a yearly basis.
However, submitting an estimate for 2 years would lock LawnCare USA into the same price for
both years, regardless of possible increases in their costs.
5-38
5-36
(25 min.) ABC, overhead allocation in production
1. Calculate the overhead rates using activity-based costing for purchases, storage, set-ups,
and machine runs.
Activity level
Cost driver rate (¥)
Cost Pool (¥)
Purchases
Purchase orders
2,000
¥100,000 = ¥ 50 per order
100,000
2,000
Storage
Store issue notes
1,000
¥90,000 = ¥90 per issue
90,000
1,000
Setups
Set-ups
800
¥80,000 = ¥100 per set-up
80,000
800
Machine runs
Machine hours
30,000
¥150,000
150,000
30,000
= ¥5 per machine hour
2. Calculate the unit costs for Suzuka and Yahama spare parts including the direct costs
and allocated overheads.
Suzuka
Yahama
Unit rate
Amount ¥ Unit rate
Amount (¥)
4,000
2,000
Units
Direct materials
10,000
8,000
Direct labor
30,000
40,000
Variable overhead
5,000
2,000
Overheads:
¥50 x 400
Purchases
20,000 ¥50 x 500
25,000
¥90
x
200
¥90
x
250
Storage
18,000
22,500
¥100 x 50
Set-sups
5,000 ¥100 x 20
2,000
¥5 x 10,000
Machine runs
50,000 ¥5 x 4,000
20,000
Total manufacturing costs
138,000
119,500
¥138,000 = ¥34.50
¥119,500 = ¥59.75
Cost per unit
4,000
2,000
3. Comment on the activities that have the highest cost drivers and any alternatives for
reducing such costs.
The activities that have the highest cost driver rates are set-ups (¥100) and storage (¥90). These
two activities though have the highest unit costs, but their total costs are less than the other
overheads costs. Managers will consider whether cost driver rates are better outsourced to vendors
to reduce the cost of production. Of course, such decisions can also be made when the comparative
cost is cheaper to do so.
5-39
5-37
(30-40 min.) Activity-based costing, merchandising.
1.
Revenues
Cost of goods sold
Gross margin
Other operating costs
Operating income
Gross margin %
2.
General
Supermarket Drugstore
Chains
Chains
$3,704,000
$3,145,000
3,612,000
2,990,000
$ 92,000
$ 155,000
2.48%
4.93%
Mom-and-Pop
Single
Stores
Total
$1,988,000
$8,837,000
1,804,000
8,406,000
$ 184,000
$ 431,000
313,075
$ 117,925
9.26%
The per-unit cost driver rates are:
1. Customer purchase order processing,
$87,500 ÷ 2,500 (200 + 500 + 1,800) orders
2. Line item ordering,
$67,500 ÷ 22,500 (2,100 + 4,800 + 15,600) line items
3. Store delivery,
$67,620 ÷ 1,380 (110 + 280 + 990) deliveries
4. Cartons shipped,
$80,000 ÷ 80,000 (34,000 + 23,000 + 23,000) cartons
5. Shelf-stocking,
$10,455 ÷ 615 (310 + 210 + 95) hours
= $35 per order
= $ 3 per line item
= $49 per delivery
= $ 1 per carton
= $17 per hour
3. The activity-based costing of each distribution market for 2020 is:
1. Customer purchase order
processing
($35  200; 500; 1,800)
2. Line item ordering
($3  2,100; 4,800; 15,600)
3. Store delivery
($49  110; 280; 990)
4. Cartons shipped
($1  34,000; 23,000; 23,000)
5. Shelf-stocking
($17  310; 210; 95)
General
Supermarket
Chains
Drugstore
Chains
Mom-andPop
Single Stores
$ 7,000
$17,500
$ 63,000
$ 87,500
6,300
14,400
46,800
67,500
5,390
13,720
48,510
67,620
34,000
23,000
23,000
80,000
5,270
$57,960
3,570
$72,190
1,615
$182,925
10,455
$313,075
5-40
Total
The revised operating income statement is:
General
Supermarket
Chains
Revenues
$3,704,000
Cost of goods sold
3,612,000
Gross margin
92,000
Other operating costs
57,960
Operating income $ 34,040
4.
Drugstore
Chains
$3,145,000
2,990,000
155,000
72,190
$ 82,810
Mom-and-Pop
Single
Stores
$1,988,000
1,804,000
184,000
182,925
$
1,075
Total
$8,837,000
8,406,000
431,000
313,075
$ 117,925
The ranking of the three markets are:
Using Gross Margin
1. Mom-and-Pop Single Stores
2. Drugstore Chains
3. General Supermarket Chains
Using Operating Income
9.26%
4.93%
2.48%
1. Drugstore Chains
2. General Supermarket Chains
3. Mom-and-Pop Single Stores
2.63%
0.92%
0.05%
The activity-based analysis of costs highlights how the Mom-and-Pop Single Stores use a larger
amount of Pharmassist’s resources per revenue dollar than do the other two markets. The ratio of
the other operating costs to revenues across the three markets is:
General Supermarket Chains
Drugstore Chains
Mom-and-Pop Single Stores
1.56%
2.30%
9.20%
($57,960 ÷ $3,704,000)
($72,190 ÷ $3,145,000)
($182,925 ÷ $1,988,000)
This is a classic illustration of the maxim that “all revenue dollars are not created equal.” The
analysis indicates that the Mom-and-Pop Single Stores are the least profitable market. Pharmassist
should work to increase profits in this market through (1) a possible surcharge, (2) decreasing the
number of orders, (3) offering discounts for quantity purchases, etc.
Other issues for Pharmassist to consider include:
a. Choosing the appropriate cost drivers for each area. The problem gives a cost driver
for each chosen activity area. However, it is likely that over time further refinements
in cost drivers would be necessary. For example, not all store deliveries are equally
easy to make, depending on parking availability, accessibility of the storage/ shelf
space to the delivery point, etc. Similarly, not all cartons are equally easy to deliver––
their weight, size, or likely breakage component are factors that can vary across carton
types.
b. Deciding how to handle costs that may be common across several activities. For
example, (3) store delivery and (4) cartons shipped to stores have the common cost of
the same trip. Some organizations may treat (3) as the primary activity and attribute
5-41
only incremental costs to (4). Similarly, (1) order processing and (2) line item ordering
may have common costs.
c. Behavioral factors are likely to be a challenge for Flair. He must now tell those
salespeople who specialize in Mom-and-Pop accounts that they have been less
profitable than previously thought.
5-42
5-38 (30-40 min.)
management.
Choosing cost drivers, activity-based costing, activity-based
1.
Direct materials—bedsheets
Direct materials—curtains
Direct manufacturing labor—bedsheets
Direct manufacturing labor—curtains
Setup
Shipping
Design
Plant utilities and administration
Output unit-level costs
Output unit-level costs
Output unit-level costs
Output unit-level costs
Batch-level costs
Batch-level costs
Product-sustaining costs
Facility-sustaining costs
2.
Direct materials—bedsheets
Direct materials—curtains
Direct manufacturing labor—bedsheets
Direct manufacturing labor—curtains
Setup
Shipping
Design
Plant utilities and administration
Number of bedsheets
Number of curtains
Number of bedsheets
Number of curtains
Number of batches
Number of batches
Number of designs
Hours of production
Direct material and direct manufacturing labor are costs that can be easily traced to output, which
in this case is the number of bedsheets or curtains produced.
Setup and shipping are both a function of the number of batches produced.
Design is related to the number of designs created for each product.
Plant utilities and administration result from general activity level in the plant. Thus, hours of
production seems to be an appropriate cost driver.
3.
Direct materials—bedsheets
Direct materials—curtains
Direct manufacturing labor—
bedsheets
Direct manufacturing labor—
curtains
Setup
Shipping
Design
Plant utilities and administration
$382,260 ÷ 3,075 bedsheets
$510,425 ÷ 6,240 curtains
$124.31 per bedhseet
$81.80 per curtain
$112,500 ÷ 3,075 bedsheets
$36.59 per bedhseet
$126,000
$78,250
$84,500
$193,200
$255,775
÷ 6,240 curtains
÷
250 batches
÷
250 batches
÷
10 designs
÷ 4,410 hours
5-43
$20.19
$313.00
$338.00
$19,320.00
$58.00
per curtain
per batch
per batch
per design
per hour
4.
Curtains Bedsheets Total
Direct materials
Direct manufacturing labor
$510,425
126,000
$382,260
112,500
$892,685
238,500
Setup ($313 × 150; 100 batches)
46,950
31,300
78,250
Shipping ($338 × 150; 100 batches)
50,700
33,800
84,500
Design ($19,320 × 4; 6 designs)
77,280
Plant utilities and administration
101,790
($58 × 1,755; 2,655 hours)
$913,145
Budgeted total costs
Divided by number of curtains/bedsheets
÷ 6240
Budgeted cost per curtain/bedsheet
$146.34
115,920
153,990
193,200
255,780
$829,770 $1,742,915
÷ 3075
$269.84
5. Based on this analysis, more than 50% of product cost relates to direct material. Managers
should determine whether the material costs can be reduced. Producing in small lots increases the
setup and shipping costs. While both are relatively small components of product cost, management
may want to evaluate ways to reduce the number of setups and the cost per setup. Of the indirect
costs, the product- and facility-sustaining costs are the highest. Management should review the
design process for cost savings and examine why it takes so long to produce bedsheets relative to
curtains.
5-44
5-39
1a.
(40 min.) ABC, health care.
Medical supplies costs
Medical supplies rate
$600,000
=Number of patient visits = 40,000 patient visits
= $15 per patient visit
Rent and clinic maintenance rate
=
Rent and maintenance costs
Square feet of space
$180,000
= 16,000 sq.feet
= $11.25 per square foot
Laboratory services costs
Laboratory services rate
$216,000
= Number of laboratory tests = 18,000 laboratory tests
= $12 per laboratory test
General overhead costs
General overhead rate
$540,000
= Number of patient visits = 40,000 patient visits
= $13.50 per patient visit
These cost drivers are chosen as the ones that best match the descriptions of why the costs arise.
Other answers are acceptable (especially for General overhead, including administrative staff),
provided that clear explanations are given.
1b. Activity-based costs for each department and cost per patient visit in each of the departments
follow:
Urgent Care
Direct labor
Physicians at $200,000 × 3; 1
X-ray technicians at $50,000 × 2; 0
Nurses at $60,000 × 7; 5
Nutritionist at $50,000 × 0; 1
Direct labor costs
Medical supplies1 $15 × 17,500; 22,500
Rent and clinic maintenance2
$11.25 × 6,000; 10,000
Laboratory services3 $12 × 15,000; 3,000
General overhead4 $13.50 × 17,500; 22,500
Total costs
Cost per patient visit in Urgent Care
Cost per patient visit in Living Well
1
2
$1,866,250
17,500
$1,339,750
22,500
Living Well
Total
$ 600,000
100,000
420,000
0
1,120,000
262,500
$ 200,000
0
300,000
50,000
550,000
337,500
$ 800,000
100,000
720,000
50,000
1,670,000
600,000
67,500
180,000
236,250
$1,866,250
112,500
36,000
303,750
$1,339,750
180,000
216,000
540,000
$3,206,000
= $106.64 per patient visit
= $59.54 per patient visit
Allocated using patient visits
Allocated using square feet of clinic space
5-45
3
4
Allocated using number of laboratory tests
Allocated using number of patient visits
1c. The ABC system more accurately allocates costs because it identifies better cost drivers. The
ABC system chooses cost drivers for overhead costs that have a cause-and-effect relationship
between the cost drivers and the costs. Of course, Alvarez should continue to evaluate if better
cost drivers can be found than the ones they have identified so far.
By implementing the ABC system, Alvarez can gain a more detailed understanding of costs
and cost drivers. This is valuable information from a cost management perspective. The system
can yield insight into the efficiencies with which various activities are performed. Alvarez can then
examine if redundant activities can be eliminated. Alvarez can study trends and work toward
improving the efficiency of the activities.
In addition, the ABC system will help Alvarez determine which department is the most
costly to operate. This will be useful in making long-run decisions as to which services to offer or
emphasize. The ABC system will also assist Alvarez in setting rates for the services in each of the
departments that more accurately reflect their costs.
2.
The concern with using costs (per patient visit) as the rule to allocate resources to its
departments is that it emphasizes “input” to the exclusion of “outputs” or effectiveness of the
departments. After all, Alvarez’s goal is to effectively treat patients while controlling costs, not
minimize costs per patient visit. The problem, of course, is measuring outputs.
Unlike many manufacturing companies, where the outputs are obvious because they are
tangible and measurable, the outputs of service organizations are more difficult to measure.
In addition, allocating additional resources to the Living Well department may result in a
reduced need for Urgent Care services. While this may seem like a poor business decision, as
medical providers, the staff at Phoenix Medical Associates must keep the wellbeing of their
patients as a priority.
5-46
5-40
(30 min). ABC system in the medical industry.
1.
Compute the rate for each activity pool of the clinic.
Activity
Annual Cost Cost Driver
Number of
Days/Hours
Daily care
₦2,100,000
Nursing days
10,000
Accommodation
and feeding
₦4,500,000
After medical care
₦1,500,000
Patient days
Number of
consultation
hours
45,000
82,000
Activity Rate
₦2,100,000 = ₦210
10,000
₦4,500,000 = ₦100
45,000
₦1,500,000 = ₦18.29
82,000
2.
Compute the daily rate for each of the medical problems.
(5,000 × ₦ 210) + (30,000 × ₦ 100) + (20,000 × ₦ 18.29)
Malaria
= ₦ 147.19
Typhoid fever
Tuberculosis
Diarrhea
30,000
(3,000 × ₦ 210) + (12,000 × ₦ 100) + (15,000 × ₦ 18.29)
= ₦ 175.36
12,000
(1,500 × ₦ 210) + (1,800 × ₦ 100) + (20,000 × ₦ 18.29)
= ₦ 478.22
1,800
(500 × ₦ 210) + (1,200 × ₦ 100) + (27,000 × ₦ 18.29)
= ₦ 599.03
1,200
3.
Compute the cost of providing medical care for the first quarter to patients using
ABC method.
Medical problem
Number of Patients
Rate
Amount
Days
Malaria
1,000
₦ 147.19
₦ 147,190
Typhoid fever
300
₦ 175.36
₦ 52,608
Tuberculosis
700
₦ 478.22
₦ 334,754
Diarrhea
500
₦ 599.03
₦ 299,515
TOTAL
2,500
₦ 834,067
4. Comment in the application of ABC in the medical industry.
ABC is useful in allocating costs in the medical industry. As medical treatments vary on the nature
of medical problem, the cost drivers are different. For example, cost of medical laboratory test,
treatment, consultation, drugs, accommodation will all constitute the cost drivers which can be
charged to the various activities (treatment of the medical problems).
In the case of Adamac Clinic, the activities include three major areas of daily care,
accommodation and feeding and after care consultations. The cost drivers derived by the clinic is
used to charge the various activities to the cost of treatment.
5-47
5-41
(30 min.) Unused capacity, activity-based costing, activity-based management.
1.
Indirect manufacturing
labor costs
Machine setup costs
Equipment and
maintenance costs
Facility rent costs
Cost
$ 72,000
$ 40,500
$235,000
Allocation Base
$240,000 direct
labor cost
500 batches
23,500 MH
$200,000
6,250 sq. ft.
Allocation Rate
30% of direct
labor cost
$81/batch
$10/MH
$32/sq. ft.
2. Budgeted cost of unused capacity = $32 per sq. ft. (6,250 – 2,860 −2,140) sq. ft.
= $32  1,250 sq. ft. = $40,000
3.
Basic
Deluxe
Direct materials
$325,000
$240,000
Direct manufacturing labor
110,000
130,000
33,000
39,000
Indirect manuf. labor ($110,000 and $130,000  30%)
24,300
16,200
Machine setup (300 and 200 batches  $81/batch)
Equipment and maintenance costs (11,000 and
110,000
125,000
12,500 MH  $10/MH)
91,520
68,480
Facility rent (2,860 and 2,140 sq. ft.  $32/sq. ft.)
Total cost
$693,820
$618,680
Divided by number of units
 5,000
 3,000
Cost per unit
$ 138.76
$ 206.23
4. Although the excess capacity is currently costing Whitewater $40,000 annually, having excess
capacity allows for the company to accept special orders if they are received, expand production
of either of the existing models, or add a new product line in the future. Whitewater should consider
if there is available labor and machine hours before increasing production to use the space, as well
as demand for the product. Whitewater may also consider renting out the available space to a
compatible outside user, with the option to take the space back if needed.
.
5-48
5-42
(50 min.) ABC, implementation, ethics.
1.
Plum Electronics should not emphasize the Maximum model and should not phase out
the Mammoth model. Under activity-based costing, the Maximum model has an operating
income percentage of less than 3%, while the Mammoth model has an operating income
percentage of nearly 43%.
Cost driver rates for the various activities identified in the activity-based costing (ABC) system
are as follows:
Soldering
$ 1,036,200  1,570,000 = $ 0.66 per solder point
Shipments
946,000 
20,000 = 47.30 per shipment
Quality control
1,364,000 
77,500 = 17.60 per inspection
Purchase orders
1,045,440  190,080 = 5.50 per order
Machine power
63,360  192,000 = 0.33 per machine-hour
Machine setups
825,000 
30,000 = 27.50 per setup
Plum Electronics
Calculation of Costs of Each Model
under Activity-Based Costing
Direct materials ($228.80  22,000; $642.40  4,000)
Direct manuf. labor ($13.20  1.5 hrs.  22,000;
$13.20  3.5hrs.  4,000)
Machine costs ($19.80  8 hrs.  22,000;
$19.80  4 hrs.  4,000)
Total direct costs
Indirect costs
Soldering ($0.66  1,185,000; $0.66  385,000)
Shipments ($47.30  16,200; $47.30  3,800)
Quality control ($17.60  56,200; $17.60  21,300)
Purchase orders ($5.50  80,100; $5.50  109,980)
Machine power ($0.33  176,000; $0.33  16,000)
Machine setups ($27.50  16,000; $27.50  14,000)
Total indirect costs
Total costs
Mammoth
$ 5,033,600
435,600
184,800
3,484,800
8,954,000
316,800
3,071,200
782,100
766,260
989,120
440,550
58,080
440,000
3,476,110
$12,430,110
254,100
179,740
374,880
604,890
5,280
385,000
1,803,890
$4,875,090
Profitability analysis
Revenues
Cost of goods sold
Gross margin
Mammoth
$21,780,000
12,430,110
$ 9,349,890
Maximum
$5,016,000
4,875,090
$ 140,910
5-49
Maximum
$2,569,600
Total
$26,796,000
17,305,200
$ 9,490,800
Per-unit calculations:
Units sold
Gross margin per unit
($9,349,890  22,000;
$140,910  4,000)
22,000
4,000
$425.00
$
35.23
2.
Plum’s simple costing system allocates all manufacturing overhead other than machine
costs on the basis of machine-hours, an output unit-level cost driver. Consequently, the more
machine-hours per unit that a product needs, the greater the manufacturing overhead allocated to
it. Because Mammoth uses twice the number of machine-hours per unit compared to Maximum, a
large amount of manufacturing overhead is allocated to Mammoth.
The ABC analysis recognizes several batch-level cost drivers such as purchase orders,
shipments, and setups. Maximum uses these resources much more intensively than Mammoth. The
ABC system recognizes Maximum’s use of these overhead resources. Consider, for example,
purchase order costs. The simple system allocates these costs on the basis of machine-hours. As a
result, each unit of Mammoth is allocated twice the purchase order costs of each unit of Maximum.
The ABC system allocates $440,550 of purchase order costs to Mammoth (equal to $20.02
[$440,550  22,000] per unit) and $604,890 of purchase order costs to Maximum (equal to $151.23
[$604,890  4,000] per unit). Each unit of Maximum uses 8.31 ($151.23  $20.02) times the
purchases order costs of each unit of Mammoth.
Recognizing Maximum’s more intensive use of manufacturing overhead results in
Maximum showing a much lower profitability under the ABC system. By the same token, the ABC
analysis shows that Mammoth is quite profitable. The simple costing system overcosted Mammoth
and so made it appear less profitable.
3.
Clark’s comments about ABC implementation are valid. When designing and
implementing ABC systems, managers and management accountants need to trade off the costs of
the system against its benefits. Adding more activities would make the system harder to understand
and more costly to implement, but it would probably improve the accuracy of cost information,
which, in turn, would help Plum make better decisions. Similarly, using inspection-hours and
setup-hours as allocation bases would also probably lead to more accurate cost information, but it
would increase measurement costs.
4.
Activity-based management (ABM) is the use of information from activity-based costing to
make improvements in a firm. For example, a firm could revise product prices on the basis of
revised cost information. For the long term, activity-based costing can assist management in
making decisions regarding the viability of product lines, distribution channels, marketing
strategies, etc. ABM highlights possible improvements, including reduction or elimination of nonvalue-added activities, selecting lower cost activities, sharing activities with other products, and
eliminating waste. ABM is an integrated approach that focuses management’s attention on
activities with the ultimate aim of continuous improvement. As a whole-company philosophy,
ABM focuses on strategic, as well as tactical and operational activities of the company.
5-50
5.
Incorrect reporting of ABC costs with the goal of retaining both the Mammoth and
Maximum product lines is unethical. In assessing the situation, the specific “Standards of Ethical
Conduct for Management Accountants” that the management accountant should consider are listed
below.
Competence
Clear reports using relevant and reliable information should be prepared. Preparing reports on the
basis of incorrect costs in order to retain product lines violates competence standards. It is unethical
for Jacobs to change the ABC system with the specific goal of reporting different product cost
numbers that Clark favors.
Integrity
The management accountant has a responsibility to avoid actual or apparent conflicts of interest
and advise all appropriate parties of any potential conflict. Jacobs may be tempted to change the
product cost numbers to please Clark, the division president. This action, however, would violate
the responsibility for integrity. The Standards of Ethical Conduct require the management
accountant to communicate favorable as well as unfavorable information.
Credibility
The management accountant’s standards of ethical conduct require that information should be
fairly and objectively communicated and that all relevant information should be disclosed. From
a management accountant’s standpoint, adjusting the product cost numbers to make both the
Mammoth and Maximum lines look profitable would violate the standard of objectivity.
Jacobs should indicate to Clark that the product cost calculations are, indeed, appropriate. If
Clark still insists on modifying the product cost numbers, Jacobs should raise the matter with one
of Clark’s superiors. If, after taking all these steps, there is continued pressure to modify product
cost numbers, Jacobs should consider resigning from the company rather than engage in unethical
behavior.
5-51
5-43
(30-40 mins.) Activity-based costing, activity-based management, merchandising.
1.
Main Street Books and Café
Income Statement
For the Year Ended 31 December, 2020
Books
CDs
Café
Total
$3,720,480
$2,315,360 $736,216 $6,772,056
2,656,727
1,722,311 556,685 4,935,723
18,250
18,250
Revenues
Cost of Merchandise
Cost of Café Cleaning
Allocated Selling, General and Administration
Costsa
(0.300986
×
$2,656,727;
$1,722,311;
$556,685)
799,638
Operating income
$ 264,115
a
518,392 167,554 1,485,584
$ 74,657 $ (6,273) $ 332,499
Overhead rate = $1,485,584 ÷ $4,935,723 = 0.300986 per cost of merchandise dollar
2. Selling, general, and administration (S, G, & A) is comprised of a variety of costs that are
unlikely to be consumed uniformly across product lines based on the cost of merchandise. Main
Street Books and Café should consider an activity-based costing system to clarify how each
product line uses these S, G, & A resources.
Number of purchase orders
Number of deliveries received
Hours of shelf-stocking time
Items sold
Purchasing
Receiving
Stocking
Customer support
Books
2,800
1,400
15,000
124,016
CDs
2,500
1,700
14,000
115,768
Café
2,000
1,600
10,000
368,108
Total
7,300
4,700
39,000
607,892
$474,500 ÷ 7,300 orders placed = $65 per purchase order
$432,400 ÷ 4,700 deliveries = $92 per delivery
$487,500 ÷ 39,000 hours = $12.50 per stocking hour
$91,184 ÷ 607,892 items sold = $0.15 per item sold
5-52
Books
$3,720,480
2,656,727
1,063,753
CDs
$2,315,360
1,722,311
593,049
Café
$ 736,216
556,685
179,531
18,250
Total
$6,772,056
4,935,723
1,836,333
18,250
182,000
162,500
130,000
474,500
128,800
156,400
147,200
432,400
187,500
175,000
125,000
487,500
18,603
516,903
546,850
17,365
511,265
$ 81,784
Revenues
Cost of Merchandise
Gross margin
Cost of Café Cleaning
Purchasing
($65 × 2,800; 2,500; 2,000)
Receiving
($92 × 1,400; 1,700; 1,600)
Shelf-stocking
($12.50 × 15,000; 14,000; 10,000)
Customer support
($0.15 × 124,016; 115,768; 368,108
Total S, G, & A costs
Operating income
$
55,216
475,666
$(296,135)
91,184
1,503,834
$ 332,499
Comparing product line income statements in requirements 1 and 2, it appears that books are
much more profitable, and café loses a lot more money under the ABC system compared to the
simple system. The reason is that books use far fewer S, G, & A resources relative to its
merchandise costs, and café uses far greater S, G, & A resources relative to its merchandise
costs.
3.
To: Main Street Books and Café Management Team
From: Cost Analyst
Re: Costing System
The current accounting system allocates indirect costs (S, G, & A) to product lines based on the
Cost of Merchandise sold. Using this method, the S, G, & A costs are assigned 54%, 35%, and
11%, to the Books, CDs, and Café product lines, respectively.
I recommend that the organization switch to an activity-based costing (ABC) method. With
ABC, the product lines are assigned indirect costs based on their consumption of the activities that
give rise to the costs. An ABC analysis reveals that the Café consumes considerably more than
11% of indirect costs. Instead, the café generally requires 25–35% of the purchasing, receiving,
and stocking activity and 60% of the customer support.
`The current accounting technique masks the losses being produced by the café because it
assumes all indirect costs are driven by the dollar amount of merchandise sold. By adopting ABC,
management can evaluate the costs of operating the three product lines and make more informed
pricing and product mix decisions. For example, management may want to consider increasing
prices of the food and drinks served in the café. Before deciding whether to increase prices or to
close the café, management must consider the beneficial effect that having a cafe has on the other
product lines.
An ABC analysis can also help Main Street Books and Café manage its costs by reducing
the number of activities that each product line demands and by reducing the cost of each activity.
These actions will improve the profitability of each product line. ABC analysis can also be used
to plan and manage the various activities.
5-53
Try It! 5-1
We first calculate the budgeted indirect cost rate for the overhead cost pool:
Total budgeted direct manufacturing labor-hours = (0.4hrs. × 24,640) + (0.5 hrs. × 6,250) = 12,981 hours
Budgeted indirect-cost rate =
=
Budgeted total costs in indirect-cost pool
Budgeted total quantity of cost-allocation base
$220,677
12,981 direct manufacturing labor-hours
= $17 per direct manufacturing labor-hour
5-54
Direct materials
24,640
6,250
Basic Lamps
Designer Lamps
Total
per Unit
Total
(1)
(2)=(1)÷24,640
(3)
per Unit
(4)=(3)÷6,250
Total
(5)=(1)+(3)
$123,200
$ 5.00
$118,750
$19.00
$241,950
295,680
12.00
93,750
15.00
389,430
418,880
17.00
212,500
34.00
631,380
167,552
6.80
53,125
8.50
220,677
$586,432
$23.80
$265,625
$42.50
$852,057
(Basic: $5 x 24,640;
Designer: $19 x 6,250)
Direct manufacturing labor
(Basic: $30 × 0.4hrs. × 24,640;
Designer: $30 × 0.5hrs. ×
6,250)
Total direct costs (Step 2)
Indirect costs allocated (Step 6)
$17 × 9,856 hours; $17 ×3,125
hours
Total costs
5-55
Try It! 5-2
We first calculate the overhead rates for each indirect cost pool:
1 Quantity of lamps produced
2 Number of lamps produced
per batch
3 = (1)÷(2) Number of batches
4 Setup time per batch
5 = (3)×(4) Total setup-hours
6 Direct manufacturing laborhours per lamp
7 = (1)×(6) Total direct
manufacturing labor-hours
Budgeted indirect-cost rate =
=
Basic Lamps
24,640 lamps
320 lamps per batch
Designer Lamps
6,250 lamps
50 lamps per batch
77 batches
1 hour per batch
77 setup-hours
0.4 hours
125 batches
2 hours per batch
250 setup-hours
0.5 hours
9,856 hours
3,125 hours
Budgeted total costs in indirect-cost pool
Budgeted total quantity of cost-allocation base
$130,800
327 setup labor-hours
= $400 per setup labor-hour
Budgeted indirect-cost rate =
=
Budgeted total costs in indirect-cost pool
Budgeted total quantity of cost-allocation base
$89,877
12,981 direct manufacturing labor-hours
= $6.9237 per direct manufacturing labor-hour
5-56
Total
327 setup-hours
12,981 hours
Direct materials
(Basic: $5 x 24,640;
Designer: $19 x 6,250)
Direct manufacturing labor
(Basic: $30 × 0.4hrs. × 24,640;
Designer: $30 × 0.5hrs. ×
6,250)
Total direct costs
Indirect costs of activities
Setup of lamps ($400 x 1 hr.
x 77 batches; $400 x 2 hrs. x
125 batches)
General manufacturing
Overhead ($6.9237 x
9,856 hrs.; $6.9237 x 3,125
hrs.)
Total indirect costs
Total costs
24,640
Basic Lamps
Total
per Unit
(1)
(2)=(1)÷24,640
$123,200
$5.00
6,250
Designer Lamps
Total
per Unit
(3)
(4)=(3)÷6,250
$118,750
$19.00
Total
(5)=(1)+(3)
$241,950
295,680
12.00
93,750
15.00
389,430
418,880
17.00
212,500
34.00
631,380
30,800
1.25
100,000
16.00
130,800
68,240
2.77
21,637
3.46
89,877
99,040
4.02
121,637
19.46
220,677
$517,920
$21.02
$334,137
$53.46
$852,057
5-57
CHAPTER 6
MASTER BUDGET AND RESPONSIBILITY ACCOUNTING
6-1
The budgeting cycle includes the following elements:
a. Planning the performance of the company as a whole as well as planning the
performance of its subunits. Management agrees on what is expected.
b. Providing a frame of reference, a set of specific expectations against which actual
results can be compared.
c. Investigating variations from plans. If necessary, corrective action follows
investigation.
d. Planning again, in light of feedback and changed conditions.
6-2
A master budget a detailed financial plan which sets out, in money terms, the estimates
for income and expenditure in respect of a future period. It is prepared based on the
organizational objectives for that period, together with the strategy planned to achieve the
objectives.
The purpose of a master budget is to serve the needs of management in respect of financial
planning and judgements. It provides the basis for the management functions of planning and
control. It also provides the clear guidelines for managers and supervisors and is the major way
in which organizational objectives are translated into specific tasks.
A master budget is composed of various budgets of the organization, and comprises of cash
budget, manufacturing budget, and the operating budgets. The master profit and loss budget is
prepared from each of the elements of operating budget: sales, production; distribution and
administrative; and the financial budget.
The master budget is a useful tool that contains the summaries of all organizational budgets for
the period. It provides the budgeted income statement and the budgeted balance sheet or
statement of financial position (as used by most IFRS compliant organizations).
6-3
1. It provides an opportunity for managers to re-evaluate existing activities and evaluate
possible new activities.
2. It compels managers to think ahead by formalizing their responsibilities for planning.
3. It aids managers in communicating objectives to units and coordinating actions across the
organization.
4. It provides benchmarks to evaluate subsequent performance.
6-4
1. What are our objectives?
2. What set of integrated choices can we make along the value chain to create value for our
customers while distinguishing ourselves from our competitors?
3. What organizational and financial structures serve us best?
4. What are the risks and opportunities of alternative strategies, and what are our contingency
plans if our preferred plan fails?
6-5
Yes, budgets can promote coordination and communication among all aspects of
production or service and all departments in a company. Budgets can provide a communication
6-1
mechanism that seamlessly links all subunits and their employees, helping them understand their
individual goals or objectives of the company. This understanding can facilitate coordination
among individual departments within the company. In turn, the coordination forces executives to
take into account the relationships among the individual departments.
6-6
In many organizations, budgets impel managers to plan. Without budgets, managers drift
from crisis to crisis. Research also shows that budgets can motivate managers to meet targets and
improve their performance. Thus, many top managers believe that budgets meet the cost-benefit
test.
6-7
A rolling budget, also called a continuous budget, is a budget or plan that is always
available for a specified future period, by continually adding a period (month, quarter, or year) to
the period that just ended. A four-quarter rolling budget for 2020 is superseded by a four-quarter
rolling budget for April 2020 to March 2021, and so on.
6-8
The steps in preparing an operating budget are as follows:
1. Prepare the revenues budget.
2. Prepare the production budget (in units).
3. Prepare the direct material usage budget and direct material purchases budget.
4. Prepare the direct manufacturing labor budget.
5. Prepare the manufacturing overhead budget.
6. Prepare the ending inventories budget.
7. Prepare the cost of goods sold budget.
8. Prepare the operating (nonmanufacturing) costs budget.
9. Prepare the budgeted income statement.
6-9
Usually, a revenues budget is the starting point for the operating budget because the
forecasted level of unit sales or revenues has a major impact on the production capacity, the
inventory levels planned, and determines all of the costs required to support the budgeted
revenues.
6-10 Sensitivity analysis adds an extra dimension to budgeting. It enables managers to
examine how budgeted amounts change with changes in the underlying assumptions. This assists
managers in monitoring those assumptions that are most critical to a company in attaining its
budget and allows them to make timely adjustments to plans when appropriate.
6-11 The key emphasis in Kaizen budgeting is continuous improvement, resulting in cost
reductions, during the budget period.
6-12 Nonoutput-based cost drivers can be incorporated into budgeting by the use of activitybased budgeting (ABB). ABB focuses on the budgeted cost of activities necessary to produce
and sell products and services. Nonoutput-based cost drivers, such as the number of parts,
number of batches, and number of new products can be used with ABB.
6-2
6-13 The choice of the type of responsibility center determines what the manager is
accountable for and thereby affects the manager’s behavior. For example, if a revenue center is
chosen, the manager will focus on revenues, not on costs or investments. The choice of a
responsibility center type guides the variables to be included in the budgeting exercise.
6-14 Budgeting in multinational companies may involve budgeting in several different foreign
currencies. Further, management accountants must translate operating performance into a single
currency for reporting to shareholders by budgeting for exchange rates. Managers and
accountants must understand the factors that impact exchange rates and, where possible, plan
financial strategies to limit the downside of unexpected unfavorable moves in currency
valuations. In developing budgets for operations in different countries, they must also have good
understanding of political, legal, and economic issues in those countries.
6-15 Cash budgets are significantly important for cash planning and control, especially to
avoid having idle cash and unexpected cash deficiencies. The cash budget can help managers to
not only identify the periods of idle cash and periods of cash shortage but also to determine
necessary cash balances in line with their needs in any given period during the budget year. It
allows managers to make appropriate decisions in terms of either using excess cash or financing
from outside to achieve the company’s goals.
6-16 Master budget.
Choice ‘d’ is the correct option. Master budget involves all the above; it’s a summary of all other
budgets and is expressed as a budgeted income and as well as in the balance sheet.
It comprises of the operating budget and the financial budget. Operating budget - focuses on the
income statement and its supporting schedules. It is sometimes called a profit plan, although it
may show a budgeted loss or may be used to simply budget expenses in an agency with no
revenues. Financial budget - focuses on the effects that the operating budget and other plans (e.g.
capital budgets and repayments of debt) will have on cash.
It is used for both planning and control of organizational activities within the budget period. It
contains a quantitative expression of the organization’s plan and the full budgetary process
includes planning and control. The preparation of a master budget involves full and genuine
participation, clear goal definition and good communications of all involved in the organization.
Choice ‘a’ is incorrect as master budget contains quantitative expression of the organization’s
plan and the full budgetary process includes planning and control.
The preparation of a master budget also involves full and genuine participation, clear goal
definition and good communications of all involved in the organization.
Choice ‘b’ is incorrect. The preparation of a master budget involves full and genuine
participation, clear goal definition and good communications of all involved in the organization.
Choice ‘c’ is incorrect. A master budget is serves as a summary of all other budgets and is
expressed as a budgeted income and as well as in the balance sheet. It is used for both planning
and control of organizational activities within the budget period.
6-3
6-17 Operating and financial budgets.
Choice ‘a’ is correct. The number of grams of material to be purchased is based on the
production needs, target ending inventory and the inventory of material already on hand. The
computation is shown below.
Materials needed for production
80,000 units
× 4 kgs/unit
320,000 kgs
Add desired ending inventory
40,000 kgs
Total material needs
360,000 kgs
Deduct beginning inventory of material on hand
30,000 kgs
Grams of material to be purchased
330,000 kgs
Choice ‘b’ is incorrect. The desired ending inventory was subtracted instead addition and the
opening raw material inventory was added in the computation.
Choice ‘c’ is incorrect as the opening raw material inventory is not subtracted from the total
material required.
Choice ‘d’ is incorrect as the opening inventory is added and ending inventory is deducted.
6-18 Production budget.
Choice ‘d’ is the correct option. The units to be produced are found by adding the units expected
to be sold to the targeted ending inventory and then deducting the beginning inventory as shown
below:
Sales
Add targeted ending inventory
Total needed
Deduct beginning inventory
Units to be produced
80,000 units
14,000 units
94,000 units
6000 units
88,000 units
Choice ‘a’ is incorrect. The production unit has been based on the total needs only without
subtracting the beginning inventory units.
Choice ‘b’ is incorrect. The production budget added the beginning inventory units to the total
units needed. The beginning inventory should be subtracted instead.
Choice ‘c’ is incorrect. The production unit has been based on the total needs plus the opening
inventory units. The beginning inventory units ought to be subtracted instead.
6-19 Responsibility centers.
Choice "3" is correct.
The question asks which of a series of statements is/are correct for a responsibility accounting
system. "None of the above" is not an available option, and neither is "All of the above."
Statement I says that, in a cost center, managers are responsible for controlling costs but not
revenue. Statement I is correct.
Statement II says that the idea behind responsibility accounting is that a manager should be held
responsible for those items that the manager can control to a significant extent. Statement II is
correct.
6-4
Statement III says that, to be effective, a good responsibility accounting system must help
managers to plan and to control. Planning without control and control without planning is not
effective. Statement III is correct.
Statement IV says that costs that are allocated to a responsibility center are normally controllable
by the responsibility center manager. Costs that are allocated are normally not controllable by the
responsibility center manager. Statement IV is incorrect.
6-20 Cash budget
Choice "d" is correct. All of the elements listed should be considered when building the cash
budget. Accrued wages will be factored into the determination of cash disbursements in year 2,
which is part of the cash budget. Financing budgets, a component of the cash budget, cover how
a company will fund its current operations. One of the methods the company may use is a line of
credit, which will have limits as to how much cash a company can access at a given time. The
accounts payable balance is important as well, as eventually vendors must be paid in cash in year
2 for credit purchases made by the company in year 1.
Choice "a" is incorrect. This choice leaves out accounts payable, which eventually must be paid
with cash in year 2.
Choice "b" is incorrect. This choice leaves out the analysis of limits on a line of credit that the
company may need to fund its operations in year 2.
Choice "c" is incorrect. This choice leaves out accrued wages, which will ultimately have to be
paid by the company in year 2.
6-5
6-21
(15 min.) Sales budget, healthcare.
1.
2020
Synergy
A tests
B tests
Units
12,200
16,400
2021
Selling Prices
£290
£240
% Change in Units
+ 6%
–10%
Expected Units
12,932
14,760
Synergy Sales Budget
For the Year Ended December 31, 2021
A Tests
B Tests
2.
Synergy
A Tests
B Tests
2020 Units
12,200
16,400
Selling Price
£290
£240
2021 Selling Prices
£290
£230
Units Sold
12,932
14,760
Total Revenues
£3,750,280
£3,542,400
£7,292,680
2021 % Change in Units
+6%
–7%
Expected 2021 Units
12,932
15,252
Synergy Sales Budget
For the Year Ended December 31, 2021
A Tests
B Tests
Selling Price
£290
£230
Units Sold
12,932
15,252
Total Revenues
£3,750,280
£3,507,960
£7,258,240
Expected revenues at the new 2021 prices are £7,258,240, which is lower than the expected 2021
revenues of £7,292,680 at the 2020 prices. If Synergy’s goal is to maximize sales revenue and if
its forecasts are reliable, the company should not lower its price for a B tests in 2021.
While this is an example for understanding the accounting aspect for a company’s profit and
loss, given the nature of the global pandemic, management of healthcare firms should consider
the overall ethics involved in pricing such tests with regard to helping all individuals get access
to such tests.
6-6
6-22
Sales budget.
Peanuts
Projected sales
Groundnut
Cashew nut
Fruits nut
Total sales budget (€’000)
100,000 packs
120,000 packs
300,000 packs
6-23
Selling price per
pack
€10
€12
€15
Total sales (€’000)
1,000
1,440
4,500
6,940
(5 min.) Direct materials purchases budget.
Direct materials to be used in production (pounds) (825,000÷2)
Add target ending direct materials inventory (pounds)
Total requirements (pounds)
Deduct beginning direct materials inventory (pounds)
Direct materials to be purchased (pounds)
6-24 (10 min.) Preparing cash budget.
Month
January
February
March
Total
Augustine Company
Budgeted cash receipt
Budgeted Sales
Cash receipts
£10,000,000
× 10% =
£ 1,000,000
£12,000,000
× 20% =
£ 2,400,000
£13,000,000
× 60% =
£ 7,800,000
£11,200,000
6-7
412,500
43,500
456,000
35,200
420,800
6-25
(15–20 min.) Revenues, production, and purchases budget.
1.
2.
4,000 cars  $35,200 = $140,800,000
Budgeted sales (Model XE8 cars)
Add target ending finished goods inventory
Total requirements (units)
Deduct beginning finished goods inventory
Units to be produced
3.
Direct materials (tires) to be used in production,
3,850 × 5 (tires)
Add target ending direct materials inventory
Total requirements
Deduct beginning direct materials inventory
Direct materials to be purchased (tires)
Cost per tire
Direct materials purchase cost
4,000
450
4,450
600
3,850
19,250
400
19,650
350
19,300
×
$45
$ 868,500
4. Deluxe Motorcar does not maintain a high inventory of tires. Note the relatively small
inventory of wheels. The company appears to be using something close to a just-in-time
inventory system, which is already saving the company the cost of holding materials
inventory. Nevertheless, Deluxe Motorcar’s managers would want to check why the target
ending inventory of tires (400) is greater than the beginning inventory of 350. Could the
production time lag between the order of tires placed and the ordered tires received to reduce
the need to hold more inventories?
Furthermore, Deluxe Motorcar could help and advice its tire supplier to improve the
quality of its tires by taking more quality control measures and to improve efficiency and
productivity of the employees by conducting effective training programs which may result in
reduction of the cost of manufacturing tires with a less number of defective tires. It would
certainly reduce the price the supplier charges Deluxe Motorcar. Toyota routinely aids its
suppliers in this way and reduces costs through better coordination between suppliers and the
company.
6-8
6-26
(30 min.) Revenues and production budget.
1.
12-ounce bottles
1-gallon units
a
b
Selling
Price
$0.20
1.50
Units
Sold
5,040,000a
2,040,000b
Total
Revenues
$1,008,000
3,060,000
$4,068,000
420,000 × 12 months = 5,040,000
170,000 × 12 months = 2,040,000
2.
Budgeted unit sales (12-ounce bottles)
Add target ending finished goods inventory
Total requirements
Deduct beginning finished goods inventory
Units to be produced
5,040,000
680,000
5,720,000
890,000
4,830,000
3.
Beginning inventory = budgeted sales + target ending inventory – budgeted production
= 2,040,000 + 240,000 – 1,900,000
= 380,000 1-gallon units
6-27 (30 min.) Budgeting: direct material usage, manufacturing cost, and gross margin.
1.
Direct Material Usage Budget in Quantity and Dollars
Material
Wool
Physical Units Budget
Direct materials required for
Blue Rugs (200,000 rugs × 36 skeins and 0.8 gal.)
7,200,000 skeins
Cost Budget
Available from beginning direct materials inventory:
(a)
Wool: 458,000 skeins
Dye: 4,000 gallons
To be purchased this period: (b)
Wool: (7,200,000 – 458,000) skeins × $2 per skein
Dye: (160,000 – 4,000) gal. × $6 per gal.
Direct materials to be used this period: (a) + (b)
2.
6-9
$
Dye
Total
160,000 gal.
961,800
$ 23,680
13,484,000
$14,445,800
936,000
$ 959,680
$15,405,480
$31, 620, 000
Weaving budgeted =
= $2.55 per DMLH
overhead rate
12, 400, 000 DMLH
Dyeing budgeted = $17, 280, 000 = $12 per MH
overhead rate
1, 440, 000 MH
3.
Budgeted Unit Cost of Blue Rug
Wool
Dye
Direct manufacturing labor
Dyeing overhead
Weaving overhead
Total
1
Input per
Unit of
Output
36 skeins
0.8 gal.
62 hrs.
1
7.2 mach-hrs.
62 DMLH
Cost per
Unit of Input
$ 2
6
13
12
2.55
Total
72.00
4.80
806.00
86.40
158.10
$1,127.30
$
0.2 machine hour per skein  36 skeins per rug = 7.2 machine-hrs. per rug.
4.
Revenue Budget
Blue Rugs
Blue Rugs
Selling
Units Price Total Revenues
200,000 $2,000 $400,000,000
185,000 $2,000 $370,000,000
5a.
Sales = 200,000 rugs
Cost of Goods Sold Budget
From Schedule
Beginning finished goods inventory
Direct materials used
Direct manufacturing labor ($806 × 200,000)
Dyeing overhead ($86.40 × 200,000)
Weaving overhead ($158.10 × 200,000)
Cost of goods available for sale
Deduct ending finished goods inventory
Cost of goods sold
$ 15,405,480
161,200,000
17,280,000
31,620,000
5b.
Sales = 185,000 rugs
6-10
Total
$
0
225,505,480
225,505,480
0
$225,505,480
Production = 200,000 rugs
Cost of Goods Sold Budget
From Schedule
Beginning finished goods inventory
Direct materials used
Direct manufacturing labor ($806 × 200,000)
Dyeing overhead ($86.40 × 200,000)
Weaving overhead ($158.10 × 200,000)
Cost of goods available for sale
Deduct ending finished goods inventory
($1,127.30 × 15,000)
Cost of goods sold
Total
$
$ 15,405,480
161,200,000
17,280,000
31,620,000
0
225,505,480
225,505,480
16,909,500
$208,595,980
Some students assume that Xander will produce only 185,000 rugs to match 185,000 rugs that
are expected to be sold and carry no finished good inventory of the rugs. In this case the Cost of
goods sold budget will be as follows. The Cost of Goods Sold budget is higher because the fixed
overhead costs in the dyeing and weaving cost pools do not get “inventoried” in the closing
inventory of rugs but are instead expensed in the current period.
Sales = 185,000 rugs
Cost of Goods Sold Budget for Producing 185,000 rugs
From Schedule
Beginning finished goods inventory
Direct materials useda
Direct manufacturing labor ($806 × 185,000)
Variable dyeing overhead ($70.55b × 185,000)
Fixed dyeing overheadc
Variable weaving overhead ($119.15d × 185,000)
Fixed weaving overheade
Cost of goods available for sale
Deduct ending finished goods inventory
Cost of goods sold
a
Total
$
$ 14,253,480
149,110,000
13,051,750
3,170,000
22,042750
7,790,000
0
209,417,980
209,417,980
0
$209,417,980
[$961,800 + (185,000 rugs×36 skeins−458,000)×$2] + [$23,680 + (185,000 rugs×0.8 gallons−4,000)×$6]
Variable dyeing overhead cost per rug = ($6,560,000 + $7,550,000) ÷ 200,000 rugs = $70.55 per rug
c
Fixed dyeing overhead costs = $347,000 + $2,100,000 + $723,000 = $3,170,000
d
Variable weaving overhead cost per rug = ($15,400,000 + $5,540,000 + $2,890,000) ÷ 200,000 rugs = $119.15 per rug
e
Fixed weaving overhead costs = $1,700,000 + $274,000 + $5,816,000 = $7,790,000
b
6-11
6.
Revenue
Less: Cost of goods sold
Gross margin
200,000 rugs sold
$400,000,000
225,505,480
$174,494,520
185,000 rugs sold
200,000 rugs produced
$370,000,000
208,595,980
$161,404,020
185,000 rugs sold
185,000 rugs produced
$370,000,000
209,417,980
$160,582,020
7.
If sales drop to 185,000 blue rugs, Xander should look to reduce fixed costs and produce
less to reduce variable costs and inventory costs.
8.
Top management can look for ways to increase (stretch) sales and improve quality,
efficiency, and input prices to reduce costs in each cost category such as direct materials, direct
manufacturing labor, and overhead costs. Top management can also use the budget to coordinate
and communicate across different parts of the organization, create a framework for judging
performance and facilitating learning, and motivate managers and employees to achieve “stretch”
targets of higher revenues and lower costs.
6-28
(20 min.) Budgeting, service company.
1.
Direct Labor Budget in Hours and Dollars
Total
Hours Budget
Direct labor hours required
(1,000 jobs × 12 hours per job)
12,000 hours
Cost Budget
Wages (12,000 hours × $15 per hour)
Cost per direct-labor hour ($180,000 ÷ 12,000 DLH)
$180,000
$15.00/DLH
2. Budgeted overhead rate
per DLH
3. Budgeted Total Cost and Average Cost of 600-Foot Gutter-Cleaning Job
Direct labor costs
$180,000
Overhead costs
$144,000
Total costs of 1,000 jobs
$324,000
Budgeted cost of = $324,000 ÷ 1,000 = $324 per job.
6-12
4. Revenues Budget
Feet of Gutter Surface
600,000 ft. (1,000 jobs × 600 ft./job)
Price per Foot
$0.60
Total Revenue
$360,000
5. Operating Income Budget (1,000 jobs) = Revenue − Expenses
= $360,000 − $324,000 = $36,000
Operating Income Budget
6. The following table shows Ever Clean’s profitability if sales decline to 900 jobs.
$324,000
Revenue (900 jobs  600 sq. ft. 0.60/sq. ft.
$162,000
Wages (900 jobs  12 hours per job × $15 per hour)
70,200
Supplies (900 jobs  12 hours per job × $6.50 per hour)
Fixed indirect labor costs
25,000
Fixed depreciation costs
17,000
Other fixed costs
24,000
298,200
$ 25,800
If revenue should fall to 900 jobs, Clark should examine the company’s fixed overhead costs to
determine if any cuts are possible. Variable product costs will naturally decline with a decline in
jobs, but Clark should evaluate if variable supplies cost of $6.50 per direct labor hour could be
reduced. Fixed costs will not decline without management acting. While depreciation cost is not
likely something that management can reduce, the fixed indirect costs and “other” fixed
overhead costs are significant and should be examined.
6-13
6-29
(15-25 min.) Budgets for production and direct manufacturing labor.
Roletter Company
Budget for Production and Direct Manufacturing Labor
for the Quarter Ended March 31, 2020
Budgeted sales (units)
Add target ending finished goods
inventorya (units)
Total requirements (units)
Deduct beginning finished goods
inventory (units)
Units to be produced
Direct manufacturing labor-hours
(DMLH) per unit
Total hours of direct manufacturing
labor time needed
Direct manufacturing labor costs:
Wages ($12.00 per DMLH)
Pension contributions
($0.50 per DMLH)
Workers’ compensation insurance
($0.20 per DMLH)
Employee medical insurance
($0.30 per DMLH)
Social Security tax (employer’s share)
($12.00  0.075 = $0.90 per DMLH)
Total direct manufacturing
labor costs
January
10,000
February
14,000
March Quarter
7,000
31,000
17,500
27,500
11,000
25,000
12,000
19,000
12,000
43,000
17,500
10,000
17,500
7,500
11,000
8,000
17,500
25,500
× 2.0
× 2.0
 1.5
20,000
15,000
12,000
47,000
$240,000
$180,000
$144,000
$564,000
10,000
7,500
6,000
23,500
4,000
3,000
2,400
9,400
6,000
4,500
3,600
14,100
18,000
13,500
10,800
42,300
$278,000
$208,500
$166,800
$653,300
a100%
of the first following month’s sales plus 50% of the second following month’s sales.
Note that the employee Social Security tax of 7.5% is irrelevant. Such taxes are withheld from
employees’ wages and paid to the government by the employer on behalf of the employees;
therefore, the 7.5% amounts are not additional costs to the employer.
2. The budget process would prompt Roletter’s management to look for ways to reduce finished
goods inventories, the manufacturing labor hours needed to produce each unit both before and
after installing new labor-saving machinery; some of the other costs such as Social Security tax
and workers’ compensation insurance may be fixed by law, while pension contributions and
medical insurance might be features that make Roletter an attractive employer.
3. We already see one example of a decision that Roletter’s management took based on the
budgeted expenses—installing labor-saving machines ahead of wage increases. Roletter’s
management should also continue to work with employees to increase labor productivity.
6-14
6-30
(20–30 min.) Activity-based budgeting.
1.
Activity
Ordering
$45  14; 24; 14
Delivery
$41  12; 62; 19
Shelf-stocking
$10.50  16; 172; 94
Customer support
$0.09  4,600; 34,200; 10,750
Total budgeted indirect costs
Percentage of total indirect costs
Total indirect costs allocated
according to COGS
(35%; 25%; 40%  13,574)
Cost
Hierarchy
Batch-level
Batch-level
Output-unitlevel
Output-unitlevel
Soft
Drinks
Fresh
Snacks
Packaged
Food
$ 630
$1,080
$ 630
$ 2,340
492
2,542
779
3,813
168
1,806
987
2,961
414
$1,704
3,078
$8,506
968
$3,364
4,460
$13,574
12.5%
62.7%
24.8%
$4,751
$3,393
$5,430
Total
2.
Refer to the last row of the table in requirement 1. Fresh snacks, which represents the
smallest portion of COGS (25%), is the product category that consumes the largest share (62.7%)
of the indirect resources. Fresh snacks demand the highest level of ordering, delivery, shelfstocking, and customer support resources of all three product categories—it has to be ordered,
delivered, and stocked in small, perishable batches, and convenience store customers often
require more assistance when purchasing.
3.
An ABB approach recognizes how different products require different mixes of support
activities. The relative percentage of how each product area uses the cost driver at each activity
area is:
Cost
Soft
Fresh
Packaged
Activity
Hierarchy
Drinks Snacks
Food
Total
Ordering
Batch-level
27%
46%
27%
100%
Delivery
Batch-level
13
67
20
100
Shelf-stocking
Output-unit-level
6
61
33
100
Customer support Output-unit-level
9
69
22
100
By recognizing these differences, Jiffy Mart’s managers are better able to budget for different
unit sales levels and different mixes of individual product-line items sold. Using a single cost
driver (such as COGS) assumes homogeneity in the use of indirect costs (support activities)
across product lines which does not occur at Jiffy Mart. If Jiffy Mart had used COGS to allocate
costs, Fresh Snacks would have been allocated 25% of the indirect costs, much lower than the
62.7% of the indirect costs based on an analysis of the activities it actually uses. Soft Drinks
would have been allocated 35% and Packaged Food 40% of the indirect costs, much higher than
the 12.5% and 24.8% respectively based on the cost of activities they actually use. Other benefits
cited by managers include: (1) better identification of resource needs, (2) clearer linking of costs
with staff responsibilities, (3) better ability to manage costs by focusing on products that demand
the most resources and (4) identification of budgetary slack.
6-15
6-31
(20–30 min.) Kaizen approach to activity-based budgeting (continuation of 6-30).
1.
Activity
Ordering
Delivery
Shelf-stocking
Customer support
a
Cost Hierarchy
Batch-level
Batch-level
Output-unit-level
Output-unit-level
Budgeted Cost-Driver Rates
January
February
March
a
$45.00
$44.82000
$44.64072b
41.00
40.83600
40.67266
10.50
10.45800
10.41617
0.09
0.08964
0.08928
$45 × 0.996 = $44.82000; b$44.82000 × 0.996 = $44.64072
The March 2021 rates can be used to compute the total budgeted cost for each activity area in
March 2021:
Activity
Ordering
$44.64072  14; 24; 14
Delivery
$40.67266  12; 62; 19
Shelf-stocking
$10.41617  16; 172; 94
Customer support
$0.08928  4,600;
34,200; 10,750
Total
Cost
Hierarchy
Soft
Drinks
Fresh
Produce
Packaged
Food
Batch-level
$ 625
$1,071
$ 625
$ 2,321
Batch-level
488
2,522
773
3,783
Output-unit-level
167
1,792
979
2,938
Output-unit-level
411
$1,691
3,053
$8,438
960
$3,337
4,424
$13,466
Total
2.
A Kaizen budgeting approach signals management’s commitment to systematic cost
reduction. Compare the budgeted costs from Question 6-30 and 6-31.
ShelfCustomer
Ordering Delivery
Stocking
Support
Exercise 6-30
$2,340
$3,813
$2,961
$4,460
Exercise 6-31 (Kaizen)
2,321
3,783
2,938
4,424
The Kaizen budget number will show unfavorable variances for managers whose activities
do not meet the required monthly cost reductions. This likely will put more pressure on managers
to seek out cost reductions creatively by working “smarter” within Jiffy Mart or by having
“better” interactions with suppliers or customers.
One limitation of Kaizen budgeting, as illustrated in this question, is that it assumes small
incremental improvements each month. It is possible that some cost improvements arise from
large discontinuous changes in operating processes, supplier networks, or customer interactions.
Companies need to highlight the importance of seeking these large discontinuous improvements
as well as the small incremental improvements.
A second limitation is the difficulty and challenge of determining the rate of improvement
(0.4% in this example) and whether a constant percentage improvement can be sustained over a
period of time. Jiffy’s managers might determine this rate of improvement by benchmarking
against other companies or evaluating Jiffy’s performance over time. It might decrease the rate
of improvement if it concludes that the rate of improvement is difficult to sustain and needs to be
lowered.
6-16
6-32
(15 min.)
Responsibility and controllability.
1. (a) Production manager
(b) Purchasing Manager
The purchasing manager has control of the cost to the extent that he/she is doing the purchasing
and can seek or contract for the best price. The production manager is responsible for the cost
because he or she is responsible for the output, quality, and cost of the product. He or she should
work with the purchasing manager. Together, they can find a combination of better motor and
better price for the motor than the production manager has found.
2. (a) Warehouse Manager
(b) Warehouse Manager
In the case of the increased utility costs, the warehouse manager would be responsible for the
costs and also the ability to control costs. The company should look into installing thermostats
in the warehouse with timers so that the air conditioning can start up before the workers arrive in
the morning, but do not remain on all night and on weekends.
3. (a) Van 3 driver
(b) Service manager and Van 3 driver
The driver of each van has the responsibility to stay within budget for the costs of the service
vehicle. The service manager can control costs by setting policies to which the drivers must
adhere, including not using the van for personal use. The service manager could also install GPS
in the vans to make sure drivers are where they are supposed to be, and can fire the driver of Van
3 for misusing company property. (Using the van for personal driving affects the tax
deductibility of the van for the firm as well).
4. (a) Prestige’s service manager
(b) Regency manager
Because Regency has a maintenance contract with Prestige, both the mall manager (who can
control costs) and Prestige’s service manager (who is responsible for the costs) should work
together to make sure Regency schedules routine maintenance for the mall’s fountains. This will
decrease the number and cost of repair emergencies. The manager should also consider the
average cost of service calls over the months where there were no calls.
5. (a) Service manager
(b) Sales manager and Service manager
The service manager, who is responsible for service costs, should attempt to schedule service
calls to the five clients at the same time to control transportation costs. The sales manager
should have anticipated the additional cost of service calls before writing contracts with these
five new clients. While it may not be possible to begin charging for travel time immediately due
to service contracts, Prestige should consider adding a surcharge for traveling longer distances if
it intends to expand the geographic scope of its business.
6-17
6. (a) Service manager
(b) External forces and service manager
Like the cost of utilities, external forces determine the cost of employee health insurance.
However, unlike utilities, it is possible that the service manager can seek out bids from other
providers or negotiate a better rate with the existing health insurance provider. The service
manager may also choose to require employees to pay a greater share of the cost of the health
insurance premium to offset, at least partially, the increase.
6-33
(15 min.) Responsibility, controllability, and stretch targets.
1. Each driver is responsible for controlling and keeping an accurate accounting of his or her
time. Because the drivers are paid for mileage while driving and an hourly rate while in idle,
there is an incentive to report less travel time and more idle time. The cost could be controlled by
using global positioning systems (GPS) to track the movement and location of the motor
coaches.
2. Each driver is responsible for adhering to company policy regarding meal stops. Because
decreased customer satisfaction can be costly to the company in terms of lost repeat business, it
is important that Bartlett review the policy with this driver. While it is not uncommon for motor
coach drivers to receive free meals at restaurants in exchange for bringing customers, a sizeable
kickback may be in direct conflict with the driver’s responsibility to Sunshine Tours to provide
good customer service. Bartlett can control costs by making clear to that driver’s customers the
policy that they may choose meal stops and follow up with him if that is not happening.
3. The maintenance technician is clearly responsible for completing all of the preventative
maintenance and controlling costs. Requiring the technician to work significant overtime will
likely decrease his efficiency. Ignoring routine maintenance will end up costing the company
more money in fuel and repair costs. If the technician cannot complete the tasks during busy
months, the company should consider outsourcing some of the more routine maintenance jobs or
hiring additional help during those months.
4. Bartlett has designed the stretch target system correctly. Taking advantage of loss aversion,
Bartlett has set a stretch target of 50 contracts rewarding the representative with a 12 percent
commission (assuming paying this amount of commission is profitable). If the sales
representative does not meet the target, the commission decreases to 8 percent. This will
motivate the representatives to achieve 50 contracts.
In establishing “stretch targets,” Bartlett should be sure that there are sufficient potential
contracts to allow all three sales representatives to achieve the higher target. Otherwise, the
stretch target may cause friction among the sales representatives. One or more of the sales
representatives may decide that the 8 percent commission is not sufficient incentive to stay with
the company, and may leave to work for a competitor, resulting in overall reduced sales.
6-18
5. The drivers are responsible for driving the motor coaches at fuel-efficient speeds on the
highway. The maintenance technician is responsible for maintaining the vehicles to improve
efficiency. An increase in fuel consumption would be difficult to pin on either employee
because either could be responsible. However, the bonus offered to drivers would have to
exceed the loss of pay due to driving slower, because Bartlett pays drivers by the mile, and the
loss in personal comfort from sitting in a hot or cold bus may outweigh the bonus from fuel
savings while the bus is idle. “Stretch targets” such as these are more challenging when
employees from different departments must both work in order to achieve them but this may be
necessary to get better fuel efficiency. For the reduced emissions target, Bartlett could consider
rewarding just the technicians, as the maintenance they perform has a direct impact on emissions.
6-34
(15-20 min.) Cash budget in a trading firm
1.
Prepare a cash budget for January, February, and March.
Receipts
Opening balance
Cash sales (see Note 1)
Insurance claim
Total cash available
Payments
Cash purchases (see Note 2)
Wages
Overheads (less depreciation)
Taxation
Total payments
Cash balance
Cumulative cash balance
January
(£)
30,000
79,500
109,500
February
(£)
24,000
77,250
101,250
March
(£)
17,250
78,000
25,000
120,250
55,500
15,000
15,000
85,500
24,000
24,000
46,000
15,000
15,000
8,000
84,000
17,250
41,250
54,000
15,000
15,000
84,000
36,250
77,500
6-19
Note 1: Cash sales computation:
November (15% x 80,000)
December (25% x 90,000)
January (60% x 75,000)
December (15% x 90,000)
January (25% x 75,000)
February (60% x 75,000)
January (15% x 75,000)
February (25% x 75,000)
March (60% x 80,000)
Cash sales for January
£
12,000
22,500
45,000
79,500
Cash sales for February
£
13,000
18,750
45,000
77,250
Cash sales for March
£
11,250
18,750
48,000
78,000
Note 2: Computation of cash purchases:
December (10% x 60,000)
January (90% x 55,000)
January (10% x 55,000)
February (90% x 45,000)
February (10% x 45,000)
March (90% x 55,000)
Cash payment for January
£
6,000
49,500
55,500
Cash payment for February
£
5,500
40,500
46,000
Cash payment for March
£
4,500
49,500
54,000
6-20
2. Comment on how management that ensure that the appropriate cash level is sustained.
The management should review the credit policy of the business. For example, they could allow
trade debtors to settle their account within two months of purchase by instalments of pay 70% in
the month of purchase and 30% the following month.
They could also negotiate to settle their credit purchases within three months perhaps in three
instalments. This allows more cash to be available for the business.
3. Discuss the importance of cash budget to a business organization.
Cash budget is one of the most important budgets prepared in an organization. It shows the effect
of budgeted activities including capital investments on the cash flow of the organization. Cash
budget is a continuous activity with budgets being rolled forward as time progresses. Cash
budgets are prepared in order to ensure that there is sufficient cash in hand to cope adequately
with budgeted activities. The cash budget may show that there is likely to be a deficiency of cash
in some future period; in which case, overdrafts or loans will have to be arranged or activities
reduced. The cash budget can also show that there is likely to be a cash surplus, in which case,
appropriate investment for the surplus can be planned rather than merely leaving the cash idle in
a current account.
6-35
(40 min.) Budget schedules for a manufacturer.
1a.
Revenues Budget
Units sold
Selling price
Budgeted revenues
b.
Olympique
130
A$229
A$29,770
Victoria Aces
190
A$296
A$56,240
Total
A$86,010
Production Budget in Units
Olympique Victoria Aces
130
190
22
27
Budgeted unit sales
Add budgeted ending fin. goods (fg)
inventory
Total requirements
Deduct beginning fin. goods inventory
Budgeted production
152
12
140
6-21
217
17
200
c.
Direct Materials Usage Budget (units)
Olympique jerseys:
1. Budgeted input per fg. unit
2. Budgeted production
3. Budgeted usage (1 × 2)
Victoria Aces jerseys:
4. Budgeted input per fg. unit
5. Budgeted production
6. Budgeted usage (4 × 5)
7. Total direct materials usage (3 +
6)
Direct Materials (DM)
Budget
8. Beginning inventory
Red
Blue
Olympique
logo
patches
Victoria
Aces logo
patches
4
140
560
–
–
–
1
140
140
–
–
–
–
–
–
5
200
1,000
–
–
–
1
200
200
560
1,000
140
200
35
15
45
60
A$9
A$12
A$7
A$6
A$315
A$180
A$315
A$360
525
A$10
985
A$11
95
A$7
140
A$8
A$5,250
A$10,835
A$665
A$1,120
A$17,870
A$5,565
A$11,015
A$980
A$1,480
A$19,040
Total
Cost
9. Unit price (FIFO)
10. Cost of DM used from beginning
inventory (8 × 9)
11. Materials to be used from
purchases (7 – 8)
12. Cost of DM in March
13. Cost of DM purchased and used in
March (11 × 12)
14. Direct materials to be used (10 +
13)
6-22
A$1,170
Direct Materials Purchases Budget
Red
Budgeted usage
(from line 7)
Add target ending inventory
Total requirements
Deduct beginning inventory
Total DM purchases
Purchase price (March)
Total purchases
560
25
585
35
550
A$ 10
A$5,500
Blue
1,000
25
1,025
15
1,010
A$ 11
A$11,110
Olympique
logos
140
25
165
45
120
A$ 7
A$840
Direct Manufacturing Labor Budget
Direct
Budgeted
Manuf. LaborUnits
Hours per
Total
Produced
Output Unit
Hours
Olympique jerseys
140
3
420
Victoria Aces jerseys 200
4
800
1,220
Victoria
Aces logos
200
25
225
60
165
A$ 8
A$1,320
Total
A$18,770
d.
e.
Hourly
Rate
A$27
A$27
Manufacturing Overhead Budget
Variable manufacturing overhead costs (1,220 × $16)
Fixed manufacturing overhead costs
Total manufacturing overhead costs
A$19,520
14,640
A$34,160
Total manuf. overhead cost per hour = A$34,160 ÷ 1,220 = A$28 per direct
manufacturing labor-hour
Fixed manuf. overhead cost per hour = A$ 14,640 ÷ 1,220 = A$12 per direct
manufacturing labor-hour
f.
Total
A$11,340
A$21,600
A$32,940
Computation of unit costs of ending inventory of finished goods
Olympique
Victoria Aces
Jerseys
Jerseys
Direct materials
Red fabric (A$10 × 4, 0)
A$40
A$0
Blue fabric (A$11 × 0, 5)
0
55
Olympique logos (A$7 × 1, 0)
7
0
Victoria Aces logos (A$8 × 0, 1)
0
8
Direct manufacturing labor (A$27 × 3,
81
108
4)
Manufacturing overhead
Variable (A$16 × 3, 4)
48
64
6-23
Fixed (A$12 × 3, 4)
Total manufacturing cost
36
A$212
48
A$283
Ending Inventories Budget
Cost per Unit
Direct Materials
Red fabric
Blue fabric
Olympique logo patches
Victoria Aces logo patches
25
25
25
25
A$ 250
275
175
200
900
212
283
22
27
4,664
7,641
12,305
A$13,205
Total
2.
Total
A$ 10
11
7
8
Finished Goods
Olympique jerseys
Victoria Aces jerseys
g.
Units
Cost of goods sold budget
Beginning fin. goods inventory, March 1, 2020 (A$1,440 + A$2,550)
A$3,990
Direct materials used (from DM cost budget)
A$19,040
Direct manufacturing labor (Dir. manuf. labor budget)
32,940
Manufacturing overhead (Manuf. overhead budget)
34,160
Cost of goods manufactured
Cost of goods available for sale
Deduct ending fin. goods inventory, March 31, 2020 (Inventories budget)
12,305
Cost of goods sold
86,140
90,130
A$77,825
Areas where continuous improvement might be incorporated into the budgeting process:
(a) Direct materials. Either an improvement in usage or price could be budgeted. For
example, the budgeted usage amounts for the fabric could be related to the maximum
improvement (current usage – minimum possible usage) of yards of fabric for either
blanket. It may also be feasible to decrease the price paid, particularly with quantity
discounts on things like the logo patches.
(b) Direct manufacturing labor. The budgeted usage of 3 hours/4 hours could be
continuously revised on a monthly basis. Similarly, the manufacturing labor cost per
hour of $27 could be continuously revised down. The former appears more feasible
than the latter.
(c) Variable manufacturing overhead. By budgeting more efficient use of the allocation
base, a signal is given for continuous improvement. A second approach is to budget
continuous improvement in the budgeted variable overhead cost per unit of the
allocation base.
6-24
(d) Fixed manufacturing overhead. The approach here is to budget for reductions in the
year-to-year amounts of fixed overhead. If these costs are appropriately classified as
fixed, then they are more difficult to adjust down on a monthly basis.
6-36
1.
(45 min.) Budgeted costs, Kaizen improvements.
Increase in Costs for the Year
Assume EverGreen uses New Dye
Units to dye
Cost differential ($1.50 – $0.75) per ounce × 4 ounces
Increase in costs
60,000
× $3.00
$180,000
Because the fine is only $140,000, EverGreen would be financially better off by not switching.
2.
If EverGreen switches to the new dye, costs will increase by $180,000.
If EverGreen implements Kaizen budgeting, costs will be reduced as follows:
Original monthly costs
Input
Fabric
Labor
Unit cost
$9.00
$5.00
Number of units
6,250*
6,250*
Total
* (15,000 + 60,000)/12 months = 6,250 units
Monthly decrease in costs
Fabric
Labor cost
$56,250 Month 1
Month 1
55,688
Month 2
Month 2
55,131
Month 3
Month 3
54,580
Month 4
Month 4
54,034
Month 5
Month 5
53,494
Month 6
Month 6
52,959
Month 7
Month 7
52,429
Month 8
Month 8
51,905
Month 9
Month 9
51,386
Month 10
Month 10
50,872
Month 11
Month 11
50,363
Month 12
Month 12
$639,091
TOTAL
Total cost
$56,250
31,250
Annual cost
$675,000
375,000
$87,500
$1,050,000
$31,250
30,938
30,629
30,323
30,020
29,720
29,423
29,129
28,838
28,550
28,265
27,982
$355,067
6-25
$994,158
Difference between costs with and without Kaizen improvements
($1,050,000 – $994,158)
$ 55,842
This means costs increase a net amount of $180,000 – 55,842 = $124,158.
3.
Reduction in materials can be accomplished by reducing waste and scrap. Reduction in
direct labor can be accomplished by improving the efficiency of operations and
decreasing down time.
Employees who make and dye the T-shirts may have suggestions for ways to do their
jobs more efficiently. For instance, employees may recommend process changes that
reduce idle time, setup time, and scrap. To motivate workers to improve efficiency, many
companies have set up programs that share productivity gains with the workers.
EverGreen must be careful that productivity improvements and cost reductions do not in
any way compromise product quality.
6-37
(10-15 min). Budgeted operating in a multiple product environment.
1.
John Dawling Brothers
Revenues Budget for 2021
Tablefrig
Tablefrez
Budgeted revenues
Units
40,000
80,000
Price
$75
90
Total
$3,000,000
7,200,000
$10,200,000
John Dawling Brothers
Budgeted Operating Income for 2021
Sales revenue
Deduct variable costs:
Direct materials
Direct labor
Variable overheads
Contribution
Deduct fixed costs
Operating income
Tablefrig
3,000,000
816,000
840,000
420,000
2,076,000
924,000
Tablefrez
7,200,000
1,584,000
3,360,000
1,680,000
John Dawling Brothers
6-26
6,624,000
576,000
Total
10,200,000
8,700,000
1,500,000
800,000
$ 700,000
2.
Revenues Budget for 2022
Units
32,000
80,000
15,000
Tablefrig
Tablefrez
Tablefrig II
Budgeted revenues
Price
$75
90
115
Total
$2,400,000
7,200,000
1,725,000
$11,325,000
John Dawling Brothers
Budgeted Operating Income for 2022
Tablefrig
Sales revenue
Deduct variable costs
Direct materials
Direct labor
Variable overheads
Contribution
Deduct fixed costs
Operating income
Tablefrig II
2,400,000
816,000
840,000
420,000
Tablefrez
1,725,000
375,000
690,000
345,000
2,076,000
324,000
1,410,000
315,000
1,584,000
3,360,000
1,680,000
Total
7,200,000
11,325,000
6,624,000
576,000
10,110,000
1,215,000
1,000,000
$ 215,000
3.
Operating income budget is used to estimate the operating income achievable from a
project or the whole of the organization. In the case of the John Dawling Brothers Ltd, the
introduction of new product lines- Tablefrig II, requires that the operating income is achieved in
order to sustain the production of the product. Operating income budget therefore helps
organizations to focus on their high-income generating products and to review the production of
products with low profit margins.
6-38
(30 min.) Budgeted income statement.
1.
Spin Cycle Company
Budgeted Income Statement for 2021
(in thousands)
Revenues
Equipment ($12,000 × 1.10 × 1.15)
Maintenance contracts ($4,000 × 1.10)
Total revenues
Cost of goods sold ($10,000 × 1.10 × 1.08)
Gross margin
Operating costs:
Marketing costs ($800 + $200)
Distribution costs ($200 × 1.10)
Customer maintenance costs ($300 + $60)
Administration costs
Total operating costs
Operating income
6-27
$15,180
4,400
$19,580
11,880
7,700
1,000
220
360
900
2,480
$ 5,220
2.
The budget aligns with Spin Cycle’s key strategy of customer satisfaction through
maintaining exercise cycles by hiring maintenance technicians and increasing costs of customer
maintenance by 20% ($60,000 ÷ $300,000) more than the 10% forecasted increase in sales.
3.
Preparing a budget helps Spin Cycle manage costs based on revenues and production
needs, look for opportunities to increase efficiencies, reduce costs, particularly in areas where
costs are high, coordinate and communicate across different parts of the organization, create a
framework for judging performance and facilitating learning, and motivate managers and
employees to achieve “stretch” targets of higher revenues and lower costs.
6-39
(15 min.) Responsibility of purchasing agent.
The procurement of meat patties and cheese slices is usually the responsibility of the purchasing
agent, though the costs of these items are not under his control. It is usually controllable by the
Central Warehouse. However, in this scenario, Kelly, the cook, has taken the responsibility for
the cost of the meat to be used in meat patties and cheese slices from the local market by making
a purchasing decision. As Christa holds the purchasing agent responsible for the costs of meat
and cheese, and presuming that Kelly knew this, Kelly should have discussed her decision with
the purchasing agent before sending the kitchen helper to the local market.
In any case, Christa should not be angry because her employees acted to satisfy the customers on
a short-term emergency basis. Assuming that the Central Warehouse does not consistently have
problems with their freezer, there is no way the purchasing agent could foresee the incident
beforehand and plan accordingly. The problem only lasted four days, which, in the course of the
year (or even the month) will not seriously harm the profits of a restaurant that sells a variety of
foods along with the cheeseburger. However, if they had not cooked the cheeseburger with local
ingredients when they went out of meat patties and cheese slices for four days, there could have
been a long-term implications on customer satisfaction and customer loyalty, and in the long run
this could harm profits as customers could have found other restaurants to frequent for lunch.
6-28
6-40
*Correction to the question*
Product
Akra
Omra
Okore
Quantity
4,000
8,000
6,000
Price (€)
60
70
80
(30-35 mins.) Operating budget and absorption of overhead.
1.
a. Sales budget:
Product
Quantity
Selling price
$
Akra
4000
60
Omra
8000
70
Okore
6000
80
TOTAL
Sales amount
$
240,000
560,000
480,000
1,280,000
b. Production budget:
Product
Akra
Omra
Okore
TOTAL
Production (units)
4,100
8,300
6,200
18,600
Sales budget
4000
8000
6000
c. Material usage budget:
Product
Red
Akra
20,500
Omra
33,200
Okore
18,600
TOTAL
72,300
d. Material purchase budget:
Product
Red
Purchases (Qty)
64,300
Cost price per unit ($)
2
Purchase ($)
128,600
TOTAL
Inventory increase
100
300
200
Blue
12,300
33,200
12,400
57,900
Black
4,100
16,600
6,200
26,900
Ox Blood
8,200
24,900
31,000
64,100
Blue
53,900
3
161,700
Black
24,900
4
99,600
Ox Blood
58,100
5
290,500
$680,400
6-29
e. Direct labor usage budget:
Product
Production budget
Akra
4,100
Omra
8,300
Okore
6,200
TOTAL
Budgeted labor:
Rate per hour
Total direct labor costs
TOTAL
a = 4,100 x 3 hrs, b = 8,300 x 4 hrs, c = 6,200 x 5 hrs
d = 4,100 x 1.5 hrs, e = 8,300 x 2 hrs, f = 6,200 x 2.5 hrs.
Assemblers
12,300a
33,200b
31,000c
76,500
Crafters
6,150d
16,600e
15,500f
38,250
$0.50
38,250
$0.60
22,950
$61,200
2.
Prepare the statement showing the valuation of finished inventory at the end of the
period.
Product
Quantity
Unit Cost
Inventory Value ($)
(Unit)
($)
Akra
1,100
39
42,900
Omra
3,300
51
168,300
Okore
2,200
51
112,200
TOTAL
323,400
3.
Prepare a budget for the operating income for the period showing the amount of
profit contributed by each product.
Sales units
Selling price per unit
($)
Revenue
Product costs:
Materials
Labor
Production Overhead
Selling & Distribution
Operating income ($)
Products
a = Akra
b = Omra
c = Okore
TOTAL
Akra
4,000
60
Omra
8,000
70
Okore
6,000
80
Total
240,000
560,000
480,000
1,280,000
132,000
9,600
12,445a
30,090
55,865
344,000
25,600
33,590b
70,220
86,590
246,000
24,000
31,365c
60,190
118,445
722,000
59,200
77,400
160,500
260,900
Hours
18,450
49,800
46,500
114,750
Costs ($)
12,445
33,590
31,365
77,400
6-30
Material Cost per unit: Akra = 5 x $2 + 3 x $3 + 1 x $4 +2 x $5 = $33
Omra = 4 x $2 + 4 x $3 + 2 x $4 + 3 x $5 = $43
Okore = 3 x $2 + 2 x $3 + 1 x $4 + 5 x $5 = $41
Labor Cost per unit: Akra = 3 x $0.50 + 1.5 x $0.60 = $2.40
Omra = 4 x +$0.50 + 2 x $0.60 = $3.20
Okore = 5 x $0.50 +2.5 x $0.60 = $4.00
4.
Comment on the usefulness of the above operating budgets to management.
Operating budgets such as production budget, material usage budget, material purchase budget,
and direct labor usage budget are used by management to coordinate the operations of the
organization. Each budget is prepared to shadow the operations of the other. For example, the
production budget is prepared based on the sales unit requirement of the business, and the
purchases budget is based on the requirement of the raw materials required by the production.
Properly planned and administered budgeting process ensure smooth control of the current
operations of the business.
6-31
6-41 (25 min.) Cash budget (Continuation of 6-40) (Appendix)
Cash Budget
April 30
Cash balance, April 1
Add receipts
Cash sales ($178,400 × 10%)
Credit card sales ($178,400 × 90% × 98%)
Total cash available for needs (x)
Deduct cash disbursements
Direct materials ($8,000 + $20,024 × 50%)
Direct manufacturing labor
Manufacturing overhead ($109,832 ─ $25,000 depreciation)
Nonmanufacturing salaries
Sales commissions
Other operating fixed costs ($16,000 ─ $10,000 depreciation)
Machinery purchase
Income taxes
Total disbursements (y)
Financing
Repayment of loan
1
Interest at 12% ($2,000  12%  )
12
Total effects of financing (z)
Ending cash balance, April 30 (x) ─ (y) ─ (z)
$
5,900
17,840
157,349
$181,089
$ 18,012
27,300
84,832
16,800
1,784
6,000
13,000
5,000
$172,728
$
2,000
20
$
$
2,020
6,341
Note: The solution assumes that the loan is repaid. Some students may point out that the cash
balance at the end of April after the loan is paid is anticipated to be $6,341, which is less than
$7,000 and so Animal Gear would not repay the loan. Under this assumption, the $2,000
repayment would not be shown. Our assumption is that Animal Gear has $8,361 ($181,089
−$172,728) at the end of April before the loan is paid which is more than $7,000 and so the loan
will be repaid.
2.
Animal Gear’s managers prepare a cash budget in addition to the operating income
budget to plan cash flows to ensure that the company has adequate cash to pay vendors, meet
payroll, and pay operating expenses as these payments come due. Animal Gear could be very
profitable on an accrual accounting basis, but the pattern of cash receipts from revenues might be
delayed and result in insufficient cash being available to make scheduled payments for its
expenses. Animal Gear’s managers may then need to initiate a plan to borrow money to finance
any shortfall. Building a profitable operating plan does not guarantee that adequate cash will be
available, so Animal Gear’s managers need to prepare a cash budget in addition to an operating
income budget.
6-32
6-42
1.
(60 min.)
Comprehensive operating budget, budgeted balance sheet.
Schedule 1: Revenues Budget for January 2021
Snowboards
2.
Units Selling Price
2,900
$650
Total Revenues
$1,885,000
Schedule 2: Production Budget (in Units) for January 2021
Snowboards
2,900
200
3,100
500
2,600
Budgeted unit sales (Schedule 1)
Add target ending finished goods inventory
Total requirements
Deduct beginning finished goods inventory
Units to be produced
3.
Schedule 3A: Direct Materials Usage Budget for January 2021
Wood
Fiberglass
Total
Physical Units Budget
Wood: 2,600 × 9 b.f.
Fiberglass: 2,600 × 10 yards
To be used in production
Cost Budget
Available from beginning inventory
Wood: 2,040 b.f. × $32.00
Fiberglass: 1,040 b.f. × $8.00
To be used from purchases this period
Wood: (23,400 – 2,040) × $34.00
Fiberglass: (26,000 – 1,040) × $9.00
Total cost of direct materials to be used
23,400
_______
23,400
26,000
26,000
$ 65,280
$
726,240
_______
$791,520
8,320
224,640
$232,960
$1,024,480
Schedule 3B: Direct Materials Purchases Budget for January 2021
Wood
Physical Units Budget
Production usage (from Schedule 3A)
Add target ending inventory
Total requirements
Deduct beginning inventory
Purchases
Cost Budget
Wood: 22,900 × $34.00
Fiberglass: 27,000 × $9.00
Purchases
Fiberglass
23,400
1,540
24,940
2,040
22,900
26,000
2,040
28,040
1,040
27,000
$778,600
________
$778,600
$243,000
$243,000
6-33
Total
$1,021,600
4.
Schedule 4: Direct Manufacturing Labor Budget for January 2021
Labor Category
Manufacturing labor
5.
Cost Driver
Units
2,600
DML Hours per
Driver Unit
5.00
Total
Hours
13,000
Wage
Rate
$29.00
Total
$377,000
Schedule 5: Manufacturing Overhead Budget for January 2021
At Budgeted Level of 13,000
Direct Manufacturing Labor-Hours
Variable manufacturing overhead costs
($7.00 × 13,000)
Fixed manufacturing overhead costs
Total manufacturing overhead costs
6.
7.
8.
$172,000
= $13.23 per hour
13,000
$172,000
Budgeted manufacturing overhead cost per output unit:
= $66.15 per output unit
2,600
Schedule 6A: Computation of Unit Costs of Manufacturing Finished Goods in January 2021
Budgeted manufacturing overhead rate:
Direct materials
Wood
Fiberglass
Direct manufacturing labor
Total manufacturing overhead
a
$ 91,000
81,000
$172,000
Cost per
Unit of
Inputa
Inputsb
$34.00
9.00
29.00
9.00
10.00
5.00
Total
$306.00
90.00
145.00
66.15
$607.15
Cost is per board foot, yard, or per hour
Inputs is the amount of each input per board
b
9.
Schedule 6B: Ending Inventories Budget, January 31, 2021
Direct materials
Wood
Fiberglass
Finished goods
Snowboards
Total Ending Inventory
Units
Cost per
Unit
Total
1,540
2,040
$ 34.00
9.00
$ 52,360
18,360
200
607.15
121,430
$192,150
6-34
10. Schedule 7: Cost of Goods Sold Budget for January 2021
From
Schedule
Beginning finished goods inventory
January 1, 2021, $374.80 × 500
Given
Direct materials used
3A
$1,024,480
Direct manufacturing labor
4
377,000
Manufacturing overhead
5
172,000
Cost of goods manufactured
Cost of goods available for sale
Deduct ending finished goods
inventory, January 31, 2021
6B
Cost of goods sold
11. Budgeted Income Statement for Skulas for January 2021
Revenues
Schedule 1
Cost of goods sold
Schedule 7
Gross margin
Operating costs
Variable marketing costs ($250 × 38)
$ 9,500
Fixed nonmanufacturing costs
35,000
Operating income
Total
$
187,400
1,573,480
1,760,880
121,430
$1,639,450
$1,885,000
1,639,450
245,550
44,500
$ 201,050
12.
The CEO would want to probe if the revenue budget is sufficiently stretched. Is the
revenue growing faster than the market? Should the company increase marketing and advertising
spending to grow sales? Would increasing the sales force or giving salespersons stronger
incentives result in higher sales?
The CEO would want to ask the production manager if production could be more closely
tailored to demand? Could the efficiency and productivity of direct materials and direct
manufacturing labor be increased? Could direct materials inventory be reduced?
The CEO should set stretch targets that are challenging but achievable because creating
some performance anxiety motivates employees to exert extra effort and attain better
performance. A major rationale for stretch targets is the psychological motivation that comes
from loss aversion—people feel the pain of loss more than the joy of success. Setting challenging
targets motivates employees to reach these targets because failing to achieve a target is seen as
failing. At no point should the pressure for performance push employees to engage in illegal or
unethical practices. So, while setting stretch targets, the CEO must place great emphasis on
adhering to codes of conduct and following appropriate norms and values. The CEO should also
not set targets that are very difficult or impossible to achieve. Such targets demotivate employees
because they give up on trying to achieve them.
13.
Preparing a budget helps Skulas manage costs based on revenues and production needs,
look for opportunities to increase efficiencies, reduce costs, particularly in areas where costs are
high, coordinate and communicate across different parts of the organization, create a framework
for judging performance and facilitating learning, and motivate management and employees to
achieve “stretch” targets of higher revenues and lower costs.
6-35
6-43
(30 min.) Cash budgeting, chapter appendix.
1.
Cash Collections from Receivables
From sales in:
December (60%  $1,650,000)
January (40%  $1,885,000)
Total
$ 990,000
754,000
$1,744,000
Cash Disbursements for Material Purchases
For purchases in:
December (50% × $820,000)
January (50% × $1,021,600a)
Total
a6-42,
$410,000
510,800
$920,800
Schedule 3B
Cash Disbursements for Fixed Overhead Costs
Fixed manufacturing overhead ($81,000b – $64,000)
Fixed nonmanufacturing overhead ($35,000c – $10,000)
Total
b6-42,
c6-42,
$17,000
25,000
$42,000
Schedule 5
Budgeted Income Statement
Cash Budget for January 2021
Beginning cash balance
$ 124,000
Add receipts: Collection of receivables
Total cash available
1,744,000
$1,868,000
Deduct disbursements:
Material purchases
Direct manufacturing labor
Variable manufacturing overhead
Fixed manufacturing overhead
Variable marketing costs
Fixed operating (nonmanufacturing) costs
Cash dividends
Total disbursements
Ending cash balance
$ 920,800
377,000
91,000
17,000
9,500
25,000
160,000
1,600,300
$ 267,700
6-36
2. Yes. Skulas has a budgeted cash balance of $267,700 on January 31, 2021, after paying the
dividend of $160,000 at the end of January.
3. Skulas’ managers prepare a cash budget in addition to the operating income budget to plan
cash flows to ensure that the company has adequate cash to pay vendors, meet payroll, and pay
operating expenses as these payments come due. Skulas could be very profitable on an accrual
accounting basis, but the pattern of cash receipts from revenues might be delayed and result in
insufficient cash being available to make scheduled payments for its expenses. Skulas’ managers
may then need to initiate a plan to borrow money to finance any shortfall. Building a profitable
operating plan does not guarantee that adequate cash will be available, so Skulas’ managers need
to prepare a cash budget in addition to an operating income budget.
4.
Budgeted Balance Sheet for Skulas as of January 31, 2021
Cash
$ 267,700
Accounts receivable (60% × $1,885,000)
1,131,000
Inventory
Schedule 6B
192,150
Property, plant, and equipment (net)
1,175,600
Total assets
$2,766,450
Accounts Payable (50% × $1,021,600a)
Long-term liabilities
Stockholders’ equity
Total liabilities and stockholders’ equity
a6-42,
Schedule 3B
6-37
$ 510,800
182,000
2,073,650
$2,766,450
6-44
(60 min.) Comprehensive problem; ABC manufacturing, two products.
1.
Revenues Budget
For the Year Ending December 31, 2021
Swing Sets
Play Forts
Total
Units
980
1480
Selling
Price Total Revenues
$1,000
$ 980,000
$1,200
1,776,000
$2,756,000
2a.
Total budgeted marketing costs = Budgeted variable marketing costs + Budgeted fixed marketing costs
= $82,680 + $192,920 = $275,600
Marketing allocation rate = $275,600 ÷ $2,756,000 = $0.10 per sales dollar
2b.
Total budgeted distribution costs = Budgeted variable distribn. costs + Budgeted fixed distribn. costs
= $0 + $295,500 = $295,500
Swing Sets:
Play Forts:
Total
980 units ÷ 10 units per delivery
1,480 units ÷ 5 units per delivery
98 deliveries
296 deliveries
394deliveries
Delivery allocation rate = $295,500 ÷ 394 deliveries = $750 per delivery
3.
Production Budget (in Units)
For the Year Ending December 31, 2021
Product
Swing Sets Play Forts
Budgeted unit sales
980
1,480
Add target ending finished goods inventory
100
120
Total required units
1,080
1,600
Deduct beginning finished goods inventory
80
100
Units of finished goods to be produced
1,000
1,500
6-38
4a.
Machine setup overhead
Units to be produced
Units per batch
Number of setups
Hours to setup per batch
Total setup hours
Swing Sets
Play Forts
Total
1,000
÷20
50
×2
100
1,500
÷10
150
×1
150
250
Total budgeted setup costs = Budgeted variable setup costs + Budgeted fixed setup costs
= $2,600 + $4,900 = $7,500
Machine setup = $7,500 ÷ 250 setup hours = $30 per setup hour
allocation rate
b.
Swing Sets:
Play Forts:
Total
1,000 units × 2 MH per unit
1,500 units × 5 MH per unit
2,000 MH
7,500 MH
9,500 MH
Total budgeted processing costs = Budgeted variable processing costs + Budgeted fixed processing costs
= $180,000 + $200,000 = $380,000
Processing allocation rate = $380,000 ÷ 9,500 MH = $40 per MH
c.
Total budgeted inspection costs = Budgeted variable inspection costs + Budgeted fixed inspection costs
= $10,000 + $5,000 = $15,000
Inspection allocation rate = $15,000 ÷ 2,500 units = $6 per unit
6-39
5.
Direct Material Usage Budget in Quantity and Dollars
For the Year Ending December 31, 2021
Material
Wood
Physical Units Budget
Direct materials required for
Swing Sets (1,000 units × 120 b.f. and 40 ft.)
Play Forts (1,500 units × 200 b.f. and 0 ft.)
Total quantity of direct materials to be used
Chain
120,000 b.f.
300,000 b.f.
420,000 b.f.
Cost Budget
Available from beginning direct materials inventory
(under a FIFO cost-flow assumption)
To be purchased this period
Wood: (420,000 b.f. – 20,000 b.f.) × $2 per b.f.
Chain: (40,000 ft. – 2,000) × $5 per ft.
Direct materials to be used this period
Total
40,000 ft.
0 ft.
40,000 ft.
$ 38,500
$
9,000
800,000
_ ______
$838,500
190,000
$199,000
$1,037,500
Direct Materials Purchases Budget
For the Year Ending December 31, 2021
Wood
Physical Units Budget
To be used in production (requirement 5)
Add: Target ending direct material inventory
Total requirements
Deduct: Beginning direct material inventory
Purchases to be made
Material
Chain
420,000 b.f.
18,000 b.f.
438,000 b.f.
20,000 b.f.
418,000 b.f.
Cost Budget
Wood: 418,000 b.f.  $2 per b.f.
Chain : 39,800 ft.  $5 per ft.
Purchases
$836,000
__ _____
$836,000
Total
40,000 ft.
1,800 ft.
41,800 ft.
2,000 ft.
39,800 ft.
$199,000
$199,000
$1,035,000
6. Total budgeted matls. handlg. cost = Budgeted variable matls. handlg. cost + Budgeted fixed
matls. handlg. cost
= $13,600 + $20,000 = $33,600
Materials handling = $33,600 ÷ 420,000 b.f. = $0.08 per b.f. of Wood
allocation rate
6-40
7.
Direct Manufacturing Labor Costs Budget
For the Year Ending December 31, 2021
Output Units
Produced
1,000
1,500
Swing Sets
Play Forts
Total
Direct Manufacturing
Labor-Hours per Unit
12
15
Total Hourly Wage
Total
Hours
Rate
12,000
$20
$240,000
22,500
20
450,000
$690,000
8.
Manufacturing Overhead Cost Budget
For the Year Ending December 31, 2021
Materials handling
Machine setup
Processing
Inspection
Total
Variable
$ 13,600
2,600
180,000
10,000
$206,200
Fixed
$ 20,000
4,900
200,000
5,000
$229,900
Total
$ 33,600
7,500
380,000
15,000
$436,100
9.
Unit Costs of Ending Finished Goods Inventory
For the Year Ending December 31, 2021
Wood
Chain
Direct manufacturing labor
Materials handling
Machine setup
Processing
Inspection
Totals
Cost per
Unit of
Input
$2.00
5.00
20.00
0.08
30.00
40.00
6.00
Swing Sets
Input per
Unit of
Output
Total
120 b.f.
$240.00
40 ft.
200.00
12 hrs.
240.00
120 b.f.
9.60
0.10 hrs.a
3.00
2 MH
80.00
1 unit
6.00
$778.60
a
Play Forts
Input per
Unit of
Output
Total
200 b.f.
$400.00
─
─
15 hrs.
300.00
200 b.f.
16.00
0.10 hrsa
3.00
5 MH
200.00
1 unit
6.00
$925.00
100 setup-hours ÷ 1,000 units = 0.10 hours per unit; 150 setup hours ÷ 1,500 units = 0.10 hours per unit
6-41
Ending Inventories Budget
December 31, 2021
Direct Materials
Wood
Chain
Finished goods
Swing Sets
Play Forts
Total ending inventory
Quantity
Cost per unit
18,000 b.f.
1,800 ft.
$2.00
5.00
$ 36,000
9,000
$778.60
925.00
$ 77,860
111,000
100
120
Total
$ 45,000
188,860
$233,860
10.
Cost of Goods Sold Budget
For the Year Ending December 31, 2021
Beginning finished goods inventory, Jan. 1
($61,000 + $90,000)
Direct materials used (requirement 5)
$1,037,500
Direct manufacturing labor (requirement 7)
690,000
Manufacturing overhead (requirement 8)
436,100
Cost of goods manufactured
Cost of goods available for sale
Deduct: Ending finished goods inventory, December 31
(requirement 9)
Cost of goods sold
11.
Nonmanufacturing Costs Budget
For the Year Ending December 31, 2021
Marketing
Distribution
Total
Variable
$82,680
0
$82,680
Fixed
$192,920
295,500
$488,420
12.
Budgeted Income Statement
For the Year Ending December 31, 2021
Revenue
$2,756,000
Cost of goods sold
2,125,740
Gross margin
630,260
Operating (nonmanufacturing) costs
571,100
Operating income
$ 59,160
6-42
Total
$275,600
295,500
$571,100
$ 151,000
2,163,600
2,314,600
188,860
$2,125,740
13.
Preparing a budget helps Butler manage costs based on revenues and production needs,
look for opportunities to increase efficiencies, reduce costs, particularly in areas where costs are
high, coordinate and communicate across different parts of the organization, create a framework
for judging performance and facilitating learning, and motivate management and employees to
achieve “stretch” targets of higher revenues and lower costs.
6-45
Cash budget (Continuation of 6-44)
Cash Budget for 2021
Beginning cash balance
Add receipts:
Collections from customersa
Total cash available
Deduct disbursements:
Material purchasesb
Direct manufacturing labor
Variable manufacturing overhead
Fixed manufacturing overheadc
Variable marketing costs
Fixed marketing costsd
Equipment purchase
Total disbursements
Excess or (deficiency) of cash
Need to borrow
Ending cash balance
$
40,000
2,758,000
$2,798,000
$1,030,000
690,000
206,200
114,950
82,860
77,168
610,000
2,811,178
(13,178)
39,000
$ 25,822
a$170,000
beg. accounts receivable + $2,756,000 sales in 2021 - $168,000 ending accounts receivable =
$2,758,000 disbursed
b$85,000 beg. accounts payable + $1,035,000 direct material purchases - $90,000 ending accounts
payable = $1,030,000 disbursed
c$229,900 fixed manufacturing overhead – (50% × $229,900) depreciation = $114,950 disbursed
d$192,920 fixed marketing overhead – (60% × $192,620) depreciation = $77,168 disbursed
2. The cash budget for 2021 does not show when during the year the equipment will be
purchased. As a result, Butler’s managers do not know when to plan to borrow the $39,000 to
achieve the minimum ending cash balance at the end of the year. It could be improved by
preparing a cash budget for each month of the year. The problem did not present the data in such
a way to make that possible here, but an actual company would have sufficient information.
3. Butler’s managers prepare a cash budget in addition to the operating income budget to plan
cash flows to ensure that the company has adequate cash to pay vendors, meet payroll, and pay
operating expenses as these payments come due. Butler could be very profitable on an accrual
accounting basis, but the pattern of cash receipts from revenues might be delayed and result in
insufficient cash being available to make scheduled payments for its expenses. Butler’s managers
may then need to initiate a plan to borrow money to finance any shortfall. Building a profitable
operating plan does not guarantee that adequate cash will be available, so Butler’s managers
need to prepare a cash budget in addition to an operating income budget.
6-43
6-46 (15 min.) Budgeting and ethics.
1. The standards proposed by Kurt are not challenging. In fact, he set the target at the level his
department currently achieves.
Direct materials: 7.9 lbs. × 100 units = 790 lbs.
Direct manufacturing labor: 29 min. × 100 units = 2,900 min ÷ 60 = 48.33 hrs.
Machine time: 23.6 min. × 100 units = 2,360 min. ÷ 60 = 39.33 hrs. approx
2. Kurt probably chose these standards so that his department would be able to make the goal and
receive any resulting reward. With a little effort, his department can likely beat these goals.
3. Top management should point out that the targets set by Kurt are targets that the department
already achieves. Top management is seeking targets that are slightly difficult to achieve, a
stretch target that would challenge workers.
As discussed in the chapter, benchmarking might also be used to highlight the easy targets set
by Kurt and to determine more challenging targets. Perhaps the organization has multiple plant
locations that could be used as comparisons. Alternatively, management could use industry
averages. Also, management should work with Kurt to better understand his department and
encourage him to set more realistic targets. Finally, the reward structure should be designed to
encourage increasing productivity, not beating the budget. Management could also set
continuous improvement standards.
6-47
(30 min.) Kaizen budgeting for carbon emissions.
1. Yes, the company would achieve its goal. Total carbon emissions for 2022 are calculated in
the following table. Each quarter’s emissions are 98% of the previous quarter’s emissions since
Angler reduces emissions by 2% each quarter. Total emissions in 2022 would be 129,132 +
126,549 + 124,018 + 121,538 = 501,237 metric tons, which is below the Environmental
Protection Agency (EPA) guideline of 505,000 metric tons for 2022.
Quarter
2021 Q1
2021 Q2
2021 Q3
2022 Q4
2022 Q1
2022 Q2
2022 Q3
2022 Q4
a
Quarterly Emissions
140,000 metric tons
137,200a metric tons
134,456b metric tons
131,767 metric tons
129,132 metric tons
126,549 metric tons
124,018 metric tons
121,538 metric tons
137,200 = 140,000 × 0.98; b134,456 = 137,200 × 0.98
6-44
2. Angler’s emissions are below the EPA guideline of 505,000 metric tons. Consequently the
EPA will not assess Angler a fine of $800,000.
Current annual emissions
Emissions in 2022
Reduction in emissions
560,000 metric tons
501,237 metric tons
58,763 metric tons
Fine avoided
Cost at $14 per metric ton reduction, 58,763 × $14
Net benefit (cost) of plan
$800,000
822,682
$ (22,682)
3. While this plan would cost Angler marginally by $22,682, avoidance of the EPA fine should
not be the company’s sole motivation in carrying out this plan. Reducing carbon emissions is
good for the environment, and will contribute to a smaller impact on climate change. Research
has shown that good environmental and sustainability practices has positive effects on investors,
consumers, and employees. Angler may also be able to share this plan with the general
population and gain favorable publicity. Environmentally responsible companies also build the
capacity to be more innovative across other areas of their business, improve efficiency and
reduce costs. Angler may want to continue to reduce carbon emissions if they have the
technology to do so.
6-48 (60 min.) Comprehensive budgeting problem; activity-based costing, operating and
financial budgets.
1a.
Revenues Budget
For the Month of June, 2021
Regular
Deluxe
Total
Units Selling Price Total Revenues
2,000
$120
$240,000
3,000
195
585,000
$825,000
6-45
b.
Production Budget
For the Month of June, 2021
Budgeted unit sales
Add: target ending finished goods inventory
Total required units
Deduct: beginning finished goods inventory
Units of finished goods to be produced
Product
Regular
Deluxe
2,000
3,000
400
600
2,400
3,600
250
650
2,150
2,950
c.
Direct Material Usage Budget in Quantity and Dollars
For the Month of June, 2021
Material
Cloth
Wood
Physical Units Budget
Direct materials required for
Regular (2,150 units × 1.3 yd.; 0 b.f.)
Deluxe (2,950 units × 1.5 yds.; 2 b.f.)
Total quantity of direct materials to be used
Total
2,795 yds.
0 b.f.
4,425 yds. 5,900 b.f.
7,220 yds. 5,900 b.f.
Cost Budget
Available from beginning direct materials inventory
(under a FIFO cost-flow assumption)
To be purchased this period
Cloth: (7,220 yd. – 610 yd.) × $5.25 per yd.
Wood: (5,900 – 800) × $7.50 per b. f.
Direct materials to be used this period
6-46
$ 3,219
$ 6,060
34,703
$37,922
38,250
$44,310
$82,232
Direct Materials Purchases Budget
For the Month of June, 2021
Material
Cloth
Wood
Physical Units Budget
To be used in production
Add: Target ending direct material inventory
Total requirements
Deduct: beginning direct material inventory
Purchases to be made
Cost Budget
Cloth: (6,996 yds. × $5.25 per yd.)
Wood: (5,395 ft × $7.50 per b.f.)
Total
7,220 yds.
386 yds.
7,606 yds.
610 yds.
6,996 yds.
$36,729
______
$36,729
Total
5,900 ft
295 ft
6,195 ft
800 ft
5,395 ft
$40,463
$40,463
$77,192
d.
Direct Manufacturing Labor Costs Budget
For the Month of June, 2021
Regular
Deluxe
Total
Output Units
Produced
2,150
2,950
Direct Manufacturing
Labor-Hours per Unit
5
7
Total Hourly Wage
Hours
Rate
10,750
$15
20,650
15
31,400
Total
$161,250
309,750
$471,000
e.
Manufacturing Overhead Costs Budget
For the Month of June 2021
Total
Machine setup
(Regular, 43 batchesa × 2 hrs./batch + Deluxe, 59 batchesb × 3 hrs./batch)  $18/hour
Processing (31,400 DMLH  $1.80)
Inspection [(2,150 + 2,950) pairs  $1.35 per pair]
Total
aRegular:
2,150 pairs ÷ 50 pairs per batch = 43; bDeluxe: 2,950 pairs ÷ 50 pairs per batch = 59
6-47
$ 4,734
56,520
6,885
$68,139
f.
Cloth
Wood
Direct manufacturing labor
Machine setup
Processing
Inspection
Total
a
b
Unit Costs of Ending Finished Goods Inventory
For the Month of June, 2021
Regular
Deluxe
Cost per
Input per
Input per
Unit of Input
Unit of Output
Total
Unit of Output
Total
$ 5.25
1.3 yd
$ 6.83
1.5 yd
$ 7.88
7.50
0 b.f.
0.00
2 b.f.
15.00
15.00
5 hr.
75.00
7 hrs.
105.00
18.00
0.04 hra
0.72
0.06 hrb
1.08
1.80
5 hrs
9.00
7 hrs
12.60
1.35
1 pair
1.35
1 pair
1.35
$92.90
$142.91
2 hours per setup ÷ 50 pairs per batch = 0.04 hr. per unit
3 hours per setup ÷ 50 pairs per batch = 0.06 hr. per unit
Ending Inventories Budget
June, 2021
Direct Materials
Cloth
Wood
Finished goods
Regular
Deluxe
Total ending inventory
Quantity
Cost per unit
386 yards
295 b.f.
$5.25
7.50
$2,026.50
2,212.50
$ 92.90
142.91
$37,160
85,746
400
600
Total
$ 4,239
122,906
$127,145
g.
Cost of Goods Sold Budget
For the Month of June, 2021
Beginning finished goods inventory, June 1 ($23,250 + $92,625)
Direct materials used (requirement c)
Direct manufacturing labor (requirement d)
Manufacturing overhead (requirement e)
Cost of goods manufactured
Cost of goods available for sale
Deduct ending finished goods inventory, June 30 (requirement f)
Cost of goods sold
6-48
$115,875
$ 82,232
471,000
68,139
621,371
737,246
122,906
$614,340
h.
Nonmanufacturing Costs Budget
For the Month of June, 2021
Total
Marketing and general administration
8% × $825,000
Shipping
(5,000 pairs ÷ 40 pairs per shipment) × $15
Total
$66,000
1,875
$67,875
2.
Cash Budget
June 30, 2021
Cash balance, June 1 (from Balance Sheet)
Add receipts
Collections from May accounts receivable
Collections from June accounts receivable
($825,000  60%)
Total collection from customers
Total cash available for needs (x)
Deduct cash disbursements
Direct material purchases in May
Direct material purchases in June
($77,192  80%)
Direct manufacturing labor
Manufacturing overhead
($68,139  70% because 30% is depreciation)
Nonmanufacturing costs
($67,875  90% because 10% is depreciation)
Taxes
Dividends
Total disbursements (y)
Financing
Interest at 6% ($150,000  6%  1 ÷ 12) (z)
Ending cash balance, June 30 (x) – (y) – (z)
6-49
$
9,435
307,800
495,000
802,800
$812,235
$ 15,600
61,754
471,000
47,697
61,088
10,800
15,000
$682,939
$
750
$128,546
3.
Budgeted Income Statement
For the Month of June, 2021
Revenues
Cost of goods sold
Gross margin
Operating (nonmanufacturing) costs
Bad debt expense (2% × $825,000)
Interest expense (for June)
Operating income
Income tax expense
Net income
$825,000
614,340
210,660
$67,875
16,500
750
85,125
$125,535
25,107
$100,428
Budgeted Balance Sheet
June 30, 2021
Assets
Cash
Accounts receivable ($825,000 × 40%)
Less: allowance for doubtful accounts
Inventories
Direct materials
Finished goods
Fixed assets
Less: accumulated depreciation
($136,335 + $68,139  30% + $67,875 × 10%))
Total assets
Liabilities and Equity
Accounts payable ($77,192 × 20%)
Interest payable
Income taxes payable
Long-term debt
Common stock
Retained earnings ($698,904 + $100,428 – $15,000))
Total liabilities and equity
6-50
$ 128,546
$330,000
16,500
313,500
$
4,239
122,906
127,145
$870,000
163,564
706,436
$1,275,627
$
15,438
750
25,107
150,000
300,000
784,332
$1,275,627
Try It 6-1 Solution
Knox
Ayer
Total
Schedule 1: Revenues Budget
for the Year Ending December 31, 2020
Units
Selling Price
Total Revenues
22,100
$29
$ 640,900
15,000
39
585,000
$1,225,900
Schedule 2: Production Budget (in Units)
for the Year Ending December 31, 2020
Product
Knox
Ayer
Budgeted sales in units (Schedule 1)
22,100
15,000
Add target ending finished goods inventory
2,200
1,200
Total required units
24,300
16,200
Deduct beginning finished goods inventory
3,300
1,200
Units of finished goods to be produced
21,000
15,000
6-51
Try It 6-2 Solution
Schedule 3A: Direct Material Usage Budget in Quantity and Dollars
for the Year Ending December 31, 2020
Material
Metal
Fabric
Total
Physical Units Budget
Direct materials required for Knox lamps
126,000 pounds
21,000 yards
(21,000 units × 6 pounds and 1 yard)
Direct materials required for Ayer lamps
105,000 pounds
45,000 yards
(15,000 units × 7 pounds and 3 yards)
Total quantity of direct materials to be used
231,000 pounds
66,000 yards
Cost Budget
Available from beginning direct materials inventory
(under a FIFO cost-flow assumption) (Given)
Metal: 10,000 pounds × $2 per pound
$ 20,000
Fabric: 3,000 yards × $3 per yard
$ 9,000
To be purchased and used this period
Metal: (231,000 – 10,000) pounds × $2 per pound
442,000
Fabric:(66,000 – 3,000) yards × $3 per yard
189,000
Direct materials to be used this period
$462,000
$198,000
$660,000
Schedule 3B: Direct Material Purchases Budget
for the Year Ending December 31, 2020
Metal
Physical Units Budget
To be used in production (from Schedule 3A)
Add target ending inventory
Total requirements
Deduct beginning inventory
Purchases to be made
Cost Budget
Metal: 229,000 pounds × $2 per pound
Fabric: 64,000 yards × $3 per yard
Direct materials to be purchased this period
231,000 pounds
8,000 pounds
239,000 pounds
10,000 pounds
229,000 pounds
Material
Fabric
Total
66,000 yards
1,000 yards
67,000 yards
3,000 yards
64,000 yards
$458,000
$458,000
6-52
$192,000
$192,000
$650,000
Knox
Ayer
Total
Schedule 4: Direct Manufacturing Labor Costs Budget
for the Year Ending December 31, 2020
Direct
Output Units
Manufacturing
Produced
Labor-Hours
Total
Hourly
(Schedule 2)
per Unit
Hours
Wage Rate
21,000
0.1
2,100
$18
15,000
0.2
3,000
18
5,100
6-53
Total
$37,800
54,000
$91,800
Try It 6-3 Solution
Knox
21,000 lamps
200 lamps/batch
105 batches
2 hours/batch
210 hours
1. Quantity of lamps to be produced
2. Number of lamps to be produced per batch
3. Number of batches (1) ÷ (2)
4. Setup time per batch
5. Total setup-hours (3) × (4)
Ayer
15,000 lamps
100 lamps/batch
150 batches
3 hours/batch
450 hours
Schedule 5: Manufacturing Overhead Costs Budget
for the Year Ending December 31, 2020
Machine Setup Overhead Costs
Variable costs ($80 per setup-hour × 660 setup-hours)
Fixed costs (to support capacity of 660 setup-hours)
Total machine setup overhead costs
6-54
$ 52,800
71,000
$123,800
Try It 6-4 Solution (Please note the Machine setup overhead input per unit of output for
Ayer should be 0.03 hrs and not 0.015 hrs as given in the problem.)
If 0.015 hours is used, Machine set up costs for Ayer will be $2.10 ($140 × 0.015) instead of
$4.20 and the total cost will be $28.70 instead of $30.80.
The ending inventories for Ayer will be $34,440 (1,200 × 28.70) and total finished goods
inventory will be $74,480 ($40,040 + $34,440).
The total ending inventory will be $93,480 ($19,000 + $74,480).
Schedule 6A: Budgeted Unit Costs of Ending Finished
Goods Inventory December 31, 2020
Product
Knox
Ayer
Input per
Input per
Cost per Unit
Unit of
Unit of
of Input
Output
Total
Output
Metal
$ 2
6 pounds
$12.00
7 pounds
Fabric
3
1 yard
3.00
3 yards
Direct manufacturing labor
18
0.1 hrs.
1.80
0.2 hrs.
Machine setup overhead
140
0.01 hrs.
1.40
0.03 hrs.
Total
$18.20
Total
$14.00
9.00
3.60
4.20
$30.80
Under the FIFO method, managers use this unit cost to calculate the cost of target ending
inventories of finished goods in Schedule 6B.
Schedule 6B: Ending Inventories Budget December 31, 2020
Quantity
Cost per Unit
Direct materials
Metal
8,000
$ 2.00
$16,000
Fabric
1,000
3.00
3,000
Finished goods
Knox
2,200
$18.20
$40,040
Ayer
1,200
30.80
36,960
Total ending inventory
6-55
Total
$19,000
77,000
$96,000
Try It 6-5 Solution
Schedule 7: Cost of Goods Sold Budget
for the Year Ending December 31, 2020
From Schedule
Beginning finished goods inventory, January 1, 2020
Given
Direct materials used
3A
Direct manufacturing labor
4
Manufacturing overhead
5
Cost of goods manufactured
Cost of goods available for sale
Deduct ending finished goods inventory, December
6B
31, 2020
Cost of goods sold
Total
$ 94,500
$660,000
91,800
123,800
875,600
970,100
77,000
$893,100
Schedule 8: Nonmanufacturing Costs Budget
for the Year Ending December 31, 2020
Business Function
Variable Costs Fixed Costs Total Costs
$ 24,518
$ 42,000
$ 66,518
Marketing (Variable cost: $1,225,900  0.02)
105,000
47,000
152,000
Distribution (Variable cost: $3.0035,000 cu. ft.)
Administration costs
0
79,000
79,000
$129,518
$168,000
$297,518
Budgeted Income Statement for Firelight Corporation
for the Year Ending December 31, 2020
From Schedule
Revenues
Given*
Cost of goods sold
7
Gross margin
Operating costs
Marketing costs
8
$ 66,518
Distribution costs
8
152,000
Administration costs
8
79,000
Operating income
6-56
Total
$1,225,900
893,100
332,800
$
297,518
35,282
Try It 6-6 Solution
Schedule of Cash Collections
Quarters
1
Accounts receivable balance on 1-12020 (Fourth-quarter sales from
2019 collected in first quarter of
2020)
From first-quarter 2020 sales
($315,900  0.65; $315,900  0.35)
From second-quarter 2020 sales
($340,000  0.65; $340,000  0.35)
From third-quarter 2020 sales
($280,000  0.65; $280,000  0.35)
From fourth-quarter 2020 sales
($290,000  0..65)
Total collections
2
3
4
$105,000
205,335
$110,565
221,000
$310,335
6-57
$331,565
$119,000
182,000
$ 98,000
$301,000
188,500
$286,500
CHAPTER 7
FLEXIBLE BUDGETS, DIRECT-COST VARIANCES,
AND MANAGEMENT CONTROL
7-1
Variances combine planning and control functions (and strategy setting) of management
and facilitate management by exception, whereby managers focus more on areas that are not
operating as expected than on areas that are. For example, large variances can sometimes
indicate that a company should consider a change in strategy or a change in standard setting and
control.
Variances help identify deviations from planned performance and be used for evaluating
performance and to motivate managers.
7-2
Standard costs are carefully determined prices, costs, or quantities that are used as
benchmarks for judging performance. Standards are usually expressed on a per-unit basis.
Managers use standard costs to set performance; they are periodically compared with actual costs
incurred and income generated in order to establish any variances.
7-3
All variances can have either a favorable or an unfavorable impact on operating incomes.
Favorable variances have a positive impact on operating income and increase it (relative to the
budgeted amount), while unfavorable variances have a negative impact on the operating income
and decrease it.
7-4
A flexible budget is developed using budgeted revenues or cost amounts based on the
actual output level in the budget period. The actual level of output is unknown until the end of
the budget period. A budget that has been adjusted in this way is known as flexed budget.
7-5
A flexible-budget analysis enables a manager to distinguish how much of the difference
between an actual result and a budgeted amount is due to (a) the difference between actual and
budgeted output levels, and (b) the difference between actual and budgeted selling prices,
variable costs, and fixed costs.
7-6
A flexible budget can be similar to a static budget if the actual outputs are equal to the
planned outputs. This is because the only difference between a static budget and a flexible
budget is that the static budget is prepared for the planned output, whereas the flexible budget is
based on the actual output.
7-7
Most organizations use standard costs to analyze the difference between what was
budgeted and the actual performance of the organization. It is useful to make comparisons in
terms of cost per unit rather than total cost of an item in the budget. Such costs per unit may be
estimated in advance and used as a standard for comparison with the actual costs incurred.
7-8
There could be a link between all the components of variances (including materials) and
therefore, the manager should not investigate the variances in isolation. For example, buying low
quality materials at a lower price can lead to a favorable price variance for materials. However,
at the same time it may lead to the use of more materials for the same outputs and this, in turn,
could lead to unfavorable quantity variances, or vice versa.
7-1
7-9
Possible causes of a favorable direct materials price variance are:
 purchasing officer negotiated more skillfully than was planned in the budget,
 purchasing manager bought in larger lot sizes than budgeted, thus obtaining quantity
discounts,
 materials prices decreased unexpectedly due to, say, industry oversupply,
 budgeted purchase prices were set without careful analysis of the market, and
 purchasing manager received unfavorable terms on nonpurchase price factors (such as
lower quality materials).
7-10 Some possible reasons for an unfavorable direct manufacturing labor efficiency variance
are the hiring and use of underskilled workers; inefficient scheduling of work so that the
workforce was not optimally occupied; poor maintenance of machines resulting in a high
proportion of non-value-added labor; unrealistic time standards. Each of these factors would
result in actual direct manufacturing labor-hours being higher than indicated by the standard
work rate.
7-11 Variance analysis, by providing information about actual performance relative to
standards, can form the basis of continuous operational improvement. The underlying causes of
unfavorable variances are identified and corrective action taken where possible. Favorable
variances can also provide information if the organization can identify why a favorable variance
occurred. Steps can often be taken to replicate those conditions more often. As the easier changes
are made, and perhaps some standards tightened, the harder issues will be revealed for the
organization to act on—this is continuous improvement.
7-12 An individual business function, such as production, is interdependent with other
business functions. Factors outside of production can explain why variances arise in the
production area. For example:
 poor design of products or processes can lead to a sizable number of defects,
 marketing personnel making promises for delivery times that require a large number
of rush orders can create production-scheduling difficulties, and
 purchase of poor-quality materials by the purchasing manager can result in defects
and waste.
7-13 The management accountant might be correct in stating the above if the plant manager is
unaware of the cause and effect relationships which exist among most components of variances.
For example, a low-quality product made by the production department or a low-quality material
provided by purchase department could lead to lower sales and result in unfavorable operating
income variance.
7-14 The direct materials efficiency variance can be decomposed into two parts: a direct
materials mix variance that reflects the impact of using a cheaper mix of inputs to produce a
given quantity of output, and the direct materials yield variance, which captures the impact of
using less input to achieve a given quantity of output.
7-15 It is true that benchmarking is the continuous process of comparing your firm’s
performance against the best levels of performance in competing companies or companies with
similar processes. However, variance analysis is part of the process and can be considered as a
7-2
tool for assessing the firm’s performance especially in terms of production costs.
7-16 Choice ‘a’ is incorrect because the computation includes only the Actual input quantity ×
budgeted price.
Choice ‘b’ is correct. Material efficiency variance is the difference between the [Actual input
quantity × budgeted price] – [Budgeted input quantity × budgeted price]. This can be represented
in the chart as:
Actual input quantity × budgeted price
55,000kg × €0.20 = €11,000
Budgeted input quantity × budgeted price (flexible budget)
53,000kg × €0.20 = €10,600
€400 Unfavorable
Choice ‘c’ is incorrect because the computation includes only the Budgeted input quantity
(flexible budget) × budgeted price.
Choice ‘d’ is incorrect because the computation adds the Actual input quantity × budgeted price
to the Budgeted input quantity (flexible budget) × budgeted price.
7-17 Choice ‘a’ is incorrect because the computation includes only the Actual input quantity ×
budgeted price.
Choice ‘b’ is incorrect because the computation includes only the Actual input quantity × Actual
price
Choice ‘c’ is correct. Material price variance is the difference between the [Actual input quantity
× actual price] – [Actual input quantity × budgeted price]. This can be represented in the chart as:
Actual input quantity × actual price
Actual input quantity × budgeted price
55,000kg x €0.23 = €12,650
55,000kg x €0.20 = €11,000
Choice ‘d’ is incorrect because the computation adds the Actual input quantity × actual price to
the Actual input quantity × budgeted price
7-18 Choice ‘a’ is incorrect because the computation includes only the Actual input hours ×
budgeted price.
Choice ‘b’ is incorrect because the computation includes only the Actual input hours × Actual
price
Choice ‘c’ is incorrect because the computation adds the Actual input hours × actual price to the
Actual input hours × budgeted price
Choice ‘d’ is correct. Labor price variance is the difference between the [Actual input hours ×
actual price] – [Actual input hours × budgeted price]. This can be represented in the chart as:
7-3
Actual input hours × actual price
41,500 hours × €1.75 = €72,625
Actual input hours × budgeted price
41,500 hours x €1.50 = €62,250
€10,375 Unfavorable
7-19 Choice ‘a’ is incorrect because the computation includes only the Actual input hours ×
budgeted price.
Choice ‘b’ is correct. Labor efficiency variance is the difference between the [Actual input hours
x budgeted price] – [Budgeted input hours x budgeted price]. This can be represented in the chart
as:
Actual input hours × budgeted price
Budgeted input hours × budgeted price (flexible
budget)
41,500 hrs × €1.50 = €62,250
42,400 hrs × €1.50 = €63,600
€1,350 Favorable
Choice ‘c’ is incorrect because the computation includes only the Budgeted input hours (flexible
budget) × budgeted price.
Choice ‘d’ is incorrect because the computation adds the Actual input quantity × actual price to
the Budgeted input hours (flexible budget) × budgeted price.
7-20 Choice ‘a’ is correct. Fixed overhead variance is the difference between the Budgeted
fixed costs – Actual fixed costs. This can be represented in the chart as:
Budgeted fixed costs
€13,000
Actual fixed costs
€11,600
€1,400 Favorable
Choice ‘b’ is incorrect because the computation includes only the Actual fixed cost incurred.
Choice ‘c’ is incorrect because the computation includes only the Budgeted fixed costs.
Choice ‘d’ is incorrect because the computation adds the Actual costs to the Budgeted costs.
7-4
7-21
(20–30 min.) Flexible budget.
Units (tires) sold
Revenues
Variable costs
Contribution margin
Fixed costs
Actual
Results
(1)
2,800g
$313,600a
229,600d
84,000
50,000g
FlexibleBudget
Variances
(2) = (1) – (3)
0
$ 5,600 F
22,400 U
16,800 U
4,000 F
Flexible
Budget
(3)
2,800
$308,000b
207,200e
100,800
54,000g
Sales-Volume
Variances
(4) = (3) – (5)
200 U
$22,000 U
14,800 F
7,200 U
0
Static
Budget
(5)
3,000g
$330,000c
222,000f
108,000
54,000g
Operating income
$ 34,000
$12,800 U
$ 46,800
$ 7,200 U
$ 54,000
$12,800 U
$ 7,200 U
Total flexible-budget variance
Total sales-volume variance
$20,000 U
Total static-budget variance
a
112 × 2,800 = $313,600
$110 × 2,800 = $308,000
c
$110 × 3,000 = $330,000
d
Given. Unit variable cost = $229,600 ÷ 2,800 = $82 per tire
e
$74 × 2,800 = $207,200
f
$74 × 3,000 = $222,000
g
Given
b
2.
The key information items are:
Units
Unit selling price
Unit variable cost
Fixed costs
Actual
2,800
$ 112
$
82
$50,000
Budgeted
3,000
$ 110
$
74
$54,000
The total static-budget variance in operating income is $20,000 U. There is both an unfavorable
total flexible-budget variance ($12,800) and an unfavorable sales-volume variance ($7,200).
The unfavorable sales-volume variance arises solely because actual units manufactured
and sold were 200 less than the budgeted 3,000 units. The unfavorable flexible-budget variance
of $12,800 in operating income is due primarily to the $8 increase in unit variable costs. This
increase in unit variable costs is only partially offset by the $2 increase in unit selling price and
the $4,000 decrease in fixed costs.
7-5
7-22
(15
min.) Flexible budget.
The existing performance report is a Level 1 analysis, based on a static budget. It makes no
adjustment for changes in output levels. The budgeted output level is 10,000 units––direct
materials of €410,000 in the static budget ÷ budgeted direct materials cost per luxury wallet of
€41.
The following is a Level 2 analysis that presents a flexible-budget variance and a salesvolume variance of each direct cost category.
Variance Analysis for L’Accessorio
Output units
Direct materials
Direct manufacturing labor
Direct marketing labor
Total direct costs
Actual
Results
(1)
9,000
€373,500
48,600
103,500
€525,600
FlexibleBudget
Variances
(2) = (1) – (3)
0
€4,500 U
3,600 U
4,500 U
€12,600 U
Flexible
Budget
(3)
9,000
€369000
45000
99000
€513000
SalesVolume
Variances
(4) = (3) – (5)
1,000 U
€41,000 F
5,000 F
11,000 F
€57,000 F
Static
Budget
(5)
10,000
€410,000
50,000
110,000
€570,000
€12,600 U
€57,000 F
Flexible-budget variance
Sales-volume variance
€44,400 F
The Level 1 analysis shows total direct costs have a €44,400 favorable variance.
However, the Level 2 analysis reveals that this favorable variance is due to the reduction in
output of 1,000 units from the budgeted 10,000 units. Once this reduction in output is taken into
account (via a flexible budget), the flexible-budget variance shows each direct cost category to
have an unfavorable variance indicating less efficient use of each direct cost item than was
budgeted, or the use of more costly direct cost items than was budgeted, or both.
Each direct cost category has an actual unit variable cost that exceeds its budgeted unit
cost:
Units
Direct materials
Direct manufacturing labor
Direct marketing labor
Actual
9,000
€ 41.50
€ 5.40
€ 11.50
Budgeted
10,000
€ 41.00
€ 5.00
€ 11.00
Analysis of price and efficiency variances for each cost category could assist in further
identifying causes of these more aggregated (Level 2) variances.
7-6
7-23 (25-30 min.) Flexible-budget preparation and analysis.
a.
Prepare a static-budget-based variance analysis of last month’s performance.
Actual Budget (£)
Static-Budget
Static Budget (£)
(1)
Variances (£)
(3)
(2) = (1) – (3)
Output (units)
15,000
5,000 U
20,000
£
£
Revenue
153,900a
56,100 U
210,000c
Direct labor
Direct materials
Contribution margin
Fixed costs
Operating income
(4,000 hrs)
35,040d
(32,000 meters) 23,360g
95,500
67,350
28,150
46,000f
30,000h
134,000
66,000
68,000
10,960 F
6,640 F
38,500 U
1,350 U
39,850 U
£39,850 U
Total static-budget variance
b. Prepare a flexible-budget-based variance analysis of last month’s performance.
Actual
budget £)
(1)
Output
(units)
Revenue
Direct labor
Direct
materials
Contribution
margin
Fixed costs
Operating
income
15,000
£
153,900a
35,040d
23,360g
FlexibleBudget
Variances (£)
(2) = (1) – (3)
0
Flexible
Sales
budget
Volume
(£) Variances (£)
(3)
(4) = (3) – (5)
15,000
5,000 U
£
3,600 U 157,500b
540 U
860 U
e
34,500
95,500
5,000 U
22,500i
100,500
67,350
28,150
1,350 F
6,350 U
66,000
34,500
Total flexible-budget variance
7-7
52,500 U
£
210,000c
11,500 F
46,000f
7,500 F
30,000h
33,500 U
134,000
0
33,500 U
66,000
68,000
Total sales-volume variance
£39,850 U
Total statics-budget variance
a. £10.26 × 15,000 = £153,900
b. £10.50 × 15,000 = £157,500
Static
budget
(£)
(5)
20,000
c. £10.50 × 20,000 = £210,000
d. £8.75 × 4000 = £35,040
e. £2.30 × 15,000 = £34,500
f. £2.30 × 20,000 = £46,000
g. £0.73 × 32,000 = £23,360
h. £1.50 × 20,000 = £30,000
i. £1.50 × 15,000 = £22,500
c. Which departmental manager(s) contributed the most for the success or failure of the
budget during the month? Explain your answer.
The flexible budget figures indicate that the sales department, which is responsible for the
revenue of the business, was largely responsible for the poor performance of the business. There
was a shortfall of £52,500 in sales revenue and £1,350 in fixed costs budgets leading to a fall of
£6,350 in the operating income. The company recorded favorable performance in the variable
costs.
7-24
(30 min.) Flexible budget, working backward.
1. Variance Analysis for The Alpha Company for the year ended December 31, 2020
Units sold
Revenues (sales)
Variable costs
Contribution margin
Fixed cost
Operating income
Actual
Flexible-Budget Flexible Sales-Volume
Results
Variances
Budget
Variances
(1)
(2) = (1) - (3)
(3)
(4) = (3) – (5)
150,000
0
150,000
10,000 F
a
$975,000
300,000 F $675,000
45,000 F
b
675,000
300,000 U
375,000
25,000 U
300,000
0 300,000
20,000 F
150,000
20,000 U 130,000
0
$150,000
20,000 U $170,000
20,000 F
$20,000 U
Static
Budget
(5)
140,000
$630,000
350,000
280,000
130,000
$150,000
$20,000 F
Total flexible-budget variance
Total sales volume variance
$0
Total static-budget variance
a
b
150,000 × $4.50 = $675,000; $630,000  140,000 = $4.50
150,000 × $2.50 = $375,000; $350,000  140,000 = $2.50
2.
Actual selling price:
Budgeted selling price:
Actual variable cost per unit:
Budgeted variable cost per unit:
$975,000
630,000
675,000
350,000
3.
A zero total static-budget variance may be due to offsetting total flexible-budget and total
7-8
÷
÷
÷
÷
150,000
140,000
150,000
140,000
=
=
=
=
$6.50
$4.50
$4.50
$2.50
sales-volume variances. In this case, these two variances exactly offset each other:
Total flexible-budget variance
Total sales-volume variance
$20,000 Unfavorable
$20,000 Favorable
A closer look at the variance components reveals some major deviations from plan.
Actual
variable costs increased from $2.50 to $4.50, causing an unfavorable flexible-budget
variable cost variance of $300,000. Such an increase could be a result of, for example, a jump in
direct material prices. Alpha was able to pass most of the increase in costs onto their
customers—actual selling price increased by 44.44% [($6.50 – $4.50) $4.50], bringing about an
offsetting favorable flexible-budget revenue variance in the amount of $300,000. An increase in
the actual number of units sold also contributed to more favorable results. The company should
examine why the units sold increased despite an increase in direct material prices. For example,
Alpha’s customers may have stocked up, anticipating future increases in direct material prices.
Alternatively, Alpha’s selling price increases may have been lower than competitors’ price
increases. Understanding the reasons why actual results differ from budgeted amounts can help
Alpha better manage its costs and pricing decisions in the future. The important lesson learned
here is that a superficial examination of summary level data (Levels 0 and 1) may be insufficient.
It is imperative to scrutinize data at a more detailed level (Level 2). Had Alpha not been able to
pass costs on to customers, losses would have been considerable.
7-9
7-25
Budgeted and actual performance for the week:
Unit sold
Revenues
Direct material
Direct
manufacturing
labor
Contribution
margin
Fixed
manufacturing
costs
Operating
income
Actual
results (€)
(1)
25
2,100
385
1,176b
Flexible – Budget
Variances (€)
(2) = (1) – (3)
0
100 F
85 U
24 F
Flexible
Budget (€)
(3)
25
2,000
300
1,200c
Sales – Volume
Variances (€)
(4) = (3) – (5)
5U
400 F
60 U
240 U
Static Budget
(€)
(5)
a
30
2,400
360
1,440d
539
39 U
500
100 F
600
280
20 U
240
0
240
259
1U
260
100 F
360
a
3 workers x 40 hrs per week / 4 hrs per cabinet = 30 cabinets
(40 hrs per week *2 workers * €12 ) + (2 workers * 6 overtime hours each* €18) = €1,176
Note: actual number of hrs = (40 hrs per week *2 workers) + (2 workers * 6 overtime hours each) = 92 hrs
c
€1,440 / 30 (Budgeted DL cost per unit) x 25 units (actual units produced)
d
3 workers x 40 hrs per week x €12
b
Working(s):
Sales
Static budget
Units Price
€
30
80
Flexed
Amount Units Price
€
€
2,400
25
80
Actual
Amount Units Price
€
€
2,000
25
84
Labor
120
1,440
1,200
12
100
12
7-10
80
12
92
12
18
12.78
Amount
€
2,100
1,176
60
Materials
Contribution
Fixed costs
Profit
i.
ii.
iii.
6
360
600
240
360
50
6
300
500
240
260
55
7
385
539
280
259
Direct material price variance
(Actual price of input – Budgeted price of input) x Actual quantity of input = Price variance
(€6 - €7) x 55sq m = €55 U
Material efficiency variance
(Actual quantity of input – Budgeted quantity of input allowed for actual output) x Budgeted price of input = efficiency
variance
(50sq m – 55 sq m) x €6 = €30 U
Note: 2 sq meters of timber required to make a unit. Therefore 25 units x 2 sq meters = 50 sq meters.
Direct labor price variance
(Actual price of input – Budgeted price of input) x Actual quantity of input = Price variance
(€12 - €12.78) x 92 hrs = €72 U
Note: €12.78 = Actual costs of labor = €1,176 (see also Working table above)
Total actual hrs
92
iv.
Manufacturing labor efficiency variance
(Actual quantity of input – Budgeted quantity of input allowed for actual output) x Budgeted price of input = efficiency
variance
(100hrs – 92hrs) x €12 = €96 F
7-11
7-26
(20–30 min.) Price and efficiency variances.
1.
The key information items are:
Actual
43,000
11,000
$ 0.65
Output units (Tiles)
Input units (pounds of clay)
Cost per input unit
Budgeted
40,000
10,000
$ 0.70
Modern tiles budgets to obtain four tiles from each pound of clay.
The flexible-budget variance is $ 375 F..
Clay costs
Actual
Results
(1)
$7,150a
FlexibleBudget
Variance
(2) = (1) – (3)
$375 F
Flexible
Budget
(3)
$7,525b
Sales-Volume
Variance
(4) = (3) – (5)
$525 U
Static
Budget
(5)
$7,000c
a
11,000 × $0.65 = $7,150
43,000 × 0.25 × $0.70 = $7,525
c
40,000 × 0.25 × $0.70 = $7,000
b
2.
Actual Costs
Incurred
(Actual Input Qty.
× Actual Price)
$13,600a
Actual Input Qty.
× Budgeted Price
$14,720b
Flexible Budget
(Budgeted Input
Qty. Allowed for
Actual Output
× Budgeted Price)
$13,616c
$550 F
$175 U
Price variance
Efficiency variance
$375 F
Flexible-budget variance
a
11,000 × $0.65 = $7,150
b
11,000 × $0.70 = $7,700
c
43,000 × 0.25 × $0.70 = $7,525
3.
The favorable flexible-budget variance of $375 has two offsetting components:
(a) favorable price variance of $550––reflects the $0.65 actual purchase cost being lower
than the $0.70 budgeted purchase cost per pound.
(b) unfavorable efficiency variance of $175––reflects the actual materials yield of 3.90
tiles per pound of clay (43,000 ÷ 11,000 = 3.90) being less than the budgeted yield of
4.00 (40,000 ÷ 10,000 = 4.00). The company used more clay (materials) to make the
tiles than was budgeted.
A possible explanation may be that Modern tiles purchased lower quality clay at a lower cost per
pound.
7-12
7-27 (15 min.) Materials and manufacturing labor variances.
Direct
Materials
Actual Costs
Incurred
(Actual Input Qty.
× Actual Price)
$150,000
Actual Input Qty.
× Budgeted Price
$162,000
$12,000 F
Price variance
Flexible Budget
(Budgeted Input
Qty. Allowed for
Actual Output
× Budgeted Price)
$168,000
$6,000 F
Efficiency variance
$18,000 F
Flexible-budget variance
Direct
Mfg. Labor
$100,000
$95,000
$5,000 U
Price variance
$90,000
$5,000 U
Efficiency variance
$10,000 U
Flexible-budget variance
7-13
7-28
(20 min.) Direct materials and direct manufacturing labor variances.
1.
May 2020
Units
Direct materials
Direct labor
Total price variance
Total efficiency
variance
Actual
Results
(1)
450
Price
Variance
(2) = (1)–(3)
$1,710.0
$13,338.00 0
$ 5,535.00 $ 67.50
$1,777.5
0
U
U
Actual
Quantity 
Budgeted
Price
(3)
Efficiency
Variance
(4) = (3) – (5)
Flexible
Budget
(5)
450
$11,628.00a
$ 5,467.50c
$918.00
$364.50
U
F
$10,710.00b
$ 5,832.00d
$553.50
U
U
a
6,840 meters × $1.70 per meter = $11,628
450 lots × 14 meters per lot × $1.70 per meter = $10,710
c
675 hours × $8.10 per hour = $5,467.50
d
450 lots × 1.6 hours per lot × $8.10 per hour = $5,832
b
Total flexible-budget variance for both inputs = $1,777.50U + $553.50U = $2,331.00U
Total flexible-budget cost of direct materials and direct labor = $10,710 + $5,832 = $16,542
Total flexible-budget variance as % of total flexible-budget costs = $2,331.00 ÷ $16,542 = 14.09%
2. Efficiencies have improved in the direction indicated by the production manager—but, it is
unclear whether they are a trend or a one-time occurrence. Also, overall, variances are still 7.8
percent of flexible input budget. SallyMay should continue to use the new material, especially
considering its superior quality and feel, but it may want to keep the following points in mind:
 The new material costs substantially more than the old ($1.95 in 2019 and $1.852 in 2020
versus $1.70 per meter). Its price is unlikely to come down even more within the coming
year. Standard material price should be re-examined and possibly changed.
 SallyMay should continue to work to reduce direct materials and direct manufacturing
labor content. The reductions from May 2019 to May 2020 are a good development and
should be encouraged.
7-14
7-29
(30 min.) Price and efficiency variances, journal entries.
1. Direct materials and direct manufacturing labor are analyzed in turn:
Actual Costs
Incurred
(Actual Input Qty.
× Actual Price)
Direct
Materials
(100,000 × $4.65a)
$465,000
Actual Input Qty.
× Budgeted Price
Purchases
Usage
(100,000 × $4.50)
$450,000
(98,055 × $4.50)
$441,248
$15,000 U
Price variance
Direct
Manufacturing
Labor
a
b
Flexible Budget
(Budgeted Input
Qty. Allowed for
Actual Output
× Budgeted Price)
b
(4,900 × $31.5 )
$154,350
(9,850 × 10 × $4.50)
$443,250
$2,002 F
Efficiency variance
(4,900 × $30)
$147,000
$7,350 U
Price variance
(9,850 × 0.5 × $30) or
(4,925 × $30)
$147,750
$750 F
Efficiency variance
$465,000 ÷ 100,000 = $4.65
$154,350 ÷ 4,900 = $31.5
2.
Direct Materials Control
Direct Materials Price Variance
Accounts Payable or Cash Control
450,000
15,000
Work-in-Process Control
Direct Materials Control
Direct Materials Efficiency Variance
443,250
Work-in-Process Control
Direct Manuf. Labor Price Variance
Wages Payable Control
Direct Manuf. Labor Efficiency Variance
147,750
7,350
465,000
441,248
2,002
154,350
750
3.
Some students’ comments will be immersed in conjecture about higher prices for
materials, better quality materials, higher grade labor, better efficiency in use of materials, and so
forth. A possibility is that approximately the same labor force, paid somewhat more, is taking
slightly less time with better materials and causing less waste and spoilage.
A key point in this problem is that all of these efficiency variances are likely to be
insignificant. They are so small as to be nearly meaningless. Fluctuations about standards are
bound to occur in a random fashion. Practically, from a control viewpoint, a standard is a band
or range of acceptable performance rather than a single-figure measure.
4.
The purchasing point is where responsibility for price variances is found most often
because it is the earliest point at which Schuyler has information about prices. The production
point is where Schuyler identifies responsibility for efficiency variances. Schuyler calculates
variances at different points in time to match different responsibility areas.
7-30
(20-30 min.) Materials and manufacturing labor variances, standard costs.
1.
Direct Materials
Actual Costs
Incurred
(Actual Input Qty.
× Actual Price)
Actual Input Qty.
× Budgeted Price
(3,700 sq. mt. × €5.10)
€18,870
(3,700 sq. mt. × €5.00)
€18,500
Flexible Budget
(Budgeted Input
Qty. Allowed for
Actual Output
× Budgeted Price)
(2,000 × 2 × €5.00)
(4,000 sq. mt. × €5.00)
€20,000
$370 U
Price variance
$1,500 F
Efficiency variance
€1,130 F
Flexible-budget variance
The unfavorable materials price variance may be unrelated to the favorable materials efficiency
variance. For example, (a) the purchasing officer may be less skillful than assumed in the budget, or
(b) there was an unexpected increase in materials price per square meter due to reduced competition.
Similarly, the favorable materials efficiency variance may be unrelated to the unfavorable
materials price variance. For example, (a) the production manager may have been able to employ
higher-skilled workers, or (b) the budgeted materials standards were set too loosely.
It is also possible that the two variances are interrelated. The higher materials input price may
be due to higher-quality materials being purchased. Less material was used than budgeted due to the
high quality of the materials.
Direct Manufacturing Labor
Actual Costs
Actual Input Qty.
× Budgeted Price
Incurred
(Actual Input Qty.
× Actual Price)
(900 hrs. × €9.80)
€8,820
(900 hrs. × €10.00)
€9,000
Flexible Budget (Budgeted Input
Qty. Allowed for
Actual Output
× Budgeted Price)
(2,000 × 0.5 × €10.00)
(1,000 hrs. × €10.00)
€10,000
€180 F
€1,000 F
Price variance
Efficiency variance
€1,180 F
Flexible-budget variance
The favorable labor price variance may be due to, say, (a) a reduction in labor rates due to a
recession, or (b) the standard being set without detailed analysis of labor compensation. The
favorable labor efficiency variance may be due to, say, (a) more efficient workers being employed,
(b) a redesign in the plant enabling labor to be more productive, or (c) the use of higher quality
materials.
2.
Control
Point
Purchasing
Actual Costs
Incurred
(Actual Input Qty.
× Actual Price)
(6,000 sq. mt.× €5.10)
€30,600
Actual Input Qty.
× Budgeted Price
(6,000 sq. mt. × €5.00)
€30,000
Flexible Budget
(Budgeted Input
Qty. Allowed for
Actual Output
× Budgeted Price)
€600 U
Price variance
Production
(3,700 sq. mt.× €5.00)
€18,500
(2,000 × 2 × €5.00)
€20,000
€1,500 F
Efficiency variance
Direct manufacturing labor variances are the same as in requirement 1.
7-31
a.
(20-25 min.) Journal entries and T-accounts (continuation of 7-30).
For requirement 1 from Exercise 7-30:
Direct Materials Control
Direct Materials Price Variance
Accounts Payable Control
To record purchase of direct materials.
18,500
370
18,870
b.
Work-in-Process Control
Direct Materials Efficiency Variance
Direct Materials Control
To record direct materials used.
20,000
1,500
18,500
c.
Work-in-Process Control
Direct Manufacturing Labor Price Variance
Direct Manufacturing Labor Efficiency Variance
Wages Payable Control
To record liability for and allocation of direct labor costs..
10,000
180
1,000
8,820
b.
Direct
Materials Control
(a) 18,500 (b) 18,500
Work-in-Process Control
(b) 20,000
(c) 10,000
Wages Payable Control
(c) 8,820
Direct Materials
Price Variance
(a) 370
Direct
Manufacturing
Labor Price Variance
(c) 180
Accounts Payable Control
(a) 18,870
For requirement 2 from Exercise 7-30:
Direct Materials
Efficiency Variance
(b) 1,500
Direct Manuf. Labor
Efficiency Variance
(c) 1,000
The following journal entries pertain to the measurement of price and efficiency variances when
6,000 sq. meters of direct materials are purchased:
a.
Direct Materials Control
Direct Materials Price Variance
Accounts Payable Control
To record direct materials purchased.
30,000
600
30,600
b.
Work-in-Process Control
Direct Materials Control
Direct Materials Efficiency Variance
To record direct materials used.
20,000
18,500
1,500
Direct
Materials Control
(a) 30,000
(b) 18,500
Accounts Payable Control
(a) 30,600
Direct Materials
Price Variance
(a) 600
Work-in-Process Control
(b) 20,000
Direct Materials
Efficiency Variance
(b) 1,500
The T-account entries related to direct manufacturing labor are the same as in requirement 1. The
difference between standard costing and normal costing for direct cost items is:
Direct Costs
Standard Costs
Standard price(s)
× Standard input
allowed for actual
outputs achieved
Normal Costs
Actual price(s)
× Actual input
These journal entries differ from the normal costing entries because work-in-process control is no
longer carried at “actual” costs. Furthermore, direct materials control is carried at standard unit
prices rather than actual unit prices. Finally, variances appear for direct materials and direct
manufacturing labor under standard costing but not under normal costing.
7-32
25 min.) Price and efficiency variances, benchmarking.
1.
Direct materials
Direct labor
Variable overhead
Budgeted variable cost
Direct materials
Direct labor
Variable overhead
Budgeted variable cost
Direct materials
Direct labor
Variable overhead
Budgeted variable cost
Mineola Plant
Prices and quantities
13.50 lbs @ $ 9.20 per lb
3
hrs @ $10.15 per hr
Bayside Plant
Prices and quantities
14.00 lbs @ $ 9.00 per lb
2.7 hrs @ $10.20 per hr
Land Art
Prices and quantities
13.00 lbs @ $ 8.80 per lb
2.5 hrs @ $10.00 per hr
Cost per lot
$124.20
30.45
12.00
$166.65
Cost per lot
$126.00
27.54
11.00
$164.54
Cost per lot
$114.40
25.00
11.00
$150.40
2.
Mineola Plant
Lots
Direct Materials
Direct Labor
Actual
Results
(1)
1,000
$124,200
$ 30,450
Price
Variance
(2) = (1) – (3)
Actual
Quantity 
Budgeted
Price (3)
Efficiency
Variance
(4) = (3) – (5)
$5,400 U
$450 U
$118,800b
$ 30,000c
$4,400 U
$5,000 U
Flexible
Budgeta
(5)
1,000
$114,400
$ 25,000
a
Using Land Art’s prices and quantities as the standard:
Direct materials: (13 lbs./lot × 1,000 lots) × $8.80/lb. = $114,400
Direct labor: (2.5 hrs./lot × 1,000 lots) × $10.00/hr. = $25,000
b
(13.50 lbs./lot × 1,000 lots) × $8.80 per lb. = $118,800
c
(3 hours/lot × 1,000 lots) × $10/hr. = $30,000
Bayside Plant
Lots
Direct Materials
Direct Labor
Actual
Results
(1)
1,000
$126,000
$ 27,540
Price
Variance
(2) = (1) – (3)
Actual
Quantity 
Budgeted
Price (3)
Efficiency
Variance
(4) = (3) – (5)
$2,800 U
$540 U
$123,200b
$ 27,000c
$8,800 U
$2,000 U
Flexible
Budgeta
(5)
1,000
$114,400
$ 25,000
a
Using Land Art’s prices and quantities as the standard:
Direct materials: (13 lb./lot × 1,000 lots) × $8.80/lb. = $114,400
Direct labor: (2.5 hrs./lot × 1,000 lots) × $10.00/lb. = $25,000
b
(14 lbs./lot × 1,000 lots) × $8.80 per lb. = $123,200
c(2.7 hours/lot × 1,000 lots) × $10/hr. = $27,000
3. Using an objective, external benchmark, like that of a competitor, will preempt the possibility
of any one plant feeling that the other is being favored. That this competitor, Land Art, is
successful will also put positive pressure on the two plants to improve (note that all variances are
unfavorable). Issues that Topiary should keep in mind include the following:
 Ensure that Land Art is indeed the best and most relevant standard (for example, is there
another competitor in the marketplace which should be considered?).
 Ensure that the data is reliable.
 Ensure that Land Art is similar enough to use as a standard (if Land Art has a different
business model, for example, it may be following a strategy of lowering costs that Topiary
may not want to emulate because Topiary is trying to differentiate its products).
7-33
(45 min.)
Static and flexible budgets, service sector.
1.
Revenue (8,200 × 0.8% × $145,000)
Variable costs:
Professional labor (8 × $45 × 8,200)
Credit verification ($100 × 8,200)
Federal documentation fees ($120 × 8,200)
Courier services ($50 × 8,200)
Total variable costs
Contribution margin
Fixed administrative costs
Fixed technology costs
Operating income
Static Budget
$9,512,000
2,952,000
820,000
984,000
410,000
5,166,000
4,346,000
800,000
1,300,000
$2,246,000
2.
Actual results for third quarter 2020:
Revenue (10,250 × 0.8% × $162,000)
Variable costs:
Professional labor (9.5 × $50 × 10,250)
Credit verification ($100 × 10,250)
Federal documentation fees ($125 × 10,250)
Courier services ($54 × 10,250)
Total variable costs
Contribution margin
Fixed administrative costs
Fixed technology costs
Operating income
$13,284,000
4,868,750
1,025,000
1,281,250
553,500
7,728,500
5,555,500
945,000
_ 1,415,000
$ 3,195,500
Level 2 Analysis
Loans
Actual
Results
(1)
FlexibleBudget
Variances
(1) – (3)
10,250
0
Flexible
Budget
(3)
10,250
SalesVolume
Variances
(3) – (5)
2,050 F
Static
Budget
(5)
8,200
Revenue
$13,284,000 $1,394,000 F $11,890,000 $2,378,000 $9,512,000
Variable costs:
Professional labor
4,868,750 1,178,750 U 3,690,000
738,000 U 2,952,000
Credit verification
1,025,000
0
1,025,000
205,000 U 820,000
Federal doc. Fees
1,281,250
51,250 U 1,230,000
246,000 U 984,000
Courier services
553,500
41,000
512,500
102,500 U 410,000
Total variable costs
7,728,500 1,271,000 U 6,457,500 1,291,500 U 5,166,000
Contribution margin
5,555,500
123,000 F
5,432,500 1,086,500 F 4,346,000
Fixed administrative costs
945,000
145,000 U
800,000
0
800,000
Fixed technology costs
1,415,000
115,000 U 1,300,000
0
1,300,000
Operating income
$ 3,195,500 $ 137,000 U $ 3,332,500 $1,086,500 F $2,246,000
$137,000 U
Total flexiblebudget variance
$1,086,500 F
Total salesvolume variance
$949,500 F
Total static-budget variance
3.
Actual Costs
Incurred
(Actual Input Qty.
× Actual Price)
(1)
(10,250 × 9.5 × $50)
97,375 hrs. × $50/hr.
$4,868,750
Actual Input Qty.
× Budgeted Price
(2)
(10,250 × 9.5 × $45)
97,375 hrs. × $45/hr.
$4,381,875
$486,875 U
Price variance
Flexible Budget
(Budgeted Input
Qty. Allowed for
Actual Output
× Budgeted Price)
(3)
(10,250 × 8.0 × $45)
82,000 hrs. ×$45/hr.
$3,690,000
$691,875 U
Efficiency variance
$1,178,750 U
Flexible-budget variance
4.
Effectiveness refers to the degree to which a predetermined objective is accomplished.
One objective of StuFi professional labor is to maximize loan-based revenue (0.8% of loan
amount × number of loans). The professional staff has increased the number of loans from a
budgeted 8,200 to 10,250, a significant increase. Additionally, the average loan amount
increased from a budgeted $145,000 to $162,000. The result is an increase in revenue from the
budgeted $9,512,000 to actual $13,284,000.
With both a higher number of loans and a higher average amount per loan, there was an
increase in the effectiveness of professional labor in the third quarter of 2020.
7-34
(30 min.) Flexible budget, direct materials and direct manufacturing labor variances.
1.
Units sold
Revenues
Variance Analysis for Milan Statuary for 2020
FlexibleSalesActual
Budget
Flexible Volume
Static
Results
Variances
Budget
Variances
Budget
(1)
(2) = (1) – (3)
(3)
(4) = (3) – (5)
(5)
a
5,100
0
5,100
1,000 U
6,100a
$3,723,000b $153,000 F $3,570,000c $700,000 U $4,270,000d
$ 7,000 U $1,142,400e $224,000 F $1,366,400f
8,500 F
581,400g 114,000 F
695,400h
150,000 F 1,350,000a
0
1,350,000a
$151,500 F $3,073,800 $338,000 F $3,411,800
$304,500 F $ 496,200 $362,000 U $ 858,200
Direct materials
$1,149,400
Direct manufacturing labor 572,900a
Fixed costs
1,200,000a
Total costs
$2,922,300
Operating income
$ 800,700
a
$304,500 F
$362,000 U
Flexible-budget variance
Sales-volume variance
$57,500 U
Static-budget variance
Given
$730/unit × 5,100 units = $3,723,000
c
$700/unit × 5,100 units = $3,570,000
d
$700/unit × 6,100 units = $4,270,000
e
$224/unit × 5,100 units = $1,142,400
f
$224/unit × 6,100 units = $1,366,400
g
$114/unit × 5,100 units = $581,400
h
$114/unit × 6,100 units = $695,400
2.
b
Actual Incurred
(Actual Input Qty.
× Actual Price)
Direct materials
Actual Input Qty.
× Budgeted Price
$1,149,400a
$980,000b
Flexible Budget
(Budgeted Input
Qty. Allowed for
Actual Output ×
Budgeted Price)
$1,142,400c
$169,400 U
Price variance
$144,000 U
Efficiency variance
$7,000 U
Flexible-budget variance
Direct manufacturing labor
$572,900d
$510,000e
$581,400f
$62,900 U
$71,400 F
Price variance
Efficiency variance
$8,500 F
Flexible-budget variance
a
70,000 pounds × $16.42/pound = $1,149,400
70,000 pounds × $14/pound = $980,000
c
5,100 statues × 16 pounds/statue × $14/pound = 81,600 pounds × $14/pound = $1,142,400
d
17,000 hours × $33.70/hour = $572,900
e
17,000 hours × $30/hour = $510,000
f
5,100 statues × 3.8 hours/statue × $30/hour = 19,380 hours × $30/hour = $581,400
b
7-35
(30 min.) Variance analysis, nonmanufacturing setting
1. This is a problem of two equations and two unknowns. The two equations relate to the
number of cars detailed and the labor costs (the wages paid to the employees).
X = number of cars detailed by the experienced employee
Y = number of cars detailed by the less experienced employees (combined)
Budget:
X + Y = 280
$30X + $15Y = $6,720
Actual: X + Y
= 320
$30X + $15Y = $8,400
Substitution:
30X + 15(280 – X) = 6,720
15X = 2,520
X= 168 cars
Y=112 cars
Substitution:
30X + 15(320 – X) = 8,400
15X = 3,600
X = 240 cars
Y=80 cars
Budget: The experienced employee is budgeted to detail 168 cars (and earn
$5,040), and the less experienced employees are budgeted to detail 56 cars each
and earn $840 apiece.
Actual: The experienced employee details 240 cars (and grosses $7,200 for the
month), and the other two wash 40 each and gross $600 apiece.
2.
Cars detailed
Revenues
Variable costs
Supplies
Labor – Experienced
Labor – Less experienced
Total variable costs
Contribution Margin
Fixed costs
Operating income
a
320 × ($53,200/280)
320 × ($1,260/280)
c
320 × ($5,040/280)
d
320 × ($1,680/280)
b
Actual
Results
(1)
320
FlexibleBudget
Variances
(2)=(1) – (3)
Flexible
Budget
(3)
320
Sales Volume
Variance
(4)=(3) – (5)
Static
Budget
(5)
280
$72,000
$ 11,200 F
$60,800a
$ 7,600 F
$ 53,200
1,360
7,200
1,200
9,760
62,240
9,800
$52,440
80F
1,440U
720F
640 U
10,560 F
0
$ 10,560 F
1,440b
5,760c
1,920d
9,120
51,680
9,800
$41,880
180 U
720 U
240 U
1,140 U
6,460 F
0
$ 6,460 F
1,260
5,040
1,680
7,980
45,220
9,800
$35,420
3. Actual sales price = $72,000 ÷ 320 = $225
Sales Price Variance
= (Actual sales price – Budgeted sales price) × Actual number of offices cleaned:
= ($225 – $190) × 320
= $11,200 Favorable
Labor efficiency for experienced worker:
Standard cars expected to be completed by experienced worker based on actual number
of cars detailed = (168 ÷ 280) × 320 = 192 cars
Labor efficiency variance = Budgeted wage rate per car × (Actual cars detailed –
budgeted cars detailed)
= $30 × (240 – 192)
= $1,440 Unfavorable
Labor efficiency for less-experienced workers:
Standard cars expected to be completed by less-experienced workers based on actual
number of cars detailed = (112 ÷ 280) × 320 = 128 cars
Labor efficiency variance = Budgeted wage rate per car × (Actual cars detailed –
budgeted cars detailed)
= $15 × (80 – 128)
= $720Favorable
4. In addition to understanding the variances computed above, Marcus should attempt to
keep track of the number of cars worked on by each employee, as well as the number of
hours spent on each car. In addition, Marcus should look at the prices charged for
detailing, in relation to the hours spent on each job. It should also be considered whether
the experienced worker should be asked to take less time per car, given his prior years at
work and the fact that he is paid twice the wage rate of the less-experienced employees.
7-36
(30 mins.) Comprehensive variance analysis review.
Actual results
Units sold
Selling price per unit
Revenues (1,400 × $152)
1,400 units
$152
$212,800
Direct materials purchased and used:
Direct materials per unit
Total direct materials cost (22,000 sq. meters × $5.50)
Direct labor:
Actual direct labor rate per hour
Total direct labor costs (6,800 hours × $5.00)
Variable costs:
Variable cost per unit
Total variable costs (6,800 hours × $2.21)
Fixed overheads
Static Budgeted Amounts
Units sold
Selling price per unit
Revenues (1,000 hours × $150)
Direct materials purchased:
Direct materials per unit
Total direct materials costs (1,000 units × $67.50)
Direct labor:
Direct labor rate per hour
Total direct labor cost (1,000 units × $30.00)
Variable costs:
Variable costs per unit
Total variable costs (1,000 units × $15.00)
Fixed costs
1.
Revenues
Variable costs
Direct materials
Direct labor
Variable costs
Total variable costs
Contribution margin
Fixed costs
Operating income
2. Actual operating income
Static-budget operating income
Actual
Results
$212,800
121,000
34,000
15,000
170,000
42,800
6,000
$36,800
$36,800
30,000
$5.50
$121,000
$5.00
$34,000
$2.21
$15,000
$6,000
1,000
$150
$150,000
$67.50
$67,500
$30.00
$30,000
$15.00
$15, 000
$7,500
Static-Budget
Amounts
$150,000
67,500
30,000
15,000
112,500
37,500
7,500
$30,000
Total static-budget variance
$ 6,800 F
Flexible-budget-based variance analysis for June:
Actual
Results
(1)
Units sold
1,400
Flexible-Budget
Variances
(2) = (1) – (3)
Flexible
Budget
(3)
0
SalesVolume
Variances
(4) = (3) – (5)
1,400
400
$
Static
Budget
(5)
1,000
60,000
Revenues
Variable costs
Direct materials
Direct labor
Variable costs
Total variable costs
Contribution margin
Fixed costs
$212,800
$ 2,800 F
$210,000 F
$150,000
121,000
34,000
15,000
170,000
42,800
6,000
26,500 U
8,000 F
6,000 F
12,500 U
9,700 U
1,500 F
94,500
42,000
21,000
157,500
52,500
7,500
27,000 U
12,000 U
6,000 U
45,000 U
15,000 F
0
67,500
30,000
15,000
112,500
37,500
7,500
Operating income
$36,800
$8,200 U
$45,000
$15,000 F
$30,000
$6,800 F
Total static-budget variance
$8,200 U
Total flexible-budget
variance
3.
4.
5.
Flexible-budget operating income = $45,000.
Flexible-budget variance for operating income = $8,200 U.
Sales-volume variance for operating income = $15,000 U.
$15,000 F
Total sales-volume
variance
7-37
(20 min.) Possible causes for price and efficiency variances
1.
Actual Costs
Incurred
(Actual Input Qty.
× Actual Price)
(1)
Direct
Materials
€ 72,500
Actual Input Qty.
× Budgeted Price
(2)
(2,640,000 × € 0.029)
€ 76,560
€ 4,060 F
€ 6,960 U
Price variance
Direct
Manufacturing
Labor
€ 1540 F
Price variance
2.
Efficiency variance
(1,300 × € 13)
€ 16,900
€ 15,360
Flexible Budget
(Budgeted Input
Qty. Allowed for
Actual Output
× Budgeted Price)
(3)
(12,000 × 200 × € .029)
€ 69,600
(12,000 × (1/10) × € 13)
€ 15,600
€ 1,300 U
Efficiency variance
The favorable materials price variance, paired with the unfavorable materials efficiency
variance could be an indication that the company purchased less expensive ingredients,
but at the cost of lower quality. Lower quality ingredients may have resulted in a higher
than standard number of rejected units. That theory is supported by the unfavorable labor
efficiency variance, as rejects cause both an unfavorable materials efficiency and
unfavorable labor efficiency variance.
The favorable labor price variance suggests that less experienced workers may
have worked more hours than more experienced workers. Those workers would have
probably worked slower, and their lack of experience may have caused higher than
normal rejects or waste.
The company should look at the number of rejected units, and if they are indeed
abnormal, determine the cause of the rejects. Is it because of faulty materials, underskilled workers, or a combination of both? Perhaps additional training will help. If rejects
are not the problem, employees may be wasting both time and materials.
7-38
(35 min.) Material cost variances, use of variances for performance evaluation
1. Materials Variances
Actual Costs
Incurred
(Actual Input Qty.
× Actual Price)
Direct
Materials
(5,200 × $17a)
$88,400
Actual Input Qty.
× Budgeted Price
Purchases
Usage
(5,200 × $18)
(4,700 × $18)
$93,600
$84,600
$5,200 F
Price variance
a
Flexible Budget
(Budgeted Input Qty. Allowed
for Actual Output
× Budgeted Price)
(400 × 8 × $18)
(3,200 × $18)
$57,600
$27,000 U
Efficiency variance
$88,400 ÷5,200 = $17
2. The favorable price variance is due to the $1 difference ($18 - $17) between the standard
price based on the previous suppliers and the actual price paid through the on-line
marketplace. The unfavorable efficiency variance could be due to several factors
including inexperienced workers and machine malfunctions. But the likely cause here is
that the lower-priced titanium was lower quality or less refined, which led to more waste.
The labor efficiency variance could be affected if the lower quality titanium caused the
workers to use more time.
3. Switching suppliers was not a good idea. The $5,200 savings in the cost of titanium was
outweighed by the $27,000 extra material usage. In addition, the $27,000 U efficiency
variance does not recognize the total impact of the lower quality titanium because, of the
5,200 pounds purchased, only 4,700 pounds were used. If the quantity of materials used
in production is relatively the same, Best Bikes could expect the remaining 500 lbs to
produce approximately 40 more units. At standard, 40 more units should take 40 × 8 =
320 lbs. There could be an additional unfavorable efficiency variance of
(500  $18)
$9,000
(40 × 8 × $18)
$5,760
$3,240U
4. The purchasing manager’s performance evaluation should not be based solely on the
price variance. The short-run reduction in purchase costs was more than offset by higher
usage rates. His evaluation should be based on the total costs of the company as a whole.
In addition, the production manager’s performance evaluation should not be based solely
on the efficiency variances. In this case, the production manager was not responsible for
the purchase of the lower-quality titanium, which led to the unfavorable efficiency scores.
In general, it is important for Johnson to understand that not all favorable material price
variances are “good news,” because of the negative effects that can arise in the
production process from the purchase of inferior inputs. They can lead to unfavorable
efficiency variances for both materials and labor. Johnson should also that understand
efficiency variances may arise for many different reasons and she needs to know these
reasons before evaluating performance.
5. Variances should be used to help Best Bikes understand what led to the current set of
financial results, as well as how to perform better in the future. They are a way to
facilitate the continuous improvement efforts of the company. Rather than focusing solely
on the price of titanium, Bentfield can balance price and quality in future purchase
decisions.
6. Future problems can arise in the supply chain. Bentfield may need to go back to the
previous suppliers. But Best Bikes’ relationship with them may have been damaged and
they may now be selling all their available titanium to other manufacturers. Lower quality
bicycles could also affect Best Bikes’ reputation with the distributors, the bike shops and
customers, leading to higher warranty claims and customer dissatisfaction, and decreased
sales in the future.
7-39
(30 min.) Direct manufacturing labor and direct materials variances, missing data.
1.
Direct mfg. labor
Flexible Budget
(Budgeted Input
Qty. Allowed for
Actual Input Qty. Actual Output
× Budgeted Price × Budgeted Price)
$586,300b
$786,500c
Actual Costs
Incurred (Actual
Input Qty.× Actual Price)
$594,500a
$8200 U
Price variance
$200,200 F
Efficiency variance
$192,000 F
Flexible-budget variance
a
Given (or 41,000 hours × $14.50/hour)
41,000 hours × $14.30/hour = $586,300
c
5,500 units × 10 hours/unit × $14.30/hour = $786,500
b
2.
The favorable direct materials efficiency variance of $1,700 indicates that fewer pounds
of direct materials were used than the budgeted quantity allowed for actual output.
$1,700 efficiency variance
= = $2 per pound budgeted price = 850 pounds
Budgeted pounds allowed for the output achieved = 5,500 × 40 = 220,000 pounds
Actual pounds of direct materials used = 220,000 – 850 = 219,150 pounds
3. Actual price paid per pound = 432,000/160,000
= $2.70 per pound
4.
Actual Costs Incurred
(Actual Input × Actual Price)
$432,000a
Actual Input ×
Budgeted Price
$320,000b
$112,000 U
Price variance
a
b
Given
160,000 pounds × $2/pound = $320,000
7-40
1.
(35 min.) Direct materials efficiency, mix, and yield variances
Peanuts ($1 × 50 cups)
Dried cranberries ($2 × 30 cups)
Chocolate pieces ($3 × 20 cups)
Budgeted cost per batch
$
$
50
60
60
170
Number of batches
Budgeted Cost
× 100
$17,000
2. Solution Exhibit 7-40A presents the total price variance ($22 F), the total efficiency
variance ($820 U), and the total flexible-budget variance ($798 U).
SOLUTION EXHIBIT 7-40A
Columnar presentation of direct materials price and efficiency variances for GoodFoods
3. Solution Exhibit 7-40B presents the total direct materials yield ($1700 U) and mix
variances ($880 F).
SOLUTION EXHIBIT 7-40A
Columnar presentation of direct materials yield and mix variances for GoodFoods
4.
The total mix variance combines with the total yield variance to equal the total efficiency
variance calculated in part 2. The direct materials mix variance of $880 F indicates that the actual
product mix uses relatively more of less-expensive ingredients than planned. In this case, the actual mix
contains more peanuts while using fewer dried cranberries, and only slightly more chocolate pieces.
The direct materials yield variance of $1700 U occurs because the amount of total inputs needed
(11,000 cups) exceeded the budgeted amount (10,000 cups) expected to produce 100 batches. The
direct materials yield variance is significant enough to be investigated. The mix variance may be within
expectations but should be monitored since it is favorable largely due to the use of fewer dried
cranberries, which is considered an important element of the product’s appeal to customers.
7-41
(20–30 min.) Direct materials and manufacturing labor variances, solving nknowns.
All given items are designated by an asterisk.
Direct
Manufacturing
Labor
Actual Costs
Incurred
(Actual Input Qty.
× Actual Price)
Actual Input Qty.
× Budgeted Price
Flexible Budget
(Budgeted Input
Qty. Allowed for
Actual Output
× Budgeted Price)
(2,225 × $16.76)
$37,300
(2,225 × $16*)
$35,600
(4,700* × 0.5* × $16*)
$37,600
$1,700 U*
Price variance
Direct
Materials
(10,600 × $3.42)
$36,300*
Purchases
(10,600 × $3*)
$31,800
$4,500 U*
Price variance
1. 4,700 units × 0.5 hours/unit = 2,350 hours
$2,000 F*
Efficiency variance
Usage
(10,367 × $3*)
$31,100
(4,700* × 2* × $3*)
$28,200
$2,900 U*
Efficiency variance
2. Flexible budget – Efficiency variance = $37,600 – $2,000 = $35,600
Actual dir. manuf. labor hours = $35,600 ÷ Budgeted price of $16/hour = 2,225 hours
3. $35,600 + Price variance, $1,700 = $37,300, the actual direct manuf. labor cost
Actual rate = Actual cost ÷ Actual hours = $37,300 ÷ 2,225 hours = $17/hour (rounded)
4. Standard qty. of direct materials = 4,700 units × 2 pounds/unit = 9,400 pounds
5. Flexible budget + Dir. matls. effcy. var. = $28,200 + $2,900 = $31,100
Actual quantity of dir. matls. used = $31,100 ÷ Budgeted price per lb
= $31,100 ÷ $3/lb = 10,367 lbs
6. Actual cost of direct materials, $36,300 – Price variance, $4,500 = $31,800
Actual qty. of direct materials purchased = $31,800 ÷ Budgeted price, $3/lb = 10,600 lbs.
7. Actual direct materials price = $36,300 ÷ 10,600 lbs = $3.42 per lb
7-42 (20 min.) Direct materials and manufacturing labor variances, journal entries
1.
Direct Materials:
Actual Costs
Incurred
(Actual Input Qty.
× Actual Price)
Wool (given)
$9,000
Actual Input Qty.
× Budgeted Price
3,500 $3.40
$11,900
Flexible Budget
(Budgeted Input
Qty. Allowed for
Actual Output
× Budgeted Price)
20013 $3.40
$8,840
$2,900 F
$3,060 U
Price variance
Efficiency variance
$160 U
Flexible-budget variance
Direct Manufacturing Labor:
Actual Costs
Incurred
(Actual Input Qty.
× Actual Price)
(given)
$5,520
Actual Input Qty.
× Budgeted Price
580 $9
$5,220
Flexible Budget
(Budgeted Input
Qty. Allowed for
Actual Output
× Budgeted Price)
200 3 $9
$5,400
$300 U
Price variance
$180 F
Efficiency variance
$120 F
Flexible-budget variance
2.
Direct Materials Price Variance (time of purchase = time of use)
Direct Materials Control
11,900
Direct Materials Price Variance
2,900
Accounts Payable Control or Cash
9,000
Direct Materials Efficiency Variance
Work in Process Control
Direct Materials Efficiency Variance
Direct Materials Control
Direct Manufacturing Labor Variances
8,840
3,060
11,900
Work in Process Control
Direct Mfg. Labor Price Variance
Direct Mfg. Labor Efficiency Variance
Wages Payable or Cash
5,400
300
180
5,520
3.
Plausible explanations for the above variances include that Zanella paid a little less for
the wool, but the wool was lower quality (more knots in the yarn that had to be cut out), and
workers had to use more of it. Zanella used more experienced workers in April than she usually
does. This resulted in payment of higher wages per hour, but the new workers were more
efficient and took fewer hours than normal. However, overall, the higher wage rates resulted in
Zanella’s total wage bill being higher than expected.
7-43
(30 min.) Use of materials and manufacturing labor variances for benchmarking
1.
Unit variable cost (dollars) and component percentages for each firm:
Firm A
DM
DL
VOH
Total
2.
$10.80
11.20
12.80
$34.80
31.0%
32.2%
36.8%
100.0%
Firm B
$ 9.45
13.20
14.40
$37.05
25.5%
35.6%
38.9%
100.0%
Variance analysis for Firm A using Firm B as the standard.
The Direct Materials Price Variance is computed as:
=
=
(Firm A Price – Firm B Price) × Firm A Usage
($4.80 - $5.25) × 2.25 oz.
$1.0125 F
The Direct Materials Efficiency Variance is computed as follows:
=
=
(Firm A Usage – Firm B Usage) x Firm B Price
(2.25 oz. – 1.80 oz.) × $5.25
$2.3625 U
The Direct Labor Price Variance is computed as:
=
=
(Firm A Rate – Firm B Rate) × Firm A Hours
($14.00 – $11.00) × 0.80
$2.40 U
The Direct Labor Efficiency Variance is computed as follows:
=
=
(Firm A Usage – Firm B Usage) × Firm B Rate
(0.80 hrs. – 1.20 hrs.) × $11.00
$4.40 F
3.
To: Controller
From: Junior Accountant
Re: Benchmarking & productivity improvements
Date: September 15, 2020
Benchmarking advantages
- We can see how productive we are relative to our closest competitor and the industry
benchmark
- We can see the specific areas in which there may be opportunities for us to reduce costs
Benchmarking disadvantages
- Our closest competitor is targeting the market for high-end and custom-made lenses. I'm
not sure that looking at their costs helps with understanding ours better
- We may focus too much on cost differentials and not enough on differentiating ourselves,
maintaining our competitive advantages, and growing our margins
Areas to discuss
- We may want to find out whether the glass used by Firm B is of better quality since Firm B
uses less glass per lens. It pays more per oz. of glass than we do.
- We may want to analyze the wage rate we are paying our employees. We may be hiring
higher skilled labor because the labor efficiency variance is favorable compared to Firm B
resulting in lower labor cost per lens.
- It is interesting that the trade association benchmarks fall in between the various quantities
and prices for materials, labor and overhead.
7-44
(35 min.) Direct manufacturing labor variances: price, efficiency, mix and yield.
1.
George ($30 × 6 hrs.)
Earl ($20 × 4 hrs.)
Cost per guitar
Number of guitars
Total budgeted cost
$
$
$
180
80
260
× 25 units
6,500
2. Solution Exhibit 7-44A presents the total price variance ($0), the total efficiency variance
($10 U), and the total flexible-budget variance ($10U).
Total direct labor price variance can also be computed as:
Total direct labor price variance can also be computed as:
Direct labor price variance for each input = (Actual price − Budgeted price) ×
Actual quantity
George = ($30 – $30) × 145
= $0
Earl = ($20 – $20) × 108
= 0
Total direct labor price variance
$0
3.
4. Solution Exhibit 7-44B presents the total direct labor yield and mix variances for Trevor
Joseph Guitars.
The total direct labor yield variance can also be computed as the sum of the direct labor yield
variances for each input:
George = (253 – 250) × 0.60 × $30 = 3 × 0.60 × $30 = $54 U
Earl = (253 – 250) × 0.40× $20 = 3 × 0.40 × $20 = 24 U
Total direct labor yield variance
= $78 U
The total direct labor mix variance can also be computed as the sum of the direct labor mix
variances for each input:
George = (0.573 – 0.60) × 253 × $30 = 0.027 × 253 × $30 = $205 F
Earl = (0.427 – 0.40) × 253 × $20 = –0.027 × 253 × $20 = 137 U
Total direct labor mix variance
= $68 F
The sum of the direct labor mix variance and the direct labor yield variance equals the direct
labor efficiency variance. The favorable mix variance arises from using more of the cheaper
labor (and less of the costlier labor) than the budgeted mix. The yield variance indicates that the
guitars required more total inputs (253 hours) than expected (250 hours) for the production of 25
guitars. Both variances are relatively small and probably within tolerable limits. It is likely that
Earl, who is less experienced, worked more slowly than George, which caused the unfavorable
yield variance. Trevor Joseph should be careful that using more of the cheaper labor does not
reduce the quality of the guitar or how customers perceive it.
1. 7-45
(30 min.)
Actual Costs
Incurred
(Actual Input Qty.
× Actual Price)
Direct
Materials
(820,000* × $1.97a)
$1,615,400
Direct-cost and selling price variances. Materials Variances
Actual Input Qty.
× Budgeted Price
Purchases
Usage
(820,000* × $2*) (800,000* × $2*)
$1,640,000
$1,600,000
$24,600 F*
Price variance
a
Flexible Budget
(Budgeted Input Qty. Allowed
for Actual Output
× Budgeted Price)
(1.2 yds* × 660,000 × $2*)
(792,000 × $2)
$1,584,000
$16,000 U*
Efficiency variance
$1,615,400 ÷820,000 = $1.97
Actual Costs
Incurred
(Actual Input Qty.
× Actual Price)
Direct
Manufacturing
Labor
Flexible Budget
(Budgeted Input
Qty. Allowed for
Actual Output
× Budgeted Price)
Actual Input Qty.
× Budgeted Price
(530,000 × $15.05)
$7,976,500*
$26,500 U*
Price variance
(530,000 × $15*)
$7,950,000
(660,000* × 0.8 × $15*)
$7,920,000
$30,000 U*
Efficiency variance
1. 800,000 yds. DM used × $2/yd. = $1,600,000 − $16,000 U DM Eff Var. = $1,584,000 Flex Budget
Flexible budget $1,584,000 ÷ Budgeted price of $2 per yd. = Budgeted input allowed 792,000 yds.
Budgeted input allowed 792,000 yds. ÷ 1.2 yds. per shirts = 660,000 shirts produced
2. $1,640,000 (820,000 × $2) − $26,400 F DM Price Variance = $1,615,400 Actual Cost DM purchased
Actual Cost DM purchased, $1,615,400 ÷ 820,000 yds. = $1.97 per yd.
3. $7,976,500 Actual DL cost ÷ $15.05 DL cost per hour = 530,000 DL hours worked
4. Actual DL Cost $7,976,500 – DL Price Variance $26,500 U = Actual DL × Budg. price $7,950,000
Actual DL × Budgeted price, $7,950,000 ÷ 530,000 DL hrs. = $15/ DL per hr.
5. $7,950,000 – DL Efficiency Var. $30,000 U = $7,920,000
$7,920,000 ÷ $15 DL std. rate = 528,000 std. DL hrs.
528,000 std. DL hrs. ÷ 660,000 shirts produced = 0.8 DL hrs. per shirt
7-46
(35 min.) Variances in the service sector
1.
Skilled ($30 × 4 hrs.)
Unskilled ($12 × 1 hrs.)
Cost per job
Number of jobs
Total budgeted cost
$
120
12
$
132
× 800 units
$105,600
2. Solution Exhibit 7-46A presents the total price variance ($632 F), the total efficiency variance
($1,524 U), and the total flexible-budget variance ($ 892U).
 SOLUTION EXHIBIT 7-46A
Columnar Presentation of Direct Labor Price and Efficiency Variances for Clean Ride Enterprises
Skilled
Unskilled
Actual Costs
Incurred
(Actual Input Quantity
× Actual Price)
(1)
$ 99,540
6,952
$106,492
Flexible Budget
(Budgeted Input Quantity
Allowed for Actual Output
× Budgeted Price)
(3)
3,200 × $30 = $ 96,000
800 × $12 =
9,600
$105,600
Actual Input Quantity
× Budgeted Price
(2)
3,318 × $30 = $99,540
632 × $12 =
7,584
$107,124
$632 F
Total price variance
$1,524 U
Total efficiency variance
$892 U
Total flexible-budget variance
F = favorable effect on operating income; U = unfavorable effect on operating income
3. In a company where there is a mixture of workers, some at higher wages and others at lower,
all working on the same projects, an unfavorable efficiency variance can be the result of which
employees worked on the project, not just how many hours were spent. If higher paid workers
worked more than their standard percentage of the time, an unfavorable efficiency variance will
result.
4.
Skilled:
Unskilled:
Total
Actual
Quantity
of Input
3,318 hours
632 hours
3,950 hours
Actual
Mix
84.0%
16.0%
100.0%
Budgeted Quantity
of Input for Actual Output
4 hours × 800 units = 3,200 hours
1 hours × 800 units =
800 hours
4,000 hours
Budgeted
Mix
80%
20%
100%
5. Solution Exhibit 7-46B presents the total direct labor yield and mix variances for Relaxing
Day spa.
 SOLUTION EXHIBIT 7-46B
Columnar Presentation of Direct Labor Yield and Mix Variances for Relaxing Day spa
Actual Total Quantity
of All Inputs Used
× Actual Input Mix
× Budgeted Price
(1)
Skilled: 3,950 × 0.84 × $30 = $ 99,540
Unskilled: 3,950 × 0.16 × $12 =
7,584
$107,124
Actual Total Quantity
of All Inputs Used
× Budgeted Input Mix
× Budgeted Price
(2)
3,950 × 0.80 × $30 = $ 94,800
3,950 × 0.20 × $12 =
9,480
$104,280
Flexible Budget:
Budgeted Total Quantity of
All Inputs Allowed for
Actual Output ×
Budgeted Input Mix
× Budgeted Price
(3)
3,000 × 0.60 × $20 = $ 96,000
3,000 × 0.40 × $10 =
9,600
$105,600
$2,844 U
$1,320 F
Total mix variance
Total yield variance
$1,524 U
Total efficiency variance
F = favorable effect on operating income; U = unfavorable effect on operating income.
6. While the efficiency variance was unfavorable, it was due to the mix of labor, not the total
hours used. The unfavorable mix variance is the result of a higher than standard percentage of
skilled labor (84% vs. 80%) used. The yield variance, which is a more accurate measure of
hours used, is favorable because total hours (3,950) were actually lower than the standard for 800
detail jobs (3,000). The skilled labor workers were probably able to work more quickly than the
unskilled.
In light of the information regarding the vacancies in the unskilled positions, last month
could be treated as an outlier (especially in terms of the mix of labor employed), and more
normal variances will likely follow in future months. While it is recommended that variances be
calculated monthly, no corrective action with the employees appears necessary but hiring in the
proper mix could reduce these variances.
7-47
(30 min.) Price and efficiency variances, benchmarking and ethics.
1. Budgeted navigation systems per unit = 4,080 systems ÷ 4,000 units = 1.02 systems
Budgeted cost of navigation system = $81,600 ÷ 4,080 units = $20 per system
Budgeted sheets of polarized glass per unit = 800 sheets ÷ 4,000 units = 0.20 sheets
Budgeted cost of sheet of polarized glass = $40,000 ÷ 800 sheets = $50 per sheet
Budgeted ounces of specialty plastic per unit = 4,000 ounces ÷ 4,000 units = 1 ounce per unit
Budgeted cost of specialty plastic = $12,000 ÷ 4,000 ounces = $3 per ounce
Budgeted direct manufacturing labor cost per hour ($36,000 ÷ 2,000) = $18 per hour
Budgeted direct manufacturing labor hours per unit = 2,000 hours ÷ 4,000 units = 0.50 hours
per unit
Actual output achieved = 4,400 XS units
Actual Costs
Incurred
(Actual Input Qty.
× Actual Price)
Navigation
Systems
$89,000
Actual Input Qty.
× Budgeted Price
(4,450 × $20)
$89,000
$0
Price variance
Polarized
Glass
(816 × $50)
$40,800
$40,300
$500 F
Price variance
Plastic
Casing
(4,250 × $3)
$12,750
$12,500
$250 F
Price variance
Direct
Manufacturing
Labor
(2,040 × $18)
$36,720
$37,200
$480 U
Price variance
Flexible Budget
(Budgeted Input
Qty. Allowed for
Actual Output
× Budgeted Price)
(4,400 × 1.02 × $20)
$89,760
$760 F
Efficiency variance
(4,400 × 0.20 × $50)
$44,000
$3,200 F
Efficiency variance
(4,400 × 1 × $3)
$13,200
$450 F
Efficiency variance
(4,400 × 0.50 × $18)
$39,600
$2,880 F
Efficiency variance
2. Actions employees may have taken include:
(a) Adding steps that are not necessary in working on a GPS unit.
(b) Taking more time on each step than is necessary.
(c) Creating problem situations so that the budgeted amount of average downtime and
rates of spoilage of materials will be overstated.
(d)
Creating defects in units so that the budgeted amount of average rework will be
overstated.
Employees may take these actions for several possible reasons.
(a) They may be paid on a piece-rate basis with incentives for above-budgeted
production.
(b) They may want to create a relaxed work atmosphere, and a less demanding standard
can reduce stress.
(c) They have a “them vs. us” mentality rather than a partnership perspective.
(d) They may want to gain all the benefits that ensue from superior performance (job
security, wage rate increases) without putting in the extra effort required.
This behavior is unethical if it is deliberately designed to undermine the credibility of the
standards used at Sunto Scientific.
3.
If Williams does nothing about standard costs, his behavior will violate the “Standards of
Ethical Conduct for Management Accountants.” In particular, he would be violating the
(a) standards of competence, by not performing technical duties in accordance with
relevant standards;
(b) standards of integrity, by passively subverting the attainment of the organization’s
objective to control costs; and
(c) standards of credibility, by not communicating information fairly and not disclosing
all relevant cost information.
4.
Williams should discuss the situation with Kelso and point out that the standards are lax
and that this practice is unethical. If Kelso does not agree to change, Williams should escalate the
issue up the hierarchy in order to effect change. If organizational change is not forthcoming,
Williams should be prepared to resign rather than compromise his professional ethics.
5.
are
Main pros of using Competitive Intelligence Institute information to compute variances
(a) Highlights to Sunto in a direct way how it may or may not be cost-competitive.
(b) Provides a “reality check” to many internal positions about efficiency or
effectiveness.
Main cons are
(a) Sunto (and the Savannah plant in particular) may not be comparable to companies in
the database.
(b) Cost data about other companies may not be reliable.
(c) Cost of Competitive Intelligence Institute reports.
Try It! 7-1
(a) Static-budget variance for revenues = (1,500 units × $190) − (1,400 units × $200)
= $285,000 − $280,000
= $5,000 F
(b) Static-budget variance for variable costs = $162,750 − (1,400 units × $110)
= $8,750 U
(c) Static-budget variance for fixed costs = $75,000 − $77,000
= $2,000 F
(d) Static-budget variance for operating income = $1,750 U
Units sold
Revenues
Variable costs
Contribution margin
Fixed costs
Operating income
Actual
Results
1,500
Static
Budget
1,400
Static-Budget
Variance
100 F
$285,000
162,750
$122,250
75,000
$ 47,250
$280,000
154,000
$126,000
77,000
$ 49,000
$5,000
8,750
3,750
2,000
$1,750
F
U
U
F
U
Try It! 7-2
(a) Flexible budget for revenues = Actual units × Budgeted selling price per unit
= 1,500 units × $200
= $300,000
(b) Flexible budget for variable costs = Actual units × Budgeted variable cost per unit
= 1,500 units × $110
= $165,000
(c) Flexible budget for fixed costs = Static budget
= $77,000
(d) Flexible budget for operating income = $300,000 − $165,000 − $77,000
= $58,000
Try It! 7-3
Variance Analysis for Jay Draperies
Units sold
Revenues (a)
Variable costs (b)
Contribution margin
Fixed costs (c)
Operating income (d)
Actual
Results
(1)
1,500
$285,000
162,750
122,250
75,000
$ 47,250
Level 2
FlexibleBudget
Variances
(2) = (1)-(3)
$ 15,000 U
2,250 F
12,750 U
2,000 F
$10,750 U
Flexible
Budget
(3)
1,500
$300,000
165,000
135,000
77,000
$ 58,000
$10,750 U
Flexible-budget variance
Level 1
Sales Volume
Variance
(4) = (3)-(5)
$20,000 F
11,000 U
9,000 F
0
$ 9,000 F
a. Direct materials variances:
Actual unit cost
= $67,200 ÷ 14,000 square yards
= $4.80 per square yard
Price variance
= 14,000 × ($4.80 − $5.00)
= $2,800 F
Efficiency variance = $5.00 × [14,000 − (1,500 × 10)]
= $5,000 F
b. Direct manufacturing labor variances:
Actual labor rate
= $95,550 ÷ 7,800 hours
= $12.25 per hour
Price variance
= 7,800 × ($12.25 − $12.00)
= $1,950 U
Efficiency variance = $12.00 × (7,800 − 1,500 × 5)
= $3,600 U
$280,000
154,000
126,000
77,000
$ 49,000
$ 9,000 F
Sales-volume variance
$1,750 U
Static-budget variance
Try It! 7-4
Static
Budget
(5)
1,400
CHAPTER 8
FLEXIBLE BUDGETS, OVERHEAD COST VARIANCES, AND
MANAGEMENT CONTROL
8-1
Effective planning of variable overhead costs involves:
1. Planning to undertake only those variable overhead activities that add value for
customers using the product or service, and
2. Planning to use the drivers of costs in those activities in the most efficient way.
8-2
Features to be considered in planning variable overhead costs – the focus of management
is on the activities that create a superior product or service for their customers and eliminate
activities that do not add value.
Planning fixed overhead costs – managers undertake essential activities and plan to be efficient
in such undertakings by choosing the appropriate level of capacity that will be of benefit to the
organization.
8-3
Since both IFRS and U.S. GAAP require organizations to report actual incomes and
expenses in financial statements, standard costing cannot be used in year -end financial
statements. It represents predetermined costs assigned for units of material, labor and other
costs of production for a specific period and the actual costs incurred may be different, thus
creating a ‘variance.’ Standard costing is used for internal management decision making,
especially in those organizations with repetitive business processes. It helps managers make
informed decisions for effective cost allocation and evaluation of production performance.
8-4
Steps in developing a budgeted variable-overhead cost rate are:
1. Choose the period to be used for the budget,
2. Select the cost-allocation bases to use in allocating variable overhead costs to the
output produced,
3. Identify the variable overhead costs associated with each cost-allocation base, and
4. Compute the rate per unit of each cost-allocation base used to allocate variable
overhead costs to output produced.
8-5
A flexible budget is designed to adjust the permitted cost levels to suit the level of
activity attained. This is usually achieved by analyzing costs into their variable and fixed
elements so that the budget may be adjusted according to the actual level of activity.
8-6
Possible reasons for a favorable variable-overhead efficiency variance are:
 Workers more skillful in using machines than budgeted,
 Production scheduler was able to schedule jobs better than budgeted, resulting in
lower-than-budgeted machine-hours,
 Machines operated with fewer slowdowns than budgeted, and
 Machine time standards were overly lenient.
8-1
8-7
A direct materials efficiency variance indicates whether more or less direct materials
were used than was budgeted for the actual output achieved. A variable manufacturing overhead
efficiency variance indicates whether more or less of the chosen allocation base was used than
was budgeted for the actual output achieved.
8-8
Steps in developing a budgeted fixed-overhead rate are
1. Choose the period to use for the budget,
2. Select the cost-allocation base to use in allocating fixed overhead costs to output
produced,
3. Identify the fixed-overhead costs associated with each cost-allocation base, and
4. Compute the rate per unit of each cost-allocation base used to allocate fixed overhead
costs to output produced.
8-9
The variable overhead flexible-budget variance can be explained by calculating the
spending variance and the efficiency variance.
It indicates that the actual variable manufacturing overhead exceeded the flexible -budget
amount by €8,000.
8-10 For planning and control purposes, fixed overhead costs are a lump sum amount that is
not controlled on a per-unit basis. In contrast, for inventory costing purposes, fixed overhead
costs are allocated to products on a per-unit basis.
8-11 An important caveat is what change in selling price might have been necessary to attain
the level of sales assumed in the denominator of the fixed manufacturing overhead rate. For
example, the entry of a new low-price competitor may have reduced demand below the
denominator level if the budgeted selling price was maintained. An unfavorable productionvolume variance may be small relative to the selling-price variance had prices been dropped to
attain the denominator level of unit sales.
8-2
8-12 A strong case can be made for writing off an unfavorable production-volume variance to
cost of goods sold. The alternative is prorating it among inventories and cost of goods sold, but
this would “penalize” the units produced (and in inventory) for the cost of unused capacity, i.e.,
for the units not produced. But, if we take the view that the denominator level is a “soft”
number—i.e., it is only an estimate, and it is never expected to be reached exactly, then it makes
more sense to prorate the production volume variance—whether favorable or not—among the
inventory stock and cost of goods sold. Prorating a favorable variance is also more conservative:
it results in a lower operating income than if the favorable variance had all been written off to
cost of goods sold. Finally, prorating also dampens the efficacy of any steps taken by company
management to manage operating income through manipulation of the production volume
variance. In sum, a production-volume variance need not always be written off to cost of goods
sold.
8-13
The four variances are:
 Variable manufacturing overhead costs
 spending variance
 efficiency variance
 Fixed manufacturing overhead costs
 spending variance
 production-volume variance
8-14 Interdependencies among the variances could arise for the spending and efficiency
variances. For example, if the chosen allocation base for the variable overhead efficiency
variance is only one of several cost drivers, the variable overhead spending variance will include
the effect of the other cost drivers. As a second example, interdependencies can be induced when
there are misclassifications of costs as fixed when they are variable, and vice versa.
8-15 Flexible-budget variance analysis can be used in the control of costs in an activity area by
isolating spending and efficiency variances at different levels in the cost hierarchy. For example,
an analysis of batch costs can show the price and efficiency variances from being able to use
longer production runs in each batch relative to the batch size assumed in the flexible budget.
8-3
8-16 Choice ‘a’ is not correct.
Choice ‘b’ is correct.
Choice ‘c’ is incorrect.
Choice ‘d’ is incorrect.
8-17 Choice ‘a’ is correct. $346,400, the same lump sum as the static budget
Choice ‘b’ is incorrect.
Choice ‘c’ is incorrect.
Choice ‘d’ is incorrect.
8-18 Choice "c" is correct. The variable overhead efficiency variance is calculated as the
difference between actual direct labor hours used versus standard (budgeted) direct labor hours
allowed, multiplied by the standard variable overhead rate. If standard hours are below actual
hours, this would mean more hours were used than expected and would therefore cause an
unfavorable variance.
Choice "a" is incorrect. Overall overhead variance is calculated as actual costs versus allocated
costs, and this situation would be favorable because allocated is above actual.
Choice "b" is incorrect. The volume variance focuses on actual versus budgeted units of
production.
Choice "d" is incorrect. The actual variable overhead rate does not factor into the variable
overhead efficiency variance calculation.
8-19
Choice "2" is correct.
The question asks for the amount of overallocated or underallocated overhead at the end of a
month.
For Culpepper, factory (manufacturing) overhead is allocated based on 40 percent of direct
manufacturing labor cost. Direct manufacturing labor cost is $400,000, and factory
(manufacturing) overhead allocated would be $160,000. Actual overhead is $175,000. Factory
(manufacturing) overhead is therefore underallocated by $15,000.
8-20
Choice "4" is correct.
Choice ‘d’ is correct. All the options are correct.
Choice ‘a’ is a correct statement. The flexible budget amount for fixed overhead does not change
with changes in production. The amount is not variable but fixed cost.
Choice ‘b’ is a correct statement. Fixed cost flexible budget variance is the difference between
actual and budgeted fixed costs in a flexible budget.
Choice ‘c’ is a correct statement. Fixed overhead volume variance and fixed overhead budget
variance are the two main components of total fixed overhead variance.
8-4
8-21
(10-15 min.) Variable overhead variance analysis
Budegeted Overhead
40,000
Standard Variable Overhead rate per unit = Budgeted Production = 80,000 = 0.50 krona per unit
Variable Overhead Recovered (i.e. charged to production)
= Actual Production × Standard rate per unit
= 96,000 × 0.50 krona = 48,000 krona
Actual Variable Overhead = 56,000 krona
Variable Overhead Variance
= 𝐴𝑐𝑡𝑢𝑎𝑙 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑 − 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝑅𝑒𝑐𝑜𝑣𝑒𝑟𝑒𝑑
= 56,000 krona − 48,000 krona −
= 8,000 krona Favorable
8-5
8-22
(20-25 min.) Fixed Overheads Analysis in the Service Sector.
Calculation on the basis of Standard hours:
Budgeted Hours = 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑜𝑢𝑡𝑝𝑢𝑡 × 𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑡𝑖𝑚𝑒 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡
= 1,000 × 4 hours = 4,000 hours
Standard Variable Overhead Rate per Hour=
Budgeted overhead
Budegeted hours
=
A$3,000
4,000
= A$0.75
Standard hours of Actual Production = 900 units × 4 hours = 3,600 hours
Variable overhead recovered by Actual production:
= Standard rate per hour × Standard hours of actual production
= A$0.75 × 3,600 = A$2,700
Variable Overhead Expenditure Variance
= Actual overhead – (Actual hours × Budgeted rate per hour) = A$2,680 − (1,700 × 0.75)
= A$2,680 – A$1,275 = A$1,405 unfavorable
Variable Overhead Efficiency Variance
= (Actual hours – Budgeted hours of actual production) x Budgeted rate per hour
= (1,700 − 3,600) x 0.75 = A$1,425 favorable
NOTE: Variable Overhead Cost Variance = Expenditure + Efficiency A$20 Favorable
Alternatively, this can also be calculated based on units of output, as below.
Calculation on the basis of Units of Output:
Standard Variable Overhead Rate per unit = Budgeted Overhead = $ 3,000 = $ 3 per unit
Budgeted output
1,000
Variable Overhead recovered by Actual output = Actual Output x Standard rate per unit
= 900 units x 3 = A$2,700
Standard Output in Actual hours = Actual hours__
= 1,700 = 425 units
Standard time per unit
4
Variable Overhead Cost Variance
= Overhead recovered – Actual overhead
= A$2,700 – A$2,680 = A$20 Favorable
Variable Overhead Expenditure Variance
= Actual Overhead – (Standard output x Standard Rate per unit)
= A$2,680 – (425 units x A$3) = A$1,405 Unfavorable
Variable Overhead Efficiency Variance
= Standard rate per unit x (Standard Output – Actual Output)
= A$3 x (425 – 900) units = A$1,425 Favorable
8-6
8-23
(30 min.)
Variable manufacturing overhead, variance analysis.
1. Denominator level = (3,200,000 × 0.02 hours) = 64,000 hours
Actual
Results
2,800,000
50,400
0.018
£680,400
£13.50
£0.243
1. Output units (baguettes)
2. Direct manufacturing labor-hours
3. Labor-hours per output unit (2 1)
4. Variable manuf. overhead (MOH) costs
5. Variable MOH per labor-hour (4 2)
6. Variable MOH per output unit (4 1)
a
Flexible
Budget Amounts
2,800,000
56,000a
0.020
£560,000
£10
£0.200
2,800,000 ´ 0.020 = 56,000 hours
Variable Manufacturing Overhead Variance Analysis for Baking Bad for 2020:
Actual Costs
Incurred
Actual Input Qty.
× Actual Rate
(1)
(50,400 × £13.50)
£680,400
Actual Input Qty.
× Budgeted Rate
(2)
(50,400 × £10)
£504,000
£176,400 U
Spending Variance
Flexible Budget:
Budgeted Input Qty.
Allowed for
Actual Output
× Budgeted Rate
(3)
(56,000 × £10)
£560,000
£56,000 F
Efficiency Variance
Allocated:
Budgeted Input Qty.
Allowed for
Actual Output
× Budgeted Rate
(4)
(56,000 × £10)
£560,000
Never a Variance
£120,400 U
Flexible Budget Variance
Never a Variance
3.
Spending variance of £176,400 U. It is unfavorable because variable manufacturing
overhead was 35 percent higher than planned. A possible explanation could be an increase in
energy rates relative to the rate per standard labor-hour assumed in the flexible budget.
Efficiency variance of £56,000 F. It is favorable because the actual number of direct
manufacturing labor-hours required was lower than the number of hours in the flexible budget.
Labor was more efficient in producing the tarts than management had anticipated in the budget.
This could occur because of improved morale in the company, which could result from an
increase in wages or an improvement in the compensation scheme.
Flexible-budget variance of £120,400 U. It is unfavorable because the favorable
efficiency variance was not large enough to compensate for the large unfavorable spending
variance.
8-7
8-24
(30 min.) Fixed manufacturing overhead, variance analysis (continuation of 8-23).
1. Budgeted standard direct manufacturing labor used = 0.02 per tart
Budgeted output = 3,200,000 baguettes
Budgeted standard direct manufacturing labor-hours
= 3,200,000 × 0.02
= 64,000 hours
Budgeted fixed manufacturing overhead costs
= 64,000 × £4.00 per hour
= £256,000
Actual output
= 2,800,000 tarts
Allocated fixed manufacturing overhead
= 2,800,000 × 0.02 × £4
= £224,000
Fixed Manufacturing Overhead Variance Analysis for Baking Bad for 2020:
Same Budgeted
Lump Sum
(as in Static Budget)
Actual Costs
Regardless of
Incurred
Output Level
(1)
(2)
£272,000
£256,000
Flexible Budget:
Same Budgeted
Lump Sum
(as in Static Budget)
Regardless of
Output Level
(3)
£256,000
£16,000 U
Spending variance
Never a variance
£16,000 U
Flexible-budget variance
Allocated:
Budgeted Input Qty.
Allowed for
Actual Output
× Budgeted Rate
(4)
(2,800,000 × 0.02 × £4)
£224,000
£32,000 U
Production-volume variance
£32,000 U
Production-volume variance
£48,000 U
Underallocated fixed overhead
(Total fixed overhead variance)
2.
The fixed manufacturing overhead is underallocated by $48,000.
3. The production-volume variance of $32,000 U captures the difference between the budgeted
3,200,0000 baguettes and the lower actual 2,800,000 baguettes produced—the fixed cost
capacity not used. The spending variance of $16,000 U means that the actual aggregate of
fixed costs ($272,000) exceeds the budget amount ($256,000). For example, monthly leasing
rates for baguette-making machines may have increased above those in the budget for 2020.
8-8
8-25
(30–40 min.) Manufacturing overhead, variance analysis.
1.
The summary information is:
The Principles Corporation (June 2020)
Outputs units (number of assembled units)
Hours of assembly time
Assembly hours per unit
Variable mfg. overhead cost per hour of assembly
time
Variable mfg. overhead costs
Fixed mfg. overhead costs
Fixed mfg. overhead costs per hour of assembly time
Actual
225
360
1.60b
Flexible
Budget
225
450c
2.00
Static
Budget
110
220a
2.00
€32.00
€14,400e
€10,780
€32.00
€7,040f
€10,780
€49.00h
€33.15d
€11,933
€12,180
€33.83g
a
110 units × 2 assembly hours per unit = 220 hours
360 hours ÷ 225 units = 1.60 assembly hours per unit
c
225 units × 2 assembly hours per unit = 450 hours
d
€11,933 ÷ 360 assembly hours = €33.15 per assembly hour
e
450 assembly hours × €32 per assembly hour = €14,400
f
220 assembly hours × €32 per assembly hour = €7,040
g
€12,180 ÷ 360 assembly hours = €33.83 per assembly hour
h €10,780 ÷ 220 assembly hours = €49 per assembly hour
b
Variable Manufacturing Overhead
Actual Costs Incurred $11,933
Actual input quantity × Budgeted rate = 360 per assembly hour × €32 per assembly hour
= €11,520
Flexible Budget
Allocated Budget
Spending variance
Efficiency variance
= Budgeted input quantity allowed for actual output × Budgeted rate
= 450 per assembly hour × €32 per assembly hour
= €14,400
= Budgeted input quantity allowed for actual output × Budgeted rate
= 450 per assembly hour × €32 per assembly hour
= €14,400
= €11,933 − €11,520 = €413 U
= €11,520 − €14,400 = €2,880 F
Flexible budget variance
= Efficiency variance - Spending variance
= €2,467 F
Overallocated variable overhead
= $2,467 F
Fixed Manufacturing Overhead
Actual Costs Incurred $12,180
Static budget lump sum (regardless of output level) = Flexible Budget = €10,780
8-9
Allocated Budget
= Budgeted input quantity allowed for actual output × Budgeted rate
= 450 per assembly hour × €49 per assembly hour
= €22,050
Spending variance
= €12,180 − €10,780 = €1,400 U
Production volume variance = €22,050 − €10,780 = €11,270 F
Flexible budget variance
= €1,400 U
Overallocated fixed overhead = Production volume variance − Flexible budget variance
= €11,270 − €1,400 = €9,870 F
The summary analysis is:
Manufacturing Overhead
Variable
Fixed
Spending
€413 U
€1,400 U
Variance
Efficiency
Production Volume
€2,880 F
Never a variance
Never a variance €11,270 F
2. Variable Manufacturing Costs and Variances
a. Variable Manufacturing Overhead Control
Accounts Payable Control and various other accounts
To record actual variable manufacturing overhead costs
incurred.
11,933
b. Work-in-Process Control
Variable Manufacturing Overhead Allocated
To record variable manufacturing overhead allocated.
14,400
c. Variable Manufacturing Overhead Allocated
Variable Manufacturing Overhead Spending Variance
Variable Manufacturing Overhead Control
Variable Manufacturing Overhead Efficiency Variance
To isolate variances for the accounting period.
14,400
413
11,933
14,400
11,933
2,880
d. Variable Manufacturing Overhead Efficiency Variance
2,880
Variable Manufacturing Overhead Spending Variance
413
Cost of Goods Sold
2,467
To write off variable manufacturing overhead variances to cost of goods sold.
Fixed Manufacturing Costs and Variances
a. Fixed Manufacturing Overhead Control
Salaries Payable, Acc. Depreciation, various other accounts
To record actual fixed manufacturing overhead costs incurred.
12,180
b. Work-in-Process Control
Fixed Manufacturing Overhead Allocated
22,050
8-10
12,180
22,050
To record fixed manufacturing overhead allocated.
c. Fixed Manufacturing Overhead Allocated
Fixed Manufacturing Overhead Spending Variance
Fixed Manufacturing Overhead Production-Volume Variance
Fixed Manufacturing Overhead Control
To isolate variances for the accounting period.
22,050
1,400
11,270
12,180
d. Fixed Manufacturing Overhead Production-Volume Variance
11,270
Fixed Manufacturing Overhead Spending Variance
1,400
Cost of Goods Sold
9,870
To write off fixed manufacturing overhead variances to cost of goods sold.
3.
Planning and control of variable manufacturing overhead costs have both a long-run and
a short-run focus. It involves Principles planning to undertake only value-added overhead
activities (a long-run view) and then managing the cost drivers of those activities in the most
efficient way (a short-run view). Planning and control of fixed manufacturing overhead costs at
Principles have primarily a long-run focus. It involves undertaking only value-added fixedoverhead activities for a budgeted level of output. Principles make most of the key decisions that
determine the level of fixed-overhead costs at the start of the accounting period.
8-11
8-26
1.
2.
3.
4.
5.
(1015 min.) 4-variance analysis, fill in the blanks.
Variable
Spending variance
$400 U
Efficiency variance
2,400 F
Production-volume variance
NEVER
Flexible-budget variance
2,000 F
Underallocated (overallocated) MOH
2,000 F
Fixed
$5,000 U
NEVER
1,500 F
5,000 U
3,500 U
These relationships could be presented in the same way as in Exhibit 8-4.
Flexible Budget:
Budgeted Input Qty.
Allowed for
Actual Costs Actual Input Qty.
Actual Output
Incurred
× Budgeted Rate
× Budgeted Rate
(1)
(2)
(3)
Variable
MOH
$36,000
$35,600
$38,000
$400 U
$2,400 F
Spending variance
Efficiency variance
Allocated:
Budgeted Input
Qty.
Allowed for
Actual Output
× Budgeted Rate
(4)
$38,000
Never a variance
$2,000 F
Flexible-budget variance
Never a variance
$2,000 F
Overallocated variable overhead
(Total variable overhead variance)
Fixed
MOH
Actual Costs
Incurred
(1)
Same Budgeted
Lump Sum
(as in Static Budget)
Regardless of
Output Level
(2)
Flexible Budget:
Same Budgeted
Lump Sum
(as in Static Budget)
Regardless of
Output Level
(3)
$20,000
$15,000
$15,000
$5,000 U
Spending variance
Never a variance
$1,500 F
Production-volume variance
$5,000 U
Flexible-budget variance
$1,500 F
Production-volume variance
$3,500 U
Underallocated fixed overhead
(Total fixed overhead variance)
8-12
Allocated:
Budgeted Input
Qty.
Allowed for
Actual Output
× Budgeted Rate
(4)
$16,500
An overview of the four overhead variances is:
4-Variance
Analysis
Variable
Overhead
Fixed
Overhead
8-27
Spending
Variance
$400 U
$5,000 U
Efficiency
Variance
ProductionVolume
Variance
$2,400 F
Never a variance
Never a variance
$1,500 F
(20–30 min.) Straightforward 4-variance overhead analysis.
1. The budget for fixed manufacturing overhead is 4,000 units × 5 machine-hours × $14
machine-hours/unit = $280,000.
An overview of the 4-variance analysis is:
4-Variance
Analysis
Variable
Manufacturing
Overhead
Fixed
Manufacturing
Overhead
Spending
Variance
Efficiency
Variance
ProductionVolume Variance
$16,000 U
$7,000 U
Never a Variance
$23,000 U
Never a Variance
$14,000 F
Solution Exhibit 8-27 has details of these variances.
A detailed comparison of actual and flexible budgeted amounts is:
Actual
4,200
22,000
b
5.24
$170,000
d
$7.73
$303,000
f
$13.77
Output units (auto parts)
Allocation base (machine-hours)
Allocation base per output unit
Variable MOH
Variable MOH per hour
Fixed MOH
Fixed MOH per hour
a
4,200 units × 5 machine-hours/unit = 21,000 machine-hours
22,000 ÷ 4,200 = 5.24 machine-hours per unit
c
4,200 units × 5 machine-hours per unit × $7.00 per machine-hour = $147,000
d
$170,000 ÷ 22,000 = $7.73
b
8-13
Flexible Budget
4,200
a
21,000
5.00
c
$147,000
$7.00
e
$280,000
$14.00
e
f
4,000 units × 5 machine-hours per unit × $14 per machine-hour = $280,000
$303,000 ÷ 22,000 machine-hours = $13.77 per machine-hour
2.
Variable Manufacturing Overhead Control
Accounts Payable Control and other accounts
170,000
Work-in-Process Control
Variable Manufacturing Overhead Allocated
147,000
Variable Manufacturing Overhead Allocated
Variable Manufacturing Overhead Spending Variance
Variable Manufacturing Overhead Efficiency Variance
Variable Manufacturing Overhead Control
147,000
16,000
7,000
Fixed Manufacturing Overhead Control
Wages Payable Control, Accumulated Depreciation
Control, etc.
303,000
Work-in-Process Control
Fixed Manufacturing Overhead Allocated
294,000
170,000
147,000
170,000
303,000
Fixed Manufacturing Overhead Allocated
294,000
Fixed Manufacturing Overhead Spending Variance
23,000
Fixed Manufacturing Overhead Production-Volume Variance
Fixed Manufacturing Overhead Control
294,000
14,000
303,000
3.
Individual fixed manufacturing overhead items are not usually affected very much by
day-to-day control. Instead, they are controlled periodically through planning decisions and
budgeting procedures that may sometimes have horizons covering six months or a year (for
example, management salaries) and sometimes covering many years (for example, long-term
leases and depreciation on plant and equipment).
4.
The fixed overhead spending variance is caused by the actual realization of fixed costs
differing from the budgeted amounts. Some fixed costs are known because they are
contractually specified, such as rent or insurance, although if the rental or insurance contract
expires during the year, the fixed amount can change. Other fixed costs are estimated, such as
the cost of managerial salaries which may depend on bonuses and other payments not known at
the beginning of the period. In this example, the spending variance is unfavorable, so actual
FOH is greater than the budgeted amount of FOH.
The fixed overhead production volume variance is caused by production being over or
under expected capacity. You may be under capacity when demand drops from expected levels,
or if there are problems with production. Over capacity is usually driven by favorable demand
shocks or a desire to increase inventories. The fact that there is a favorable volume variance
indicates that production exceeded the expected level of output (4,200 units actual relative to a
denominator level of 4,000 output units).
8-14
SOLUTION EXHIBIT 8-27
Actual Costs
Incurred
(1)
Variable
MOH
$170,000
Actual Input
× Budgeted Rate
(2)
(22,000 × $7)
$154,000
$16,000 U
Spending variance
Flexible Budget:
Budgeted Input
Allowed for
Actual Output
× Budgeted Rate
(3)
(4,200 × 5 × $7)
$147,000
$7,000 U
Efficiency variance
$23,000 U
Flexible-budget variance
Allocated:
Budgeted Input
Allowed for
Actual Output
× Budgeted Rate
(4)
(4,200 × 5 × $7)
$147,000
Never a variance
Never a variance
$23,000 U
Underallocated variable overhead
(Total variable overhead variance)
Actual Costs
Incurred
(1)
Fixed
MOH
$303,000
Same Budgeted
Lump Sum
(as in Static Budget)
Regardless of
Output Level
(2)
(4,000 × 5 × $14)
$280,000
$23,000 U
Spending variance
Flexible Budget:
Same Budgeted
Lump Sum
(as in Static Budget)
Regardless of
Output Level
(3)
(4,000 × 5 × $14)
$280,000
Never a variance
Allocated:
Budgeted Input
Allowed for
Actual Output
× Budgeted Rate
(4)
(4,200 × 5 × $14)
$294,000
$14,000 F
Production-volume
variance
$23,000 U
$14,000 F
Production-volume
Flexible-budget variance
variance
$9,000 U
Overallocated fixed overhead
(Total fixed overhead variance)
8-15
8-28 3040 min.) Straightforward coverage of manufacturing overhead, standard-costing
system.
1.
Solution Exhibit 8-28 shows the computations. Summary details are:
Actual
65,500
76,400
1.17b
$618,840
Output units
Allocation base (machine-hours)
Allocation base per output unit
Variable MOH
Variable MOH per hour
Fixed MOH
Fixed MOH per hour
a
b
c
d
$8.10
$145,790
e
$1.91
Flexible Budget
65,500
a
78,600
1.2
c
$628,800
$8.00
$144,000
–
65,500 × 1.2 = 78,600 d $618,840 ÷ 76,400 = $8.10
76,400 ÷ 65,500 = 1.17 e $145,790 ÷ 76,400 = $1.91
65,500 × 1.2 × $8 = $628,800
An overview of the 4-variance analysis is:
4-Variance
Analysis
Variable
Manufacturing
Overhead
Fixed
Manufacturing
Overhead
2.
Spending
Variance
Efficiency
Variance
$7,640 U
$1,790 U
$17,600 F
Never a variance
Production
Volume Variance
Never a variance
$13,200 F
Variable Manufacturing Overhead Control
Accounts Payable Control and other accounts
618,840
Work-in-Process Control
Variable Manufacturing Overhead Allocated
628,800
618,840
628,800
Variable Manufacturing Overhead Allocated
628,800
Variable Manufacturing Overhead Spending Variance
7,640
Variable Manufacturing Overhead Efficiency Variance
Variable Manufacturing Overhead Control
17,600
618,840
Fixed Manufacturing Overhead Control
Wages Payable Control, Accumulated
Depreciation Control, etc.
145,790
145,790
Work-in-Process Control
157,200
8-16
Fixed Manufacturing Overhead Allocated
Fixed Manufacturing Overhead Allocated
157,200
Fixed Manufacturing Overhead Spending Variance
1,790
Fixed Manufacturing Overhead Production-Volume Variance
Fixed Manufacturing Overhead Control
157,200
13,200
145,790
3.
The control of variable manufacturing overhead requires the identification of the cost
drivers for such items as energy, supplies, and repairs. Control often entails monitoring
nonfinancial measures that affect each cost item, one by one. Examples are kilowatt-hours used,
quantities of lubricants used, and repair parts and hours used. The most convincing way to
discover why overhead performance did not agree with a budget is to investigate possible causes,
line item by line item.
4.
The variable overhead spending variance is unfavorable. This means the actual rate
applied to the manufacturing costs is higher than the budgeted rate. Because variable overhead
consists of several different costs, this could be for a variety of reasons, such as the utility rates
being higher than estimated or the indirect materials costs per unit of denominator activity being
more than estimated.
The variable overhead efficiency variance is favorable, which implies that the estimated
denominator activity was too high. Because the denominator activity is machine hours, this could
be the result of efficient use of machines, better scheduling of production runs, or machines that
are well maintained and thus are working at more than the expected level of efficiency.
8-17
SOLUTION EXHIBIT 8-28
Actual Costs
Incurred
(1)
Variable
Manufacturing
Overhead
$537,470
Flexible Budget:
Budgeted Input
Allowed for
Actual Output
× Budgeted Rate
(3)
(79,800 × $7)
$558,600
Actual Input
× Budgeted Rate
(2)
(75,700 × $7)
$529,900
$7,570 U
$28,700 F
Spending variance Efficiency variance
Allocated:
Budgeted Input
Allowed for
Actual Output
× Budgeted Rate
(4)
(79,800 × $7)
$558,600
Never a variance
$21,130 F
Flexible-budget variance
Never a variance
$21,130 F
Overallocated variable overhead
(Total variable overhead variance)
Fixed
Manufacturing
Overhead
Actual Costs
Incurred
(1)
Same Budgeted
Lump Sum
(as in Static Budget)
Regardless of
Output Level
(2)
Flexible Budget:
Same Budgeted
Lump Sum
(as in Static Budget)
Regardless of
Output Level
(3)
$146,101
$136,000
$136,000
$10,101 U
Spending variance
Never a variance
$10,101 U
Flexible-budget variance
Allocated:
Budgeted Input
Allowed for
Actual Output
× Budgeted Rate
(4)
(79,800 × $2*)
$159,600
$23,600 F
Production-volume variance
$23,600 F
Production-volume variance
$13,499 F
Overallocated fixed overhead
(Total fixed overhead variance)
Fixed manufacturing overhead budgeted rate = $144,000 / 72,000 machine hours
= $2 per machine hour
8-18
8-29
(20–25 min.) Overhead variances, service sector.
1.
Hot Meals Now
(May 2020)
Output units (number of deliveries)
Hours per delivery
Hours of delivery time
Variable overhead costs per delivery hour
Variable overhead (VOH) costs
Fixed overhead costs
Fixed overhead cost per hour
Actual
Results
8,600
0.66a
5,660
$2.00d
Flexible
Budget
8,600
0.70
6,020b
$1.75
Static
Budget
12,000
0.70
8,400c
$1.75
$11,320
$39,600
$10,535e
$33,600
$14,700f
$33,600
$4.67g
a
5,660 hours ÷ 8,600 deliveries = 0.66 hours per delivery
hrs. per delivery × actual number of deliveries = 0.70 × 8,600 = 6,020 hours
c
hrs. per delivery × expected number of deliveries = 0.70 × 12,000 = 8,400 hours
d
$11,320 VOH costs ÷ 5,660 delivery hours = $2.00 per delivery hour
e
8,600 deliveries × 0.70 hours per delivery × $1.75 VOH cost per delivery hour = $14,700
f
12,000 deliveries × 0.70 hours per delivery × $1.75 VOH cost per delivery hour = $14,700
f
Static budget delivery hours = 12,000 units × 0.70 hours/unit = 8,400 hours;
g
Fixed overhead rate = Fixed overhead costs ÷ static budget delivery hours = $33,600 ÷ 8,400
hours = $4 per hour
b
VARIABLE OVERHEAD
Actual Costs
Incurred
$11,320
Actual Input Qty. ×
Budgeted Rate
5,660 hrs × $1.75 per
hr.
$9,905
$1,415 U
Spending variance
Flexible Budget:
Budgeted Input Qty.
Allowed for
Actual Output
× Budgeted Rate
6,020 hrs × $1.75 per hr.
$10,535
$630 F
Efficiency variance
8-19
2.
FIXED OVERHEAD
Actual Costs
Incurred
$39,600
Flexible Budget:
Same Budgeted
Lump Sum
(as in Static Budget)
Regardless of Output
Level
$33,600
$6,000 U
Spending variance
Allocated:
Budgeted Input Qty. Allowed
for
Actual Output
× Budgeted Rate
6,020 hrs. × $4/hr.
$24,080
$9,520 U
Production-volume variance
3.
The spending variances for variable and fixed overhead are both unfavorable. This means
that HMN had increases over budget in either or both the cost of individual items (such as
telephone calls and gasoline) in the overhead cost pools, or the usage of these individual items
per unit of the allocation base (delivery time). The favorable efficiency variance for variable
overhead costs results from more efficient use of the cost allocation base––each delivery takes
0.66 hours versus a budgeted 0.70 hours.
HMN can best manage its fixed overhead costs by long-term planning of capacity rather
than day-to-day decisions. This involves planning to undertake only value-added fixed-overhead
activities and then determining the appropriate level for those activities. Most fixed overhead
costs are committed well before they are incurred. In contrast, for variable overhead, a mix of
long-run planning and daily monitoring of the use of individual items is required to manage costs
efficiently. HMN should plan to undertake only value-added variable-overhead activities (a longrun focus) and then manage the cost drivers of those activities in the most efficient way (a shortrun focus).
There is no production-volume variance for variable overhead costs. The unfavorable
production-volume variance for fixed overhead costs arises because HMN has unused fixed
overhead resources that it may seek to reduce in the long run.
8-20
8-30 (4550 min.) Total overhead, 3-variance analysis.
1. This problem has two major purposes: (a) to give experience with data allocated on a total
overhead basis instead of on separate variable and fixed bases and (b) to reinforce distinctions
between actual hours of input, budgeted (standard) hours allowed for actual output, and
denominator level.
An analysis of direct manufacturing labor will provide the data for actual hours of input
and standard hours allowed. One approach is to plug the known figures (designated by asterisks)
into the analytical framework and solve for the unknowns. The direct manufacturing labor price
variance can be computed by adding $7,500U to $1,875F. The complete picture is as follows:
Actual Costs
Incurred
(15,000 hrs. × $17.00)
$255,000*
Actual Input
× Budgeted Rate
(15,000 hrs. × $18.00*)
$270,000
Flexible Budget:
Budgeted Input
Allowed for
Actual Output
× Budgeted Rate
(14,500 hrs. × $18.00*)
$261,000
$15,000 F
$9,000 U*
Price variance
Efficiency variance
$6,000 F*
Flexible-budget variance
*
Given
Direct Labor calculations
Actual input × Budgeted rate = Actual costs + Price variance
= $255,000 + $15,000 = $270,000
Actual input = $270,000 ÷ Budgeted rate = $270,000 ÷ $18 = 15,000 hours
Budgeted input × Budgeted rate = $270,000 – Efficiency variance
= $270,000 – $9,000 = $261,000
Budgeted input = $261,000 ÷ Budgeted rate = $261,000 ÷ 18 = 14,500 hours
2.
The calculations for total overhead are given below.
Variable overhead rate
= $90,000* ÷ 12,000* hrs. = $7.50 per standard labor-hour
Budgeted fixed overhead costs = $110,000* – (8,000* × $7.50) = $50,000
If total overhead is allocated at 80% of direct labor-cost, the single overhead rate must be
80% of $18.00, or $14.4 per hour. Therefore, the fixed overhead component of the rate must be
$14.40 – $7.50, or $6.90 per direct labor-hour.
8-21
Let D = denominator level in input units
Budgeted fixed overhead costs
Budgeted fixed overhead rate per input unit = Denominator level input units
$50,000
$6.90 = D
D = 7246 direct labor-hours (approximately)
A summary 3-variance analysis for May follows:
Actual Costs
Incurred
$160,000*
Actual Inputs
× Budgeted Rate
$50,000 + (15,000 × $7.50)
$162,500
$2,500 F
Spending variance
Flexible Budget:
Budgeted Input
Allowed for
Actual Output
× Budgeted Rate
$50,000 + ($7.50 ×
14,500)
$158,750
$3,750 U
Efficiency variance
$1,250 U
Flexible-budget variance
Allocated:
Budgeted Input
Allowed for
Actual Output
× Budgeted Rate
(14,500 hrs. ×
$14.40)
$208,800
$50,050 F*
Production-volume variance
$50,050 F*
Production-volume variance
*
Known figure
An overview of the 3-variance analysis using the block format in the text is:
3-Variance
Analysis
Total
Overhead
Spending
Variance
Efficiency
Variance
Production
Volume Variance
$2,500 F
$3,750 U
$50,050 F
3.
The control of variable manufacturing overhead requires the identification of the cost
drivers for such items as energy, supplies, equipment, and maintenance. Control often entails
monitoring nonfinancial measures that affect each cost item, one by one. Examples are kilowatts
used, quantities of lubricants used, and equipment parts and hours used. The most convincing
way to discover why overhead performance did not agree with a budget is to investigate possible
causes, line item by line item.
Individual fixed manufacturing overhead items are not usually affected very much by dayto-day control. Instead, they are controlled periodically through planning decisions and
budgeting that may sometimes have horizons covering six months or a year (for example,
management salaries) and sometimes covering many years (for example, long-term leases and
depreciation on plant and equipment).
8-22
8-31
(35 min.) Production-volume variance analysis and sales volume variance.
1. and 2.
Fixed Overhead Variance Analysis for Marissa Designs, Inc. for February
Actual Fixed
Overhead
$11,400
Static Budget
Fixed Overhead
$10,800
Standard Hours
× Budgeted Rate
(720 × 1.5 × $6*)
$6,480
$600 U
$4,320 U
Spending variance
variance
Production-volume
* fixed overhead rate = (budgeted fixed overhead)/(budgeted DL hours at capacity)
= $10,800/(1,200 × 1.5 hours)
= $10,800/1,800 hours
= $6/hour
3.
An unfavorable production-volume variance measures the cost of unused capacity.
Production at capacity would result in a production-volume variance of zero because the fixed
overhead rate is based on expected hours at capacity production. However, the existence of an
unfavorable volume variance does not necessarily imply that management is doing a poor job or
incurring unnecessary costs. Two reasons can be identified:
a.
For most products, demand varies from month to month while commitment to the
factors that determine capacity, e.g., size of the workshop or supervisory staff, tends to remain
relatively constant. If Marissa wants to meet demand in high demand months, it will have excess
capacity in low demand months. In addition, forecasts of future demand contain uncertainty due
to unknown future factors. Having some excess capacity would allow Marissa to produce enough
to cover peak demand as well as slack to deal with unexpected demand surges in non-peak
months.
b.
Basic economics provides a demand curve that shows a tradeoff between price
charged and quantity demanded. Potentially, Marissa could have a lower net revenue if they
produce at capacity and sell at a lower price than if they sell at a higher price at some level below
capacity.
In addition, the unfavorable production-volume variance may not represent a feasible cost
savings associated with lower capacity. Even if Marissa could shift to lower fixed costs by
lowering capacity, the fixed cost may behave as a step function. If so, fixed costs would decrease
in fixed amounts associated with a range of production capacity, not a specific production
volume. The production-volume variance would only accurately identify potential cost savings if
the fixed cost function is continuous, not discrete.
8-23
4. The static-budget operating income for February is:
Revenues $55 × 1,200
Variable costs $25 × 1,200
Fixed overhead costs
Static-budget operating income
$66,000
30,000
10,800
$25,200
The flexible-budget operating income for February is:
Revenues $55 × 720
Variable costs $25 × 720
Fixed overhead costs
Flexible-budget operating income
$39,600
18,000
10,800
$10,800
The sales-volume variance represents the difference between the static-budget operating income
and the flexible-budget operating income:
Static-budget operating income
Flexible-budget operating income
Sales-volume variance
$25,200
10,800
$14,400 U
Equivalently, the sales-volume variance captures the fact that when Marissa sells 720 units
instead of the budgeted 1,200, only the revenue and the variable costs are affected. Fixed costs
remain unchanged. Therefore, the shortfall in profit is equal to the budgeted contribution margin
per unit times the shortfall in output relative to budget.
Sales volume variance
= (Budgeted selling price – Budgeted variable cost per unit) × Difference in qty of units sold
relative to the static budget
= ($55 – $25) × 480 = $30 × 480 = $14,400 U
In contrast, we computed in requirement 2 that the production-volume variance was $4,320 U.
This captures only the portion of the budgeted fixed overhead expected to be unabsorbed because
of the 480-unit shortfall. To compare it to the sales-volume variance, consider the following:
Budgeted selling price
Budgeted variable cost per unit
Budgeted fixed cost per unit ($10,800 ÷ 1,200)
Budgeted cost per unit
Budgeted profit per unit
Operating income based on budgeted profit per unit
$21 per unit × 720 units
8-24
$55
$25
9_
34
$ 21
$15,120
The $4,320 U production-volume variance explains the difference between operating income
based on the budgeted profit per unit and the flexible-budget operating income:
Operating income based on budgeted profit per unit
Production-volume variance
Flexible-budget operating income
$15,120
4,320 U
$10,800
Because the sales-volume variance represents the difference between the static- and
flexible-budget operating incomes, the difference between the sales-volume and
production-volume variances, which is referred to as the operating-income volume
variance, is:
Operating-income volume variance
= Sales-volume variance – Production-volume variance
= Static-budget operating income – Operating income based on budgeted profit per unit
= $25,200 U – $15,120 U = $10,080 U.
The operating-income volume variance explains the difference between the staticbudget operating income and the budgeted operating income for the units actually sold.
The static-budget operating income is $25,200 and the budgeted operating income for
720 units would have been $15,120 ($21 operating income per unit × 720 units). The
difference, $10,080 U, is the operating-income volume variance, i.e., the 480 unit drop in
actual volume relative to budgeted volume would have caused an expected drop of
$10,080 in operating income, at the budgeted operating income of $21 per unit. The
operating-income volume variance assumes that $4,320 in fixed cost ($9 per unit × 480
units) would be saved if production and sales volumes decreased by 480 units.
8-25
8-32
(20 min.) Overhead variances, service setting.
1. and 2. Variable and Fixed Technology Overhead Variance Analysis for Alpha Capital
Company for the first quarter of 2020:
Actual
Costs
Incurred
Variable
Technology
Overhead
Actual Input Qty.
 Budgeted Rate
$22,000
$100 U
(7,300  $3)
$21,900
e. Spending variance
Fixed
Technology
Overhead
$19,200
Flexible Budget:
Budgeted Input Qty.
Allowed for
Actual Output
 Budgeted Rate
(14,500 0.5  $3)
$21,750
$150 U
f. Efficiency variance
$19,500
$19,500
$300 F
h. Spending variance
3.
Allocated:
(Budgeted Input Qty.
Allowed for
Actual Output
 Budgeted Rate)
(14,500 0.5  $3)
$21,750
Never a variance
(14,500  0.5  $3.00)
$21,750
$2,250 F
Never a variance
g. Production volume variance
Alpha has done a reasonable job overall of managing its technology overhead costs. It
has both an unfavorable variable overhead spending and efficiency variance. Alpha had
an unfavorable efficiency variance because it used too many CPU units of processing
time relative to the number of client interactions it had. This is not an issue if the goal
was to meet the high-performance computing needs of clients and resulted in higher
levels of client satisfaction or revenues. For the 7,300 CPU units used, Alpha spent
$3.0136 per unit relative to the budgeted $3.00, so the price/spending variance on
variable technology overhead was also unfavorable but, again, if the goal is to meet high
performance computing needs of clients and it resulted in higher levels of client
satisfaction or revenues, the cost trade may have been a good decision. The two
unfavorable variances were relatively small so it may not have impacted the profits
significantly.
From the standpoint of capacity utilization, Alpha Capital was successful at
managing their fixed technology overhead resources. They handled 14,500 client
interactions, compared to an expected output of 13,000. It would be useful to know what
the firm views as the maximum attainable level of capacity given its current spending on
technology. The firm should attempt to identify if their current technology resources will
be sufficient to sustain their added customer processing in the future and if a higher
spending level is likely in future years.
8-26
8-33
(20-30 min.) Flexible Budget Variances.
a. Flexible budget
Units
Revenue
Variable Costs:
Material
Labor
Factory Overhead
Contribution Margin
Fixed Costs:
Factory Overhead
Office Expenses
Operating Income
Actual
40,000
236,000
Flexed
40,000
240,000
Variance
-4,000
Unfavorable
76,000
63,200
34,000
62,800
80,000
60,000
32,000
68,000
-4,000
3,200
2,000
-5,200
Favorable
Unfavorable
Unfavorable
Unfavorable
12,880
22,000
27,920
12,000
20,000
36,000
880
2,000
-8,080
Unfavorable
Unfavorable
Unfavorable
b. Since revenues and variable costs vary directly with number of units, we need to calculate
budgeted price and variable costs per unit by dividing static budget amounts by 30,000
budgeted units. This yields price per unit of €6.00, material cost per unit of €2.00, labor cost
per unit of €1.50 per unit and variable factory overhead of €0.80 per unit. These figures are
then multiplied by actual units sold i.e. 40,000 units to obtain flexible budget revenue and
variable costs.
For income items (revenue, contribution margin and operating income in this example), the
flexible budget variance is favorable when actual numbers exceed flexible budget numbers
and vice versa. For cost items, excess of flexible budget numbers over actual number means
favorable variance and vice versa. The fixed costs are constant and remain same in both
static and flexed budgets.
8-27
8-34
(35 min.) Flexible-budget variances, review of Chapters 7 and 8.
1. Solution Exhibit 8-34 contains a columnar presentation of the variances for Darby Design
Company (DDC) for April 2020.
SOLUTION EXHIBIT 8-34
Direct
Materials
Actual Costs
Incurred:
Actual Input Qty.
× Actual Rate
(12,900  $10)
$129,000
Actual Input Qty.
× Budgeted Price
Purchases
Usage
(12,900  $9)
(9,000  $9)
$116,100
$81,000
$12,900 U
a. Price variance
Direct
Manufacturing
Labor
$5,400 F
b. Efficiency variance
(29,600  $16)
$473,600
$621,600
$148,000 U
Variable
Manufacturing
Overhead
d. Efficiency variance
Actual Input Qty.
 Budgeted Rate
$64,900
(32,000  1.2  $16)
$614,400
$140,800 F
c. Price variance
Actual
Costs
Incurred
Flexible Budget:
Budgeted Input Qty.
Allowed for
Actual Output
× Budgeted Price
(32,000 0.3  $9)
$86,400
Flexible Budget:
Budgeted Input Qty.
Allowed for
Actual Output
 Budgeted Rate
(9,000  $4)
$36,000
Allocated:
(Budgeted Input Qty.
Allowed for
Actual Output
 Budgeted Rate)
(9,600  $4)
$38,400
$28,900 U
(9,600  $4)
$38,400
$2,400 F
e. Spending variance f. Efficiency variance Never a variance
Fixed
Manufacturing $160,000
$143,500*
Overhead
$16,500 U
h. Spending variance
variance
8-28
(32,000 0.3  $14)
$134,400
$143,500
$9,100 U
Never a variance
g. Production volume
*
Denominator level (Annual) in pounds of material: 410,000 × 0.3 = 123,000 pounds
Annual Budgeted Fixed Overhead: 123,000 × $14/lb = $1,722,000
Monthly budgeted FOH: $1,722,000 / 12 = $143,500
2.
The direct materials price variance indicates that DDC paid more for brass than they
had planned. If this is because they purchased a higher quality of brass, it may explain why they
used less brass than expected (leading to a favorable material efficiency variance). In turn,
because variable manufacturing overhead is assigned based on pounds of materials used, this
directly led to the favorable variable overhead efficiency variance. The purchase of a better
quality of brass may also explain why it took less labor time to produce the doorknobs than
expected (the favorable direct labor efficiency variance). Finally, the unfavorable direct labor
price variance could imply that the workers who were hired were more experienced than
expected, which could also be related to the positive direct material and direct labor efficiency
variances.
8-35
(30 min.) Comprehensive variance analysis.
Budgeted number of machine-hours planned can be calculated by multiplying the number of
units planned (budgeted) by the number of machine-hours allocated per unit:
588 units  3 machine-hours per unit = 1,764 machine-hours.
2.
Budgeted fixed MOH costs per machine-hour can be computed by dividing the flexible
budget amount for fixed MOH (which is the same as the static budget) by the number of
machine-hours planned (calculated in 1.):
$343,980 ÷ 1,764 machine-hours = $195.00 per machine-hour.
3.
Budgeted variable MOH costs per machine-hour are calculated as budgeted variable
MOH costs divided by the budgeted number of machine-hours planned:
$72,324 ÷ 1,764 machine-hours = $41.00 per machine-hour.
4.
Budgeted number of machine-hours allowed for actual output achieved can be calculated by dividing the flexible-budget amount for variable MOH by budgeted variable
MOH costs per machine-hour: $79,950 ÷ $41.00 per machine-hour= 1,950 machinehours allowed.
5.
The actual number of output units is the budgeted number of machine-hours allowed for
actual output achieved divided by the planned allocation rate of machine hours per unit:
1,950 machine-hours ÷ 3 machine-hours per unit = 650 units.
6.
The actual number of machine-hours used per output unit is the actual number of
machine hours used (given) divided by the actual number of units manufactured:
1,170 machine-hours ÷ 650 units = 1.8 machine-hours used per output unit.
8-29
8-36
(25-30 min.) Variable Overheads Flexible Budget in Manufacturing Sector
1. Calculate the following variances, indicating whether each is favorable or
unfavorable
Bruno Ltd
a. Direct Material Cost:
(a) Price Variance:
= 12,500kg x £(0.88 – 0.80)
= $1,000 (Unfavorable)
(b) Usage Variance:
= (9,500kg – 10,000kga) x £0.80
= £400 (Favorable)
a
400 padlocks x 25 kg per unit standard raw material.
b. Direct Labor Cost:
(a) Rate Variance:
= 1,100 hours x (£12 - £11.80)
= 220 (Favorable)
(b) Efficiency Variance:
= (1,100 – 1,200) hours x £12
= £1,200 (Favorable)
c. Variable Overhead:
(a) Expenditure variance:
= £2,600 – (1,100 hours x £2)
= £400 (Unfavorable)
(b) Efficiency variance:
= (1,100 – 1,200) hours x £2
= £200 (Favorable)
d. Fixed Overhead:
(a) Expenditure variance:
= (1,400 hours x £1) – 1,420
= £20 (Unfavorable)
(b) Volume variance:
= 1,400 hours – (1,200 hours x £1)
= £200 (Unfavorable)
(c) Capacity Variance:
= (1,400 hours – 1,100 hours) x £1
= £300 (Unfavorable)
(d) Efficiency variance:
= (1,200 hours – 1,100 hours) x £1
8-30
= £100 (Favorable)
e. Reconciliation of Standard and Actual Cost of Production
£
Standard Cost: 400 units at £65 each
Actual Cost
Less: Raw materials stock at standard cost:
(12,500 – 9,500) = 3,000kg @ £0.80
£
26,000
28,000
2,400
--------
(25,600)
-------------------400 (Favorable)
============
£
£
(Unfavorable) (Favorable)
1,000
400
220
1,200
400
200
20
200
---------------£1,620
£2,020
=====
=====
Material Price
Material Usage
Labor Rate
Labor Efficiency
Variable Overhead Expenditure
Variable Overhead Efficiency
Fixed Overhead Expenditure
Fixed Overhead Volume
Difference = Total Variance of £400 (Favorable)
2. What are the possible causes of overhead variances?
Overhead variances are more complex than basic labor and material variances, mainly
because of the conventions of the overhead absorption process. Overhead absorption rates
are calculated from estimates of expenditure and activity overheads are frequently
absorbed into production by means of labor hours, overhead variances can also arise when
labor efficiency is greater or less than planned.
8-31
8-37
30 –35 min.) Overhead Budget Analysis
Delta Rubber Plastic Company Ltd.
Overhead Budget Report for the year ended 31st December 2020
Budget
Actual
Variance
Favorable/Unfavorable
Production
100,000
125,000
Indirect materials
50,000
60,000
(10,000)
Unfavorable
Indirect labor
40,000
45,000
(5,000)
Unfavorable
Supervisory salaries
100,000
105,000
(5,000)
Unfavorable
Rent
80,000
80,000
0
Utilities
40,000
45,000
(5,000)
Unfavorable
Depreciation
20,000
20,000
0
Unfavorable
Total overhead
$330,000
$355,000
($25,000)
b). It appears that company’s accountant made an error by treating variable costs as fixed. If
Niger Delta Ltd has increased production from 100,000 units to 125,000 units, the variable costs
should also increase. The accountant should flex the budget to determine how much overhead he
should have incurred at the current activity level.
Some costs are variable, they change in response to activity levels while other costs are fixed and
remain the same. For example, direct materials are variable costs because the more units
produced, the more materials are required.
On the other hand, some overhead costs, such as rent, are fixed, and will stay the same. An
analysis of the costs will indicate that indirect materials, indirect labor, and utilities are variable
costs. On the other hand, supervisory salaries, rent, and depreciation are fixed.
c). Flexible budget
Original
Budget
Production
Indirect materials
Indirect labor
Utilities
Total
Variable
Cost per Unit
100,000 units
----------------$50,000
$40,000
$40,000
------------$130,000
========
Flexible
Budget
125,000 units
---------------------
0.50
0.40
0.40
-----------$1.30
=======
8-32
62,500
50,000
50,000
-----------------$162,500
==========
In the original budget, making 100,000 units resulted in total variable costs of $130,000.
Dividing total cost of each category by the budgeted production level results in variable cost per
unit of $0.50 for indirect materials, $0.40 for indirect labor, and $0.40 for utilities.
To compute the value of the flexible budget, multiply the variable cost per unit by the actual
production volume. Here, the figure indicates that the variable costs of producing 125,000 should
total $162,500 (125,000 units x $1.30).
d). Compare the actual performance with the flexed budget.
Delta Rubber Plastic Company Ltd.
Overhead Budget Report (Flexible)
For the year ended December 31, 2020
Flexible
Budget
Production (units)
125,000
-----------
Actual
Variance
Favorable/
Unfavorable
125,000
-----------
Variable Costs:
Indirect Costs
Indirect labor
Utilities
$62,500
$50,000
$50,000
----------Total Variable Costs $162,500
-----------
60,000
45,000
45,000
----------#150,000
------------
2,500
5,000
5,000
----------
Favorable
Favorable
Favorable
105,000
80,000
20,000
----------205,000
----------$355,000
=======
(5,000)
0
0
----------
Unfavorable
$7,500
======
Favorable
Fixed Costs:
Supervisory salaries
Rent
Depreciation
Total Fixed Costs
Total Overhead
$100,000
$80,000
$20,000
----------$200,000
----------$362,500
======
By adjusting for the change in production level, Delta Rubber Plastic Company Ltd.’s variance is
suddenly favorable. Actual overhead of $355,000 was $7,500 less than the $362,500 flexible
budget.
8-33
2.
(a) Variable Manufacturing Overhead Variance Analysis for Best Around, Inc. for 2020
Actual Costs
Incurred
(1)
$12,075,000
Flexible Budget:
Budgeted Input Qty.
Allowed for
Actual Output
× Budgeted Rate
(3)
(1,125,000  $10)
$11,250,000
Actual Input Qty.
× Budgeted Rate
(2)
(1,200,000  $10)
$12,000,000
$75,000 U
Spending variance
$750,000 U
Efficiency variance
Allocated:
Budgeted Input Qty.
Allowed for
Actual Output
× Budgeted Rate
(4)
(1,125,000  $10)
$11,250,000
Never a variance
$825,000 U
Flexible-budget variance
$825000 U
Underallocated variable overhead
(Total variable overhead variance)
Never a variance
(b) Fixed Manufacturing Overhead Variance Analysis for Best Around, Inc. for 2020
Actual Costs
Incurred
(1)
Same Budgeted
Lump Sum
(as in Static Budget)
Regardless of
Output Level
(2)
Flexible Budget:
Same Budgeted
Lump Sum
(as in Static Budget)
Regardless of
Output Level
(3)
$17,100,000
$17,000,000
$17,000,000
$100,000 U
Spending variance
Never a variance
$100,000 U
Flexible-budget variance
Allocated:
Budgeted Input Qty.
Allowed for
Actual Output
× Budgeted Rate
(4)
(1,125,000 × $17)
$19,125,000
$2,125,000 F*
Production-volume variance
$2,125,000 F*
Production-volume variance
$2,025,000 F
Overallocated fixed overhead
(Total fixed overhead variance)
*
Alternative computation: 1,125,000 budgeted hrs. allowed – 1,000,000 denominator hrs. = 125,000 hrs.
125,000  $17 = $2,125,000 F
8-34
3.
The underallocated variable manufacturing overhead was $825,000 and overallocated
fixed overhead was $2,025,000. The flexible-budget variance and underallocated overhead are
always the same amount for variable manufacturing overhead, because the flexible-budget
amount of variable manufacturing overhead and the allocated amount of variable manufacturing
overhead coincide. In contrast, the budgeted and allocated amounts for fixed manufacturing
overhead only coincide when the budgeted input of the allocation base for the actual output level
achieved exactly equals the denominator level.
4.
The choice of the denominator level will affect inventory costs. The new fixed
manufacturing overhead rate would be $17,000,000 ÷ 1,700,000 = $10.00 per machine-hour. In
turn, the allocated amount of fixed manufacturing overhead and the production-volume variance
would change as seen below:
Actual
Budget
$17,100,000
$17,000,000
Allocated
1,125,000 × $10.00 =
$11,250,000
$100,000 U
$5,750,000 U*
Flexible-budget variance
Prodn. volume variance
$5,850,000 U
Total fixed overhead variance
*
Alternate computation: (1,700,000 – 1,125,000) × $10.00 = $5,750,000 U
The major point of this requirement is that inventory costs (and, hence, income determination)
can be heavily affected by the choice of the denominator level used for setting the fixed
manufacturing overhead rate.
8-35
8-38
(30 min.) Overhead variance, missing information.
Known figures denoted by an *
Case A:
Variable
Manufacturing
Overhead
Fixed
Manufacturing
Overhead
Actual Costs
Incurred
Actual Input
Qty.
× Budgeted Rate
Flexible Budget:
Budgeted Input
Qty.
Allowed for
Actual Output
× Budgeted Rate
Allocated:
Budgeted Input
Qty.
Allowed for
Actual Output
× Budgeted Rate
$120,400*
(6,270 × $20)
$125,400
(6,200* × $20)
$124,000*
(6,200* × $20)
$124,000*
$84,920*
$5,000* F
$1,400 U
Spending variance
Efficiency variance
(Lump sum)
$88,200*
$3,280 F
Spending variance
Never a variance
(Lump sum)
$88,200*
Never a variance
$1,400 U
Production-volume
variance
Total budgeted manufacturing overhead = $124,000 + $88,200 = $212,200
8-36
(6,200* × $14a)
$86,800*
Case B:
Actual Costs
Incurred
Variable
Manufacturing
Overhead
$45,640
Actual Input
Qty.
× Budgeted Rate
Flexible Budget:
Budgeted Input
Qty.
Allowed for
Actual Output
× Budgeted Rate
Allocated:
Budgeted Input
Qty.
Allowed for
Actual Output
× Budgeted Rate
(1,141  $42.00*)
$47,922
(1,200b 
$42.00*)
$50,400b
(1,200  $42.00*)
$50,400
$2,282 F*
Spending variance
Fixed
Manufacturing
Overhead
$23,180*
$2,478 F*
Efficiency variance
(Lump sum)
$20,000*
$3,180 U
Spending variance
Never a variance
(Lump sum)
$20,000*
Never a variance
$24,000c
$4,000 F*
Production-volume
variance
Total budgeted manufacturing overhead = $50,400 + $20,000 = $70,400
a
Budgeted FMOH rate = Standard fixed manufacturing overhead allocated ÷ Standard machinehours allowed for actual output achieved = $86,800 ÷ 6,200 = $14.
b
Budgeted hours allowed for actual output achieved must be derived from the output level
variance before this figure can be derived, or because the fixed manufacturing overhead rate is
$20,000 ÷ 1,000 = $20 and the allocated amount is $24,000, the budgeted hours allowed for the
actual output achieved must be 1,200 ($24,000 ÷ $20).
c
1,200  ($20,000* ÷ 1,000*) = $24,000.
8-37
8-39
1.
(1525 min.) Flexible budgets, 4-variance analysis.
Budgeted hours allowed
per unit of output
Budgeted DLH
= Budgeted actual output
= 2,304,000 ÷ 576,000 = 4 hours per unit
Budgeted DMLH allowed for August output = 46,000 units  4 hrs./unit = 184,000 DMLH
Allocated total MOH = 184,000 DMLHBudgeted total MOH rate per hour
= 184,000  $1.45* = $266,800
*Budgeted total MOH rate per hour = Annual budgeted fixed costs ÷ Annual budgeted DMLH
= $3,340,800 ÷ 2,304,000 = $1.45 per DMLH
2, 3, 4, 5. See Solution Exhibit 8-39
Variable manuf. overhead rate per DMLH = $0.40 + $0.25 = $0.65
Fixed manuf. overhead rate per DMLH
= $0.30 + $0.15 + $0.35 = $0.80
Fixed manuf. overhead budget for August = ($691,200 + $345,600 + $806,400) ÷ 12
= $1,843,200 ÷ 12 = $153,600
or,
Fixed manuf. overhead budget for August
= $57,600 + $28,800 + $67,200 = $153,600
Using the format of Exhibit 8-5 for variable manufacturing overhead and then fixed
manufacturing overhead:
Actual variable manuf. overhead: $76,800 + $89,400 = $166,200
Actual fixed manuf. overhead: $47,100 + $39,900 + $75,900 = $162,900
An overview of the 4-variance analysis using the block format of the text is:
Spending
Variance
Efficiency
Variance
ProductionVolume
Variance
Variable
Manufacturing
Overhead
$40,620 U
$5,980 U
Never a variance
Fixed
Manufacturing
Overhead
$9,300 U
Never a variance
$6,400 U
4-Variance
Analysis
8-38
SOLUTION EXHIBIT 8-39
Variable Manufacturing Overhead
Actual Costs
Incurred
(1)
$166,200
Actual Input Qty.
× Budgeted Rate
(2)
(193,200  $0.65)
$125,580
$40,620 U
Spending variance
Flexible Budget:
Budgeted Input Qty.
Allowed for
Actual Output
× Budgeted Rate
(3)
(184,000  $0.65)
$119,600
$5,980 U
Efficiency variance
Allocated:
Budgeted Input Qty.
Allowed for
Actual Output
× Budgeted Rate
(4)
(184,000  $0.65)
$119,600
Never a variance
Fixed Manufacturing Overhead
Actual Costs
Incurred
(1)
Same Budgeted
Lump Sum
(as in Static Budget)
Regardless of
Output Level
(2)
Flexible Budget:
Same Budgeted
Lump Sum
(as in Static Budget)
Regardless of
Output Level
(3)
$162,900
$153,600
$153,600
$9,300 U
Spending variance
Never a variance
8-39
Allocated:
Budgeted Input
Allowed for
Actual Output
× Budgeted Rate
(4)
(184,000  $0.80)
$147,200
$6,400 U
Production-volume variance
8-40
(20 min.) Activity-based costing, batch-level variance analysis
1. Static budget number of crates = Budgeted pairs shipped / Budgeted pairs per crate
= 300,000/15 = 20,000 crates
2. Flexible budget number of crates = Actual pairs shipped / Budgeted pairs per crate
= 270,000/15 = 18,000 crates
3. Actual number of crates shipped = Actual pairs shipped / Actual pairs per box
= 270,000/10 = 27,000 crates
4. Static budget number of hours = Static budget number of crates × budgeted hours per box
= 20,000 × 1.0 = 20,000 hours
Fixed overhead rate = Static budget fixed overhead / static budget number of hours
= $60,000/20,000 = $3.00 per hour
5.
Variable Direct Variance Analysis for Omega’s Fleet Feet, Inc. for 2020
Actual
Variable Cost
(27,000 × 1.2 × $18)
$583,200
Actual Hours
× Budgeted Rate
(27,000 × 1.2 × $20)
$648,000
$64,800 F
Price variance
6.
Budgeted Hours Allowed for
Actual Output × Budgeted Rate
(18,000 × 1.0 × $20)
$360,000
$288,000 U
Efficiency variance
Fixed Overhead Variance Analysis for Omega’s Fleet Feet, Inc. for 2020
Actual
Fixed Overhead
Static Budget
Fixed Overhead
$62,000
$60,000
$2,000 U
Spending variance
8-40
Budgeted Hours Allowed for
Actual Output × Budgeted Rate
(18,000 × 1.0 × $3.0)
$54,000
$6,000 U
Production volume variance
8-41 (30 – 40 minutes) Overhead variances and sales volume variance
1.
Variable overhead variances:
Actual
Variable Overhead
$527,000
Actual Hours
× Budgeted Rate
(310,000 × $1.80)
$558,000
$31,000 F
Spending variance
Budgeted Hours
× Budgeted Rate
(120,000 × 2.5* × $1.80)
$540,000
$18,000 U
Efficiency variance
*Standard machine hours per suitcase = Budgeted machine-hours ÷ Budgeted suitcases
= 375,000÷150,000 = 2.5 hours per suitcase
Fixed overhead variances:
Actual
Fixed Overhead
Static Budget
Fixed Overhead
$532,400
$525,000
7,400 U
Spending variance
Standard Hours
× Budgeted Rate
(120,000 × 2.5 × $1.40*)
$420,000
$105,000 U
Production-volume variance
*FOH rate is $525,000 / 375,000 std. machine-hours = $1.40 per machine-hour
2.
Units sold
Unit price
Revenues
Variable costs
Direct materials
Direct labor
Variable overhead
Total variable costs
Contribution margin
Fixed manufacturing
costs
Operating income
Actual
Results
(1)
120,000
$72
$8,640,000
FlexibleBudget
Variances
(2) = (1) –
(3)
Sales-Volume
Variances
(4) = (3) – (5)
$960,000 U
Flexible
Budget
(3)
120,000
$80
$9,600,000
$2,400,000 U
Static
Budget
(5)
150,000
$80
$12,000,000
2,400,000
2,160,000
527,000
5,087,000
3,553,000
0
0
13,000 F
13,000 F
947,000 U
2,400,000
2,160,000
540,000
5,100,000
4,500,000
600,000 F
540,000 F
135,000 F
1,275,000 F
1,125,000 U
3,000,000
2,700,000
675,000
6,375,000
5,625,000
532,400
$3,020,600
7,400 U
$954,400 U
525,000
$3,975,000
0
$1,125,000 U
525,000
$5,100,000
8-41
3. Budgeted cost per rolling suitcase:
Direct materials per bag (given)
Direct labor per bag (given)
Variable overhead ($1.80 per hour × 2.5 MH)
Fixed overhead ($1.40 per hour × 2.5 MH)
Total
Budgeted sales revenue, 120,000 actual units sold
120,000 × $80
Budgeted Cost of Goods sold
120,000 × $46
Budgeted operating income
4. Budgeted operating income (from #3)
Less: Unfavorable volume variance (from #1)
Flexible budget operating income
Less: Unfavorable flexible budget variance (#2)
Actual operating income
$20.00
18.00
4.50
3.50
$46.00
$9,600,000
5,520,000
$4,080,000
$4,080,000
105,000
$ 3,975,000
954,400
$3,020,600
5. Operating income volume variance:
Budgeted operating income for actual output – static budget operating income
= $4,080,000 – $5,100,000 = $1,020,000 U
Sales volume variance
= production volume variance + operating income volume variance
= $105,000 U + $1,020,000 U = $1,125,000 U
8-42
8-42
(30–40 min.) Variances in activity-based costing
The variance calculations are also the same except variances are calculated for three activities
rather than one. Note that total actual variable overhead costs remain at $100,000, but they are
simply broken out into 3 activities ($100,000 = $42,000 for purchase orders + $31,000 for
product testing + $27,000 for energy costs). Also, the flexible budget totaling $115,500 is broken
down into ($52,500 purchase orders) + ($42,000 product testing) + ($21,000 energy).
i.
Ronaldo’s Ice Cream
Computation of Variable Overhead Variance Analysis using Activity-Based Costing
For Purchase Orders:
Spending Variance:
= Actual Cost
= $42,000
= $42,000
= $2,000 (Unfavorable)
Efficiency Variance:
= (AQ × SR)
= (1,600 x $25)
= $40,000
= $(12,500) (Favorable)
For Product Testing:
Spending Variance:
= Actual Cost
= $31,000
= $31,000
= $(5,000) (Favorable)
Efficiency Variance:
= (AQ × SR)
= (180,000 x $0.20)
= $36,000
= $(6,000) (Favorable)
For Energy:
Spending Variance:
= Actual Cost
= $27,000
= $27,000
= $(1,750) (Favorable)
-
(AQ × SR)
(1,600 x $25)
$40,000
−
-
(SQ × SR)
(2,100 orders x $25 per order)
$52,500
-
(AQ × SR)
(180,000 test minutes x $0.20 per minute)
$36,000
−
-
(SQ × SR)
(210,000 orders x $0.20)
$42,000
-
(AQ × SR)
(575,000 test minutes x $0.05 per minute)
$28,750
8-43
Efficiency Variance:
= (AQ × SR)
= (575,000 x $0.05)
= $28,750
= $7,750 (Unfavorable)
−
-
(SQ × SR)
(420,000 x $0.05)
$21,000
ii. Spending Variance: $2,000 unfavorable variable overhead spending variance = $42,000
−$40,000. Variance is unfavorable because the actual variable overhead cost is higher than the
expected cost given actual quantity of 1,600 purchase orders.
Efficiency Variance: $(12,500) favorable variable overhead efficiency variance = $40,000 –
$52,500. Variance is favorable because the 1,600 actual purchase orders are lower than the 2,100
expected (budgeted) purchase orders.
Note: AQ = Actual quantity of activity. SR = Standard variable manufacturing overhead rate per
unit of activity. SQ = Standard quantity of activity given actual production of 210,000 units.
Standard quantity of 2,100 purchase orders = Standard of 0.01 purchase orders per unit ×
210,000 actual units produced.
This type of costing system and resulting variance analysis provides management with further
information regarding variable overhead costs and variances. Management often establishes
criteria to decide which variances to investigate. Assume that management of Ronaldo’s Ice
Cream chooses to investigate the $7,750 unfavorable efficiency variance associated with energy.
The management would like to know why 575,000 minutes of actual machine time were used
instead of the expected 420,000 minutes. Perhaps the machines were operating poorly due to
cutbacks in maintenance, or maybe new employees were not as efficient using the machines.
Whatever the cause, Ronaldo’s has identified the issue by integrating its activity-based costing
system with the cost variance analysis concepts.
8-44
8-43 (3040 min.) Comprehensive review of Chapters 7 and 8, working backward from
given variances.
1.
Solution Exhibit 8-43 outlines the Chapter 7 and 8 framework underlying this solution.
a.
Pounds of direct materials purchased = $179,300 ÷ $1.10 = 163,000 pounds
b.
Pounds of excess direct materials used = $75,900 ÷ $11.50 = 6,600 pounds
c.
Variable manufacturing overhead spending variance = $10,400 – $18,100 = $7,700 F
d.
Standard direct manufacturing labor rate = $1,250,000 ÷ 50,000 hours = $25 per hour
Actual direct manufacturing labor rate = $25 + $0.50 = $25.50
Actual direct manufacturing labor-hours = $535,500 ÷ $25.50
= 21,000 hours
e.
Standard variable manufacturing overhead rate = $500,000 ÷ 50,000
= $10 per direct manuf. labor-hour
Variable manuf. overhead efficiency variance of $18,100 ÷ $10 = 1,810 excess hours
Actual hours – Excess hours = Standard hours allowed for units produced
21,000 – 1,810 = 19,190 hours
f.
Budgeted fixed manufacturing overhead rate
= $1,000,000 ÷ 50,000 hours
= $20 per direct manuf. labor-hour
Fixed manufacturing overhead allocated = $20  19,190 hours = $383,800
Production-volume variance = $1,000,000 – $383,800 = $616,200 U
5.
The control of variable manufacturing overhead requires the identification of the cost
drivers for such items as energy, supplies, and repairs. Control often entails monitoring
nonfinancial measures that affect each cost item, one by one. Examples are kilowatts used,
quantities of lubricants used, and repair parts and hours used. The most convincing way to
discover why overhead performance did not agree with a budget is to investigate possible causes,
line item by line item.
Individual fixed overhead items are not usually affected very much by day-to-day
control. Instead, they are controlled periodically through planning decisions and budgeting
procedures that may sometimes have planning horizons covering six months or a year (for
example, management salaries) and sometimes covering many years (for example, long-term
leases and depreciation on plant and equipment).
8-45
SOLUTION EXHIBIT 8-43
Direct
Materials
Direct
Manuf.
Labor
Flexible Budget:
Budgeted Input Qty.
Actual Input Qty.
Allowed for
Actual Output
 Budgeted Rate
Purchases
Usage
 Budgeted Rate
163,000  $11.50
126,600  $11.50
6  20,000  $11.50
$1,874,500
$1,455,900
$1,380,000
$75,900 U
$179,300 F
Efficiency
variance
Price variance
Actual Costs
Incurred
(Actual Input Qty.
 Actual Rate)
163,000  $10.40
$1,695,200
21,000  $25.50
$535,500
21,000  $25
$525,000
$10,500 U
Price variance
19,190  $25
$479,750
$45,250 U
Efficiency variance
$55,750 U
Flexible-budget variance
Variable
MOH
Actual Costs
Incurred
Actual Input Qty.
 Actual Rate
21,000  $9.63333
$202,300
Actual Input Qty.
 Budgeted Rate
21,000  $10
$210,000
Flexible Budget:
Budgeted Input Qty.
Allowed for
Actual Output
 Budgeted Rate
19,190 $10
$191,900
$7,700 F
Spending variance
$18,100 U
Efficiency
$10,400 U variance
Flexible-budget variance
Actual Costs
Incurred
(1)
Fixed
MOH
$957,550
Never a variance
Never a variance
Flexible Budget:
Same Budgeted
Same Budgeted
Lump Sum
Lump Sum
(as in Static Budget) (as in Static Budget)
Regardless of
Regardless of
Output Level
Output Level
(2)
(3)
50,000 × $20
$1,000,000
$1,000,000
$42,450 F
Never a variance
Spending variance
volume variance $42,450 F
Flexible-budget variance
8-46
Allocated:
Budgeted Input Qty.
Allowed for
Actual Output
 Budgeted Rate
19,190  $10
$191,900
Allocated:
Budgeted Input Qty.
Allowed for
Actual Output
× Budgeted Rate
(4)
19,190× $20
$383,800
$616,200 U
$616,200 U
Production volume variance
8-44
1.
(3050 min.) Review of Chapters 7 and 8, 3-variance analysis.
Total standard production costs are based on 7,600 units of output.
Direct materials, 7,600  $20.00
7,600  5 lbs.  $4.00 (or 38,000 lbs.  $4.00)
Direct manufacturing labor, 7,600  $64.00
7,600  4 hrs.  $16.00 (or 30,400 hrs.  $16.00)
Manufacturing overhead:
Variable, 7,600  $32.00 (or 30,400 hrs.  $8.00)
Fixed, 7,600  $36.00 (or 30,400 hrs.  $9.00)
Total
The following is for later use:
Fixed manufacturing overhead, a lump-sum budget
*
Fixed manufacturing overhead rate =
$ 152,000
486,400
243,200
273,600
$1,155,200
$333,000*
Budgeted fixed manufacturing overhead
Denominator level
$9.00 = Budget/37,000 hours
Budget = 37,000 hours  $9.00 = $333000
2. Solution Exhibit 8-44 presents a columnar presentation of the variances for Beal. An
overview of the 3-variance analysis using the block format of the text is:
3-Variance
Analysis
Total Manufacturing
Overhead
Spending
Variance
Efficiency
Variance
Production
Volume Variance
$65,800 U
$8,000 U
$59,400 U
8-47
SOLUTION EXHIBIT 8-44
Flexible Budget:
Actual Costs
Budgeted Input Qty.
Incurred:
Actual Input Qty.
Allowed for
Actual Input Qty.
Actual Output
 Budgeted Price
× Actual Rate
Purchases
Usage
× Budgeted Price
Direct
(40,300  $3.80) (40,300  $4.00)
(37,300  $4.00)
(38,000  $4.00)
Materials
$153,140
$161,200
$149,200
$152,000
$8,060 F
a. Price variance
Direct
Manuf.
Labor
(31,400  $16.25)
$510,250
$2,800 F
b. Efficiency variance
(31,400  $16.00)
$502,400
$7,850 U
c. Price variance
Variable
Manuf.
Overhead
(30,400  $16.00)
$486,400
$16,000 U
d. Efficiency variance
Actual
Costs
Incurred
Actual Input Qty.
 Budgeted Rate
Flexible Budget:
Budgeted Input Qty.
Allowed for
Actual Output
 Budgeted Rate
(not given)
(31,400  $8.00)
$251,200
(30,400  $8.00)
$243,200
$8,000 U
Efficiency variance
Fixed
Manuf.
Overhead
(not given)
$333,000
Total
Manuf.
Overhead
(given)
$650,000
($333,000 + $251,200)
$584,200
$65,800 U
e. Spending variance
*
Denominator level in hours
Production volume in standard hours allowed
Production-volume variance
($243,200 + $273,600)
$516,800
$59,400 U
g. Prodn. volume variance
37,000
30,400
6,600 hours × $9.00 = $59,400 U
8-48
(30,400  $9.00)
$273,600
$59,400 U*
Prodn. volume variance
($243,200 + $333,000)
$576,200
$8,000 U
f. Efficiency variance
(30,400  $8.00)
$243,200
Never a variance
$333,000
Never a variance
Allocated:
(Budgeted Input Qty.
Allowed for
Actual Output
 Budgeted Rate)
8-45 (20 minutes) Non-financial variances
1.
Variance Analysis of Inspection Hours for Kathy’s Kettle Potato Chips for May
Actual Hours
For Inspections
120 hours
Actual Pounds
Inspected/Budgeted
Pounds per hour
22,300 lbs÷200 lbs./hr.
111.5 hours
8.5 hours U
Efficiency Variance
2.
Standard Pounds Inspected
for Actual Output /Budgeted
Pounds per hour
(113,000 × 0.2) lbs.÷(200 lbs./hr.)
113 hours
1.5 hours F
Quantity Variance
Variance Analysis of Pounds Failing Inspection for Kathy’s Kettle Potato Chips for May
Actual Pounds
Failing Inspections
215 lbs
Actual pounds
Standard Pounds Inspected
Inspected × Budgeted
for Actual Output × Budgeted
Inspection Failure Rate
Inspection Failure Rate
(22,300 lbs × 0.01)
(113,000 × 0.2 × 0.01)
223 lbs
226 lbs
8 lbs F
Quality Variance
3 lbs F
Quantity Variance
8-49
8-46 (30 minutes) Overhead variances, service sector
1.
In the columnar presentation of variable overhead variance analysis, all numbers shown in
bold are calculated from the given information, in the order (a) - (e).
VARIABLE MANUFACTURING OVERHEAD
Actual Costs
Incurred
(c)
$89,500
Actual Input Qty.
 Budgeted Rate
(b)
15,000
$6.00

RAM hrs.
per RAM hr.
$90,000
$500 F
Spending variance
Flexible Budget:
Budgeted Input Qty.
Allowed for
Budgeted
Actual Output 
Rate
(a)
14,850
$6.00

RAM hrs.
per RAM hr.
$89,100
$900 U (d)
Efficiency variance
$400 U (e)
Flexible-budget variance
a.
14,850 RAM hours

$6 per RAM hour = $89,100
b.
15,000 RAM hours

$6 per RAM hour = $90,000
c.
Actual VMOH = $90,000 – $500F (VOH spending variance) = $89,500
d.
VOH efficiency variance = $90,000 – $89,100 = $900 U
e.
VOH flexible budget variance = $900U – $500F = $400 U
f.
Allocated variable overhead will be the same as the flexible budget variable overhead of
$89,100. The actual variable overhead cost is $89,500. Therefore, variable overhead is
underallocated by $400.
8-50
2.
In the columnar presentation of fixed overhead variance analysis, all numbers shown in
bold are calculated from the given information, in the order (a) – (e).
Actual Costs
Incurred
$30,375
FIXED MANUFACTURING OVERHEAD
Flexible Budget:
Allocated:
Static Budget Lump Sum Budgeted Input Qty.
Regardless of Output
Allowed for
Budgeted
Level
Actual Output
Rate

(a)
(c)
14,850
$1.60* (b)

RAM hrs.
per RAM hr.
$28,800
$23,760
$1,575 U
Spending variance
$5,040 U (d)
Production-volume variance
$1,575 U (e)
Flexible-budget variance
a.
Actual FOH costs = $30,375
Static budget FOH lump sum = $30,375 – $1,575 spending variance = $28,800
b.
*FOH allocation rate = $28,800 FOH static-budget lump sum  18,000 static-budget RAM-hours
= $1.60 per RAM hour
c.
Allocated FOH = 14,850 RAM hours
d.
Production Volume Varaince = $28,800 – $23,760 = $5,040 U
e.
FOH flexible budget variance = FOH spending variance = $1,575 U
f.
Allocated fixed overhead is $23,760. The actual fixed overhead cost is $30,375. Therefore,
fixed overhead is underallocated by $6,615. This is the sum of the fixed overhead spending
variance of $1,575 and the production-volume variance of $5,040.

$1.60 per RAM hour = $23,760
8-51
8-47
(30 min.) Direct-cost and overhead variances, income statement.
Direct materials,
200,000  2 yds.  $3.00
Direct manufacturing labor
200,000  0.5 hrs.  $18.00
Fixed manufacturing overhead
Lump-sum
Total
$1,200,000
1,800,000
_ 400,000
$3,400,000
Standard cost per unit = $3,400,000/200,000 = $17.00 per unit
Fixed manufacturing overhead rate
= Budgeted fixed manufacturing overhead / Denominator level
= $400,000/(180,000 × 0.5 hrs.)
= $400,000/ 90,000 hours
= $4.444 per labor hour
1.
Solution Exhibit 8-47 presents a columnar presentation of the variances. Based on the
exhibit, the variances are as follows:
a.
b.
c.
d.
e.
f.
g.
Direct materials efficiency variance = $30,000 U
Direct materials price variance = $20,500 U
Direct labor efficiency variance = Never a variance
Direct labor price variance = $5,000 F
Total manufacturing overhead spending variance = $50,000 U
Fixed overhead flexible budget variance = Spending variance = $50,000 U
Fixed overhead production-volume variance = $44,400 F
Note that the total variances for the period equal:
$30,000 U + $20,500 U + Never + $5,000 F + $50,000 U + $44,400 F = $51,100 U.
This represents the cumulative amount by which costs were under-applied during the year.
8-52
SOLUTION EXHIBIT 8-47
Actual Costs
Incurred:
Actual Input Qty.
× Actual Rate
Direct
Materials
Actual Input Qty.
Budgeted Price
Purchases
Usage
(410,000  $3.05)
$1,250,500
(410,000  $3)
$1,230,000
(410,000  $3)
$1,230,000
$20,500 U
Price variance
Direct
Manuf.
Labor
(100,000  $18.00)
$1,800,000
$5,000 F
Price variance
Actual
Costs
Incurred
Actual Input Qty.
 Budgeted Rate
$450,000
$400,000
$50,000 U
Spending variance
2.
(200,000  2  $3)
$1,200,000
$30,000 U
Efficiency variance
(100,000 $17.95)
$1,795,000
Fixed
Manuf.
Overhead
Flexible Budget:
Budgeted Input Qty.
Allowed for
Actual Output
× Budgeted Price
200,000  0.5 hrs  $18.00)
$1,800,000
Never
Efficiency variance
Flexible Budget:
Allocated:
Budgeted Input Qty.
(Budgeted Input Qty.
Allowed for
Allowed for
Actual Output
Actual Output
 Budgeted Rate
 Budgeted Rate)
$400,000
Never a variance
(200,000  0.5 hrs  $4.444)
$444,400
$44,400 F
Prodn. volume variance
Sales Revenue = 160,000 units sold × $25.00
Cost of Goods sold:
At standard:
160,000 × $17.00
(+) Prorated share of underapplied cost: $51,100 × (160,000/200,000)
Total
Gross Margin = $4,000,000 (–) $2,760,880
= $1,239,120
8-53
= $4,000,000
= $2,720,000
= $40,880
$2,760,880
8-48 (40 minutes) Overhead variances, ethics
1.
a. Shanghai plant:
Expected output in units
Direct labor hours per unit
Total budgeted labor hours
2,000,000
0.50
1,000,000
Budgeted fixed OH rate = $2,400,000 / 1,000,000 DLH = $2.40 per DLH
Shenzhen plant:
Expected output in units
2,100,000
Direct labor hours per unit
0.50
Total budgeted labor hours
1,050,000
Budgeted fixed OH rate = $2,205,000 / 1,050,000 DLH = $2.10 per DLH
b.
Allocation of common fixed costs:
To Shanghai: $3,150,000 × 2/3 = $2,100,000
To Shenzhen:
$3,150,000 × 1/3 = $1,050,000
Shanghai plant:
Budgeted fixed OH rate = ($2,400,000 + $2,100,000) / 1,000,000 DLH = $4.50 per DLH
Shenzhen plant:
Budgeted fixed OH rate = ($2,205,000 + $1,050,000)/ 1,050,000 DLH = $3.10 per DLH
2.
Variable overhead variances:
Shanghai plant:
Actual
Variable Overhead
(1,020,000 × $3.20)
$3,264,000
Actual hours
× Budgeted rate
(1,020,000 × $3.30)
$3,366,000
Budgeted input allowed for
Actual output × Budgeted rate
(1,950,000 × 0.50 × $3.30)
$3,217,500
$102,000 F
$148,500 U
Spending variance
Efficiency variance
Shenzhen plant:
Actual
Actual hours
Budgeted input allowed for
Variable Overhead
× Budgeted rate
Actual output × Budgeted rate
(1,225,000 × $3.20)
(1,225,000 × $3.10) (2,175,000 × 0.50 × $3.10)
$3,920,000
$3,797,500
$3,371,250
$122,500 U
Spending variance
8-54
$426,250 U
Efficiency variance
3. Fixed overhead variances
a. Excluding the allocated common costs
Shanghai plant:
Actual
Fixed Overhead
$2,440,000
$2,400,000
Static Budget
Budgeted input allowed for
Fixed Overhead
Actual output × Budgeted Rate
(1,950,000 × 0.50 × $2.40)
$2,340,000
$40,000 U
Spending variance
Shenzhen plant:
Actual
Fixed Overhead
$2,300,000
$60,000 U
Production-volume variance
Static Budge
Budgeted input allowed for
Fixed Overhead
Actual output × Budgeted Rate
(2,175,000 × 0.50 × $2.10)
$2,205,000
$2,283,750
$95,000 U
Spending variance
$78,750 F
Production-volume variance
b. Including allocated common costs
Shanghai plant:
Actual
Static Budget
Budgeted input allowed for
Fixed Overhead
Fixed Overhead
Actual output ×Budgeted Rate
$2,440,000 + (2/3 ×$3,075,000) ($2,400,000 + $2,100,000)
(1,950,000 × 0.50 × $4.50)
$4,500,000
$4,387,500
$4,490,000
$10,000 F
Spending variance
$112,500 U
Production-volume variance
Shenzhen plant:
Actual
Static Budget
Budgeted input allowed for
Fixed Overhead
Fixed Overhead
Actual output × Budgeted Rate
$2,300,000 + (1/3 × $3,075,000) ($2,205,000 + $1,050,000)
(2,175,000 × 0.50 × $3.10)
$3,255,000
$3,371,250
$3,325,000
$70,000 U
Spending variance
$116,250 F
Production-volume variance
8-55
4.
5.
Ken Wooi Keong’s attempt did not fully work. Even though he tried to allocate a
significantly larger amount of common cost to the Shanghai plant than to the Shenzhen
plant, the cost becomes part of the fixed overhead rate and thus will only cause a large
unfavorable spending variance for the Shanghai plant if the cost itself is much larger than
expected. Because the actual common costs were lower, the result was actually to shift
Shanghai’s spending variance from unfavorable to favorable! Also, the spending variance
for the Shenzhen plant is already larger than that of the Shanghai plant, and the gap
between them only increases when the common fixed costs are added to both plants. That
said, the inclusion of the common fixed cost does exacerbate the impact of the
underproduction by Shanghai relative to budget (via the higher unfavorable production
volume variance) while increasing the favorable volume variance for Shenzhen.
Common fixed costs should not be allocated to units that are being evaluated for
performance because common fixed costs are not controllable by those units. Thus, the
units should not be responsible for such costs.
Ken Wooi Keong’s behavior is not ethical. He attempted to make his friend better off by
manipulating costs and overhead rates, rather than focusing on which cost system would
provide the best measure of relative performance among the divisions.
8-56
Try It! 8-1
a.
Budgeted variable overhead = $25 per hour × (20,000 × 0.75) machine-hours
= $375,000
b.
Variable overhead spending variance = ($26 − $25) × 13,000
= $13,000 U
c.
Variable overhead efficiency variance = [13,000 − (18,000 × 0.75)] × $25
= $12,500 F
Try It! 8-2
a.
Fixed overhead rate
= (Expected overhead ÷ Expected machine-hours)
= ($300,000 ÷ 15,000)
= $20 per hour
b.
Fixed overhead spending variance = $290,000 − $300,000
= $10,000 F
c.
Budgeted machine-hours per unit = 15,000 hours ÷ 20,000 unit
= 0.75 hours per unit
Allocated fixed overhead = 18,000 units × 0.75 hours × $20 per hour = $270,000
Production-volume variance = $300,000 − $270,000
= $30,000 U
Try It! 8-3
3-Variance
Analysis
Spending
Variance
Efficiency
Variance
Production
Volume Variance
Variable Manufacturing Overhead
$13,000 U
$12,500 F
Never a variance
Fixed Manufacturing Overhead
$10,000 F
Never a variance
$30,000 U
a.
Total spending variance = $13,000 U + $10,000 F = $3,000 U
b.
Total overhead variance = $13,000 U + $12,500 F + $10,000 F + $30,000 U
= $20,500 U
8-57
Try It! 8-4
a.
Spending variance = $12,150 − $12,000 = $150 U
b.
Budgeted setup hours = (15,000 ÷ 250 units per batch) × 5 hours per batch
= 300 hours
Fixed setup overhead rate = $12,000 ÷ 300 = $40 per setup hour
c.
Fixed setup overhead allocation = [(13,000 ÷ 250) × 5 × $40]
= $10,400
Production-volume variance = Budgeted costs ($12,000) – Overhead allocation ($10,400)
= $1,600 U
8-58
CHAPTER 9
INVENTORY COSTING AND CAPACITY ANALYSIS
9-1
No. Differences in operating income between variable costing and absorption costing are
due to accounting for fixed manufacturing costs. Under variable costing only variable
manufacturing costs are included as inventoriable costs. Under absorption costing both variable
and fixed manufacturing costs are included as inventoriable costs. Fixed marketing and
distribution costs are not accounted for differently under variable costing and absorption costing.
9-2
Variable costing treats fixed production overhead as a period cost while absorption
costing treats fixed production overhead as a product cost.
A period cost is a cost charged against profit or loss in full in the period it is incurred.
Variable costing charges only variable production cost to product and treats fixed production
cost as a period cost. This is because fixed cost does not vary with activity level.
A product cost is a cost that can be traced and identified with the cost of production as
both variable and fixed cost of production. Absorption costing believes that fixed production
overhead should not be charged against profit or loss rather, it should be spread across the units
of production.
9-3
No. The difference between absorption costing and variable costs is due to accounting for
fixed manufacturing costs. As service or merchandising companies have no fixed manufacturing
costs, these companies do not make choices between absorption costing and variable costing.
9-4
The main issue between variable costing and absorption costing is the proper timing of
the release of fixed manufacturing costs as costs of the period:
a. at the time of incurrence, or
b. at the time the finished units to which the fixed overhead relates are sold.
Variable costing uses (a) and absorption costing uses (b).
9-5
No. A company that makes a variable-cost/fixed-cost distinction is not forced to use any
specific costing method. The Stassen Company example in the text of Chapter 9 makes a
variable-cost/fixed-cost distinction. As illustrated, it can use variable costing, absorption costing,
or throughput costing.
A company that does not make a variable-cost/fixed-cost distinction cannot use variable
costing or throughput costing. However, it is not forced to adopt absorption costing. For internal
reporting, it could, for example, classify all costs as costs of the period in which they are
incurred.
9-6
Variable costing does not view fixed costs as unimportant or irrelevant, but it maintains
that the distinction between behaviors of different costs is crucial for certain decisions. The
planning and management of fixed costs is critical, irrespective of what inventory costing
method is used.
9-7
Under absorption costing, heavy reductions of inventory during the accounting period
might combine with low production and a large production volume variance. This combination
could result in lower operating income even if the unit sales level rises.
9-1
9-8
(a) The factors that affect the breakeven point under variable costing are:
1. Fixed (manufacturing and operating) costs.
2. Contribution margin per unit.
(b) The factors that affect the breakeven point under absorption costing are:
1. Fixed (manufacturing and operating) costs.
2. Contribution margin per unit.
3. Production level in units in excess of breakeven sales in units.
4. Denominator level chosen to set the fixed manufacturing cost rate.
9-9
Examples of dysfunctional decisions managers may make to increase reported operating
income are:
a. Plant managers may switch production to those orders that absorb the highest amount of
fixed manufacturing overhead, irrespective of the demand by customers.
b. Plant managers may accept a particular order to increase production even though another
plant in the same company is better suited to handle that order.
c. Plant managers may defer maintenance beyond the current period to free up more time for
production.
9-10 Approaches used to reduce the negative aspects associated with using absorption costing
include:
a. Change the accounting system:
 Adopt either variable or throughput costing, both of which reduce the incentives of
managers to produce for inventory.
 Adopt an inventory holding charge for managers who tie up funds in inventory.
b. Extend the time period used to evaluate performance. By evaluating performance over a
longer time period (e.g., 3 to 5 years), the incentive to take short-run actions that reduce longterm income is lessened.
c. Include nonfinancial as well as financial variables in the measures used to evaluate
performance.
9-11 The theoretical capacity and practical capacity denominator-level concepts emphasize
what a plant can supply. The normal capacity utilization and master-budget capacity utilization
concepts emphasize what customers demand for products produced by a plant.
9-12 The downward demand spiral is the continuing reduction in demand for a company’s
product that occurs when the prices of competitors’ products are not met and (as demand drops
further), higher and higher unit costs result in more and more reluctance to meet competitors’
prices. Pricing decisions need to consider competitors and customers as well as costs.
9-13 No. It depends on how a company handles the production-volume variance in the end-ofperiod financial statements. For example, if the adjusted allocation-rate approach is used, each
denominator-level capacity concept will give the same financial statement numbers at year-end.
9-14 For tax reporting in the U.S., the IRS requires only that indirect production costs are
“fairly” apportioned among all items produced. Overhead rates based on normal or master-
9-2
budget capacity utilization, as well as the practical capacity concept are permitted. At year-end,
proration of any variances between inventories and cost of goods sold is required (unless the
variance is immaterial in amount).
9-15 No. The costs of having too much capacity/too little capacity involve revenue
opportunities potentially forgone as well as costs of money tied up in plant assets.
9-3
9-16 Choice "d" is correct. Inventory under the absorption method includes fixed overhead
costs, while the variable cost method includes fixed overhead costs as period costs. Fixed
overhead costs will hit the income statement under variable costing in the period they are
incurred, while under the absorption method, an increase in inventory results in more costs (fixed
overhead) remaining on the balance sheet. These costs will not hit the income statement (and
therefore net income) until the inventory is sold, which implies the absorption method will
produce a higher net income in this situation.
The other choices are incorrect as the statements contained in them are accurate.
The statement in "a" is accurate, as all SG&A expenses, fixed and variable, will be period costs
(not included in inventory) under either method.
The statement in "b" is accurate, as the absorption method should be used for financial reporting.
The variable cost method is used internally but does not fit under GAAP and is therefore not
reported externally.
The statement in "c" is accurate, as fixed overhead costs under variable costing will hit the
income statement as an expense in the period they are incurred.
9-17
Choice ‘c’ is correct.
Profit under variable costing
Adjustment for fixed overhead absorbed (17,500 – 14,800) units × £5.20
Profit under absorption costing
£315,250
£14,040
£329,290
Note that when there is increase in inventory, absorption costing reports higher profit.
Difference in profit is accounted for by the different valuation methods used. This difference is
in the fixed overhead absorption rate.
Choice ‘a’ is incorrect. The profit figure has been computed as £315,250 – (£5.20 × 17,500) =
£224,250.
Choice ‘b’ is incorrect. The profit figure has been computed as £315,250 – (£5.20 × 14,800) =
£238,290.
Choice ‘d’ is incorrect. The adjustment for fixed overhead absorption has been deducted from
the profit figure instead of adding.
9-18
Choice ‘c’ is correct.
Selling price unit
Total variable costs per unit (£4.50 + £2.50)
Contribution per unit
Total contribution (£11 × 33,780 units)
Total fixed cost
Operating income
9-4
£18
£7
£11
£371,580
£249,000
£122,580
Note: All variable costs are deducted from revenues to derive contribution.
Choice ‘a’ is incorrect. Only the variable manufacturing cost of £4.50 has been included, causing
a profit of £207,030.
Choice ‘b’ is incorrect. Only the variable manufacturing cost of £2.50 has been included causing
a profit of £274,590.
Choice ‘d’ is incorrect. Option ‘c’ is correct.
9-19
Choice ‘a’ is correct.
If C/S is 40%, Contribution per unit = 40% × £75 = £30
Contribution margin = Contribution per unit × quantity sold
= £30 × 5,200 units = £156,000
Operating income = Total contribution less Total fixed cost
= £156,000 – £27,400
= £128,600
Choice ‘b’ is incorrect. Fixed cost has been added to the total contribution (£156,000 + £
27,400).
Choice ‘c’ is incorrect. The total contribution has been computed using the production units of
5,800 rather than the sold units of 5,200.
Choice ‘d’ is incorrect. Option ‘a’ is the correct answer.
9-20 The answer is choice "d". This is not a true statement. The I.R.S. only allows absorption
costing for financial statements, which is the same method required for U.S. GAAP.
Choices “b” and “c” are factually accurate. Variable costing is useful for decision making
because it segregates costs based on behavior, identifies the contribution margin, and expenses
fixed costs rather than unitizing them into the cost of products.
Choice “a” is again a true statement. Under absorption costing, the choice of output and
inventory affects the realized level of net income, making it more susceptible to manipulation
and a less reliable measure of managerial performance.
9-5
9-21
i.
(10 min.) Computation of overhead absorption rate, and over/under absorption
Calculation of overhead absorption rate
Budgeted Overhead Cost
¥598,500
Overhead Absorption Rate (OAR)= Budgeted Activity Level = 28,500 hours = ¥21/hour
ii.
Calculation of Over/Under absorption of overhead
January
February
¥
¥
Actual overhead cost incurred
600,000
650,000
Absorbed overhead cost
607,950
617,400
Under / (Over) absorbed overhead
(7,950)
32,600
iii.
The major cause of under or over absorption of overhead costs is based on the
changes in the production capacity. Where the actual production capacity exceeds
the budgeted, this can cause increase in the manufacturing overheads. In addition, a
decrease in the units of production can lead to reduction in the manufacturing
overheads causing under or over absorption.
9-6
9-22
(30 min.) Variable and absorption costing techniques
i.
Income statement Using Variable Costing
Technique
£
Revenues
Variable Cost of Sales:
Direct material
Direct labour
Variable manufacturing overhead
Cost of goods available for sales
Ending inventory
Variable manufacturing costs
Variable selling and distribution
expenses
Variable Cost of Sales
Contribution margin
Fixed Cost
Fixed manufacturing overhead
Operating income
£
1,260,000
(2,800 x £450)
(3,000 x £120)
(3,000 x £80)
(3,000 x £65)
(200 x £265)
(2,800 x £15)
360,000
240,000
195,000
795,000
53,000
742,000
42,000
784,000
476,000
(3,000 x £70)
210,000
266,000
ii. Income statement Using Absorption Costing Technique
£
Revenues
Cost of goods sold
Direct material
Direct labour
Variable production overhead
Fixed manufacturing overhead
Cost of goods available for sales
Deduct ending inventory
Cost of goods sold
Gross Margin
Operating costs:
Variable selling and distribution
expenses
Operating income
(2,800 x £450)
(3,000 x £120)
(3,000 x £80)
(3,000 x £65)
(3,000 x £70)
(200 x £335) see working
£
1,260,000
360,000
240,000
195,000
210,000
1,005,000
67,000
938,000
322,000
(2,800 x £15)
Working: deriving manufacturing cost of the ending inventory:
Total manufacturing cost is calculated as
follows:
£
9-7
42,000
280,000
Direct material
Direct labour
Variable manufacturing overhead
Variable Manufacturing Cost
Fixed Manufacturing Overhead
Total manufacturing Cost
120
80
65
265
70
335
iii. The operating income produced by the absorption costing technique (£280,000), is higher
profit than that of the marginal costing method (£266,000). The main reason is that the
absorption technique charges production overheads to the cost of goods produced while the
marginal costing technique considers only the variable costs in the production cost.
9-8
9-23
(40 min.)
differences.
1.
Variable and absorption costing, explaining operating-income
Key inputs for income statement computations are:
Beginning inventory
Production
Goods available for sale
Units sold
Ending inventory
January
0
1,500
1,500
1,350
150
February
150
1,400
1,550
1,400
150
March
150
1,520
1,670
1,530
140
The budgeted fixed manufacturing cost per unit and budgeted total manufacturing cost
per unit under absorption costing are:
(a)
(b)
(c)=(a)÷(b)
(d)
(e)=(c)+(d)
Budgeted fixed manufacturing costs
Budgeted production
Budgeted fixed manufacturing cost per unit
Budgeted variable manufacturing cost per unit
Budgeted total manufacturing cost per unit
9-9
January
$525,000
1,500
$350
$1,000
$1,350
February
$525,000
1,500
$350
$1,000
$1,350
March
$525,000
1,500
$350
$1,000
$1,350
(a)
Variable Costing
Revenues
Variable costs
Beginning inventoryb
Variable manufacturing costsc
Cost of goods available for sale
Deduct ending inventoryd
Variable cost of goods sold
Variable operating costse
Total variable costs
Contribution margin
Fixed costs
Fixed manufacturing costs
Fixed operating costs
Total fixed costs
Operating income
January 2020
$4,455,000
a
$
0
1,500,000
1,500,000
(150,000)
1,350,000
1,080,000
February 2020
$4,620,000
$ 150,000
1,400,000
1,550,000
(150,000)
1,400,000
1,120,000
2,430,000
2,025,000
525,000
130,000
March 2020
$5,049,000
$ 150,000
1,520,000
1,670,000
(140,000)
1,530,000
1,224,000
2,520,000
2,100,000
525,000
130,000
655,000
$1,370,000
525,000
130,000
655,000
$1,445,000
a $3,300 × 1,350; $3,300 × 1,400; $3,300 × 1,530
b $? × 0; $1,000 × 150; $1,000 × 150
c $1,000 × 1,500; $1,000 × 1,400; $1,000 × 1,520
d $1,000 × 150; $1,000 × 150; $1,000 × 140
e $800 × 1,350; $800 × 1,400; $800 × 1,530
9-10
2,754,000
2,295,000
655,000
$1,640,000
(b)
Absorption Costing
Revenuesa
Cost of goods sold
Beginning inventoryb
Variable manufacturing costsc
Allocated fixed manufacturing
costsd
Cost of goods available for sale
Deduct ending inventorye
Adjustment for prod. vol. var.f
January 2020
$4,455,000
$
0
1,500,000
$ 202,500
1,400,000
525,000
2,025,000
(202,500)
0
490,000
2,092,500
(202,500)
35,000 U
Cost of goods sold
Gross margin
Operating costs
Variable operating costsg
Fixed operating costs
Total operating costs
Operating income
February 2020
$4,620,000
1,822,500
2,632,500
1,080,000
130,000
March 2020
$5,049,000
$ 202,500
1,520,000
532,000
2,254,500
(189,000)
(7,000) F
1,925,000
2,695,000
1,120,000
130,000
1,210,000
$1,422,500
1,224,000
130,000
1,250,000
$1,445,000
a
$3,300 × 1,350; $3,300 × 1,400; $3,300 × 1,530
$? × 0; $1,350 × 150; $1,350 × 150
c
$1,000 × 1,500; $1,000 × 1,400; $1,000 × 1,520
d
$350 × 1,500; $350 × 1,400; $350 × 1,520
e
$1,350 × 150; $1,350 × 150; $1,350 × 140
f
$525,000 – $525,000; $525,000 – $490,000; $525,000 – $532,000
g
$800 × 1,350; $800 × 1,400; $800 × 1,530
b
9-11
2,058,500
2,990,500
1,354,000
$1,636,500
Fixed manufacturing Fixed manufacturing
Absorption-costing
Variable costing
costs in
costs in
2.  operating income  – operating income = 
 – 

 ending inventory   beginning inventory 
January:
$1,422,500 – $1,370,000 = ($350 × 150) – $0
$52,500 = $52,500
February:
$1,445,000 – $1,445,000 = ($350 × 150) – ($350 × 150)
$0 = $0
March:
$1,636,500 – $1,640,000 = ($350 × 140) – ($350 × 150)
– $3,500 = – $3,500
The difference between absorption and variable costing is due solely to moving fixed
manufacturing costs into inventories as inventories increase (as in January) and out of
inventories as they decrease (as in March).
9-12
9-24
(20-30 min.) Throughput costing (continuation of Exercise 9-23).
1.
January
Revenuesa
Direct material cost of
goods sold:
Beginning inventoryb
Direct materials in goods
manufacturedc
Cost of goods available
for sale
Deduct ending inventoryd
Total direct material
cost of goods sold
Throughput margin
Other costs
Manufacturinge
Operatingf
Total other costs
Operating income
February
$4,455,000
$
March
$4,620,000
$5,049,000
0
$78,750
$ 78,750
787,500
735,000
798,000
787,500
(78,750)
813,750
(78,750)
876,750
(73,500)
708,750
3,746,250
1,237,500
1,210,000
735,000
3,885,000
1,190,000
1,250,000
2,447,500
$1,298,750
803,250
4,245,750
1,247,000
1,354,000
2,440,000
$1,445,000
2,601,000
$1,644,750
a
$3,300 × 1,350; $3,300 × 1,400; $3,300 × 1,530
$? × 0; $525 × 150; $525 × 150
c
$525 × 1,500; $525 × 1,400; $525 × 1,520
d
$525 × 150; $525 × 150; $525 × 140
e
($475 × 1,500) + $525,000; ($475 × 1,400) + $525,000; ($475 × 1,520) + $525,000
f
($800 × 1,350) + $130,000; ($800 × 1,400) + $130,000; ($800 × 1,530) + $130,000
b
2.
Operating income under:
Variable costing
Absorption costing
Throughput costing
January
$1,370,000
1,422,500
1,298,750
February
$1,445,000
1,445,000
1,445,000
March
$1,640,000
1,636,500
1,644,750
Throughput costing puts greater emphasis on sales as the source of operating income than does
absorption or variable costing. Accordingly, income under throughput costing is highest in periods
where the number of units sold is relatively large (as in March) and lower in periods of weaker sales
(as in January). With production and sales the same in February, of course all three methods
produce the same operating income result.
3.
Throughput costing puts a penalty on producing without a corresponding sale in the same
period. Costs other than direct materials that are variable with respect to production are expensed
when incurred, whereas under variable costing they would be capitalized as an inventoriable cost. As
a result, throughput costing provides less incentive to produce for inventory than either absorption or
variable costing.
9-13
9-25
(40 min) Variable versus absorption costing.
1. Beginning Inventory + 2020 Production = 2020 Sales + Ending Inventory
100,000 units + 2020 Production = 400,000 units + 50,000 units
2020 Production = 350,000 units
Zeta Company
Income Statement for the, Variable Costing
for the Year Ended December 31, 2020
Revenues: $25 × 400,000
Variable costs
Beginning inventory: $6 × 100,000
Variable manufacturing costs: $6 × 350,000
Cost of goods available for sale
Deduct ending inventory: $6 × 50,000
Variable cost of goods sold
Variable operating costs: $2 × 400,000
Adjustment for variances
Total variable costs
Contribution margin
Fixed costs
Fixed manufacturing overhead costs
Fixed operating costs
Total fixed costs
Operating income
$10,000,000
$
600,000
2,100,000
2,700,000
(300,000)
2,400,000
800,000
0
3,200,000
6,800,000
1,625,000
1,100,000
Absorption Costing Data
Fixed manufacturing overhead allocation rate =
Fixed manufacturing overhead/Denominator level machine-hours
= $1,625,000 ÷ 6,500 = $250 per machine-hour
Fixed manufacturing overhead allocation rate per unit =
Fixed manufacturing overhead allocation rate/standard production rate
= $250 ÷ 50 = $5 per unit
9-14
2,725,000
$4,075,000
Zeta Company
Income Statement, Absorption Costing
For the Year Ended December 31, 2020
Revenues: $25 × 400,000
Cost of goods sold
Beginning inventory ($6 + $5) × 100,000
Variable manuf. costs: $6 × 350,000
Allocated fixed manuf. costs: $5 × 350,000
Cost of goods available for sale
Deduct ending inventory: ($6+ $5) × 50,000
Adjust for manuf. variances ($5 × 25,000)a
Cost of goods sold
Gross margin
Operating costs
Variable operating costs: $2 × 400,000
Fixed operating costs
Total operating costs
Operating income
a
$10,000,000
$ 1,100,000
2,100,000
1,750,000
$4,950,000
(550,000)
(125,000)F
4,275,000
5,725,000
$ 800,000
1,100,000
1,900,000
$3,825,000
Production volume variance = [(6,500 hours × 50) – 350,000] × $5
= (325,000 – 350,000) × $5
= $125,000
2. Zeta’s operating margins as a percentage of revenues are
Under variable costing:
Revenues
Operating income
Operating income as percentage of revenues
$10,000,000
4,075,000
40.75%
Under absorption costing:
Revenues
Operating income
Operating income as percentage of revenues
$10,000,000
3,825,000
38.25%
3. Operating income using variable costing is about 9.15 percent higher than operating income
calculated using absorption costing.
Variable costing operating income – Absorption costing operating income =
$4,075,000– $3,825,000= $250,000
Fixed manufacturing costs in beginning inventory under absorption costing –
Fixed manufacturing costs in ending inventory under absorption costing
= ($5 × 100,000) – ($5 × 50,000) = $250,000
9-15
4.
The factors the CFO should consider include
(a) Effect on managerial behavior.
(b) Effect on external users of financial statements.
I would recommend absorption costing because it considers all the manufacturing resources
(whether variable or fixed) used to produce units of output. Absorption costing has many critics.
However, the dysfunctional aspects associated with absorption costing can be reduced by
 Careful budgeting and inventory planning.
 Adding a capital charge to reduce the incentives to build up inventory.
 Monitoring nonfinancial performance measures.
9-16
9-26
(15 min.) Absorption costing in medical industry
a. Calculation of Profit using Absorption Costing Technique
£
Revenues (10,500 × £40)
Cost of Sales:
Direct material (12,500 × £15)
187,500
Direct labour (12,500 × £9)
112,500
Variable manufacturing overhead (12,500 × £5)
62,500
Fixed manufacturing overhead (12,500 × £4.05)
50,625
Cost of goods available for sales
413,125
Closing inventory (2,000 × £33.05)
66,100
347,025
Total Cost of Sales
Add under absorbed overhead
6,075
£
420,000
353,100
66,900
Gross margin
b. Calculation of Overhead Absorption Rate (OAR)
Budgeted overhead cost
Overhead Absorption Rate (OAR) = Budgeted activity level =
Calculation of Over/Under absorption of overhead
Actual overhead cost incurred
Absorbed overhead cost (10,500 x 4.05)
Under absorbed overhead
£48,600
12,000 units
= £4.05/unit
£48,600
£42,525
£6,075
Overhead is under absorbed because the absorbed overhead is less than the actual overhead
incurred.
Absorbed overhead is calculated as actual activity level x OAR.
9-17
9-27 (40 min) Absorption versus variable costing.
1. The variable manufacturing cost per unit is $30 + $25 + $60 = $115.
2020 Variable-Costing Based Income Statement
Revenues (17,500 × $450 per unit)
Variable costs
Beginning inventory
Variable manufacturing costs (18,000 units × $115 per unit)
Cost of goods available for sale
Deduct: Ending inventory (500 units × $115 per unit)
Variable cost of goods sold
Variable marketing costs (17,500 units × $45 per unit)
Total variable costs
Contribution margin
Fixed costs
Fixed manufacturing costs
Fixed administrative costs
Fixed marketing
Total fixed costs
Operating income
$7,875,000
$
0
2,070,000
2,070,000
(57,500)
2,012,500
787,500
2,800,000
5,075,000
1,200,000
965,450
1,366,400
3,531,850
$1,543,150
2. Fixed manufacturing overhead rate = $1,200,000 / 20,000 units = $60 per unit.
2020 Absorption-Costing Based Income Statement
Revenues (17,500 units × $450 per unit)
Cost of goods sold
$7,875,000
$
Beginning inventory
Variable manufacturing costs (18,000 units × $115 per unit)
Allocated fixed manufacturing costs (18,000 units × $60 per unit)
Cost of goods available for sale
Deduct ending inventory [500 units × ($115 + $60) per unit]
Add unfavorable production volume variance
Cost of goods sold
Gross margin
Operating costs
Variable marketing costs (17,500 units × $45 per unit)
Fixed administrative costs
Fixed marketing
Total operating costs
Operating income
0
2,070,000
1,080,000
3,150,000
(87,500)
120,000a U
3,182,500
4,692,500
787,500
965,450
1,366,400
3,119,350
$1,573,150
a
PVV = $1,200,000 budgeted fixed mfg. costs – $1,080,000 allocated fixed mfg. costs =
$120,000 U
3. 2020 operating income under absorption costing is greater than the operating income under
variable costing because in 2020 inventory increased by 500 units. As a result, under absorption
costing, a portion of the fixed overhead remained in the ending inventory and led to a lower cost
9-18
of goods sold (relative to variable costing). As shown below, the difference in the two operating
incomes is the same as the difference in the fixed manufacturing costs included in ending versus
beginning inventory (under absorption costing).
Operating income under absorption costing
$1,573,150
Operating income under variable costing
1,543,150
Difference in operating income under absorption versus variable
costing
$ 30,000
Under absorption costing:
Fixed mfg. costs in ending inventory (500 units × $60 per unit)
Fixed mfg. costs in beginning inventory (0 units × $60 per unit)
Change in fixed mfg. costs between ending and beginning inventory
$
$
30,000
0
30,000
4. Relative to the alternative of using contribution margin (from variable costing), the
absorption-costing based gross margin has some pros and cons as a performance measure for
Regina’s supervisors. It takes into account both variable costs and fixed costs—costs that the
supervisors should be able to control in the long run—and therefore is a more complete
measure than contribution margin, which ignores fixed costs (and may cause the supervisors
to pay less attention to fixed costs). The downside of using absorption-costing-based gross
margin is the supervisor’s temptation to use inventory levels to control the gross margin—in
particular, to shore up a sagging gross margin by building up inventories. This can be offset
by specifying, or limiting, the inventory build-up that can occur, charging the supervisor a
carrying cost for holding inventory, and using nonfinancial performance measures such as
the ratio of ending to beginning inventory.
9-19
9-28
(40 min.) Variable and absorption costing, sales, and operating-income changes.
1. Smart Safety’s annual fixed manufacturing costs are $1,300,000. It allocates $25 of fixed
manufacturing costs to each unit produced. Therefore, it must be using $1,300,000 ÷ $25 =
52,000 units (annually) as the denominator level to allocate fixed manufacturing costs to the
units produced.
We can see from Smart Safety’s income statements that it disposes of any production volume
variance against cost of goods sold. In 2020, 62,400 units were produced instead of the budgeted
52,000 units. This resulted in a favorable production volume variance of $260,000 F [(62,400 –
52,000) units × $25 per unit], which, when written off against cost of goods sold, increased gross
margin by that amount.
2.
The breakeven calculation, same for each year, is shown below:
Calculation of breakeven volume
2019
2020
2021
Selling price ($2,236,000 ÷ 52,000; $2,236,000 ÷
52,000; $2,683,000 ÷ 62,400)
$43
$43
$43
Variable cost per unit (all manufacturing)
14
14
14
Contribution margin per unit
$29
$29
$29
Total fixed costs
(fixed mfg. costs + fixed selling & admin. costs) $1,508,000 $1,508,000 $1,508,000
Breakeven quantity =
Total fixed costs ÷ contribution margin per unit
52,000
52,000
52,000
3.
Variable Costing
Sales (units)
Revenues
Variable cost of goods sold
Beginning inventory $14 × 0; 0; 10,400
Variable manuf. costs $14 × 52,000; 62,400; 52,000
Deduct ending inventory $14 × 0; 10,400; 0
Variable cost of goods sold
Contribution margin
Fixed manufacturing costs
Fixed selling and administrative expenses
Operating income
Explaining variable costing operating income
Contribution margin
($26 contribution margin per unit × sales units)
Total fixed costs
Operating income
9-20
2019
2020
2021
52,000
52,000
62,400
$2,236,000 $2,236,000 $2,683,000
0
0
145,600
728,000
873,600
728,000
0 (145,600)
0
728,000
728,000
873,600
$1,508,000 $1,508,000 $1,809,600
$1,300,000 $1,300,000 $1,300,000
208,000
208,000
208,000
$
0 $
0 $ 301,600
$1,508,000 $1,508,000 $1,809,600
1,508,000 1,508,000 1,508,000
$
0 $
0 $ 301,600
4.
Reconciliation of absorption/variable costing
operating incomes
(1) Absorption costing operating income
(2) Variable costing operating income
(3) Difference in operating incomes = (1) – (2)
2019
$0
0
$0
2020
2021
$260,000 $ 41,600
0
301,600
$260,000
$(260,000)
(4) Fixed mfg. costs in ending inventory under absorption
costing (ending inventory in units × $25 per unit)
$0
$260,000
(5) Fixed mfg. costs in beginning inventory under absorption
costing (beginning inventory in units × $25 per unit)
(6) Difference = (4) – (5)
0
$0
0
$260,000
$
0
260,000
$(260,000)
In the table above, row (3) shows the difference between the operating income under absorption
costing and the operating income under variable costing, for each of the three years. In 2019, the
difference is $0; in 2020, absorption costing income is greater by $260,000; and in 2021, it is less
by $260,000. Row (6) above shows the difference between the fixed costs in ending inventory
and the fixed costs in beginning inventory under absorption costing; this figure is $0 in 2019,
$260,000 in 2020, and –$260,000 in 2021. Row (3) and row (6) explain and reconcile the
operating income differences between absorption costing and variable costing.
Stuart Weil is surprised at the non-zero, positive net income (reported under absorption
costing) in 2020, when sales were at the ‘breakeven volume’ of 52,000; further, he is concerned
about the drop in operating income in 2021, when, in fact, sales increased to 62,400 units. In
2020, starting with zero inventories, 62,400 units were produced and 52,000 were sold, i.e., at
the end of the year, 10,400 units remained in inventory. These 10,400 units had each absorbed
$25 of fixed costs (total of $260,000), which would remain as assets on Smart Safety’s balance
sheet until they were sold. Cost of goods sold, representing only the costs of the 52,000 units
sold in 2020, was accordingly reduced by $260,000, the production volume variance, resulting in
a positive operating income even though sales were at breakeven levels. The following year, in
2021, production was 52,000 units, sales were 62,400 units, i.e., all of the fixed costs that were
included in 2020 ending inventory flowed through COGS in 2021. Contribution margin in 2021
was $1,809,600 (62,400 units × $29), but in absorption costing, COGS also contains the
allocated fixed manufacturing costs of the units sold, which were $1,560,000 (62,400 units ×
$25), resulting in an operating income of $41,600 = 1,809,600 – $1,560,000 – $208,000 (fixed
sales and admin.) Hence the drop in operating income under absorption costing, even though
sales were greater than the computed breakeven volume: inventory levels decreased sufficiently
in 2021 to cause 2021’s operating income to be lower than 2020 operating income.
Note that beginning and ending with zero inventories during the 2019-2021 period, under
both costing methods, Smart Safety’s total operating income was $301,600.
9-21
9-29
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
(10 min.) Capacity management, denominator-level capacity concepts.
a
a, b
c, d
d
d
c
b (or a)
a
c, d
a, b
b
9-22
9-30
(20 min.) Denominator-level problem.
1.
Budgeted fixed manufacturing overhead costs rates:
Denominator
Level Capacity
Concept
Theoretical
Practical
Normal
Master-budget
Budgeted Fixed
Manufacturing
Overhead per
Period
$ 6,480,000
6,480,000
6,480,000
6,480,000
Budgeted
Capacity
Level
5,400
3,840
3,240
3,600
Budgeted Fixed
Manufacturing
Overhead Cost
Rate
$ 1,200.00
1,687.50
2,000.00
1,800.00
The rates are different because of varying denominator-level concepts. Theoretical and practical
capacity levels are driven by supply-side concepts, i.e., “how much can I produce?” Normal and
master-budget capacity levels are driven by demand-side concepts, i.e., “how much can I sell?” (or
“how much should I produce?”)
2. The variances that arise from use of the theoretical or practical level concepts will signal that there
is a divergence between the supply of capacity and the demand for capacity. This is useful input to
managers. As a general rule, however, it is important not to place undue reliance on the production
volume variance as a measure of the economic costs of unused capacity.
3. Under a cost-based pricing system, the choice of a master-budget level denominator will lead to
high prices when demand is low (more fixed costs allocated to the individual product level), further
eroding demand; conversely, it will lead to low prices when demand is high, forgoing profits. This
has been referred to as the downward demand spiral—the continuing reduction in demand that
occurs when the prices of competitors are not met and demand drops, resulting in even higher unit
costs and even more reluctance to meet the prices of competitors. The positive aspects of the masterbudget denominator level are that it is based on demand for the product and indicates the price at
which all costs per unit would be recovered to enable the company to make a profit. Master-budget
denominator level is also a good benchmark against which to evaluate performance.
9-23
9-31
(30 min.) Variable and absorption costing and breakeven points.
1.
Production = Sales + Ending Inventory – Beginning Inventory
= 242,400 + 24,800  32,600
= 234,600 ICs.
2.
Breakeven point in ICs:
a. Variable Costing
Total fixed costs + Target operating income
Q=
Contribution margin per unit
($1,876,800+$3,284,400)+$0
$5,161,200
Q=
=
= 224,400 ICs
$47−$13−$11
$23
b. Absorption costing
Fixed manufacturing cost rate = $1,876,800 ÷ 234,600 = $8 per IC
Q=
TFC + TOI + [Fixed Manuf. cost rate × (Breakeven sales in units − Units produced)
Contribution margin per unit
$5,161,200 + $0 +[$8 (Q−234,600)]
$5,161,200+8Q−$1,876,800
$3,284,400 + 8Q
Q=
=
=
$23
$23
$23
23Q  8Q = $3,284,400
15Q = $3,284,400
Q = 218,960 ICs.
3.
If direct materials costs increase from $13 to $15 per IC, this will lower the unit
contribution margin from $23 in 2020 to $21 in 2021.
a. Variable Costing (Q) =
$5,161,200
b. Absorption Costing (Q) =
= 245,772 ICs (rounded up)
$21
$3,284,400+$8 Q
$21
$21Q = $3,284,400 + $8 Q
$13 Q = $3,284,400
Q = 252,646 ICs (rounded up)
9-24
9-32
(40 min.) Variable costing versus absorption costing.
2020 Production = Sales + Ending Inventory – Beginning Inventory
= 575,000 + 45,000 – 35,000 = 585,000
1. Absorption Costing:
Stenback Company Income Statement
For the Year Ended December 31, 2020
Revenues (575,000 × $13.00)
Cost of goods sold:
Beginning inventory (35,000 × $6.00a)
Variable manufacturing costs (585,000 × $5.20)
Allocated fixed manufacturing costs (585,000 × $0.80)
Cost of goods available for sale
Deduct ending inventory (45,000 × $6.00)
Add adjustment for prod.-vol. variance (65,000b × $0.80)
Cost of goods sold
Gross margin
Operating costs:
Variable operating costs (575,000 × $2)
Fixed operating costs
Total operating costs
Operating income
a
b
$7,475,000
$ 210,000
3,042,000
468,000
3,720,000
(270,000)
52,000 U
3,502,000
3,973,000
1,150,000
55,000
1,205,000
$ 2,768,000
$4.00 + $1.20 + ($16.00 ÷ 20) = $5.20 + $0.80 = $6.00
[(20 units per mach. hr. × 32,500 mach. hrs.) – 585,000 units)] = 65,000 units unfavorable
2. Variable Costing:
Stenback Company Income Statement
For the Year Ended December 31, 2020
Revenues (575,000 × $13.00)
Variable cost of goods sold:
Beginning inventory (35,000 × $5.20)
Variable manufacturing costs
(585,000 × $5.20)
Cost of goods available for sale
Deduct ending inventory (45,000 × $5.20)
Variable cost of goods sold
Variable operating costs (575,000 × $2)
Contribution margin
Fixed costs:
Fixed manufacturing overhead costs
Fixed operating costs
Total fixed costs
Operating income
$7,475,000
$
182,000
3,042,000
3,224,000
(234,000)
2,990,000
1,150,000
3,335,000
520,000
55,000
575,000
$ 2,760,000
9-25
3. The difference in operating income between the two costing methods is:
VariableAbsorptioncosting
costing 
–
 operating operating
 income
income 
=
Fixed
manuf.
costs
 in ending
 inventory
$2,768,000 – $2,760,000
$8,000
$8,000
Fixed
manuf. costs 
– in beginning 
inventory 
= [(45,000 × $0.80) – (35,000 × $0.80)]
= $36,000 – $28,000
= $8,000
The absorption-costing operating income exceeds the variable costing figure by $8,000 because of
the increase of $8,000 during 2020 of the amount of fixed manufacturing costs in ending inventory
vis-a-vis beginning inventory.
4.
Total fixed manufacturing costs
Actual and budget line
$520,000
$468,000
Unfavorable
production-volume
variance
production} Favorable
volume variance
{
Allocated line
@ $16.00
29,250
32,500
Machine-hours
5.
Absorption costing is more likely to lead to buildups of inventory than does variable
costing. Absorption costing enables managers to increase reported operating income by building up
inventory which reduces the amount of fixed manufacturing overhead included in the current
period’s cost of goods sold.
Ways to reduce this incentive include:
(a) Careful budgeting and inventory planning.
(b) Change the accounting system to variable costing or throughput costing.
(c) Incorporate a carrying charge for carrying inventory.
(d) Use a longer time period to evaluate performance than a quarter or a year.
(e) Include nonfinancial as well as financial measures when evaluating management performance.
9-26
9-33
(20 min.) Throughput costing.
1. Throughput Costing:
Stenback Company Income Statement
For the Year Ended December 31, 2020
Revenues (575,000 × $13.00)
Direct material cost of goods sold:
Beginning inventory (35,000 × $4.00)
Direct materials in goods manufactureda
Cost of goods available for sale
Deduct ending inventoryb
Total direct material cost of goods sold
Throughput margin
Other costs
Manufacturing costs
Other operating costs
Total other costs
Operating income
a
$7,475,000
$ 140,000
2,340,000
2,480,000
(180,000)
2,300,000
5,175,000
1,222,000c
1,205,000d
2,427,000
$ 2,748,000
585,000 × $4.00
b
45,000 × $4.00
(585,000 × $1.20) + $520,000
d
(575,000 × $2) + $55,000
c
2.
Stenback Company - Reconciliation
Variable Costing
Throughput Costing
Difference
Reasons for differences:
Variable Manufacturing Cost (other than
materials) (575,000 × $1.20)
Variable Operating Cost (575,000 × $2.00)
Lower expensing of Variable Manufacturing
Cost (other than materials) under Variable
costing: 10,000 units increase in inventory
during the year × $1.20 per unit
Contribution/
Throughput Margin
$3,335,000
$5,175,000
$1,840,000
Operating
Income
$2,760,000
$2,748,000
$(12,000)
$690,000
$1,150,000
$ (12,000)
3. Yes, I do agree. Because fixed manufacturing costs are expensed in the period incurred
under throughput costing, there is no opportunity for managers to affect operating income by
manipulating production levels. When a significant majority of an item’s cost is direct
materials, when direct labor is really more fixed than variable (you have staff for direct labor
and you don’t stop paying them for varying levels of production) and when production levels
vary significantly creating large variances for fixed costs, using throughput costing can
provide a more stable per unit cost for a company’s product. It is important for managers of
Stenback, and other companies, to have as stable a unit cost as possible for decision-making.
9-27
9-34
(30–40 min.) Reconciliation of operating income under absorption and variable
techniques
i. Income statement Using Variable Costing Technique
Autumn
£
£
Total Sales @ £80
(23,400 x £80) 1,872,000
Variable Cost of Sales:
Beginning inventory @ £12
Direct material
136,800
Direct labour
133,950
Variable manufacturing overhead
71,250
342,000
Cost of goods available for sales @ £12
Ending inventory @ £12 (see Working 1)
61,200
280,800
Variable cost of Production
Variable selling expenses @ £1.5 (see
Working 3)
35,100
Variable admin expenses (10% of sales
value)
187,200
503,100
Variable Cost of Sales
Total contribution
1,368,900
Fixed Costs:
Fixed manufacturing overhead
120,000
Fixed selling expenses
25,500
Fixed admin expenses (25% of sales
value)
468,000
Total fixed cost
613,500
755,400
Operating income
Income statement Using Absorption Costing Technique
Autumn
£
£
Total Sales @ £80
Total Cost of Sales:
Beginning inventory @ £16
Direct material
Direct labour
Variable manufacturing overhead
Fixed manufacturing overhead @ £4
(23,400 x £80)
136,800
133,950
71,250
114,000
9-28
Summer
£
£
(35,700 x £80) 2,856,000
61,200
146,880
143,820
76,500
428,400
428,400
53,550
285,600
767,550
2,088,450
122,000
25,500
714,000
861,500
1,226,950
Summer
£
£
1,872,000 (35,700 x £80) 2,856,000
81,600
146,880
143,820
76,500
122,400
(see Working 4)
Cost of goods available for sales @ £16
(£456,000/28,500)
Ending inventory @ £16 (see Working 2)
Total cost of Production
Add or deduct over/(under) absorbed
overhead (see Working 5)
Gross margin
Other expenses:
Variable selling expenses @ £1.5
(see Working 3)
Variable admin expenses (10% of
sales value)
Fixed selling expenses
Fixed admin expenses (25% of sales
value)
Total fixed cost
Operating income
(£16 x 30,600)
456,000 + £81,600
571,200
81,600
374,400
571,200
(£16 x 28,500)
(£16 x 5,100)
6,000
380,400
1,491,600
(400)
570,800
2,285,200
35,100
53,550
187,200
25,500
285,600
25,500
468,000
714,000
715,800
775,800
Working
1. Computation of Variable cost per unit
Autumn
Total variable production cost (£) 342,000
Total quantity produced (unit)
28,500
342,000 ÷ 28,500 =
Variable production cost per unit £12
Summer
367,200
30,600
367,200 ÷ 30,600 =
£12
2. Computation of Opening inventory
Opening
Add production
28,500
Goods available for sales
28,500
Sales
23,400
5,100
Closing inventory
5,100
30,600
35,700
35,700
-
3. Variable cost per unit
£42,750
Autumn = 28,500 𝑢𝑛𝑖𝑡𝑠 = £1.5
£45,900
Summer = 30,600 𝑢𝑛𝑖𝑡𝑠 = £1.5
4. Calculation of OAR
£470,400
Budgeted monthly overhead cost = 12 months = £39,200
Budgeted monthly production =
117,600 units
12 months
9-29
= 9,800 units
1,078,650
1,206,550
Overhead Absorption Rate (OAR) =
Budgeted monthly overhead Cost
Budgeted monthly Activity Level
5. i. Calculation of Over/Under absorption of overhead
Autumn (£)
Actual overhead cost incurred
120,000
Absorbed overhead cost
114,000
under / (Over) absorbed overhead
6,000
=
£39,200
9,800 units
= £4
Summer (£)
122,000
122,400
(400)
ii. Calculation of differences in operating income
Beginning inventory
Ending inventory
Upward/Downward movement of inventory
Fixed overhead absorption rate
Difference in Profits (5,100 x £4)
Autumn
5,100
5,100
£4
£20,400
Summer
5,100
5,100
£4
£20,400
Reconciliation of operating income
Profit under variable costing
Add / less adjustment for fixed overhead
Profit under absorption costing
£
755,400
20,400
775,800
£
1,226,950
20,400
1,206,550
Alternatively
Profit under absorption costing
Less / Add adjustment for fixed overhead
Profit under variable costing
£
775,800
20,400
755,400
£
1,206,550
20,400
1,226,950
iii. The differences in operating income between variable costing and absorption costing are due
to accounting for fixed manufacturing costs. Under variable costing only variable manufacturing
costs are included as inventoriable costs. In the absorption costing approach, both variable and
fixed manufacturing costs are included as inventoriable costs. Fixed marketing and distribution
costs are not accounted for differently under variable costing and absorption costing.
9-30
9-35
(30-35 min.) Comparison of variable costing and absorption costing.
1. Since production volume variance is unfavorable, the budgeted fixed manufacturing overhead
must be larger than the fixed manufacturing overhead allocated.
Production - volume
variance
Budgeted fixed
Fixed manufacturing
= manufacturing overhead – overhead allocated
$350,000
= $1,400,000 – Allocated
Allocated
= $1,050,000, which is 75% of $1,400,000
If 75% of the budgeted fixed costs were allocated, the plant must have been operating at 75% of
denominator level in 2020.
2. The problem provides the ending inventory balances for 2019 and 2020 under both, variable and
absorption costing. Under variable costing, all fixed costs are written off as period costs, i.e., they
are not inventoried. Under absorption costing, inventories include variable and fixed costs.
Therefore, the difference between inventory under absorption costing and inventory under variable
costing is the amount of fixed costs included in the inventory.
Inventories:
December 31, 2019
December 31, 2020
Absorption
Costing
Variable
Costing
Fixed Manuf.
Overhead
in Inventory
$1,745,000
195,000
$1,465,000
75,000
$280,000
120,000
3. Note that the answer to (3) is independent of (1). The difference in operating income of $160,000
($1,345,000 – $1,185,000) is explained by the release of $160,000 of fixed manufacturing costs
when the inventories were decreased during 2020:
Inventories:
December 31, 2019
December 31, 2020
Release of fixed manuf. costs
Absorption
Costing
Variable
Costing
$1,745,000
195,000
$1,465,000
75,000
Fixed Manuf.
Overhead
in Inventory
$280,000
120,000
$160,000
The above schedule in this requirement is a formal presentation of the equation:
Variable
Absorpting
costing
costing 
–
 operating operating
 income income 
($1,185,000 – $1,345,000)
=
Fixed
Fixed
manuf.
costs in manuf. costs in
 ending – beginning 
 inventory
inventory 
=
($120,000 – $280,000)
9-31
– $160,000
=
– $160,000
4. Under absorption costing, operating income is a function of both sales and production (i.e.,
change in inventory levels). During 2020, Gammaro experienced a severe decline in
inventory levels: sales were probably higher than anticipated, production was probably lower
than planned (at 75% of denominator level), resulting in much of the 2020 beginning
inventory passing through cost of goods sold in 2020. This means that under absorption
costing, large amounts of inventoried fixed costs have flown through 2020 cost of goods
sold, resulting in a smaller operating income than in 2019, despite an increase in sales
volume.
9-32
9-36
(30 min.) Effects of differing production levels on absorption costing income:
Metrics to minimize inventory buildups.
26,000
32,500
33,800
Books
Books
Books
Revenues
$2,106,000
$2,106,000
$2,106,000
a
Cost of goods sold
1,586,000
1,586,000
1,586,000
Production-volume variance
0b
(104,000)c
(124,800)d
Net cost of goods sold
1,586,000
1,482,000
Gross Margin
$ 520,000
$ 624,000
$ 644,800
1,461,200
a
Cost per unit = ($45 + $416,000/26,000 books sold) = $61 per book
CGS = $61  26,000 = $1,586,000
b
volume variance = Budgeted fixed cost – fixed overhead rate  production
$416,000 – ($16  26,000 books) = $0
c
volume variance = Budgeted fixed cost – fixed overhead rate  production
$416,000 – ($16  32,500 books) = – $104,000
d
volume variance = Budgeted fixed cost – fixed overhead rate  production
$416,000 – ($16  33,800 books) = – $124,800
2.
26,000
Books
Beginning inventory
+ Production
32,500
Books
0
26,000 books
26,000
26,000
0 books
× $61
$0
– Books sold
Ending inventory
 Cost per book
Cost of Ending Inventory
0
32,500 books
32,500
26,000
6,500 books
×
$61
$396,500
33,800
Books
0
33,800 books
33,800
26,000
7,800 books
×
$61
$475,800
3a.
26,000
Books
Gross margin
Less 5%  Ending inventory
Adjusted gross margin
32,500
33,800
Books
Books
$520,000
$624,000
0
(19,825)
$520,000
$604,175
$644,800
(23,790)
$621,010
While adjusting for ending inventory does to some degree mitigate the increase in inventory
associated with excess production, it may be difficult to mechanically compensate for all of the
increased income. In addition, it does nothing to hold the manager responsible for the poor
decisions from the organization’s standpoint.
3b.
9-33
26,000
Books
1) Inventory change:
End inventory ─ begin inventory
books
2) Excess production (%)
Production ÷ sales

32,500
Books
0
33,800
Books
6,500 books
26,000 ÷ 26,000
1.0
32,500 ÷ 26,000
1.25
7,800
33,800 ÷26,000
1.3
A ratio of ending inventory to beginning inventory, as suggested in the book, is not
possible because beginning inventory was zero, so we substituted change in inventory
level.
For these nonfinancial measures to be useful they must be incorporated into the reward function
of the manager.
9-34
9-37
(25-30 min.) Alternative denominator-level capacity concepts, effect on operating income.
1.
Denominator-Level
Capacity Concept
Theoretical capacity
Practical capacity
Normal capacity utilization
Master-budget utilization
(a) January-June 2020
(b) July-December 2020
Budgeted Fixed
Manuf. Overhead
per Period
(1)
$28,300,000
28,300,000
28,300,000
Days of
Hours of
Production Production
per Period
per Day
(2)
(3)
360
24
352
20
352
20
14,150,000
14,150,000
176
176
Barrels
per Hour
(4)
530
500
395
Budgeted
Denominator Level
(Barrels)
(5) = (2)  (3)  (4)
4,579,200
3,520,000
2,780,800
Budgeted Fixed
Manufacturing
Overhead Rate
per Barrel
(6) = (1)  (5)
$ 6.18
8.04
10.18
310
480
1,091,200
1,689,600
12.97
8.37
20
20
The differences arise for several reasons:
a. The theoretical and practical capacity concepts emphasize supply factors and are consequently
higher, while normal capacity utilization and master-budget utilization emphasize demand
factors.
b. The two separate six-month rates for the master-budget utilization concept differ because of
seasonal differences in budgeted production.
2.
Using column (6) from above,
Denominator-Level
Capacity Concept
Theoretical capacity
Practical capacity
Normal capacity utilization
a
$79,464,000  2,640,000 barrels
Budgeted
Fixed Mfg.
Overhead
Rate per Barrel
(6)
$6.18
8.04
10.18
Per Barrel
Budgeted
Variable
Mfg.
Cost Rate
(7)
$30.10a
30.10
30.10
Budgeted
Total Mfg
Cost Rate
(8) =
(6) + (7)
$36.28
38.14
40.28
9-35
Fixed Mfg.
Overhead
Costs Allocated
(9) =
2,640,000  (6)
$16,315,200
21,225,600
26,875,200
Fixed
Mfg. Overhead
Variance
(10) =
$26,900,000 – (9)
$10,584,800 U
5,674,400 U
24,800 U
Absorption-Costing Income Statement
Revenues (2,460,000 bbls.  $44 per bbl.)
Cost of goods sold
Beginning inventory
Variable mfg. costs
Fixed mfg. overhead costs allocated
(2,640,000 units  $6.18; $8.04; $10.18 per unit)
Cost of goods available for sale
Deduct ending inventory
(180,000 units  $36.28; $38.14; $40.28 per unit)
Adjustment for variances (add: all unfavorable)
Cost of goods sold
Gross margin
Other costs
Operating income
Theoretical
Capacity
$108,240,000
Practical
Capacity
$108,240,000
Normal
Capacity
Utilization
$108,240,000
0
79,464,000
0
79,464,000
0
79,464,000
16,315,200
95,779,200
21,225,600
100,689,600
26,875,200
106,339,200
(6,865,200)
5,674,400 U
99,498,800
8,741,200
0
$ 8,741,200
(7,250,400)
24,800U
99,113,600
9,126,400
0
$ 9,126,400
(6,530,400)
10,584,800 U
99,833,600
8,406,400
0
$ 8,406,400
9-36
9-38
(20 min.)
Motivational considerations in denominator-level capacity
selection (continuation of 9-37).
1. If the plant manager gets a bonus based on operating income, he/she will prefer the denominatorlevel capacity to be based on normal capacity utilization (or master-budget utilization). In times of
rising inventories, as in 2020, this denominator level will maximize the fixed overhead trapped in
ending inventories and will minimize COGS and maximize operating income. Of course, the plant
manager cannot always hope to increase inventories every period, but on the whole, he/she would
still prefer to use normal capacity utilization because the smaller the denominator, the higher the
amount of overhead costs capitalized for inventory units. Thus, if the plant manager wishes to be
able to “adjust” plant operating income by building inventory, normal capacity utilization (or masterbudget capacity utilization) would be preferred.
2. Given the data in this question, the theoretical capacity concept reports the lowest operating
income and thus (other things being equal) the lowest tax bill for 2020. Zing Lager benefits by
having deductions as early as possible. The theoretical capacity denominator-level concept
maximizes the deductions for manufacturing costs.
3. The IRS may restrict the flexibility of a company in several ways:
a. Restrict the denominator-level concept choice (to say, practical capacity).
b. Restrict the cost line items that can be expensed rather than inventoried.
c. Restrict the ability of a company to use shorter write-off periods or more accelerated writeoff periods for inventoriable costs.
d. Require proration or allocation of variances to represent actual costs and actual capacity
used.
9-37
9-39 (25 min.)
income.
Denominator-level choices, changes in inventory levels, effect on operating
1.
Denominator level in units
Budgeted fixed manuf. costs
Budgeted fixed manuf. cost allocated per unit
Production in units
Allocated fixed manuf. costs (production in units
Theoretical
Capacity
275,000
$2,915,000
$
10.60
235,000

budgeted fixed manuf. cost allocated per unit) $2,491,000
Production volume variance (budgeted fixed
manuf.
costs – allocated fixed manuf. costs)a
$ 424,000
a
Practical
Capacity
265,000
$2,915,000
$
11.00
235,000
Normal
Capacity
Utilization
233,200
$2,915,000
$
12.50
235,000
$2,585,000
$2,937,500
U$
330,000 U $ 22,500
F
PVV is unfavorable if budgeted fixed manuf. costs are greater than allocated fixed costs
2.
Units produced
Budgeted fixed mfg. cost allocated per unit
Budgeted var. mfg. cost per unit
Budgeted cost per unit of inventory or
production
Theoretical Practical
Capacity
Capacity
235,000
235,000
$10.60
$11.00
$8.00
$8.00
$15.60
ABSORPTION-COSTING BASED INCOME
STATEMENTS
Revenues ($39 selling price per unit  units sold)
Cost of goods sold
Beginning inventory (35,000 units  budgeted
cost per unit of inventory)
Variable manufacturing costs
(235,000 units  $8 per unit)
Allocated fixed manufacturing overhead
(235,000
units  budgeted fixed mfg. cost allocated per
unit)
Cost of goods available for sale
Deduct ending inventory (20,000b units 
budgeted
cost per unit of inventory)
Adjustment for production-volume variance
Normal
Capacity
Utilization
235,000
$12.50
$8.00
$16.50
$17.50
$9,750,000
$9,750,000
$9,750,000
651,000
665,000
717,500
1,880,000
1,880,000
1,880,000
2,491,000
5,022,000
2,585,000
5,130,000
2,937,000
5,534,500
9-38
(372,000)
424,000 U
(380,000)
330,000 U
(410,000)
(22,500) F
Total cost of goods sold
Gross margin
Operating costs
Operating income
5,074,000
4,676,000
200,000
$4,476,000
5,080,000
4,670,000
200,000
$4,470,000
5,102,000
4,648,000
200,000
$4,448,000
b
Ending inventory = Beginning inventory + production – sales = 35,000 + 235,000 – 250,000 = 20,000
units
20,000 × $18.60; 20,000 × $19.00; 20,000 ×$20.50
3.
Donaldson’s 2020 beginning inventory was 35,000 units; its ending inventory was 20,000 units.
So, during 2020, there was a drop of 15,000 units in inventory levels (matching the 15,000 more units
sold than produced). The smaller the denominator level, the larger is the budgeted fixed cost allocated to
each unit of production, and when those units are sold (all the current production is sold, and then
some), the larger is the cost of each unit sold, and the smaller is the operating income. Normal capacity
utilization is the smallest capacity of the three; hence, in this year, when production was less than sales,
the absorption-costing based operating income is the smallest when normal capacity utilization is used
as the denominator level.
4.
Reconciliation
Theoretical Capacity Operating Income—
Practical Capacity Operating Income
Decrease in inventory level during 2020
$6,000
15,000
Fixed mfg cost allocated per unit under
practical capacity—fixed mfg. cost allocated
per unit under theoretical capacity ($11 – $10.60) $0.40
Additional allocated fixed cost included in COGS
under practical capacity = 15,000 units  $0.40 per unit =
$6,000
More fixed manufacturing costs are included in inventory under practical capacity, so when inventory
level decreases (as it did in 2020), more fixed manufacturing costs are included in COGS under practical
capacity than under theoretical capacity, resulting in a lower operating income.
9-39
9-40
(60 min.) Variable and absorption costing and breakeven points
2020 Variable-Costing Based Operating Income Statement
Revenues (995 boards × $750 per board)
Variable costs
Beginning inventory (240 boards × $325 per board)
Variable manufacturing costs (900 boards × $325 per board)
Cost of goods available for sale
Deduct: Ending inventory (145 boards × $325 per board)
Variable cost of goods sold
Variable shipping costs (995 boards × $15 per board)
$746,250
$
78,000
292,500
370,500
(47,125)
323,375
14,925
Total variable costs
338,300
Contribution margin
Fixed costs
Fixed manufacturing costs
Fixed selling and administrative
407,950
280,000
112,000
Total fixed costs
392,000
$
15,950
Operating income
2.
2020 Absorption-Costing Based Operating Income Statement
Revenues (995 boards × $750 per board)
Cost of goods sold
Beginning inventory (240 boards × $605a per board)
$145,200
Variable manufacturing costs (900 boards × $325 per board)
292,500
Allocated fixed manufacturing costs (900 boards × $280 per
board)
252,000
Cost of goods available for sale
689,700
Deduct ending inventory (145 boards × $605 per board)
(87,725)
Cost of goods sold at standard cost
$746,250
601,975
Production-volume variance [$280 × (1,000 – 900)]
Gross margin
Operating costs
Variable shipping costs (995 boards × $15 per board)
Fixed selling and administrative
Total operating costs
Operating income
28,000 U
629,975
116,275
14,925
112,000
126,925
$(10,650)
9-40
a
Fixed manufacturing cost per unit = Fixed manufacturing cost/denominator level of production
= $280,000/1,000 snowboards
= $280 per snowboard
$280 fixed manufacturing cost + $325 variable manufacturing cost = $605 per board
3. Breakeven point in units:
a.
Variable Costing
(Q) =
b.
Total fixed costs+Target operating income
Contribution margin per unit
=
($280,000+$112,000)+$0
$750−($325+$15)
=
$392,000
$410
= 956 units
Absorption costing:
Fixed manufacturing cost rate = $280,000 ÷ 1,000 = $280 per snowboard

Fixed
 Breakeven

Units  


fixed + operating +  manufacturing×  sales 
 in units produced  
costs income  cost rate


Q=
Contribution margin per unit
Total
Q=
Target
($280,000 + $112,000) + $0 + $280 (Q - 900)
$410
$410Q = $392,000 + $280Q – $252,000
$410Q  $280Q = $392,000 – $252,000
$130Q = $140,000
Q = 1,077 snowboards
4. Proof of breakeven point:
a. Variable Costing:
Revenues, $750 × 956 units
Variable costs, $340 × 956
Contribution margin, $410 × 956
Fixed costs
Operating income
$717,000
325,040
392,000
391,960
$
40*
b. Absorption costing:
Revenues, $750 × 1,077 units
Cost of goods sold:
Cost of goods @ standard cost, $605 × 1,077 units
Production-volume variance, $280 × (1,000 – 900)
Gross margin
679,585
Variable shipping costs, $15 × 1,077 units
Fixed selling and administrative costs
112,000
Operating income
9-41
$807,750
651,585
28,000 U
128,165
16,155
128,155
$
10*
*This is not zero due to rounding to 956 and 1,077 whole units sold.
5.
If $20,000 of fixed administrative costs were reclassified as production costs, there would
be no change in breakeven sales using variable costing. This is because all fixed costs, regardless
of whether they are for production or administrative activities, are treated the same way in a
variable costing system. However, this is not true for absorption costing. The change in
classification would impact the fixed manufacturing overhead rate that is applied to units of
production. If sales and production are unequal, the additional fixed overhead would either
increase or decrease breakeven sales.
6.
The additional $30 per unit variable production cost will cause unit contribution margin to
decrease from $410 to $380. This decrease will cause the breakeven point to increase.
In the case of variable costing:
Q = $392,000 ÷ $380
Q = 1,032 units (rounded)
In the case of absorption costing:
$380Q = $392,000 + $280Q – $252,000
$380Q – $280Q = $392,000 – $252,000
$100Q = $140,000
Q = 1,400 units
9-42
9-41
(20 min.) Downward demand spiral.
1. Fixed manufacturing overhead rate = $576,000/24,000 units = $24 per unit
Manufacturing cost per unit:
$20 direct materials + $35 direct mfg. labor + $9 var. mfg. OH + $24 fixed mfg. OH = $88
Selling price: $88 × 130% = $114.40
2. Fixed manufacturing overhead rate = $576,000/18,000 units = $32 per unit
Manufacturing cost per unit:
$20 direct materials + $35 direct mfg. labor + $9 var. mfg. OH + $32 fixed mfg. OH = $96
Selling price: $96 × 130% = $124.80
By using budgeted units produced, and not practical capacity, as the denominator level,
Gostkowski is burdening its products with the cost of unused capacity. Apparently, the competitor has
not done this, and because of its higher selling price, Gostkowski’s sales decline. Consequently, 2021
budgeted quantities are even lower, which increases the unit cost and selling price. This phenomenon is
known as the downward demand spiral, and it causes Gostkowski to continually inflate its selling price,
which in turn leads to progressively lower sales.
3. Fixed manufacturing overhead rate = $576,000/48,000 units = $12 per unit
Manufacturing cost per unit:
$20 direct materials + $35 direct mfg. labor + $9 var. mfg. OH + $12 fixed mfg. OH = $76
Selling price: $76 × 130% = $98.80
If Gostkowski had used practical capacity as its denominator level of activity, its initial selling price
of $98.60 would have been virtually in line with the $98.40 selling price of Gostkowski’s
competitor, and it would likely have resulted in higher sales. Using practical capacity will result in a
higher unfavorable production-volume variance, which will most likely be written off to cost of
goods sold and reduce operating income. However, as sales and production increase in future years
and the company “grows into” its capacity, the amount of unused capacity will be lower, resulting in
future cost savings.
9-43
9-42
(35 min.) Absorption costing and production volume variance -- alternative capacity bases
1.
Inventoriable cost per unit = Variable production cost + Fixed manufacturing overhead/Capacity
Capacity
Type
Theoretical
Practical
Normal
Master
Budget
Capacity
Level
1,000,000
600,000
300,000
250,000
Fixed Mfg.
Overhead
$1,200,000
$1,200,000
$1,200,000
$1,200,000
Fixed Mfg.
Overhead
Rate
$1.20
$2.00
$4.00
$4.80
Variable
Production
Cost
$3.00
$3.00
$3.00
$3.00
Inventoriable
Cost
Per
Unit
$4.20
$5.00
$7.00
$7.80
2.
Kappa’s actual production level is 350,000 CFLs. We can compute the production-volume
variance as:
Production-volume Variance = Budgeted Fixed Mfg. Overhead
– (Fixed Mfg. Overhead Rate × Actual Production Level)
Capacity
Type
Theoretical
Practical
Normal
Master
Budget
Capacity
Level
1,000,000
600,000
300,000
250,000
Fixed Mfg.
Overhead
Fixed Mfg. Rate
×
Fixed Mfg. Overhead Actual
Overhead
Rate
Production
$1,200,000
$1.20
$ 420,000
$1,200,000
$2.00
$ 700,000
$1,200,000
$4.00
$1,400,000
$1,200,000
$4.80
$1,680,000
Productionvolume
Variance
$780,000 U
$500,000 U
$200,000 F
$480,000 F
3.
Operating Income for Kappa given production of 350,000 CFLs and sales of 275,000 CFLs @
$10 apiece:
Theoretical
Practical
Revenue a
$2,750,000
$2,750,000
Less: Cost of
goods sold b
1,155,000
1,375,000
Productionvolume variance
780,000 U
500,000U
Gross margin
815,000
875,000
Variable selling
c
68,750
68,750
Fixed selling
250,000
250,000
Operating
income
$ 496,250
$ 556,250
a
Normal
$2,750,000
Master
Budget
$2,750,000
1,925,000
2,145,000
(200,000) F
1,025,000
(480,000) F
1,085,000
68,750
250,000
68,750
250,000
$ 706,250
$ 766,250
275,000 × 10
275,000 ×4.20, ×5.00, ×7.00, ×7.80
b
9-44
c
275,000 × 0.25
9-45
9-43 (35 min.) Operating income effects of denominator-level choice and disposal of
production-volume variance (continuation of 9-42).
1.
Because no beginning inventories exist, if Kappa sells all 350,000 CFLs manufactured, its
operating income will be the same under all four capacity options. Calculations are provided below:
a
Theoretical
$3,500,000
Revenue
Less: Cost of
goods sold b
1,470,000
Less: Production
volume variance
780,000 U
Gross margin
1,250,000
Variable selling c
87,500
Fixed selling
250,000
Operating
income
$ 912,500
Practical
$3,500,000
Normal
$3,500,000
1,750,000
2,450,000
2,730,000
500,000 U
1,250,000
87,500
250,000
(200,000) F
1,250,000
87,500
250,000
(480,000) F
1,250,000
87,500
250,000
$ 912,500
$ 912,500
Master Budget
$3,500,000
$ 912,500
a
350,000 × 10
350,000 × 4.20, ×5.00, ×7.00, ×7.80
c
350,000 × 0.25
b
2.
If the manager of Kappa produces and sells 350,000 CFLs, then all capacity levels will result in
the same operating income of $912,500 (see requirement 1 above). If the manager of Kappa is able to
sell only 275,000 of the CFLs produced and if the production-volume variance is closed to cost of goods
sold, then the operating income is given as in requirement 3 of 9-42. Both sets of numbers are
reproduced below.
Theoretical
Income with sales of 350,000
CFLs
$ 912,500
Income with sales of 275,000
CFLs
$ 496,250
Decrease in income when
there is over-production
$ 416,250
Master
Budget
Practical
Normal
$ 912,500
$ 912,500
$ 912,500
$ 556,250
$ 706,250
$ 766,250
$ 356,250
$
206,250
$ 146,250
Comparing these results, it is clear that for a given level of overproduction relative to sales, the
manager’s performance will appear better if he/she uses as the denominator a level that is lower. In this
example, setting the denominator to equal the master budget (the lowest of the four capacity levels here),
minimizes the loss to the manager from being unable to sell the entire production quantity of 350,000
CFLs.
9-46
3.
In this scenario, the manager of Kappa produces 350,000 CFLs and sells 275,000 of them, and
the production volume variance is prorated. Given the absence of ending work in process inventory or
beginning inventory of any kind, the fraction of the production volume variance that is absorbed into the
cost of goods sold is given by 275,000/350,000 or 78.57%. The operating income under various
denominator levels is then given by the following modification of the solution to requirement 3 of 9-42:
Theoretical
Revenue
$2,750,000
Less: Cost of
goods sold
1,155,000
Less:
Prorated
productionvolume variance a
612,846 U
Gross margin
982,154
b
Variable selling
68,750
Fixed selling
250,000
Operating income $ 663,404
a
Practical
$2,750,000
Normal
$2,750,000
Master
Budget
$2,750,000
1,375,000
1,925,000
2,145,000
392,850 U
982,150
68,750
250,000
$ 663,400
(157,140) F
982,140
68,750
250,000
$ 663,390
(377,136) F
982,136
68,750
250,000
$ 663,386
(78.57/100)×780,000, ×500,000, × (200,000), × (480,000)
275,000 × 0.25
b
Under the proration approach, operating income is $663,400 (rounded off of nearest hundred) regardless
of the denominator initially used. Thus, in contrast to the case where the production volume variance is
written off to cost of goods sold, there is no temptation under the proration approach for the manager to
play games with the choice of denominator level.
9-47
9-44
(30 min.) Variable and absorption costing, actual costing.
1.
Because no beginning inventories exist, the cost of the ending inventory must be the same as the
cost of goods sold for the period. So, the unit cost of goods sold under variable costing is $8.20.
Variable cost of goods sold
= Units sold × Unit variable cost of goods sold
= 200,000 × $8.20
= $1,640,000
Variable nonmanufacturing expenses = $0
Sales Revenue
= $2,700,000
Contribution Margin
= $2,700,000 – $1,640,000 – $0
= $1,060,000
2.
The profit under variable costing is given as $460,000. We just calculated the contribution
margin of Beta as $1,060,000. The difference, $600,000 ($1,060,000– $460,000) must represent the total
fixed costs incurred by Beta in 2020.
Fixed marketing and administrative costs are given as $341,250. The remainder, $258,750($600,000 –
$341,250) is therefore the fixed manufacturing costs for 2020.
3.
The unit cost of ending inventory, as well as the unit cost of goods produced and sold, is
$8.20under variable costing and $9.35 under absorption costing. The difference, $1.15 ($9.35– $8.20) is
the unit fixed manufacturing cost of goods produced during the period.
In requirement 2, we calculated that the total fixed manufacturing costs are $258,750.
So, Units produced
= Total manufacturing costs/Unit fixed manufacturing cost of production
= $258,750/$1.15
= 225,000 six-packs.
4.
In 2020, Beta incurred a total of 225,000 × $8.20 = $1,845,000 in variable manufacturing costs.
This includes $1,012,500 in direct materials costs (given), $450,000 in direct manufacturing labor costs
(given), and the rest in variable manufacturing overhead.
So, variable manufacturing overhead = $1,845,000 – $1,012,500 – $450,000
= $382,500.
5.
Under variable costing, the proportion of variable manufacturing overhead corresponding to the
units sold, relative to units produced, is expensed as variable cost of goods sold. This equals:
$382,500 × (200,000 units produced)/(225,000 units sold) = $340,000.
Moreover, the entire amount of fixed manufacturing overhead, totaling $258,750, is expensed.
So, total manufacturing overhead expensed = $340,000 + $258,750= $598,750.
9-48
9-45
(25 min.) Cost allocation, downward demand spiral.
Solution Exhibit 9-45
Budgeted fixed costs
Denominator level
Budgeted fixed cost per meal
Budgeted fixed costs  Denominator level
($1,517,000  925,000; $1,517,000  1,025,000;
$1,517,000  820,000)
Budgeted variable cost per meal
Total budgeted cost per meal
2020
Master
Budget
(1)
$1,517,000
925,000
$
$
2021
Practical
Master
Capacity
Budget
(2)
(3)
$1,517,000 $1,517,000
1,025,000
820,000
1.64 $
4.60
6.24 $
1.48 $
4.60
6.08 $
1.85
4.60
6.45
1.
The 2020 budgeted fixed costs are $1,517,000. Topman budgets for 925,000 meals in 2020, and
this is used as the denominator level to calculate the fixed cost per meal. $1,517,000  925,000 = $1.64
fixed cost per meal. (see column (1) in Solution Exhibit 9-45).
2.
In 2021, three hospitals have dropped out of the purchasing group, and the master budget is
820,000 meals. If this is used as the denominator level, fixed cost per meal = $1,517,000  820,000 =
$1.85 per meal, and the total budgeted cost per meal would be $6.45 (see column (3) in Solution Exhibit
9-45). If the hospitals have already been complaining about quality and cost and are allowed to purchase
from outside, they will not accept this higher price. More hospitals may begin to purchase meals from
outside the system, leading to a downward demand spiral, possibly putting Topman out of business.
3.
The basic problem is that Topman has excess capacity and the associated excess fixed costs. If
Smith uses the practical capacity of 1,025,000 meals as the denominator level, the fixed cost per meal
will be $1.48 (see column (2) in Solution Exhibit 9-45), and the total budgeted cost per meal would be
$6.08, probably a more acceptable price to the customers (it may even draw back the three hospitals that
have chosen to buy outside). This denominator level will also isolate the cost of unused capacity and not
allocate it to the meals produced. To make the $6.08 price per meal profitable in the long run, Smith will
have to find ways to either use the extra capacity or reduce Topman’s practical capacity and the related
fixed costs.
9-49
9-46
(20 min.) Cost allocation, responsibility accounting, ethics (continuation of 9-45).
1.
(See Solution Exhibit 9-45). If Topman uses the rate based on its master budget capacity
utilization to allocate fixed costs in 2020, it would allocate 740,000 × $1.85 = $1,369,000.
Budgeted fixed costs are $1,517,000. Therefore, the production volume variance = $1,517,000 –
$1,369,000 = $148,000 U. An unfavorable production volume variance will reduce operating
income by this amount. (Note: in this business, there are no inventories. All variances are written
off to cost of goods sold).
2.
Hospitals are charged a budgeted variable cost rate and allocated budgeted fixed costs. By
overestimating budgeted meal counts, the denominator-level is larger; hence, the amount charged
to individual hospitals is lower. Consider 2021 where the budgeted fixed cost rate is computed as
$1,517,000/820,000 meals = $1.85 per meal.
If in fact, the hospital administrators had better estimated and revealed their true demand
(say, 740,000 meals), the allocated fixed cost per meal would have been
$1,517,000/740,000 meals = $2.05 per meal, 10.8% higher than the $1.85 per meal.
Hence, by deliberately overstating budgeted meal count, hospitals are able to reduce the
price charged by Topman for each meal. In this scheme, Topman bears the downside risk of
demand overestimates.
3.
Evidence that could be collected include:
a. Budgeted meal-count estimates and actual meal-count figures each year for each hospital
controller. Over an extended time period, there should be a sizable number of both
underestimates and overestimates. Controllers could be ranked on both their percentage
of overestimation and the frequency of their overestimation.
b. Look at the underlying demand estimates by patients at individual hospitals. Each
hospital controller has other factors (such as hiring of nurses) that give insight into their
expectations of future meal-count demands. If these factors are inconsistent with the
meal-count demand figures provided to the central food-catering facility, explanations
should be sought.
4.
Two specific steps that Smith might take to reduce hospital controllers’ incentives to inflate their
estimated meal counts
a. Highlight the importance of a corporate culture of honesty and openness. Cayzer could
institute a Code of Ethics that highlights the upside of individual hospitals providing
honest estimates of demand (and the penalties for those who do not).
b. Have individual hospitals contract in advance for their budgeted meal count. Unused
amounts would be charged to each hospital at the end of the accounting period. This
approach puts a penalty on hospital administrators who overestimate demand.
c. Use an incentive scheme that has an explicit component for meal-count forecasting
accuracy. Each meal-count “forecasting error” would reduce the bonus by some amount,
say $0.05. Thus, if a hospital bids for 292,000 meals and uses 200,000 meals, its bonus
would be reduced by $0.05 × (292,000 – 200,000) = $4,600.
9-50
9-47
(40-50 min.) Absorption, variable, and throughput costing.
1. Absorption Costing Income Statement
Sales ($33,000 * 55; 58; 54)
COGS
Beginning Inv
Production Costs ($19,545 * 60; 65; 62)a
Cost of Goods Available for Sale
Deduct Ending Inventory ($19,545 * 5; 12; 20)
COGS
Gross Margin
Selling Costs
Variable ($1,400 * 55; 58; 54)
Fixed
G&A Costs
Variable ($1,005 * 55; 58; 54)
Fixed
Net Income
a
Quarter 1
$1,815,000
Quarter 2
$1,914,000
0
1,172,700
1,172,700
(97,725)
1,074,975
740,025
97,725
1,270,425
1,368,150
(234,540)
1,133,610
780,390
Quarter 3
$1,782,000
234,540
1,211,790
1,446,330
(390,900)
1,055,430
726,570
77,000
200,000
81,200
200,000
75,600
190,000
55,275
395,000
12,750
58,290
250,000
190,900
54,270
250,000
156,700
$5,400 + $3,200 + $6,400 + ($849,915 / 187) = $19,545
2. Variable Costing Income Statement
Sales ($33,000 * 55; 58; 54)
COGS
Beg Inventory
Production Costs ($15,000 * 60; 65; 62)
Cost of Goods Available for Sale
Deduct Ending Inv ($15,000 * 5; 12; 20)
COGS
Contribution Margin
Fixed Production Costsa
Selling Costs
Variable ($1,400 * 55; 58; 54)
Fixed
G&A Costs
Variable ($1,005*55;58;54)
Fixed
Net Income
a
($849,915 / 187) * 60; 65; 62
9-51
Quarter 1
$1,815,000
Quarter 2
$1,914,000
Quarter 3
$1,782,000
0
900,000
900,000
75,000
825,000
990,000
272,700
75,000
975,000
1,050,000
180,000
870,000
1,044,000
295,425
180,000
930,000
1,110,000
300,000
810,000
972,000
281,790
77,000
200,000
81,200
200,000
75,600
190,000
55,275
395,000
(9,975)
58,290
250,000
159,085
54,270
250,000
120,340
3. Throughput Costing Income Statement
Sales ($33,000 * 55; 58; 54)
COGS
Beg Inventory
Production Costs ($5,400 * 60; 65; 62)
Cost of Goods Available for Sale
Deduct Ending Inv ($5,400 * 5; 12; 20)
COGS
Throughput Margin
Other Production Costsa
Selling Costs
Variable ($1,400 * 55; 58; 54)
Fixed
G & A Costs
Variable ($1,005 * 55; 58; 54)
Fixed
Net Income
a
Quarter 1
$1,815,000
Quarter 2
$1,914,000
Quarter 3
$1,782,000
0
324,000
324,000
27,000
297,000
1,518,000
848,700
27,000
351,000
378,000
64,800
313,200
1,600,800
919,425
64,800
334,800
399,600
108,000
291,600
1,490,400
876,990
77,000
200,000
81,200
200,000
75,600
190,000
55,275
395,000
(57,975)
58,290
250,000
91,885
54,270
250,000
43,540
($3,200 + $6,400 + [$849,915 / 187]) * 60; 65; 62
4.
Quarter 1
Absorption Costing Net Income 12,750
Costs absorbed in inventory each period:
97,725
(84,975)
Quarter 2
190,900
Quarter 3
156,700
Total
$360,350
136,815
54,085
156,360
340
$390,900
($30,550)
Variable Costing Net Income
(9,975)
Costs absorbed in inventory each period:
75,000
(84,975)
159,085
120,340
$269,450
105,000
54,085
120,000
340
$300,000
($30,550)
Throughput Costing Net Income (57,975)
Costs absorbed in inventory each period:
27,000
(84,975)
91,885
43,540
$77,450
37,800
54,085
43,200
340
$108,000
($30,550)
5.Based on the information provided, I suspect that JetStar is currently using the absorption costing
method to calculate the bonus for the production manager. I reach this conclusion because inventory
is increased each quarter with no credible reason. Using absorption costing will increase net income
by the amount of fixed costs that are absorbed into inventory, thus providing the managers with a
higher bonus.
6.If Q4 sales are 65 and Q4 production is 50, inventory would decrease by 15 units. At a fixed cost
per unit of $4,545, we would expect net income calculated with absorption costing to be $68,175
LESS than variable costing. This is expected because, since inventory is DECREASING, the fixed
costs that had been absorbed will now be expensed.
9-52
9-48
(15-20 min.) Absorption costing, undesirable incentives for managers to
build up inventory.
1.
Production cost: Variable Cost: $5,500
Fixed cost = $11,019,840 / budgeted production 12,480 = $883
Total Production costs = $5,500 + $883 = $6,383
Beginning Inventory
Production
Sales
Ending Inventory
3,000
13,320
12,000
4,320
$19,149,000
$85,021,560
$76,596,000
$27,574,560
Inventory increased by 1,320 units or $8,425,560 (1,320 * $6,383)
2.
Fixed costs absorbed into inventory in 2020 = increase in inventory x fixed production costs
1,320 x $883 = $1,165,560
3.
If demand for Rollalong Inc.’s wheelchairs is variable the company may want to have a certain
amount of inventory on hand in order to meet the potentially high demand in the future. Specifically,
if Rollalong Inc. is expecting the demand to increase in the near future the company would want to
use its production capacity to build up inventory.
4. Aside from instituting an inventory limit, some of the steps management can take to control the
incentive of the plant managers to build up inventory include:
(a) Careful budgeting and inventory planning,
(b) Using an alternative income computation approach to absorption costing (such as variable
costing or throughput costing),
(c) Using a financial charge to reduce the incentives for inventory buildup,
(d) Changing the compensation package to have a longer-term focus using either an external
variable (e.g., stock options) or an internal variable (e.g., five-year average income), and
(e) Adopting non-financial performance targets, e.g., attaining but not exceeding present inventory
levels.
9-53
Try It! 9-1
(a) Under variable costing, all variable manufacturing costs are inventoriable costs. This includes
direct materials, direct manufacturing labor, and variable overhead. Therefore, the inventoriable cost
per unit under variable costing is $24 + $8 + $0.50 = $32.50.
(b) Absorption costing considers all variable manufacturing costs and all fixed manufacturing costs
as inventoriable costs. Therefore, the inventoriable cost per unit under absorption costing is $24 + $8
+ $0.50 + ($325,000 ÷ 50,000 units) = $39.
Try It! 9-2
(a) Variable costing
Revenues: 23,800 × $80
Variable cost of goods sold: $520,000 × (23,800/34,000)
Variable marketing costs
Contribution margin
Fixed manufacturing costs
Fixed marketing costs
Operating income
$1,904,000
364,000
162,100
1,377,900
425,000
81,600
$ 871,300
(b) Absorption costing
Revenues: 23,800 × $80
Cost of goods sold: ($520,000 + $425,000) × (23,800/34,000)
Gross margin
Variable marketing costs
Fixed marketing costs
Operating income
$1,904,000
661,500
1,242,500
162,100
81,600
$ 998,800
Absorption costing treats fixed manufacturing cost as a product cost, while variable costing treats it
as a period cost. SW Toys has 10,200 units in ending inventory. Under absorption costing, these
units have a fixed manufacturing cost of $12.50 per unit ($425,000/34,000). So, the total fixed
manufacturing cost in ending inventory under absorption costing is $127,500 (10,200 units ×
$12.50). Since these costs are inventoried under absorption costing, and not expensed as they would
be under variable costing, operating income is higher under absorption costing by $127,500
($998,800 - $871,300).
Try It! 9-3
(a) Absorption costing: $83 + $60 + $64 = $207
(b) Variable costing: $83 + $60 = $143
(c) Throughput costing: $83
(d) Throughput margin = 13,600 × ($330 - $83) = $3,359,200
9-54
Try It! 9-4
(a) Theoretical capacity: 900 × 2 × 12 × 30 = 648,000 units
(b) Practical capacity: 500 × 2 × 12 × 26 = 312,000 units
(c) Normal capacity utilization: 311,000 units
(d) Master-budget capacity utilization: 306,000 units
9-55
CHAPTER 10
DETERMINING HOW COSTS BEHAVE
10-1 A linear cost function expresses cost as a linear function of the number of items. It is a
mathematical expression of how a cost changes with changes in the level of activity relating to
that cost. It can be expressed as: C = aX + b. Where:
C = Total cost; X = number of items; a = variable cost; and b = fixed cost.
10-2 Linear cost function of a specific product will be a straight line. Mostly this function is
used to find the total cost of "n" units of the products produced. Understanding the linear cost
function is necessary for management in the areas of cost control, planning and decision making.
10-3
i.
ii.
iii.
Costs are generally classified into their variable and fixed components based on:
Choice of cost object – some cost items could be variable for one cost object and fixed
for another cost object.
Time horizon – a cost could be variable or fixed for a particular activity depending on the
time horizon.
Relevant range – variable and fixed cost-behavior patterns are valid for linear cost
functions only within a given relevant range.
10-4 No. High correlation merely indicates that the two variables move together in the data
examined. It is essential also to consider economic plausibility before making inferences about
cause and effect. Without any economic plausibility for a relationship, it is less likely that a high
level of correlation observed in one set of data will be similarly found in other sets of data.
10-5
Four approaches to estimating a cost function are:
1. Industrial engineering method.
2. Conference method.
3. Account analysis method.
4. Quantitative analysis of current or past cost relationships.
10-6 The industrial engineering approach estimates the cost function by analyzing the
relationship between inputs and outputs in physical terms. It is the best approach when there is a
physical relationship between input and output.
The quantitative method applies mathematical methods to fit cost functions to observed data.
This can be achieved by using spreadsheet or regression models.
10-7 The account analysis method estimates cost functions by classifying cost accounts in the
subsidiary ledger as variable, fixed, or mixed with respect to the identified level of activity.
Typically, managers use qualitative, rather than quantitative, analysis when making these costclassification decisions.
10-8
The six steps are:
1. Choose the dependent variable (the variable to be predicted, which is some type of
cost).
2. Identify the independent variable or cost driver.
10-1
3. Collect data on the dependent variable and the cost driver.
4. Plot the data.
5. Estimate the cost function.
6. Evaluate the cost driver of the estimated cost function.
Step 3 typically is the most difficult for a cost analyst.
10-9 Causality in a cost function runs from the cost driver to the dependent variable. Thus,
choosing the highest observation and the lowest observation of the cost driver is appropriate in
the high-low method.
10-10 Three criteria important when choosing among alternative cost functions are:
1. Economic plausibility.
2. Goodness of fit.
3. Slope of the regression line.
10-11 A learning curve is a function that measures how labor-hours per unit decline as units of
production increase because workers are learning and becoming better at their jobs. Two models
used to capture different forms of learning are:
1. Cumulative average-time learning model. The cumulative average time per unit
declines by a constant percentage each time the cumulative quantity of units produced
doubles.
2. Incremental unit-time learning model. The incremental time needed to produce the last
unit declines by a constant percentage each time the cumulative quantity of units
produced doubles.
10-12 Frequently encountered problems when collecting cost data on variables included in a
cost function are:
1. The time period used to measure the dependent variable is not properly matched with
the time period used to measure the cost driver(s).
2. Fixed costs are allocated as if they are variable.
3. Data are either not available for all observations or are not uniformly reliable.
4. Extreme values of observations occur.
5. A homogeneous relationship between the individual cost items in the dependent
variable cost pool and the cost driver(s) does not exist.
6. The relationship between the cost and the cost driver is not stationary.
7. Inflation has occurred in a dependent variable, a cost driver, or both.
10-2
10-13 Four key assumptions examined in specification analysis are
1. Linearity of relationship between the dependent variable and the independent variable
within the relevant range.
2. Constant variance of residuals for all values of the independent variable.
3. Independence of residuals.
4. Normal distribution of residuals.
10-14 No. A cost driver is any factor whose change causes a change in the total cost of a related
cost object. A cause-and-effect relationship underlies selection of a cost driver. Some users of
regression analysis include numerous independent variables in a regression model in an attempt
to maximize goodness of fit, irrespective of the economic plausibility of the independent
variables included. Some of the independent variables included may not be cost drivers.
10-15 No. Multicollinearity exists when two or more independent variables are highly
correlated with each other.
10-16 Choice "c" is correct. The high-low method is used to estimate both fixed and variable
costs, and can then be applied to determine a total cost formula that is used to estimate total costs
for any level of production.
The difference between the total costs ($45,000 − $21,000) is divided by the difference in units
(7,500 – 1,500) to derive a variable cost per unit of $4 ($24,000 / 6,000). Using either end of the
range, fixed costs can then be estimated. Using total costs of $45,000 for 7,500 units, with
variable costs at $4 per unit, $45,000 − 7,500($4) = $15,000 of fixed costs.
The total cost formula for HL will be equal to: $15,000 + [$4.00 × # units]. 2,000 units will
produce a total cost of: $15,000 + [$4.00 × 2,000] = $23,000.
Choice "a" is incorrect. This calculation fails to account for the fixed costs of $15,000.
Choice "b" is incorrect. This calculation incorrectly assumes that because 7,500 units cost
$45,000 (or $6 overall per unit), that 2,000 units would cost $12,000 ($6 per unit).
Choice "d" is incorrect. This calculation incorrectly applies a variable cost of $7 per unit rather
than $4.
10-17 Choice "d" is correct. The regression equation set up will be: y (total costs) = $235,000 +
$10x, with x representing volume. In order to make a $300,000 profit, sales ($15x) − costs must
equal $300,000. So the full set up will be: $15x − ($235,000 + $10x) = $300,000. Solving for x,
$5x = $535,000, or 107,000 units. At 107,000 units, sales will total $1,605,000 and costs will
total $1,305,000 for a profit of $300,000.
Choice "a" is incorrect. This choice represents a calculation error where the $15 sale price and
the $10 variable cost are added together and divided into $535,000.
Choice "b" is incorrect. 47,000 is the number of units that is required in order to breakeven.
Choice "c" is incorrect. These are the number of units above breakeven that the company must
10-3
sell in order to make a $300,000 profit.
10-18 Choice ‘a’ is correct. Using the cost function:
C = aX + b. where:
X = number of items produced
C = total cost (in $)
b = fixed cost
a = variable cost
Total Cost = Variable Cost (VC) + Fixed Cost (FC)
C = aX + b
1,000 = a (100) + 200
800
a=
=8
100
Choice ‘b’ is incorrect. The cost function has been wrongly estimated by misplacing the fixed
cost as:
C = aX + b
1,000 = a (200) + 100
Choice ‘c’ is incorrect. The cost function has been correctly used but the $200 fixed cost has
been added to the total costs of $1,000 instead of subtracting.
Choice ‘d’ is incorrect. See option ‘a’ above.
10-19 Choice "b" is correct. A correlation coefficient (used to measure the strength in the linear
relationship between independent and dependent variables) of 0.70 implies that the coefficient of
determination is 0.49. A coefficient of determination of 0.49 equates to the independent variable
(level of production) explaining 49 percent of the variation in the dependent variable (total
costs).
Choice "a" is incorrect. The coefficient of determination will always be a number between 0 and
1.
Choice "c" is incorrect. A positive correlation coefficient implies a direct relationship between
the two variables.
Choice "d" is incorrect. The correlation coefficient can only be between -1 and 1.
10-20 Choice "c" is correct. The coefficient of correlation measures the strength and direction
of the relationship between two variables. Since the company increases advertising when sales
are low and decreases advertising when sales are high, the movement is in directly opposite
directions and the coefficient would be close to - 1.0.
Choice "a" is incorrect. A coefficient of correlation of 1.0 would imply that both variables move
in the same direction at approximately the same rate. An increase in advertising when sales are
increasing would be characteristic of a correlation of coefficient of 1.0.
Choice "b" is incorrect. A coefficient of correlation of 0 would imply that there is no relationship
10-4
between advertising and sales. There is an inverse relationship between advertising and sales.
Choice "d" is incorrect. A relationship exists between advertising and sales. According to the
facts of the question, the relationship is an inverse relationship. The coefficient of correlation is
expressed as a range between −1.0 and +1.0.
10-21 (10 min.) Estimating a cost function using the Account Analysis Approach.
1. Finding b in the production cost equation,
bX
= 500,000
b x 350 units
= 500,000
b
= 500,000/350 units
= 1,428.57
The cost equation is then,
y = 17,000 + 1,428.57X
2. Using the equation above, simply substitute 400 units for X as follows:
Total production cost for next month will be:
y = ₹ 17,000 + (₹1,428.57 × 400 units)
= ₹ 17,000 + ₹ 571,428 = ₹ 588,428
3. The account analysis method is easy to use and provides a reasonably accurate estimate of
variable and fixed costs to management. However, the accuracy of this approach depends
largely on the judgement of management in the variable and fixed costs classification.
10-22 (15 min.) Identifying variable-, fixed-, and mixed-cost functions.
1.
2.
3.
See Solution Exhibit 10-22.
Contract 1: y = £50
Contract 2: y = £30 + £0.20X
Contract 3: y = £1.00X
where X is the number of miles traveled in the day.
Contract
Cost Function
1
Fixed
2
Mixed
3
Variable
10-5
SOLUTION EXHIBIT 10-22
Plots of Car Rental Contracts Offered by the Rolling Boulders Corp.
Contract 1: Fixed Costs
£100
Car Rental Costs
£80
£60
£40
£20
£0
0
10
20
30
40
50
60
70
80
90
100 110 120 130 140 150
Miles Traveled Per Day
Contract 2: Mixed Costs
£100
Car Rental Costs
£80
£60
£40
£20
£0
0
10
20
30
40
50
60
70
80
90
Miles Traveled Per Day
10-6
100 110 120 130 140 150
Contract 3: Variable Costs
£160
£140
Car Rental Costs
£120
£100
£80
£60
£40
£20
£0
0
10
20
30
40
50
60
70
80
90
100 110 120 130 140 150
Miles Traveled Per Day
10-23
1.
2.
3.
4.
5.
6.
7.
8.
9.
(20 min.) Various cost-behavior patterns.
K
B
G
J
Note that A is incorrect because, although the cost per pound eventually equals a
constant at $9.20, the total dollars of cost increases linearly from that point
onward.
I
The total costs will be the same regardless of the volume level.
L
F
This is a classic step-cost function.
K
C
10-7
10-24 (30 min.) Matching graphs with descriptions of cost and revenue behavior.
a.
b.
c.
d.
e.
f.
(1)
(6)
(9)
(2)
(8)
(10)
g.
h.
(3)
(8)
A step-cost function.
It is data plotted on a scatter diagram, showing a linear variable cost function with
constant variance of residuals. The constant variance of residuals implies that
there is a uniform dispersion of the data points about the regression line.
10-25 (15-20 min.) High-low cost approach of cost function
1. Karil Teeze Building Ltd.
₭’000
282
(100)
182
120a
62
Total overhead costs
Rent
Indirect material cost
Electrical installation costs
a.
Indirect material cost (cost per unit remains constant)=
₭90,000×80,000 hours
60,000 hours
= ₭120,000
2.
Activity
Electrical installation costs
High
80,000
62,000
Low
60,000
54,000
=
=
=
Difference
20,000
8,000
Variable M. cost/hour = ₭8,000/20,000 hours = ₭0.40/hour
Electrical installation costs (using high level) = ₭62,000 – (80,000 × 0.40) = ₭30,000
3. The required equation is y = 30,000 + 0.40X
Where x = 70,000
y = 30,000 + 0.40(60,000) = ₭54,000
4. The major criticism of high-low method is that it considers only the two extreme values
which may not necessarily be representative of the data.
The approach is simple to compute and easy to understand. It also provides a quick
insight into how the cost driver affects the overhead costs.
10-8
10-26 (30 min.) Account analysis method.
1.
Manufacturing cost classification for 2020:
Account
Direct materials
Direct manufacturing labor
Power
Supervision labor
Materials-handling labor
Maintenance labor
Depreciation
Rent, property taxes, admin
Total
Total
Costs
(1)
$ 337,500
262,500
75,000
60,000
105,000
45,000
88,000
110,000
$1,083,000
% of
Total Costs
That is
Variable
Fixed
Variable
Variable
Costs
Costs
Cost per Unit
(2)
(3) = (1)  (2) (4) = (1) – (3) (5) = (3) ÷ 75,000
100%
100
100
25
50
50
0
0
$337,500
262,500
75,000
15,000
52,500
22,500
0
0
$765,000
$
0
0
0
45,000
52,500
22,500
88,000
110,000
$318,000
$ 4.50
3.50
1.00
0.20
0.70
0.30
0.00
0.00
$10.20
Total manufacturing cost for 2020 = $1,083,000
Variable costs in 2021:
Account
Direct materials
Direct manufacturing labor
Power
Supervision labor
Materials-handling labor
Maintenance labor
Depreciation
Rent, property taxes, admin.
Total
Unit
Variable
Increase in
Cost per
Variable Variable Cost
Unit for Percentage
Cost
per Unit
2020
Increase
per Unit
for 2021
(6)
(7)
(8) = (6)  (7) (9) = (6) + (8)
$ 4.50
3.50
1.00
0.20
0.70
0.30
0.00
0.00
$10.20
8%
8
0
0
0
0
0
0
10-9
$0.36
0.28
0
0
0
0
0
0
$0.64
$ 4.86
3.78
1.00
0.20
0.70
0.30
0
0
$10.84
Total Variable
Costs for 2021
(10) = (9)  82,500
$400,950
311,850
82,500
16,500
57,750
24,750
0
0
$894,300
Fixed and total costs in 2021:
Account
Fixed
Costs
for 2020
(11)
Direct materials
$
0
Direct manufacturing labor
0
Power
0
Supervision labor
45,000
Materials-handling labor
52,500
Maintenance labor
22,500
Depreciation
88,000
Rent, property taxes, admin. 110,000
Total
$318,000
Percentage
Increase
(12)
0%
0
0
0
0
0
10
9
Dollar
Increase in
Fixed Costs
(13) =
(11)  (12)
$
0
0
0
0
0
0
8,800
9,900
$18,700
Fixed Costs
for 2021
(14) =
(11) + (13)
$
0
0
0
45,000
52,500
22,500
96,800
119,900
$336,700
Variable
Costs for
2021
(15)
Total
Costs
(16) =
(14) + (15)
$400,950 $ 400,950
311,850
311,850
82,500
82,500
16,500
61,500
57,750
110,250
24,750
47,250
0
96,800
0
119,900
$894,300 $1,231,000
Total manufacturing costs for 2021 = $1,231,000
2.
Total cost per unit, 2020
Total cost per unit, 2021
$1,083,000
= $14.44
75,000
$1,231,000
=
= $14.92
82,500
=
3.
Cost classification into variable and fixed costs is based on qualitative, rather than
quantitative, analysis. How good the classifications are depends on the knowledge of individual
managers who classify the costs. Hamwey may want to undertake quantitative analysis of costs,
using regression analysis on time-series or cross-sectional data to better estimate the fixed and
variable components of costs. Better knowledge of fixed and variable costs will help Hamwey to
price products better, to know when the products are earning a positive contribution margin, and
to better manage costs.
10-10
10-27 (15–20 min.) Estimating a cost function, high-low method.
1.
The key point to note is that the problem provides high-low values of X (annual round
trips made by a helicopter) and Y ÷ X (the operating cost per round trip). We first need to
calculate the annual operating cost Y (as in column (3) below), and then use those values to
estimate the function using the high-low method.
Highest observation of cost driver
Lowest observation of cost driver
Difference
Cost Driver:
Annual RoundTrips (X)
(1)
2,000
1,000
1,000
Operating
Cost per
Round-Trip
(2)
$300
$350
Annual
Operating
Cost (Y)
(3) = (1)  (2)
$600,000
$350,000
$250,000
Slope coefficient = $250,000 ÷ 1,000 = $250per round-trip
Constant = $600,000 – ($250 × 2,000) = $100,000
The estimated relationship is Y = $100,000 + $250 X; where Y is the annual operating cost of a
helicopter and X represents the number of round trips it makes annually.
2. The constant a (estimated as $100,000) represents the fixed costs of operating a helicopter,
irrespective of the number of round trips it makes. This would include items such as insurance,
registration, depreciation on the aircraft, and any fixed component of pilot and crew salaries. The
coefficient b (estimated as $250 per round-trip) represents the variable cost of each round trip—
costs that are incurred only when a helicopter actually flies a round trip. The coefficient b may
include costs such as landing fees, fuel, refreshments, baggage handling, and any regulatory fees
paid on a per-flight basis.
3. If each helicopter is, on average, expected to make 1,200 round trips a year, we can use the
estimated relationship to calculate the expected annual operating cost per helicopter:
Y = $100,000 + $250 X
X = 1,200
Y = $100,000 + $250 × 1,200 = $100,000 + $300,000 = $400,000
With 10 helicopters in its fleet, FlyHigh Vacations’ estimated operating budget is 10 × $400,000 =
$4,000,000.
10-11
10-28 (20 min.) Estimating a cost function, high-low method.
1.
See Solution Exhibit 10-28. There is a positive relationship between the number of
service reports (a cost driver) and the customer-service department costs. This relationship is
economically plausible.
2.
Number of
Customer-Service
Service Reports Department Costs
Highest observation of cost driver
450
£22,500
Lowest observation of cost driver
130
11,300
Difference
320
£11,200
Customer-service department costs = a + b (number of service reports)
Slope coefficient (b)
Constant (a)
£11,200
= £35 per service report
320
= £22,500 – (£35  450) = £6,750
= £11,300 – (£35  130) = £6,750
=
Customer-service = £6,750 + £35 (number of service reports)
department costs
3.
Other possible cost drivers of customer-service department costs are:
a.
Number of products replaced with a new product (and the dollar value of the new
products charged to the customer-service department).
b.
Number of products repaired and the time and cost of repairs.
SOLUTION EXHIBIT 10-28
Plot of Number of Service Reports versus Customer-Service Dept. Costs for Clement Products
Customer-Service Department Costs
£24,000
£22,000
£20,000
£18,000
£16,000
£14,000
£12,000
£10,000
100
150
200
250
300
350
Number of Service Reports
10-12
400
450
500
10-29 (30–40 min.) Linear cost approximation.
1.
Slope coefficient (b) =
Difference in cost
Difference in labor - hours
= ($521,000– $395,000)/(7,500 – 4,000)
= $36.00
Constant (a) = $521,000 – ($36.00 × 7,500) = $251,000
Cost function = $251,000 + ($36.00 × professional labor-hours)
The linear cost function is plotted in Solution Exhibit 10-29.
No, the constant component of the cost function does not represent the fixed overhead cost of the
Little Rock Reviewers Company. The relevant range of professional labor-hours is from 3,000 to
8,500. The constant component provides the best available starting point for a straight line that
approximates how a cost behaves within the 3,000 to 8,500 relevant range.
2.
A comparison at various levels of professional labor-hours follows. The linear cost
function is based on the formula of $251,000 per month plus $36.00 per professional labor-hour.
Total overhead cost behavior:
Month 1
Month 2 Month 3
Month 4 Month 5 Month 6
Professional labor-hours
3,000
4,000
5,000
6,000
7,500
8,500
Actual total overhead costs
$330,000 $395,000 $425,000 $467,000 $521,000 $577,000
Linear approximation
359,000 395,000
431,000 467,000 521,000 557,000
Actual minus linear
Approximation
$(29,000) $
0 $ (6,000) $
0 $
0 $ 20,000
The data are shown in Solution Exhibit 10-29. The linear cost function overstates costs by
$6,000 at the 5,000-hour level and understates costs by $20,000 at the 8,500-hour level.
3.
Contribution before deducting incremental overhead
Incremental overhead
Contribution after incremental overhead
The total contribution margin actually forgone is $1,000.
10-13
Based on
Actual
$31,000
30,000
$ 1,000
Based on Linear
Cost Function
$31,000
36,000
$ (5,000)
SOLUTION EXHIBIT 10-29
Linear Cost Function Plot of Professional Labor-Hours
on Total Overhead Costs for Little Rock Reviewers Company
$600,000
Total Overhead Costs
$550,000
$500,000
$450,000
$400,000
$350,000
$300,000
2,000
3,000
4,000 5,000 6,000 7,000
Professional Labor-Hours Billed
8,000
9,000
10-30 (20 min.) Using the high-low approach to estimate cost drivers
a. Labor hours:
Slope coefficient = (£139,200 - £120,000)
(3,900 - 3,100)
= £24.00 per labor-hour
Constant
= £139,200 - (£24 × 3,900) = £45,600
Labor-hour estimating equation = £45,600 + (£24 × labor hours)
b. Machine hours:
Slope coefficient = (£138,000 - £120,000)
(4,520,000 - 4,120,000)
= £0.045 per machine-hour
Constant = £138,000 - (£0.045 × 4,520,000) = -£65,400
Machine-hour estimating equation = -£65,400 + (£0.045 × machine hours)
c. Coventry factory estimated costs:
Based on labor hours = £45,600 + (£24 × 3,000) = £117,600
Based on machine hours = -£65,400 + (£0.045 × 4,000,000) = £114,600
The best estimator for the Coventry factory is the machine-hours cost driver.
This is the cheapest and therefore the best estimator.
10-14
10-31
(25 min.) Regression analysis, service company.
1.
Solution Exhibit 10-31 plots the relationship between labor-hours and overhead costs and
shows the regression line.
y = £43,563 + £14.66 X
Economic plausibility. Labor-hours appears to be an economically plausible driver of
overhead costs for the character company. Overhead costs such as scheduling, hiring and training
of workers, and managing the workforce are largely incurred to support labor.
Goodness of fit. The vertical differences between actual and predicted costs are extremely
small, indicating a very good fit. The good fit indicates a strong relationship between the laborhour cost driver and overhead costs.
Slope of regression line. The regression line has a reasonably steep slope from left to right.
Given the small scatter of the observations around the line, the positive slope indicates that, on
average, overhead costs increase as labor-hours increase.
2.
The regression analysis indicates that, within the relevant range of 1,200 to 2,200 laborhours, the variable cost per person for a birthday party equals:
Balloons, cupcakes and punch
Labor (0.25 hrs.  £20 per hour)
Variable overhead (0.25 hrs.  £14.66 per labor-hour)
Total variable cost per person
£ 7.00
5.00
3.67
£15.67
3.
To earn a positive contribution margin, the minimum bid for a 20-child birthday party
would be any amount greater than £313.40. This amount is calculated by multiplying the variable
cost per child of £15.67 by the 20 children. At a price above the variable cost of £313.40, Lucy
Hall will be earning a contribution margin toward coverage of her fixed costs.
Of course, Lucy Hall will consider other factors in developing her bid including (a) an
analysis of the competition––vigorous competition will limit Lucy’s ability to obtain a higher
price (b) a determination of whether or not her bid will set a precedent for lower prices––overall,
the prices Lucy Hall charges should generate enough contribution to cover fixed costs and earn a
reasonable profit, and (c) a judgment of how representative past historical data (used in the
regression analysis) is about future costs.
10-15
SOLUTION EXHIBIT 10-31
Regression Line of Overhead Costs on Labor-Hours for Lucy Hall’s Character Business
80,000
Overhead Costs
75,000
y = 14.664x + 43563
R² = 0.9551
70,000
65,000
60,000
55,000
50,000
1,000
1,200
1,400
1,600
1,800
Labor-Hours
2,000
2,200
2,400
10-32 (25 min.) High-low, regression
1.
Mandy will pick the highest point of activity, 4,068 parts (March) at $17,280 of cost, and
the lowest point of activity, 2,316 parts (August) at $10,272.
Highest observation of cost driver
Lowest observation of cost driver
Difference
Cost driver:
Quantity Purchased
4,068
2,316
1,752
Purchase costs = a + b × Quantity purchased
Slope Coefficient = $7,008/1,752 = $4 per part
Constant (a) = $17,280 ─ ($4 × 4,068) = $1,008
The equation Mandy gets is:
Purchase costs = $1,008 + ($4 × Quantity purchased)
10-16
Cost
$17,280
10,272
$ 7,008
2. Using the equation above, the expected purchase costs for each month will be:
Month
October
November
December
Purchase
Quantity
Expected
3,360 parts
3,720
3,000
Formula
y = $1,008 + ($4 × 3,360)
y = $1,008 + ($4 × 3,720)
y = $1,008 + ($4 × 3,000)
Expected
cost
$14,448
15,888
13,008
3. Economic Plausibility: Clearly, the cost of purchasing a part is associated with the quantity
purchased.
Goodness of Fit: As seen in Solution Exhibit 10-32, the regression line fits the data well.
The vertical distance between the regression line and observations is small. An r-squared value of
greater than 0.98 indicates that more than 98 percent of the change in cost can be explained by the
change in quantity.
Significance of the Independent Variable: The relatively steep slope of the regression line
suggests that the quantity purchased is correlated with purchasing cost for part #696.
SOLUTION EXHIBIT 10-32
Timken Manufacturing Purchase Costs for Part #696
Cost of Purchase
$18,000
y = 3.6675x + 2135.5
R² = 0.9854
$16,000
$14,000
$12,000
$10,000
$8,000
2,000
2,500
3,000
3,500
Quantity Purchased
4,000
4,500
According to the regression, Mandy’s original estimate of fixed cost is too low given all the data
points. The original slope is too steep but only by 33 cents. So, the variable rate is lower, but the
fixed cost is higher for the regression line than for the high-low cost equation.
10-17
The regression is the more accurate estimate because it uses all available data (all nine data
points), while the high-low method only relies on two data points and may therefore miss some
important information contained in the other data.
4. Using the regression equation, the purchase costs for each month will be:
Purchase
Quantity
Month
Expected
Formula
Expected cost
October
3,360 parts
y = $2,135.50 + ($3.67  3,360)
$14,466.70
November
3,720
y = $2,135.50 + ($3.67  3,720)
15,787.90
December
3,000
y = $2,135.50 + ($3.67  3,000)
13,145.50
Although the two equations are different in both fixed element and variable rate, within the
relevant range they give similar expected costs. This implies that the high and low points of the
data are a reasonable representation of the total set of points within the relevant range.
10-33
(20 min.) Learning curve, cumulative average-time learning model.
The direct manufacturing labor-hours (DMLH) required to produce the first 2, 4, and 8 units given
the assumption of a cumulative average-time learning curve of 85%, is as follows:
85% Learning Curve
Cumulative
Number
of Units (X)
(1)
1
2
4
8
Cumulative
Average Time
per Unit (y): Labor Hours
(2)
3,600
3,060
= (3,600  0.85)
2,601
= (3,060  0.85)
2,211
= (2,601  0.85)
Cumulative
Total Time:
Labor-Hours
(3) = (1)  (2)
3,600
6,120
10,404
17,688
Alternatively, to compute the values in column (2) we could use the formula
y = aXb
10-18
where a = 3,600, X = 2, 4, or 8, and b = – 0.234465, which gives
when X = 2, y = 3,600 2– 0.234465 = 6,120
when X = 4, y = 3,600 4– 0.234465 = 10,404
when X = 8, y = 3,600 8– 0.234465 = 17,688
Direct materials $82,000  2; 4; 8
Direct manufacturing labor
$20  6,120; 10,404; 17,688
Variable manufacturing overhead
$17  6,120; 10,404; 17,688
Total variable costs
10-34
Variable Costs of Producing
2 Units
4 Units
8 Units
$164,000
$328,000
$ 656,000
122,400
208,080
353,760
104,040
$390,440
176,868
$712,948
300,696
$1,310,456
(20-30 min.) Cost estimation in inflationary period
a. Calculate the fixed and variable costs.
First step is to eliminate the inflation effect from the data.
Current costs (February) = Total costs for February
Inflation rate + 1
= $2,000,000
= $1,886,792
1.06
Second step is to find the fixed and variable costs from the costs and production differences
Period
February
January
Difference
Production (units)
60,000
48,000
12,000
Total Costs ($)
1,886,792
1,800,000
86,792
The ‘real’ variable cost per unit = $86,792 = $7.23
12,000
The ‘real’ fixed costs = $1,886,792 – (60,000 x $7.23) = $1,452,992
Note: The actual costs of $2,000,000 comprises of:
($1,452,992 x 1.06) + (60,000 x $7.23 x 1.06) = $2,000,000
10-19
b. Estimate the total costs for March if the ONS expects the inflation rate to fall to 5% and
the production output is estimated to increase to 62,000 test kits.
= ($1,452,992 x 1.06 x 1.05) + (62,000 x $7.23 x 1.06 x 1.05)
= $2,116,093
c. Predictions about cost levels and cost behavior in the future are likely to be based on records of
past costs and their associated levels of activity. As a result, care must be taken when using any
form of forecasting technique as past conditions are indeed a guide to the future. Caution must be
applied when cost predictions are based on the facts of particular situations and not on arbitrary
circumstances.
10-35 (25 min.) High-low method.
1.
Machine-Hours
Highest observation of cost driver
Lowest observation of cost driver
Difference
Maintenance costs
= a + b × Machine-hours
Slope coefficient (b) =
or
140,000
95,000
45,000
$90,000
= $2 per machine-hour
45,000
Constant (a)
= $280,000 – ($2 × 140,000)
= $280,000 – $280,000 = $0
Constant (a)
= $190,000 – ($2 × 95,000)
= $190,000 – $190,000 = $0
= $2 × Machine-hours
Maintenance costs
10-20
Maintenance Costs
$280,000
$190,000
$ 90,000
2.
SOLUTION EXHIBIT 10-35
Plot and High-Low Line of Maintenance Costs as a Function of Machine-Hours
$300,000
$280,000
Maintenance Costs
$260,000
$240,000
$220,000
$200,000
$180,000
$160,000
$140,000
$120,000
$100,000
90,000
100,000 110,000 120,000 130,000 140,000 150,000
Machine-Hours
Solution Exhibit 10-35 presents the high-low line.
Economic plausibility. The cost function shows a positive economically plausible relationship
between machine-hours and maintenance costs. There is a clear-cut engineering relationship of
higher machine-hours and maintenance costs.
Goodness of fit. The high-low line appears to “fit” the data well. The vertical differences between
the actual and predicted costs appear to be quite small.
Slope of high-low line. The slope of the line appears to be reasonably steep indicating that, on
average, maintenance costs in a quarter vary with machine-hours used.
3. Using the cost function estimated in 1, predicted maintenance costs would be $2 × 100,000 =
$200,000.
Howard should budget $200,000 in quarter 13 because the relationship between machinehours and maintenance costs in Solution Exhibit 10-35 is economically plausible, has an excellent
goodness of fit, and indicates that an increase in machine-hours in a quarter causes maintenance
costs to increase in the quarter.
10-21
10-36 (30min.) High-low method and regression analysis.
1. See Solution Exhibit 10-36.
SOLUTION EXHIBIT 10-36
Total Costs
Weekly Total Costs
$26,000
$25,000
$24,000
$23,000
$22,000
$21,000
$20,000
$19,000
$18,000
$17,000
Regression Line
High-Low Line
350
400
450
500
550
Number of Orders
(Regression line solid, high low-line is dotted)
2.
Number of
Orders per week
Highest observation of cost driver (Week 9)
Lowest observation of cost driver (Week 1)
Difference
529
353
176
Weekly
Total Costs
$25,275
19,005
$ 6,270
Weekly total costs = a + b (number of orders per week)
Slope coefficient (b)
= $6,270/176=$35.625 per order
Constant (a) = $25,275 – ($35.625 × 529) = $6,429.38
= $19,005 – ($35.625 × 353) = $6,429.38
Weekly total costs = $6,429.38 + $35.625X (Number of Orders per week)
See high-low line in Solution Exhibit 10-36.
10-22
3.
Solution Exhibit 10-36 presents the regression line:
Weekly total costs
= $10,048 + $28.91 × (Number of Orders per week)
Economic Plausibility. The cost function shows a positive economically plausible
relationship between number of orders per week and weekly total costs. Number of orders is a
plausible cost driver of total weekly costs.
Goodness of fit. The regression line appears to fit the data well. The vertical differences
between the actual costs and the regression line appear to be quite small.
Significance of independent variable. The regression line has a steep positive slope and
increases by $28.91 for each additional order. Because the slope is not flat, there is a strong
relationship between number of orders and total weekly costs.
The regression line is the more accurate estimate of the relationship between number of
orders and total weekly costs because it uses all available data points while the high-low method
relies only on two data points and may therefore miss some information contained in the other
data points. In addition, because the low data point falls below the regression line, the high-low
method predicts a lower amount of fixed cost and a steeper slope (higher amount of variable cost
per order).
4.
Profit = Total weekly revenues + Total seasonal membership fees – Total weekly costs
= (Total number of orders× $35) + (700 × $75) – $229,940
= (4,478 × $35) + (700 × $75) – $229,940
= $156,730 + $52,500 – $229,940 = ($20,710).
No, the club did not make a profit.
5.
Let the average number of weekly orders be denoted by AWO. We want to find the value
of AWO for which Farm Fresh will achieve zero profit. Using the format in requirement 4, we
want:
Profit = [AWO × 10 weeks × $35] + (850 × $75) – [$10,048 + ($28.91 × AWO)] × 10 weeks
= $0
$350 × AWO + $63,750 – $100,480 – $289.1 × AWO = $0
$60.9 × AWO = $36,730
AWO = $36,730 ÷ $60.9 = 603.12
So, Farm Fresh will have to get at least 604 weekly orders in order to break even next year.
10-23
10-37 (3040 min.) High-low method, regression analysis.
1.
Solution Exhibit 10-37 presents the plots of promotional costs on revenues.
SOLUTION EXHIBIT 10-37
Plot and Regression Line of Advertising Costs and Revenues
90,000
85,000
80,000
y = 6.5844x + 46443
R² = 0.6588
Revenues
75,000
70,000
65,000
60,000
55,000
50,000
45,000
40,000
0
1,000
2,000
3,000
Advertising Costs
4,000
5,000
Solution Exhibit 10-37 also shows the regression line of advertising costs on revenues. We
evaluate the estimated regression equation using the criteria of economic plausibility, goodness of
fit, and slope of the regression line.
Economic plausibility. Advertising costs appears to be a plausible cost driver of revenues.
Restaurants frequently use newspaper advertising to promote their restaurants and increase their
patronage.
Goodness of fit. The vertical differences between actual and predicted revenues appears to
be reasonably small. This indicates that advertising costs are related to restaurant revenues.
Slope of regression line. The slope of the regression line appears to be relatively steep. Given the
small scatter of the observations around the line, the steep slope indicates that, on average,
restaurant revenues increase with newspaper advertising.
10-24
2.
The high-low method would estimate the cost function as follows:
Advertising Costs
Highest observation of cost driver
$4,500
Lowest observation of cost driver
500
Difference
$4,000
Revenues
= a + (b advertising costs)
Slope coefficient (b)
=
$27,000
= 6.75
$4,000
Constant (a)
=
=
=
=
=
$83,000  ($4,500  6.75)
$83,000 $30,375 = $52,625
$56,000  ($500 6.75)
$56,000 $3,375 = $52,625
$52,625+ (6.75 Advertising costs)
or
Constant (a)
Revenues
3.
Revenues
$83,000
56,000
$27,000
The increase in revenues for each $1,000 spent on advertising within the relevant range is
a. Using the regression equation, 6.584 $1,000 = $6,584
b. Using the high-low equation, 6.75 $1,000 = $6,750
The high-low equation does fairly well in estimating the relationship between advertising
costs and revenues. However, Schaub should use the regression equation because it uses
information from all observations. The high-low method, on the other hand, relies only on the
observations that have the highest and lowest values of the cost driver and these observations are
generally not representative of all the data.
10-38 (30 min.) Regression, activity-based costing, choosing cost drivers.
1. Both number of units inspected and inspection labor-hours are plausible cost drivers for
inspection costs. The number of units inspected is likely related to test-kit usage, which is a
significant component of inspection costs. Inspection labor-hours are a plausible cost driver if
labor hours vary per unit inspected because costs would be a function of how much time the
inspectors spend on each unit. This is particularly true if the inspectors are paid a wage, and if they
use electric or electronic machinery to test the units of product (cost of operating equipment
increases with time spent).
2. Solution Exhibit 10-38 presents (a) the plots and regression line for number of units inspected
versus inspection costs and (b) the plots and regression line for inspection labor-hours and
inspection costs.
10-25
SOLUTION EXHIBIT 10-38A
Plot and Regression Line for Units Inspected versus Inspection Costs for Parker Manufacturing
Parker Manufacturing
$7,000
y = 2.0168x + 98.793
R² = 0.9975
Inspection costs
$6,000
$5,000
$4,000
$3,000
$2,000
$1,000
$0
600
1,100
1,600
2,100
Number of units inspected
2,600
3,100
SOLUTION EXHIBIT 10-38B
Plot and Regression Line for Inspection Labor-Hours and Inspection Costs for Parker
Manufacturing
Parker Manufacturing
$6,000
y = 20.057x + 3.8863
R² = 0.8973
Inspection costs
$5,000
$4,000
$3,000
$2,000
$1,000
$0
60
110
160
210
Inspection labor-hours
260
310
Goodness of fit. As you can see from the two graphs, the regression line based on number
of units inspected better fits the data (has smaller vertical distances from the points to the line)
than the regression line based on inspection labor-hours. The activity of inspection appears to be
more closely linearly related to the number of units inspected than inspection labor-hours. Hence
10-26
number of units inspected is a better cost driver. This is probably because the number of units
inspected is closely related to test-kit usage, which is a significant component of inspection costs.
Significance of independent variable. It is hard to visually compare the slopes because the graphs
are not the same size, but both graphs have steep positive slopes indicating a strong relationship
between number of units inspected and inspection costs, and inspection labor-hours and inspection
costs. Indeed, if labor-hours per inspection do not vary much, number of units inspected and
inspection labor-hours will be closely related. Overall, it is the significant cost of test-kits that is
driven by the number of units inspected (not the inspection labor-hours spent on inspection) that
makes units inspected the preferred cost driver.
3. At 160 inspection labor hours and 1,500 units inspected:
Inspection costs using units inspected = $98.79 + ($2.02× 1,500) = $3,128.79
Inspection costs using inspection labor-hours = $3.89 + ($20.06× 160) = $3,213.49
If Sharon uses inspection-labor-hours she will estimate inspection costs to be $3,213.49, $84.70
($3,213.49 ─$3,128.79) higher than if she had used number of units inspected. If actual costs
equaled, say, $3,160, Sharon would conclude that Parker has performed efficiently in its
inspection activity because actual inspection costs would be lower than budgeted amounts. In fact,
based on the more accurate cost function, actual costs of $3,160 exceeded the budgeted amount of
$3,128.79. Sharon should find ways to improve inspection efficiency rather than mistakenly
conclude that the inspection activity has been performing well.
10-39 (15–20min.) Interpreting regression results, matching time periods.
1.
Here is the regression output for monthly operating costs as a function of the total freight
miles travelled by Unicorn vehicles:
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.927299101
R Square
0.859883623
Adjusted R
Square
0.845871986
Standard Error
132.0816002
Observations
12
ANOVA
df
Regression
Residual
Total
1
10
11
Coefficients
SS
MS
1070620.18 1070620.18
174455.49
17445.55
1245075.67
Standard
t Stat
10-27
Significance
F
F
61.37
0.00
P-value
Lower 95%
Upper
Intercept
X Variable 1
445.76
0.26
Error
112.97
0.03
3.95
7.83
0.00
0.00
194.04
0.18
95%
697.48
0.33
2. The chart below presents the data and the estimated regression line for the relationship
between monthly operating costs and freight miles traveled by Unicorn Freightways.
Economic
plausibility
A positive relationship between freight miles traveled and monthly
operating costs is economically plausible since increased levels of
economic activity should lead to the consumption of greater amounts of
labor, fuel and other operating expenses.
Goodness of fit
r2 = 86%, Adjusted r2 = 85%
Standard error of regression = 132.08
Excellent fit; there is indisputable evidence of a linear relationship between
the dependent and independent variables. The distances between the
estimated line and the actual data points are small, other than at the highest
level of activity recorded during the year.
Significance of
Independent
Variables
The t-value of 7.83 for freight miles traveled output units is significant at
the 0.05 and 0.01 levels.
3. If Bonnie expects Unicorn to generate an average of 3,600 miles each month next year, the best
estimate of operating costs is given by:
Monthly operating costs = £445.76 + (£0.26 × 3,600 miles) = £1,381.76.
Annual operating costs = £1,381.76 × 12 = £16,581.12.
10-28
4. Three variables, other than freight miles, that Bonnie might expect to be important cost drivers
for Unicorn’s operating costs are: input prices (fuel prices and wage rates), mix of agricultural
output carried (weight, volume, value), and route mix and conditions (weather, flat versus
mountainous terrain, short-haul versus long-haul carriage).
5.
Here is the regression data for monthly maintenance costs as a function of the total freight
miles travelled by Sprit vehicles:
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.87887319
R Square
0.77241808
Adjusted R
Square
0.74965989
Standard Error
106.470794
Observations
12
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
10
11
Coefficients
1170.57
-0.15
SS
MS
384747.37 384747.37
113360.30 11336.03
498107.67
Standard
Error
91.07
0.03
F
33.94
t Stat
P-value
12.85
0.00
-5.83
0.00
The data and regression estimate are provided in the chart below:
10-29
Significance
F
0.00
Lower 95%
967.66
-0.21
Upper
95%
1373.48
-0.09
6. At first glance, the regression result in requirement 5 is surprising and economically
implausible. In the regression, the coefficient on freight miles traveled has a negative sign. This
implies that the greater the number of freight miles (i.e., the more activity Unicorn carries out), the
smaller are the maintenance costs; specifically, it suggests that each extra freight mile reduces
maintenance costs by £0.15 (recall that all data are in thousands). Clearly, this estimated
relationship is not economically credible. However, one would think that freight miles should
have some positive impact on fleet maintenance costs.
The logic behind the estimated regression becomes clearer once one realizes that maintenance
costs have a discretionary component to them, especially in terms of timing. Unicorn’s peak
months of work transporting agricultural products in western Canada occur in late spring and
summer (the period from April through August). It is likely that Unicorn is simply choosing to
defer maintenance to the months when its vehicles are not in use, thereby creating a negative
relationship between monthly activity and maintenance costs. The causality also goes the other
way – if vehicles are in the shop for maintenance, they are clearly not on the road generating
freight miles. A third reason is that vehicles might need to be serviced at greater frequency during
the winter months because of the wear and tear that comes from driving on icy terrain and in poor
weather conditions.
Possible alternative specifications that would better capture the link between Unicorn’s activity
levels and the spending on maintenance are to estimate the relationship using annual data over a
period of several years, to look at spending on corrective rather than preventive maintenance, or to
look at the relation using lags (i.e., freight miles traveled in a period against the spending on
maintenance done in a subsequent period in order to service the vehicles).
10-40 (30–40 min.) Cost estimation, cumulative average-time learning curve.
1.
Cost to produce the second through the seventh troop deployment boats:
Direct materials, 6 × $201,000
Direct manufacturing labor (DML), 66,0601 × $43
Variable manufacturing overhead, 66,060 × $24
Other manufacturing overhead, 15% of DML costs
Total costs
1
$1,206,000
2,840,580
1,585,440
426,087
$6,058,107
The direct manufacturing labor-hours to produce the second to seventh boats can be calculated in
several ways, given the assumption of a cumulative average-time learning curve of 90%:
10-30
Use of table format:
Cumulative
Number of Units
(X)
(1)
1
2
90% Learning Curve
Cumulative
Average Time per Unit (y): Labor
Hours
(2)
15,700
14,130
Cumulative Total Time:
Labor-Hours
(3) = (1) × (2)
15,700
= (15,700 × 0.90)
28,260
3
13,285
39,855
4
12,717
= (14,130 × 0.90)
50,868
5
12,293
61,465
6
11,957
71,742
7
11,680
81,760
The direct labor-hours required to produce the second through the seventh boats is 81,760 –
15,700 = 66,060 hours.
Use of formula: y = aXb
where a = 15,700,
X = 7, and b = – 0.152004
– 0.152004
y= 15,700  7
= 11,680 hours
The total direct labor-hours for 7 units is 11,680 7 = 81,760 hours
Note: Some students will debate the exclusion of the $281,000 tooling cost. The question specifies
that the tooling “cost was assigned to the first boat.” Although Blue Seas may well seek to ensure
its total revenue covers the $1,533,900 cost of the first boat, the concern in this question is only
with the cost of producing six more PT109s.
10-31
2.
Cost to produce the second through the seventh boats assuming linear function for direct
labor-hours and units produced:
Direct materials, 6 × $201,000
$1,206,000
Direct manufacturing labor (DML), 6 × 15,700 hrs. × $43
4,050,600
Variable manufacturing overhead, 6 × 15,700hrs. × $24
2,260,800
Other manufacturing overhead, 15% of DML costs
607,950
Total costs
$8,124,990
The difference in predicted costs is:
Predicted cost in requirement 2
(based on linear cost function)
Predicted cost in requirement 1
(based on 90% learning curve)
Difference in favor of learning curve cost function
$8,124,990
6,058,107
$2,066,883
Note that the linear cost function assumption leads to a total cost that is almost 34 percent
higher than the cost predicted by the learning curve model. Learning curve effects are most
prevalent in large manufacturing industries such as airplanes and boats where costs can run into the
millions or hundreds of millions of dollars, resulting in very large and monetarily significant
differences between the two models. In the case of Blue Seas, if it is in fact easier to produce
additional boats as the firm gains experience, the learning curve model is the right one to use. The
firm can better forecast its future costs and use that information to submit an appropriate cost bid to
the Navy, as well as refine its pricing plans for other potential customers.
10-41 (20–30 min.) Cost estimation, incremental unit-time learning model.
1.
Cost to produce the 2nd through the 7th boats:
Direct materials, 6  $205,000
Direct manufacturing labor (DML), 73,6391  $45
Variable manufacturing overhead, 73,639  $21
Other manufacturing overhead, 25% of DML costs
Total costs
1The
$1,230,000
3,313,755
1,546,419
828,439
$6,918,613
direct labor hours to produce the second through the seventh boats can be calculated via a table
format, given the assumption of an incremental unit-time learning curve of 90%:
10-32
90% Learning Curve
Cumulative
Number of
Cumulative
Individual Unit Time for Xth
*
Total Time:
Units (X)
Unit (y) : Labor Hours
Labor-Hours
(1)
(2)
(3)
1
15,200
2
3
4
5
6
7
13,680
12,862
12,312
11,901
11,576
11,308
= (15,200  0.90)
= (13,680  0.90)
15,200
28,880
41,742
54,054
65,955
77,531
88,839
*Calculated as y = aXb where a = 15,200, b = – 0.152004, and X = 1, 2, 3,. . .7.
The direct manufacturing labor-hours to produce the second through the seventh boat is 88,839 –
15,200 = 73,639 hours.
2.
Difference in total costs to manufacture the second through the seventh boat under the
incremental unit-time learning model and the cumulative average-time learning model is
$6,918,613 (calculated in requirement 1 of this problem) – $6,170,601 (from requirement 1 of
Problem 10-41) = $748,012, i.e., the total costs are higher for the incremental unit-time model.
The incremental unit-time learning curve has a slower rate of decline in the time required
to produce successive units than does the cumulative average-time learning curve (see Problem
10-41, requirement 1). Assuming the same 90% factor is used for both curves:
Estimated Cumulative Direct Manufacturing Labor-Hours
Cumulative
Cumulative AverageIncremental Unit-Time
Number of Units
Time Learning Model
Learning Model
1
15,200
15,200
2
27,360
28,880
4
49,248
54,054
7
79,156
88,839
The reason is that, in the incremental unit-time learning model, as the number of units
double, only the last unit produced has a cost of 90% of the initial cost. In the cumulative averagetime learning model, doubling the number of units causes the average cost of all the units
produced (not just the last unit) to be 90% of the initial cost.
WLJ Boat should examine its own internal records on past jobs and seek information from
engineers, plant managers, and workers when deciding which learning curve better describes the
behavior of direct manufacturing labor-hours on the production of the PT109 boats.
10-33
10-42
(30 min.)
Regression; choosing among models.
1. See Solution Exhibit 10-42A below.
SOLUTION EXHIBIT 10-42A
(a) Regression Output for Medical Supplies Costs and Number of Procedures
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.599152481
R Square
0.358983696
Adjusted R
Square
0.294882065
Standard Error
52998.71699
Observations
12
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
10
11
SS
15730276644
28088640022
43818916667
Coefficients
36939.77
361.91
Standard
Error
56404.86
152.93
MS
1.57E+10
2.81E+09
t Stat
0.65
2.37
Durbin-Watson = 2.48
10-34
5.60
Significance
F
0.04
P-value
0.53
0.04
Lower 95%
-88738.09
21.16
F
Upper
95%
162617.63
702.66
(b) Regression Output for Medical Supplies Costs and Number of Patient-Hours
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.91669199
R Square
0.84032421
Adjusted R Square
0.82435663
Standard Error
26451.5032
Observations
12
Durbin-Watson = 1.91
ANOVA
df
Regression
Residual
Total
1
10
11
SS
36822096457
6996820210
43818916667
Coefficients
3654.86
56.76
Standard
Error
23569.51
7.82
MS
3.68E+10
7E+08
F
52.63
Significance
F
0.00
t Stat
0.16
7.25
P-value
0.88
0.00
Lower 95%
-48861.29
39.33
Durbin-Watson =
2.48
Intercept
X Variable 1
10-35
Upper
95%
56171.00
74.19
2. See Solution Exhibit 10-42B below.
SOLUTION EXHIBIT 10-42B
Plots and Regression Lines for (a) Medical Supplies Costs and Number of Procedures and (b)
Medical Supplies Costs and Number of Patient-Hours
(a)
Apollo Hospitals
Medical supplies costs
250,000
200,000
y = 361.91x + 36940
R² = 0.359
150,000
100,000
50,000
100
200
300
400
Number of procedures
500
(b)
Apollo Hospitals
Medical supplies costs
250,000
200,000
y = 56.759x + 3654.9
R² = 0.8403
150,000
100,000
50,000
1,000
1,500
2,000
2,500
3,000
3,500
Number of patient-hours
10-36
4,000
4,500
600
3.
Economic
plausibility
Number of Procedures
A positive relationship
between medical supplies costs
and the number of procedures
is economically plausible.
Number of Patient-Hours
A positive relationship between
medical supplies costs and the number
of patient-hours is also economically
plausible, especially since the time
taken to serve patients is not uniform.
Patient-hours is more likely to capture
the true level of activity in the hospital
since it accounts for the mix of
procedures performed.
Goodness of fit
r2 = 36%
r2 = 84%
Standard error of regression = $52,999 Standard error of regression = $26,452
Reasonable goodness of fit.
Excellent goodness of fit.
Significance of
Independent
Variables
The t-value of 2.37 is significant at the The t-value of 7.25 is highly
0.05 level. It is not significant at the
significant at the 0.05 and 0.01 levels.
0.01 level.
Specification
analysis of
estimation
assumptions
Based on a plot of the data, the
linearity assumption holds, but there is
some possibility that the constant
variance assumption does not hold.
The Durbin-Watson statistic of 2.48
suggests the residuals are independent.
The normality of residuals assumption
appears to hold. However, inferences
drawn from only 12 observations are
not reliable.
Based on a plot of the data, the
assumptions of linearity, constant
variance, independence of residuals
(Durbin-Watson = 1.91), and
normality of residuals hold. However,
inferences drawn from only 12
observations are not reliable.
4. The regression model using number of patient-hours should be used to estimate medical
supplies costs because the number of patient-hours is a more economically plausible cost driver
of medical supplies costs (compared to the number of procedures performed). The time taken to
prepare medical facilities and to actually deal with patient issues (surgery, post-procedure care,
etc.) is different for different procedures. The more complex the procedure, the more time is
taken with the patient to analyze and manage the problem, and the greater the supplies costs
incurred. As such, patient-hours might serve as a better driver of medical supplies costs. The
regression of number of patient-hours and medical supplies costs also has a better fit, a
substantially significant independent variable, and better satisfies the assumptions of the
estimation technique used.
10-37
10-43 (30 min.) Multiple regression (continuation of 10-42).
1. Solution Exhibit 10-43 presents the regression output for medical supplies costs using both
number of procedures and number of patient-hours as independent variables (cost drivers).
SOLUTION EXHIBIT 10-43
Regression Output for Multiple Regression for Medical Supplies Costs Using Both Number of
Procedures and Number of Patient-Hours as Independent Variables (Cost Drivers)
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.91806327
R Square
0.84284017
Adjusted R Square 0.80791577
Standard Error
27661.7936
Observations
12
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
X Variable 2
Durbin-Watson = 1.96
2.
Economic
plausibility
2
9
11
SS
36932343254
6886573413
43818916667
Coefficients
-3103.76
38.24
54.37
Standard
Error
30406.54
100.76
10.33
MS
1.85E+10
7.65E+08
F
24.13
Significance
F
0.00
t Stat
-0.10
0.38
5.26
P-value
0.92
0.71
0.00
Lower 95%
-71888.13
-189.68
31.00
Upper
95%
65680.61
266.17
77.73
A positive relationship between medical supplies costs and each of the
independent variables (number of procedures and number of patient-hours)
is economically plausible.
Goodness of fit
r2 = 84%, Adjusted r2 = 81%
Standard error of regression =$27,662
Excellent goodness of fit.
Significance of
Independent
Variables
The t-value of 0.38 for number of procedures is not significant at the 0.05
level. The t-value of 5.26 for number of patient-hours is significant at the
0.05 and 0.01 levels.
Specification
analysis of
estimation
assumptions
Assuming linearity, constant variance, and normality of residuals, the
Durbin-Watson statistic of 1.96 suggests the residuals are independent.
However, we must be cautious when drawing inferences from only 12
observations.
10-38
3. Multicollinearity is an issue that can arise with multiple regression but not simple regression
analysis. Multicollinearity means that the independent variables are highly correlated.
The correlation feature in Excel’s Data Analysis reveals a coefficient of correlation of 0.61
between number of procedures and number of patient-hours. This is close to the threshold of 0.70
that is usually taken as a sign of multicollinearity problems. As evidence, note the substantial drop
in the t-value for patient-hours from 7.25 to 5.26, despite a fairly small change in the estimated
coefficient (from $56.76 to $54.37).
4. The simple regression model using the number of patient-hours as the independent variable
achieves a comparable r2 to the multiple regression model. However, the multiple regression model
includes an insignificant independent variable, number of procedures. Adding this variable does not
improve Apollo Hospital’s ability to better estimate medical supplies costs and it also introduces
multicollinearity issues. Julie should use the simple regression model with number of patient-hours
as the independent variable to estimate medical supplies costs.
10-39
10-44 (30 min.) Cost estimation.
1. Here is the summary output for the monthly regression of Direct Labor Hours on Output Units for
Hankuk Electronics:
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.2333602
R Square
0.054457
Adjusted R
Square
-0.0400973
Standard Error
206.18345
Observations
12
ANOVA
df
Regression
Residual
Total
1
10
11
Coefficients
Intercept
345.24
X Variable 1
0.71
Durbin-Watson = 0.50
SS
24483.86
425116.1
449600
Standard
Error
589.07
0.93
MS
24483.86
42511.61
F
0.575933
Significance
F
0.465422344
t Stat
0.59
0.76
P-value
0.57
0.47
Lower 95%
-967.29
-1.37
Upper
95%
1657.77
2.79
2. The plot and regression line for monthly direct labor hours on monthly output for Hankuk
Electronics are given below:
Hankuk Electronics
Direct Labor Hours
1,600
1,400
y = 0.7091x + 345.24
R² = 0.0545
1,200
1,000
800
600
400
450
500
550
600
650
Output (Units)
10-40
700
750
Economic
plausibility
A positive relationship between direct labor hours and monthly output is
economically plausible since increased levels of production should lead to
the consumption of greater amounts of direct labor.
Goodness of fit
r2 = 0.054, Adjusted r2 = - 0.04
Standard error of regression = 206.18
Terrible fit; in fact, there is no evidence of a linear relationship between the
dependent and independent variables. At least one data point represents a
significant outlier.
Significance of
Independent
Variables
The t-value of 0.71 for output units is not significant at the 0.05 level.
3. Given Inbee’s expectation that Hankuk will produce 650 units in January 2021, her best estimate
given the linear regression above is that Hankuk will use:
345.24 + (0.71 × 650 units) = 806.74 direct labor hours.
At an estimated variable cost of $17.50 per direct labor-hour, this implies that Inbee should budget
806.74 × $17.50 = $14,118
for direct labor costs for January 2021.
Note that 650 units is in the range of output values that were used to find the regression equation,
and therefore falls in the range of predictability for this model. However, there is substantial
uncertainty around the cost estimate of $14,118. In particular, this predicted value relies on the
regression point estimate of 0.71 for the marginal impact of output on labor hours. But, the 95%
confidence interval for the slope of the regression ranges all the way from -1.37 to 2.79, and the
predicted cost would vary accordingly. One cannot reject the null hypothesis that output levels have
no impact on labor consumption, leaving the budgeted cost estimate a highly speculative one!
10-41
10-45 (30 min.) Cost estimation, learning curves (continuation of 10-44).
1. Here is the summary output for the monthly regression of the natural log of Cumulative Average
Direct Labor-Hours per Unit on the natural logarithm of Cumulative Output:
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.9989528
R Square
0.9979068
Adjusted R
Square
0.9976975
Standard Error
0.0074326
Observations
12
ANOVA
df
Regression
Residual
Total
1
10
11
Coefficients
Intercept
2.09
X Variable 1
-0.21
Durbin-Watson = 2.66
SS
MS
F
0.263368
0.000552
0.26392
0.263368
5.52E-05
4767.34
Significance
F
9.89803E15
t Stat
85.44
-69.05
P-value
0.00
0.00
Lower 95%
2.03
-0.21
Standard
Error
0.02
0.00
Upper
95%
2.14
-0.20
2. The plot of the data and the regression line estimated above are provided next.
Log of Cumulative Average DLH per unit
Hankuk Electronics
0.800
y = -0.2079x + 2.0876
R² = 0.9979
0.700
0.600
0.500
0.400
0.300
0.200
6.000
6.500
7.000
7.500
8.000
Log of Cumulative Output
10-42
8.500
9.000
Economic
plausibility
A negative relationship between cumulative average direct-labor hours per
unit and cumulative output (in natural logarithms) is economically
plausible and reflects the presence of learning effects. Specifically, as the
firm gains experience via production, it becomes more efficient and is able
to use fewer direct labor hours to make each unit of product.
Goodness of fit
r2 = 0.998, Adjusted r2 = 0.998
Standard error of regression = 0.007
Unparalleled goodness of fit. Virtually perfect linear fit in logarithms.
Significance of
Independent
Variables
The t-value of -69.05 for the logarithm of cumulative output is significant
at all conventional levels. The t-value for the intercept (85.44) is highly
significant as well.
3. The original learning curve specification, y = axb is mathematically identical to the following loglinear specification:
Ln y = Ln a + b × Ln x
The regression equation we have estimated,
Ln (Cumulative avg DLH per unit) = a + (b × Ln (Cumulative Output))
is precisely the above specification, and in particular the slope coefficient directly yields the “b”
from the learning curve equation. We know therefore that for Hankuk electronics, b = -0.208. As
explained in Exhibit 10-10, this value is related to the learning curve percentage as follows:
b = Ln (learning-curve % in decimal form) ÷ Ln 2, or
-0.208 = Ln (learning-curve % in decimal form) ÷ 0.693, or
Ln (learning-curve % in decimal form) = -0.208 × 0.693 = -0.144.
As the exponent of -0.144 is 0.8659, this implies that Hankuk is experiencing an 86.6% cumulative
average-time learning curve.
10-43
4. With an additional 650 units in January 2021, Hankuk’s cumulative output will go from 7,527 at
the end of December 2016 to 8,177 (7,527 + 650). As Ln (8,177) = 9.0091, the cumulative average
direct-labor hours in logarithmic terms are given by:
2.0876 – (0.2079 × 9.0091) = 0.2146.
The cumulative direct-labor hours per unit therefore equals Exp (0.2146) = 1.2394. This implies a
total direct labor hours of 1.2394 × 8,177 = 10,134 by the end of January. As Hankuk has used a
total of 9,480 direct labor hours at the end of December 2020, the incremental hours needed in
January therefore are 654 (10,134 – 9,480). At $17.50 per labor hour, this suggest that Inbee should
budget
654 × $17.50 = $11,445
for direct labor costs for January 2021.
While 9.0091 is outside the range of cumulative output values (measured in logarithms) used to find
the regression equation, unless there has been a structural break in the experience curve Hankuk is
facing, it is highly likely that its January costs will be in the neighborhood of $11,445. The reason is
that the estimated regression line is close to perfect and has a standard error close to zero. There is
virtually no uncertainty around the coefficient estimates. The slope coefficient, for example, has a
point estimate of -0.2079, and a narrow 95% confidence interval between -0.2146 and -0.2012.
Using either of those estimates would make barely any difference to the predicted cost for the month
of January 2021.
10-44
10-46 (25 min.) Interpreting regression results, matching time periods
1.
Here is the summary output for the monthly regression of Sales Revenue on Online
Advertising Expense:
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.15
R Square
0.02
Adjusted R
Square
-0.07
Standard Error
11837.30
Observations
12.00
ANOVA
df
Regression
Residual
Total
1
10
11
Coefficients
Intercept
51999.64
X Variable 1
-0.98
Durbin-Watson = 2.14
SS
33972689.79
1401216525
1435189215
Standard
Error
7988.68
1.99
MS
33972690
1.4E+08
F
0.242451
Significance
F
0.633072
t Stat
6.51
-0.49
P-value
0.00
0.63
Lower 95%
34199.74
-5.41
Upper
95%
69799.54
3.45
2.
Solution Exhibit 10-46A presents the data plot for the initial analysis. The formula of
Sales Revenue = $52,000 – (0.98 × Online advertising expense) indicates that there is a fixed
amount of revenue each month of $52,000, which is reduced by 0.98 times that month’s online
advertising expense. This relationship is not economically plausible, as advertising would not
reduce revenue. The data points do not appear linear, and the r-square of 0.02 indicates a very
weak goodness of fit (in fact, almost no fit at all).
10-45
SOLUTION EXHIBIT 10-46 A
Plot and Regression Line for Sales Revenue and Online Advertising Expense
$70,000
$65,000
Sales Revenue
$60,000
$55,000
$50,000
$45,000
y = -0.9789x + 52000
R² = 0.0237
$40,000
$35,000
$30,000
$25,000
$20,000
$0
$1,000 $2,000 $3,000 $4,000 $5,000 $6,000 $7,000
Online Advertising Expense
3.
Here is the summary output for the regression of monthly Sales Revenue on the prior
month’s Online Advertising Expense:
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.808588
R Square
0.653815
Adjusted R
Square
0.61535
Standard Error
7393.922
Observations
11
ANOVA
df
Regression
Residual
Total
1
9
10
Coefficients
Intercept
28361.37
X Variable 1
5.381665
Durbin-Watson = 1.71
SS
9.29E+08
4.92E+08
1.42E+09
Standard
Error
5428.687
1.305336
MS
929262059
54670085
F
16.99763
Significance
F
0.002587
t Stat
5.2243522
4.1228186
P-value
0.000546
0.002587
Lower 95%
16080.83
2.428789
10-46
Upper
95%
40641.91
8.33454
4.
Solution Exhibit 10-46 B presents the data plot for the revised analysis. The formula of
Sales Revenue = $28,361 + (5.38 × Online Advertising Expense) indicates that there is a fixed
amount of revenue each month of $28,361, which increases by 5.38 times the prior month’s
advertising expense in the online channel. This relationship is economically plausible. One
would expect a positive correlation between advertising expense and (future) sales revenue. The
slope coefficient of 5.38 has a t stat of 4.12 indicating that it is statistically significant at the 5%
level. In the revised analysis, there is improved linearity in the data points, and the r-square of
0.65 indicates a much stronger goodness of fit.
SOLUTION EXHIBIT 10-46B
Plot and Regression Line for Sales Revenue and Previous Month Online Advertising
70,000
65,000
Sales Revenue
60,000
55,000
y = 5.3817x + 28361
R² = 0.6538
50,000
45,000
40,000
35,000
30,000
0
1,000 2,000 3,000 4,000 5,000 6,000
Online Advertising Expense (Prior Month)
7,000
5.
Nandita must be very careful about making conclusions regarding cause and effect. Even
a strong goodness of fit does not prove a cause and effect relationship. The independent and
dependent variables could both be caused by a third factor, or the correlation could be simply
coincidental. However, there is enough of a correlation in the revised analysis for Nandita to
make a meaningful presentation to the store’s owner.
10-47
10-47 (40–50 min.) Purchasing Department cost drivers, activity-based costing, simple
regression analysis.
The problem reports the exact t-values from the computer runs of the data. Because the
coefficients and standard errors given in the problem are rounded to three decimal places,
dividing the coefficient by the standard error may yield slightly different t-values.
1.
Plots of the data used in Regressions 1 to 3 are in Solution Exhibit 10-47A.See Solution
Exhibit 10-47B for a comparison of the three regression models.
2.
Both Regressions 2 and 3 are well-specified regression models. The slope coefficients on
their respective independent variables are significantly different from zero. These results support
the Couture Fabrics’ presentation in which the number of purchase orders and the number of
suppliers were reported to be drivers of purchasing department costs.
In designing an activity-based cost system, Designer Wear should use number of
purchase orders and number of suppliers as cost drivers of purchasing department costs. As the
chapter appendix describes, Designer Wear can either (a) estimate a multiple regression equation
for purchasing department costs with number of purchase orders and number of suppliers as cost
drivers, or (b) divide purchasing department costs into two separate cost pools, one for costs
related to purchase orders and another for costs related to suppliers, and estimate a separate
relationship for each cost pool.
3.
Guidelines presented in the chapter could be used to gain additional evidence on cost
drivers of purchasing department costs.
1. Use physical relationships or engineering relationships to establish cause-and-effect
links. Lee could observe the purchasing department operations to gain insight into
how costs are driven.
2. Use knowledge of operations. Lee could interview operating personnel in the
purchasing department to obtain their insight on cost drivers.
10-48
SOLUTION EXHIBIT 10-47A
Regression Lines of Various Cost Drivers for Purchasing Dept. Costs for Designer Wear
Purchasing Department Costs
$2,500,000
y = 0.0031x + 1E+06
R² = 0.0796
$2,000,000
$1,500,000
$1,000,000
$500,000
$0
0
50,000,000
100,000,000
150,000,000
Dollar Value of Merchandise Purchased
Purchasing Department Costs
$2,500,000
y = 156.18x + 731687
R² = 0.4178
$2,000,000
$1,500,000
$1,000,000
$500,000
$0
0
1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000
Number of Purchase Orders
10-49
Purchasing Department Costs
$2,500,000
$2,000,000
y = 3848x + 802629
R² = 0.4018
$1,500,000
$1,000,000
$500,000
$0
0
50
100
150
Number of Suppliers
200
250
SOLUTION EXHIBIT 10-47B
Comparison of Alternative Cost Functions for Purchasing Department
Costs Estimated with Simple Regression for Designer Wear
Regression 1
PDC = a + (b  MP$)
Result presented at
seminar by Couture
Fabrics found little
support for MP$ as a
driver. Purchasing
personnel at the
Miami store believe
MP$ is not a
significant cost driver.
Regression 2
PDC = a + (b  # of POs)
Economically plausible.
The higher the number of
purchase orders, the more
tasks undertaken.
Regression 3
PDC = a + (b  # of Ss)
Economically plausible.
Increasing the number of
suppliers increases the
costs of certifying
vendors and managing
the Designer Wearsupplier relationship.
2. Goodness of fit
r2= 0.08. Poor
goodness of fit.
r2 = 0.42. Reasonable
goodness of fit.
r2 = 0.40. Reasonable
goodness of fit.
3. Significance of
independent
variables
t-value on MP$ of
0.83 is insignificant.
t-value on # of POs of 2.40 t-value on # of Ss of 2.32
is significant.
is significant.
Criterion
1. Economic
plausibility
10-50
Regression 1
Regression 2
PDC = a + (b  MP$) PDC = a + (b  # of POs)
Regression 3
PDC = a + (b  # of Ss)
Appears questionable Appears reasonable.
but no strong evidence
against linearity.
Appears reasonable.
B. Constant
variance of
residuals
Appears questionable, Appears reasonable.
but no strong evidence
against constant
variance.
Appears reasonable.
C. Independence
of residuals
Durbin-Watson
Statistic = 2.42.
Assumption of
independence is not
rejected.
Durbin-Watson
Statistic = 1.99.
Assumption of
independence is not
rejected.
Durbin-Watson
Statistic = 2.00.
Assumption of
independence is not
rejected.
D. Normality of
residuals
Database too small to
make reliable
inferences.
Database too small to
make reliable inferences.
Database too small to
make reliable inferences.
Criterion
4. Specification
analysis
A. Linearity
within the
relevant range
10-51
10-48 (30–40 min.) Purchasing Department cost drivers, multiple regression analysis
(continuation of 10-47).
The problem reports the exact t-values from the computer runs of the data. Because the
coefficients and standard errors given in the problem are rounded to three decimal places,
dividing the coefficient by the standard error may yield slightly different t-values.
1.
Regression 4 is a well-specified regression model:
Economic plausibility: Both independent variables are plausible and are supported by the
findings of the Couture Fabrics study.
Goodness of fit: The r2 of 0.63 indicates an excellent goodness of fit.
Significance of independent variables: The t-value on # of POs is 2.09 while the t-value on # of
Ss is 2.02. These t-values are either significant or border on significance.
Specification analysis: Results are available to examine the independence of residuals
assumption. The Durbin-Watson statistic of 1.91 indicates that the assumption of independence
is not rejected.
Regression 4 is consistent with the findings in Problem 10-47 that both the number of
purchase orders and the number of suppliers are drivers of purchasing department costs.
Regressions 2, 3, and 4 all satisfy the four criteria outlined in the text. Regression 4 has the best
goodness of fit (0.63 for Regression 4 compared to 0.42 and 0.40 for Regressions 2 and 3,
respectively). Most importantly, it is economically plausible that both the number of purchase
orders and the number of suppliers drive purchasing department costs. We would recommend
that Lee use Regression 4 over Regressions 2 and 3.
2. Regression 5 adds an additional independent variable (MP$) to the two independent variables
in Regression 4. This additional variable (MP$) has a t-value of –0.11, implying its slope
coefficient is insignificantly different from zero. The r 2 in Regression 5 (0.63) is the same as that
in Regression 4 (0.63), implying the addition of this third independent variable adds close to zero
explanatory power. In summary, Regression 5 adds very little to Regression 4. We would
recommend that Lee use Regression 4 over Regression 5.
3. Budgeted purchasing department costs for the Baltimore store next year are:
$481,186 + ($121.374,200) + ($2,941120) = $1,343,860
4.Multicollinearity is a frequently encountered problem in cost accounting; it does not arise in
simple regression because there is only one independent variable in a simple regression. One
consequence of multicollinearity is an increase in the standard errors of the coefficients of the
individual variables. This frequently shows up in reduced t-values for the independent variables
in the multiple regression relative to their t-values in the simple regression:
10-52
Variables
Regression 4:
# of POs
# of Ss
Regression 5:
# of POs
# of Ss
MP$
t-value in
Multiple Regression
t-value from
Simple Regressions
in Problem 10-47
2.09
2.02
2.40
2.32
1.92
1.82
-0.11
2.40
2.32
0.83
The decline in the t-values in the multiple regressions is consistent with some (but not very high)
collinearity among the independent variables. Pairwise correlations between the independent
variables are:
Correlation
# of POs and # of Ss
0.30
# of POs and MP$
0.27
# of Ss and MP$
0.35
There is no evidence of difficulties due to multicollinearity in Regressions 4 and 5.
5.
Decisions in which the regression results in Problems 10-47 and 10-48 could be useful
are as follows:
Cost management decisions: Designer Wear could restructure relationships with the suppliers so
that fewer separate purchase orders are made. Alternatively, it may aggressively reduce the
number of existing suppliers.
Purchasing policy decisions: Designer Wear could set up an internal charge system for individual
retail departments within each store. Separate charges to each department could be made for each
purchase order and each new supplier added to the existing ones. These internal charges would
signal to each department ways in which their own decisions affect the total costs of Designer
Wear.
Accounting system design decisions: Designer Wear may want to discontinue allocating
purchasing department costs on the basis of the dollar value of merchandise purchased.
Allocation bases better capturing cause-and-effect relations at Designer Wear are the number of
purchase orders and the number of suppliers.
10-53
Try It! 10-1
a. y = $1.40X
b. y = $7,000
c. y = $70 + $0.50X
d. y = $1,600 + $17X
Try It! 10-2
The highest and lowest observations of the cost driver correspond to 5,850 hours and 3,000
hours, respectively. Using those data points:
a. Slope = ($67,100 − $35,600) ÷ (6,050 – 2,900)
= $31,500 ÷ 3,150
= $10 per hour
b.
$67,100 = Constant + ($10 × 6,050)
Constant = $67,100 − ($10 × 6,050) = 6,600
c. y = $6,600 + ($10 × Hours)
d. y = $6,600 + ($10 × 3,200) = $38,600
10-54
Try It! 10-3
a. Unit
1
2
Hours Cumulative Cumulative Average
6.0
6.0
6.0
4.8
10.8
5.4
Learning percentage = 5.4 ÷ 6.0 = 0.90
b.
b
y =a×X
− 0.1520
=6×8
= 4.37 hours
(or) Cumulative average time for:
1 unit = 6 hours
2 units = 6 × 0.9 = 5.4 hours
4 units = 5.4 × 0.9 = 4.86 hours
8 units = 4.86 × 0.9 = 4.37 hours
Therefore, total time to build 8 units = 8 × 4.37 = 34.96 hours.
c. Total time = 34.96 hours
Manufacturing overhead charge = 34.96 × $25 = $874
d. As production doubles from 1 to 2 units, the incremental time of the second unit relative to
the first is 4.8 hours ÷ 6 hours = 0.8.
Therefore, this represents an 80% learning curve under the incremental unit-time learning model.
b
e. y = a × X
− 0.3219
= 6 × 16
= 2.458 hours
(or) Time for:
1st unit = 6 hours
2nd unit = 6 × 0.8 = 4.8 hours
4th unit = 4.8 × 0.8 = 3.84 hours
8th unit = 3.84 × 0.8 = 3.072 hours
16th unit = 3.072 × .8 = 2.458 hours
10-55
Try It! 10-4
a, b and c.
Plot and Regression Line of Sales Revenues on Promotional Costs
850,000
800,000
y = 14.184x + 397163
R² = 0.6271
Sales Revenues
750,000
700,000
650,000
600,000
550,000
500,000
450,000
400,000
5,000
10,000
15,000
Promotional Costs
20,000
25,000
The above plot includes the regression line of sales revenues on promotional costs. Here are the
details, from carrying out a regression analysis in Excel:
Sales Revenues  $397,163  (14.18  Promotional Costs)
Variable
Coefficient
Constant
$397,163.12
59,169.06
6.71
14.184
3.87
3.67
Independent variable:
Promotional costs
Standard Error
t-Value
r2  0.63; Durbin-Watson statistic  2.55
We evaluate the estimated regression equation using the criteria of economic plausibility,
goodness of fit, and slope of the regression line.
Economic plausibility. Promotional costs would appear to be a plausible cost driver of sales
revenues. Restaurants frequently use promotional activities such as advertising, sponsoring of
local events, etc. to engender interest among potential clients and increase their patronage.
Goodness of fit. As seen in the plot, the regression line fits the data well. The vertical differences
between actual and predicted revenues are reasonably small. This indicates that promotional
costs are related to restaurant revenues. An r-squared value of 0.627 indicates that almost 63%
of the change in revenues can be explained by the change in promotional costs.
10-56
Slope of regression line. The slope of the regression line is relatively steep. Given the small
scatter of the observations around the line, this indicates that, on average, restaurant revenues
increase with advertising promotion at a slope of 14.18. The t-value of 3.67 is statistically
significant at the 0.05 and 0.01 levels.
d.
The increase in sales revenues for each $1,000 spent on promotion, within the relevant
range, is:
$14.184  $1,000 = $14,184.
10-57
CHAPTER 11
DATA ANALYTIC THINKING AND PREDICTION
11-1 Management accountants can contribute in each step of the seven-step decision-making
process for applying machine learning techniques in business situations: (1) Gain a business
understanding of the problem (2) Obtain and explore relevant data (3) Prepare the data (4) Build
a model (5) Evaluate the model (6) Visualize and communicate insights and (7) Deploy the
model. They use their substantive expertise to evaluate the costs and benefits of different datascience based decisions, for example, to allocate marketing and sales resources.
11-2 The seven-step decision-making process for applying machine learning techniques in
business situations are (1) Gain a business understanding of the problem (2) Obtain and explore
relevant data (3) Prepare the data (4) Build a model (5) Evaluate the model (6) Visualize and
communicate insights and (7) Deploy the model.
11-3 Target leakage refers to data that are not available at the time of the analysis and should
be excluded.
11-4 The decision tree is a technique for segmenting the target variable into different regions
based on a set of rules. Decisions, for example whether to grant a customer a loan or not, are
made depending on whether the loan characteristics fall into the make loan or reject loan region.
These rules make the model easier to interpret than some other models.
11-5 Gini impurity is a way to measure the purity of a collection of observations in a set (or
rectangle). If a set of observations is very mixed it is “impure” and the Gini impurity is high. As
a set becomes more pure, that is, it contains more members of one class than another, the Gini
impurity decreases.
11-6 Overfitting is a direct outcome of the flexibility and power of data science models.
Overfitting occurs when a model adheres too closely to the specific details of a dataset such that,
in addition to signal, it captures noise from random chance, making it less effective at accurately
classifying observations from a new dataset. Overfitting limits a model’s ability to predict future
outcomes.
11-7 Pruning is a technique in which the tree is not grown to its full size, but instead is only
allowed to grow to a certain depth. It is helpful as a solution to the problem of overfitting.
11-8 Data scientists use cross-validation to compare predictions of different models on a new
set of data for which actual outcomes are already known. Managers choose the model that
predicts most accurately.
A holdout set is data the model has not seen. Data scientists would be more confident of a
model’s ability to predict, for example defaults, if the overall likelihood value in the holdout
sample is similar to the overall likelihood value in the cross-validation set.
11-9 The likelihood value ranges between 0 and 1 with a value near 0 when the predicted
probability is very far from the actual value and a value close to 1 when the predicted probability
is close to the actual value. Data scientists use this approach to compare the performance of the
models. Maximizing the likelihood value means that the across the entire sample, the chosen
model gives predictions that are closest to the actual values.
11-10 Data scientists try to balance the bias-variance tradeoff. Building complex models
reduces bias but also risks overfitting the model to noise or peculiarities in the training data. The
predictions these models make on real data have high variance, that is, the predictions on
different real-world data yield some good predictions and some bad ones. Decision scientists
build less-complex models with some bias in them (they do not fit the training data very well)
because these models make predictions with less variance (the model does reasonably well
across different data sets). Pruning trees to various depths is one technique to balance the biasvariance tradeoff. The greater the depth of a tree, the lower the bias but the higher the variance of
the model. Pruning introduces bias but it also reduces variance. At what point is the tradeoff
optimal? It is difficult to determine this a priori. Data scientists and management accountants
train different models and determine which model has a higher overall likelihood value and
makes good business sense.
11-11 The Receiver-Operating-Characteristic (ROC) Curve is a useful and commonly used tool
to evaluate a model. It plots the false positive rate (FP) on the x-axis and the true positive rate
(TP) on the y-axis. Comparing these two rates provides insight into the tradeoffs associated with
correctly identifying true positives (default loans for example) without capturing false positives
(loans that repay but predicted as defaults). Generally, increasing the true positive rate also
increases the false positive rate. Management accountants play a crucial role in determining the
costs and benefits of identifying true positives in the presence of false positives.
11-12 A confusion matrix is a matrix that shows the predicted and actual classifications at a
given threshold value. It identifies the true positives, false positives, true negatives and false
negatives at a threshold value.
11-13 False positives (FP) are negatives incorrectly predicted as positives. For example, actual
repay loans (negatives) incorrectly classified as default loans (positives). False negatives (FN)
are positives incorrectly predicted as negatives. For example, actual default loans (positives)
incorrectly classified as repay loans (negatives).
11-14 Management accountants use their insights and knowledge of the business to estimate the
payoffs. Based on the payoff matrix results, management accountants identify the costs of true
positives and false positives and true negatives and false negatives. This is crucial information in
making decisions, such as, which loans to accept and which to reject.
11-15 Management accountants work with managers to operationalize the data science model to
make decisions. In doing so, they evaluate what elements need to be modified in light of the
model inputs and how best to balance quantitative and qualitative assessments of the business
situation.
11-16 Choice “b” is correct. Data Science sits at the intersection of computer science and data
skills (to bring together and manipulate the data), math and statistics (to provide the validity
framework for analysis), and substantive expertise in the industry around which the data was
gathered. Each member of the team does not need to have exhaustive knowledge and skill in all
three areas, but each member should know enough about the specialties of the rest of the team
that they can communicate successfully. Applied sciences include chemistry, physics, biology
and astronomy. These are not a necessary component of data science unless they are specifically
applicable to the business.
Choice “a” is incorrect. Computer science and data skills are a requirement for data science.
Large quantities of data need to be collected, transmitted from place to place, compiled, stored
and organized for later reference and manipulation. This requires an array of computer hardware
and software products and skills to perform.
Choice “c” is incorrect. Math and statistics proficiency is needed to build reliable methods of
analyzing data to produce valid interpretations.
Choice “d” is incorrect. A data science team needs members with substantive expertise in the
business where the data analysis is to be applied. This expertise is the framework within which
the analysis is interpreted to form conclusions, make decisions and inform recommended
choices.
11-17 Choice “d” is correct. Data scientists produce and refine data analytics models against
data. The analyst seeks to explain what is happening in the data and to produces a model that
does so. This has the inherent risk of producing a model that explains this particular data very
well, at the expense of being able to explain general data about a specific topic, which is the
goal. After developing several candidate models, the data scientist tests the model against a
different set of data about the same topic, where the actual outcomes are already known. In this
way, the general appropriateness of the models can be judged by the correctness of their
predictions.
Choice “a” is incorrect. This is concurrent validation, a concept that is part of process validation.
It is used during the execution of the process to monitor the states of all relevant variables and
make sure the process is executing as designed.
Choice “b” is incorrect. This is data validation, a concept from computer science. When input
data is gathered, the analyst checks the data to make sure that the storage prepared for it is able to
accept it, and that it is likely the data is intended to be input.
Choice “c” is incorrect. This is retrospective validation, another concept which is part of process
validation. It is used after the process is complete to make sure the process resulted in an output
which is what the process was designed to create (and what the customer requested).
11-18 Choice “c” is correct. The steps in the data science framework detailed in the text are to
first gain a business understanding of the problem. The context is to define the problem (usually
a situation in which a decision must be made), including what data will be necessary to solve the
problem (and make the most advantageous decision). For example, we know that some
transactions are fraudulent, and our problem is to identify those as quickly and accurately as
possible. The next steps are to obtain and explore the relevant data, and to prepare the data for
analysis. The fourth step is to build a model.
This is a likely point of confusion because other analytic techniques call for a model to be built
before data is gathered, meaning that the analyst should describe the theory behind the concept
being studied. Here, building a model means that the analyst should describe the data-driven
technique for making the decision in the situation defined by our problem (fraud or not fraud).
Evaluating the model therefore means using it on a set of test data and checking the accuracy of
its predictions (did it correctly recommend flagging the transactions known to be fraudulent).
After doing this the analyst visualize and communicate insights about the quality of the model.
If the quality is appropriate to the situation, then the business deploys the model as part of its
business processes- detecting fraud in this case.
Choice “a” is incorrect. One cannot visualize and communicate insights about a model one has
neither built nor tested. Neither is it convenient to define the problem as the last step in the
process.
Choice “b” Is incorrect. It is impossible to build a model to solve a problem before defining the
problem. Deploying the model before testing is risky.
Choice “d” is incorrect. Building, deploying and evaluating a model are impossible to do without
data.
11-19 Choice “a” is correct. Decision trees are one of the simplest data analytics model types,
but they can be quite powerful when they are constructed using proper methods. Only
information that is available at the time of making a decision can be considered by the model, so
that the model can function where it is deployed. Nodes can have two or more branches,
although this is uncommon. A tree with more nodes is not necessarily better than one with fewer,
often because larger trees often overfit the test data.
The way to know which candidate decision tree is the best is not to check the statistical
measurements of the model (like f-scores or t-values or p-values), but to run cross validation
tests for all the candidates against a different set of data from the one used to construct the tree
for which the actual results are known. The decision scientist and management accountant
choose the model that makes the best predictions.
Choice “b” is incorrect. Decision trees with many branches run the risk of very precisely
subdividing the test data and making excellent predictions about the test data. These trees often
perform less well than pruned trees on the cross-validation data.
Choice “c” Is incorrect. If a decision tree uses information not available at the time of the
decision in order to predict the outcome of that decision, then it is not modelling the situation in
which it will be deployed and the model is not helpful to the decision maker.
Choice “d” is incorrect. Fully built decision trees with pure nodes overfit the training data and
do not perform well on the cross-validation and holdout data. They reduce bias but increase
variance.
11-20 Choice “a” is correct.
The process for building a decision tree has specific rules. The first branch is created by dividing
the data set such that the two resulting rectangles have the greatest purity (a high ratio of one
outcome such as fraud on one side and a high ratio of the opposite outcome on the other)
possible. This is repeated to create additional branches until each resulting rectangle is pure and
has only one outcome within it. This tree has low bias but high variance, that is, the predictions
on different real-world data yield some good predictions and some bad ones. Pruning trees to
various depths is one technique to balance the bias-variance tradeoff. Pruning introduces bias but
it also reduces variance. At what point is the tradeoff optimal? It is difficult to determine this a
priori. Data scientists and management accountants train different models pruned to different
depths and choose the model with the highest predictive accuracy.
Choice “b” is incorrect. Data scientists never use training data to choose a model. They only use
training data to build different models.
Choice “c” Is incorrect. Decision trees with pure bottom branches often overfit the test data and
do not perform well on general data. Cross validation is necessary.
Choice “d” is incorrect.
A Gini impurity threshold set ahead of the analysis is not the method to produce the best decision
trees. Going back to the data and cross validating is most effective.
11-21 (15 min.) Gini impurity.
1. There are 8 data points in this sample: 3 default loans and 5 repay loans. The diagram on the
left identifies the optimal cut. The diagram on the right shows two alternatives that do not reduce
Gini Impurity as much as the optimal cut.
2.
Optimal Cut: At credit score = 650, the Gini impurity calculations for R1 and R2 are:
2 0 0 2
𝑅1: × + × = 0.0
2 2 2 2
1 5 5 1 10
𝑅2: × + × =
= 0.278
6 6 6 6 36
Gini impurity for R1/R2 =
𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛 𝑜𝑓 𝑜𝑏𝑠𝑒𝑟𝑣𝑎𝑡𝑖𝑜𝑛𝑠 𝑖𝑛 𝑅1 × 𝐺𝑖𝑛𝑖 𝑖𝑚𝑝𝑢𝑟𝑖𝑡𝑦 𝑓𝑜𝑟 𝑅1 +
𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛 𝑜𝑓 𝑜𝑏𝑠𝑒𝑟𝑣𝑎𝑡𝑖𝑜𝑛𝑠 𝑖𝑛 𝑅2 × 𝐺𝑖𝑛𝑖 𝑖𝑚𝑝𝑢𝑟𝑖𝑡𝑦 𝑓𝑜𝑟 𝑅2
2
6 10 15
×0+ ×
=
= 0.208
8
8 36 72
Suboptimal Cuts: At credit score = 715 or income = $50,000 the resulting R1/R2 distributions
were (R1) 2 repayers and (R2) 3 defaulters and 3 repayers. The Gini impurity
calculations for R1 and R2 are:
2 0 0 2
𝑅1: × + × = 0.0
2 2 2 2
3 3 3 3 18
𝑅2: × + × =
= 0.5
6 6 6 6 36
Gini impurity for R1/R2 =
𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛 𝑜𝑓 𝑜𝑏𝑠𝑒𝑟𝑣𝑎𝑡𝑖𝑜𝑛𝑠 𝑖𝑛 𝑅1 × 𝐺𝑖𝑛𝑖 𝑖𝑚𝑝𝑢𝑟𝑖𝑡𝑦 𝑓𝑜𝑟 𝑅1 +
𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛 𝑜𝑓 𝑜𝑏𝑠𝑒𝑟𝑣𝑎𝑡𝑖𝑜𝑛𝑠 𝑖𝑛 𝑅2 × 𝐺𝑖𝑛𝑖 𝑖𝑚𝑝𝑢𝑟𝑖𝑡𝑦 𝑓𝑜𝑟 𝑅2
2
6 1
6
×0+ × =
= 0.375
8
8 2 16
3. Default loans significantly hurt profitability because Boehm and Sons lose interest income
and also the money they have loaned. Traditionally, bank officers have evaluated lenders based
on their characteristics, purpose of the loan and experience and made judgments about loan
repayment. Their goal---to avoid making loans to borrowers who they believe will have trouble
repaying. Machine learning has automated this process. Using decision trees, senior managers
predict default loans, allowing Boehm and Sons to focus their investments on repay loans and
thereby increase profitability.
11-22 (15 min.) Gini impurity.
1.
At credit score equals 650, the Gini impurity calculations for R1 and R2 are:
3 0 0 3
𝑅1: × + × = 0.0
3 3 3 3
1 3 3 1
6
𝑅2: × + × =
= 0.375
4 4 4 4 16
Gini impurity for R1/R2 =
𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛 𝑜𝑓 𝑜𝑏𝑠𝑒𝑟𝑣𝑎𝑡𝑖𝑜𝑛𝑠 𝑖𝑛 𝑅1 × 𝐺𝑖𝑛𝑖 𝑖𝑚𝑝𝑢𝑟𝑖𝑡𝑦 𝑓𝑜𝑟 𝑅1 +
𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛 𝑜𝑓 𝑜𝑏𝑠𝑒𝑟𝑣𝑎𝑡𝑖𝑜𝑛𝑠 𝑖𝑛 𝑅2 × 𝐺𝑖𝑛𝑖 𝑖𝑚𝑝𝑢𝑟𝑖𝑡𝑦 𝑓𝑜𝑟 𝑅2
3
4
× 0.0 + × 0.375 = 0.2143
7
7
At income equals $70,000, the Gini impurity calculations for R1 and R2 are:
4 1 1 4
𝑅1: × + × = 0.32
5 5 5 5
0 2 2 0
6
𝑅2: × + × =
= 0.0
2 2 2 2 16
Gini impurity for R1/R2 =
𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛 𝑜𝑓 𝑜𝑏𝑠𝑒𝑟𝑣𝑎𝑡𝑖𝑜𝑛𝑠 𝑖𝑛 𝑅1 × 𝐺𝑖𝑛𝑖 𝑖𝑚𝑝𝑢𝑟𝑖𝑡𝑦 𝑓𝑜𝑟 𝑅1 +
𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛 𝑜𝑓 𝑜𝑏𝑠𝑒𝑟𝑣𝑎𝑡𝑖𝑜𝑛𝑠 𝑖𝑛 𝑅2 × 𝐺𝑖𝑛𝑖 𝑖𝑚𝑝𝑢𝑟𝑖𝑡𝑦 𝑓𝑜𝑟 𝑅2
5
2
× 0.32 + × 0.0 = 0.2286
7
7
The two cuts have different Gini impurities, so Rech and her team are not correct that they
are equivalent; the cut at credit score = 650 should be used as the first node of the decision tree.
The intuition is that the credit score = 650 cut has more observations in the pure rectangle 3
(versus 2 observations in the pure rectangle when income = $70,000 is used to make the cut).
2. Gini impurity computations give Rech and her team insights about the value of the decision
tree approach. Insignificant reductions in Gini impurity in the first few cuts, signal that decision
trees will not be helpful in improving Donnelly Bank’s decision-making. Why? Because small
reductions in Gini impurity mean that the algorithm is not able to separate default loans from
repay loans---the decision tree model is not able to purify the sets (or rectangles) that determine
default loans and repay loans. Significant reductions in Gini impurity mean that the cuts can help
discriminate default loans from repay loans.
11-23 (15 min.) Decision trees.
1. If Credit Score <= 680 & Income <= $68,500  DEFAULT
If 715 < Credit Score <= 743  DEFAULT
If Credit Score <= 680 & Income > $68,500  REPAY
If 680 < Credit Score <= 715  REPAY
If Credit Score > 743  REPAY
2. i. DEFAULT
ii. REPAY
iii. REPAY
iv. DEFAULT
3. Brown is correct that something appears to be wrong with the model; in cut 4, loans with a
higher credit score (greater than 715) are classified as default, and loans with a lower credit score
(less than 715) are classified as repay. This may indicate that the model is overfitting the training
data. In this example, Brown’s business understanding helps him appreciate the limits of the
model. Although cut 4 may reduce the Gini impurity, it contradicts Brown’s business experience
and his knowledge of the economics of the company. Brown would alert the data science team to
these anomalies and suggest that they consider other more important variables such as debt-toincome ratio.
The data science team might also propose that they prune the decision tree to avoid
overfitting. The predictions this model will make on real data have high variance, that is, the
predictions on different real-world data will yield some good predictions and some bad ones.
Consequently, the model will perform poorly when applied to new data, even though it seems to
fit the training data more closely.
Decision scientists build less-complex models with some bias in them (they do not fit the
training data very well) because these models make predictions with less variance (the model
does reasonably well across different data sets). Pruning trees to various depths is a technique to
balance the bias-variance tradeoff. The greater the depth of a tree, the lower the bias but the
higher the variance of the model because of overfitting. Pruning introduces bias but it also
reduces variance. The data scientists and management accountants train different models and
determine the model that captures most of the signal without overfitting to the noise. The goal is
to choose a model that will work very well in predicting loans that default without incorrectly
classifying many loans that repay as defaulting loans.
11-24
(15 min.) Decision trees.
1. If Number of Lines <= 1.5  LEAVE
If 1.5 < Number of Lines <= 3.5 & Months <= 21.5  LEAVE
If 1.5 < Number of Lines <= 3.5 & Months > 21.5  STAY
If Number of Lines > 3.5  STAY
2.
Actual
Outcome
Model
Prediction
(Full Tree)
Observation
Number
of Lines
Number
of
Months
(1)
(2)
(3)
(4)
(5)
1
2
3
4
5
6
7
8
9
2
2
1
4
3
3
5
1
3
13
23
20
21
27
19
25
21
23
Leave
Stay
Stay
Stay
Stay
Leave
Stay
Stay
Stay
Leave
Stay
Leave
Stay
Stay
Leave
Stay
Leave
Stay
7/9 customers were correctly classified by the full tree. The model does reasonably well
in predicting which customers will stay with TelMark and which customers will leave.
11-25 (15 min.) Decision trees and pruning.
1.
Observation
Number
of Lines
Number of
Months
Actual
Outcome
Model
Prediction
(Pruned Tree)
(1)
(2)
(3)
(4)
(5)
1
2
3
4
5
6
7
8
9
2
2
1
4
3
3
5
1
3
13
23
20
21
27
19
25
21
23
Leave
Stay
Stay
Stay
Stay
Leave
Stay
Stay
Stay
Stay
Stay
Leave
Stay
Stay
Stay
Stay
Leave
Stay
5/9 customers were correctly classified by the pruned tree. The model does a poor job of
identifying which customers will leave and which customers will stay.
2. Sylvia should use the full tree, as this model had a higher accuracy on the validation set. A
careful student will note that the pruned tree does not use income at all when predicting churn. If
the number of lines is 2 or more, the pruned tree model predicts the customer will stay. If a
customer has only 1 line, the pruned tree model predicts the customer will leave. As a result, of
pruning, this model has a high bias because it is omitting an important signal---customer income.
3. Sylvia can use the model to advise management how to manage customer relationships to
reduce churn. For example, Sylvia could recommend that TelMark offer deals to customers with
only one phone line to get them to purchase additional lines, which the decision tree suggests
would make them less likely to leave. She could also recommend offering discounts on the first 2
years of customers’ plans so that they are more likely to stay beyond the 21.5 month threshold.
11-26 (20 min.)
1.
Maximum likelihood.
Likelihood Value
py × (1-p)1-y
Observation
Actual Outcome
(y)
Probability of Fraud
(p)
(1)
(2)
(3)
(4)
1
2
3
4
5
6
1 (fraud)
0 (clean)
0 (clean)
0 (clean)
0 (clean)
0 (clean)
0.45
0.30
0.01
0.99
0.70
0.01
0.45
0.70
0.99
0.01
0.30
0.99
2. Overall likelihood value = 0.45 * 0.70 * 0.99 * 0.01 * 0.30 * 0.99 = 0.0009
3. The overall likelihood value is very low. A low likelihood value indicates that the model’s
prediction probabilities across all observations are not close to the actual prediction probabilities
of fraudulent activities within customers’ accounts. Consequently, it would probably not be
useful for decision-making. Consider, for example, customers 4 and 5. There is no fraudulent
activity within these customers’ accounts. However, the model predicts high probabilities 0.99
and 0.70 that there is fraudulent activity in these customers’ accounts. Norse Credit will likely
often intervene in preventing these customers from doing transactions because the company is
suspicious that there is fraudulent activity in these accounts when in fact there is not. Equally
problematically, in one account with fraudulent activity (customer 1), the model assesses a low
probability (0.45) that there is fraudulent activity resulting in poor monitoring of this customer’s
account and fraud-related losses. Both types of problems will likely result in customers leaving
Norse Credit.
4.
Observation
Actual Outcome
(y)
Probability of Fraud
(p)
(1)
(2)
(3)
1
2
3
4
5
6
1 (fraud)
0 (clean)
0 (clean)
0 (clean)
0 (clean)
0 (clean)
0.99
0.20
0.33
0.01
0.01
0.01
Likelihood Value
py × (1-p)1-y
Overall likelihood = 0.99 * 0.80 * 0.67 * 0.99 * 0.99 * 0.99 = 0.5149
0.99
0.80
0.67
0.99
0.99
0.99
The overall likelihood of the new model is significantly higher than the original model, so the
new model has more prediction power. For all five customers where there is no fraudulent
activity, the model predicts a probability of fraud less than or equal to 0.33. For customer 1
where there is fraud activity, the model predicts a probability of fraud of 0.99. Customers will be
far more satisfied and feel more secure if Norse Credit protects fraudulent activity in their
accounts and does not incorrectly stop non-fraudulent customer transactions.
11-27 (15 min.)
Receiver-Operating-Characteristic (ROC) curve.
1. Because Curve 3 represents a model that allows for an increase in the true positive rate
without a significant increase in the false positive rate, it is the curve (and model) that would be
most useful for a management accountant. The management accountant can choose a cutoff
value that yields a high true positive rate (greater than 0.80) while keeping the false positive rate
small (below 0.10). In the example of identifying default loans, this cutoff would correctly
identify over 80% of default loans while only incorrectly identifying a very small number of
repay loans as default loans. The exact cutoff would depend on the payoff matrix but the ROC
curve 3 suggests that the model is very useful for making business decisions. Model 2 and 3
would be less useful for business decisions because in identifying true positives, the decision
maker must accept a large number of false positives.
2. The straight-line ROC curve 1 indicates that as the percentage of true positives identified by
the model (default loans, for example) increases, the percentage of false positives increases at the
same rate. The model is not discriminating enough in identifying true positives. In other words, it
is equally likely that the model will classify an observation as a true positive as it will classify
the observation as a false positive. This means that the straight-line ROC curve represents a
model that performs as well as random guessing.
11-28 (20 – 25 min.)
Confusion matrices, payoff matrix, and choosing cut off values.
1.
Confusion Matrix
(0.70)
Predicted
NonBuyers
Buyers
Actual
Buyers
Actual
NonBuyers
Confusion Matrix
(0.30)
Predicted
Total
Buyers
Non-Buyers
Total
20
80
100
90
10
100
100
800
900
660
240
900
120
880
1,000
750
250
1,000
2.
Payoff Matrix
Actual
Buyers
NonBuyers
Predicted
NonBuyers
Buyers
$200
$0
−$20
$0
Total payoff at cutoff = 0.70: $200(20) - $20(100) + $0(80) + $0(800) = $2,000
Total payoff at cutoff = 0.30: $200(90) - $20(660) + $0(10) + $0(240) = $4,800
SunTV should use a cutoff of 0.30 because the total payoff is higher based on the validation
set. Sun TV gains $14,000 ($200 × 70) from the 70 (90 − 20) additional customers by marketing
aggressively. The more aggressive marketing campaign costs it $11,200 ($20 × 560) from
marketing to 560 (660 – 100) additional customers. This results in an increase in profit of $2,800
($14,000 − $11,200).
3. Before building such a model, SunTV should consider the potential side effects of marketing
too aggressively. If the company’s marketing efforts irritate or offend interested customers, they
may turn those customers away leading to lost sales. SunTV could use pilot studies to evaluate
the side effects of different marketing strategies. If Sun could target customers more accurately,
it may be able to offer better promotions to attract the smart TV customers. They could then
spend their marketing dollars on the smart TV customer segment they want to attract rather than
wasting marketing dollars on customers who are not interested in buying smart TVs.
11-29 (20 min.)
1.
Model thresholds and payoff matrices.
Payoff Matrix
Actual
2.
Low Quality
Acceptable
Quality
Predicted
Low
Acceptable
Quality
Quality
$0.04
−$1.05
$0.04
$0.30
Total payoff at cutoff = 0.30: $0.04(130) - $1.05(20) + $0.04(230) + $0.30(620) = $179.40
Total payoff at cutoff = 0.50: $0.04(100) - $1.05(50) + $0.04(120) + $0.30(730) = $175.30
The data science team should use a cutoff of 0.30 because the total payoff is higher than
when using a cutoff of 0.50. At this cutoff, however, Blanda Brothers is being very conservative.
It is only supplying apples when the predicted probability of it being a low-quality apple is below
0.30. As a result, it is classifying 230 acceptable quality apples as being of low quality and
selling them at a profit of $0.04 rather than at a profit of $0.30. Cindy Hansen should carefully
evaluate the payoff matrix since small changes in these payoffs could change the cutoff.
More importantly, Cindy should evaluate whether Blanda Brothers can improve the
algorithm it is using to reduce the number of false positives and false negatives. She would then
be able to better separate the low-quality apples from the acceptable quality apples and not sell
so many acceptable quality apples as low quality apples to apple processors.
11-30 (20 min.)
1.
Model thresholds and payoff matrices (continuation of 11-24).
Payoff Matrix
Actual
Low Quality
Acceptable
Quality
Predicted
Low
Acceptable
Quality
Quality
$0.04
−$0.75
$0.04
$0.30
Total payoff at cutoff = 0.30: $0.04(130) - $0.75(20) + $0.04(230) + $0.30(620) = $185.40
Total payoff at cutoff = 0.50: $0.04(100) - $0.75(50) + $0.04(120) + $0.30(730) = $190.30
Under the lower cost of $0.75 for supplying low quality apples as good quality apples to
stores, the optimal model cutoff changes from 0.30 in the previous problem to 0.50. Blanda
Brothers is willing to supply more apples and take more risk. It is now willing to supply apples
when the predicted probability of it being a low-quality apple is below 0.50 rather than below
0.30 in Exercise 11-29. It now supplies 780 apples to stores rather than the 640 apples in
Exercise 11-29. Of these 780 apples, 50 (as compared to 20 in Exercise 11-29) are poor quality
apples and has a cost of $0.75 per apple. But it also supplies 730 (as compared to 620 goodquality apples in Exercise 11-29) with each apple netting a $0.30 profit. The lower cost (penalty)
of supplying a low-quality apple to stores allows Blanda to be more aggressive.
2. As this problem illustrates, an understanding of the costs and benefits of each outcome is
critical to determine which model cut off is optimal. It is vital for the management accountant to
carefully understand the economics of the business and share this information with the data
science team. Without this perspective, the data science team will likely choose a model cut off
that does not correctly balance the payoffs for each outcome. At the same time, the management
accountant needs to have a good understanding of the data science model to judge the level of
false positives and false negatives at each cutoff value. This allows the management accountant
to gauge the power of the model in making decisions.
If the model is not very good, the management accountant needs to assess the risks of using
it. For example, if Cindy has concerns that supplying poor-quality apples to stores risks negative
long-run consequences, she may not want to be aggressive in marketing more apples to the stores
if the model’s predictive power is not very good. However, if the risks of using the model are not
very great, Cindy may be more comfortable being aggressive in her marketing even if the model
has weak predictive power.
Problems
11-31 (15 min.) Thinking through the data.
1. In machine learning models, it is often better to obtain data that are more recent because
conditions may have changed. Machine learning relies on the past being a good predictor of the
future and more recent data often leads to better predictions. Collecting more data is, however,
costly. James must exercise judgement in evaluating the costs and benefits of updating a data set.
What should Keebler-Olson do with the older data? More data is always better provided it is
still useful for making future predictions. James must evaluate whether the economic conditions
in 2015 are similar to those in 2019. In this case, James believes they are so he suggests using the
data from before 2015 through 2019 to build and validate the model. He cautions against using
any data that may be available from before the global financial crisis that affected the economy
from 2008 through 2010 because these conditions are not representative of what Keebler-Olson
anticipates it will face in 2020. James might also propose that the data scientists run tests to
check if the post-2015 data have similar characteristics to the pre-2015 data.
2. Information about the actual performance of a loan after making the loan will not be
available to James when he is predicting whether a loan will default or repay in the future. James
should only use information available at the time of making the loan such as credit score,
income, debt-to-income ratio, size of loan, purpose of loan etc.. He should not include any
information about repayments, loan restructuring, delayed repayments, hardship plans etc. in the
model that occurs after the loan is made. This is an example of target leakage. It will make the
model appear to explain the data very well when in fact, this is occurring because the model is
using information about the actual performance of the loan over time.
11-32 (20-25 min.) Decision trees.
1. If Credit Score <= 675 and Income <= $70,000  DEFAULT
If Credit Score > 675 and $55,000 < Income <= $60,000  DEFAULT
If Credit Score <= 675 and Income > $70,000  REPAY
If Credit Score > 675 and Income > $60,000  REPAY
If Credit Score > 675 and Income <= $55,000  REPAY
2.
Observation
Income
Credit
Score
Actual
Outcome
Model
Prediction
(Full Tree)
(1)
(2)
(3)
(4)
(5)
1
2
3
4
5
6
7
8
$85,000
$62,000
$72,000
$75,000
$71,000
$59,000
$48,000
$57,000
710
650
660
640
680
705
690
685
(0) Repay
(1) Default
(0) Repay
(0) Repay
(0) Repay
(0) Repay
(1) Default
(0) Repay
(0) Repay
(1) Default
(0) Repay
(0) Repay
(0) Repay
(1) Default
(0) Repay
(1) Default
5/8 loans were correctly classified by the full tree. Predicting only 62.5% (5/8) correctly
indicates that the model is not performing well.
3. James notices that at a depth of 3, loans with a higher income (greater than $55,000) are
predicted to default and loans with a lower income (less than $55,000) are predicted to repay.
James believes that this may be the result of the model overfitting to some peculiarities (errors or
random occurrences) in the training sample.
To address the issue of overfitting, James should propose pruning the tree at a depth of 3.
Why? Because the predictions this model will make on real data will have high variance, that is,
the predictions on different real-world data will yield some good predictions and some bad ones.
Consequently, the model will perform poorly when applied to new data, even though it seems to
fit the training data well.
Less-complex models with some bias in them (they do not fit the training data very well)
have lower variance in their predictions (the model does reasonably well across different data
sets). Pruning trees is a technique to balance the bias-variance tradeoff. The greater the depth of a
tree, the lower the bias but the higher the variance of the model because of overfitting. Pruning
introduces bias but it also reduces variance. The goal is to identify a model that captures most of
the signal without overfitting to the noise. Such a model will do a good job of predicting loans
that default without incorrectly classifying too many loans that repay as defaulting loans.
11-33 (20-25 min.)
1.
Decision trees and pruning (continuation of 11-32).
Observation
Income
Credit
Score
Actual
Outcome
Model
Prediction
(Pruned Tree)
(1)
(2)
(3)
(4)
(5)
1
2
3
4
5
6
7
8
$85,000
$62,000
$72,000
$75,000
$71,000
$59,000
$48,000
$57,000
710
650
660
640
680
705
690
685
(0) Repay
(1) Default
(0) Repay
(0) Repay
(0) Repay
(0) Repay
(1) Default
(0) Repay
(0) Repay
(1) Default
(0) Repay
(0) Repay
(0) Repay
(0) Repay
(0) Repay
(0) Repay
7/8 loans were correctly classified by the pruned tree.
2. James should use the pruned tree because this model has a higher accuracy on the validation
set. The pruned tree does much better than the full tree in predicting default and repay loans.
Although pruning introduces bias compared to the full tree, there is less overfitting and
consequently lower variance.
3. James would need to explain the bias-variance tradeoff to the preident. Building complex
models reduces bias but also risks overfitting the model to noise or peculiarities in the training
data. The predictions these models make on real data have high variance, that is, the predictions
on different real-world data yield some good predictions and some bad ones. Consequently, the
model would perform poorly when applied to new data, even though it seems to fit the training
data more closely.
Decision scientists build less-complex models with some bias in them (they do not fit the
training data very well) because these models make predictions with less variance (the model
does reasonably well across different data sets). Pruning trees to various depths is one technique
to balance the bias-variance tradeoff. The greater the depth of a tree, the lower the bias but the
higher the variance of the model because of overfitting. Pruning introduces bias but it also
reduces variance. At what point is the tradeoff optimal? It is difficult to determine this a priori.
The data scientists and management accountants train different models and determine the model
that captures most of the signal without overfitting to the noise. This model will work very well
in predicting loans that will default without incorrectly classifying too many repay loans as
default loans.
11-34 (35-40 min.)
Calculate likelihood values (continuation of 11-32 and 11-33).
1.
For Full Tree
Likelihood
Value
py × (1-p)1-y
For Pruned Tree
Probability
of Default
(p)
Likelihood
Value
py × (1-p)1-y
Observation
Income
Credit
Score
Actual
Outcome
(y)
Probability
of Default
(p)
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
1
2
3
4
5
6
7
8
$85,000
$62,000
$72,000
$75,000
$71,000
$59,000
$48,000
$57,000
710
650
660
640
680
705
690
685
(0) Repay
(1) Default
(0) Repay
(0) Repay
(0) Repay
(0) Repay
(1) Default
(0) Repay
0.01
0.99
0.01
0.01
0.01
0.99
0.01
0.99
0.99
0.99
0.99
0.99
0.99
0.01
0.01
0.01
0.01
0.99
0.01
0.01
0.01
0.33
0.33
0.33
0.99
0.99
0.99
0.99
0.99
0.67
0.33
0.67
2. Overall likelihood value of full tree = 0.99 * 0.99 * 0.99 * 0.99 * 0.99 * 0.01 * 0.01 * 0.01 = 9.5099E-7
Overall likelihood value of pruned tree = 0.99 * 0.99 * 0.01 * 0.99 * 0.67 * 0.99 * 0.33 * 0.67 = 0.1409
The overall likelihood value for the pruned tree is good but the overall likelihood value for the full
tree is very small.
3. James would be comfortable using the pruned tree model to make predictions but would not want to
use the full tree model. This is consistent with the conclusion in Problem 11-33, requirement 2 when
evaluating the tree based only on the proportion of correctly classified observations. The likelihood
value of the pruned tree is larger because it makes better predictions for the last three observations (6, 7,
8) in the validation sample. The better predictions are because pruning reduces overfitting the model to
special features of the training data that adds noise to the predictions.
11-35
(25min.)
Payoff matrix and choosing cut off values (continuation of 11-32, 11-33,
and 11-34).
1.
Payoff Matrix
Predicted
Default
Repay
Actual
Default
Actual
Repay
$14
-$60
$14
$48
2.
Confusion Matrix
(0.5)
Predicted
Default
Repay
Actual
Default
Actual
Repay
3.
Confusion Matrix
(0.25)
Predicted
Default Repay
1
1
2
0
0
6
2
4
Total payoff at cutoff = 0.5: $14(1) - $60(1) + $14(0) + $48(6) = $242
Total payoff at cutoff = 0.25: $14(2) - $60(0) + $14(2) + $48(4) = $248
James should use a cutoff of 0.25 because it results in a higher total payoff on the validation
set. This means that James classifies any loan with a probability of default greater than 0.25 as a
default loan. Keebler-Olson only makes loans when the probability of default is less than 0.25.
At this cutoff, however, Keebler-Olson is being very conservative. It classifies 2 repay loans as
being default loans and invests in the alternative investment yielding $14 instead of earning $48
if it had made the loan. It does so because choosing this lower cutoff avoids the false negative of
lending to loan 7, which defaults and costs Keebler-Olson $60. James should carefully evaluate
the payoff matrix since small changes in these payoffs could change the cutoff.
More importantly, James should evaluate whether Keebler-Olson can improve the algorithm
it is using to reduce the number of false positives and false negatives. He would then be able to
better separate the default loans from the repay loans and not forgo investing in repay loans that
yield a high payoff.
11-36 (30-35 min.)
Maximum likelihood.
1.
Observation #
Model Probability (p)
Actual Outcome (y)
Likelihood
1
2
3
4
5
6
7
0.99 0.01 0.33 0.20 0.01 0.33 0.33
1
0
1
0
0
0
0
0.99 0.99 0.33 0.80 0.99 0.67 0.67
2. Overall likelihood = 0.99 * 0.99 * 0.33 * 0.80 * 0.99 * 0.67 * 0.67 = 0.1150
3. Turcotte’s prediction model takes into account various operating parameters of the machines
used to make brake pads and details from inspecting the product to predict whether there are
latent defects in the brake pads. The re-inspection machines then do more rigorous lighting and
abrasion tests to check if the brake pads are defective.
The overall likelihood value for this model is reasonably high. This indicates that the model
does well in predicting those brake pads that are defective from those brake pads that are
working. Consequently, it has the potential to improve decision-making at Turcotte. It will help
Turcotte to not ship defective brake pads to customers and thereby improve customer satisfaction
with the potential to gain future customer business. Sarah might also want to explore if reducing
defective brake pads to the customer reduces customers’ costs as well, creating a win-win
situation. Turcotte would also benefit from reducing re-inspection costs.
Seeing the value of this prediction model, Sarah may want to encourage the data science
team to improve the model itself, while also working to reduce the cost of re-inspection. The
next task would be develop a payoff matrix and choose a cutoff value for deciding whether to
release a brake pad to Turcotte’s customers.
11-37
(30-35 min.)
Payoff matrix and choosing cut off values (continuation of 11-36).
1.
Payoff Matrix
Predicted
Defective Working
Actual
Defective
Actual
Working
$5
-$50
$17
$25
2.
Confusion Matrix
(0.50)
Predicted
Actual
Defective
Actual
Working
3.
Confusion Matrix
(0.30)
Predicted
Defective
Working
Defective
Working
1
1
2
0
0
5
2
3
Total payoff at cutoff = 0.50: $5(1) - $50(1) + $17(0) + $25(5) = $80
Total payoff at cutoff = 0.30: $5(2) - $50(0) + $17(2) + $25(3) = $119
Sarah should use a cutoff of 0.30 because it results in a higher total payoff on the
validation set. This means that Turcotte classifies any brake pads with a probability of being
defective greater than 0.30 as a defective brake pad and re-inspects it. Turcotte is being very
conservative. It only ships brake pads when the probability of being defective is less than 0.30.
The benefit of the lower cutoff is that it avoids the false negative of shipping brake pad 3 as a
working brake pad when it is defective, costing Turcotte $50. The cost of this conservatism is
that 2 brake pads that are actually working well (brake pads 6 and 7) have to incur the cost of reinspection. This is still worthwhile doing because the re-inspection costs of $8 are small relative
to the loss from shipping a defective brake pad.
Sarah should evaluate whether Turcotte Manufacturing can improve the algorithm it is
using to reduce the number of false positives and false negatives. She would then be able to
better separate the defective brake pads from the working brake pads and not incur unnecessary
additional advanced re-inspection costs.
4.
Let the net loss from shipping a defective brake pad to a customer be $X.
The payoff at cutoff = 0.50: $5(1) - $X(1) + $17(0) + $25(5)
The payoff at cutoff = 0.30 = $5(2) - $X(0) + $17(2) + $25(3) = $119
To find the point of indifference between these cutoff values we set these payoff to be the
same. So
$5(1) - $X(1) + $17(0) + $25(5) = $5(2) - $X(0) + $17(2) + $25(3) = $119
$130 – X = $119
X = $11
If the net loss from supplying a defective brake pad to a customer is less than $11, Turcotte
Manufacturing would choose a cutoff of 0.50. For this to occur the cost of supplying a defective
brake pad would need to decrease by nearly $40, an unlikely outcome. The sensitivity analysis
indicates to Sarah that under the current manufacturing process, being more conservative is the
correct strategy. The key insight is the ratio of re-inspection costs versus shipping a defective
product. When re-inspection costs ($8) is low relative to the loss from shipping products ($50),
Turcotte is better off being conservative.
11-38 (45 min.)
Receiver-Operating-Characteristic (ROC) curve.
1.
Predicted
Probability of
Household
Having Kids
Ranked from
Highest to Lowest
0.95
0.55
0.33
0.01
Cumulative
Number of
Households
With No Kids
Cumulative
Number of
Households
With Kids
False
Positive
Rate
(x-axis)
True
Positive
Rate
(y-axis)
0
30
0
0.30
135
585
900
50
90
100
0.15
0.65
1.00
0.50
0.90
1.00
2.
This ROC curve reflects a significant improvement over the baseline 45-degree line. Ideally,
ROC curves would move up along the y-axis indicating an increase in the true positive rate
without a significant increase in the false positive rate. These ROC curves are most useful to the
management accountant. The ROC curve here is not that good but it appears to be good enough
for decision-making. The management accountant can choose a cutoff value that yields a high
true positive rate (0.50, say) while keeping the false positive rate small (0.15). In this example,
this cutoff would correctly identify over 50% of households with kids entering school for the
first time while only incorrectly identifying a very small number of households with no such kids
as households who have kids entering school for the first time. The exact cutoff would depend on
the payoff matrix
3.
Confusion Matrix
(0.50)
Predicted
Kids
No Kids
Actual
Kids
Actual
No Kids
Confusion Matrix
(0.25)
Predicted
Kids
No Kids
50
50
90
10
135
765
585
315
4.
Payoff Matrix
Predicted
Kids
No Kids
Actual
Kids
Actual
No Kids
$25
$10
−$2
$0
Total payoff at cutoff = 0.50: $25(50) + $10(50) - $2(135) + $0(765) = $1,480
Total payoff at cutoff = 0.25: $25(90) + $10(10) - $2(585) + $0(315) = $1,180
Caitlin should use a cutoff of 0.50 because it results in a higher total payoff on the validation
set. She only markets to those households that the model assesses a probability of having kids
going to school for the first time of greater than 0.50. The benefit of the higher cutoff is that it
avoids the false positive of sending marketing materials to too many households that do not have
kids going to school for the first time. At this cutoff, Stapleton is being conservative and only
seeking to attract 50 of the 100 households that have kids going to school for the first time. The
cost of this conservatism is that she does not identify more households with kids going to school
for the first time. This is still worthwhile doing because if she tries to attract more households
with kids going to school for the first time, Stapleton will spend a lot more money marketing to
several households that do not have kids going to school for the first time.
Sarah should evaluate whether Stapleton can improve the algorithm it is using to reduce the
number of false positives and false negatives. She would then be able to better separate
households with kids going to school for the first time from households that do not have kids
going to school for the first time and not incur unnecessary additional marketing costs.
5. Stapleton might be willing to lower the cutoff and market to more households if the cost of a
false positive (-$2) is small relative to the benefit of identifying a true positive which in this
example is $15 ($25 − $10). For example, if the gain from identifying a true positive were $25,
Stapleton would be willing to accept a relatively high rate of false positives because the costs
will be outweighed by the benefits of more true positives.
11-39 (25 min.) Model thresholds and payoff matrices.
1.
Confusion Matrix
Confusion Matrix
(0.40)
(0.55)
Predicted
Predicted
Default
Repay
Total
Default Repay
Actual
50
10
60
40
20
Default
Actual
200
140
340
120
220
Repay
250
150
400
160
240
Total
60
340
400
2.
Payoff Matrix
Predicted
Default
Repay
Actual
Default
Actual
Repay
$90
-$650
$90
$300
Total payoff at cutoff = 0.40: $90(50) - $650(10) + $90(200) + $300(140) = $58,000
Total payoff at cutoff = 0.55: $90(40) - $650(20) + $90(120) + $300(220) = $67,400
David should use a cutoff of 0.55 because it results in a higher total payoff on the validation
set. At this cutoff, Spruce Bank is being aggressive and making loans whenever the cutoff
probability of default is below 0.55 rather than making loans when the cutoff probability of
default is below 0.40. It is willing to take this greater risk because it can make 80 (220 – 140)
more loans that will repay even though it will make 10 (20 – 10) more loans that will default.
David should evaluate whether Spruce Bank can improve the algorithm it is using to reduce
the number of false positives and false negatives. He would then be able to better separate repay
loans from default loans and not incur losses from loans that are predicted to repay but that
actually default.
11-40 (15 min.) Model thresholds and payoff matrices, sensitivity analysis (continuation
of 11-39).
1. Worst case payoff at cutoff = 0.40: $90(50) - $750(10) + $90(200) + $300(140) = $57,000
Worst case payoff at cutoff = 0.55: $90(40) - $750(20) + $90(120) + $300(220) = $65,400
Best case payoff at cutoff = 0.40: $90(50) - $550(10) + $90(200) + $300(140) = $59,000
Best case payoff at cutoff = 0.55: $90(40) - $550(20) + $90(120) + $300(220) = $69,400
2. The analysis shows that under both the worst and best-case payoff scenarios, David should
use a cutoff of 0.55 because it results in a higher total payoff on the validation set. These
sensitivity analyses give David confidence that errors in estimating the loss on default loans does
not affect his decision to be aggressive in lending decisions.
TRY IT ANSWERS
ANSWER: Try It 11-1
a. Gini Impurity at Cut 1
At level of machine automation equals 1.95, the Gini impurity calculations for R1 and R2
are:
𝑅1:
𝑅2:
2
2
7
7
2 7 7 2 28
× (1 − ) + × (1 − ) = × + × =
9
9
9
9
9 9 9 9 81
6
6
1
1
6 1 1 6 12
× (1 − ) + × (1 − ) = × + × =
7
7
7
7
7 7 7 7 49
Weighted average Gini impurity for R1 and R2 =
𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛 𝑜𝑓 𝑜𝑏𝑠𝑒𝑟𝑣𝑎𝑡𝑖𝑜𝑛𝑠 𝑖𝑛 𝑅1 × 𝐺𝑖𝑛𝑖 𝑖𝑚𝑝𝑢𝑟𝑖𝑡𝑦 𝑓𝑜𝑟 𝑅1 +
𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛 𝑜𝑓 𝑜𝑏𝑠𝑒𝑟𝑣𝑎𝑡𝑖𝑜𝑛𝑠 𝑖𝑛 𝑅2 × 𝐺𝑖𝑛𝑖 𝑖𝑚𝑝𝑢𝑟𝑖𝑡𝑦 𝑓𝑜𝑟 𝑅2
9 28 7 12
7
3
×
+
×
=
+
= 0.302
16 81 16 49 36 28
b. No other first cut on the experience or automation dimension has fewer than three
misclassifications. No cut creates a greater reduction in Gini impurity.
c. Although not required by the Try It problem, we present a diagram showing all the
cuts to build out a full decision tree.
ANSWER: Try It 11-2
The rules for classifying a product as a defect for the decision tree pruned to depth 4 are:
 If automation < 1.95 and experience < 18, then classify the product as defective with
probability 1.
 If 1.95 < automation < 2.5 and experience > 6.25, then classify the product as
defective with probability 1/3.
 If automation > 1.95 and experience < 6.25, then classify the product as defective with
probability 1.
In all other cases, classify the product as a good (non-defective) product.
ANSWER: Try It 11-3
1. and 2. In the table below see columns 5 and 6.
3. Overall likelihood value = 0.09344
Table Likelihood Value of Predictions for Pruned Decision Tree in Validation Sample
Actual
Likelihood
Years of
Level of
Experience
Automation
(1)
(2)
(3)
(4)
(5)
(6)
1
9
3.5
0 (Good)
0.01
0.99
2
15
1.5
1 (Defect)
0.99
0.99
3
10
2.25
0 (Good)
0.33
0.67
4
11
2.1
1 (Defect)
0.33
0.33
5
12
2.6
0 (Good)
0.01
0.99
6
19
1.7
0 (Good)
0.01
0.99
7
8.5
2.3
0 (Good)
0.33
0.67
8
11
3.4
0 (Good)
0.01
0.99
9
10
3.2
0 (Good)
0.01
0.99
10
11.5
2.3
0 (Good)
0.33
0.67
Observation
Probability of
Outcome
Defect (p)
Value
py × (1-p)1-y
(y)
Overall likelihood value
Lp = 0.09344
Lp = 0.996 × 0.673 × 0.33 = 0.09344
Observation #
1
Automation Level 3.5
9
Years’
Experience
0
Actual Outcome
0.01
Prob. of Defect
Likelihood Value 0.99
2
1.5
15
3
2.25
10
4
2.1
11
5
2.6
12
6
1.7
19
7
2.3
8.5
8
3.4
11
9
3.2
10
10
2.3
11.5
1
0.99
0.99
0
0.33
0.67
1
0.33
0.33
0
0.01
0.99
0
0.01
0.99
0
0.33
0.67
0
0
0.01 0.01
0.99 0.99
0
0.33
0.67
ANSWER: Try It 11-4
a. and b. The following tables show the confusion matrix at the defective probability cut-off of
0.30 and 0.50 and the payoff matrix are shown in the following tables:
Defect
Actual
Good
Confusion Matrix
(0.30)
Predicted
Confusion Matrix
(0.50)
Predicted
Defect
Good
Defect
Good
Defect
Good
(A)
2
(Y)
3
(Z)
0
(B)
5
(A)
1
(Y)
0
(Z)
1
(B)
8
(A)
$40
(Y)
$40
(Z)
$(300)
(B)
$200
Payoff Matrix
Predicted
c. As the following tables and calculations show, Wyatt should set the defective probability
cutoff at 0.50 to maximize profitability. Wyatt gets a return of $1,340 when the defective
probability cut-off is set at 0.50 versus a return of $1,200 when the defective probability cutoff is set at 0.30. What is the insight underlying this result? Lowering the defective
probability cutoff to 0.30 means that Wyatt will only make SB171 when the probability of a
defective product is lower than 0.30. Setting the cutoff so low means it will not produce a
defective SB171 but it also means that it will not produce three good SB171s (false
positives). The money lost from not producing SB171s when they should have been
produced is much more than the cost of producing one more defective SB171.
The tables below show the payoffs in each of the quadrants obtained by multiplying the
observations in the confusion matrix with the corresponding values in the payoff matrix.
The total payoff is the sum of the values in all four quadrants.
Defect
Actual
Good
Payoff Values (0.30)
Payoff Values (0.50)
Predicted
Predicted
Defect
Good
Defect
Good
(A)
$80
(Y)
$120
(Z)
$0
(B)
$1,000
(A)
$40
(Y)
$0
(Z)
$(300)
(B)
$1,600
$1,200
Total
$1,340
Total
The calculations are the same as those in the preceding table, just presented differently.
Each number in parentheses is the product of the numbers in the confusion matrix and the
corresponding values in the payoff matrix.
If the defective probability cutoff is set at 0.30, the payoff is
= (2 × $40) + (0 × -$300) + (3 × $40) + (5 × $200)
= $80 + $0 + $120 + $1,000
= $1,200
If the defective probability cutoff is set at 0.50, the payoff is
= (1 × $40) + (1 × -$300) + (0 × $40) + (8 × $200)
= $40 - $300 + $0 + $1,600
= $1,340
CHAPTER 12
DECISION MAKING AND RELEVANT INFORMATION
12-1
1.
2.
3.
4.
5.
The five steps in the decision process outlined in Exhibit 12-1 of the text are
Identify the problem and uncertainties.
Obtain information.
Make predictions about the future.
Make decisions by choosing among alternatives.
Implement the decision, evaluate performance, and learn.
12-2 Relevant costs are expected future costs that differ among the alternative courses of
action being considered. Historical costs are irrelevant because they are past costs and, therefore,
cannot differ among alternative future courses of action.
12-3 This is a type of decision that involves accepting or rejecting special orders when there is
idle production capacity and the special orders have no long-run implications.
12-4 Quantitative factors are outcomes that are measured in numerical terms. Some
quantitative factors are financial––that is, they can be easily expressed in monetary terms. Direct
materials are an example of a quantitative financial factor. Other quantitative nonfinancial
factors, such as on-time flight arrivals, cannot be easily expressed in monetary terms. Qualitative
factors are outcomes that are difficult to measure accurately in numerical terms. An example is
employee morale.
12-5 Decision making is concerned with the future and with the choice between alternatives.
Relevant information for decision making is concerned with future costs and revenues that will
alter as a result of a decision. Managers use their deep understanding of costs to make decisions.
They gather information about financial markets, consumer preferences, and economic trends
before determining whether to offer new services to customers.
12-6 No. Some variable costs may not differ among the alternatives under consideration and,
hence, will be irrelevant. Some fixed costs may differ among the alternatives and, hence, will be
relevant.
12-7 No. Some of the total manufacturing cost per unit of a product may be fixed and, hence,
will not differ between the make and buy alternatives. These fixed costs are irrelevant to the
make-or-buy decision. The key comparison is between purchase costs and the costs that will be
saved if the company purchases the component parts from outside plus the additional benefits of
using the resources freed up in the next best alternative use (opportunity cost). Furthermore,
managers should consider nonfinancial factors such as quality and timely delivery when making
outsourcing decisions.
12-8 Opportunity cost is the contribution to income that is forgone (rejected) by not using a
limited resource in its next-best alternative use.
12-1
12-9 No. When deciding on the quantity of inventory to buy, managers must consider both the
purchase cost per unit and the opportunity cost of funds invested in the inventory. For example,
the purchase cost per unit may be low when the quantity of inventory purchased is large, but the
benefit of the lower cost may be more than offset by the high opportunity cost of the funds
invested in acquiring and holding inventory.
12-10 No. Managers should aim to get the highest contribution margin per unit of the
constraining (that is, scarce, limiting, or critical) factor. The constraining factor is what restricts
or limits the production or sale of a given product (for example, availability of machine-hours).
12-11 No. For example, if the revenues that will be lost exceed the costs that will be saved, the
branch or business segment should not be shut down. Shutting down will only increase the loss.
Allocated costs and fixed costs that will not be saved are irrelevant to the shut-down decision.
12-12 Cost written off as depreciation is irrelevant when it pertains to a past cost such as
equipment already purchased. But the purchase cost of new equipment to be acquired in the
future that will then be written off as depreciation is often relevant.
12-13 No. Managers often favor the alternative that makes their performance look best, so they
focus on the measures used in the performance-evaluation model. If the performance-evaluation
model does not emphasize maximizing operating income or minimizing costs, managers will
most likely not choose the alternative that maximizes operating income or minimizes costs.
12-14 The three steps in solving a linear programming problem are:
(i) Determine the objective function.
(ii) Specify the constraints.
(iii) Compute the optimal solution.
12-15 The text outlines two methods of determining the optimal solution to an LP problem:
(i) Trial-and-error approach
(ii) Graphic approach
Most LP applications in practice use standard software packages that rely on the simplex method
to compute the optimal solution.
12-2
12-16 Choice ‘c’ is the correct option. If the project is initiated, the firm will forego the £80 rent
that they could obtain. This is the opportunity cost of the workshop and is the value to be
included in the project appraisal.
Choice ‘a’ is incorrect. The recorded historical cost of £50 is inappropriate for the purpose. The
opportunity cost has to be used in the assessment.
Choice ‘b’ is incorrect. This has been obtained by deducting the £50 historical cost from the
opportunity cost of £80.
Choice‘d’ is incorrect. This has been obtained by adding the £80 opportunity cost to the
historical cost of £50.
12-17 Choice‘d’ is correct. Qualitative factors such as quality, dependability, sensitivity of
confidential of information held by the firm, and the availability of the technical know-how of
the organization are all important considerations. All the options ‘a’- ‘c’ are relevant factors in
‘make-or-buy’ decisions.
12-18 Choice "d" is correct. If the selling price is greater than the variable cost per unit of the special
order (at full capacity) plus the contribution margin per unit of the next best alternative (the opportunity
cost), then the company will accept the special order.
Choice "a" is incorrect. Variable costs have to be taken into account, in addition to the contribution
margin of the next best alternative.
Choice "b" is incorrect. The contribution margin of the next best alternative (rather than the special
order) must be taken into account in order to determine whether to accept the special order.
Choice "c" is incorrect. The variable costs of the special order (not the next best alternative) must be
accounted for in this determination.
12-19 Choice "c" is correct. Whether to keep or drop a segment will depend on whether the
contribution margin of the segment in question exceeds avoidable fixed costs (relevant costs that
wouldn’t exist if the segment did not exist). Unavoidable fixed costs will be incurred regardless of
whether or not the segment is kept, so they are not factored into the decision.
Choice "a" is incorrect. Fixed costs need to be broken out between avoidable and unavoidable in order to
make the determination as to whether to keep or drop a segment. Lees Corp. would only drop the
segment if the contribution margin of the segment is less than the avoidable fixed (relevant) cost.
Choice "b" is incorrect. The contribution margin needs to be compared to avoidable fixed costs in order
to determine whether to keep or drop a segment.
Choice "d" is incorrect. Unavoidable fixed costs will be incurred regardless, so contribution margin of
the segment needs to be compared to the avoidable fixed costs as the key elements to determine whether
to keep or drop a segment.
12-20 Choice "a" is correct. Sunk costs are not relevant since they were incurred in the past and cannot
be recovered as a result of the company’s current decision.
Variable costs are relevant as also any avoidable fixed costs associated with the decision.
Opportunity cost is the cost of foregoing the next best alternative when making a decision. These costs
are relevant since the company has alternative courses of action.
Choice "b" is incorrect. Sunk costs are not relevant since they were incurred in the past and cannot be
recovered as a result of the company’s current decision.
12-3
Choice "c" is incorrect. Opportunity cost is the cost of foregoing the next best alternative when making a
decision. These costs are relevant since the company has alternative courses of action.
Choice "d" is incorrect. Sunk costs are not relevant since they were incurred in the past and cannot be
recovered as a result of the company’s current decision.
Variable costs are relevant as also any avoidable fixed costs associated with the decision.
12-21 (15 min.) Relevant costing in a make-or-buy decision.
1.
The decision should not be based by comparing the costs of training each guard dog at
£20,820 with the price of £5,000 per guard dog offered by Billy Jack. The decision should be
made by comparing the variable costs and the price from Billy Jack. The costs of the 60 trained
guard dogs can be computed as:
Total relevant
costs
(£)
Make
Buy
Relevant items
Purchase from Billy Jack (60 x £5,000)
Relevant cost
per dog (£)
Make
300,000
Purchase of dogs (60 x £250)
Wages (60 x £1850)
Variable overhead costs (60 x £1,000)
Buy
5,000
15,000
250
111,000
1,850
60,000
1,000
Total relevant costs
186,000
3,100
Difference in favour of training the guard dogs
114,000
1,900
Graham Douglas will save £1,900 per dog and a total of £114,000 if the business trains its own
dogs rather than buying from Billy Jack.
Managers have to consider quantitative, qualitative, and strategic consideration in makeor-buy decisions. They have to consider factors such as supplier’s reputation for quality and
timely supply. They also have to consider the strategic effects of decision on other product lines
of the company.
2.
12-4
12-22 (20 min.) Relevant and irrelevant costs.
1.
Relevant costs
Variable costs
Avoidable fixed costs
Purchase price
Unit relevant cost
Make
Buy
$190
10
____
$200
$260
$260
DeCesare Computers should reject Peach’s offer. The $80 of fixed costs is irrelevant because it
will be incurred regardless of this decision. When comparing relevant costs between the choices,
Peach’s offer price is higher than the cost to continue to produce.
2.
Cash operating costs (3 years)
Current disposal value of old machine
Cost of new machine
Total relevant costs
Keep
$52,500
_ _____
$52,500
Replace
$46,500
(2,200)
9,000
$53,300
Difference
$6,000
2,200
(9,000)
$ (800)
LN Manufacturing should keep the old machine. The cost savings are less than the cost to
purchase the new machine.
12-5
12-23 (15-20 min.) Relevant costing in an agricultural business.
1.
Mahogany wood. Relevant cost:£2.70 per centimeter.
The original purchase price is irrelevant and, as it is not intended to be purchased immediately,
so is the current replenishment price. The relevant cost is the replenishment cost at the expected
purchase time.
Iroko wood. Relevant cost: £0.55 per centimeter.
Once again, the historical purchase price is not relevant and as there is adequate stock for current
needs, there is no question of replenishment. The only alternative use for the material is to sell at
£0.55 per centimeter.
Cedar wood. Relevant cost: £0.21 per centimeter.
As the material will be replenished within a week, the current replenishment price is relevant.
2.
It will be noted that the recorded historical cost, which is the cost for normal cost
ascertainment purposes, is not the relevant figure in any of the above examples. This is typical in
decision making and it means that care must be taken to ascertain the intended purpose for any
cost which is supplied so that relevant information can be provided at all times.
12-6
12-24
1.
(30 min.) Special order, activity-based costing.
Direct materials cost per unit ($350,000  10,000 units) = $35 per unit
Direct manufacturing labor cost per unit ($375,000  10,000 units) = $37.50 per unit
Variable cost per batch = $500 per batch
Gold Plus’s operating income under the alternatives of accepting/rejecting the special
order are:
Revenues
Variable costs:
Direct materials
Direct manufacturing labor
Batch manufacturing costs
Fixed costs:
Fixed manufacturing costs
Fixed marketing costs
Total costs
Operating income
Without OneWith OneTime Only
Time Only
Special Order Special Order
10,000 Units 11,000 Units
$1,500,000
$1,600,000
Difference
1,000 Units
$100,000
350,000
375,000
100,000
385,000
2
412,500
3
112,500
1
35,000
37,500
12,500
300,000
275,000
1,400,000
$ 100,000
300,000
275,000
1,485,000
$ 115,000
––
––
85,000
$ 15,000
$350,000 + ($35  1,000 units)
$375,000 + ($37.50  1,000 units)
3
$100,000 + ($500  25 batches)
1
2
Alternatively, we could calculate the incremental revenue and the incremental costs of the
additional 1,000 units as follows:
Incremental revenue $100  1,000
Incremental direct manufacturing costs
Incremental direct manufacturing costs
Incremental batch manufacturing costs
Total incremental costs
Total incremental operating income from
accepting the special order
$35  1,000 units
$37.50  1,000 units
$500  25 batches
$100,000
35,000
37,500
12,500
85,000
$ 15,000
Gold Plus should accept the one-time-only special order if it has no long-term implications
because accepting the order increases Gold Plus’s operating income by $15,000.
If, however, accepting the special order would cause the regular customers to be
dissatisfied or to demand lower prices, then Gold Plus will have to trade off the $15,000 gain
from accepting the special order against the operating income it might lose from regular
customers.
12-7
2.
Gold Plus has a capacity of 10,500 medals. Therefore, if it accepts the special one-time
order of 1,000 medals, it can sell only 9,500 medals instead of the 10,000 medals that it currently
sells to existing customers. That is, by accepting the special order, Gold Plus must forgo sales of
500 medals to its regular customers. Alternatively, Gold Plus can reject the special order and
continue to sell 9,500 medals to its regular customers.
Gold Plus’ operating income from selling 9,500 medals to regular customers and 1,000
medals under one-time special order follow:
1
Revenues (9,500  $150) + (1,000  $100)
Direct materials (9,500  $35) + (1,000  $35)
Direct manufacturing labor (9,500  $37.50) + (1,000  $37.50)
1
Batch manufacturing costs (190  $500) + (25  $500)
Fixed manufacturing costs
Fixed marketing costs
Total costs
$1,525,000
367,500
393,750
107,500
300,000
275,000
1,443,750
Operating income
$
81,250
Gold Plus makes regular medals in batch sizes of 50. To produce 9,500 medals requires 190 (9,500 ÷ 50) batches.
Accepting the special order will result in a decrease in operating income of $18,750
($100,000 – $81,250). The special order should, therefore, be rejected.
A more direct approach would be to focus on the incremental effects––the benefits of
accepting the special order of 1,000 units versus the costs of selling 500 fewer units to regular
customers. Increase in operating income from the 1,000-unit special order equals $15,000
(requirement 1). The loss in operating income from selling 500 fewer units to regular customers
equals:
Lost revenue, $150  500
Savings in direct materials costs, $35  500
Savings in direct manufacturing labor costs, $37.50  500
Savings in batch manufacturing costs, $500  10
Operating income lost
$(75,000)
17,500
18,750
5,000
$(33,750)
Accepting the special order will result in a decrease in operating income of $18,750 ($15,000 –
$33,750). The special order should, therefore, be rejected.
Note: Even if operating income had increased by accepting the special order, Gold Plus
should consider the effect on its regular customers of accepting the special order. For example,
would selling 1,000 fewer medals to its regular customers cause these customers to find new
suppliers that might adversely impact Gold Plus’s business in the long run.
12-8
3.
Gold Plus should not accept the special order.
Increase in operating income by selling 1,000 units
under the special order (requirement 1)
Operating income lost from existing customers ($10  10,000)
Net effect on operating income of accepting special order
The special order should, therefore, be rejected.
12-9
$ 15,000
(100,000)
$ (85,000)
12-25 (30 min.) Make versus buy, activity-based costing.
1.
The expected manufacturing cost per unit of CMCBs in 2021 is as follows:
Direct materials, $170  10,000
Direct manufacturing labor, $45  10,000
Variable batch manufacturing costs, $1,500  80
Fixed manufacturing costs
Avoidable fixed manufacturing costs
Unavoidable fixed manufacturing costs
Total manufacturing costs
Total
Manufacturing
Costs of CMCB
(1)
$1,700,000
450,000
120,000
Manufacturing
Cost per Unit
(2) = (1) ÷ 10,000
$170
45
12
320,000
800,000
$3,390,000
32
80
$339
2.
The following table identifies the incremental costs in 2021 if Svenson (a) made CMCBs
and (b) purchased CMCBs from Minton.
Incremental Items
Cost of purchasing CMCBs from Minton
Direct materials
Direct manufacturing labor
Variable batch manufacturing costs
Avoidable fixed manufacturing costs
Total incremental costs
Difference in favor of making
Total
Incremental Costs
Make
Buy
$3,000,000
$1,700,000
450,000
120,000
320,000
$2,590,000 $3,000,000

$410,000
Per-Unit
Incremental Costs
Make
Buy
$300
$170
45
12
32
$259
$300

$41
Note that the opportunity cost of using capacity to make CMCBs is zero because Svenson would
keep this capacity idle if it purchases CMCBs from Minton.
Svenson should continue to manufacture the CMCBs internally because the incremental
costs to manufacture are $259 per unit compared to the $300 per unit that Minton has quoted.
Note that the unavoidable fixed manufacturing costs of $800,000 ($80 per unit) will continue to
be incurred whether Svenson makes or buys CMCBs. These are not incremental costs under
either the make or the buy alternative and,hence, are irrelevant.
12-10
3.
Svenson should continue to make CMCBs. The simplest way to analyze this problem is
to recognize that Svenson would prefer to keep any excess capacity idle rather than use it to
make CB3s. Why? Because expected incremental future revenues from CB3s, $2,000,000, are
less than expected incremental future costs, $2,150,000. If Svenson keeps its capacity idle, we
know from requirement 2 that it should make CMCBs rather than buy them.
An important point to note is that, because Svenson forgoes no contribution by not being
able to make and sell CB3s, the opportunity cost of using its facilities to make CMCBs is zero.
It is, therefore, not forgoing any profits by using the capacity to manufacture CMCBs. If it does
not manufacture CMCBs, rather than lose money on CB3s, Svenson will keep capacity idle.
A longer and more detailed approach is to use the total alternatives or opportunity cost
analyses shown in Exhibit 12-7 of the chapter.
Choices for Svenson
Make CMCBs
Buy CMCBs
and Do Not
and Make
Relevant Items
Make CB3s
CB3s, if Profitable
TOTAL-ALTERNATIVES APPROACH TO MAKE-OR-BUY DECISIONS
Total incremental costs of
making/buying CMCBs (from
requirement 2)
$2,590,000
$3,000,000
0
0
$2,590,000
$3,000,000
Because incremental future costs
exceed incremental future revenues
from CB3s, Svenson will make zero
CB3s even if it buys CMCBs from
Minton
Total relevant costs
Svenson will minimize manufacturing costs and maximize operating income by making CMCBs.
OPPORTUNITY-COST APPROACH TO MAKE-OR-BUY DECISIONS
Total incremental costs of
making/buying CMCBs (from
requirement 2)
Opportunity cost: profit contribution
forgone because capacity will not
be used to make CB3s
Total relevant costs
$2,590,000
$3,000,000
0*
$2,590,000
0
$3,000,000
*Opportunity
cost is zerobecause Svenson does not give up anything by not making CB3s. Svenson is best off
leaving the capacity idle (rather than manufacturing and selling CB3s).
12-11
12-26 (15 min.) Opportunity cost, make-or-buy decisions
.
Relevant items
Outside purchase from Calwson (€50 x 18,000)
Direct materials (€10 x 18,000)
Direct labor (€12 x 18,000)
Variable overhead(60% x €25 x 18,000)
Opportunity cost
Fixed manufacturing overhead reduction(€5 x 18,000)
Total relevant cost
Difference in favor of producing the electrical units
Total
relevant costs
Make Buy
€’000 €’000
900
180
216
270
50
90
806
94
Relevant cost
per unit
Make
Buy
€
€
50
10
12
15
2.78
5
44.78
5.22
1. Oscar Ltd will save a total of €94,000 if the electrical units are manufactured by the
company. Make decision is the best outcome.
2. The maximum acceptable purchase price to the management of Oscar Ltd will be the
relevant cost of producing the electrical units internally which is €44.78. In a make-orbuy decision, managers have to consider the difference between the relevant
manufacturing cost and the buying in price.
3. Oscar Ltd may consider the effect on their customers of buying the electrical units from
their competitors. Knowing that the product was bought from a known competitor may
undermine customers’ confidence. There is also the concern of quality of the product and
whether the electrical units are of same standard as those produced by Oscar Ltd. They
will also have to consider other factors such as: would it be a one-off purchase? Could
the item or brand will not be regular should customers decide to buy more?
12-12
12-27 (20-25 min.) Short-run decision making, accept or reject decisions.
.
Alpha Cables Ltd
Incremental analysis on Accept or Reject Special Order Decision
€
€
Increase in Sales Revenue (€10.50 x 6,000)
63,000
Less: Incremental costs:
Direct Materials (€6.25 x 6,000)
37,500
Direct Labor (€3.75 x 6,000)
22,500
60,000
Incremental Profit
3,000
1.
Decision: As a result of the fact that the order will increase the total contribution of the
organization by €3,000, then it should be accepted. It is however assumed that the special order
will not involve any selling expenses.
2.
Relevant Cost of Production per Unit:
€
6.25
3.75
10.00
====
Direct Materials
Direct Labor
TOTAL
Decision: The management of Alpha Cables Ltdwill be willing to pay to an outside supplier
the maximum price of €10.00 per unit representing the relevant cost of production to the
organization.
(iii)
Short run pricing include pricing for a one-time-only special offer. This can be an
opportunity where a manager will have to bid against its competitors. In such a situation
incremental costs of undertaking the order should be taken into account. This is a short-run
pricing decision which involves a time horizon of only few months. The short-run cost includes
both the fixed and variable costs. Some factors remain fixed due to the time constraints imposed
on a company.
12-13
12-28 (10 min.) Selection of most profitable product.
Product
Material
Labor
Costs
Selling
price
Sales
provision
Net selling
price
CMPP
CM per kg.
Material
Priority
Sales
CM
Total CM
Used material
Ending material
CM Max
Sales (restricted)
CM restricted
A
5
30
35
70
B
3
36
39
60
C
6
60
66
100
D
8
30
38
80
7
6
10
8
63
54
90
72
28
56
15
50
24
40
34
42.5
1
2
4
3
Product A
3000
28
84000
1500
500
84000
3000
84000
Product B
8000
15
120000
2400
–1900
120000
1666
24,990
12-14
Product A +B
204000
108,990
12-29 (25 min.) Theory of constraints, throughput contribution, relevant costs.
1.
Finishing is a bottleneck operation. Therefore, producing 1,150 more units will generate
additional contribution (throughput) margin and operating income.
Increase in contribution (throughput) margin ($70 – $30)  1,150
$46,000
Incremental costs of the jigs and tools
35,000
Increase in operating income investing in jigs and tools
$11,000
Pierce should invest in the modern jigs and tools because the benefit of higher contribution
(throughput) margin of $46,000 exceeds the cost of $35,000
2.
The Machining Department has excess capacity and is not a bottleneck operation.
Increasing its capacity further will not increase contribution (throughput) margin. There is,
therefore, no benefit from spending $4,000 to increase the Machining Department's capacity by
9,000 units. Pierce should not implement the change to do setups faster.
3.
Finishing is a bottleneck operation. Therefore, getting an outside contractor to produce
9,500 units will increase contribution (throughput) margin.
Increase in contribution (throughput) margin ($70 – $30)  9,500
Incremental contracting costs $9  9,500
Increase in operating income by contracting 9,500 units of finishing
$380,000
85,500
$294,500
Pierce should contract with an outside contractor to do 9,500 units of finishing at $9 per unit
because the benefit of higher throughput margin of $380,000 exceeds the cost of $85,500. The
fact that the cost of $9 per unit is three times Pierce's finishing cost of $3 per unit is irrelevant.
4.
Operating costs in the Machining Department of $540,000, or $6 per unit, are fixed costs.
Pierce will not save any of these costs by subcontracting machining of 5,000 units to Hammond
Corporation. Total costs will be greater by $15,000 ($3 per unit  5,000 units) under the
subcontracting alternative. Machining more filing cabinets will not increase contribution
(throughput) margin, which is constrained by the finishing capacity. Pierce should not accept
Hammond’s offer. The fact that Hammond’s costs of machining per unit are half of what it costs
Pierce in-house is irrelevant.
5.
The cost of 1,700 defective units in the Machining Operation is $30 per unit  1,700 units
= $51,000. Because the Machining Operation has a capacity of 110,000 units, it can still produce
and transfer 90,000 good units to the Finishing Operation. There is, therefore, no opportunity
cost of producing defective units in the Machining Operation.
6.
The cost of 1,700 defective units in the Finishing Operation is:
Cost of direct materials used in the defective units $30 per unit  1,700 units
Opportunity cost, lost contribution (throughput) margin $40 per unit  1,700 units
Total cost of defective unit in the Finishing Operation
$ 51,000
68,000
$119,000
Alternatively, the cost of 1,700 defective units in the Finishing Operation equals the revenues
lost by selling 1,700 fewer units = $70 per unit  1,700 units = $119,000. The cost of the
12-15
defective unit at a bottleneck operation is much higher than at a non-bottleneck operation
because of the opportunity cost of lost contribution margin at the bottleneck operation.
12-16
12-30 (25 min.) Factors affecting investment decisions by managers and accept or reject
decisions
LMTC Ltd
a.Saving or Deficit from making 30,000 units.
£’000
£’000
Supplier’s quotation (£46 x 30,000 units)
1,380
Less: Relevant cost of making:
Material (£6 x 30,000 units)
180
Labor (£8 x 30,000 units)
240
Variable Overhead (£12 + (1/3 x £24) x 30,000 units)
600
Opportunity cost
65
Cost savings on fixed overhead [(1/4 x £16) x 30,000 units]
120
1,205
Savings
175
Based on the computation above, LMTC Ltd should opt to make the product. This is because the
company will save £175,000 if it produces the PE clothes rather than outsource the production.
b. The following factors are also considered by managers in make-or-buy decisions:
i.
Managers usually seek to understand the opportunity cost of any investment decision. A
relevant factor in choosing any alternative is the benefit sacrificed by not choosing some
other alternatives.
ii.
Past costs are not of themselves relevant for decision making but may be of value in
predicting future cost levels.
iii.
Managers focus on only those costs that will change and opportunity costs. Allocated
overhead costs are ignored.
12-31 (20 min.) Choosing customers.
If Rodeo accepts the additional business from Julie, it would take an additional 1,000 machinehours. If Rodeo accepts all of Julie’s and Trent’s business for February, it would require 5,000
machine-hours (3,000 hours for Trent and 2,000 hours for Julie). Rodeo has only 4,000 hours of
machine capacity. It must, therefore, choose how much of the Trent or Julie business to accept.
To maximize operating income, Rodeo should maximize contribution margin per unit of
the constrained resource. (Fixed costs will remain unchanged at $170,000 regardless of the
business Rodeo chooses to accept in February and are, therefore, irrelevant.) The contribution
margin per unit of the constrained resource for each customer in January is:
12-17
Contribution margin per machine-hour
Trent
Corporation
Julie
Corporation
$126,000
= $42
3,000
$55,000
= $55
1,000
Because the $140,000 of additional Julie business in February is identical to jobs done in
January, it will also have a contribution margin of $55 per machine-hour, which is greater than
the contribution margin of $42 per machine-hour from Trent. To maximize operating income,
Rodeo should first allocate all the capacity needed to take the Julie Corporation business (2,000
machine-hours) and then allocate the remaining 2,000 (4,000 – 2,000) machine-hours to Trent.
Contribution margin per machine-hour
Machine-hours to be worked
Contribution margin
Fixed costs
Operating income
Trent
Corporation
$42
 2,000
$84,000
Julie
Corporation
$55
 2,000
$110,000
Total
$194,000
170,000
$ 24,000
An alternative approach is to use the opportunity cost approach. The opportunity cost of
giving up 1,000 machine-hours for the Trent Corporation jobs is the contribution margin forgone
of $42 per machine-hour  1,000 machine-hours equal to $42,000. The contribution margin
gained from using the 1,000 machine-hours for the Julie Corporation business is the contribution
margin per machine-hour of $55  1,000 machine-hours equal to $55,000.
The net benefit is:
Contribution margin from Julie Corporation business
Less: Opportunity cost (of giving up Trent Corporation business)
Net benefit
$55,000
(42,000)
$13,000
Although taking the Julie Corporation business over the Trent Corporation business will
maximize Rodeo’s profits in the short run, Rodeo’s managers must also consider the long-run
effects of this decision. Will Julie Corporation continue to demand the same level of business
going forward? Will turning down the Trent business affect customer satisfaction? If Rodeo
turns down the Trent business, will Trent continue to place orders with Rodeo or seek alternative
suppliers? Rodeo’s managers need to consider these long-run effects and then decide whether it
should accept Julie’s business at the cost of Trent’s. In other words, choosing customers is a
strategic decision. If it sees long-run benefit in working with Trent, Rodeo’s managers must also
look for ways to increase the profitability of the business it does with Trent by increasing prices
or reducing costs.
12-18
12-32 (20 min.) Relevance of equipment costs.
1.
The current market value and annual operating costs of the old oven, and the purchase
price, installation cost, and annual operating costs of the new oven are relevant when deciding
whether to replace the oven because these are future costs that would differ between the
alternatives of keeping or replacing the old oven.
2.
The original cost and book value of the old oven are irrelevant because they are
variations of the same past (sunk) cost. All past costs are irrelevant because past costs will be the
same whether Papa’s Pizza keeps or replaces the oven. No decision can change what has already
been incurred in the past.
3.
Papa’s Pizza should purchase the new oven, based on the following calculations:
Keep the old oven
Operating costs for 5 years
($14,000 × 5)
Cost of keeping the old oven
$(70,000)
$(70,000)
Replace the old oven
Current market value of old oven
Purchase price of the new oven
Installation cost of the new oven
Operating costs for 5 years
($6,000 × 5)
Net cost of the new oven
$ 42,000
(75,000)
(2,000)
(30,000)
$(65,000)
The cost of replacing the old oven is $65,000, while the cost of continuing to operate the old
oven is $70,000.
4.
The manager may be reluctant to replace because it might reflect badly on him for having
purchased the old oven in the first place if the new oven was available a year later.
5.
At a purchase price of $80,000, Papa’s Pizza would be indifferent between purchasing
the new oven and continuing to use the old oven ($75,000 current purchase price + $5,000
savings above). Note that a cost of $80,000, the cost of replacing the old oven would be $70,000,
equal to the cost of keeping the old oven.
12-19
12-33 (30 min.)
Equipment upgrade versus replacement.
1.
Based on the analysis in the table below, TechGuide will be better off by $337,500 over
three years if it replaces the current equipment.
Comparing Relevant Costs of Upgrade and
Replace Alternatives
Cash operating costs
$150; $75 per desk  7,500 desks per yr.  3 yrs.
Current disposal price
One time capital costs, written off periodically as
depreciation
Total relevant costs
Over 3 years
Upgrade
Replace
(1)
(2)
Difference in
favor of Replace
(3) = (1) – (2)
$3,375,000
$1,687,500
(450,000)
$1,687,500
450,000
3,000,000
$6,375,000
4,800,000
$6,037,500
(1,800,000)
$337,500
3
= $1,080,000 would either be
5
written off as depreciation over three years under the upgrade option or all at once in the current
year under the replace option. Its net effect would be the same in both alternatives: to increase
costs by $1,080,000 over three years; hence,it is irrelevant in this analysis.
Note that the book value of the current machine, $1,800,000 
2.
Suppose the capital expenditure to replace the equipment is $X. From requirement 1,
column (2), substituting for the one-time capital cost of replacement, the relevant cost of
replacing is $1,687,500 – $450,000 + $X. From column (1), the relevant cost of upgrading is
$6,375,000. We want to find X such that
$1,687,500 – $450,000 + $X< $6,375,000 (i.e., TechGuide will favor replacing)
Solving the above inequality gives us X< $6,375,000 – $1,237,500 = $5,137,500.
TechGuide would prefer to replace, rather than upgrade, if the replacement cost of the new
equipment does not exceed $5,137,500. Note that this result can also be obtained by taking the
original replacement cost of $4,800,000 and adding to it the $337,500 difference in favor of
replacement calculated in requirement 1.
12-20
3.
Suppose the units produced and sold over 3 years equal y. Using data from requirement 1,
column (1), the relevant cost of upgrade would be $150y + $3,000,000, and from column(2), the
relevant cost of replacing the equipment would be $75y– $450,000 + $4,800,000. TechGuide
would want to upgrade when
$150y + $3,000,000 < $75y – $450,000 + $4,800,000
$75y < $1,350,000
y < $1,350,000  $75 = 18,000 units
That is,upgrade when y< 18,000 units (or 6,000 per year for 3 years) andreplace when y> 18,000
units over 3 years.
When production and sales volume is low (less than 6,000 per year), the higher operating
costs under the upgrade option are more than offset by the savings in capital costs from
upgrading. When production and sales volume is high, the higher capital costs of replacement are
more than offset by the savings in operating costs in the replace option.
4.
Operating income for the first year under the upgrade and replace alternatives are shown
below:
Year 1
Upgrade
Replace
(1)
(2)
Revenues (7,500  $750)
$5,625,000
$5,625,000
Cash operating costs
$150; $75 per desk  7,500 desks per year
1,125,000
562,500
a
Depreciation ($1,080,000 + $3,000,000)  3; $4,800,000  3
1,360,000
1,600,000
Loss on disposal of old equipment (0; $1,080,000 –
$450,000)
0
630,000
Total costs
2,485,000
2,792,500
Operating Income
$3,140,000
$2,832,500
a
The book value of the current production equipment is $1,800,000
useful life of 3 years.
 5  3 = $1,080,000; it has a remaining
First-year operating income is higher by $307,500 ($3,140,000 – $2,832,500) under the upgrade
alternative, and Dan Doria, with his one-year horizon and operating income-based bonus, will
choose the upgrade alternative, even though, as seen in requirement 1, the replace alternative is
better in the long run for TechGuide. This exercise illustrates the possible conflict between the
decision model and the performance evaluation model.
12-21
12-34 (20 min.) Relevantcosts in investment decision making
Julie Bolts Ltd
1. (i) Materials
Since Iron-cast rods material is regularly used, using the existing stock of the materials
means that more of the materials will be purchased. The relevant cost is therefore the
replacement cost. The replacement cost per kg is (£20,500/2000) plus 10% = £10.25 x
1.10 =
£11.28 per kg.
Copper-cast material has no other use, and if the existing stock are used for the contract,
the opportunity cost is the cost of not being able to sell them at £20 per kg.
£
Iron-cast rods material
3,500 kg at £11.28 per kg
39,480
Copper-cast material
500kg at £20 per kg
10,000
49,480
(ii) Factory Labor
The contribution earned by the factory labor in making 3-D Bolts is
£38
= £9.50 per skilled labor hour.
4 hours per unit
£
Labor cost
800 hours at £10.00
8,000
Opportunity cost of labor
800 hours at £9.50
7,600
Total relevant cost
15,600
2. The variable overhead costs associated with the contract would be relevant because they
would represent additional or incremental costs caused directly by the contract. However,
it is important to avoid making the general assumption that all variable costs are relevant,
and all fixed costs are not. Fixed manufacturing costs are relevant where additional
production units cause an increase in the fixed costs.
12-22
12-35 (15-20 min.) Short-run pricing, capacity constraints.
1. Cost of making one kilogram of hard cheese:
Milk (10 liters  $1.50 per liter)
Variable direct manufacturing labor
Variable manufacturing overhead
Fixed manufacturing cost allocated
Total manufacturing cost
$15
4
2
5
$26
If Jersey Acres Dairy can get all the Holstein milk it needs and has sufficient production
capacity, then the minimum price per kilo it should charge for the hard cheese is the variable cost
per kilo = $15 + $4 + $2 = $21 per kilo. The fixed manufacturing costs are unaffected by the
decision and are therefore irrelevant. Of course, Jersey Acres should try to get as high a price
above $21 that the gourmet restaurant is willing to pay.
2.
If milk is in short supply, then each kilo of hard cheese displaces 2.5 kilos of soft cheese
(10 liters of milk per kilo of hard cheese versus 4 liters of milk per kilo of soft cheese). Then, for
the hard cheese, the minimum price Jersey Acres should charge is the variable cost per kilo of
hard cheese plus the contribution margin from 2.5 kilos of soft cheese, or,
$21 + (2.5  $8 per kilo) = $41 per kilo
That is, if milk is in short supply, Jersey Acres should not agree to produce any hard cheese
unless the buyer is willing to pay at least $41 per kilo.
12-23
12-36 (20 min.) International outsourcing.
1.
Cost to purchase each figurine from Indonesian supplier =
27,300 IDR
 $3.
9,100 IDR/$
Cost of purchasing 400,000 figurines from Indonesian supplier = $3 400,000 figurines =
$1,200,000.
Costs of
manufacturing
figurines in
Cleveland
facility
=
Variable
manufacturing
cost per unit

Quantity of
figurines
produced
+
Incremental fixed
manufacturing
costs
= ($2.85  400,000 units) + $200,000
= $1,340,000
Variable and fixed selling and distribution costs are irrelevant because they do not differ between
the two alternatives of purchasing the figurines from the Indonesian supplier or manufacturing
the figurines in Queensland.
Cuddly Critters should purchase the figurines from the Indonesian supplier because the
cost of $1,200,000 is less than the relevant cost of $1,340,000 to manufacture the figurines in
Cleveland.
2.
If Cuddly Critters enters into a forward contract to purchase 27,300 IDRs for $3.40, each
figurine acquired from the Indonesian supplier will cost $3.40.
Total cost of purchasing 400,000 figurines from Indonesian supplier = $3.40  400,000
figurines = $1,360,000.
Cost of manufacturing 400,000 figurines in Queensland (see requirement 1) =
$1,340,000.
As in requirement 1, selling and distribution costs are irrelevant.
Cuddly Critters should manufacture the figurines in Queensland because the relevant cost
of $1,340,000 to manufacture the figurines in Queensland is less than the cost of $1,360,000 to
enter into the forward contract and purchase the figurines from the Indonesian supplier.
3.
In deciding whether to purchase figurines from the Indonesian supplier, Cuddly Critters
should consider factors such as (a) quality, (b) delivery lead times, (c) fluctuations in the value of
the Indonesian Rupiah relative to the dollar, and (d) the negative public and media reaction to not
providing jobs in Queensland and instead supporting job creation in Indonesia.
12-24
12-37 (30 min.) Relevant costs, opportunity costs.
1.
TS-12 has a higher relevant operating income than TS-11. Based on this analysis, TS-12
should be introduced immediately:
TS-11
$170
Relevant revenue per unit
Relevant cost per unit:
Variable cost per unit
Total relevant costs
Relevant operating income
$ 0
TS-12
$220
$43
0
$170
43
$177
Reasons for other cost items being irrelevant are
TS-11
 Cost of TS 11 watches—already incurred
 Development costs—already incurred
 Marketing and administrative—fixed costs of period
TS-12
 Development costs—already incurred
 Marketing and administration—fixed costs of period
Note that total marketing and administration costs will not change whether TS-12 is introduced
on July 1, 2020, or on October 1, 2020.
2.
Other factors to be considered:
a. Customer satisfaction. If TS-12 is significantly better than TS-11 for its customers, a
customer-driven organization would immediately introduce it unless other factors
offset this bias toward “do what is best for the customer.”
b. Quality level of TS-12. It is critical for new products to function well. Consider an
immediate release only if TS-12 passes all quality tests and can be supportedfully by
the salesforce.
c. Importance of being perceived to be a market leader. Being first in the market with a
new product can give Time Sprint a “first-mover advantage,” e.g., capturing an initial
large share of the market that, in itself, causes future potential customers to lean
toward purchasing TS-12. Moreover, by introducing TS-12 earlier, Time Sprint can
get quick feedback from users about ways to further refine the product while its
competitors are still working on their own first versions. Moreover, by locking in
early customers, Time Sprint may increase the likelihood of these customers also
buying future upgrades of TS-12.
d. Morale of developers. These are key people at Time Sprint. Delaying introduction of
a new product can hurt their morale, especially if a competitor then preempts Time
Sprint from being viewed as a market leader.
12-25
12-38 (25 min.) Opportunity costs and relevant costs
1. Yes, Sandy should accept the job per the following calculations.
Sandy has 40 hours of available capacity but needs 60 hours for the Jenny’s Pizza job. If Sandy
accepts the Jenny’s Pizza’s job, Sandy would have to give up 20 (60 – 40) hours of its current
business. The opportunity cost of each hour of current business that it gives up can be calculated
as follows:
Revenues ($175 × 160 hours)
$28,000
Variable costs ($100 × 160 hours)
16,000
Contribution margin
$12,000
Contribution margin per hour = $12,000 ÷ 160 hours = $75 per hour
The opportunity cost of giving up 20 hours of its current business is;
Contribution margin from 20 hours = $75 per hour × 20 hours = $1,500
The relevant revenues and relevant costs of accepting the Jenny’s Pizza business is as follows:
Increase in revenues ($150 × 60 hours)
$9,000
Increase in variable costs ($100 × 60 hours)
(6,000)
Opportunity cost (lost contribution margin)
(1,500)
Increase in operating income
$1,500
Accepting the Jenny’s Pizza offer will increase Sandy’s Paint Shop’s operating income so Sandy
should accept the Jenny’s Pizza offer.
2. The fixed costs of painting, marketing and administration do not differ among the three
alternatives and are therefore irrelevant. The easiest approach is to simply compare the
contribution margin (revenues minus variable costs) under each alternative.
Accept special order
Reject Perry’s offer
$33,500a
20,000d
$13,500
Revenues
Variable costs
Contribution margin
a
b
d
e
($175×140) + ($150 × 60);
($100×140) + ($100 × 60);
Accept special order
Accept Perry’s offer
$37,000b
22,500e
$14,500
Reject special offer
$28,000c
16,000f
$12,000
($175×160) + ($150 × 60); c$175×160
($100×160) + ($100 ×40) + ($125×20); f$100×160
Sandy should accept the special order and accept Perry’s offer since it generates the highest
contribution margin.
3. Sandy should consider the negative long-term effect on customer relationships of accepting
the Jenny’s Pizza job for $150 per hour below what it charges its current customers. If the
current customers find out, Sandy may face pressure to reduce prices to all customers from $175
per hour to $150 per hour. If this were the case, the contribution margin in column 2 from
accepting the special order and accepting Perry’s offer would decrease to $10,500 (because
revenue would decrease by $4,000 from $37,000 to $33,000 ($150 × 220 hours) and the
contribution margin in column 1 from accepting the special order and rejecting Perry’s offer
12-26
would decrease to $10,000 (because revenue would decrease by $3,500 from $33,500 to $30,000
($150 × 200 hours). In this case, Sandy would be better off rejecting the special order and
continuing to charge $175 per hour for paint jobs even if it cannot operate at full capacity of 200
hours.
In deciding whether to use the paint crew from Perry, Sandy should consider factors such as
(a) the quality of the work done by Perry’s crewand (b) the timeliness with which they do the
work because the work done by Perry’s crew would affect Sandy’s reputation in the market.
Sandy should also consider how well Perry’s crew and Sandy’s crew will work together and
also the consequences of having the two crews work together. For example, if Perry’s Paint Shop
pays its crew better than Sandy’s Paint Shop, Sandy’s crew may ask for a raise. If this were to
happen, Sandy’s higher labor costs would be a relevant cost of accepting the special order.
12-27
12-39 (20 min.)Opportunity costs.
1.
The opportunity cost to Wild Orchid of producing the 3,500 units of Stronglast is the
contribution margin lost on the 3,500 units of Everlast that would have to be forgone, as
computed below:
Selling price
$
52
Variable costs per unit:
Direct materials
$10
Direct manufacturing labor
2
Variable manufacturing overhead
8
Variable marketing costs
4
24
Contribution margin per unit
$
28
Contribution margin for 3,500 units ($28  3,500 units)
$98,000
The opportunity cost is $98,000. Opportunity cost is the maximum contribution to
operating income that is forgone (rejected) by not using a limited resource in its next-best
alternative use.
2.
Contribution margin from manufacturing 3,500 units of Stronglast and purchasing 3,500
units of Everlast from Chesapeake is $105,000, as follows:
Manufacture
Stronglast
Selling price
Variable costs per unit:
Purchase costs
Direct materials
Direct manufacturing labor
Variable manufacturing costs
Variable marketing overhead
Variable costs per unit
Contribution margin per unit
Contribution margin from selling 3,500 units
of Stronglast and 3,500 units of Everlast
($18  3,500 units; $12  3,500 units)
$
40
$
–
10
2
8
2
22
18
$63,000
Purchase
Everlast
$
Total
52
36
$
4
40
12
$42,000
$105,000
As calculated in requirement 1, Wild Orchid’s contribution margin from continuing to
manufacture 3,500 units of Everlast is $98,000. Accepting the Apex Company and Chesapeake
offer will benefit Wild Orchid by $7,000 ($105,000 – $98,000). Hence, Wild Orchid should
accept the Apex Company and Chesapeake Corporation’s offers.
3.
The minimum price would be any price greater than $22, the sum of the incremental costs
of manufacturing and marketing Stronglast as computed in requirement 2. This follows because,
if Wild Orchid has surplus capacity, the opportunity cost = $0. For the short-run decision of
whether to accept Apex’s offer, fixed costs of Wild Orchid are irrelevant. Only the incremental
costs need to be covered for it to be worthwhile for Wild Orchid to accept the Apex offer.
12-28
12-40 (30–40 min.) Make or buy, unknown level of volume.
1.
The variable costs required to manufacture 150,000 starter assemblies are
Direct materials
Direct manufacturing labor
Variable manufacturing overhead
Total variable costs
$400,000
300,000
200,000
$900,000
The variable costs per unit are $900,000 ÷ 150,000 = $6.00 per unit.
Let X = number of starter assemblies required in the next 12 months.
The data can be presented in both “all data” and “relevant data” formats:
Variable manufacturing costs
Fixed general manufacturing overhead
Fixed overhead, avoidable
Division 2 manager’s salary
Division 3 manager’s salary
Purchase cost, if bought from
Tutwiler Electronics
Total costs
All Data
Relevant Data
Alternative Alternative Alternative Alternative
1:
2:
1:
2: Buy
Make
Buy
Make
$
6X
–
$
6X
–
300,000
$300,000
–
–
200,000
–
200,000
–
80,000
100,000
80,000
$100,000
100,000
–
100,000
–
–
$680,000
+ $ 6X
8X
$400,000
+ $ 8X
–
$380,000
+ $ 6X
8X
$100,000
+ $ 8X
The number of units at which the costs of make and buy are equivalent is
All data analysis:
or
Relevant data analysis:
$680,000 + $6X = $400,000 + $8X
2X = 280,000
X = 140,000
$380,000 + $6X = $100,000 + $8X
2X = 280,000
X= 140,000
Assuming cost minimization is the objective, then
• If production is expected to be less than 140,000 units, it is preferable to buy units
from Tutwiler.
• If production is expected to exceed 140,000 units, it is preferable to manufacture
internally (make) the units.
• If production is expected to be 140,000 units, Denver will be indifferent between
buying units from Tutwiler and manufacturing (making) the unitsinternally.
12-29
2.
The information on the storage cost, which is avoidable if self-manufacture is
discontinued, is relevant; these storage charges represent current outlays that are avoidable if
self-manufacture is discontinued. Assume these $100,000 charges are represented as an
opportunity cost of the make alternative. The costs of internal manufacture that incorporate this
$100,000 opportunity cost are
All data analysis:
Relevant data analysis:
$780,000 + $6X
$480,000 + $6X
Alternatively stated, we would add the following line to the table shown in requirement 1
causing the total costs line to change as follows:
Outside storage charges
Total costs
1
All Data
Alternative 1:
Alternative 2:
Make
Buy
Relevant Data
Alternative 1:
Alternative 2:
Make
Buy
$100,000
$780,0001 + 6X
$100,000
$480,0002 + 6X
$0
$400,000 + 8X
$0
$100,000 + 8X
$780,000 = $680,000 + $100,000 2$480,000 = $380,000 + $100,000
The number of units at which the costs of make and buy are equivalent is
All data analysis:
Relevant data analysis:
$780,000 + $6X = $400,000 + $8X
2X = 380,000
X = 190,000
$480,000 + $6X = $100,000 + $8X
2X = 380,000
X = 190,000
If production is expected to be less than 190,000, it is preferable to buy units from Tutwiler. If
production is expected to exceed 190,000, it is preferable to manufacture the units internally.
12-30
12-41 (30 min.) Make versus buy, activity-based costing, opportunity costs.
1.
Relevant costs under buy alternative:
Purchases, 30,000  $23.00
$690,000
Relevant costs under make alternative:
Direct materials
Direct manufacturing labor
Variable manufacturing overhead
Inspection, setup, materials handling
Total relevant costs under make alternative
$300,000
150,000
90,000
120,000
$660,000
The allocated fixed plant administration, taxes, and insurance will not change if Allen
makes or buys the upholstery for the chairs. Hence, these costs are irrelevant to the make-or-buy
decision. The analysis indicates that it is less costly for Allen to make rather than buy the
upholstery for the chairs from the outside supplier.
2.
Relevant costs under the make alternative:
Relevant costs (as computed in requirement 1)
Relevant costs under the buy alternative:
Costs of purchases (30,000  $23.00)
Additional contribution margin from using the space
where the upholstery for the chairsto make pillows
to match the chairs, 10,000  ($25 – $15)
Total relevant costs under the buy alternative
$660,000
$690,000
(100,000)
$590,000
Allen should buy the upholstery for the chairs from an outside vendor and use its own
capacity to make pillows.
3. In this requirement, the decision on making the pillows is irrelevant to the analysis because
the pillows increase operating income and they will be made whether the upholstery for the
chairs are purchased or made.
Relevant cost of manufacturing upholstery for the chairs:
Variable costs, ($10 + $5 + $3 + $4* = $22)  24,000
Relevant cost of buying upholstery for the chairs, $23 24,000
$528,000
552,000
*$120,000 30,000 units = $4 per unit
In this case, it is cheaper for Allen to manufacture rather than buy the upholstery for the
chairs. Lexington should make the upholstery for the chairs.
12-31
12-42 (25 min.) Product mix, constrained resource.
1.
Selling price
Variable costs:
Direct materials (DM)
Labor and other costs
Total variable costs
Contribution margin
Pounds of DM per unit
Contribution margin per lb.
A130
$252
B324
$ 168
72
45
84
81
156
126
$ 96
$ 42
÷8 lbs.
÷5 lbs.
$ 12 per lb. $8.40 per lb.
C587
$210
27
120
147
$ 63
÷ 3 lbs.
$ 21 per lb.
First, satisfy minimum requirements.
Minimum units
Times pounds per unit
Pounds needed to produce minimum units
A130
200
×8 lb. per unit
1,600 lb.
B324
200
×5 lb. per unit
1,000 lb.
C587
200
×3 lb. per unit
600 lb.
Total
3,200 lb.
The remaining 1,800 pounds (5,000 – 3,200) should be devoted to C587 because it has the
highest contribution margin per pound of direct material. Because each unit of C587 requires 3
pounds of Brac, the remaining 1,800 pounds can be used to produce another 600 units of C587.
The following combination yields the highest contribution margin given the 5,000 pounds
constraint on availability of Brac.
A130: 200 units
B324:200 units
C587: 800 units (200 minimum + 600 extra)
2. The demand for Wechsler’s products exceeds the materials available. Assuming that fixed
costs are covered by the original product mix, Wechsler would be willing to pay up to an
additional $21 per pound (the contribution margin per pound of C587) for another 1,200 pounds
of Brac. That is, Wechsler would be willing to pay $9 + $21 = $30 per pound of Brac for the
pounds of Bracthat will be used to produce C587.1 If sufficient demand does not exist for 400
additional units (1,200 pounds ÷ 3 pounds per unit) of C587, then the maximum price Wechsler
would be willing to pay is an additional $12 per pound (the contribution margin per pound of
A130) for the pounds of Wechsler that will be used to produce A130. In this case Wechsler
would be willing to pay $9 + $12 = $21 pound. If all the 1,200 pounds of Brac are not used to
satisfy the demand for C587 and A130, then the maximum price Wechsler would be willing to
pay is an additional $8.40 per pound (the contribution margin per pound of B324) for the pounds
of Brac that will be used to produce B324. Wechsler would be willing to pay $8.40 + $9 =
$17.40 per pound of Brac.
1An
alternative calculation focuses on column 3 for C587 of the table in requirement 1.
Selling price
$210
Variable labor and other costs (excluding direct materials)
120
Contribution margin
$ 90
Divided by pounds of direct material per unit
÷3 lbs.
Direct material cost per pound that Wechsler can pay
without contribution margin becoming negative
$ 30
12-32
12-43 (30–40 min.) Product mix, relevant costs.
1.
Selling price
Variable manufacturing cost per unit
Variable marketing cost per unit
Total variable costs per unit
Contribution margin per unit
Contribution margin per hour of the
constrained resource
Total contribution margin from selling only A6
or only EX4
A6: $50  50,000; EX4: $60  50,000
Less Lease costs of high-precision machine
to produce and sell EX4
Net relevant benefit
$
$
A6
200
120
30
150
50
$
$
EX4
300
200
70
270
30
$50
= $50
1
$30
= $60
0.5
$2,500,000
$3,000,000
0
$2,500,000
600,000
$2,400,000
Even though EX4 has the higher contribution margin per unit of the constrained resource, the
fact that Gormley must incur additional costs of $600,000 to achieve this higher contribution
margin means that Gormley is better off using its entire 50,000-hour capacity on the regular
machine to produce and sell 50,000 units (50,000 hours  1 hour per unit) of A6. The additional
contribution from selling EX4 rather than A6 is $500,000 ($3,000,000  $2,500,000), which is
not enough to cover the additional costs of leasing the high-precision machine. Note that,
because all other overhead costs are fixed and cannot be changed, they are irrelevant for the
decision. Gormley produces 50,000 units of A6, which increases operating income by
$2,500,000.
2.
If capacity of the regular machines is increased by 15,000 machine-hours to 65,000
machine-hours (50,000 originally + 15,000 new), the net relevant benefit from producing A6 and
EX4 is as follows:
A6
EX4
Total contribution margin from selling only
A6 or only EX4
A6: $50  65,000; EX4: $60  65,000
$3,250,000
$3,900,000
Less Lease costs of high-precision machine
that would be incurred if EX4 is produced and sold
600,000
Less Cost of increasing capacity by
15,000 hours on regular machine
300,000
300,000
Net relevant benefit
$2,950,000
$3,000,000
Adding 15,000 machine-hours of capacity for regular machines and using all the capacity to
produce EX4 increases operating income by $3,000,000.
Investing in the additional capacity increases Gormley’s operating income by $500,000
($3,000,000 calculated in requirement 2 minus $2,500,000 calculated in requirement 1), so
12-33
Gormley should add 15,000 hours to the regular machine. With the extra capacity available to it,
Gormley should use its entire capacity to produce EX4. Using all 65,000 hours of capacity to
produce EX4 rather than to produce A6 generates additional contribution margin of $650,000
($3,900,000  $3,250,000), which is more than the additional cost of $600,000 to lease the highprecision machine. Gormley should therefore produce and sell 130,000 units of EX4 (65,000
hours  0.5 hours per unit of EX4) and zero units of A6.
3.
A6
$200
120
30
150
$ 50
Selling price
Variable manufacturing costs per unit
Variable marketing costs per unit
Total variable costs per unit
Contribution margin per unit
Contribution margin per unit of the constrained resource
EX4
$300
200
70
270
$ 30
V2
$240
140
30
170
$ 70
$30
$50
= $50;
= $60; .= $70
1
0.5
The first step is to compare the operating profits that Gormley could earn if it accepted the Clark
Corporation offer for 20,000 units with the operating profits Gormley is currently earning. V2
has the highest contribution margin per hour on the regular machine and requires no additional
investment such as leasing a high-precision machine. To produce the 20,000 units of V2
requested by Clark Corporation, Gormley would require 20,000 hours on the regular machine
resulting in contribution margin of $70 20,000 = $1,400,000.
Gormley now has 45,000 hours available on the regular machine to produce A6 or EX4.
Total contribution margin from selling only
A6 or only EX4
A6: $50  45,000; EX4: $60  45,000
Less Lease costs of high-precision machine
to produce and sell EX4
Net relevant benefit
A6
EX4
$2,250,000
$2,700,000

$2,250,000
600,000
$2,100,000
Gormley should use all the 45,000 hours of available capacity to produce 45,000 units of A6. Thus, the
product mix that maximizes operating income is 20,000 units of V2, 45,000 units of A6, and zero units
of EX4. This optimal mix results in a contribution margin of $3,650,000 ($1,400,000 from V2 and
$2,250,000 from A6). Relative to requirement 2, operating income increases by $650,000 ($3,650,000
minus $3,000,000 calculated in requirement 2). Hence, Gormley should accept the Clark Corporation
business and supply 20,000 units of V2.
12-34
12-44 (20 min.) Theory of constraints, throughput contribution, relevant costs.
1.
It will cost Rush $50 per unit to reduce manufacturing time. But manufacturing is not a
bottleneck operation; installation is. Therefore, manufacturing more equipment will not increase
sales and throughput margin. Rush Industries should not implement the new manufacturing
method.
2.
Increase in throughput margin, $25,000  35 units,
Additional relevant costs of new direct materials, $2,000  310 units,
Increase/(Decrease) in operating income
$ 875,000
620,000
$ 255,000
The benefits from higher margin exceeds the additional incremental costs by $225,000 and,
therefore, Rush Industries should implement the new design
Alternatively, compare throughput margin under each alternative.
With the modification, throughput margin is $23,000  310
Current throughput margin is $25,000 275
Increase/(Decrease) in operating income
$7,130,000
6,875,000
$ 255,000
The throughput margin resulting from the proposed change in direct materials is greater than the
current throughput margin. Therefore, Nebraska Industries should implement the new design.
3.
Increase in throughput margin, $25,000  7 units
Increase in relevant costs
Increase in operating income
$ 175,000
55,000
$ 120,000
The additional throughput margin exceeds incremental costs by $120,000, so Rush Industries
should implement the new installation technique.
4.
Motivating installation workers to increase productivity is worthwhile because
installation is a bottleneck operation, and any increase in productivity at the bottleneck will
increase throughput margin. On the other hand, motivating workers in the manufacturing
department to increase productivity is not worthwhile. Manufacturing is not a bottleneck
operation, so any increase in output will result only in extra inventory of equipment. Rush
Industries should encourage manufacturing to produce only as much equipment as the
installation department needs, not to produce as much as it can. Under these circumstances, it
would not be a good idea to evaluate and compensate manufacturing workers on the basis of
their productivity.
12-35
12-45 (30-35 min.) Theory of constraints, contribution margin, sensitivity analysis.
1.
Assuming only one type of doll is produced, the maximum production in each department
given their resource constraints is:
Chatty Chelsey
Talking Tanya
Molding
Department
Assembly
Department
Contribution Margin
36,000 lbs
 18,000
2 lbs
36,000 lbs
 12,000
3 lbs
8,500 hours
 34,000
1/4 hours
8,500 hours
 25,500
1/3 hours
$39 − 2 × $8 – 1/4 × $12
= $20
$50 − 3 × $8–1/3 × $12
= $22
For both types of dolls, the constraining resource is the availability of material because this
constraint causes the lowest maximum production.
If only Chatty Chelsey is produced, TT can produce 18,000 dolls with a contribution margin of
18,000 ×$20 = $360,000
If only Talking Tanya is produced, TT can produce 12,000 dolls with a contribution margin of
12,000 ×$22 = $264,000.
TT should produce Chatty Chelseys.
2.
As shown in Requirement 1, available material in the Molding department is the limiting
constraint.
If TT sells three Chatty Chelseys for each Talking Tanya, then the maximum number of
Talking Tanya dolls the Molding Department can produce (where the number of Talking Tanya
dolls is denoted as T) is:
(T ×3 lbs.) + ([3 × T] × 2 lbs.) = 36,000lbs.
3T + 6T = 36,000
9T = 36,000
T = 4,000
The Molding Department can produce 4,000 Talking Tanya dolls, and 3 ×4,000 (or 12,000)
Chatty Chelsey dolls.
Because TT can only produce 4,000 Talking Tanyas and 12,000 Chatty Chelseys before it runs
out of ingredients, the maximum contribution margin (CM) is:
Contribution margin
from Chatty Chelsey
+
Contribution margin
from Talking Tanya
= 12,000 × $20 + 4,000 × $22
= $240,000 + 88,000
= $328,000
3.
With 900 more pounds of materials, TT would produce more dolls. Using the same
technique as in Requirement 2, the increase in production is:
(T×3 lbs.) + ([3×T] ×2 lbs.) = 900 lbs.
12-36
3T + 6T = 900
T = 100
TT would produce 100 extra Talking Tanya dolls and 300 extra Chatty Chelsey dolls.
Contribution margin would increase by
Contribution margin + Contribution margin = 300  $20 + 100  $22
from Chatty Chelsey from Talking Tanya = $6,000 + $2,200
= $8,200
4.
With 65 more labor hours, production would not change. The limiting constraint is pounds
of material, not labor hours. TT already has more labor hours available than it needs.
12-37
12-46 (25 min.) Closing down divisions.
1. and 2.
Sales
Variable costs of goods sold
($440,000 0.90; $930,000 0.80)
Variable S,G& A
($96,000 0.50; $202,500 0.50)
Total variable costs
Contribution margin
Fixed costs of goods sold
($440,000  0.10; $930,000  0.20)
Fixed S,G& A
($96,000  0.50; $202,500  0.50)
Total fixed costs
Fixed costs savings if shutdown
($92,000 0.40; $287,250  0.40)
Division A
Division B
$504,000
$948,000
396,000
744,000
48,000
444,000
$ 60,000
101,250
845,250
$102,750
Division A
Division B
$ 44,000
$186,000
48,000
$ 92,000
101,250
$287,250
$ 36,800
$114,900
Division A’s contribution margin of $60,000 more than covers its avoidable fixed costs
of $36,800. The difference of $23,200 helps cover the company’s unavoidable fixed costs.
Because $36,800 of Division A’s fixed costs are avoidable, the remaining $55,200 is
unavoidable and will be incurred regardless of whether Division A continues to operate.
Division A’s $32,000 loss is the rest of the unavoidable fixed costs ($55,200 – $23,200). If
Division A is closed, the remaining divisions will need to generate sufficient profits to cover the
entire $55,200 unavoidable fixed cost. Consequently, Division A should not be closed because it
helps defray $23,200 of this cost.
Division B earns a positive contribution margin of $102,750. Division B also generates
$114,900 of avoidable fixed costs. Based strictly on financial considerations, Division B should
be closed because the company will save $12,150 ($114,900 –$102,750). Division B is currently
incurring $114,900 in fixed costs that it could have avoided while earning only $102,750 in
contribution margin.
An alternative set of calculations is as follows:
Total variable costs
Avoidable fixed costs if shutdown
Total cost savings if shutdown
Loss of revenues if shutdown
Cost savings minus loss of revenues
12-38
Division A
Division B
$444,000
36,800
480,800
(504,000)
$ (23,200)
$845,250
114,900
960,150
(948,000)
$ 12,150
Division A should not be shut down because loss of revenues if Division A is shut down exceeds
cost savings by $23,200. Division B should be shut down because cost savings from shutting
down Division B exceeds loss of revenues by $12,150.
3.
Before deciding to close Division B, management should consider the role that the
Division’s product line plays relative to other product lines. For instance, if the product
manufactured by Division B attracts customers to the company, then dropping Division B may
have a detrimental effect on the revenues of the remaining divisions. Management may also
want to consider the impact on the morale of the remaining employees if Division B is closed.
Talented employees may become fearful of losing their jobs and seek employment elsewhere.
12-39
12-47 (30 min.) Dropping a product line, selling more tours
1.
Barrett should not drop the deluxe tours, as follows:
Lost revenues from deluxe tours
Avoidable operating costs from dropping deluxe tours:
Administrative salaries
Guide wages
Supplies
Vehicle fuel
Total avoidable costs
Lost operating income from dropping deluxe tours
$(660,000)
50,000
380,000
100,000
24,000
554,000
$(106,000)
Note: Equipment depreciation, allocated corporate costs, and unavoidable administrative salaries
are irrelevant to the decision.
2.
Barrett should drop the deluxe tours, as follows:
Change in revenues
Change in operating costs:
Administrative salaries
Guide wages
Supplies
Vehicle fuel
Total change in operating costs
Change in operating income
Basic
$225,000
Deluxe
$(660,000)
Total
$(435,000)
0
65,000
25,000
15,000
105,000
$120,000
(50,000)
(380,000)
(100,000)
(24,000)
(554,000)
$(106,000)
(50,000)
(315,000)
(75,000)
(9,000)
(449,000)
$ 14,000
3.
Barrett should consider if it is possible to increase the number of deluxe tours sold, or if it
is possible to reduce the costs of those tours before dropping them. He could also investigate the
possibility of increasing the price of the deluxe tours if customers would tolerate it
12-40
12-48 (30–40 min.) Optimal product mix.
1.
Let D represent the batches of Della’s Delight made and sold.
Let B represent the batches of Bonny’s Bourbon made and sold.
The contribution margin per batch of Della’s Delight is $300.
The contribution margin per batch of Bonny’s Bourbon is $250.
The LP formulation for the decision is:
Maximize
Subject to
$300D + $250 B
30D + 15B  660 (Mixing Department constraint)
15B  270 (Filling Department constraint)
10D + 15B  300 (Baking Department constraint)
2.
Solution Exhibit 12-48 presents a graphical summary of the relationships. The optimal
corner is the point (18, 8) i.e., 18 batches of Della’s Delights and 8 batches of Bonny’s Bourbons.
SOLUTION EXHIBIT 12-48
Graphic Solution to Find Optimal Mix, Della Simpson, Inc.
Della Simpson Production Model
50
45
0, 44
Mixing Dept. Constraint
B (batches of Bonny's Bourbons)
40
35
Equal Contribution
Margin Lines
30
Optimal Corner (18,8)
25
20
Filling Dept. Constraint
3, 18
0, 18
15
10
Feasible Region
5
Baking Dept. Constraint
0
0
5
10
15
20
22, 0
25
D (batches of Della's Delight)
12-41
30
35
40
We next calculate the optimal production mix using the trial-and-error method.
The corner point where the Mixing Dept. and Baking Dept. constraints intersect can be
calculated as (18, 8)by solving:
30D + 15B = 660 (1) Mixing Dept. constraint
10D + 15B = 300 (2) Baking Dept. constraint
Subtracting (2) from (1), we have
20D
= 360
or D
= 18
Substituting in (2)
(10  18) + 15B = 300
that is,
15B = 300  180 = 120
or
B = 8
The corner point where the Filling and Baking Department constraints intersect can be calculated
as (3,18) by substituting B = 18 (Filling Department constraint) into the Baking Department
constraint:
10 D + (15  18) = 300
10 D = 300  270 = 30
D= 3
The feasible region, defined by five corner points, is shaded in Solution Exhibit 12-48. We next
use the trial-and-error method to check the contribution margins at each of the five corner points
of the area of feasible solutions.
Trial
1
2
3
4
5
Corner (D,B)
(0,0)
(22,0)
(18,8)
(3,18)
(0,18)
Total Contribution Margin
($300  0) + ($250  0) = $0
($300  22) + ($250  0) = $6,600
($300  18) + ($250  8) = $7,400
($300  3) + ($250  18) = $5,400
($300  0) + ($250  18) = $4,500
The optimal solution that maximizes contribution margin and operating income is 18 batches of
Della’s Delights and 8batches of Bonny’s Bourbons.
12-42
12-49
(25 min.) Dropping a customer, activity-based costing, ethics.
1. CRS would not benefit from dropping Donnelly’s Pizza because it would lose $43,680 in
revenues and save $43,344 in costs resulting in a $336 decrease in operating income.
Difference:
Incremental
(Loss in Revenues)
and Savings in Costs from
Dropping Donnelly’s Pizza
Revenues
Cost of goods sold
Order processing [$14,000 – (10% × $14,000)]
Delivery [($3,500 – (20% × $3,500)]
Rush orders
Sales calls
Total costs
Effect on operating income (loss)
$(43,680)
26,180
12,600
2,800
924
840
43,344
$ (336)
2. The drop in gross margin percentage indicates that Sara may be giving Donnelly’s Pizza
excessive discounts, perhaps in excess of company guidelines. If CRS awards bonuses based on
sales rather than some measure of operating income, it may encourage sales representatives to
lower margins in order to increase sales. CRS may want to consider basing bonuses on customer
margin. The company may also want to enforce more stringent discounting guidelines.
3. Justin could suggest that Sara approach Donnelly’s Pizza about reducing the number of
different orders that they place. If the orders could be placed less frequently, the company could
reduce both order processing and delivery costs. Sara could also investigate the causes of the
rush orders to see if they could be avoided.
Justin should not rework the numbers. Referring to “Standards of Ethical Conduct for
Management Accountants,” in Exhibit 1-7,JustinAnders should consider the request of
SaraBrinkleyto be unethical for the following reasons.
Competence
 Prepare complete and clear reports and recommendations after appropriate analysis of
relevant and reliable information. Adjusting cost numbers violates the competence standard.
Integrity
 Refrain from either actively or passively subverting the attainment of the organization’s
legitimate and ethical objectives. Justin has the responsibility to act in the best interests of
CRS.

Communicate unfavorable as well as favorable information and professional judgments or
opinions. Justin needs to communicate the proper and accurate results of the analysis,
regardless of whether or not it pleases SaraBrinkley.
12-43

Refrain from engaging in or supporting any activity that would discredit the profession.
Falsifying the analysis would discredit Justin and the profession.
Credibility
 Communicate information fairly and objectively. Justin needs to perform an objective
analysis of Donnelly’s Pizza profitability and communicate the results fairly.

Disclose fully all relevant information that could reasonably be expected to influence an
intended user’s understanding of the reports, comments, and recommendations presented.
Justin needs to fully present an accurate analysis.
Confidentiality
 Not affected by this decision.
Justin should indicate to Sarathat the costs he has derived are correct. If Sara still insists on
making the changes to lower the costs to serve Donnelly’s Pizza, Justin should raise the
matter with Sara’s superior, after informing Sara of his plans. If, after taking all these steps,
there is a continued pressure to understate costs, Justinshould consider resigning from the
company rather than engage in unethical conduct.
12-44
12-50 (30 min.)
Equipment replacement decisions and performance evaluation.
1.
Operating income for the first year under the keep and replace alternatives are shown
below.
Year 1
Cash operating costs
Depreciation
($540,000  2; $900,000÷ 5)
Loss on disposal of old machine
($360,000 – $216,000; $0)
Total costs
Replace
With New
Machine
(1)
$ 800,000
270,000
144,000
$1,214,000
Keep Old
Machine
(2)
$ 995,000
Cost
Difference
by Replacing
(3) = (1) – (2)
$(195,000)
180,000
90,000
0
$1,175,000
144,000
$ 39,000
First-year costs are lower by $39,000 under the keep machine alternative, and Susan Smith, with
her one-year horizon and operating income-based bonus, will choose to keep the machine.
2.
Based on the analysis in the table below, Sanchez Manufacturing will be better off by
$66,000 over two years if it replaces the current equipment.
Comparing Relevant Costs of
Replace and Keep Alternatives
Cash operating costs
Current disposal price
One time capital costs, written off
periodically asdepreciation
Total relevant cashflow
Over 2 Years
Replace
Keep
(1)
(2)
$1,600,000
$1,990,000
(216,000)
0
540,000
$1,924,000
0
$1,990,000
Cash Outflow
By Replacing
(3) = (1) – (2)
$(390,000)
(216,000)
540,000
$ (66,000)
Note that the book value of the current machine ($360,000) would either be written off as
depreciation over two years under the keep option, or, all at once in the current year under the
replace option. Its net effect would be the same in both alternatives: to increase costs by
$360,000 over two years; hence, it is irrelevant in this analysis.
This problem illustrates the conflict between the decision model and the performance
evaluation model. From the perspective of Sanchez Manufacturing, the old machine should be
replaced. Over the longer two-year horizon, replacing the old machine with the new equipment
saves Sanchez Manufacturing $66,000. From a performance evaluation perspective, SusanSmith
prefers to keep the old machine because operating income in the first year will be $39,000 higher
if she keeps rather than replaces the old machine. Chapter 24 describes methods that companies
use to reduce the conflict between the decision model and the performance evaluation model.
12-45
3.
Smith would be willing to purchase the new equipment if the effect on operating income
in the first year would be zero or positive, that is, if the cost of operating the new equipment in
the first year were equal to or lower than the cost of operating the old machine.
From requirement 1, the cost difference in the first year from replacing the old machine
needs to be reduced by $39,000. This means that depreciation on the new equipment must be
$39,000 less than it is, so $270,000 – $39,000 = $231,000.
The new equipment is being depreciated over a two-year period with zero residual value
so the cost of the equipment equals $231,000  2 = $462,000. If the new equipment can be
purchased for $462,000 or less, SusanSmith will be willing to purchase it because the
performance evaluation model would be consistent with the decision model.
Note that over the two-year period, Sanchez Manufacturing will be better off purchasing
the new equipment for $462,000 by $144,000, as the following presentation of the analysis done
in requirement 2 shows:
Cash Outflow
by Replacing
Cash operating costs
Current disposal price
One-time capital costs, written off periodically as depreciation
Total relevant cash flow
12-46
–$390,000
–$216,000
+$462,000
–$144,000
Try It 12-1Solution
The relevant revenues and costs are the expected future revenues and costs that differ as a result
of Gannett accepting the special offer:
Revenues ($65 per hour × 800 hours)
$52,000
Variable landscaping costs ($60 per hour  800 hours)
Increase in operating income by accepting the one-time special order
48,000
$ 4,000
The fixed landscapingcosts and all marketing costs (including variable marketing costs) are
irrelevant in this case because these costs will not change in total whether the special order is
accepted or rejected. In this example, by focusing only on the relevant amounts, the manager
avoids a misleading implication: to reject the special order because the $65-per-hour selling price
is lower than the landscaping cost per hour of $68.33, which includes both relevant variable
landscaping costs and irrelevant fixed landscaping costs.
12-47
Try It 12-2 Solution
Gannett could use either the Total Alternatives Approach or the Opportunity-Cost Approach to
make a decision.
Total Alternatives Approach
The two options available to Gannett are
1. Do 9,400 hours of landscaping work for its current customers and 4,600 hours of work for
Gerald Corporation
2. Do 13,200 hours of landscaping work for its current customers
The table below presents the relevant revenues and relevant costs, those future revenues and
costs that differ between the alternatives. It shows that Gannett is better off rejecting Gerald’s
offer because it reduces operating income by $113,550 ($650,100 − $536,550).
Current customers: 9,400 hours
Gerald:
4,600 hours
Current customers: 13,200 hours
Relevant revenues
($115×9,400+$80×4,600)
$1,449,000
$1,518,000
($115×13,200)
Relevant costs
Variable landscaping costs
840,000
($60× 14,000)
792,000
($60×13,200)
Variable marketing costs
72,450
(5%×$1,449,000)
75,900
(5%×$1,518,000)
Total relevant costs
Relevant operating income
912,450
867,900
$ 536,550
$ 650,100
The Opportunity Cost Approach
In the opportunity-cost approach, the options are defined as follows
1. Accept Gerald’s offer for 4,600 hours of landscaping work
2. Reject Gerald’s offer
The analysis focuses only on Gerald’s offer.
We first calculate the opportunity cost of accepting Gerald’s offer.
There is no opportunity cost for the first 800 hours of equipment time since Gannett has 14,000
12-48
hours of equipment time and its current customers require only 13,200 hours.
For using the next 3,800 hours of equipment time on the Gerald offer, Gannett will have to forgo
contribution margin on the 3,800 hours of services it would have sold to its existing customers.
Revenue from 3,800 hours of landscaping for existing customers ($115×3,800 hours) $437,000
Variable costs of landscaping ($60 × 3,800 hours)
228,000
Variable marketing costs (5% × $437,000)
21,850
Contribution margin from 3,800 hours of landscaping from serving existing customers $187,150
The opportunity cost of accepting Gerald’s offer is $187,150.
We next focus only on Gerald’s offer and the effect on operating income from accepting it.
Accept Gerald’s offer
Incremental future revenues
Reject Gerald’s offer
$0
$368,000 ($80 × 4,600 hours)
Incremental future costs
Variable landscaping costs
Variable marketing costs
0
18,400 (5%×$368,000)
Opportunity cost of using
3,800 hours of equipment for
the Gerald offer and forgoing
the profit contribution on
existing customers
187,150
Total relevant costs
481,550
Effect on operating income of
accepting Gerald’s offer
0
276,000 ($60 × 4,600 hours)
$ (113,550)
0
0
$0
The opportunity cost approach yields the same conclusions as the total alternatives approach.
Gannett’s operating income decreases by $113,550 if it accepts Gerald’s offer. Note that by
considering only the incremental revenues and incremental costs, it would appear that Gannett
should accept Gerald’s offer because incremental revenues exceeds incremental costs of the
Gerald offer by $73,600 ($368,000 − $276,000– $18,400). But there is an opportunity cost of
$187,150 by using the equipment for Gerald’s business because the next-best use of this
equipment by Gannett would result in using 3,800 hours to service existing customers that would
increase operating income by $187,150. Unless the contract with Gerald results in more than
$187,150 in operating income, Gannett should reject the offer.
12-49
Try It 12-3Solution
This problem is one of making product (or customer)-mix decisions with capacity constraints.
Gannett’s managers should choose the product with the highest contribution margin per unit of
the constraining resource (equipment hours). That’s the resource that restricts or limits the sale
of Gannett’s services.
Contribution margin from regular customers:
Revenues ($115× 13,200 hours)
$1,518,000
Variable landscaping costs (largely labor), which vary
with the number of hours worked ($60 per hour × 13,200 hours)
792,000
Variable marketing costs (5% of revenue)
75,900
Total variable costs
867,900
Contribution margin
$ 650,100
Contribution margin per hour of equipment time from regular customers
($650,100÷13,200 hours)
$49.25 per hour
Contribution margin from Russell Corporation:
Revenues ($100 × 4,600 hours)
$460,000
Variable landscaping costs (largely labor), which vary
with the number of hours worked ($50 per hour × 4,600 hours)
230,000
Variable marketing costs (5% of revenue)
23,000
Total variable costs
253,000
Contribution margin
$207,000
Contribution margin per hour of equipment time from Hudson Corporation
($207,000÷4,600 hours)
$45.00 per hour
To maximize operating income, Gannett should allocate as much of its capacity to customers
who generate the most contribution margin per unit of the constraining resource (equipment).
That is, Gannett should first allocate equipment capacity to existing customers ($49.25 per hour)
and only the balance to Russell Corporation ($45.00 per hour). Gannett maximizes total
contribution margin by allocating 13,200 hours of equipment capacity to existing customers
yielding contribution margin of $650,100 ($49.25 per hour × 13,200hours) and only the balance
800 hours to Russell Corporation yielding contribution margin of $36,000 ($45.00 per hour ×
800hours) for a total contribution margin of $686,100 ($650,100 + $36,000).
12-50
Try It 12-4Solution
1.
Sloan should close down the Oakland store (see Exhibit Try It 12-4, Column 1). Closing
down the store results in a loss of revenues of $1,600,000 but cost savings of $1,605,000 (from
cost of goods sold, rent, labor, utilities, and corporate costs). Note that by closing down the
Oakland store, Sloan Corporation will save none of the equipment-related costs because this is a
past cost. Also note that the relevant corporate overhead costs are the actual corporate overhead
costs $90,000 that Sloan expects to save by closing the Oakland store. The corporate overhead of
$80,000 allocated to the Oakland store is irrelevant to the analysis.
2.
Exhibit Try It 12-4, Column 2, presents the relevant revenues and relevant costs of
opening another store like the Oakland store and shows that it increases Sloan’s operating
income by $34,000. Incremental revenues of $1,600,000 exceed the incremental costs of
$1,566,000 (from higher cost of goods sold, rent, labor, utilities, and some additional corporate
costs). Note that the cost of equipment written off as depreciation is relevant because it is an
expected future cost that Sloan will incur only if it opens the new store. Also note that the
relevant corporate overhead costs are the $9,000 of actual corporate overhead costs that Sloan
expects to incur as a result of opening the new store. Sloan may, in fact, allocate more than
$9,000 of corporate overhead to the new store, but this allocation is irrelevant to the analysis.
The key reason that Sloan’s operating income increases either if it closes down the Oakland
store or if it opens another store like it is the behavior of corporate overhead costs. By closing
down the Oakland store, Sloan can significantly reduce corporate overhead costs presumably by
reducing the corporate staff that oversees the Oakland operation. On the other hand, adding
another store like Oakland does not increase actual corporate costs by much, presumably because
the existing corporatestaff will be able to oversee the new store as well.
EXHIBIT TRY-IT 12-4
Relevant-Revenue and Relevant-Cost Analysis of Closing Oakland Store and Opening Another
Store Like It.
(Loss in Revenues)
and Savings in
Costs from Closing
Oakland Store
(1)
Revenues
Cost of goods sold
Variable operating costs (labor, utilities)
Lease rent
Depreciation of equipment
Corporate overhead costs
Total costs
Effect on operating income (loss)
$(1,600,000)
1,230,000
120,000
165,000
0
90,000
1,605,000
$ 5,000
12-51
Incremental
Revenues and
(Incremental Costs)
of Opening New Store
Like Oakland Store
(2)
$1,600,000
(1,230,000)
(120,000)
(165,000)
(42,000)
(9,000)
(1,566,000)
$ 34,000
CHAPTER 13
STRATEGY, BALANCED SCORECARD, AND
STRATEGIC PROFITABILITY ANALYSIS
13-1 Strategy specifies how an organization matches its own capabilities with the
opportunities in the marketplace to accomplish its objectives.
13-2 Competitors – companies in the industry have high fixed costs and persistent pressures to
reduce selling prices and utilize capacity fully.
Bargaining power of customers – customers negotiate aggressively to reduce prices because of
large quantity purchases.
13-3 Two generic strategies are (1) product differentiation, an organization’s ability to offer
products or services perceived by its customers to be superior and unique relative to the products
or services of its competitors, and (2) cost leadership, an organization’s ability to achieve lower
costs relative to competitors through productivity and efficiency improvements, elimination of
waste, and tight cost control.
13-4 A customer preference map describes how different competitors perform across various
product attributes desired by customers, such as price, quality, customer service, and product
features.
13-5 Reengineering is the fundamental rethinking and redesign of business processes to
achieve improvements in critical measures of performance such as cost, quality, service, speed,
and customer satisfaction.
13-6 The four key perspectives in the balanced scorecard are (1) Financial perspective—this
perspective evaluates the profitability of the strategy and the creation of shareholder value;
(2) Customer perspective—this perspective identifies the targeted customer and market segments
and measures the company’s success in these segments; (3) Internal business process
perspective—this perspective focuses on internal operations that further both the customer
perspective by creating value for customers and the financial perspective by increasing
shareholder value; and (4) Learning and growth perspective—this perspective identifies the
capabilities at which the organization must excel to achieve superior internal processes that
create value for customers and shareholders.
13-7 A strategy map is a diagram that describes how an organization creates value by
connecting strategic objectives in explicit cause-and-effect relationships with each other in the
financial, customer, internal-business-process, and learning-and-growth perspectives.
A balanced scorecard translates an organization’s mission and strategy into a set of performance
measures that provides the framework for implementing its strategy.
13-1
13-8 The financial perspective evaluates the profitability of the strategy and the creation of
shareholder value.
The customer perspective identifies targeted customer and market segments and measures a
company’s success in these areas.
13-9
1.
2.
3.
4.
5.
Pitfalls to avoid when implementing a balanced scorecard are the following:
Don’t assume the cause-and-effect linkages are precise; they are merely hypotheses. An
organization must gather evidence of these linkages over time.
Don’t seek improvements across all of the measures all of the time.
Don’t use only objective measures in the balanced scorecard.
Don’t fail to consider both costs and benefits of different initiatives before including
these initiatives in the balanced scorecard.
Don’t ignore nonfinancial measures when evaluating managers and employees.
13-10 Three key components in doing a strategic analysis of operating income are:
1.
The growth component, which measures the change in operating income attributable
solely to the change in quantity of output sold from one year to the next.
2.
The price-recovery component, which measures the change in operating income
attributable solely to changes in the prices of inputs and outputs from one year to the
next.
3.
The productivity component, which measures the change in costs attributable to a change
in the quantity and mix of inputs used in the current year relative to the quantity and mix
of inputs that would have been used in the previous year to produce current year output.
13-11 An analyst can incorporate other factors such as the growth in the overall market and
reductions in selling prices resulting from productivity gains into a strategic analysis of operating
income. By doing so, the analyst can attribute the sources of operating income changes to
particular factors of interests. For example, the analyst will combine the operating income effects
of strategic price reductions and any resulting growth with the productivity component to
evaluate a company’s cost leadership strategy.
13-12 Engineered costs result from a cause-and-effect relationship between the cost driver,
output, and the (direct or indirect) resources used to produce that output. Discretionary costs
arise from periodic (usually annual) decisions regarding the maximum amount to be incurred.
They have no measurable cause-and-effect relationship between output and resources used.
13-13 Downsizing (also called rightsizing) is an integrated approach configuring processes,
products, and people to match costs to the activities that need to be performed to operate
effectively and efficiently in the present and future. Downsizing is an attempt to eliminate
unused capacity.
13-14 A partial productivity measure is the quantity of output produced divided by the quantity
of an individual input used (e.g., direct materials or direct manufacturing labor).
13-15 No. Total factor productivity (TFP) and partial productivity measures work best together
because the strengths of one offset weaknesses in the other. TFP measures are comprehensive,
13-2
consider all inputs together, and explicitly consider economic substitution among inputs.
Physical partial productivity measures are easier to calculate and understand and, as in the case
of labor productivity, relate directly to employees’ tasks. Partial productivity measures are also
easier to compare across different plants and different time periods.
13-3
13-16 Choice “b” is correct. Since Jacobs is already established in its industry, profits will increase
when barriers to entry are higher because it helps to prevent new firms from entering the industry.
Significant up‐front capital requirements are high barriers to entry which make it more difficult for new
firms trying to enter into the industry and help keep profits higher for those firms already in the industry.
Choice “a” is incorrect. Profits will increase when buyers have higher switching costs because they are
less likely to search for other firms to meet their needs.
Choice “c” is incorrect. Profitability increases when there are many suppliers.
Choice “d” is incorrect. If rival firms are willing to spend a lot on advertising, Jacobs’ profits will likely
suffer as it tries to keep up with its competitors.
13-17 Choice ‘d’ is correct. All the options are correct. In order to sustain its long-run financial
performance, an organization must strengthen all links across its different balanced scorecard
perspectives, (choice ‘a’) which includes financial perspective; customer perspective, internal
business process perspective and learning and growth perspective. A major benefit of balances
scorecard is that it promotes causal thinking (choice ‘b’) where improvement in one activity
causes an improvement in another. To successfully implement a balanced scorecard, subordinate
managers and executives require commitment and leadership from top management (choice ‘c’).
13-18 Choice 2 is correct. The balanced scorecard divides performance measures into financial,
customer, internal business process, and learning and growth (item II) and internal business processes
are what the company does in its attempt to satisfy customers (item III). It is not a comprehensive
management information system as described in item I. Some students may interpret item I as only
describing multiple measures of performance to evaluate success. If interpreted this way, item I would
be a correct statement about the balanced scorecard. In this case, Choice 4 would be correct since all
three statements (I, II, and III) would be correct statements with respect to the balanced scorecard.
13-4
13-19
(15 min.)
Balanced scorecard.
1.
Pineway Electric’s 2020 strategy is a cost leadership strategy. Pineway plans to grow by
producing high-quality motors at a low cost delivered to customers at a low price and in a timely
manner. Pineway’s motors are not differentiated, and there are many other manufacturers who
produce similar motors. To succeed, Pineway must produce high-quality motors at lower costs
relative to competitors through productivity and efficiency improvements.
2.
Solution Exhibit 13-19A shows the customer preference map for electric motors for
Pineway and Ramsey on price, timeliness, quality, and design.
SOLUTION EXHIBIT 13-19A
Customer Preference Map for Electric Motors
Product Attributes
Price

Kearney
Ramsey
Pineway
Ridgecrest

Delivery Time

Quality

Design
1
2
3
4
Poor
5
Very good
Attribute Rating
13-5
3.
Solution Exhibit 13-19B presents the strategy map for Pineway for 2020.
SOLUTION EXHIBIT 13-19B
Strategy Map for Pineway for 2020
The strategy map indicates that developing process skill is an important objective because it has
a strong tie to improving manufacturing processes that is a trigger point that has strong ties to
improving productivity to reduce costs, improving quality, and delivering on-time, all of which
are necessary to increase customer satisfaction (a focal point). Improving productivity and
quality are distinctive objectives that give Pineway competitive advantage. The overlap between
strong ties and distinctive objectives means that Pineway has a very good ability to successfully
implement its strategy.
13-6
4.
Measures that we would expect to see on a Pineway’s balanced scorecard for 2020 are
Financial Perspective
(1) Operating income from productivity gain, (2) operating income from growth, (3) cost
reductions in key areas.
These measures evaluate whether Pineway has successfully reduced costs and generated
growth through cost leadership.
Customer Perspective
(1) Market share in electric motors market, (2) number of new customers, (3) customer
satisfaction index. The logic is that improvements in these customer measures are
leading indicators of whether Pineway’s cost leadership strategy is succeeding with its
customers and helping it to achieve superior financial performance.
Internal Business Process Perspective
(1) Productivity, (2) defect rates (2) order delivery time, (3) on-time delivery, (4) number of
major process improvements.
Improvements in these measures are key drivers of achieving cost leadership, quality, and
on-time delivery and are expected to lead to more satisfied customers and in turn to superior
financial performance
Learning and Growth Perspective
(1) Percentage of employees trained in process and quality management, (2) employee
satisfaction ratings.
Improvements in these measures aim to improve Pineway’s ability to achieve cost
leadership and have a cause-and-effect relationship with improvements in internal business
processes, which in turn lead to customer satisfaction and financial performance.
13-7
13-20 (20 min.)
Analysis of growth, price-recovery, and productivity components
(continuation of 13-19).
1.
Pineway’s operating income gain is consistent with the cost leadership strategy identified
in requirement 1 of Exercise 13-19. The increase in operating income in 2020 was driven by the
$145,000 gain in productivity in 2020. Pineway took advantage of its productivity gain to reduce
the prices of its motors and to fuel growth. It increased market share by growing even though
the total market size was unchanged.
2.
The productivity component measures the change in costs attributable to a change in the
quantity and mix of inputs used in a year relative to the quantity and mix of inputs that would
have been used in a previous year to produce the current year output. It measures the amount by
which operating income increases and costs decrease through the productive use of input
quantities. When comparing productivities across years, the productivity calculations use current
year input prices in all calculations. Hence, the productivity component is unaffected by input
price changes.
The productivity component represents savings in both variable costs and fixed costs.
With respect to variable costs, such as direct materials, productivity improvements immediately
translate into cost savings. In the case of fixed costs, such as fixed manufacturing conversion
costs, productivity gains result only if management takes actions to reduce unused capacity. For
example, reengineering manufacturing processes will decrease the capacity needed to produce a
given level of output, but it will lead to a productivity gain only if management reduces the
unused capacity by, say, selling off the excess capacity.
13-8
13-21 (20 min.)
Strategy, balanced scorecard, merchandising operation.
1.
Dhyanchand & Sons follows a product differentiation strategy. Dhyanchand’s designs are
“trendsetting,” its T-shirts are distinctive, and it aims to make its T-shirts a “must have” for each
and every teenager. These are all clear signs of a product differentiation strategy, and to succeed,
Dhyanchand must continue to innovate and be able to charge a premium price for its product.
2.
Possible key elements of Dhyanchand’s balance scorecard, given its product
differentiation strategy:
Financial Perspective
(1) Increase in operating income from charging higher margins,
(2) Price premium earned on products.
These measures will indicate whether Dhyanchand has been able to charge premium prices and
achieve operating income increases through product differentiation.
Customer Perspective
(1) Market share in distinctive, name-brand T-shirts,
(2) Customer satisfaction,
(3) New customers,
(4) Number of mentions of Dhyanchand’s T-shirts in the leading fashion magazines
Dhyanchand’s strategy should result in improvements in these customer measures that
help evaluate whether Dhyanchand’s product differentiation strategy is succeeding with its
customers. These measures are, in turn, leading indicators of superior financial performance.
Internal Business Process Perspective
(1) Quality of silk-screening (number of colors, use of glitter, durability of the design),
(2) Frequency of new designs,
(3) Time between concept and delivery of design
Improvements in these measures are expected to result in more distinctive and
trendsetting designs delivered to its customers and in turn, superior financial performance.
Learning and Growth Perspective
(1) Ability to attract and retain talented designers
(2) Improvements in silk-screening processes,
(3) Continuous education and skill levels of marketing and sales staff, (4) employee
satisfaction
Improvements in these measures are expected to improve Dhyanchand’s capabilities to produce
distinctive designs that have a cause-and-effect relationship with improvements in internal
business processes, which in turn lead to customer satisfaction and financial performance.
13-9
13-22 (25–30 min.) Strategic analysis of operating income (continuation of 13-21).
1.
Operating Income Statement
2019
2020
$6,560,000 $7,689,000
Revenues ($32 × 205,000; $33 × 233,000)
Costs
T-shirts purchased ($17 × 225,500; $15 × 257,000)
Administrative costs
Total costs
Operating income
3,833,500 3,855,000
1,739,000 1,691,000
5,572,500 5,546,000
$ 987,500 $2,143,000
Change in operating income
2.
$1,155,500 F
The Growth Component
Revenue effect
of growth
=
Actual units of 
 Actual units of
 output sold  output sold 


 in 2017

in 2016


Selling
×
price
in 2016
= (233,000  205,000)  $32 = $896,000 F
Cost effect of
=
growth for
variable costs
Actual units of 
 Units of input
 required to

input used



 produce 2017
to produce 


2016 ouput 
 output in 2016
Cost effect of
growth for
fixed costs
=
Input
×
price
in 2016
Actual 
 Actual units of capacity in
 2016 because adequate

units of



 capacity exists to produce
capacity 


in 2016 
 2017 output in 2016
Price per unit
×
of capacity
in 2016
Direct materials (purchased T-shirts) that would be required in 2020 to sell 233,000 T-shirts
instead of the 205,000 sold in 2019, assuming the 2019 input-output relationship continued into
 233,000

 225,500  . Administrative capacity will not
2020, equal 256,300 purchased T-shirts 
 205,000

change because adequate capacity exists in 2019 to support year 2020 output and customers.
The cost effects of growth component are
Direct materials costs
(256,300  225,500) 
Administrative costs
(4,700 – 4,700)

Cost effect of growth
13-10
$17
$370
=
=
$523,600 U
0
$523,600 U
In summary, the net increase in operating income as a result of the growth component equals:
Revenue effect of growth
$896,000 F
Cost effect of growth
523,600 U
Change in operating income due to growth
$372,400 F
The Price-Recovery Component
Revenue effect of
price-recovery
Actual units
Selling price 
 Selling price
=

  of output
in 2016 
 in 2017
sold in 2017
= ($33 $32)  233,000 = $233,000 F
Input  Units of input required
 Input


to produce 2017
price-recovery for =  price in  price in  ×


output in 2016
variable costs
2016 
 2017
Cost effect of
Actual units of capacity in
Price per 
 Price per
 unit of

2016 because adequate
unit of
 ×
price-recovery for = 

 capacity
capacity exists to produce
capacity 
fixed costs


2017 output in 2016
in 2016 
 in 2017
Cost effect of
Direct materials costs
($15  $17)  256,300 = $512,600 F
Administrative costs
($380  $370)  4,700 = 47,000 U
Total cost effect of price-recovery component
$465,600 F
In summary, the net increase in operating income as a result of the price-recovery component
equals:
Revenue effect of price-recovery
Cost effect of price-recovery
Change in operating income due to price-recovery
The Productivity Component
Units of input 
 Actual units of
Input
 input used

required to
  price
productivity for = 

 to produce
produce 2017 
in 2017
variable costs


ouput in 2016 
 2017 output
Cost effect of
Actual units of capacity in 
Price per
 Actual
 units of

2016 because adequate
  unit of
productivity for = 

 capacity capacity exists to produce 
capacity
fixed costs


in
2017
2017
output
in
2016
in 2017


Cost effect of
13-11
$233,000 F
465,600 F
$698,600 F
The productivity component of cost changes:
Direct materials costs
(257,000  256,300) 
Administrative costs
(4,450  4,700) 
Change in operating income due to productivity
$15 =
$380 =
$10,500U
95,000 F
$84,500 F
The change in operating income between 2019 and 2020 can be analyzed as follows:
Revenues
Costs
Operating income
Income
Statement
Amounts
in 2019
(1)
$6,560,000
Income
Revenue and Cost Effect
Statement
Revenue and Cost Effects of
of
Amounts
Cost Effects
PriceProductivit
in 2020
of Growth
Recovery
y
(5) =
in 2020
in 2020
in 2020 (1) + (2) + (3) +
(2)
(3)
(4)
(4)

$896,000 F
$233,000 F
$7,689,000
5,572,500
523,600 U
465,600 F
$84,500 F
5,546,000
$ 987,500
$372,400 F
$698,600 F
$84,500 F
$2,143,000
$1,155,500 F
Change in operating income
3.
The analysis of operating income indicates that growth, price-recovery, and productivity
all resulted in favorable changes in operating income in 2020. Further, a significant amount of
the increase in operating income resulted from Dhyanchand’s product differentiation strategy.
The company was able to continue to charge a premium price while growing sales even as the
cost of shirts decreased. It was also able to earn additional operating income by improving its
productivity.
13-12
13-23 (20 min.)
Analysis of growth, price-recovery, and productivity components
(continuation of 13-22).
Effect of the industry-market-size factor on operating income
Of the 28,000-unit (233,000 – 205,000) increase in sales between 2019 and 2020, 20,500
(10%  205,000) units are due to growth in market size, and 7,500 (28,000 – 20,500) units are
due to an increase in market share.
The change in Dhyanchand’s operating income from the industry-market size factor
rather than from specific strategic actions is:
$372,400 (the growth component in Exercise 13-22) 
20,500
28,000
Effect of product differentiation on operating income
The change in operating income due to:
Increase in the selling price (revenue effect of price recovery)
Decrease in price of inputs (cost effect of price recovery)
$272,650 F
$233,000 F
465,600 F
Growth in market share due to product differentiation
$372,400 (the growth component in Exercise 13-22) 
7,500
28,000
99,750 F
Change in operating income due to product differentiation
$798,350 F
Effect of cost leadership on operating income
The change in operating income from cost leadership is:
Productivity component
$ 84,500 F
The change in operating income between 2019 and 2020 can be summarized as follows:
Change due to industry-market-size
Change due to product differentiation
Change due to cost leadership
Change in operating income
$ 272,650 F
798,350 F
84,500 F
$1,155,500 F
Dhyanchand has been very successful in implementing its product differentiation
strategy. Nearly 69% ($798,350  $1,155,500) of the increase in operating income during 2020
was due to product differentiation, i.e., the distinctiveness of its T-shirts. It was able to raise
prices of its products despite a decline in the cost of the T-shirts purchased. Dhyanchand’s
operating income increase in 2020 was also helped by a growth in the overall market and a small
productivity improvement, which it did not pass on to its customers in the form of lower prices.
13-13
13-24 (15 min.)
Identifying and managing unused capacity (continuation of 13-21).
1.
The amount and cost of unused capacity at the beginning of year 2020 based on year
2020 production follows:
Administrative, 4,700  4,200; (4,700 – 4,200)  $380
Amount of
Cost of Unused
Unused Capacity
Capacity
500
$190,000
2.
Dhyanchand can reduce administrative capacity by another 250 customers (4,450 – 250 =
4,200 actual customers). Dhyanchand will save another 250  $380 = $95,000. This is the
maximum amount of costs Dhyanchand can save in 2020, in addition to the $95,000 ($380 × 250
customers) that Dhyanchand already saved when downsizing from 4,700 customers to 4,450
customers.
3.
Before Dhyanchand downsizes administrative capacity, it should consider whether sales
increases in the future would lead to a greater demand for and utilization of capacity as new
customers are drawn to Dhyanchand’s distinctive products—at that point, customer service may
be the key to new customer retention and further growth. Also, the market feedback often
provided by customer service staff is probably key to Dhyanchand’s cutting-edge fashion
strategy; some of this may be lost if administrative capacity is cut back. In addition, significant
reductions in capacity usually mean laying off people, which can hurt employee morale.
13-14
13-25 (15 min.)
Strategy, balanced scorecard.
1.
Methuen Corporation follows a product differentiation strategy in 2020. Methuen’s D4H
machine is distinct from its competitors and generally regarded as superior to competitors’
products. To succeed, Methuen must continue to differentiate its product and charge a premium
price.
2.
Balanced Scorecard measures for 2020 follow:
Financial Perspective
(1) Increase in operating income from charging higher margins, (2) price premium earned on
products
These measures indicate whether Methuen has been able to charge premium prices and
achieve operating income increases through product differentiation.
Customer Perspective
(1) Market share in industry, (2) customer satisfaction ratings, (3) number of new customers
Methuen’s strategy should result in improvements in these customer measures that help
evaluate whether Methuen’s product differentiation strategy is succeeding with its customers.
These measures are leading indicators of superior financial performance.
Internal Business Process Perspective
(1) Manufacturing quality and reduced wastage of direct materials, (2) new product features
added, (3) order delivery time
Improvements in these measures are expected to result in more distinctive products
delivered to its customers and in turn superior financial performance.
Learning and Growth Perspective
(1) Development time for designing new machines, (2) improvements in manufacturing
processes, (3) employee education and skill levels, (4) employee satisfaction
Improvements in these measures are likely to improve Methuen’s capabilities to produce
distinctive products that have a cause-and-effect relationship with improvements in internal
business processes, which in turn lead to customer satisfaction and financial performance.
13-15
13-26 (30 min.)
1.
Strategic analysis of operating income (continuation of 13-25).
Operating income for each year is as follows:
Revenue ($43,000  200; $45,000  210)
Costs
Direct materials costs ($7.25  310,000; $8  317,500)
Manufacturing conversion costs
Selling & customer service costs
Total costs
Operating income
Change in operating income
2.
2019
$8,600,000
2020
$9,450,000
2,247,500
2,540,000
2,145,000
2,172,500
1,045,000
900,000
5,437,500
5,612,500
$3,162,500
$3,837,500
$675,000 F
The Growth Component
= (210  200)  $43,000 = $430,000 F
Kilograms of direct materials that would be required in 2020 to produce 210 units instead of the
200 units produced in 2019, assuming the 2019 input-output relationship continued into 2020,
equal 325,500 kilograms (310,000/ 200)  210. Manufacturing conversion costs and selling and
customer-service capacity will not change because adequate capacity exists in 2019 to support
year 2020 output and customers.
The cost effects of growth component are:
Direct materials costs
(325,500  310,000) 
$7.25 =
Manufacturing conversion costs
(275  275)  $7,800 =
Selling & customer-service costs
(95  95)  $11,000 =
Cost effect of growth
$112,375 U
0
0
$112,375 U
In summary, the net increase in operating income as a result of the growth component equals:
Revenue effect of growth
$430,000 F
Cost effect of growth
112,375 U
Change in operating income due to growth
$317,625 F
The Price-Recovery Component
= ($45,000  $43,000)  210 = $420,000 F
13-16
Direct materials costs
Manufacturing conversion costs
Selling & customer-service costs
Cost effect of price-recovery
($8  $7.25)  325,500 = $244,125 U
($7,900  $7,800) 
275 = 27,500 U
($10,000  $11,000) 
95 = 95,000 F
$176,625 U
In summary, the net increase in operating income as a result of the price-recovery component equals:
Revenue effect of price-recovery
Cost effect of price-recovery
Change in operating income due to price-recovery
$420,000 F
176,625 U
$243,375 F
The Productivity Component
The productivity components of cost changes are:
Direct materials costs
(317,500  325,500) 
Manufacturing conversion costs
(275  275) 
Selling & customer-service costs
(90  95) 
Change in operating income due to productivity
$8 =
$7,900 =
$10,000 =
$64,000 F
0
50,000 F
$114,000 F
The change in operating income between 2019 and 2020 can be analyzed as follows:
Revenues
Costs
Operating income
Income
Statement
Amounts
in 2019
(1)
$8,600,000
5,437,500
$3,162,500
Revenue and
Cost Effects
of Growth
Component
in 2020
(2)
$430,000 F
112,375 U
$317,625 F
Revenue and
Cost Effect
Cost Effects of
of
Price-Recovery Productivity
Component
Component
in 2020
in 2020
(3)
(4)
$420,000 F

176,625 U
$114,000 F
$243,375 F
$114,000 F
$675,000 F
Income
Statement
Amounts in 2020
(5) =
(1) + (2) + (3) + (4)
$9,450,000
5,612,500
$3,837,500
Change in operating income
3.
The analysis of operating income indicates that a significant amount of the increase in
operating income resulted from Methuen’s product differentiation strategy. The company was
able to continue to charge a premium price while growing sales. Methuen was also able to earn
additional operating income by improving its productivity.
13-17
13-27 (20 min.)
Analysis of growth, price-recovery, and productivity components
(continuation of 13-25 and 13-26).
Effect of the industry-market-size factor on operating income
Of the 10-unit increase in sales from 200 to 210 units, 3% or 6 (3%  200) units is due to
growth in market size, and 4 (10  6) units is due to an increase in market share.
The change in Methuen’s operating income from the industry-market size factor rather
than from specific strategic actions is:
6
$317,625 (the growth component in Exercise 13-26) 
$190,575 F
10
Effect of product differentiation on operating income
The change in operating income due to:
Increase in the selling price of D4H (revenue effect of price recovery)
$420,000 F
Increase in price of inputs (cost effect of price recovery)
176,625 U
Growth in market share due to product differentiation
$317,625 (the growth component in Exercise 13-26) 
Change in operating income due to product differentiation
Effect of cost leadership on operating income
The change in operating income from cost leadership is:
Productivity component
4
10
127,050 F
$370,425 F
$ 114,000 F
The change in operating income between 2019 and 2020 can be summarized as follows:
Change due to industry-market-size
Change due to product differentiation
Change due to cost leadership
Change in operating income
$190,575 F
370,425 F
114,000 F
$675,000 F
Methuen has been successful in implementing its product differentiation strategy. 55%
($370,425  $675,000) of the increase in operating income during 2020 was due to product
differentiation, i.e., the distinctiveness of its machines. The company was able to raise the prices
of its machines faster than the costs of its inputs and still grow market share. Methuen’s
operating income increase in 2020 was also helped by a growth in the overall market and some
productivity improvements.
13-18
13-28 (15 min.)
Identifying and managing unused capacity (continuation of 13-25).
1.
The amount and cost of unused capacity at the beginning of year 2020 based on year
2020 production follows:
Manufacturing, 275  210; (275 – 210)  $7,900
Selling and customer service, 90 – 79; (90 – 79)  $10,000
2.
Amount of
Unused
Capacity
65
11
Cost of
Unused
Capacity
$513,500
110,000
40  $7,900 = $316,000.
3.
Methuen may choose not to downsize because it projects sales increases that would lead
to a greater demand for and utilization of capacity. Methuen may have also decided not to
downsize because downsizing requires a significant reduction in capacity. For example, Methuen
may have chosen to downsize some manufacturing capacity if it could do so in increments of
say, 10, rather than 40 units. Also, Methuen may be focused on product differentiation, which is
key to its strategy, rather than on cost reduction. Not reducing significant capacity also helps to
boost and maintain employee morale.
13-19
13-29 (15 min.)
Strategy, balanced scorecard, service company.
1.
Krater Associates’ strategy in 2020 is cost leadership. Krater’s architectural services are
not distinct from its competitors. The market for these services is very competitive. Krater plans
to grow by producing high-quality service at a low cost delivered to customers in a timely
manner.
2.
Balanced Scorecard measures for 2020 follow:
Financial Perspective
(1) Increase operating income from productivity gains and growth, (2) revenues per employee,
(3) cost reductions in key areas, for example, architect support
These measures indicate whether Krater has been able to lower costs and achieve
operating income increases through cost leadership.
Customer Perspective
(1) Market share, (2) number of new customers, (3) customer responsiveness index, (4) customer
satisfaction index
Krater’s strategy should result in improvements in these customer measures that help
evaluate whether Krater’s cost leadership strategy is succeeding with its customers. These
measures are leading indicators of superior financial performance.
Internal Business Process Perspective
(1) Time to complete customer jobs, (2) time lost due to errors, (3) quality of job (are the
architectural designs what the customer wanted?)
Improvements in these measures are key drivers of achieving cost leadership and are
expected to lead to more satisfied customers, lower costs, and superior financial performance.
Learning and Growth Perspective
(1) Time required to analyze and design steps, (2) time taken to perform key steps in the design
process, (3) skill levels of employees, (4) hours of employee training, (5) employee satisfaction
and motivation
Improvements in these measures are likely to improve Krater’s ability to achieve cost
leadership and have a cause-and-effect relationship with improvements in internal business
processes, customer satisfaction, and financial performance.
13-20
13-30 (30 min.)
1.
Strategic analysis of operating income (continuation of 13-29).
Operating income for each year is as follows:
Revenues ($36,000  44; $35,000  46)
Costs
Architect labor costs
($38  19,000; $39  30,000)
Software implementation support costs
($2,700  61; $2,900  61)
Total costs
Operating income
Change in operating income
2.
2019
$1,584,000
2020
$1,610,000
722,000
1,170,000
164,700
176,900
886,700
1,346,900
$ 697,300
$ 263,100
$434,200 U
The Growth Component
= (46 – 44)  $36,000 = $72,000 F
Architect labor-hours that would be required in 2020 to complete 46 jobs instead of the 44
jobs completed in 2019, assuming the 2019 input-output relationship continued into 2020, equal
(19,000/ 44)  46 = 19,864 labor-hours. Architect (software implementation) support capacity
would not change since adequate capacity exists in 2019 to support year 2020 output and
customers.
The cost effects of growth component are
Architect labor costs
(19,863.64 – 19,000)
Architect (Software implementation) support cost (61 – 61)
Cost effect of growth

$38 =
 $2,700 =
$32,832 U
0
$32,832 U
In summary, the net increase in operating income as a result of the growth component equals:
Revenue effect of growth
$72,000 F
Cost effect of growth
32,832 U
Change in operating income due to growth
$39,168 F
The Price-Recovery Component
=
($35,000 – $36,000)  46 = $46,000 U
13-21
Architect labor costs
($39 – $38)  19,864 =
Architect (Software implementation) support costs ($2,900 – $2,700)  61 =
Cost effect of price recovery
$19,864 U
12,200 U
$32,064 U
In summary, the net decrease in operating income as a result of the price-recovery component
equals:
Revenue effect of price-recovery
$46,000 U
Cost effect of price-recovery
32,064 U
Change in operating income due to price recovery
$78,064 U
The Productivity Component
The productivity component of cost changes are:
Architect labor costs
(30,000 – 19,864) 
Architect (Software implementation) support costs (61 – 61) 
Change in operating income due to productivity
$39
$2,900
= $395,304 F
=
0
$395,304 F
The change in operating income between 2019 and 2020 can be analyzed as follows:
Revenues
Costs
Operating income
Income
Statement
Amounts
in 2019
(1)
Revenue and
Cost Effects
of Growth
Component
in 2020
(2)
$1,584,000
886,700
$ 697,300
$72,000 F
32,832 U
$39,168 F
Revenue and
Income
Cost Effects of Cost Effect of
Statement
Price-Recovery Productivity
Amounts
Component
Component
in 2020
in 2020
in 2020
(5) =
(3)
(4)
(1) + (2) + (3) + (4)
$46,000 U

32,064 U $395,304 U
$78,064 U $395,304 U
$434,200 F
Change in operating income
$1,610,000
1,346,900
$ 263,100
3.
The analysis of operating income indicates that a significant amount of the decrease in
operating income resulted from Krater’s productivity loss in 2020. The company had to reduce
selling prices while architect labor costs were increasing but, most importantly, it experienced a
significant decline in its productivity. The unfavorable price recovery component indicates that
Krater could not pass on increases in labor-related wages via price increases to its customers,
13-22
very likely because the market was very competitive and its product was not differentiated from
competitors’ offerings.
13-23
13-31 (25 min.)
Analysis of growth, price-recovery, and productivity components
(continuation of 13-29 and 13-30).
Effect of industry-market-size factor on operating income
Of the 2-unit increase in sales from 44 to 46 jobs, 10% or 4.4 jobs (10%  44) are due to growth
in market size, and -2.4 (2  4.4) jobs are due to an decrease in market share.
The change in Krater’s operating income from the industry market-size factor rather than
from specific strategic actions is:
$39,168 (the growth component in Exercise 13-30)  (4.4/ 2)
$ 86,170 F
Effect of product differentiation on operating income
Increase in prices of inputs (cost effect of price recovery)
Effect of cost leadership on operating income
Productivity component
Effect of strategic decision to reduce selling price, $1,000  46
Growth in market share due to productivity improvement
and strategic decision to reduce selling price
$39,168 (the growth component in Exercise 13-30)  (-2.4/ 2)
Change in operating income due to cost leadership
$ 32,064 U
$395,304 U
46,000 U
47,002 U
$ 488,306 U
The change in operating income between 2019 and 2020 can then be summarized as
Change due to industry-market-size
Change due to product differentiation
Change due to cost leadership
Change in operating income
$ 86,170 F
32,064 U
488,306 U
$ 434,200 U
Krater has been very unsuccessful in implementing its cost leadership strategy. Despite the
strategic decrease in the selling price of a job by $1,000, the company was unable to grow its
market share. Most importantly, Krater suffered tremendous losses in productivity in 2020: It
look 30,000 architect labor-hours in 2020 to complete 46 jobs whereas it took 19,000 architect
labor-hours to complete 44 jobs in 2019.
13-24
13-32 (20 min.) Identifying and managing unused capacity (continuation of 13-29).
1.
The amount and cost of unused capacity at the beginning of year 2020 when Krater
makes its capacity decisions for the year based on work done in year 2020 follows:
Amount of Cost of
Unused
Unused
Capacity Capacity
Architect (software implementation) support, (61  46); (61  46)  $2,900
15
$43,500
2.
Krater can reduce architect (software implementation) support capacity from 61 jobs to
49 (61  15) jobs. Krater will save 15  $2,900 = $43,500. This is the maximum amount of costs
Krater can save by downsizing in 2020. It cannot reduce capacity further because it would then
not have enough capacity to do 46 jobs in 2020 (jobs that contribute significantly to operating
income).
3.
Krater may have chosen not to downsize because it projects sales increases in the near
term that would lead to greater demand for and utilization of capacity. Krater may have also
decided not to downsize because downsizing requires a significant reduction in capacity. For
example, Krater may have chosen to downsize some architect (software implementation) support
capacity if it could do so in, say, increments of 10, rather than 15 units. Not reducing significant
capacity by laying off employees boosts employee morale and keeps employees more motivated
and productive.
13-25
13-33 (15-20 min.) Balanced scorecard and strategy.
1.
R and J currently follows a cost leadership strategy, which is reflected in its lower price
compared to Stone Manufacturing. The Baxter vacuum is similar to products offered by
competitors just a simpler version. Stone Manufacturing is following a product differentiation
strategy by offering a product with more complex features at a higher price.
2. & 3.
To achieve its goals, R and J could include the following measures under each
perspective of the balanced scorecard:
Financial Perspective
Operating income from productivity and quality improvement
Operating income from growth
Revenue growth
Customer Perspective
Market share
Number of additional customers
Customer-satisfaction ratings
Internal-BusinessProcess Perspective
Percentage of defective products sold
Percentage of products that need to be reworked
Number of major improvements in manufacturing processes
Learning-and-Growth
Perspective
Employee-satisfaction ratings
Percentage of employees trained in quality management
Percentage of line workers empowered to manage processes
Percentage of manufacturing processes with real-time feedback
13-26
13-34 (30 min.) Strategic analysis of operating income.
1.
Operating income for each year is as follows:
Revenue ($125  15,000; $100  25,000)
Costs
Direct materials costs ($30  18,000; $30  27,000)
Conversion costs
Selling & customer service costs
Total costs
Operating income
Change in operating income
2.
2019
$1,875,000
2020
$2,500,000
540,000
810,000
660,000
616,000
35,000
38,000
1,235,000
1,464,000
$640,000
$1,036,000
$396,000 F
The Growth Component
= (25,000  15,000)  $125 = $1,250,000 F
Direct materials that would be required in 2020 to produce 25,000 units instead of the 15,000
units produced in 2019, assuming the 2019 input-output relationship continued into 2020, equal
(18,000/ 15,000)  25,000 = 30,000 kits. Conversion costs and selling and customer-service costs
will not change because adequate capacity exists in 2019 to support year 2020 output and
customers.
The cost effects of growth component are:
Direct materials costs
(30,000  18,000) 
Conversion costs
(30,000  30,000) 
Selling & customer-service costs
(200  200) 
Cost effect of growth
13-27
$ 30
$ 22
$ 175
= $360,000 U
=
0
=
0
$360,000 U
In summary, the net increase in operating income as a result of the growth component equals:
Revenue effect of growth
$1,250,000 F
Cost effect of growth
$360,000 U
Change in operating income due to growth
$890,000 F
The Price-Recovery Component
= ($100  $125)  25,000 = $625,000 U
($30 - $30)  30,000 = $0
($22 - $22)  30,000 = $0
($190 - $175)  200 = $3,000 U
$3,000 U
Direct materials costs
Conversion costs
Selling & customer-services costs
Cost effect of price-recovery
In summary, the net increase in operating income as a result of the price-recovery component
equals:
Revenue effect of price-recovery
$625,000 U
Cost effect of price-recovery
3,000 U
Change in operating income due to price-recovery
$628,000 U
The Productivity Component
The productivity componenst of cost changes are:
Direct materials costs
(27,000  30,000) 
Conversion costs
(28,000 – 30,000) 
Selling & customer-service costs
(200  200) 
Change in operating income due to productivity
$30 =
$22 =
$190 =
$90,000 F
44,000 F
0
$134,000 F
The change in operating income between 2019 and 2020 can be analyzed as follows:
Revenues
Income
Statement
Amounts
in 2019
(1)
$1,875,000
Revenue and
Cost Effects
of Growth
Component
in 2020
(2)
$1,250,000 F
Revenue and
Cost Effects of
Price-Recovery
Component
in 2020
(3)
$625,000 U
13-28
Cost Effect
of
Productivity
Component
in 2020
(4)

Income
Statement
Amounts
in 2020
(5) =
(1) + (2) + (3) + (4)
$2,500,000
Costs
Operating income
1,235,000
$640,000
360,000 U
$890,000 F
3,000 U
$628,000 U
$396,000 F
$134,000 F
$134,000 F
1,464,000
$1,036,000
Change in operating income
3.
XBlast successfully increased its operating income from 2019 to 2020. Input prices
remained largely stable from 2019 to 2020. By lowering the selling price, XBlast was able to sell
67% more HOV-Xs. In addition, XBlast was able to increase productivity of direct materials
costs and conversion costs.
13-29
13-35 (15-20 min.) Analysis of growth, price-recovery, and productivity components
(continuation of 13-34).
Effect of the industry-market-size factor on operating income
Of the 10,000-unit increase in sales from 15,000 to 25,000 units, 25% or 3,750 (25%  15,000)
units are due to growth in market size, and 6,250 (10,000  3,750) units are due to an increase in
market share.
The change in XBlast’s operating income from the industry-market size factor rather than from
specific strategic actions is:
$890,000 (the growth component in Exercise 13-34)  3,750/10,000
$333,750 F
Effect of product differentiation on operating income
The change in operating income due to:
Increase in price of inputs (cost effect of price recovery)
$ 3,000 U
Effect of cost leadership on operating income
The change in operating income from cost leadership is:
Productivity component
$134,000 F
Decrease in selling price (revenue effect of price recovery)
625,000 U
Growth in market share due to cost leadership
890,000 (the growth component in Exercise 13-34)  6,250/ 10,000 556,250 F
Change in operating income due to cost leadership
$ 65,250 F
The change in operating income between 2019 and 2020 can be summarized as follows:
Change due to industry market-size
Change due to product differentiation
Change due to cost leadership
Change in operating income
$333,750 F
3,000 U
65,250 F
$396,000 F
While the XBlast’s operating income increase in 2020 was largely helped by a growth in
the overall market size, XBlast has been successful in implementing its cost leadership strategy.
XBlast was able to increase its productivity and, by cutting its selling price, was able to gain
market share that might also benefit it in future periods.
13-30
13-36 (15-20 min.)
Identifying and managing unused capacity (continuation of 13-34).
1. The amount and cost of unused capacity at the beginning of year 2020 when XBlast makes its
capacity decisions for the year based on year 2020 production follows:
Manufacturing, 28,000  27,000; (28,000 – 27,000)  $22
Selling and customer service, 200 – 150; (200– 150)  $190
Amount of
Unused
Capacity
1,000
50
Cost of
Unused
Capacity
$22,000
$ 9,500
2.
XBlast can reduce selling and customer-service capacity 50 customers (200 – 150 = 50
customers). XBlast will save 50  $190 = $9,500. This is the maximum amount of costs XBlast
can save in 2020.
3.
XBlast may have chosen not to downsize because it projects sales increases in the near
term that would lead to greater demand for and utilization of selling and customer-service
capacity. It is difficult to reduce and then immediately increase capacity. Not reducing
significant capacity by laying off employees boosts employee morale and keeps employees more
motivated and productive.
13-31
13-37 (20-30 min.) Balanced scorecard.
Perspectives
▪ Financial
Strategic
Objectives
Performance
Measures
▪ Increase shareholder value
▪
▪
▪
▪
▪
▪
▪ Increase profit generated
by each salesperson
▪ Profit per salesperson
▪ Customer
▪ Acquire new customers
▪ Retain customers
▪ Develop profitable customers
▪
▪
▪
▪
▪ Internal Business
Process
▪ Improve manufacturing
quality
▪ Introduction of new products
▪ Percentage of defective
product units
▪ Number of new products
▪ Minimize invoice error rate
▪ On-time delivery by suppliers
▪ Percentage of error-free invoices
▪ Percentage of on-time deliveries
by suppliers
▪ Number of patents
▪ Increase proprietary products
▪ Learning and
Growth
▪ Increase information system
capabilities
▪ Enhance employee skills
13-32
Earnings per share
Net income
Return on assets
Return on sales
Return on equity
Product cost per unit
Number of new customers
Percentage of customers retained
Customer profitability
Customer cost per unit
▪ Percentage of processes with
real-time feedback
▪ Employee turnover rate
▪ Average job-related training
hours per employee
13-38 (20 min.) Balanced scorecard.
1.
Unearth’s strategy is to focus on “service-oriented customers” who are willing to pay a
higher price for services. Even though Petrol is largely a commodity product, Unearth wants to
differentiate itself through the service it provides at its retailing stations.
Does the scorecard represent Unearth’s strategy? By and large it does. The focus of the
scorecard is on measures of process improvement, quality, market share, and financial success
from product differentiation and charging higher prices for customer service. There are some
deficiencies that the subsequent assignment questions raise but, abstracting from these concerns
for the moment, the scorecard does focus on implementing a product differentiation strategy.
Having concluded that the scorecard has been reasonably well designed, how has Unearth
performed relative to its strategy in 2020? It appears from the scorecard that Unearth was
successful in implementing its strategy in 2020. It achieved all targets in the financial, internal
business, and learning and growth perspectives. The only target it missed was the market share
target in the customer perspective. At this stage, students may raise some questions about
whether this is a good scorecard measure. Requirement 3 gets at this issue in more detail. The
bottom line is that measuring “market share in the overall Petrol market” rather than in the
“service-oriented customer” market segment is not a good scorecard measure, so not achieving
this target may not be as big an issue as it may seem at first.
2.
Yes, Unearth should include some measure of employee satisfaction and employee
training in the learning and growth perspective. Unearth’s differentiation strategy and ability to
charge a premium price is based on customer service. The key to good, fast, and friendly
customer service is well-trained and satisfied employees. Untrained and dissatisfied employees
will have poor interactions with customers and cause the strategy to fail. Hence, training and
employee satisfaction are very important to Unearth for implementing its strategy. These
measures are leading indicators of whether Unearth will be able to successfully implement its
strategy and should be measured on the balanced scorecard.
3.
Unearth’s strategy is to focus on the 60% of Petrol consumers who are service-oriented,
not on the 40% price-shopper segment. To evaluate if it has been successful in implementing its
strategy, Unearth needs to measure its market share in its targeted market segment, “serviceoriented customer,” not its market share in the overall market. Given Unearth’s strategy, it
should not be concerned if its market share in the price-shopper segment declines. In fact,
charging premium prices will probably cause its market share in this segment to decline. Unearth
should replace “market share in overall Petrol market” with “market share in the service-oriented
customer segment” in its balanced scorecard customer measure. Unearth may also want to
consider putting a customer satisfaction measure on the scorecard. This measure should capture
an overall evaluation of customer reactions to the facility, the convenience store, employee
interactions, and quick turnaround. The customer satisfaction measure would serve as a leading
indicator of market share in the service-oriented customer segment.
4.
Although there is a cause-and-effect link between internal business process measures and
customer measures on the current scorecard, Unearth should add more measures to tighten this
linkage. In particular, the current scorecard measures focus exclusively on refinery operations
and not on gas station operations. Unearth should add measures of gas station performance such
as cleanliness of the facility, turnaround time at the gas pumps, the shopping experience at the
13-33
convenience store, and the service provided by employees. Many companies do random audits of
their facilities to evaluate how well their branches and retail outlets are performing. These
measures would serve as leading indicators of customer satisfaction and market share in
Unearth’s targeted segments.
5.
Unearth is correct in not measuring changes in operating income from productivity
improvements on its scorecard under the financial perspective. Unearth’s strategy is to grow by
charging premium prices for customer service. The scorecard measures focus on Unearth’s
success in implementing this strategy. Productivity gains per se are not critical to Unearth’s
strategy and, therefore, should not be measured on the scorecard.
13-34
13-39 (30 min.) Balanced scorecard.
1.
The market for color laser printers is competitive. Vic’s strategy is to produce and sell
high-quality laser printers at a low cost. The key to achieving higher quality is reducing defects
in its manufacturing operations. The key to managing costs is dealing with the high fixed costs of
Vic’s automated manufacturing facility. To reduce costs per unit, Vic would have to either
produce more units or eliminate excess capacity.
The scorecard correctly measures and evaluates Vic’s broad strategy of growth through
productivity gains and cost leadership. There are some deficiencies, of course, that subsequent
assignment questions will consider.
It appears from the scorecard that Vic was not successful in implementing its strategy in
2020. Although it achieved targeted performance in the learning and growth and internal
business process perspectives, it significantly missed its targets in the customer and financial
perspectives. Vic has not had the success it targeted in the market and has not been able to
reduce fixed costs.
2.
Vic’s scorecard does not provide any explanation of why the target market share was not
met in 2020. Was it due to poor quality? Higher prices? Poor post-sales service? Inadequate
supply of products? Poor distribution? Aggressive competitors? The scorecard is not helpful for
understanding the reasons underlying the poor market share.
Vic may want to include some measures in the customer perspective (and internal business
process perspective) that get at these issues. These measures would then serve as leading
indicators (based on cause-and-effect relationships) for lower market share. For example, Vic
should measure customer satisfaction with its printers on various dimensions of product features,
quality, price, service, and availability. It should measure how well its printers match up against
other color laser printers on the market. This is critical information for Vic to successfully
implement its strategy.
3.
Vic should include a measure of employee satisfaction to the learning and growth
perspective and a measure of new product development to the internal business process
perspective. The focus of its current scorecard measures is on processes and not on people and
products.
Vic considers training and empowering workers as important for implementing its highquality, low-cost strategy. Therefore, employee training and employee satisfaction should appear
in the learning and growth perspective of the scorecard. Vic can then evaluate if improving
employee-related measures results in improved internal-business process measures, market share
and financial performance.
Adding new product development measures to internal business processes is also
important. As Vic reduces defects, Vic’s costs will not automatically decrease because many of
Vic’s costs are fixed. Instead, Vic will have more capacity available to it. The key question is
how Vic will obtain value from this capacity. One important way is to use the capacity to
produce and sell new models of its products. Of course, if this strategy is to work, Vic must
develop new products at the same time that it is improving quality. Hence, the scorecard should
contain some measure to monitor progress in new product development. Improving quality
without developing and selling new products (or downsizing) will result in weak financial
performance. The new product development need not focus on designing innovative products
13-35
that can command a price premium because Vic’s strategy is one of cost leadership and not
product differentiation but rather on product extensions that could help it grow sales.
4.
Improving quality and significantly downsizing to eliminate unused capacity is difficult.
Recall that the key to improving quality at Vic Corporation is training and empowering workers.
As quality improvements occur, capacity will be freed up, but because costs are fixed, quality
improvements will not automatically lead to lower costs. To reduce costs, Vic’s management
must take actions such as selling equipment and laying off employees. But how can management
lay off the very employees whose hard work and skills led to improved quality? If it did lay off
employees now, will the remaining employees ever work hard to improve quality in the future?
For these reasons, Vic’s management should first focus on using the newly available capacity to
sell more products. If it cannot do so and must downsize, management should try to downsize in
a way that would not hurt employee morale, such as through retirements and voluntary
severance.
If it had to downsize, the preferred approach for Vic to follow is to first downsize by
laying off employees, assure the remaining employees that there will be no more layoffs, and
then seek to improve quality.
13-36
13-40 (20-25 min.) Balanced Scorecard and performance measurement in the
manufacturing industry.
Report To: The board of Monza
From: A. Accountant Date: September 2016
Subject: Performance measurement and management issues at Monza
This report addresses the problems of using the balanced scorecard within Monza. The current
and proposed performance measures are evaluated, and the main current measure is discussed in
detail. Quality costs and the new quality program at the manufacturing division are analyzed.
Finally, the lean philosophy is applied to the new information system for the drug development
division.
(i)
Problems with using the balanced scorecard
The balanced scorecard (BSC) provides no aggregate or single summary measure of performance
unlike the value-based approach. Also, there is no simple, direct link between shareholder value,
the main objective of Monza, and the balanced scorecard measures.
The measures in the scorecard can conflict, for example, cost controls (financial
perspective) can obstruct the investment needed in order to speed up manufacturing processes
(internal business perspective). Overall, the measures should seek to align with the fundamental
need to create shareholder value.
It can be difficult to select measures. In particular, there is the danger of losing sight of
key information in a plethora of indicators. This may be an issue for Monza as it has only had
three indicators in the past and this will now increase significantly (a potential of 12, if there is
one for each level of management in the four perspectives).
T
here must be management commitment to the change inthe scorecard. In particular, there
must not be a return to focus on the financial measures which have been used in the past at
Monza. Management should acquire the expertise for understanding non-financial measures
through training.
There are potentially significant costs in collecting the additional information which will
be needed for the new performance measures. Many of the measures will be non-financial and so
new information systems will be required to collect and record the data.
(ii)
Choice of current and proposed performance measures
Current measures
The current measures are all historic, financial ones and so the BSC approach will bring a
longer-term view by using non-financial measures which consider those factors which might
drive future growth, for example, those in the learning and growth perspective. The current
measures do not directly link to shareholder value which appears to be the overall aim of the
company. A measure such as economic value added would do this more effectively.
The three measures do give a broad view of financial performance. ROCE is a
widelyused measure through which it should be possible to benchmark against competitors. As
far as the divisions are concerned, there is a measure of success in selling through revenue
growth, though this may not be due to only the sales division but also the drugs brought to
13-37
market by the development division. Average cost to develop a new drug is a financial measure
of the development division’s performance but this does not measure its aim of innovation in
development. Indeed, this measure may conflict with that aim as cost control of development
may hinder innovative thinking. It would appear more appropriate to have a cost control measure
associated with manufacturing as its goal is to be more efficient. The performance of the
manufacturing division is only measured indirectly through its effect on the financial
performance of the company as a whole.
Consultants’ proposed measures
The suggested measures do not seem to deviate much from the existing measures, though there
may be an advantage in this as the new system would be using existing information systems and
known measures in that case. However, this advantage is secondary to the need to find measures
which will drive useful performance in the four perspectives.
The proposed measures from the consultants’ interim report mostly fit within the standard
four perspectives of the BSC, although revenue growth is more appropriate as a measure from
the financial perspective. Customer perspective measures should focus on the strategies which
will achieve success in the eyes of the customers rather than just measuring the results of those
strategies. Examples of this would be measuring the efficacy of the drugs which are developed
by Monza or the reputation of Monza’s medicines among the medical community.
Taking the others in turn, ROCE does not seem to be directly linked to shareholder value
as, for example, economic value added or net present value would be. ROCE considers the
performance over the whole capital base while the shareholders will be more directly concerned
with returns on their equity investment. As a profit-based measure, ROCE may also be failing to
target cash-generation which is ultimately driving dividend payments and value creation for
shareholders.
As already indicated, cost control in business processes is important but other measures
of success such as time to market for the development of new products and quality initiatives
should also be considered.
The fourth perspective is particularly relevant to a high-technology firm such as Monza.
There will be considerable competitive advantage in having a highly skilled workforce, however,
the measure proposed is imprecise as it values all training days, whether for knowledge workers
or unskilled laborers, as equally valuable. Measures of the number of innovations within each
division may be appropriate as these will be qualitatively different (new compounds developed,
manufacturing quality improvements and sales techniques/initiatives developed). Overall, the
initial proposed set of measures does appear limited and does not address the overall aim of
Monza or the problem of the narrowness of the existing set of measures.
13-38
13-41 (25 min.) Balanced Scorecard, social performance.
1.
The market for cable and Internet providers is competitive. Highland State’s strategy
follows a cost-leadership strategy—providing quality service at low cost by being efficient, and
effective.
The scorecard correctly measures and evaluates Highland State’s strategy of growth
through productivity gains and cost leadership. There are, however, some deficiencies that
subsequent assignment questions will consider.
It appears from the scorecard that Highland State was not successful in implementing its
strategy in 2020. Although it achieved targeted performance in most of the learning and growth
and internal business process perspectives, it significantly missed its targets in the customer and
financial perspectives. Highland State has not had the success it targeted in the market and has
not been able to improve efficiency in order to reduce costs.
Highland State’s scorecard does not provide an explanation of why the target customer
satisfaction measure was not met in 2020. Was it due to poor quality? Higher prices? Poor postsales service? Aggressive competitors? The scorecard is not helpful for understanding the
reasons underlying the poor customer satisfaction.
2.
Highland State should not include R&D costs in its internal business process perspective.
It should not focus on developing innovative services because it is not following a product
differentiation strategy. It needs to cut these costs and focus instead on providing customers a
quality service at the lowest costs, and faster and more efficient installation, consistent with its
low-cost strategy.
3. There is a cause-and-effect relationship between the installation time per customer and
customer satisfaction but not between money spent in R&D and customer satisfaction. As
discussed in requirement 2 above, I would drop the R&D measure. I would then add measures
for the quality of the installation service to the internal business process perspective. How much
time does it take to schedule an appointment after the customer calls? Does the service work
flawlessly after it has been installed? Do customers call Highland State to fix problems? How
much time is spent on post-installation support? The point is to add more measures to the internal
business process perspective so that Highland State can get a better understanding of the reasons
underlying increases and decreases in customer satisfaction.
In the customer perspective, I would add measures to track Highland State’s market share
in Barcelona. Do increases in customer satisfaction translate into higher market shares? Is
Highland State correctly identifying the factors that customers care deeply about and making
improvements in those areas faster than its competitors?
Although not required by the question, the instructor could ask the class what else
Highland State might want to include in the learning and growth perspective to support the
customer and internal business process perspectives. The learning and growth measures would
then serve as leading indicators (based on cause-and-effect relationships) for the internalbusiness processes and customer satisfaction. For example, Highland State could include a
measure related to employee satisfaction or retention. For example, higher employee satisfaction
would lead to greater ownership of employees in providing a quality service. This is critical for
Highland State to successfully implement its strategy.
13-39
4.
Highland State included social and environmental performance measures in its balanced
scorecard because it believes strong environmental and social performance gives it a competitive
advantage by (1) attracting and inspiring outstanding employees, (2) enhancing its reputation
with socially conscious customers, investors and analysts, and (3) boosting its image with
governments and citizens, all of which contribute to long-run financial performance. Highland
State also believes that focusing on environmental and social performance in addition to
financial performance helps it to innovate in technologies, processes, products, and business
models to reduce the trade-offs between financial and sustainability goals and build
transformational leadership and change capabilities to implement these “triple bottom line”
strategies.
Following the concept of shared value, Highland State includes social and environmental
measures (together with business goals and measures) in its balanced scorecard to evaluate how
well it is doing toward achieving its social and environmental goals. The balanced scorecard
indicates that Highland State’s social and environmental initiatives are having mixed results.
Highland State’s focus on safety certification training aims to decrease workplace injuries and to
reduce overall costs. So far, the safety certification goals have not been met and workplace
injuries have not been reduced to their target levels. Highland State would need to consider if the
safety certification training has been as effective as it was intended. Similarly increasing the
number of new programs with community organizations aims to increase the number of new
customers acquired as a result of these initiatives and in turn to increase revenue from new
customers. Even though the number of new programs started exceeded the target, it did not result
in the targeted number of new customers nor the target revenues from new customers. Highland
State would need to re-evaluate the kinds of new programs it is implementing.
Not all companies believe in implementing sustainability goals, but those that do find the
balanced scorecard to be a useful tool to simultaneously implement both financial and
sustainability goals.
13-40
13-42 (30 min.) Balanced scorecard, public sector.
(a)
As relatively simple measures of what an organization has achieved, it is unsurprising
that outputs can be attractive indicators of success. For example, the outputs from the body that
looks after roadworks might include the number of repairs completed, miles of roadway
refurbished or newly built, and at what cost. Outcomes can be more com-plex. They require an
organization to consider whether what it is doing is making a difference and to what. From our
previous example, this could include looking to see whether traffic flow is better, journey times
shorter, if there are fewer accidents, or if the works contributed to wider economic
development. Another example, improving the wellbeing of children in a certain area might
require an improvement across a range of areas – from housing standards to access to preschool care and education. Thus, collaboration might be required to achieve the best outcomes.
Benefits (rather than requirements) may arise across multiple organizations in the long term.
For example, links between outcomes across education, social care and health. Also, conflicts
can arise across public bodies due to conflicting objectives – social care and long-term benefits
of recipients staying in their community compared to the Police’s need to re-duce crime which
could lead to arrest and subsequent imprisonment through the criminal justice system.
(b)
The key motivation for a move to a Balanced Scorecard approach in the private sector is
to go beyond a focus solely on financial measures. In the public sector, however, much more
non-financial performance is measured as a matter of routine. Standard methods of
performance management, with suites of key performance indicators and reporting of progress
against actions, do tend to look at areas such as stakeholder satisfaction, staff satisfaction,
training and achievement of outcomes, but they are reported and presented in a less coherent
way than that with a Balanced Scorecard. Linkages, dependencies and relationships between
performance measures are often overlooked or not considered when the information is
displayed in the standard manner. Balanced scorecards can be more effective, as they are a way
of translating an organization’s strategy and mission into measures that can be monitored to
illustrate progress and success. They originated in the United States in the 1990s and were used
as a way of linking non-financial measures of success with the more commonlyused financial
measures (sales, profits, shareholder dividends, etc.)
There are four key areas in the traditional scorecard:
a. Financial Measures
b. Customer (External) Perspective
c. Internal Perspective
d. Learning & Growth Perspective
These have been adapted for the public sector, and some organizations have added further areas
to reflect better the different priorities for the public sector. Whilst developed initially for
businesses, the balanced scorecard approach has been adapted for public service organizations.
Clearly, the objectives and strategy of such an organization can still be translated into a
scorecard of performance measures:
 Financial Measures: budgets and other financial aspects (unit costs, for example).
 Customer Perspective: covers a range of stakeholders, including citizens, service
users, non- executive roles, regulators and Government.
13-41

Internal Perspective (Processes): the key processes for improving effective service
delivery, as well as some inward-looking strategic objectives which the organization
has set itself.
 Learning & Growth Perspective (People): the development of the organization’s
workforce and how the organization itself learns as it delivers services.
One example is for a local council in the United Kingdom – London Borough of Barking &
Dagenham: As part of their 2020 vision document, London Borough of Barking & Dagenham
have developed a balanced scorecard, with five elements, rather than the traditional four. In
addition to categories for ‘Customer First’, ‘Funding for the Future’, ‘People Matter’ and
‘Performance Counts’, there is an overarching category – ‘Community First’. This is to
recognize the Council’s role in community leadership, promoting the social, economic and
environmental well-being of the area. There is a strategic scorecard for the whole Council, with
performance indicators for each area, supplemented by a framework of service and scorecards,
bringing together a total of 200 performance indicators. Furthermore, the scorecard approach has
been adapted to produce a strategic approach for the Council, with 17 strategic objectives
(covering the basic four categories) which support 7 community objectives. Although in its early
stages, the Council say that this approach has already brought them a number of benefits
‘Because the scorecards link our externally focused community priorities to strategic objectives,
service priorities and individual performance measures they have helped to clarify the picture
and have direct relevance at many levels of the organization. Services are measurably improving
as performance management becomes valued.’
The advantages include:
1. A clear and easy to understand reporting tool and format for senior managers and other
stakeholders
2. It covers multiple aspects of an organization's performance and operation - e.g. not just
financial performance - so the impact of decisions can be monitored over these aspects
3. Grouping performance measures into areas can draw out links within such areas and
across different areas, given the sometimes complex and/or conflicting nature of public
sector objectives
Balanced Scorecards allow users to look at short-, medium- and longer-term issues through a
single "dashboard" To implement such an approach will need knowledge and experience of
successful change management, as there will often be a significant shift in mindsets and how the
organization looks at its own performance. As stated above, consensus on developing the
objectives, measures, targets and actions will be crucial and time should be devoted to achieving
this, utilizing proportional avenues of communication and engagement, as appropriate. The
benefits of a Balanced Scorecard approach will need to be sold to those involved, to win 'hearts
and minds' and ensure ownership and full engagement.
The disadvantages include:
1. Having four categories can present difficulties with determining which categories a
measure should go in
2. Can require a lot of resources in terms of time and cost
3. Information may be incomplete, therefore not giving an accurate overall picture
4. There may be a resistance within the organization, as the approach requires a different
mindset and processes from more conventional performance management
13-42
5. Difficult to use scientifically, as the link between financial investment, savings, and other
elements is not always known and may not be ‘proved’
6. While balanced, finance traditionally remains the overriding concern, i.e. other
dimensions are used to create better financial performance (profit). In public sectors, the
decision is more about the prioritization of scarce financial resources, which requires
some adaption and lateral thinking to the original model
(c) A BSC approach may not be suitable for every organization for some or all of these
reasons, but where resources and an open attitude to change are available, then pursuing
such a change in performance management and reporting can lead to a better
understanding of what an organization wants to achieve, and how it can go about
achieving it.
13-43
13-43 (20 min.)
1.
Partial productivity measurement.
Goldstein Company’s partial productivity ratios in 2020 are as follows:
Direct materials
partial productivity
= (Quantity of output produced in 2020/ Yards of direct materials used
in 2020)
= (3,348,000/ 2,160,000) = 1.55 wallets per yard
Conversion costs
partial productivity
= (Quantity of output produced in 2020/ Units of manuf. capacity in
2020)
= (3,348,000/ 3,100,000) = 1.08 wallets per unit of capacity
To compare partial productivities in 2020 with partial productivities in 2019, we first calculate
the inputs that would have been used in 2019 to produce year 2020’s 3,348,000 units of output
assuming the year 2019 relationship between inputs and outputs.
Direct materials
= 1,875,000 yards (2019)  (3,348,000 output units in 2020/
2,700,000 out put units in 2019)
= 1,875,000 yards  1.24 = 2,325,000 yards
Alternatively, we can calculate direct materials that would have been used in year 2019 to
produce year 2020’s 3,348,000 output as
1,875,000 yards  2,700,000 units = 0.6944 yards per unit  3,348,000 units = 2,325,000 yards.
Manufacturing capacity =
3,600,000 units of capacity, because manufacturing capacity is
fixed, and adequate capacity existed in 2019 to produce year 2020
output.
Partial productivity calculations for 2019 based on year 2020 output (to make the partial
productivities comparable across the two years):
Direct materials
partial productivity
= (Quantity of output produced in 2020/ Yard of direct materials that
would have been used in 2019 to produce year 2020 output)
= (3,348,000/ 2,325,000) = 1.44 wallets per yard
Conversion costs
partial productivity
= (Quantity of output produced in 2020/ Units of manufacturing
capacity that would have been used in 2019 to produce year 2020
output)
= (3,348,000/ 3,600,000) = 0.93 wallets per unit of capacity
13-44
The calculations indicate that Goldstein improved the partial productivity of direct materials and
conversion costs between 2019 and 2020 via efficiency improvements and by reducing unused
manufacturing capacity.
2.
Goldstein Company management can use the partial productivity measures to set targets
for the next year. Partial productivity measures can easily be compared over multiple periods.
For example, they may specify bonus payments if partial productivity of direct materials
increases to 1.95 units of output per yard and if partial productivity of conversion costs improves
to 1.25 units of output per unit of capacity. A major advantage of partial productivity measures is
that they focus on a single input; hence, they are simple to calculate and easy to understand at the
operations level. Managers and operators can also examine these numbers to understand the
reasons underlying productivity changes from one period to the next—better training of workers,
lower labor turnover, better incentives, or improved methods. Management can then implement
and sustain these factors in the future.
13-45
13-44 (25 min.) Total factor productivity (continuation of 13-43).
1.
Total factor productivity for 2020 using 2020 prices
= (Quantity of output produced in 2020/ Costs of inputs used in 2020 based on 2020 prices)
= (3,348,000/ [(2,160,000  $4.40) + ($10,540,000)])
= (3,348,000/ [$9,504,00 + $10,540,000])
= (3,348,000/ $20,044,000)
= 0.167 units of output per dollar of input
2.
By itself, the 2020 TFP of 0.167 units per dollar of input is not particularly helpful. We
need something to compare the 2020 TFP against. We use, as a benchmark, TFP calculated using
the inputs that Goldstein would have used in 2019 to produce 3,348,200 units of output at 2020
prices. Using the current year’s (2020) prices in both calculations control for input price
differences and focus the analysis on the adjustments the manager made in the quantities of
inputs in response to changes in prices.
2020 price of capacity =
=
=
Benchmark TFP
(Cost of capacity in 2020/ Capacity in 2020)
($10,540,000/ 3,100,000 units)
$3.40 per unit of capacity
= (Quantity of output produced in 2020/ Costs of inputs that would have
been used in 2019 to produce 2020 output at year 2020 input prices)
= (3,348,000/ [(2,325,000  $4.40) + (3,600,000  $3.40)])
= (3,348,000/ [$10,230,000 + $12,240,000])
= (3,348,000/ $22,470,000)
= 0.149 units of output per dollar of input
Using 2020 prices, total factor productivity increased 12.1% [(0.167  0.149)  0.149]
from 2019 to 2020.
3.
Total factor productivity increased because Goldstein produced more output per dollar of
input in 2020 relative to 2019, measured in both years using 2020 prices. The change in partial
productivity of direct materials and conversion costs tells us that Goldstein used less materials
and capacity in 2020 relative to output, than in 2019.
A major advantage of TFP over partial productivity measures is that TFP combines the
productivity of all inputs and so measures gains from using fewer physical inputs and
substitution among inputs.
Partial productivities cannot be combined to indicate the overall effect on cost as a result
of these individual improvements. The TFP measure allows managers to evaluate the change in
13-46
overall productivity by simultaneously combining all inputs to measure gains from using fewer
physical inputs as well as substitution among inputs.
13-47
Try It! 13-1
1.
The following is Nile's strategy map. The strong ties are indicated by bolder arrows, for
example, attracting and retaining quality employees and employee training, improving delivery
time, product offerings and customer service. Attracting and retaining quality employees and
employee training are also trigger points for improving delivery time, product offerings and
customer service. Achieving these internal business process objectives leads to higher customer
satisfaction which in turn increases market share, operating income growth and shareholder
value. The three internal business process perspectives are what make Nile distinctive. If Nile
can be better than its competitors in these perspectives, it has an excellent chance of achieving
consistent superior performance.
SOLUTION EXHIBIT TRY IT 13-1
Strategy Map for Nile Company
13-48
2.
To achieve its goals, Nile includes the following measures under each perspective of the
balanced scorecard related to its strategy map:
Financial Perspective
Customer Perspective
Internal-BusinessProcess Perspective
Learning-and-Growth
Perspective
Strategic Objective
Increase operating income:
Increase shareholder value:
Balanced Scorecard Measure
Operating income from product differentiation
Operating income from growth
Revenue growth
Increase market share:
Market share
Increase customer satisfaction:
Number of additional customers
Customer-satisfaction ratings
Reduce delivery time:
Average number of days to deliver product
Increase product offerings:
Number of new products available
Improve customer service:
Number of customer complaints
Improve quality of employee training:
Percentage of employees trained
Attract and retain quality employees:
Employee turnover of high-rated employees
Employee satisfaction
Enhance information system capabilities: Average system customer response time
13-49
Try It! 13-2
1.
Operating income for each year is as follows:
Revenues ($3,500  450; $3,300  650)
Costs
Engineering labor costs
($39  27,000; $40  32,000)
Engineering support costs
($310  850; $360  850)
Total costs
Operating income
Change in operating income
2019
$1,575,000
2020
$2,145,000
1,053,000
1,280,000
263,500
306,000
1,316,500
1,586,000
$ 258,500
$ 559,000
$300,500 F
2.
The Growth Component
=
(650 – 450)  $3,500 = $700,000
Engineering labor-hours that would be required in 2020 to complete 650 jobs instead of the
450 jobs done in 2019, assuming the 2019 input-output relationship continued into 2020, equal
(27,000/ 450)  650 = 39,000 labor-hours. Engineering support capacity would not change since
adequate capacity exists in 2019 to support year 2020 jobs.
The cost effects of growth component are
Engineering labor costs
Engineering support costs
Cost effect of growth
(39,000 – 27,000) 
(850 – 850) 
13-50
$39 = $468,000 U
$310 =
0
$468,000 U
In summary, the net increase in operating income as a result of the growth component equals:
Revenue effect of growth
$700,000 F
Cost effect of growth
468,000 U
Change in operating income due to growth
$232,000 F
The Price-Recovery Component
= ($3,300 – $3,500)  650 = $130,000 U
($40 – $39)  39,000
($360 – $310) 
850
Engineering labor costs
Engineering support costs
Cost effect of price recovery
=
=
$39,000 U
42,500 U
$81,500 U
In summary, the net decrease in operating income as a result of the price-recovery component
equals:
Revenue effect of price-recovery
$130,000 U
Cost effect of price-recovery
81,500 U
Change in operating income due to price recovery
$211,500 U
The Productivity Component
The productivity component of cost changes are:
Engineering labor costs
(32,000 – 39,000) 
Engineering support costs
(850 – 850) 
Change in operating income due to productivity
$40
$360
= $280,000 F
=
0
$280,000 F
The change in operating income between 2019 and 2020 can be analyzed as follows:
Income
Statement
Amounts
in 2019
(1)
Revenues
Costs
$1,575,000
1,316,500
Revenue and
Cost Effects
of Growth
Component
in 2020
(2)
Revenue and
Cost Effects of
Price-Recovery
Component
in 2020
(3)
Cost Effect of
Productivity
Component
in 2020
(4)
$130,000 U
81,500 U

$280,000 F
$700,000 F
468,000 U
13-51
Income
Statement
Amounts
in 2020
(5) =
(1) + (2) + (3) + (4)
$2,145,000
1,586,000
Operating income
$ 258,500
$232,000 F
$211,500 U $280,000 F
$300,500 F
Change in operating income
$ 559,000
3.
The analysis of operating income indicates that a significant amount of the increase in
operating income resulted from Costa’s productivity improvements in 2020. The company had to
reduce selling prices while labor costs were increasing but it was able to increase operating
income by improving its productivity. The productivity gains also allowed Costa to be
competitive and grow the business. The unfavorable price recovery component indicates that
Costa could not pass on increases in labor-related wages via price increases to its customers (it,
in fact, had to decrease prices), very likely because its product was not differentiated from
competitors’ offerings.
13-52
Try It! 13-3
Effect of industry-market-size factor on operating income
Of the 200 jobs increase in sales from 450 to 650 jobs, 14% or 63 jobs (14%  450) are due to
growth in market size, and 137 (200  63) jobs are due to an increase in market share.
The change in Costa’s operating income from the industry market-size factor rather than
from specific strategic actions is:
$232,000 (the growth component in Try It 13-2)  (63/ 200)
$ 73,080 F
Effect of product differentiation on operating income
Increase in prices of inputs (cost effect of price recovery)
Effect of cost leadership on operating income
Productivity component
Effect of strategic decision to reduce selling price, $200  650
Growth in market share due to productivity improvement
and strategic decision to reduce selling price
$232,000 (the growth component in Try It 13-2)  (137/ 200)
Change in operating income due to cost leadership
$ 81,500 U
$280,000 F
130,000 U
158,920 F
$308,920 F
The change in operating income between 2019 and 2020 can then be summarized as
Change due to industry-market-size
Change due to product differentiation
Change due to cost leadership
Change in operating income
$ 73,080 F
81,500 U
308,920 F
$300,500 F
Costa has been very successful in implementing its cost leadership strategy. Despite the
increase in the cost of engineering labor and engineering support, Costa strategically decreased
the selling price of a job by $200. That is, Costa took advantage of its productivity gains to
reduce price, gain market share, and increase operating income.
13-53
Try It! 13-4
1.
The amount and cost of unused capacity at the beginning of year 2020 when Costa makes
its capacity decisions for the year based on jobs done in year 2020 follows:
Amount of
Unused
Capacity
Engineering support 850  650; (850  650)  $360
200
Cost of
Unused
Capacity
$72,000
2.
Costa can reduce engineering support capacity by 200 jobs from 850 jobs to 650 jobs.
Costa will save 200  $360 = $72,000. This is the maximum amount of costs Costa can save by
downsizing in 2020. It cannot reduce capacity further (by another 50 jobs to 600 jobs) because it
would then not have enough capacity to do 650 jobs in 2020 (jobs that contribute significantly to
operating income).
3.
Costa may have chosen not to downsize because it projects sales increases in the near
term that would lead to greater demand for and utilization of capacity. Costa may have also
decided not to downsize because downsizing requires a significant reduction in capacity and
capability of the organization. Not reducing significant capacity by laying off employees boosts
employee morale and keeps employees more motivated and productive.
13-54
CHAPTER 14
PRICING DECISIONS AND COST MANAGEMENT
14-1 The three major influences on pricing decisions are
1.
Customers
2.
Competitors
3.
Costs
14-2 Not necessarily. For a one-time-only special order, the relevant costs are only those costs
that will change as a result of accepting the order. In this case, full product costs will rarely be
relevant. It is more likely that full product costs will be relevant costs for long-run pricing
decisions.
14-3 Four purposes of cost allocation are as follows:
1.
To provide information for economic decisions
2.
To motivate managers and other employees
3.
To justify costs or compute reimbursement amounts
4.
To measure income and assets
14-4 Activity-based costing helps managers in pricing decisions in two ways.
1.
It gives managers more accurate product-cost information for making pricing decisions.
2.
It helps managers to manage costs during value engineering by identifying the cost
impact of eliminating, reducing, or changing various activities.
14-5 Two alternative approaches to long-run pricing decisions are the following:
1.
Market-based pricing, an important form of which is target pricing. The market-based
approach asks, “Given what our customers want and how our competitors will react to what we
do, what price should we charge?”
2.
Cost-based pricing which asks, “What does it cost us to make this product and, hence,
what price should we charge that will recoup our costs and achieve a target return on
investment?”
14-6 A target cost per unit is the estimated long-run cost per unit of a product (or service) that,
when sold at the target price, enables the company to achieve the targeted operating income per
unit.
14-7 Value engineering is a systematic evaluation of all aspects of the value-chain business
functions, with the objective of reducing costs while satisfying customer needs. Value
engineering via improvement in product and process designs is a principal technique that
companies use to achieve target cost per unit.
14-8 A value-added cost is a cost that customers perceive as adding value, or utility, to a
product or service. Examples are costs of materials, direct labor, tools, and machinery. A
nonvalue-added cost is a cost that customers do not perceive as adding value, or utility, to a
product or service. Examples of nonvalue-added costs are costs of rework, scrap, expediting, and
breakdown maintenance.
14-1
14-9 No. It is important to distinguish between when costs are locked in and when costs are
incurred because it is difficult to alter or reduce costs that have already been locked in.
14-10 Cost-plus pricing is a pricing approach in which managers add a markup to cost in order
to determine price.
14-11 Cost-plus pricing methods vary with the bases used to calculate prices. Examples are
(a) variable manufacturing costs; (b) manufacturing function costs; (c) variable product costs;
and (d) full product costs.
14-12 Life-cycle budgeting is an estimate of the revenues and costs attributable to each product
from its initial R&D to its final customer servicing and support.
14-13 Three benefits of using a product life-cycle reporting format are the following:
1.
The full set of revenues and costs associated with each product becomes more visible.
2.
Differences among products in the percentage of total costs committed at early stages in
the life cycle are highlighted.
3.
Interrelationships among business function cost categories are highlighted.
14-14 Price discrimination is the practice of charging different customers different prices for the
same product or service. An example is an airlines aiming to charge business travelers higher
prices by charging a higher price for tickets that do not include a Saturday night.
14-15 Peak-load pricing is the practice of charging a higher price for the same product or service
when demand approaches the physical limit of the capacity to produce that product or service.
An example is Uber Technologies Inc. using surge pricing during high-demand times such as on
Saturday nights.
14-2
14-16 Choice "b" is the correct answer. The statement is incorrect because a product with a perfectly
inelastic demand would not see demand change as prices change.
Choice "a" is incorrect. This statement is true. Perfectly inelastic demand indicates that the demand will
stay nearly the same as prices change.
Choice "c" is incorrect. This statement is true. When demand is price elastic, lower prices stimulate
demand (and profit).
Choice "d" is incorrect. This statement is true. When demand is price elastic, higher prices reduce
demand.
14-3
14-17 (25-30 min.) Value-added, nonvalue-added costs.
1.
Category
Value-added costs
Examples
a. Materials and labor for regular repairs
Nonvalue-added costs
b. Rework costs
c. Expediting costs caused by work delays
g. Breakdown maintenance of equipment
Total
$
Gray area
d. Materials handling costs
e. Materials procurement and inspection costs
f. Preventive maintenance of equipment
Total
$
$1,100,000
90,000
65,000
75,000
$ 230,000
80,000
45,000
55,000
$ 180,000
Classifications of value-added, nonvalue-added, and gray area costs are often not clear-cut.
Other classifications of some of the cost categories are also plausible. For example, some
students may include materials handling, materials procurement, and inspection costs and
preventive maintenance as value-added costs (costs that customers perceive as adding value and
as being necessary for good repair service) rather than as in the gray area. Preventive
maintenance, for instance, might be regarded as value-added because it helps prevent nonvalueadding breakdown maintenance.
2.
Total costs in the gray area are $180,000. Of this, we assume 60%, or $108,000, are
value-added and 40%, or $72,000, are nonvalue-added.
Total value-added costs: $1,100,000 + $108,000
$1,208,000
Total nonvalue-added costs: $230,000 + $72,000
302,000
Total costs
$1,510,000
Nonvalue-added costs are $302,000 ÷ $1,510,000 = 20% of total costs.
Value-added costs are $1,208,000 ÷ $1,510,000 = 80% of total costs.
14-4
3.
Program
(a) Quality improvement programs to
• reduce rework costs by 40% (0.40 $90,000)
• reduce expediting costs by 40%
(0.40 $65,000)
• reduce materials and labor costs by 5%
(0.05  $1,100,000)
Total effect
(b) Working with suppliers to
• reduce materials procurement and inspection costs by
20% (0.20  $45,000)
• reduce materials handling costs by 30%
(0.30 $80,000)
Total effect
Transferring 60% of gray area costs (0.60
$33,000 = $19,800) as value-added and 40%
(0.40 $33,000 = $13,200) as nonvalue-added
Effect on value-added and nonvalue-added costs
(c) Maintenance programs to
• increase preventive maintenance costs by 70%
(0.70  $55,000)
• decrease breakdown maintenance costs by 50%
(0.50  $75,000)
Total effect
Transferring 60% of gray area costs (0.60 $38,500 =
$23,100) as value-added and 40% (0.40 $38,500 =
$15,400) as nonvalue-added
Effect on value-added and nonvalue-added costs
Total effect of all programs
Value-added and nonvalue-added costs calculated in
requirement 2
Expected value-added and nonvalue-added costs after
implementing these programs
Effect on Costs Classified as
ValueNonvalueGray
Added
Added
Area
–$36,000
– 26,000
–$ 55,000
–$ 55,000
–$ 62,000
–$9,000
–24,000
– 33,000
–$ 19,800
–$ 19,800
–$13,200
–$13,200
+33,000
$ 0
+$38,500
–$37,500
37,500
–
+$23,100
+$ 23,100
–$ 51,700
+15,400
–$ 22,100
–$ 97,300
1,208,000
302,000
$1,156,300
$204,700
+ 38,500
–38,500
$
0
If these programs had been implemented, total costs would have decreased from $1,510,000
(requirement 2) to $1,156,300 + $204,700 = $1,361,000, and the percentage of nonvalue-added
costs would decrease from 20% (requirement 2) to $204,700 ÷ $1,316,000 = 15%. These are
significant improvements in Magill’s performance.
Some students might question whether Magill should implement program (c) because the
costs of preventive maintenance of $38,500 exceeds the cost of breakdown maintenance of
$37,500. The instructor may want to point out that if all costs of breakdown maintenance (loss of
reputation, disruption of schedules etc.) are fully accounted for (which they are probably not),
Magill may wish to not do preventive maintenance reducing costs by another $1,000. This may
also cause students to debate why preventive maintenance is in the gray area of costs. It is value
added only when the preventive maintenance activity reduces breakdown maintenance costs.
14-5
14-18 (25–30 min.) Target operating income, value-added costs, service company.
1.
The classification of total costs in 2020 into value-added, nonvalue-added, or in the gray
area in between follows:
Value
Gray
NonvalueTotal
Added
Area
added
(4) =
(1)
(2)
(3)
(1)+(2)+(3)
Doing calculations and preparing drawings
77% × €390,000
€300,300
€300,300
Checking calculations and drawings
3% × €390,000
€11,700
11,700
Correcting errors found in drawings
8% × €390,000
31,200
31,200
Making changes in response to client
requests 5% × €390,000
19,500
19,500
Correcting errors to meet government
building code, 7% × €390,000
27,300
27,300
Total professional labor costs
319,800 11,700
58,500
390,000
Administrative and support costs at 44%
(€171,600 ÷ €390,000) of professional
labor costs
140,712
5,148
25,740
171,600
Travel
15,000
—
15,000
Total
€475,512 €16,848
€84,240
€576,600
Doing calculations and responding to client requests for changes are value-added costs because
customers perceive these costs as necessary for the service of preparing architectural drawings.
Costs incurred on correcting errors in drawings and making changes because they were
inconsistent with building codes are nonvalue-added costs. Customers do not perceive these costs
as necessary and would be unwilling to pay for them. Europa should seek to eliminate these costs
by making sure that all associates are well-informed regarding building code requirements and by
training associates to improve the quality of their drawings. Checking calculations and drawings
is in the gray area (some, but not all, checking may be needed). There is room for disagreement
on these classifications. For example, checking calculations may be regarded as value added.
2. The consequences of classifying a non-value-added cost as a value-added cost is that
managers may hesitate to reduce these costs thinking that if they eliminate these costs it would
reduce the value or utility (usefulness) customers experience from using the product or service.
But if these costs are really non-value-added costs, mangers should try to reduce these costs
because these costs support activities that customers do not value.
For these reasons, managers who are unsure if a cost is value-added or nonvalue-added,
often classify costs as nonvalue-added. The nonvalue-added classification focuses organization
attention on reducing these costs. The risk with this approach is that an organization may cut
some costs that are value-adding, leading to poor customer experiences. Distinguishing valueadded from nonvalue-added costs is valuable but also requires the exercise of careful judgment.
14-6
3.
Reduction in professional labor-hours by
a. Correcting errors in drawings (8% × 7,500)
b. Correcting errors to conform to building code (7% × 7,500)
Total
Cost savings in professional labor costs (1,125 hours × €52)
Cost savings in variable administrative and support
costs (44% × €58,500)
Total cost savings
Current operating income in 2020
Add cost savings from eliminating errors
Operating income in 2020 if errors eliminated
600 hours
525 hours
1,125 hours
€ 58,500
25,740
€ 84,240
€124,650
84,240
€208,890
4.
Currently 85% × 7,500 hours = 6,375 hours are billed to clients generating revenues of
€701,250. The remaining 15% of professional labor-hours (15% × 7,500 = 1,125 hours) is lost in
making corrections. Europa bills clients at the rate of €701,250 ÷ 6,375 = €110 per professional
labor-hour. If the 1,125 professional labor-hours currently not being billed to clients were billed
to clients, Europa’s revenues would increase by 1,125 hours × €110 = €123,750 from €701,250 to
€825,000 (€701,250 + €123,750).
Costs remain unchanged
Professional labor costs
Administrative and support (44% × €390,000)
Travel
Total costs
Europa’s operating income would be
Revenues
Total costs
Operating income
€390,000
171,600
15,000
€576,600
€825,000
576,600
€248,400
Operating income would increase by €123,750 (€248,400 – €124,650) or 99.3% (€123,750 ÷
€124,650). Eliminating 15% of nonvalue-added costs results in a doubling of operating income if
the resources saved could be used to generate revenues. For this reason, organizations place great
emphasis on reducing and eliminating nonvalue-added costs.
14-7
14-19 (25-30 min.) Target prices, target costs, activity-based costing.
1.
Snappy’s operating income in 2019 is as follows:
Total for
250,000 Tiles
(1)
$1,000,000
750,000
25,000
120,000
60,000
955,000
$ 45,000
Revenues ($4  250,000)
Purchase cost of tiles ($3  250,000)
Ordering costs ($50  500)
Receiving and storage ($30  4,000)
Shipping ($40  1,500)
Total costs
Operating income
Per Unit
(2) = (1) ÷ 250,000
$4.00
3.00
0.10
0.48
0.24
3.82
$0.18
2.
Price to retailers in 2020 is 95% of 2019 price = 0.95  $4 = $3.80; cost per tile in 2020 is
96% of 2019 cost = 0.96  $3 = $2.88.
Snappy’s operating income in 2020 is as follows:
Revenues ($3.80  250,000)
Purchase cost of tiles ($2.88  250,000)
Ordering costs ($50  500)
Receiving and storage ($30  4,000)
Shipping ($40  1,500)
Total costs
Operating income
Total for
250,000 Tiles
(1)
$950,000
720,000
25,000
120,000
60,000
925,000
$ 25,000
Per Unit
(2) = (1) ÷ 250,000
$3.80
2.88
0.10
0.48
0.24
3.70
$0.10
3.
Snappy’s operating income in 2020, if it makes changes in ordering and material handling,
will be as follows:
Total for
250,000 Tiles
Per Unit
(1)
(2) = (1) ÷ 250,000
$950,000
$3.80
Revenues ($3.80  250,000)
720,000
2.88
Purchase cost of tiles ($2.88  250,000)
5,000
0.02
Ordering costs ($25  200)
87,500
0.35
Receiving and storage ($28  3,125)
60,000
0.24
Shipping ($40  1,500)
872,500
3.49
Total costs
$ 77,500
$0.31
Operating income
Through better cost management, Snappy will be able to achieve its target operating income of
$0.30 per tile despite the fact that its revenue per tile has decreased by $0.20 ($4.00 – $3.80),
while its purchase cost per tile has decreased by only $0.12 ($3.00 – $2.88).
14-8
14-20 (20 min.)
Target costs, effect of product-design changes on product costs.
1. and 2.Manufacturing costs of HJ6 in 2019 and 2020 are as follows:
2019
Total
(1)
$3,780,000
Direct materials, $1,400 × 2,700; $1,300 × 4,600
Batch-level costs (setup, prodn.-order, matl. handlg.)
$8,900 × 60; $8,000 × 70
534,000
Manuf. operations costs,
$64 × 20,000; $48 × 30,000
1,280,000
Engineering change costs,
$16,000 × 24; $8,000 × 7
384,000
Total
$5,978,000
3.
Per Unit
(2) =
(1) ÷ 2,700
$1,400
2020
Per Unit
Total
(4) =
(3)
(3) ÷ 4,600
$5,980,000 $1,300
198
560,000
122
474
1,440,000
313
142
$2,214
56,000
$8,036,000
12
$1,747
Target manufacturing cost Manufacturing cost
per unit of HJ6 in 2017 = per unit in 2016 × 95%
= $2,214 × 0.95 = $2,103
Actual manufacturing cost per unit of HJ6 in 2020 was $1,747. Hence, Neuro did achieve its
target manufacturing cost per unit.
4.
To reduce the manufacturing cost per unit in 2020, Neuro reduced the cost per unit in
each of the four cost categories—direct materials costs, batch-level costs, manufacturing
operations costs, and engineering change costs. It also reduced machine-hours, reduced the
number of batches by increasing the size of each batch and decreased the number of engineering
changes made—the quantities of the cost drivers. In 2019, Neuro used 7.407 machine-hours per
unit of HJ6 (20,000 machine-hours  2,700 units). In 2020, Neuro used 6.522 machine-hours per
unit of HJ6 (30,000 machine-hours  4,600 units). In 2019 Neuro needed 60 batches to produce
2,700 units or 45 (2,700 ÷ 60) units per batch. In 2020, Neuro produced 4,600 unit in 70 batches
or 66 (4,600 ÷ 70) units per batch. Neuro reduced engineering changes from 24 in 2019 to 7 in
2020. Neuro achieved these gains through value engineering activities that retained only those
product features that customers wanted while eliminating nonvalue-added activities and costs.
5.
Neuro’s managers might encounter the following challenges in achieving the target costs:
•
Employees may feel they are being pushed too hard to attain target costs. The actual
costs in 2020 are well below the target costs.
•
Employees may feel that the severe cost cutting may result in quality problems that
they will then be blamed for, such as not making the necessary engineering changes
Organizational conflicts may develop as the burden of cost cutting falls unequally on
different business functions in the company’s value chain
•
To overcome these challenges, managers should: (1) encourage employee participation and
engagement; (2) focus on the customer; (3) clearly communicate goals and the strategy behind
them; and (4) set cost-cutting targets for all value-chain functions to encourage a culture of
teamwork and cooperation.
14-9
14-21 (25 min.) Target costs, effect of process-design changes on service costs.
1. and 2.Audit costs in 2019 and 2020 are as follows:
2019
Total
Per unit
(2)=
(1) ÷ 150
Consultation labor
$35 × 2.2 hrs. × 150; $35 × 2 hrs. × 178
$11,550.00
$ 77.00
Cost of new contacts, $9 × 215; $7 × 275
1,935.00
12.90
Travel costs, $0.55 × 1,756; $0.65 × 1,327
965.80
6.44
Preparing and filing costs
$9.10 × 1,218; $9.50 × 1,367
11,083.80
73.89
Total
$25,534.60
$170.23
3.
2020
Total
Per unit
(4)=
(3) ÷ 178
$12,460.00
1,925.00
862.55
$ 70.00
10.81
4.85
12,986.50
$28,234.05
72.96
$158.62
Target cost per audit in 2020 = Cost per audit in 2019 × 95%
= $170.23 × 0.95 = $161.72
Actual cost per audit in 2020 was $158.62. Hence, Sun Systems did achieve its target cost per
audit of $161.72. In spite of rising transportation costs and clerical wages, the company was able
to reduce the cost per audit in 2020. This was possible by reducing the number of miles driven
per appointment from 11.7 miles (1,756 ÷ 150) in 2019 to 7.5 miles (1,327 ÷ 178)in 2020. This
could be due to a implementing a better scheduling system to maximize the number of
appointments in a given area. Also, the number of clerical hours per audit decreased from 8.12
hours (1,218 ÷ 150) in 2019 to 7.68 hours (1,367 ÷ 178) in 2020. This could be due to process
improvements in preparing the required forms. There is also a reduction in consultant labor hours
and consultation labor cost per audit. Presumably, there is no reduction in customer satisfaction.
4. The challenges Sun Systems may face in achieving their target cost include employee
resistance to changes in processes, unexpected increases in the cost of supplies, fuel, etc., and
new compliance requirements imposed from the federal and/or state governments that increase
clerical time on each audit. To overcome these challenges, Sun Systems managers should
encourage employee participation and celebrate small improvements toward achieving the target
cost and set cost-cutting targets after taking into account the external environment such as cost of
supplies and new compliance requirements. Managers should create a culture where employees
are encouraged to continuously improve the energy audit process.
14-10
14-22 (20 min.) Cost-plus target return on investment pricing.
1.
Target operating income = target return on investment  invested capital
Target operating income (20% of $1,000,000)
$200,000
Total fixed costs
340,000
Target contribution margin
$540,000
Target contribution per room-night, ($540,000 ÷ 16,000)
Add variable costs per room-night
Price to be charged per room-night
Proof
Total room revenues ($37.75  16,000 room-nights)
Total costs:
Variable costs ($4  16,000)
Fixed costs
Total costs
Operating income
$33.75
4.00
$37.75
$604,000
$ 64,000
340,000
404,000
$200,000
The full cost of a room = variable cost per room + fixed cost per room
The full cost of a room = $4 + ($340,000 ÷ 16,000) = $4 + $21.25 = $25.25
Markup per room
= Rental price per room – Full cost of a room
= $37.75 – $25.25 = $12.50
Markup percentage as a fraction of full cost = $12.50 ÷ $25.25 = 49.5%
2.
If price is reduced by 10%, the number of rooms Branch could rent would increase by 10%.
The new price per room would be 90% of $37.75
$ 33.975
The number of rooms Branch expects to rent is 110% of 16,000
17,600
The contribution margin per room would be $33.975 – $4
$ 29.975
Contribution margin ($29.975  17,600)
$527,560
Because the contribution margin of $527,560 at the reduced price of $33.975 is less than
the contribution margin of $540,000 at a price of $37.75, Branch should not reduce the price of
the rooms. Note that the fixed costs of $340,000 will be the same under the $37.75 and the
$33.975 price alternatives and hence, are irrelevant to the analysis.
14-11
14-23 (25 min.) Cost-plus, target pricing, working backwards.
1.
Investment
Return on investment
Operating income (12%  $2,400,000)
Operating income per unit ($288,000  3,200)
Full cost per unit (90 ÷ 0.08)
Selling price ($1,125 + $90)
Markup percentage on variable cost ($90  $500)
$2,400,000
12%
$288,000
$90
$1,125
$1,215
18%
Total fixed costs = (Full cost per unit – Variable cost per unit)  Units sold
= ($1,125 – $500)  3,200 units = $2,000,000
2.
Contribution margin per unit = $1,215 – $500 = $715
Increase in sales = 10%  3,200 units = 320 units
Increase in contribution margin = $715  320 units =
Less: Advertising costs
Increase in operating income
$228,800
175,000
$ 53,800
Tin Roof should spend $175,000 in advertising because it increases operating income by
$53,800.
3.
Revenues ($1,215 × 2,900 units)
Target full cost at 8% markup ($3,523,500 ÷ 1.08)
Less: Target total fixed costs ($2,000,000 – $125,000)
Target total variable costs
Divided by number of units
Target variable cost per unit
14-12
$3,523,500
$3,262,500
1,875,000
$1,387,500
÷
2,900 units
$ 478.45
14-24 Life-cycle budgeting and costing.
1.
Projected Life Cycle Income Statement
Revenues [$375 × (10,000 + 40,000 + 5,000)]
Variable costs:
Months 7–12 ($100 × 10,000 )
$20,625,000
1,000,000
Months 13–36 ($78 × 40,000 )
3,120,000
Months 37–42 ($67 × 5,000 )
335,000
Total variable costs
Fixed costs:
Design costs
Production ($1,300,000 + $4,900,000 + $800,000)
Marketing ($1,000,000 + $2,325,000 + $475,000)
Distribution ($200,000 + $700,000 + $100,000)
Total fixed costs
Life cycle operating income
4,455,000
500,000
7,000,000
3,800,000
1,000,000
12,300,000
$ 3,870,000
Average profit per sweeper = $3,870,000/(10,000 + 40,000 + 5,000) = $70.36
2.
Projected Life Cycle Income Statement (in 000s)
Months 7–12
Revenues ($375 × 10,000)
Variable costs:
Months 7–12 ($100 × 10,000 )
$3,750,000
1,000,000
Fixed costs:
Production
Marketing
Distribution
Total fixed costs
Operating income
1,300,000
1,000,000
200,000
2,500,000
$ 250,000
Average profit per sweeper = $250,000/10,000 = $25
Projected Life Cycle Income Statement (in 000s)
Months 13–36
Revenues ($375 × 40,000)
Variable costs:
$15,000,000
14-13
Months 13-36 ($78 × 40,000 )
3,120,000
Fixed costs:
Production
Marketing
Distribution
Total fixed costs
Operating income
4,900,000
2,325,000
700,000
7,925,000
$ 3,955.000
Average profit per sweeper = $3,955,000/40,000 = $98.88
Projected Life Cycle Income Statement (in 000s)
Months 37–42
Revenues ($375 × 5,000)
Variable costs:
Months 37–42 ($67 × 500 )
$ 1,875,000
335,000
Fixed costs:
Production
Marketing
Distribution
Total fixed costs
Operating income
800,000
475,000
100,000
1,375,000
$ 165.000
Average profit per sweeper = $165,000/5,000 = $33.00
3.
In analyzing the relative profitability of the product during the three sales phases of its
life cycle, the results are as expected. During the initial growth phase, all fixed costs, including
marketing, are higher in order to successfully launch the new product. In addition, variable costs
are higher per unit because the company has not yet capitalized on economies of scale. As the
product moves into its maturity phase, the company begins to see the benefits of economies of
scale and leaner production practices. The results are lower variable and fixed costs. Also, the
company will likely not need to spend as much on marketing because the product in now well
established. This phase results in the highest profit per unit. Lastly, in the decline phase, variable
costs per unit are the lowest because the company is maximizing its efficiencies. Marketing is at
its lowest because the company is expecting to phase out the product. However, during this final
phase of the product’s life cycle, fixed costs per unit are higher than in the maturity phase
because the company is not maximizing its production volume. The company is producing
fewer units, which leads to higher fixed cost per unit. The product is still more profitable than in
the growth phase, but not as profitable as in maturity.
The company may need to analyze the probability that the price will be able to remain constant
through the product’s entire life cycle. Because technology is rapidly changing, this product may
become obsolete sooner than expected. The company also has not accounted for the time value
of money, which may make a big difference in the desired outcome, depending on the
14-14
company’s required rate of return. In addition, the company has not budgeted for all possible
expenses such as warranty claims and returns. These should be considered as well in the overall
plan. Lastly, the company may want to investigate possible methods of value engineering to
gain even more efficiencies and profitability over the life of the product.
4.
Projected Life Cycle Income Statement
Revenues [$425 × 9,500 + $375 × (38,000 + 5,000)]
Variable costs:
Months 7–12 ($100 × 9,500 )
Months 13–36 ($78 × 38,000 )
$20,162,500
950,000
2,964,000
Months 37–42 ($67 × 5,000 )
335,000
Total variable costs
Fixed costs:
Design costs
Production ($1,300,000 + $4,900,000 + $800,000)
Marketing ($1,000,000 + $2,325,000 + $475,000)
Distribution ($200,000 + $700,000 + $100,000)
Total fixed costs
Life cycle operating income
4,249,000
500,000
7,000,000
3,800,000
1,000,000
12,300,000
$ 3,613,500
Average profit per sweeper = $3,613,500/(9,500 + 38,000 + 5,000) = $68.83
Jurgensen earns more profit under its original plan ($3,870,000) than it does if it increases the
price to $425 for the first six months ($3,613,500). The decline in sales as a result of increasing
the price reduces operating income. Therefore, Jurgensen should price the sweepers at $375 for
the first six months rather than increase the price to $425.
14-15
14-25 (25 min.)
Considerations other than cost in pricing decisions.
1.
Guest nights on weeknights:
18 weeknights × 100 rooms × 65% = 1,170
Guest nights on weekend nights:
12 weekend nights × 100 rooms × 90% = 1,080
Total guest nights in June = 1,170 + 1,080 = 2,250
Breakfasts served:
1,170 weeknight guest nights × 2 = 2,340
1,080 weekend guest nights × 4 = 4,320
Total breakfasts served in June = 2,340 + 4,320 = 6,660
Total costs for June:
Depreciation
Administrative costs
Fixed housekeeping and supplies
Variable housekeeping and supplies (2,250 × $30)
Fixed breakfast costs
Variable breakfast costs (6,660 × $6)
Total costs for June
Cost per guest night ($198,460 ÷ 2,250)
Revenue for June ($85 × 2,250)
Total costs for June
Operating income/(loss)
$ 25,000
38,000
16,000
67,500
12,000
39,960
$198,460
$88.20
$191,250
198,460
$ (7,210)
New weeknight guest nights
18 weeknights × 100 rooms × 75% = 1,350
New weekend guest nights
12 weeknights × 100 rooms × 90% = 1,080
Total guest nights in June l = 1,350 + 1,080 = 2,430
Breakfasts served:
1,350 weeknight guest nights × 2 = 2,700
1,080 weekend guest nights × 4 = 4,320
Total breakfasts served in June = 2,700 + 4,320 = 7,020
Total costs for June:
Depreciation
Administrative costs
Fixed housekeeping and supplies
Variable housekeeping and supplies (2,430 × $30)
Fixed breakfast costs
Variable breakfast costs (7,020 × $6)
Total costs
Revenue [(1,350 × $75) + (1,080 × $105)]
Total costs for June
Operating income
$ 25,000
38,000
16,000
72,900
12,000
42,120
$206,020
$214,650
206,020
$ 8,630
2.
14-16
Yes, this pricing arrangement would increase operating income by $15,840 from an
operating loss of $7,210 to an operating income of $8,630 ($8,630 + $7,210 = $15,840).
3.
Guests typically do not come to the amusement park on weekdays because adults are
busy at work and children have to attend school. The weeknight guests are families who stay at
the hotel for convenience. They are willing to consider other hotel options or even not travel at
all if the price is high and unaffordable. Reducing the weeknight price is important to entice
families to try to come to the amusement park on weekdays. The demand of weeknight guests is
elastic.
In contrast, weekends are really the only time when families can conveniently come to
the amusement park given their busy weekday schedules. The demand of pleasure travelers on
weekends is inelastic. Because of the differences in preferences of the weeknight and weekend
guests, Fun Stay Express can price discriminate between these guests by charging $30 more on
weekends than on weeknights and still have weekend travelers stay at the hotel.
4.
Fun Stay Express would need to charge a minimum of $48 per night for the last-minute
rooms, an amount equal to the variable cost per room. Variable cost per room night = $30 per
room night + $6 × 3 breakfasts = $48. Any price above $48 would increase Executive Suites
operating income
14-17
14-26 (25 min.)
Cost-plus, target pricing, working backward.
1.
In the following table, work backward from operating income to calculate the selling
price.
Selling price
$
9.17 (plug)
Less: Variable cost per unit
2.25
Unit contribution margin
$
6.92
Number of units produced and sold
× 500,000 units
Contribution margin
$3,460,000
Less: Fixed costs
3,250,000
Operating income
$ 210,000
a) Total sales revenue = $9.17  500,000 units = $4,585,000
b) Selling price = $9.17 (from above)
Alternatively,
Operating income
$ 210,000
Add fixed costs
3,250,000
Contribution margin
3,460,000
Add variable costs ($2.25 × 500,000 units)
1,125,000
Sales revenue
$4,585,000
Selling price = (Sales revenue/ Units sold) = ($4, 585,000/ 500,000) = $9.17
c) Rate of return on investment = (Operating income/ Total investment in assets)
= ($210,000/ $2,500,000) = 8.4%
d)
2.
Markup % on full cost
Total cost = ($2.25  500,000 units) + $3,250,000 = $4,375,000
Unit cost = ($4,375,000/ 500,000) = $8.75
Markup % = ($9.17 - $8.75)/ $8.75 = 4.8%
Or ($4,585,000 - $4,375,000)/ $4,375,000 = 4.8%
New fixed costs
New variable costs
New total costs
New total sales (4.8%
markup)
New selling price
Alternatively,
New unit cost
New selling price
=$3,250,000 – $250,000 = $3,000,000
= $2.25 – $0.75 = $1.50
= ($1.50 × 500,000 units) + $3,000,000 = $3,750,000
= $3,750,000  1.048 = $3,930,000
= $3,930,000 ÷ 500,000 units = $7.86
= $3,750,000 ÷ 500,000 units = $7.50
= $7.50  1.048 = $7.86
14-18
3.
New units sold = 500,000 units × 85% = $425,000 units
Budgeted Operating Income
for the Year Ending December 31, 20xx
Revenues ($7.86  425,000 units)
Variable costs ($1.50  425,000 units)
Contribution margin
Fixed costs
Operating income
$3,340,500
637,500
2,703,000
3,000,000
$ (297,000)
4.
The CEO has not considered customers in these pricing decisions. Will customers
continue to want the product at these prices? What are competitors doing? The CEO should take
a more market-based approach to pricing.
The CEO should also think about the effect of cost cutting on employee participation and
morale and whether the cuts are falling disproportionately on any specific value-chain function.
14-19
14-27 (30 min.)Value engineering, target pricing, and target costs.
1.
Product design and licensing
$1,000,000
Direct materials
1,800,000
Direct manufacturing labor
1,200,000
Variable manufacturing overhead
600,000
Fixed manufacturing overhead
2,000,000
Fixed marketing
3,000,000
Total cost
$9,600,000
Cost per unit ($9,600,000 ÷ 400,000)
$24.00
Target cost per unit ($38 × 0.60)
$22.80
The original cost estimate of $9,600,000 does not meet the company’s requirements.
Value engineering will be needed to reduce the cost per unit to the target cost.
Tiffany’s operating income will be $5,600,000 ($38 × 400,000 – $9,600,000)
2.
Total cost
Less: Reduction in material costs ($1,800,000 × 45%)
Add: Increase in design costs
Total costs of redesigned table
Revised cost per unit ($9,090,000 ÷ 400,000 units)
Target cost per unit ($38 × 0.60)
$9,600,000
(810,000)
300,000
$9,090,000
$22.73
$22.80
The design change allows the table to meet its goal of target costs less than
60% of revenue and target operating income greater than 40% of revenue. The cost of
materials is a locked-in cost because they are designed into the product formula.
3.
Total cost
Add: Increase in marketing costs
Total costs of redesigned table
Revised cost per unit ($10,000,000 ÷ 400,000 units)
Target cost per unit ($42 × 0.60)
$ 9,600,000
400,000
$10,000,000
$25
$25.20
Yes, this proposal does allow the company to meet its goal of target costs less than 60% of
revenue and target operating income greater than 40% of revenue.
4.
The company has many considerations, both quantitative and qualitative, when deciding
between the preceding requirements 2 and 3. Although both options meet the target costing
objectives, they will provide different amounts of income in both the short and potentially long
term. In the short term, the alternative in requirement 2 will result in income of ($38 × 400,000)
– $9,090,000 = $6,110,000. The alternative in requirement 3 will provide a higher income of
($42 × 400,000) – $10,000,000 = $6,800,000 and will be preferred.
In the long run, however, there are other considerations that might favor the alternative in
requirement 2 and using the chemical equivalent of the nectar obtained from the plant in South
14-20
America. For example, will the nectar become more expensive in future periods? If so, could
the product be reengineered at a later time or are the materials locked-in with the design for the
full product life cycle. If the company chemically engineers the material, will this tarnish the
quality of the product or more importantly, the company’s brand image? How might this affect
the price in future periods and/or the sales of other products within the company?
14-21
14-28 (30 min.) Target service costs, value engineering, activity-based costing.
1.
Weekly Revenue:
55,000 patrons  $35
Desired profit margin:
$1,925,000  35%
Targeted weekly cost
Targeted cost per patron; $1,251,250 ÷ 55,000
Weekly costs:
Ticket sales
Online ticket sales: 55,000  15%  $1
On-site sales: 55,000  85%  $2
Ticket verification: 55,000  $1.50
Operating attractions: 11,340a runs  $90.00
Litter patrol: 1,750b 20
Total weekly costs
Cost per patron: $1,239,850 ÷ 55,000
Operating profit: ($1,925,000 – $1,239,850)
a
$1,925,000
673,750
$1,251,250
$22.75
$8,250
93,500
82,500
1,020,600
35,000
$1,239,850
$22.54
$ 685,150
6 runs per hour  10 hours per day  7 days per week  27 attractions = 11,340 runs per week
(25 acres ÷ 1 acre per hour)  10 hours per day  7 days per week = 1,750 litter patrol hours
Lagoon does achieve its target profit of 35% of revenues.
b
2.
Weekly Revenue:
55,000 patrons  $33
Weekly costs
Ticket sales:
Online ticket sales: 55,000  40%  $0.75 + $1,000
On-site sales: 55,000  60%  $2
Ticket verification: 55,000  1.50
Operating attractions: 10,332a runs  $90
Litter patrol: 1,400b $20 + $250
Total weekly costs
Operating profit
$1,815,000
17,500
66,000
82,500
929,880
28,250
1,124,130
$ 690,870
6 runs per hour  10 hours per day  7 days per week  19 attractions + 6 runs per hour  7 hours per day
 7 days per week  8 attractions = 10,332 runs per week
b
(25 acres ÷ 1.25 acres per hour)  10 hours per day  7 days per week = 1,400 litter patrol hours
a
This profit is slightly greater than Lagoon’s current profitability.
Yes, the changes and improvements will allow Lagoon to maintain its desired profit
margin of 35% ($690,870 ÷ $1,815,000 = 38%).
14-22
3.
The challenges that Lagoon might encounter in achieving the target cost are mostly
employee related. If the employees resist the changes, or struggle with the implementation of the
improvements, the target cost will be in danger of not being met. Lagoon might counter these
struggles by training employees to implement these changes successfully and by adapting its
incentive program to reward the desired improvements.
14-23
14-29 (25 min.) Cost-plus, target return on investment pricing.
1. Target operating income = Return on capital in dollars = $15,000,000 × 10% = $1,500,000
2.
Revenues*
Variable costs [($4.00 + $1.00)  300,000 cases
Contribution margin
Fixed costs ($300,000 + $400,000 + $200,000)
Operating income (from requirement 1)
$3,900,000
1,500,000
2,400,000
900,000
$1,500,000
* solve backwards for revenues
Selling price =
$3,900,000
= $13 per case.
300,000 cases
Markup % on full cost
Full cost = $1,500,000 + $900,000 = $2,400,000
Unit cost = $2,400,000 ÷ 300,000 cases = $8.00 per case
Markup % on full cost =
$13 - $8
= 62.50%
$13
3.
Budgeted Operating Income
For the year ending December 31, 2020
Revenues ($15  288,000 cases*)
$4,320,000
Variable costs ($5  288,000 cases)
1,440,000
Contribution margin
2,880,000
Fixed costs
900,000
Operating income
$1,980,000
*New units = 300,000 cases  96% = 288,000 cases
Return on investment =
$1,980,000
= 13.2%
$15,000,000
Yes, increasing the selling price is a good idea because operating income increases without
increasing invested capital, which results in a higher return on investment. The new return on
investment exceeds the 10% target return on investment.
14-24
14-30 (20 min.) Cost-plus, time and materials, ethics.
1.
As shown in the table below, Dickenson will tell Lowry that she will have to pay $759 to
get the air conditioning system repaired and $692 to get it replaced.
COST
Labor Materials
Repair option (7 hrs.  $45 per hr.; $120)
$315
$120
Replace option (4 hrs.  $45 per hr.; $230)
180
230
PRICE (80% markup on labor cost; 60%
markup on materials)
Labor Materials
Repair option ($315  1.8; $120  1.6)
$567
$192
Replace option ($180  1.8; $230  1.6)
324
368
Total Cost
$435
410
Total Price
$759
692
2.
If the repair and replace options are equally effective, Lowry will choose to get the air
conditioning system replaced for $692 (rather than spend $759 on repairing it).
3.
A&L Mechanical will earn a greater contribution toward overhead in the repair option
($324 = $759 – $435) than in the replace option ($282 = $692 – $410). Therefore, Dickenson
will recommend the repair option to Lowry, which is not the one she would prefer. Recognizing
this conflict, Dickenson may even present only the repair option to Michelle Lowry. Of course,
he runs the risk of Lowry walking away and thinking of other options (at which point, he could
present the replace option as a compromise). The problem is that Dickenson has superior
information about the repairs needed but his incentives may cause him to not reveal his
information and instead use it to his advantage. It is only the seller’s desire to build a reputation,
to have a long-term relationship with the customer, and to have the customer recommend the
seller to other potential buyers of the service, that encourages an honest discussion of the
options.
The ethical course of action would be to honestly present both options to Lowry and have
her choose. To have their employees act ethically, organizations do not reward employees on the
basis of the profits earned on various jobs. They also develop codes of conduct and core values
and beliefs that specify appropriate and inappropriate behaviors
14-25
14-31 (25 min.)
1.
Cost-plus and market-based pricing.
Florida Temps’ full cost per hour of supplying contract labor is
Variable costs
Fixed costs ($328,000 ÷ 82,000 hours)
Full cost per hour
$11
4
$15
Price per hour at full cost plus 15% = $15  1.15 = $17.25 per hour.
2.
Contribution margins for different prices and demand realizations are as follows:
Price per Hour
(1)
$16
18
19
20
22
Variable Cost
per Hour
(2)
$11
11
11
11
11
Contribution
Margin per
Hour
(3)=(1)–(2)
$5
7
8
9
11
Demand in
Hours
(4)
123,000
101,000
82,000
71,000
66,000
Total
Contribution
(5)=(3)×(4)
$615,000
707,000
656,000
639,000
726,000
Fixed costs will remain the same regardless of the demand realizations. Fixed costs are,
therefore, irrelevant because they do not differ among the alternatives.
The table above indicates that Florida Temps can maximize contribution margin
($726,000) and operating income by charging a price of $1 per hour.
3.
The cost-plus approach to pricing in requirement 1 does not explicitly consider the effect
of prices on demand. The approach in requirement 2 models the interaction between price and
demand and determines the optimal level of profitability using concepts of relevant costs. The
two different approaches lead to two different prices in requirements 1 and 2. As the chapter
describes, pricing decisions should consider both demand or market considerations and supply or
cost factors. The approach in requirement 2 is the more balanced approach. In most cases, of
course, managers use the cost-plus method of requirement 1 as only a starting point. They then
modify the cost-plus price on the basis of market considerations—anticipated customer reaction
to alternative price levels and the prices charged by competitors for similar products.
14-26
14-32 Cost-plus and market-based pricing.
1. Single rate =
$1, 224, 220
112, 000 test - hours
= $10.93 per test-hour (TH)
Hourly billing rate for HTT and ACT = $10.93 × 1.30 = $14.21
2. Labor and supervision =
$436,800
112, 000 test - hours
Setup and facility costs =
Utilities =
$351,820
700 setup hours
$435, 600
12, 000 machine - hours
= $3.90 per test-hour
= $502.60 per setup-hour
= $36.30 per machine-hour (MH)
3.
HTT
Labor and supervision
($3.90 × 78,400; 33,600 test-hours)1
Setup and facility cost
($502.60 × 140; 560 setup-hours)2
Utilities
($36.30×6,000; 6,000 machinehours)3
Total cost
Number of testing hours (TH)
Cost per testing hour
Mark-up
Billing rate per testing hour
ACT
Total
$305,760
$131,040
$ 436,800
70,364
281,456
351,820
217,800
$593,924
÷ 78,400 TH
$7.58 per TH
× 1.30
$ 9.85 per TH
217,800
$630,296
÷ 33,600 TH
$ 18.76 per TH
× 1.30
$ 24.39 per TH
435,600
$1,224,220
1
112,000 test-hours × 70% = 78,400 test-hours; 112,000 test-hours × 30% = 33,600 test-hours
700 setup-hours × 20% = 140 setup-hours; 700 setup-hours × 80% = 560 setup-hours
3
12,000 machine-hours × 50% = 6,000 machine-hours; 12,000 machine-hours × 50% = 6,000
machine-hours
2
The billing rates based on the activity-based cost structure make more sense. These billing rates
reflect the ways the testing procedures consume the firm’s resources.
4. To stay competitive, Quick Test needs to be more efficient in arctic testing. Roughly 45% of
 281, 456

arctic testing’s total cost 
= 45%  occurs in setups and facility costs. Perhaps the setup
 630, 296

activity can be redesigned to achieve cost savings. Quick Test should also look for savings in the
labor and supervision cost per test-hour and the total number of test-hours used in arctic testing,
as well as the utility cost per machine-hour and the total number of machine hours used in arctic
testing. This may require redesigning the test, redesigning processes, and achieving efficiency
and productivity improvements.
14-27
14-33 (25-30 min.) Cost-plus and market-based pricing.
1.
Total Project Life-Cycle Costs
Variable costs:
Metal extraction and processing ($50 per ton × 30,000 tons)
Fixed costs:
Metal extraction and processing ($5,500 × 24 months)
Rent on temporary buildings ($4,500 × 27 months)
Administration ($2,000 × 27 months)
Clean-up ($33,000 × 3 months)
Land restoration
Costs of selling land
Total life-cycle cost
$1,500,000
132,000
121,500
54,000
99,000
223,500
120,000
$2,250,000
2.
Projected Life Cycle Income Statement
Revenue ($80 per ton  30,000 tons)
Sale of land (plug after inputting other numbers)
Total life-cycle cost
Life-cycle operating income ($30 per ton × 30,000 tons)
Mark-up percentage on project life-cycle cost =
$2,400,000
750,000
(2,250,000)
$900,000
Life cycle operating income
Total life-cycle cost
($900,000/ $2,250,000) = 40%
The company would have to sell the land for $750,000.
3.
Revenue ($70 per ton  30,000 tons)
Sale of land
Total revenue
Total life-cycle cost at mark-up of 35%
($2,709,000 ÷ 1.4)
The company would need to reduce total life-cycle costs by
($2,250,000 – $1,935,000)
Check
Revenue
Sale of land
Total life-cycle cost
Life-cycle operating income
Mark-up percentage = ($774,000/ $1,935,000) = 40%
14-28
$2,100,000
609,000
$2,709,000
$1,935,000
$ 315,000
$2,100,000
609,000
(1,935,000)
$774,000
14-34 (30 min.)Airline pricing, considerations other than cost in pricing.
1.
a.
b.
c.
If the fare is $800,
Europa Airways would expect to have 300 business and 150 pleasure travelers.
Variable costs per passenger would be $85.
Contribution margin per passenger = $800 – $85 = $715.
If the fare is $1,800,
a. Europa Airways would expect to have 285 business and 30 pleasure travelers.
b. Variable costs per passenger would be $195.
c. Contribution margin per passenger = $1,800 – $195 = $1,605.
Contribution margin from business travelers at prices of $800 and $1,800, respectively, follow:
At a price of $800: $715 × 300 passengers
= $214,500
At a price of $1,800: $1,605 × 285 passengers
= $457,425
Europa Airways would maximize contribution margin and operating income by charging
business travelers a fare of $1,800.
Contribution margin from pleasure travelers at prices of $800 and $1,800, respectively, follow:
At a price of $800: $715 × 150 passengers
= $107,250
At a price of $1,800: $1,605 × 30 passengers
= $ 48,150
Europa Airways would maximize contribution margin and operating income by charging
pleasure travelers a fare of $800.
Europa Airways would maximize contribution margin and operating income by a price
differentiation strategy, where business travelers are charged $1,800 and pleasure travelers $800.
In deciding between the alternative prices, all other costs such as fuel costs, allocated
annual lease costs, allocated ground services costs, and allocated flight crew salaries are
irrelevant. Why? Because these costs will not change whatever price Europa Airways chooses to
charge.
2.
The elasticity of demand of the two classes of passengers drives the different demands of
the travelers. Business travelers are relatively price insensitive because they must get to their
destination during the week (exclusive of weekends) and their fares are paid by their companies.
A 225% increase in fares from $800 to $1,800 will deter only 5% of the business passengers
from flying with Europa Airways.
In contrast, a similar fare increase will lead to an 80% drop in pleasure travelers who are
paying for their own travels, unlike business travelers, and who may have alternative vacation
plans they could pursue instead.
3.
Because business travelers often want to return within the same week, while pleasure
travelers often stay over weekends, a requirement that a Saturday night stay is needed to qualify
for the $800 discount fare would discriminate between the passenger categories. This price
discrimination is legal because airlines are service companies rather than manufacturing
companies and because these practices do not, nor are they intended to, destroy competition.
14-29
14-35 (15-20 min.) Pricing products using the target-costing approach.
1.
Estimated cost per unit: ($50 + $30 + $30 + [$206,250/ 3,750]) = $165
2.
ProDry could charge between $166 and $310 and make a profit.
3.
Target cost for the hair dryer is selling price – Total target operating income per unit
$310 - $165 = $145 (target cost per unit).
4.
To achieve its target operating income, the company must increase the selling price or
decrease costs. Since the customers appear willing to pay no more than $310 per dryer, the
company should concentrate on decreasing costs. All direct materials should be reviewed and
perhaps alternatives can be found at lower prices. Or, the company can purchase higher
quantities at lower prices.Reverse engineering should be employed with the objective of
reducing costs. Also, the company should review the allocation bases for both variable and fixed
overhead costs to ensure accuracy.
5.
Yes, target costs should include all costs, variable costs as well as costs that are fixed in
the short run, because in the long run a company’s prices and revenues must exceed its total costs
if it is to remain in business. In contrast, for short-run pricing or one-time-only special-order
decisions, managers should only consider costs that vary in the short run.
14-30
14-36 (15 min.) Pricing products using the cost-plus approach (continued from 14-35).
1.
If ProDry used a cost-plus approach, it would cost the hair dryer at $330 ($165 estimated
costs + $165 target operating income). Using this method, ProDry would price the hair dryer
above the price that customers are willing to pay.
2.
The company could focus on reducing costs. In addition, the company could revisit the
target operating income of $165.
14-31
14-37 (25–30 min.) Value engineering, target pricing, and locked-in costs.
1.
Design cost
Direct materials
Direct manufacturing labor
Variable manufacturing overhead
Fixed manufacturing overhead
Marketing
Total cost
Cost per unit ($150,000 ÷ 75)
Target cost per unit ($2,500 × 0.75)
Profit per unit ($2,500 – $2,000)
$
8,000
32,000
38,000
32,000
26,000
14,000
$150,000
$2,000
$1,875
$ 500
The cost estimate developed by Nampa does not meet Wood Creations’ requirements.
Value engineering will be needed to reduce the cost per unit to the target cost.
2.
Total costs (requirement 1)
Less: Reduction in material costs ($32,000 × 60%)
Add: Increase in design costs
Total costs of redesigned table
Revised cost per unit ($131,900 ÷ 75)
Revised target cost per unit ($2,400 × 0.75)
Profit per unit ($2,400 – $1,758.67)
$ 150,000
(19,200)
1,100
$ 131,900
$1,758.67
$1,800.00
$ 641.33
The design change allows the sculpture to meet Wood Creations’ requirements for target
costing. The cost of materials is a locked-in cost once the design is finalized.
3.
Revised total cost ($150,000 + $3,000)
Revised cost per unit ($153,000 ÷ 75)
Revised target cost per unit ($2,700 × 0.75)
Profit per unit ($2,700 – $2,040)
$ 153,000
$ 2,040
$ 2,025
$
660
No, this proposal does not allow the sculpture to meet Wood Creations’ requirements for
target costing. Value engineering will be needed to reduce the cost per unit to the target cost.
4.
Requirement 2
$180,000
131,900
$ 48,100
Revenue ($2,400 × 75; $2,700 × 75)
Total costs
Operating income
Requirement 3
$202,500
153,000
$ 49,500
Even without value engineering, Wood Creations should implement the actions in requirement 3.
It should spend $3,000 on marketing if it can achieve a price higher than $2,700 even though it
14-32
does not achieve the target cost because it earns a higher overall operating income. Doing value
engineering will help it increase operating income even more relative to requirement 2.
5.
The challenges that Wood Creations might encounter in achieving the target cost are
mostly employee related. If the employees resist the changes, or struggle with the
implementation of the improvements, the target cost will be in danger of not being met. Wood
Creations might counter these struggles by adapting its incentive program to reward the desired
effects of the changes and improvements.
Wood Creations would also need to think about the customer and whether reducing
material costs would reduce demand. For example, the customer may prefer the highest grade of
wood that Jensen has used rather than the standard grade of wood that Wood Creations might use
to achieve the target cost.
14-33
Try It! 14-1
Guppy Inc.’s operating income in 2019 is as follows:
Revenues ($7 250,000)
Purchase cost of Packs ($3 250,000)
Ordering costs ($100 800)
Receiving and storage ($60  4,500)
Shipping ($70  1,500)
Total costs
Operating income
Total for
250,000 Packs
(1)
$1,750,000
750,000
80,000
270,000
105,000
1,205,000
$ 545,000
Per Unit
(2) = (1) ÷ 250,000
$7.00
3.00
0.32
1.08
0.42
4.82
$2.18
Try It! 14-2
Price to retailers in 2020 is 94% of 2019 price = 0.94 $7 = $6.58
Cost per pack in 2020 is 95% of 2019 cost = 0.95 $3 = $2.85.
Guppy Inc.’s operating income in 2020 is as follows:
Total for
250,000 Packs
(1)
$1,645,000
Revenues ($6.58 250,000)
712,500
Purchase cost of packs ($2.85 250,000)
80,000
Ordering costs ($100 800)
270,000
Receiving and storage ($60  4,500)
105,000
Shipping ($70  1,500)
1,167,500
Total costs
$
477,500
Operating income
Per Unit
(2) = (1) ÷ 250,000
$6.58
2.85
0.32
1.08
0.42
4.67
$1.91
Recall from Try It 14-1 that Guppy Inc.’s operating income in 2019 is $545,000 and target
operating income per unit is $2.18 ($545,000 ÷ 250,000 units).
Guppy will need to reduce its total costs by $67,500 ($545,000 − $477,500) or $0.27 ($67,500 ÷
250,000) per unit if it is to achieve its target operating income in 2020.
The total target cost is $1,100,000 ($1,167,500 − $67,500) and the target cost per unit is $4.40
($4.67 − $0.27).
14-34
Try It! 14-3
Guppy Inc.’s operating income in 2020, if it makes changes in ordering and receiving and
storage, will be as follows:
Total for
250,000 Packs
Per Unit
(1)
(2) = (1) ÷ 250,000
$1,645,000
$6.58
Revenues ($6.58 250,000)
712,500
2.85
Purchase cost of packs ($2.85 250,000)
52,500
0.21
Ordering costs ($75 700)
200,000
0.80
Receiving and storage ($50 4,000)
105,000
0.42
Shipping ($70  1,500)
1,070,000
4.28
Total costs
$
575,000
$2.30
Operating income
Through value engineering that reduces the quantity of the activity and the cost-driver rate,
Guppy Inc. exceeds its target operating income of $545,000 and $2.18 per pencil pack despite
the fact that its revenue per pencil pack has decreased by $0.42 ($7.00 – $6.58), while its
purchase cost per pencil pack has decreased by only $0.15 ($3.00 – $2.85).
Try It! 14-4
The following table shows the total costs for 250,000 packs and the cost per pack in 2020 using
Dory Inc.’s activity-based costing system.
Total for
250,000 Packs
(1)
$1,187,500
22,500
180,000
135,000
$1,525,000
Purchase cost of packs ($4.75 250,000)
Ordering costs ($75 300)
Receiving and storage ($50  3,600)
Shipping ($90  1,500)
Total costs
Cost Base
Estimated Cost
per Unit
(1)
Markup
Percentage
(2)
Per Unit
(2) = (1) ÷ 250,000
$4.75
0.09
0.72
0.54
$6.10
Markup
Component
(3) (1)  (2)
Prospective
Selling Price
(4) (1) (3)
Purchase cost
$4.75
20%
$0.95
$5.70
Full cost of the product
6.10
6%
0.37
6.47
The different cost bases and markup percentages give two prospective selling prices that are
close to each other. The final selling price will be adjusted after taking into account customer and
competitor reactions.
14-35
CHAPTER 15
COST ALLOCATION, CUSTOMER-PROFITABILITY
ANALYSIS, AND SALES-VARIANCE ANALYSIS
15-1 Disagree. Cost accounting data plays a key role in many management planning and
control decisions. The division president will be able to make better operating and strategy
decisions by being involved in key decisions about cost pools and cost allocation bases. Such an
understanding, for example, can help the division president evaluate the profitability of different
customers.
15-2 Managers should consider the following factors in the allocation of resources:
1. Likelihood of customer retention
2. Potential for sales growth
3. Long-run customer profitability
4. Increases in overall demand from having reference customers
5. Ability to learn from customers.
15-3 Companies that separately record (a) the list price and (b) the discount have sufficient
information to subsequently examine the level of discounting for each individual customer and
by each individual salesperson.
15-4 No. A customer-profitability profile highlights differences in the current period’s
profitability across customers. Dropping customers should be the last resort. An unprofitable
customer in one period may be highly profitable in subsequent future periods. Moreover, costs
assigned to individual customers need not be purely variable with respect to short-run
elimination of sales to those customers. Thus, when customers are dropped, costs assigned to
those customers may not disappear in the short run.
15-5 Five categories in a customer cost hierarchy are identified in the chapter. The examples
given relate to the Provalue Division of Astel Computers used in the chapter:

Customer output-unit-level costs—costs of activities to sell each unit (computer) to a
customer. An example is product-handling costs of each computer sold.

Customer batch-level costs—costs of activities that are related to a group of units
(computers) sold to a customer. Examples are costs incurred to process orders or to make
deliveries.

Customer-sustaining costs—costs of activities to support individual customers, regardless
of the number of units or batches of product delivered to the customer. Examples are costs
of visits to customers or costs of displays at customer sites.

Distribution-channel costs—costs of activities related to a particular distribution channel
rather than to each unit of product, each batch of product, or specific customers. An
example is the salary of the manager of Provalue Division’s wholesale distribution channel.

Division-sustaining costs—costs of division activities that cannot be traced to individual
customers or distribution channels. An example is the salary of the Provalue Division
manager.
15-1
15-6 Charting cumulative profits by customer or product type generates a whale curve. This
provides information on the profitability of customers and clearly differentiates the most
profitable from the least profitable.
15-7 Disagree. In general, companies have three choices regarding the allocation of corporate
costs to divisions: allocate all corporate costs, allocate some corporate costs (those “controllable”
by the divisions), and allocate none of the corporate costs. Which one of these is appropriate
depends on several factors: the composition of corporate costs, the purpose of the costing
exercise, and the time horizon, to name a few. For example, one can easily justify allocating all
corporate costs when they are closely related to the running of the divisions and when the
purpose of costing is, say, pricing products or motivating managers to consume corporate
resources judiciously.
15-8 The ‘fairness or equity’ criterion is often applied in the government sector. This is
because cost allocations are very critical in government contracts where the parties to the
contract find it fair or equitable if there is an established criterion for a contract price. However,
what is fair or equitable can sometimes be a matter of judgement.
15-9 Disagree. If corporate costs allocated to a division can be reallocated to the indirect cost
pools of the division on the basis of a logical cause-and-effect relationship, then it is in fact
preferable to do so—this will result in fewer division-indirect-cost pools and a more costeffective cost allocation system. This reallocation of allocated corporate costs should only be
done if the allocation base used for the division indirect cost pool has the same cause-and-effect
relationship with every cost in that indirect cost pool, including the reallocated corporate cost.
15-10 Disagree. A company will frequently allocate costs that are fixed in the short run to
customers to determine long-run profitability of customers. In the long run, a company must
ensure that the revenues received from a customer exceed the total resources consumed to
support the customer, regardless of whether these costs are variable or fixed in the short run. For
short-run decisions, however, costs that are fixed in the short run may often be irrelevant.
15-11 When allocating costs to divisions, channels, and customers, companies must construct
cost pools that are, to the extent possible, homogeneous, so that all costs in the cost pool have the
same or a similar cause-and-effect or benefits-received relationship with the cost-allocation base.
If each cost category has a cause-and-effect or benefits-received relationship with a different
cost-allocation base, the company should maintain separate cost pools for each of these costs.
Determining homogeneous cost pools requires judgment and should be revisited on a regular
basis.
15-12 Using the levels approach introduced in Chapter 7, the sales-volume variance is a Level 2
variance. By sequencing through Level 3 (sales-mix and sales-quantity variances) and then
Level 4 (market-size and market-share variances), managers can gain insight into the causes of a
specific sales-volume variance caused by changes in the mix and quantity of the products sold as
well as changes in market size and market share.
15-13 The total sales-mix variance arises from differences in the budgeted contribution margin
of the actual and budgeted sales mix. The composite unit concept enables the effect of individual
15-2
product changes to be summarized in a single intuitive number by using weights based on the
mix of individual units in the actual and budgeted mix of products sold.
15-14 A favorable sales-quantity variance arises because the actual units of all products sold
exceed the budgeted units of all products sold.
15-15 The sales-quantity variance can be decomposed into (a) a market-size variance (which
arises when the actual total market size in units is different from the budgeted market size in
units) and (b) a market share variance (which arises when the actual market share of a company
is different from its budgeted market share). Both variances use the budgeted average
contribution margin per unit.
15-16 Choice ‘b’ is correct. The sales price variance is computed as:
(actual sales price – budgeted sales price) x actual sales volume.
(£30 -£35)  5,500 units = £27,500 unfavorable.
Choice ‘a’ is incorrect. The £27,500 is not favorable. The actual sales price has been subtracted
from the budgeted sales price. Note: this is a common error in sales price variance computation.
Choice ‘c’ is incorrect. The computation has been wrongly done as:(£30 – £35)  8,000 units =
£40,000 unfavorable.
Choice ‘d’ is incorrect. The computation has been wrongly done as: (£35 – £30)  8,000 units =
£40,000 favorable.
15-17 Choice ‘a’ is correct. The sales volume variance is computed as contribution margin ×
(budgeted quantity – actual quantity). Thus, £25  2,500 units = £62,500 unfavorable. It is
unfavorable as the actual quantity is less than the budgeted units. Thus, subsequently Choice ‘b’
is incorrect.
Choice ‘c’ is incorrect. The sales volume variance has been wrongly computed as:
£35  2,500 units = £87,500. The difference in the units sold has been wrongly multiplied by the
budgeted sales price.
Choice ‘d’ is incorrect. The sales vo