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eBook e Collection Introduction to Management Accounting Entire Ebook This is a Protected PDF document. Please enter your user name and password to unlock the text. User Name: Password: Unlock Remember my user name and password. If you are experiencing problems unlocking this document or you have questions regarding Protectedpdf files please contact a Technical Support representative: In the United States: 1-877-832-4867 In Canada: 1-800-859-3682 Outside the U.S. and Canada: 1-602-387-2222 Email: technicalsupport@apollogrp.edu. Introduction to Management Accounting ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Charles T. Horngren Series in Accounting Charles T. Horngren, Consulting Editor Auditing: An Integrated Approach, 8/E Arens/Loebbecke Financial Statement Analysis, 2/E Foster Governmental and Nonprofit Accounting: Theory & Practice, 8/E Freeman/Shoulders Financial Accounting, 6/E Harrison/Horngren Cases in Financial Reporting, 5/E Hirst/McAnally Cost Accounting: A Managerial Emphasis, 12/E Horngren/Foster/Datar Accounting, 6/E Horngren/Harrison/Bamber Introduction to Financial Accounting, 9/E Horngren/Sundem/Elliott Introduction to Management Accounting, 14/E Horngren/Sundem/Stratton/Burgstahler/Schatzberg ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Introduction to Management Accounting Fourteenth Edition Charles T. Horngren Stanford University Gary L. Sundem University of Washington Seattle William O. Stratton Dixie State College of Utah David Burgstahler University of Washington Seattle Jeff Schatzberg University of Arizona ISBN: 0-536-47129-0 Upper Saddle River, NJ 07458 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Library of Congress Cataloging-in-Publication Data Introduction to management accounting / Charles T. Horngren . . . [et al.]--Fourteenth ed. p. cm.--(Charles T. Horngren series in accounting) Rev. ed. of: Introduction to management accounting / Charles T. Horngren, Gary L. Sundem, William O. Stratton. 13th ed. c2005. Includes bibliographical references and index. ISBN 978-0-13-612921-9 1. Managerial accounting. I. Horngren, Charles T. II. Horngren, Charles T. Introduction to management accounting. HF5657.4.1587 2007 658.1511--dc22 2007009641 Executive Editor: Steve Sartori Editor-in-Chief: David Parker Manager, Product Development: Ashley Santora Project Manager: Susie Abraham Editorial Assistant: MaryBeth Ward Marketing Manager: Jodi Bassett Marketing Assistant: Ian Gold Senior Managing Editor: Cynthia Zonneveld Production Editor: Kevin H. 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This publication is protected by Copyright and permission should be obtained from the publisher prior to any prohibited reproduction, storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise. For information regarding permission(s), write to: Rights and Permissions Department. Pearson Prentice HallTM is a trademark of Pearson Education, Inc. Pearson is a registered trademark of Pearson plc Prentice Hall is a registered trademark of Pearson Education, Inc. Pearson Education LTD. Pearson Education Singapore, Pte. Ltd Pearson Education, Canada, Ltd Pearson EducationJapan Pearson Education Australia PTY, Limited Pearson Education North Asia Ltd Pearson Educacin de Mexico, S.A. de C.V . Pearson Education Malaysia, Pte. Ltd. ISBN: 0-536-47129-0 10 9 8 7 6 5 4 3 2 1 ISBN-13: 978-0-13-612921-9 ISBN-10: 0-13-612921-8 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. To Joan, Chelsea, Erik, Marissa Liz, Garth, Jens, Reed, Grant Norma, Gina, Adam, Nisha, Tiana Sheryl, Travis Jane, Vanessa, Courtney ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Charles T. Horngren is the Edmund W. Littlefield Professor of Accounting, emeritus, at Stanford University. A graduate of Marquette University, he received his MBA from Harvard University and his Ph.D. from the University of Chicago. He is also the recipient of honorary doctorates from Marquette University and DePaul University. A certified public accountant, Horngren served on the Accounting Principles Board for six years, the Financial Accounting Standards Board Advisory Council for five years, and the Council of the American Institute of Certified Public Accountants for three years. For six years, he served as a trustee of the Financial Accounting Foundation, which oversees the Financial Accounting Standards Board and the Government Accounting Standards Board. Horngren is a member of the Accounting Hall of Fame. A member of the American Accounting Association, Horngren has been its president and its director of research. He received its first annual Outstanding Accounting Educator Award. He also received its Lifetime Contribution to Management Accounting Award. The California Certified Public Accountants Foundation gave Horngren its Faculty Excellence Award and its Distinguished Professor Award. He is the first person to have received both awards. The American Institute of Certified Public Accountants presented its first Outstanding Educator Award to Horngren. Horngren was named Accountant of the Year, Education, by the national professional accounting fraternity, Beta Alpha Psi. Professor Horngren is also a member of the Institute of Management Accountants, where he has received its Distinguished Service Award. He was a member of the Institute's Board of Regents, which administers the Certified Management Accountant examinations. Horngren is the author of other accounting books published by Prentice Hall: Cost Accounting: A Managerial Emphasis, Twelfth Edition, 2003 (with Srikant Datar and George Foster); Introduction to Financial Accounting, Ninth Edition, 2002 (with Gary L. Sundem and John A. Elliott); Accounting, Sixth Edition, 2005 (with Walter T. Harrison Jr. and Linda Bamber); and Financial Accounting, Sixth Edition, 2004 (with Walter T. Harrison Jr.). Horngren is the Consulting Editor for the Charles T. Horngren Series in Accounting. Gary L. Sundem is the Julius A. Roller Professor of Accounting at the University of Washington, Seattle. He received his B.A. degree from Carleton College and his MBA and Ph.D. degrees from Stanford University. Professor Sundem was the 19921993 President of the American Accounting Association. He was Executive Director of the Accounting Education Change Commission, 19891991, and served as Editor of The Accounting Review, 19821986. A member of the Institute of Management Accountants, Sundem is past president of the Seattle chapter. He has served on IMA's national board of directors and chaired its Academic Relations and Professional Development committees. He chaired the AACSB's Accounting Accreditation Committee, 19971999, and is currently VP-Education for the International Association for Accounting Education and Research. Professor Sundem has numerous publications in accounting and finance journals including Issues in Accounting Education, The Accounting Review, Journal of Accounting Research, and The Journal of Finance. He was selected as the Outstanding Accounting Educator by the American Accounting Association in 1998 and by the Washington Society of CPAs in 1987. vi Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. ISBN: 0-536-47129-0 About the Authors vii William O. Stratton is Professor of Accounting at Dixie State College of Utah. He received B.S. degrees from Florida State University and Pennsylvania State University, his MBA from Boston University, and his Ph.D. from the Claremont Graduate University. A certified management accountant, Stratton has lectured extensively at management accounting conferences in North America, South America, and Europe. He has developed and delivered professional workshops on activity-based management and performance achievement to manufacturing and service organizations throughout the United States and South America. In 1993, Professor Stratton was awarded the Boeing Competition prize for classroom innovation. Stratton has numerous publications in accounting and international business journals including Strategic Finance, CMA Management, Decision Sciences, IIE Transactions, Cost Management, Synergie, and Journal of Corporate Accounting & Finance. David Burgstahler is Gerhard G. Mueller Endowed Professor in Accounting at the University of Washington, Seattle. He received his B.Ac. degree from the University of MinnesotaDuluth, and his Ph.D. from the University of Iowa. He has been Associate Dean for Masters Programs and Executive Education and Acting Dean at the University of Washington Business School. He has served on more than 40 Ph.D. supervisory committees and has been recognized multiple times as Beta Alpha Psi Professor of the Year and as MBA Professor of the Quarter at the University of Washington. Professor Burgstahler is Vice President--Publications of the American Accounting Association 20072009 and has served on a number of Association committees. Professor Burgstahler received the American Accounting Association-American Institute of Certified Public Accountants Notable Contributions to the Accounting Literature Award in 2002. He has numerous publications in journals including The Accounting Review, Journal of Management Accounting Research, Journal of Accounting Research, Journal of Accounting and Economics, Contemporary Accounting Research, Auditing: A Journal of Practice and Theory, Behavioral Research in Accounting, and The CPA Journal. Jeff Schatzberg is the Humberto Lopez Professor of Accounting in the Eller College of Management at the University of Arizona. Professor Schatzberg received his BA (in Philosophy), MA (in accounting) and Ph.D. (in business administration), all at the University of Iowa. Professor Schatzberg has numerous publications in the most prestigious accounting and business journals, including the Journal of Accounting Research, The Accounting Review, Contemporary Accounting Research, and Auditing: A Journal of Practice and Theory. His teaching and research interests are in managerial accounting and auditing. He has given numerous seminars at several U.S. universities and international schools in Canada, England, Wales, Norway, France, Germany, and Switzerland. Jeff has also served on the editorial board of several scholarly accounting journals. Professor Schatzberg has been teaching undergraduate, masters, and MBA managerial accounting courses at the University of Arizona for the past 20 years. He has extensive experience in executive education worldwide (e.g., United States, Asia, and Mexico), has developed customized managerial accounting programs and performed consulting for numerous companies (e.g., Raytheon, Honeywell, and Intel), and has taught executives in many multi-national firms (e.g., IBM, Motorola, LG, BenQ, Acer, and Mattel). In 1998, 2002, and 2005 Jeff received the "MBA Faculty of the Year Award" from the Eller Graduate School of Business at the University of Arizona, and the Arizona Society of CPA's "Excellence in Teaching Award" in 1997. Jeff is a CPA and worked for several years as an auditor and tax accountant in the Phoenix office of KPMG Peat Marwick. Jeff 's work experience includes both manufacturing and service industry firms, as well as notfor-profit institutions. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Part 1 1 2 3 4 5 6 Focus on Decision Making Managerial Accounting, the Business Organization, and Professional Ethics 2 Introduction to Cost Behavior and Cost-Volume Relationships 44 Measurement of Cost Behavior 92 Cost Management Systems and Activity-Based Costing 134 Relevant Information for Decision Making with a Focus on Pricing Decisions 196 Relevant Information for Decision Making with a Focus on Operational Decisions 246 Part 2 7 8 9 10 Accounting for Planning and Control Introduction to Budgets and Preparing the Master Budget 294 Flexible Budgets and Variance Analysis 340 Management Control Systems and Responsibility Accounting 384 Management Control in Decentralized Organizations 426 Part 3 Capital Budgeting 11 Capital Budgeting 472 Part 4 Product Costing 12 Cost Allocation 522 13 Accounting for Overhead Costs 588 14 Job-Costing and Process-Costing Systems 636 Part 5 Basic Financial Accounting 15 Basic Accounting: Concepts, Techniques, and Conventions 680 16 Understanding Corporate Annual Reports: Basic Financial Statements 726 17 Understanding and Analyzing Consolidated Financial Statements 784 APPENDIX A: RECOMMENDED READINGS A2 APPENDIX B: FUNDAMENTALS OF COMPOUND INTEREST AND THE USE OF PRESENT-VALUE TABLES A8 APPENDIX C: EXCERPTS FROM FORM 10-K OF NIKE, INC. GLOSSARY G1 INDEX I1 PHOTO CREDITS ISBN: 0-536-47129-0 A15 P1 ix Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Part 1 Focus on Decision Making 2 1 Managerial Accounting, the Business Organization, and Professional Ethics Chapter Opener: Starbucks 3 Accounting and Decision Making 5 Importance of Ethics 8 Management Accounting in Service and Nonprofit Organizations 10 Cost-Benefit and Behavioral Considerations 11 The Management Process and Accounting 11 Planning and Control for Product Life Cycles and the Value Chain 14 Accounting's Position in the Organization 17 Career Opportunities in Management Accounting 20 Adaptation to Change 21 Changes in Business Processes 23 Ethical Conduct for Professional Accountants 25 Highlights to Remember 30 Accounting Vocabulary 31 Fundamental Assignment Material 32 Additional Assignment Material 34 2 Introduction to Cost Behavior and Cost-Volume Relationships 44 Chapter Opener: Boeing Company 45 Identifying Resources, Activities, Costs, and Cost Drivers Variable- and Fixed-Cost Behavior 48 Cost-Volume-Profit Analysis 53 Additional Uses of Cost-Volume Analysis 64 Nonprofit Application 67 Highlights to Remember 69 Appendix 2A: Sales-Mix Analysis 70 Appendix 2B: Impact of Income Taxes 71 Accounting Vocabulary 72 Fundamental Assignment Material 73 Additional Assignment Material 75 46 3 Measurement of Cost Behavior 92 Chapter Opener: America West 93 Cost Drivers and Cost Behavior 94 Management Influence on Cost Behavior 97 Cost Functions 100 Methods of Measuring Cost Functions 103 ISBN: 0-536-47129-0 Highlights to Remember 112 Appendix 3: Use and Interpretation of Least-Squares Regression Accounting Vocabulary 116 Fundamental Assignment Material 116 Additional Assignment Material 118 113 xi Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. xii Contents 4 Cost Management Systems and Activity-Based Costing 134 Chapter Opener: AT&T 135 Cost Management Systems 136 Cost Accounting Systems 137 Cost Terms Used for Strategic Decision Making and Operational Control Purposes 139 Cost Terms Used for External Reporting Purposes 146 Traditional and Activity-Based Cost Accounting Systems 150 Activity-Based Management: A Cost Management System Tool 159 Highlights to Remember 161 Appendix 4: Detailed Illustration of Traditional and Activity-Based Cost Accounting Systems 162 Accounting Vocabulary 172 Fundamental Assignment Material 172 Additional Assignment Material 178 5 Relevant Information for Decision Making with a Focus on Pricing Decisions 196 Chapter Opener: Grand Canyon Railway 197 The Concept of Relevance 198 Pricing Special Sales Orders 203 Basic Principles for Pricing Decisions 209 General Influences on Pricing in Practice 212 Cost-Plus Pricing 213 Target Costing 220 Highlights to Remember 224 Accounting Vocabulary 225 Fundamental Assignment Material 225 Additional Assignment Material 229 6 Relevant Information for Decision Making with a Focus on Operational Decisions 246 Chapter Opener: Nantucket Nectars 247 Analyzing Relevant Information: Focusing on Futuristic and Differential Attributes 248 Make-or-Buy Decisions 251 Deletion or Addition of Products, Services, or Departments 257 Optimal Use of Limited Resources: Product-Mix Decisions 260 Joint Product Costs: Sell or Process Further Decisions 262 Keeping or Replacing Equipment 263 Identify Irrelevant or Misspecified Costs 267 Conflicts Between Decision Making and Performance Evaluation 268 Highlights to Remember 270 Accounting Vocabulary 271 Fundamental Assignment Material 271 Additional Assignment Material 275 Part 2 Accounting for Planning and Control ISBN: 0-536-47129-0 7 Introduction to Budgets and Preparing the Master Budget 294 Chapter Opener: Ritz-Carlton 295 Budgets and the Organization 296 Potential Problems in Implementing Budgets 299 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Contents xiii Types of Budgets 304 Preparing the Master Budget 306 Budgets as Financial Planning Models 319 Highlights to Remember 320 Appendix 7: Use of Spreadsheets for Budgeting Accounting Vocabulary 323 Fundamental Assignment Material 323 Additional Assignment Material 325 321 8 Flexible Budgets and Variance Analysis 340 Chapter Opener: McDonald's 341 Using Budgets to Evaluate Actual Results Isolating the Causes of Variances 348 Flexible-Budget Variances in Detail 354 Overhead Variances 360 Highlights to Remember 364 Accounting Vocabulary 364 Fundamental Assignment Material 365 Additional Assignment Material 367 342 9 Management Control Systems and Responsibility Accounting 384 Chapter Opener: Health Net 385 Management Control Systems 386 Management Control Systems and Organizational Goals 386 Designing Management Control Systems 388 Controllability and Measurement of Financial Performance 395 Management Control Systems in Service, Government, and Nonprofit Organizations 409 Future of Management Control Systems 410 Highlights to Remember 411 Accounting Vocabulary 411 Fundamental Assignment Material 411 Additional Assignment Material 414 10 Management Control in Decentralized Organizations 426 Chapter Opener: Nike 427 Centralization Versus Decentralization 428 Performance Metrics and Management Control 431 Measures of Profitability 433 Economic Profit or Economic Value Added (EVA) 435 ROI or Economic Profit? 437 A Closer Look at Invested Capital 439 Transfer Pricing 442 Keys to Successful Management Control Systems 451 Highlights to Remember 454 Accounting Vocabulary 455 Fundamental Assignment Material 455 Additional Assignment Material 458 Part 3 ISBN: 0-536-47129-0 Capital Budgeting 11 Capital Budgeting 472 Chapter Opener: Deer Valley Lodge 473 Capital Budgeting for Programs or Projects 474 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. xiv Contents Discounted-Cash-Flow Models 474 Sensitivity Analysis and Risk Assessment in DCF Models 481 The NPV Comparison of Two Projects 481 Income Taxes and Capital Budgeting 486 Confusion About Depreciation 494 Other Models for Analyzing Long-Range Decisions 494 Performance Evaluation 496 Highlights to Remember 498 Appendix 11: Capital Budgeting and Inflation 498 Accounting Vocabulary 501 Fundamental Assignment Material 501 Additional Assignment Material 504 Part 4 Product Costing 12 Cost Allocation 522 Chapter Opener: L.A. Darling 523 A General Framework for Cost Allocation 524 Allocation of Service Department Costs 527 Allocation of Costs to Product or Service Cost Objects 534 Allocation of Costs to Customer Cost Objects to Determine Customer Profitability 539 Allocation of Central Corporate Support Costs 548 Allocation of Joint Costs and By-Product Costs 550 Highlights to Remember 554 Appendix 12: Multistage ABC (MSABC) Systems 555 Accounting Vocabulary 562 Fundamental Assignment Material 562 Additional Assignment Material 566 13 Accounting for Overhead Costs 588 Chapter Opener: Dell 589 Accounting for Factory Overhead 590 Illustration of Overhead Application 591 Problems of Overhead Application 593 Variable Versus Absorption Costing 598 Fixed Overhead and Absorption Costs of Product 603 Effect of Other Variances 608 Highlights to Remember 612 Appendix 13: Comparisons of Product-Volume Variance with Other Variances 613 Accounting Vocabulary 613 Fundamental Assignment Material 613 Additional Assignment Material 618 14 Job-Costing and Process-Costing Systems 636 Chapter Opener: Jelly Belly 637 Distinction Between Job Costing and Process Costing 638 Illustration of Job Costing 638 Activity-Based Costing/Management in a Job-Costing Environment 644 Job Costing in Service and Nonprofit Organizations 647 Process Costing Basics 649 Application of Process Costing 654 Physical Units and Equivalent Units (Steps 1 and 2) 655 Calculation of Product Costs (Steps 3 to 5) 656 Effects of Beginning Inventories 658 ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Contents xv Process Costing in a JIT System: Backflush Costing Highlights to Remember 665 Accounting Vocabulary 665 Fundamental Assignment Material 665 Additional Assignment Material 668 662 Part 5 Basic Financial Accounting 15 Basic Accounting: Concepts, Techniques, and Conventions 680 Chapter Opener: General Mills 681 The Need for Accounting 682 Financial Statements--Balance Sheet and Income Statement 682 Accrual Basis and Cash Basis 687 Adjustments to the Accounts 689 Adjustment Type I: Expiration of Unexpired Costs 689 Adjustment Type II: Recognition (Earning) of Unearned Revenues 693 Adjustment Type III: Accrual of Unrecorded Expenses 694 Adjustment Type IV: Accrual of Unrecorded Revenues 695 Dividends and Retained Earnings 696 Preparing Financial Statements 698 Sole Proprietorships and Partnerships 699 Generally Accepted Accounting Principles 700 Three Measurement Conventions 702 Highlights to Remember 706 Appendix 15A: Additional Accounting Concepts Appendix 15B: Using Ledger Accounts 709 Accounting Vocabulary 712 Assignment Material 713 Fundamental Assignment Material 713 Additional Assignment Material 715 707 16 Understanding Corporate Annual Reports: Basic Financial Statements 726 Chapter Opener: Nike 727 Classified Balance Sheet 728 Income Statement 737 Statement of Changes in Stockholders' Equity Statement of Cash Flows 740 Cash Flows from Operating Activities 746 Interpreting the Cash Flow Statement 752 739 Highlights to Remember 758 Appendix 16A: Accounting for Inventory 759 Appendix 16B: Shareholder Reporting, Income Tax Reporting, and Deferred Taxes Accounting Vocabulary 765 Fundamental Assignment Material 766 Additional Assignment Material 768 764 17 Understanding and Analyzing Consolidated Financial Statements 784 Chapter Opener: General Motors 785 Part One: Intercorporate Investments Including Consolidations Market-Value and Equity Methods 786 Consolidated Financial Statements 789 Recognizing Income After Acquisition 790 Component Percentages 799 786 ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. xvi Contents Use of Ratios 800 Efficient Markets and Investor Decisions 806 Highlights to Remember 808 Appendix 17: Changing Prices and Income Measurement 809 Accounting Vocabulary 815 Fundamental Assignment Material 816 Additional Assignment Material 820 APPENDIX A: RECOMMENDED READINGS A2 APPENDIX B: FUNDAMENTALS OF COMPOUND INTEREST AND THE USE OF PRESENT-VALUE TABLES A8 APPENDIX C: EXCERPTS FROM FORM 10-K OF NIKE, INC. GLOSSARY G1 INDEX I1 PHOTO CREDITS P1 A15 ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Now more than ever, managers have to understand how their decisions affect costs. Management accounting is an essential tool that enhances a manager's ability to make effective economic decisions. Because understanding concepts is more important than memorizing techniques, Introduction to Management Accounting, 14th edition, describes both theory and common practices so students understand how to produce information that's useful in day-to-day decision making. From the first chapter, we encourage students to think about why companies use various techniques, not to blindly apply the techniques. Introduction to Management Accounting, 14th edition, deals with all business sectors--nonprofit, retail, wholesale, service, selling, and administrative situations--as well as manufacturing. The focus is on planning and control decisions, not on product costing for inventory valuation and income determination. Our Philosophy Introduce concepts and principles early, then revisit them at more complex levels as students gain understanding, and provide appropriate real-company examples at every stage. As management accounting builds on financial accounting, the concepts in management accounting build on one another. Students begin their understanding of managerial decisions by asking, "How will my decisions affect the costs and revenues of the organization?" Students then progress to more complex questions: "What is the most appropriate cost-management system for the company?" "What products or services should we emphasize?" "What do our budget variances mean?" Our goals are to choose relevant subject matter and to present it clearly and accessibly, using many examples drawn from actual companies. Companies such as Starbucks, Boeing, AT&T, McDonald's, Microsoft, and more set the stage for chapter material and are revisited throughout to help students understand management accounting concepts in a real-company context. Two different text versions fit your course structure. ISBN: 0-536-47129-0 Introduction to Management Accounting, 14th edition (Chapters 114), provides a concise treatment of management accounting topics suitable for a one-term course. Introduction to Management Accounting, 14th edition (Chapters 117), includes 3 financial accounting chapters in addition to the 14 management accounting chapters. This version is especially suited to continuing education or MBA courses where students need to learn financial and management accounting in a one-term course. The financial accounting chapters also provide material for any student who may need a financial accounting review. Introduction to Financial Accounting, 9th edition, and Introduction to Management Accounting, 14th edition, together provide a seamless presentation for any first-year accounting course. Please contact your Prentice Hall representative about cost-saving discounts when adopting both books. xvii Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. xviii Preface New Edition Enhancements and Updates The addition of two new co-authors, Dave Burgstahler and Jeff Schatzberg, has resulted in an infusion of new ideas. The most noteworthy changes include: New and revised Business First boxes provide insights into operations at well-known organizations, including Microsoft, General Electric, Southwest Airlines, HarleyDavidson, Nortel Networks, and Harvard University. New and revised chapter-opening vignettes help students understand accounting's role in current business practice. We revisit the chapter-opening company throughout the chapter discussions so that students can see how accounting influences managers in real companies. Students will recognize many of the companies, such as Starbucks, Boeing, US Airways, McDonald's, Nike, and Dell. A new problem in each chapter based on Nike's Form 10-K. These problems illustrate how publicly available information can lead to insights about a company, its costs, and its management decisions. Increased coverage of ethics, including an ethics problem in each chapter's assignment material. Significant reorganization and revision in several chapters, especially Chapters 4, 5, 6, and 12. End-of-chapter material to provide fresh, new problems Chapter-Specific Updates Chapter 1 contains expanded coverage of ethics, especially the section "Importance of Ethics"; added mention of the International Accounting Education Standards Board; expanded coverage of Six Sigma; and updated descriptions of the CMA exam and the new IMA Statement of Ethical Professional Practice. Chapter 2 includes a new exhibit that compares traditional and activity-based views of cost behavior; an expanded and clarified section on variable and fixed costs, including a new Summary Problem for Review; and revised numbers in the main example throughout the chapter. Chapter 3 provides a new US Airways vignette and a clarified section on cost drivers and cost behavior. Chapter 4 has undergone a major rewrite to simplify and clarify its content. The section on cost objectives has been moved to the beginning of the cost accounting systems section so that the idea of cost objectives can be used in describing cost accounting systems. Coverage of the basics of cost allocation has been added to this chapter, and this chapter now explains the types of inventory in a manufacturing company. The appendix on multistage ABC systems has been deleted from this chapter and moved to an appendix in Chapter 12. This chapter now includes an appendix illustrating traditional and ABC costing systems, an illustration that was previously in the chapter text. Chapter 5 is now focused on pricing considerations and contains a new Nike example. The absorption versus contribution margin approach section from Chapter 6 of the 13th edition has been moved here (where it flows much better), and the section on deletion/addition of products and the optimal use of limited resources sections have been moved to Chapter 6. ISBN: 0-536-47129-0 Chapter 6 is now focused on operating decisions, with a greater focus on incremental analysis in the first section of the chapter. The section on adding/deleting a product line has been moved here from Chapter 5, as has the section on optimizing with scarce Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Preface xix resources (enhancing the operational focus). This chapter contains a new example based on Nike and rearranged material in a new section on irrelevant and misspecified costs. Finally, the section on absorption versus contribution margin approaches has been moved to Chapter 5. Chapter 7 has been reorganized so that the conceptual discussion of budget issues appears in the first half and the extensive discussion of preparing the master budget is in the second half. This chapter also contains expanded discussion of advantages of effective budgeting and disadvantages that can arise from dysfunctional incentives, and a new Exhibit 7-1 illustrates incentives to cheat when bonus payment function is discontinuous. Exhibit 7-2 has been revised to better illustrate relationships among components of a master budget. In Chapter 8, material comparing and contrasting static and flexible budgets has been rewritten and reorganized, and the chapter includes new discussion and Exhibit 8-7 to illustrate the joint price and quantity variance. Terminology for basic variances has been changed to price and quantity variances to emphasize that the variances follow from the idea that cost is the product of price times quantity; additional emphasis has been placed on the fact that variance terminology in practice is inconsistent, so students should think about the concepts underlying the variances rather than memorizing labels. Chapter 9's introductory discussion of designing management control systems has been reorganized and rewritten. In Chapter 10, the section on transfer prices has been significantly reduced, reorganized, and simplified, and a simplified example has been carried throughout the discussion. The term residual income has been changed to economic profit, and the term performance metric is now used instead of performance measure. The example on ROI has been changed to use Nike, and the answer to the summary problem on transfer pricing has been rewritten. The example used throughout Chapter 11 has been significantly modified, with revised numbers. In addition, the chapter has been modified to simplify and smooth out the flow. Chapter 12 has seen a major revision, including an expanded section on the general framework for cost-accounting systems to include allocations for determining customer profitability. The section on cost allocation in general has been moved to Chapter 4, but we have expanded the section on allocation of costs to final cost objects to include a new section with expensive discussion of customers as the final cost objective. Detailed illustration of customer profitability has been added, including a graphic approach to assess cost to serve customers. A new Summary Problem for Your Review uses the chapteropening vignette to illustrate how to measure and manage customer profitability, and the appendix on multi-stage ABC systems has been moved here from Chapter 4. Chapter 13 includes clarified discussion of overhead cost allocation. Chapter 14 has been revised to clarify the discussion throughout the chapter. In Chapter 15, the vignette company has been changed from Microsoft to General Mills, and the coverage of a separate statement of retained earnings has been replaced with a brief coverage of the statement of changes in stockholders' equity. ISBN: 0-536-47129-0 In Chapter 16, a section on capitalization of assets has been added, and the section on the indirect method for measuring cash flows from operations has been rewritten, as has the section on choosing depreciation methods in Appendix 16A. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. xx Preface Chapter 17 now features Nike rather than Microsoft for financial statement analysis, and it contains a new exhibit that illustrates accounting for marketable securities. Finally, we have updated all financial statement references throughout. Supplements for Instructors and Students INSTRUCTOR'S RESOURCE CD-ROM This is a complete, one-step resource for instructors, including all faculty and student supplements as well as testing software. It is available upon request from your local Pearson/Prentice Hall representative. INSTRUCTOR'S RESOURCE MANUAL Substantially revised, this resource manual provides insightful and useful tips on how to best manage course content when using Introduction to Management Accounting, 14th edition, in class. Chapter-by-chapter explanations and pedagogical philosophies are clearly delineated and oriented to greatly aid the teaching process. SOLUTIONS MANUAL AND SOLUTIONS TRANSPARENCIES Comprehensive solutions are provided for all end-of-chapter material. This information is also available in acetate form for in-class presentation. The Solutions Manual includes a listing of problems covering each learning objective, sample assignment schedules, a linking of 13th edition problems to those in this edition, comments on choices of problems in each chapter, and key amounts from suggested solutions to selected problems. TEST ITEM FILE This is a ready-to-use bank of testing material that contains, for each chapter, a variety of types of questions, including true/false, multiple-choice, and critical thinking problems. For ease of use, each question is linked to chapter objectives and also provides a suggested difficulty level and references to text pages where answers can be found. TESTGEN This testing software is designed to aid in creating custom tests in minutes. Features include question randomization, a point-and-drag interface, and extensive customizable settings. POWERPOINT PRESENTATION Complete PowerPoint presentations are provided for each chapter. Instructors may download and use each presentation as it is or customize the slides to create tailor-made slide shows. Each presentation allows instructors to offer an interactive presentation using colorful graphics, outlines of chapter material, and graphical explanations of difficult topics. This is available online at http://www. prenhall.com/horngren and on the Instructor's Resource CD-ROM. COURSE WEB SITE, AT HTTP://WWW.PRENHALL.COM/HORNGREN This complete online resource offers a variety of Internet-based teaching and learning support. It provides a wealth of resources for students and faculty, including the following: An online study guide Excel spreadsheet templates STUDENT STUDY GUIDE The Student Study Guide contains a wealth of resources designed to aid students in text comprehension. Each chapter includes chapter overviews, study tips, self-test questions, demonstration problems and worked-out solutions, and more. EXCEL SPREADSHEET TEMPLATES Ready-made templates to accompany selected end-of-chapter problems can be found at http://www.prenhall.com/horngren. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. We have received ideas, assistance, miscellaneous critiques, and assorted assignment material in conversations with and by mail from many students, professors, and business leaders. Each has our gratitude, but the list is too long to enumerate here. We wish to thank the following reviewers, whose feedback was critical to this new revision: Jim Carroll, Georgian Court University William Creel, Herzing College Chris Gilbert, Glendale Community College Valerie Goodwin, Olean Business Institute Lawrence Grasso, Central Connecticut State University Henry Huang, Butler University Cody King, Georgia Southwestern State University Roman J. Klusas, University of Indianapolis Lisa Martin, Hampton College Jerold R. Miller, Chaparral College Julian Mooney, Georgia Southern University Bill Rankin, Colorado State University Patrick Rogan, Cosumnes River College Walter Smith, Siena College Ken Snow, Kaplan University & Florida Community College at Jacksonville John Stancil, Florida Southern College Holly Sudano, Florida State University Diane Tanner, University of North Florida Michael Tyler, Barry University Karen Wisniewski, County College of Morris We also thank Carolyn Streuly for help in proofing the manuscript and checking the solutions manual. Finally, students in our classes have provided invaluable feedback on previous editions, for which we are grateful. Many people at Prentice Hall also earn our deepest thanks for their thoughtful contributions, including Kevin Holm, Steve Sartori, and Susan Abraham. We also thank Cynthia Zonneveld, Kerri Tomasso, Marybeth Ward, Richard Bretan, Charles Morris, Ashley Lulling, Diane Peirano, Janet Slowik, and Christy Mahon. Charles T. Horngren Gary L. Sundem William O. Stratton David Burgstahler Jeff Schatzberg ISBN: 0-536-47129-0 xxi Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Introduction to Management Accounting ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Managerial Accounting, the Business Organization, and Professional Ethics C H A P T E R LEARNING OBJECTIVES When you have finished studying this chapter, you should be able to: 1. Describe the major users and uses of accounting information. 2. Explain why ethics is important to management accountants. 3. Describe the cost-benefit and behavioral issues involved in designing an accounting system. 4. Explain the role of budgets and performance reports in planning and control. 5. Discuss the role accountants play in the company's value-chain functions. 6. Contrast the functions of controllers and treasurers. 7. Explain why accounting is important in a variety of career paths. 8. Identify current trends in management accounting. 9. Appreciate the importance of standards of ethical conduct to professional accountants. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. S TA R B U C K S When Mei-Hwa Zhang walks into a Starbucks in Beijing, she has much the same experience as Mohammad Kumar does in a Starbucks in Kuwait or Franz Mueller does in one in Zurich. How does Starbucks manage to keep its 11,000 coffee stores the same throughout the world? All Starbucks' managers, from baristas to store managers to its chief executive officer, have common objectives. They assess how well their unit meets these objectives partly by looking at accounting reports. Accounting provides a common language to help managers around the world communicate financial information. Without this information, managers would find their task much more difficult. By the time you finish reading this book, you will be comfortable with the accounting information managers use to make their decisions. You will be able to use this information, along with other information, to develop plans, make short-term and longterm decisions, assess performance, and, in general, be a better manager. Starbucks is a young, fast-growing company that has established a worldwide reputation since its founding in 1971 in Seattle's Pike Place Market. Recently Brandchannel's Readers' Choice Award survey ranked Starbucks fourth in the world among brands with the most impact. It was ranked twenty-ninth among Fortune magazine's "100 Best Companies to Work For." Business Ethics magazine selected it among its "100 Best Corporate Citizens." The chairman of Starbucks, Howard Schultz, was selected by Business Week as one of the "Top 25 Best Managers" in the country. Finally, Fortune named Starbucks the most admired company in the food services category five years in a row, and in 2006 it was the fifth most admired company in America. How did Starbucks accomplish all this? Starbucks stores, such as this one at Great Wall of China, look very much alike, and the products and services are consistent throughout the world. This is a result of good management, and good management is a result of good information. Management accounting information is essential to managers of Starbucks, as it is to managers in any organization, large or small, for-profit or nonprofit, regardless of its location in the world. ISBN: 0-536-47129-0 3 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 4 Part 1: Focus on Decision Making If you had asked most people a decade or two ago whether consumers around the world would pay a premium price for a "better" cup of coffee, few would have answered yes. Nevertheless, the expansion of Starbucks has been nothing short of phenomenal. In 2005, Starbucks' total revenues--the amount the company received for all the items sold--were $6.4 billion, compared with only $700 million in 1996. The net income--the profit that Starbucks made--was $494 million, up from only $42 million in 1996. Total assets--the recorded value of the items owned by Starbucks--grew from less than $900 million in 1996 to more than $3.5 billion in 2005. All these numbers are accounting measures of Starbucks' success. It is the details behind these figures that managers use to make day-to-day decisions and measure performance. The cumulative success of numerous managers of Starbucks' stores in many countries adds up to these company-wide numbers. As we embark on our journey into the world of management accounting, we will explore what it takes for a company such as Starbucks to manage its activities and how managers throughout the company use accounting information to better carry out their jobs. Keep this in mind: The same basic accounting needs and procedures that supported managers in the small coffee company that Starbucks was in 1980 support the managers in the larger company it is today, and indeed they support businesses big and small, old and new, worldwide. The accounting systems may be larger and more elaborate, but the principles that govern them remain the same. Managerial accounting can help managers in all types of organizations answer vital questions. Consider the decisions you might face as a manager in the following situations: Suppose you are a Boeing engineer preparing manufacturing specifications for a new airplane, the 787. There are three possible ways to organize the assembly of the plane. Which is the most cost-effective approach? Suppose you are a product manager at General Mills and you are designing a new marketing plan for Cheerios. Market research predicts that distributing free samples in the mail will increase annual sales by 4%. Will the cost of the free samples (including the cost of distributing them) be more or less than the profits from the added sales? Bank of America offers free checking to customers who keep a minimum balance of $500 in their FirstChoiceTM Minimum Balance account. How much does it cost the bank to provide this free service? Kitsap County Special Olympics holds a series of athletic events for disabled youth. As executive director, you must decide how much money the group's annual fund drive must raise to support its planned activities. Madison Park Cafe is a dinner-only restaurant located in a middle-class neighborhood. Suppose you are the proprietor and are considering opening for lunch. To be competitive, you must price the average lunch at about $9, and you can serve about 40 patrons. Can the restaurant produce a lunch that meets its quality standards at an average cost of less than $9? The Seattle School District is negotiating with the teachers' union. Among the issues are teachers' salaries, class size, and number of extracurricular activities offered. The union and the district have both made several proposals. If you were the superintendent of schools, you would want to know how much each of the various proposals will cost. You would also like to know the added cost of increasing class size by one student per class, and whether this cost would differ for elementary, junior high, and high school levels. ISBN: 0-536-47129-0 In making decisions such as these, managers turn to management accountants for information. Larry White, former chair of the Institute for Management Accountants, Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 1: Managerial Accounting, the Business Organization, and Professional Ethics 5 sums up the role of management accounting as follows: "Management accountants are committed to helping their organization achieve its strategic goals by providing decision support, planning, and control for business operations with a high level of ethics and professional competence." In this chapter, we consider the purposes and roles of management accounting and accountants in different types of organizations, as well as some of the trends and challenges faced by accountants today. Information is useful only if decision makers can rely on it. Therefore we place special emphasis on ethics--unless accountants have high integrity, their information will have little value. Accounting and Decision Making The basic purpose of accounting information is to help you make decisions, whether you are a company president, a production manager, a hospital or school administrator, an investor--the list could go on and on. Regardless of who is making the decision, understanding accounting information allows for a more informed, and better, decision. O B J E C T I V E Describe the major users and uses of accounting information. 1 Users of Accounting Information Users of accounting information fall into two general categories: 1. Internal managers who use the information for day-to-day operating decisions and for long-range strategic decisions. 2. External parties, such as investors and government authorities, who use the information for making decisions about the company. Both internal parties (managers) and external parties use accounting information, but they often demand different types of information and use it in different ways. Management accounting produces information for managers within an organization. It is the process of identifying, measuring, accumulating, analyzing, preparing, interpreting, and communicating information that helps managers fulfill organizational objectives. In contrast, financial accounting produces information for external parties, such as stockholders, suppliers, banks, and government regulatory agencies. We list the major differences between management accounting and financial accounting in Exhibit 1-1. Despite these differences, most organizations use a general-purpose accounting system that meets most of the needs of both types of users. As managers, you need to be careful to use the right information from the accounting system for your decisions--information prepared for internal decisions should often differ from that prepared for external parties. What kinds of accounting information do managers need? Good accounting information helps an organization achieve its goals and objectives by helping to answer three types of questions: 1. Scorecard questions: Is the company doing well or poorly? Scorekeeping is the accumulation and classification of data. This aspect of accounting enables both internal and external parties to evaluate organizational performance. Starbucks' annual income statement, balance sheet, cash flow statement, and income tax filings with the government are part of the scorekeeping function performed by the company's accountants. 2. Attention-directing questions: Which problems should I look into? Attention directing means reporting and interpreting information that helps managers to focus on operating problems, imperfections, inefficiencies, and opportunities. Attention directing usually involves routine reports that compare actual results to before-the-fact expectations. For example, a Starbucks store may report profits of $120,000 when budgeted profit was management accounting The branch of accounting that produces information for managers within an organization. It is the process of identifying, measuring, accumulating, analyzing, preparing, interpreting, and communicating information that helps managers fulfill organizational objectives. financial accounting The branch of accounting that develops information for external decision makers, such as stockholders, suppliers, banks, and government regulatory agencies. scorekeeping The accumulation and classification of data. attention directing Reporting and interpreting information that helps managers to focus on operating problems, imperfections, inefficiencies, and opportunities. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 6 Part 1: Focus on Decision Making Exhibit 1-1 Distinctions Between Management Accounting and Financial Accounting Management Accounting Primary users Organization managers at various levels. No constraints other than requiring the benefits of improved management decisions to exceed information costs. Choice should consider how measurements and reports will influence managers' daily behavior. Financial Accounting Outside parties such as investors and government agencies but also organization managers. Constrained by generally accepted accounting principles (GAAP). Freedom of choice of accounting measures Behavioral implications in selecting accounting measures Choice based on how to measure and communicate economic phenomena. Behavioral considerations are secondary, although executive compensation based on reported results may have behavioral impacts. Past orientation: historical evaluation. Example: 20X2 actual performance versus 20X1 actual performance. Time focus of reports Future orientation: formal use of budgets as well as historical records. Example: 20X2 budget versus 20X2 actual performance. Flexible, varying from hourly to 10 to 15 years. Detailed reports: includes details about products, departments, territories, etc. Field is less sharply defined. Heavier use of economics, decision sciences, and behavioral sciences. Time span of reports Types of reports Less flexible; usually one year or one quarter. Summary reports: primarily report on the entity as a whole. Influence of other functional areas Field is more sharply defined. Lighter use of related disciplines. problem solving The aspect of accounting that often involves a special study to assess possible courses of action and recommends the best course to follow. $150,000. The accounting report will include information explaining why the store did not achieve its budget. 3. Problem-solving questions: Of the several alternatives being considered, which is the best? The problem-solving aspect of accounting often involves a special study to assess possible courses of action and recommend the best course to follow. For example, Starbucks experimented with adding food service and music sales to its coffee stores. After a special analysis of the revenues and costs, management decided not to expand its food operations but to continue music sales. The scorecard and attention-directing uses of information are closely related. The same information may serve a scorecard function for a manager and an attention-directing function for the manager's superior. For example, many accounting systems provide performance reports that compare actual results of decisions and activities with previously determined plans. By pinpointing where actual results differ from plans, performance reports can show managers how they are doing and show the managers' superiors where to take action. Companies produce most scorecard and attention-directing information on a routine basis every day, month, quarter, or year. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 1: Managerial Accounting, the Business Organization, and Professional Ethics 7 In contrast, managers use problem-solving information when they make long-range plans or special, nonrecurring decisions, such as whether to make or to buy parts, replace equipment, or add or drop a product. They produce this information only when there is a specific decision to make or plan to prepare. For example, Starbucks uses problem-solving information when deciding whether to run ads during the Super Bowl broadcast. MAKING MANAGERIAL DECISIONS Managers use accounting information for many different types of decisions. Accountants must make sure that they produce information that is useful for these various decisions. What type of information--scorekeeping, attention directing, or problem solving--would managers use for each of the following decisions? Why? 1. Deciding whether to replace a traditional assembly line with a fully automated robotic process. 2. Evaluating the performance of a particular division for the preceding year. 3. Identifying which products exceeded their budgeted profitability and which ones fell short of budget. Answers 1. Problem solving. This is a one-time decision for which managers need information targeted at the specific alternatives under consideration. 2. Scorekeeping. This is a routine evaluation of an organizational unit for which managers want systematic data on a regular basis. 3. Attention directing. Managers want information that highlights deviations from budget to make them aware of products that need attention. Influences on Accounting Systems Accounting information for managers usually comes from the company's general-purpose accounting system. An accounting system is a formal mechanism for gathering, organizing, and communicating information about an organization's activities. Many organizations develop systems primarily to satisfy requirements imposed by external parties, as described in the following paragraphs. Because information for managers is optional, managers must justify their information needs on a cost-benefit basis--the benefit of better managerial decisions must exceed the cost of the information. One major influence on accounting systems is the need for public companies to issue annual financial reports. These reports must adhere to a set of standards known as generally accepted accounting principles (GAAP). However, GAAP does not constrain internal accounting reports. Managers can create whatever kind of internal accounting system they want--provided they are willing to pay the cost of developing and operating the system. Another external influence on accounting systems is governmental regulations. A specific example of this is government contracting. Universities, defense contractors, and others contracting with the U.S. government must measure the costs of government contracts in specified ways or risk the government's refusal to pay. A more far-reaching example is the Foreign Corrupt Practices Act, a U.S. law forbidding bribery and other corrupt practices. The title is misleading because the act's provisions apply to all publicly held companies, even if they conduct no business outside the United States. This law requires that companies maintain their accounting records in reasonable detail and accuracy and that they have an appropriate system of internal controls--policies to protect accounting system A formal mechanism for gathering, organizing, and communicating information about an organization's activities. generally accepted accounting principles (GAAP) A set of standards to which public companies' published financial statements must adhere. Foreign Corrupt Practices Act A U.S. law forbidding bribery and other corrupt practices. The law also requires all publicly held companies to maintain their accounting records in reasonable detail and accuracy and have an appropriate system of internal controls. internal controls Policies to protect and make the most efficient use of an organization's assets. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 8 Part 1: Focus on Decision Making internal auditors Accountants who help review and evaluate accounting systems, including their internal controls, to help minimize errors, fraud, and waste. management audit A review to determine whether managers are implementing the policies and procedures specified by top management. Sarbanes-Oxley Act A 2002 law that requires more top-management oversight of a company's accounting policies and procedures. and make the most efficient use of an organization's assets. Internal auditors help review and evaluate accounting systems, including their internal controls, to help minimize errors, fraud, and waste. They also conduct management audits--reviews to determine whether managers are implementing the policies and procedures specified by top management. In general, the act focused attention on the quality of information in accounting systems. In 2002, the Sarbanes-Oxley Act added an extra level of government regulation. Driven by corporate bankruptcies blamed in part on accounting lapses (as well as deficiencies in corporate governance, lax securities regulation, and executive greed), the bill requires more top-management oversight of a company's accounting policies and procedures. By requiring chief executive officers to sign a statement certifying the accuracy of the company's financial statements, the act makes accounting numbers the concern of all managers, not just the accountants. The overall impact of Sarbanes-Oxley is controversial, especially a requirement that external auditors examine and prepare a separate report on a company's internal control system. Many managers insist that the extra costs of compliance exceed any possible benefits. One benefit, however, is that operating managers, now more than ever, must become more intimately familiar with their accounting systems. The resulting changes in the systems sometimes provide stronger controls and more informative reports. Importance of Ethics O B J E C T I V E Explain why ethics is important to management accountants. 2 Regulation of accounting systems seeks to ensure the reliability of the information that accountants provide. However, no regulation can be as effective in ensuring reliability as holding accountants to high ethical standards. Until recently, surveys showed high public confidence in the integrity of accountants. However, because of accounting's role in the corporate collapses early in this decade, public regard for accountants has fallen. A reputation for high integrity develops slowly and requires much effort, but reputations can be quickly lost. The accounting profession is now trying to rebuild its reputation. Why is integrity so important to accountants? Think of it this way: If you buy a car, you can see many of the quality details. Further, if something goes wrong with the car, you will certainly know it. You don't have to rely on the word of the salesperson. But accounting information is different. You can't see its quality. You might not notice for years that something is wrong--probably not until it's too late to do anything about it. Thus, you rely on the integrity of accountants to assure yourself that the information about a company is correct. If you cannot trust the accountant, then the information is nearly worthless. In companies such as Enron, WorldCom, Tyco, Global Crossing, Adelphia, Xerox, and many others, the accounting information provided was faulty. In some of these, there was fraud. However, even if there were no illegalities, the companies provided information that was misleading. What did accountants have to do with this? In a very few cases, accountants participated in fraudulent activities. But most of the time, they simply did not step up and challenge what they surely knew (or at least should have known) was misleading information. Exceptions were accountants who became whistle-blowers, as illustrated in the Business First box on page 9. Integrity takes more than not lying. Most of these accountants did not blatantly lie. But neither did they tell the truth--that is, they did not correct the false or confusing information. They did not make sure that the information provided was reliable, a prime duty of accountants. Why is this important to you? Because ethical habits you develop in your personal life will carry over into your life as a manager or an accountant. A recent survey of university students in the United States showed that 80% of them were appalled at the ethical behavior of corporate executives. Yet 59% of the students admitted to cheating while at the university. In another study, 56% of business graduate students admitted to cheating, compared to 47% of nonbusiness graduate students. There may be a difference in magnitude ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. ETHICS, ACCOUNTING, AND WHISTLE-BLOWERS Companies often rely on accountants to safeguard company ethics. Accountants have a special responsibility to make sure that managers act with integrity and that information disclosed to customers, suppliers, regulators, and the public is accurate. If accountants do not take this responsibility seriously, or if the company ignores the accountants' reports, dire consequences can follow. Just ask WorldCom or Enron stockholders. In both companies, an accountant decided to be a whistle-blower, one who repor ts wrongdoings to his or her super visor. The WorldCom and Enron whistle-blowers became two of the three "2002 Persons of the Year" in Time magazine. In June 2002, Cynthia Cooper, vice president of internal audit for WorldCom, told the company's board of directors that fraudulent accounting entries had turned a $662 million loss into a $2.4 billion profit in 2001. This disclosure led to additional discoveries totaling $9 billion in erroneous accounting entries--the largest accounting fraud in histor y. Cooper was proud of WorldCom and highly committed to its success. Nevertheless, when she and her internal audit team discovered the unethical actions of superiors she admired, she did not hesitate to do the right thing. She saw no joy when CEO Bernie Ebbers and CFO Scott Sullivan were handcuffed and led away. She simply applied what she had learned when she sat in the middle of the front row in her accounting classes at Mississippi State University. Accountants ask hard questions, find the answers, and act with integrity. Being a whistle-blower has not been easy for Cooper. She is a hero to some, a villain to others. But regardless of the reaction of others, Cooper knows that she did what any good accountant should do--no matter how painful it is to tell the truth. At Enron, Sherron Watkins had a different experience. An accounting major at the University of Texas at Austin who star ted her career at Ar thur Andersen, Watkins moved out of accounting when she took a position at Enron in 1993. But in the spring of 2001, she moved back into the financial arena, working directly for CFO Andrew Fastow. As she became more familiar with the accounting at Enron, she discovered the off-the-books liabilities that have now become famous. In August, she wrote a memo to CEO Kenneth Lay and met with him personally, explaining to him "an elaborate accounting hoax." Later she discovered that, rather than the hoax being investigated, her report had generated a memo from Enron's legal counsel titled "Confidential Employee Matter" that included the following: ". . . how to manage the case with the employee who made the sensitive repor t. . . . Texas law does not currently protect corporate whistle-blowers. . . . " In addition, her boss confiscated her hard drive, and she was demoted. She now regrets that she did not take the matter to higher levels, but she thought that Lay would take her allegations seriously. In the end, Watkins proved to be right. While many at Enron knew what was happening, they ignored it. Watkins's accounting background made her both able to spot the irregularities and impelled to report them. Another Enron employee, Lynn Brewer, said that "hundreds, perhaps thousands, of people inside the company knew what was going on, and chose to look the other way." Watkins made the ethical decision to reveal the wrongdoings and did not look the other way. Sources: "The Par ty Crasher," Time, December 30, 2002Januar y 6, 2003, pp. 5256; "The Night Detective," Time, December 30, 2002January 6, 2003, pp. 4550; M. Flynn, "Enron Insider Shares Her Insights," Puget Sound Business Journal, March 713, 2003, p. 50. ISBN: 0-536-47129-0 between the unethical actions of the executives or accountants and the type of cheating by university students, but the reasoning is often the same: "Everyone is doing it." "It won't hurt just this one time." "This assignment (or earnings report) is so important that the benefit of cheating is greater than the cost." "There is very little chance that I will get caught." And, as one student in an ABCNews Primetime special in 2004 said, "There's other people getting better grades than me, and they're cheating. Why am I not going to cheat? It's kind of almost stupid if you don't." None of these excuses is a legitimate justification for unethical behavior. In a world where nearly 30% of teenagers say that one has to "bend the rules to succeed," accountants and business leaders must step forward and insist on high ethical standards. We cannot deny that business executives and government officials have lied and cheated. Several have been caught and have paid the price. Although others have not been Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 10 Part 1: Focus on Decision Making caught, this does not make cheating a path to success. To the contrary. Both businesses and society run better if participants have high integrity. The appropriate attitude is not, as one student in the ABC special offered, "Whether or not you did it, if you can get the jury to say that you're not guilty, you're free." This attitude leads to behavior like that at Enron and WorldCom. Such actions destroy value. You will create more value for yourself if you maintain your integrity throughout your personal life, just as you will create more value for your company or organization by maintaining high ethical standards after you graduate and pursue your career. Managers, accountants, and students are increasingly aware of the importance of integrity. The Wall Street Journal reports two positive trends--more graduates are asking about the ethical standards and practices at companies seeking to hire them, and more companies are exploring the ethical commitment of potential employees. Later in this chapter, we will address some specific ethical standards for professional accountants. But for now, just remember that information from an unreliable source has little value. For accountants to provide reliable information, not only must they be ethical, users of the information must believe that the accountants are ethical. Integrity is hard to establish, but easy to lose. Management Accounting in Service and Nonprofit Organizations Accountants in manufacturing organizations developed many of the basic ideas of management accounting. These ideas, however, have evolved so that they apply to all types of organizations, including service and nonprofit organizations. Service organizations, for our purposes, are organizations that do not make or sell tangible goods. Public accounting firms, law firms, management consultants, real estate firms, transportation companies, banks, insurance companies, and hotels are profit-seeking service organizations. Most nonprofit organizations, such as hospitals, schools, libraries, museums, and government agencies, are also service organizations. Managers and accountants in nonprofit organizations have much in common with their counterparts in profit-seeking organizations. They raise and spend money. They prepare budgets and design and implement control systems. All managers have an obligation to use resources wisely. If used intelligently, accounting information contributes to efficient operations and helps both profit-seeking and nonprofit organizations achieve their objectives. The characteristics of service organizations, whether profit-seeking or nonprofit, include the following: 1. Labor is intensive: The highest proportions of expenses in service organizations, such as schools and law firms, are wages, salaries, and payroll-related costs, not the costs relating to the use of equipment and physical facilities. 2. Output is usually difficult to measure: Because service outputs are intangible, they are often hard to measure. For example, the output of a university might be defined as the number of degrees granted, but many critics would maintain that the real output is what is contained in the students' brains. 3. Service organizations cannot store their major inputs and outputs: Services cannot usually be stockpiled. For example, an airline cannot save an empty airline seat for a later flight, and a hotel's available labor force and rooms are either used or unused as each day occurs. ISBN: 0-536-47129-0 service organizations Organizations that do not make or sell tangible goods. Simplicity is the watchword for accounting systems in service industries and nonprofit organizations. Why? Because many professionals, such as physicians, professors, Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 1: Managerial Accounting, the Business Organization, and Professional Ethics 11 or government officials, are too busy to try to grapple with a complex system. For them to use the information, it must be in a form that is easy to understand. In fact, simplicity is a fine watchword for the design of any accounting system. Complexity tends to generate costs of gathering and interpreting data that often exceed prospective benefits. Concern for simplicity is sometimes expressed as KISS ("keep it simple, stupid," or, better yet, "keep it simple for success"). Cost-Benefit and Behavioral Considerations In addition to simplicity, managers should keep two other ideas in mind when designing accounting systems: (1) cost-benefit balances and (2) behavioral implications. The cost-benefit balance--weighing estimated costs against probable benefits--is the primary consideration in choosing among accounting systems and methods. Therefore, we will refer again and again to cost-benefit considerations throughout this book. Accounting systems are economic goods--like office supplies or labor--available at various costs. Which system does a manager want to buy? A simple file drawer for amassing receipts and canceled checks? An elaborate budgeting system based on computerized models of the organization and its subunits? Or something in between? The answer depends on the buyer's perceptions of the expected benefits in relation to the costs. For example, consider a manager at University Hospital who is considering installing a ConTrol-computerized system made by Advanced Medical Systems for controlling hospital operations. Users enter a piece of information only once and the system automatically incorporates it into budgeting, purchasing, and payables records. Such a system is efficient and is subject to few errors, but is it a good buy? That depends on its expected benefit. If its value to the hospital is greater than its cost of $300,000, then it is a good buy. If not, the manager should consider another accounting system. In estimating the benefits of an accounting system, managers should also consider behavioral implications, that is, the system's effect on the behavior, specifically the decisions, of managers. The system must provide accurate, timely reports in a form useful to managers. If managers do not use accounting reports, the reports cannot improve decisions. Management accounting reports also affect employees' feelings and behavior. Consider a performance report that a manager's superiors use to evaluate the operations for which the manager is responsible. If the report unfairly attributes excessive costs to the operation, the manager may lose confidence in the system and not let it influence future decisions. In contrast, a system that managers believe in and trust can greatly influence their decisions and actions. In a nutshell, think of management accounting as a balance between costs and benefits of accounting information coupled with an awareness of the importance of behavioral effects. Therefore, management accountants must understand related disciplines, such as economics, the decision sciences, and the behavioral sciences, to make intelligent decisions about the best information to supply to managers. O B J E C T I V E Describe the cost-benefit and behavioral issues involved in designing an accounting system. cost-benefit balance Weighing estimated costs against probable benefits, the primary consideration in choosing among accounting systems and methods. 3 behavioral implications The accounting system's effect on the behavior, specifically the decisions, of managers. The Management Process and Accounting ISBN: 0-536-47129-0 Regardless of the type of organization, managers benefit when accounting provides information that helps them plan and control the organization's operations. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 12 Part 1: Focus on Decision Making The Nature of Planning and Control decision making The purposeful choice from among a set of alternative courses of action designed to achieve some objective. planning Setting objectives for an organization and outlining how it will attain them. control Implementing plans and using feedback to evaluate the attainment of objectives. The management process is a series of activities in a cycle of planning and control. Decision making--the purposeful choice from among a set of alternative courses of action designed to achieve some objective--is the core of the management process. Decisions range from the routine (making daily production schedules) to the nonroutine (launching a new product line). There are two basic types of decisions within an organization: (1) planning decisions and (2) control decisions. In practice, planning and control are so intertwined that it seems artificial to separate them. In studying management, however, we find it useful to concentrate on either the planning phase or the control phase to simplify our analysis. The left side of Exhibit 1-2 demonstrates the planning and control cycle of current operations that could be used by a particular Starbucks store. Planning (the top box) refers to setting objectives for an organization and outlining how it will attain them. Thus, planning provides the answers to two questions: What objectives does the organization want to achieve? When and how will the organization achieve its objectives? For the Starbucks store, management wants to improve profitability. The store will accomplish this by adding new drinks and improving advertising. In contrast, control refers to implementing plans and using feedback to evaluate the attainment of objectives. The Starbucks store will expand its menu offerings and expand advertising. Management will evaluate the effectiveness of these actions based on selected performance measures, such as the percent increase in drinks sold. Feedback is crucial to the cycle of planning and control. Planning determines action, action generates feedback, and the control phase uses this feedback to influence further planning and actions. Timely, systematic reports provided by the internal accounting system are the chief source of useful feedback. None of this cycle would be possible without accounting. Exhibit 1-2 Starbucks Store-- Accounting Framework for Planning and Control Corrections and Revisions of Plans and Actions The Management Process Internal Accounting System PLANNING Increase profitability through product growth and improved marketing. Budgets, Special Reports Customer surveys Competitor analysis Advertising cost/impact analysis Revenue/advertising budgets Other Information Systems CONTROL Actions Expand number of drinks by 20% Increase advertising expense by 50% Evaluation Percent increase in drinks sold Percent increase in advertising Percent increase in revenue Accounting System Source documents such as invoices from ad agencies, register tapes Actual revenue/advertising expenses from general and subsidiary ledgers Customer surveys Competitor analysis Advertising impact Drink sales report Performance Reports Drink sales report Actual versus budgeted revenue Actual versus budgeted advertising expense ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 1: Managerial Accounting, the Business Organization, and Professional Ethics 13 Management by Exception The right side of Exhibit 1-2 shows that accounting formalizes plans by expressing them as budgets. A budget is a quantitative expression of a plan of action. The Starbucks store expresses its plan for product growth and improved marketing through revenue and advertising budgets. Budgets also help to coordinate and implement plans. They are the chief devices for disciplining management planning. Without budgets, planning may not get the front-and-center focus that it usually deserves. The accounting system supports both planning and control. The system records, measures, and classifies actions to produce performance reports (the last box in Exhibit 1-2). Performance reports provide feedback by comparing results with plans and by highlighting variances, which are deviations from plans. For example, managers of the Starbucks store evaluate the effectiveness of its advertising plan by comparing the increase in revenue and profits to the increase in advertising. Based on their evaluation, managers at Starbucks make corrections and revisions to their plans. Exhibit 1-3 shows a simple performance report for a hypothetical Starbucks store, the Mayfair Starbucks. Organizations use performance reports to judge managers' decisions and the productivity of organizational units. Performance reports compare actual results to budgets, thereby motivating managers to achieve the objectives. The first column of Exhibit 1-3 is the budget for March 20X7. It is based on a predicted level of sales and the estimated costs needed to support that level of sales. After managers and their superiors agree on a budget, it becomes the managers' target for the month. As the store sells its products and incurs costs, Starbucks' accounting system collects the revenue and cost information. At the end of the month (or weekly, or possibly even daily, if managers need quick feedback), the accounting department prepares a store-level performance report, such as the one in Exhibit 1-3. Actual reports will usually contain more details, but the format will be similar to that shown here. Store managers and their superiors use the performance report to help evaluate the store's operations. Their focus is on the variances--the deviations from the budget. The Mayfair store report shows that the store met its targeted sales, but ingredient costs were $2,500 over budget, store labor costs were $400 under budget, and other labor was $50 over budget. By investigating such variances, managers may find better ways of doing things. Since ingredients had by far the largest variance, management would undoubtedly investigate it first. Performance reports spur investigation of exceptions--items for which actual amounts differ significantly from budgeted amounts. Managers then revise operations O B J E C T I V E Explain the role of budgets and performance reports in planning and control. budget A quantitative expression of a plan of action and an aid to coordinating and implementing the plan. performance reports Feedback provided by comparing results with plans and by highlighting variances. variances Deviations from plans. 4 Exhibit 1-3 Budget Sales Less: Ingredients Store labor (baristas, etc.) Other labor (managers, supervisors) Utilities, maintenance, etc. Total expenses Total operating income ISBN: 0-536-47129-0 U = Unfavorable -- actual exceeds budget F = Favorable -- actual is less than budget Actual $50,000 $ 24,500 11,600 6,050 4,500 46,650 $3,350 Variance 0 $2,500 U 400 F 50 U 0 2,150 U $2,150 U $50,000 22,000 12,000 6,000 4,500 44,500 $5,500 Mayfair Starbucks Store--Performance Report for the Month Ended March 31, 20X7 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 14 Part 1: Focus on Decision Making management by exception Concentrating on areas that deviate from the plan and ignoring areas that are presumed to be running smoothly. to conform with the plans or revise the plans. This process is management by exception, which means concentrating on areas that deviate from the plan and ignoring areas that conform with plans and therefore are presumed to be running smoothly. Thus, the management-by-exception approach frees managers from needless concern with those phases of operations that adhere to plans. However, well-conceived plans incorporate enough discretion or flexibility so that the manager feels free to pursue any unforeseen opportunities. In other words, control should not be a straightjacket. When unfolding events call for actions not specifically authorized in the plan, managers should have the freedom to take these actions. Notice that although budgets aid planning and performance reports aid control, it is not accountants but operating managers and their subordinates who evaluate accounting reports and actually plan and control operations. Accounting assists the managerial planning and control functions by providing prompt measurements of actions and by systematically pinpointing trouble spots. Planning and Control for Product Life Cycles and the Value Chain Many management decisions relate to a single good or service, or to a group of related products. To effectively plan for and control production of such goods or services, accountants and other managers must consider the product's life cycle. Product life cycle refers to the various stages through which a product passes: conception and product development; introduction into the market; maturation of the market; and, finally, withdrawal from the market. At each stage, managers face differing costs and potential returns. Exhibit 1-4 shows a typical product life cycle. Product life cycles range from a few months (for fashion clothing or faddish toys) to many years (for automobiles or refrigerators). Some products, such as many computer software packages, have long development stages and relatively short market lives. Others, such as Boeing 777 airplanes, have a market life many times longer than their development stage. In the planning process, managers predict revenues and costs over the entire life cycle--however long or short. Then accounting systems track actual costs and revenues throughout the life cycle. Periodic comparisons between planned costs and revenues and actual costs and revenues allow managers to assess the current profitability of a product, determine its current product life-cycle stage, and make any needed changes in strategy. For example, suppose Pfizer is developing a new drug to reduce high blood pressure. The budget for the product should plan for costs without revenues in the product development stage. Pfizer will receive most of the revenues in the introduction and mature-market stages. Its pricing strategy should recognize the need for revenues to cover both development and phase-out costs as well as the direct costs of producing the product life cycle The various stages through which a product passes, from conception and development to introduction into the market to maturation and, finally, withdrawal from the market. No Sales Product Development Sales Growth Introduction to Market Stable Sales Level Mature Market Low Sales No Sales Phase-out of Product ISBN: 0-536-47129-0 Exhibit 1-4 Typical Product Life Cycle Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 1: Managerial Accounting, the Business Organization, and Professional Ethics 15 drug. During phase-out, Pfizer must balance the costs of producing the drug with both the revenue generated and the need to keep the drug on the market for those who have come to rely on it. The Value Chain In addition to considering a product's life cycle, managers making planning and control decisions must recognize those activities necessary for a company to create the goods or services that it sells. Whether making doughnuts in a shopping mall or making $50 million airplanes, all organizations try to create goods or services that their customers value. The value chain is the set of business functions or activities that add value to the products or services of an organization. These functions include: Research and development: the generation of, and experimentation with, ideas related to new products, services, or processes. Design of products, services, or processes: the detailed design and engineering of products, services, or processes. Production: the coordination and assembly of resources to produce a product or deliver a service. Marketing: the manner by which individuals or groups learn about the value and features of products or services (for example, advertising or selling activities). Distribution: the mechanism by which a company delivers products or services to the customer. Customer service: the support activities provided to the customer. Support functions: the support activities provided by other internal business functions (for example, management information systems, accounting). Exhibit 1-5 shows these business functions. Not all are of equal importance to the success of a company. Senior management must decide which of these functions enables the company to gain and maintain a competitive edge. For example, Dell Computers considers the design function a critical success factor. The features designed into Dell's computers create higher quality. In addition, the design of efficient processes used to make and deliver computers lowers costs and speeds up delivery to its customers. Dell also performs the other value-chain functions, but it concentrates on being the best process designer in the computer market. Accountants play a key role in all value-chain functions. Most obvious is the production stage, where accountants measure the costs of production and help track the effects of continuous improvement programs. They facilitate cost planning and control through the use of budgets and performance reporting. However, accounting can also have a great influence on the two preproduction value-chain functions. For example, accountants provide estimated revenue and cost data during the research and development stage and especially the design stage of the value chain. Managers use these data to decide which ideas will move forward to the production stage and which will be dropped. These data also enable managers and engineers to reduce the life-cycle costs of products or services by changing product and process designs. Using computer-based planning software, accountants can give managers rapid feedback on ideas for cost reductions long before the company must make a commitment to purchase expensive equipment. Accountants also play a role in postproduction value-chain functions. For example, marketing decisions have a significant impact on sales, but the cost of promotional programs is also significant. Accountants analyze the trade-off between increased costs and revenues. In addition, accounting information can influence decisions about distributing products or services to customers. Should a company sell its products directly to a chain of retail stores, or should it sell to a wholesaler? What transportation system should be used--trucks or trains? Accountants provide important information about the costs of O B J E C T I V E Discuss the role accountants play in the company's value-chain functions. value chain The set of business functions or activities that add value to the products or services of an organization. 5 ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 16 Part 1: Focus on Decision Making Exhibit 1-5 The Value Chain of Business Functions Research and Development Customer Service Product (Service) and Process Design CUSTOMER FOCUS Distribution Production Marketing Support activities such as management information systems and accounting are not shown. These activities support all other value chain functions. each alternative. Finally, accountants provide cost data for customer service activities, such as warranty and repair costs and the costs of goods returned. Managers compare these costs to the benefits generated by the better customer service. As you can see, cost management is important throughout the value chain. Note that customer focus is at the center of Exhibit 1-5. Each value-chain function should focus on activities that create value for the customer. Successful businesses never lose sight of the importance of maintaining a focus on the needs of their customers. For example, one of the main principles in Starbucks' mission statement is to "develop enthusiastically satisfied customers all of the time." Customers are also the focus of a very different business, commercial airplanes, as explained by Philip Condit, former chairman and chief executive officer, Boeing Company: Customers, by the choices they make, grant companies a future or condemn them to extinction. We will continuously strive to achieve total customer satisfaction. . . . We will seek to truly understand the complexity of our customers' needs, not push our own ideas or technology. The value chain and the concepts of adding value and focusing on the customer are essential for success. Accountants focus on the values created compared to the costs incurred in each link of the value chain. Therefore, we will return to the value chain and use it as a focus for discussion throughout this book. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 1: Managerial Accounting, the Business Organization, and Professional Ethics 17 MAKING MANAGERIAL DECISIONS Measuring costs at various stages of the value chain is important to Starbucks. Suppose that you are a Starbucks manager or accountant. For each of the following activities, indicate the value-chain function that is being performed and what accounting information might be helpful to managers in the function. 1. Process engineers investigate methods to reduce the time to roast coffee beans and to better preser ve their flavor. 2. A direct-to-your-home mail-order system is established to sell custom-blended coffees. 3. Arabica coffee beans are purchased and transported to company processing plants. 4. Focus groups investigate the feasibility of a new line of Frappuccino drinks. 5. A telephone hotline is established for mail-order customers to call with questions and comments on the quality and speed of delivery. 6. Each company-owned retail store undertakes a campaign to provide information to customers about the processes used to make its coffee products. Answers 1. Design. Both the design of products and, as here, design of production processes are part of the entire design function. Managers need the costs of various possible production processes to decide among the alternatives. 2. Distribution. This provides an additional way to deliver products to customers. Managers need information on the costs of a mail-order system to compare to the added profit from mail-order sales. 3. Production. The purchase price of beans and transportation (or freight-in) costs are part of product costs incurred during the production function. Starbucks purchases only premium beans, but the company is still concerned about the price paid and the added costs of transportation. 4. Research and development. These costs (mostly wages) are incurred prior to management's final decision to design and produce a new product. Predicted revenues and costs from the Frappuccino market can help managers design a drink that is both marketable and profitable. 5. Customer ser vice. These costs include all expenditures made after Starbucks has delivered the product to the customer; in this case, Starbucks obtains feedback on the quality and speed of deliver y. Managers will trade off the cost of the hotline and the value of the information generated from the calls. 6. Marketing. These costs are for activities that enhance the existing or potential customers' awareness and opinion of the product. Like many adver tising expenses, it is easy to estimate the costs of such a program but hard to quantify the benefits. Accounting's Position in the Organization The role of management accountants in organizations has changed rapidly over the last decade or so. Consider the following four work activities of management accountants: Collecting and compiling information. Preparing standardized reports. Interpreting and analyzing information. Being involved in decision making. ISBN: 0-536-47129-0 Recent surveys show that management accountants are spending less time on the first two activities and more time on the last two. In essence, the management accountant is becoming an internal consultant on information-related issues--that is, an advisor for managers about what information would be useful, what information is available, and how to analyze the information and use it in decision making. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 18 Part 1: Focus on Decision Making Line and Staff Authority line managers Managers who are directly involved with making and selling the organization's products or services. staff managers Managers who are advisory to the line managers. They have no authority over line managers, but they help the line managers by providing information and advice. As an organization grows, it must divide responsibilities among a number of managers and executives each with specific responsibilities. Line managers are directly involved with making and selling the organization's products or services. Their decisions lead directly to meeting (or not meeting) the organization's objectives. In contrast, staff managers are advisory--they support the line managers. They have no authority over line managers, but they help the line managers by providing information and advice. The organization chart in Exhibit 1-6 shows how a traditional manufacturing company divides responsibilities between line and staff managers. Notice that Sales, Engineering, Personnel, and Financial provide staff support at the corporate level, and Receiving and Storeroom, Inspection, Tool Room, Purchasing, Production Control, and Maintenance provide staff support at the factory. All of the staff support the line managers located in Manufacturing. Many modern organizations have abandoned the type of hierarchical structure shown in Exhibit 1-6 in favor of a "flatter" organization. Specialization by individuals is giving way to decision making by cross-functional teams. In such an organization, management accountants are still the information specialists, but they are not isolated in one branch of the organization chart. They do not sit in their offices and issue reports that managers use to make decisions. Instead, the management accountants are physically located with the President Sales Vice-President Engineering Vice-President Manufacturing Vice-President Personnel Vice-President Financial Vice-President or CFO Branch Sales Manager Chief Designer Employment Treasurer Research Factory-Service Departments (staff function) Job Evaluation Controller Receiving and Storeroom Inspection Tool Room Purchasing Production Control Maintenance Production Superintendent Production Departments (line function) Foundry Stamping Machining Welding and Assembly Finishing ISBN: 0-536-47129-0 Exhibit 1-6 Partial Organization Chart of a Manufacturing Company Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. THE ACCOUNTANT'S ROLE AT THE MARMON GROUP The Marmon Group embodies nearly all the reasons why management accounting is a vital and growing function in today's leading companies. Marmon, headquar tered in Chicago, is an international association of more than 100 manufacturing, distribution, and service companies with annual revenues in excess of $6.4 billion and assets of $7.4 billion. It is one of the 20 largest privately held companies in the United States. Because operations are spread out in more than 40 different countries with thousands of diverse products and services (such as workers' gloves, water coolers, railroad tank cars, medical products, and credit services for banks), managers at Marmon make extensive use of management accounting information when undertaking important decisions. What exactly is the role of management accountants at Marmon? According to Jim Smith, Marmon's former director of cost management, "The role of the management accountant is changing dramatically in most of our companies." In the past, Marmon's management accountants were basically clerical workers who spent most of their time analyzing monthly cost variances. Now, however, Marmon's management accountants work closely with operating and sales managers, providing cost information in a format that makes sense to those managers. Says Smith, "In the past few years the management accountant has become much more of a finan- cial and business strategy adviser to senior management. Operating and sales managers are demanding meaningful cost information, and management accountants are helping them see how their actions affect costs and the bottom line." Management accountants have become more important to Marmon, according to Smith, because recessions and foreign competition over the past 10 years have awakened the understanding in most managers that managing costs is an important function. Knowing what a product truly costs or the cost of servicing a particular customer has become essential to Marmon's profitability. "To help manage costs," says Smith, "accountants and managers are shying away from using one cost, often the cost used for financial reporting purposes, as the only important cost." Instead, they are now using costs calculated for the decision at hand. As Smith indicated, "Depending on the decision, any of the cost methods described in Introduction to Management Accounting are relevant." He believes this is a ver y positive change, "since it allows and, in fact, requires the management accountant to understand all of the functions in a business and how each one adds value to the product or service." Source: The Marmon Group Web site (www.marmon.com); discussions with James Smith, former director of cost management, the Marmon Group. line managers, and they work together to determine the optimal information support for the managers. We highlight some other recent changes in the role of accountants in the Business First box above. O B J E C T I V E Contrast the functions of controllers and treasurers. chief financial officer (CFO) The top executive who deals with all finance and accounting issues in an organization. The CFO generally oversees the accounting function. treasurer A manager who is concerned mainly with the company's financial matters, such as raising and managing cash. controller (comptroller) The top accounting officer of an organization who deals mainly with operating matters, such as aiding management decision making. 6 Controller and Treasurer Functions We have discussed the various roles of management accountants in an organization. The employees carrying out management accounting functions have a variety of titles. The chief financial officer (CFO), a top executive who deals with all finance and accounting issues, oversees the accounting function in most organizations. Both the treasurer and controller generally report to the CFO, as shown in Exhibit 1-6. The treasurer is concerned mainly with the company's financial matters such as raising and managing cash, the controller (also called comptroller in many government organizations) with operating matters such as aiding management decision making. Finance classes address most treasury activities; accounting is concerned mainly with the controllership activities. The controller is the organization's top accounting officer. The controller's department provides managers with specialized services, including advice and help in budgeting, analyzing variances, pricing, and making special decisions. The controller often also prepares the financial statements for external users. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 20 Part 1: Focus on Decision Making The Financial Executives Institute, an association of corporate treasurers and controllers, distinguishes the two as follows: Controllership 1. Planning for control 2. Reporting and interpreting 3. Evaluating and consulting 4. Tax administration 5. Government reporting 6. Protection of assets 7. Economic appraisal Treasurership 1. Provision of capital 2. Investor relations 3. Short-term financing 4. Banking and custody 5. Credit management and cash collections 6. Investments 7. Risk management (insurance) Management accounting is the primary means of implementing the first three functions of controllership. In a small company, one person may perform both treasury and controllership functions. Nevertheless, it is useful to differentiate the two different roles. Summary Problem for Your Review PROBLEM The following are quotes by or about controllers or treasurers. Indicate whether each refers to a treasury or controllership function and why. 1. "At Lucent, Ms. Hund-Mejean was responsible for executing over $12 billion in corporate financings, the management of customer financings activities, oversight of investor relations, and the management of over $30 billion in employee benefit assets." 2. "At [a California distribution company] we're implementing a company-wide budget for capital spending and expect to reduce capital spending by 10%." 3. "At DRS Technologies, Mr. Hardman will be responsible for . . . arranging short- and long-term financing, maintaining relationships with commercial and investment banks and credit rating agencies, overseeing domestic and international cash management, forecasting, developing and executing foreign exchange strategies, and providing interest-rate risk management and capital-structure analysis." SOLUTION 1. These are all financial activities, thus, Ms. Hund-Mejean must be a treasurer. 2. Budgeting and advising on capital spending are functions of the controller. 3. All items mentioned are financing activities, so Mr. Hardman is the treasurer at DRS Technologies. Career Opportunities in Management Accounting O B J E C T I V E Explain why accounting is important in a variety of career paths. 7 The many types and levels of accounting personnel found in the typical organization mean that there are broad opportunities awaiting those who master the accounting discipline. Average starting salaries for undergraduate accounting majors are higher than those in any discipline outside of engineering and computer sciences. In 2006, starting salaries for accounting graduates were more than 30% higher than those for social science graduates and 15% higher than general business administration graduates, according to a survey by ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 1: Managerial Accounting, the Business Organization, and Professional Ethics 21 the National Association of Colleges and Employers. At more advanced levels, managers throughout an organization find that management accounting skills enhance their understanding of the key determinants of organizational success and, thereby, help them be better managers or executives. Certified Management Accountant When accounting is mentioned, most people think first of independent auditors-- certified public accountants (CPAs) in the United States and chartered accountants (CAs) in many other nations--who reassure the public about the reliability of companies' published financial statements. The International Accounting Education Standards Board (IAESB), a part of the International Federation of Accountants, sets educational standards for auditors throughout the world. However, the majority of accountants work in private industry and government. While they produce the organizations' financial statements, they also produce management accounting information for managers. The certified management accountant (CMA) designation is the internal accountant's counterpart to the CPA. The Institute of Management Accountants (IMA), the largest U.S. professional organization focused on internal accounting, oversees the CMA program. CMAs must pass a four-part examination: (1) business analysis; (2) management accounting and reporting; (3) strategic management; and (4) business applications.1 Like the CPA designation, the CMA confers higher status on its holders, and it also leads to more responsible positions and higher pay. A recent IMA survey showed that its average certified member makes $30,000 more per year than its uncertified members. certified public accountant (CPA) In the United States, independent accountants who reassure the public about the reliability of companies' published financial statements. chartered accountant (CA) The equivalent to the CPA in many countries. International Accounting Education Standards Board (IAESB) The body that sets educational standards for auditors throughout the world. certified management accountant (CMA) The management accountant's counterpart to the CPA. Institute of Management Accountants (IMA) The largest U.S. professional organization of accountants focused on internal accounting. It oversees the CMA program. Training for Top Management Positions Why should you study management accounting if you do not plan to become an accountant-- either a CPA or CMA? Because studying accounting helps you to understand an organization's decision-making processes and how information can improve decisions in purchasing, manufacturing, wholesaling, retailing, marketing, and many other functional areas. You will develop skills that will help you to be a better manager, regardless of the type of managerial position you hold. In addition to studying accounting, working as an accountant, at least early in your career, can give you exposure to many parts of an organization. By learning about all aspects of an organization, you will be better prepared for positions as, for example, a production or marketing executive. Why? Because you will interact with managers in those areas, learn from them, and have an opportunity to impress them. According to an article in Business Week, "the main reason the controller is getting the ear of top management these days is that he or she is virtually the only person familiar with all the working parts of the company." A recent survey by Financial Executive magazine showed that 33% of chief executive officers (CEOs) in companies with revenues greater than $500 million had risen through the finance/accounting ranks, compared with 26% from operations and 21% from sales and marketing. CEOs of companies such as Pfizer and Burger King have finance backgrounds. Thus, you can see that management accounting can be a ladder to the highest-level executive positions in an organization. Adaptation to Change Businesses in the twenty-first century differ from those in the twentieth century. Markets have become more competitive, and access to information has become more important. Many companies today derive their competitive advantage from their information, not 1Information ISBN: 0-536-47129-0 can be obtained from the IMA, 10 Paragon Drive, Montvale, NJ 07645, or at www.imanet.org. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 22 Part 1: Focus on Decision Making their physical facilities. Such companies must continually improve their accounting information. The information that supported traditional companies in the 1980s and 1990s does not adequately support the modern business environment. Changes in the business environment cause accounting systems to change. Recent changes have led to a more prominent role for information, including accounting information, so they have also elevated the influence and prestige of accountants within organizations. The managing director of a prominent executive search firm, quoted in Financial Executive, summarized it well: "Today, executive searches focus on finding a CFO who not only has financial acumen but who can be a true business partner with the CEO--and who has the breadth and depth to serve as the organization's number two executive." Current Trends O B J E C T I V E Identify current trends in management accounting. 8 Four major business trends are influencing management accounting today: 1. Shift from a manufacturing-based to a service-based economy in the United States 2. Increased global competition 3. Advances in technology 4. Changes in business processes We will discuss the first three in this section and the fourth in the following section. The service sector now accounts for almost 80% of the employment in the United States. Service industries are extremely competitive, and their managers increasingly rely on accounting information. Many examples in this book are from service companies. Global competition has increased in recent years as many countries have lowered international barriers to trade, such as tariffs and duties. In addition, there has been a worldwide trend toward deregulation. The result has been a shift in the balance of economic power in the world. Nowhere has this been more evident than in the United States. To regain their competitive edge, many U.S. companies redesigned their accounting systems to provide more accurate and timely information about the cost of activities, products, or services. To be competitive, managers must understand the effects of their decisions on costs, and accountants help managers predict such effects. The dominant influence on management accounting over the past decade has been technological change, affecting both the production and the use of accounting information. The increasing capabilities and decreasing cost of computing has changed how accountants gather, store, manipulate, and report data. In many cases, databases allow managers to access data directly and to generate their own reports and analyses. Today managers and accountants work together to assure the availability of the needed data and to be sure managers know how to assemble and use the data. One of the most rapidly growing uses of technology is electronic commerce or e-commerce--conducting business online. The media focuses on business-to-consumer (B2C) transactions, but more than 90% of e-commerce is business-to-business (B2B) transactions. The business slowdown of 2001 and 2002 did little to slow the growth in e-commerce, which continues to grow nearly 50% a year. B2C may create convenience, but B2B creates real savings to the companies involved. For example, some companies have reduced procurement processing costs by as much as 70% by automating the process. Accounting for e-commerce transactions differs from traditional accounting because there is no paper trail of evidence for accountants to rely on to assure the accuracy of their data and reports. The most direct effect of technology changes on accounting systems has been the growing use of enterprise resource planning (ERP) systems--integrated information systems that support all functional areas of a company. Accounting is just one part of such a system. For example, Oracle describes its JD Edwards EnterpriseOne ERP system as electronic commerce (e-commerce) Conducting business online. B2C Electronic commerce from business to consumer. B2B Electronic commerce from one business to another business. enterprise resource planning (ERP) systems Integrated information systems that support all functional areas of a company. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 1: Managerial Accounting, the Business Organization, and Professional Ethics 23 one that "helps you integrate all aspects of your business--including customer relationship management, enterprise asset management, enterprise resource planning, supply chain management, and supplier relationship management." Other well-known ERP system providers are SAP, Microsoft Dynamics, and The Sage Group. Accountants must work with managers throughout the organization to ensure that the ERP system provides the financial information that managers need. Finally, the development of eXtensible Business Reporting Language (XBRL), an XML-based accounting language, helps communicate financial information electronically. This language is likely to greatly influence both internal and external reporting by making comparisons across companies much simpler. XBRL An XML-based accounting language that helps communicate financial information electronically. Changes in Business Processes Because management accounting supports business decisions, accounting systems must adapt to changes in management practices. Some companies implement sweeping changes in operations through business process reengineering, the fundamental rethinking and radical redesign of business processes to improve performance in areas such as cost, quality, service, and speed. This technique is especially popular in the United States, used by government units such as the U.S. Joint Forces Command in Norfolk, Virginia, as well as businesses such as Proctor & Gamble and Ford. A more targeted change leading to increased efficiency in U.S. factories has been the adoption of a just-in-time (JIT) philosophy. Originally, JIT referred to an inventory system that minimized inventories by arranging for materials and subcomponents to arrive just as they were needed for production and for goods to be made just in time to ship them to customers--no sooner and no later. But JIT has become the cornerstone of a broad management philosophy. It originated in Japanese companies such as Toyota and Kawasaki. Now many large U.S. companies use JIT, including Hewlett-Packard, Goodyear, General Motors, Intel, and Xerox, as well as many smaller firms. The essence of the JIT philosophy is to eliminate waste. Managers try to (1) reduce the time that products spend in the production process and (2) eliminate the time that products spend in activities that do not add value (such as inspection and waiting time). Another step in gaining efficiency is lean manufacturing, which applies continuous process improvements to eliminate waste from the entire enterprise. For example, Matsushita Electric's Saga plant decreased the time it takes to produce a finished product from 21/2 days to 40 minutes by replacing conveyor belts with clusters of robots. Companies reduce process time by redesigning, simplifying, and automating the production process. They use computer-aided design (CAD) to design products that can be manufactured efficiently and computer-aided manufacturing (CAM) to direct and control production equipment. Computer-integrated manufacturing (CIM) systems use CAD, CAM, robots, and computer-controlled machines. The costs of such a system are quite different from those of a less-automated system. Companies that install a full CIM system use very little labor. Instead, they acquire the robots and computercontrolled machines needed to perform the routine jobs that were previously accomplished by assembly-line workers. Besides automating production, a focus on quality is important in today's competitive environment. In the 1980s and 1990s, many companies undertook total quality management (TQM) initiatives. TQM minimizes costs by maximizing quality. It focuses on continuous improvement in quality and satisfying one's customers. Recently the focus on quality has shifted to Six Sigma, a disciplined, datadriven approach to eliminating defects in any process. Used by about 35% of major U.S. companies, Six Sigma is essentially a continuous process-improvement effort designed to reduce costs by improving quality. Pioneered in the 1980s by Motorola, companies such as General Electric in the United States and Samsung in Korea have used it as a business process reengineering The fundamental rethinking and radical redesign of business processes to improve performance in areas such as cost, quality, service, and speed. just-in-time (JIT) philosophy A philosophy to eliminate waste by reducing the time products spend in the production process and eliminating the time products spend on activities that do not add value. lean manufacturing Applying continuous process improvements to eliminate waste from the entire enterprise. computer-integrated manufacturing (CIM) systems Systems that use computer-aided design, computer-aided manufacturing, robots, and computer-controlled machines. total quality management (TQM) Initiatives that minimize costs by maximizing quality. Six Sigma A continuous process improvement effort designed to reduce costs by improving quality. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 24 Part 1: Focus on Decision Making management philosophy to transform their business. Six Sigma essentially ensures that internal processes are running as efficiently as possible. Although originally developed in manufacturing operations, staff functions, such as legal departments, also use Six Sigma today. For example, law departments in both DuPont and Tyco use Six Sigma to "improve compliance, reduce risk, contain costs, and align the law department more closely with the objectives of the business." Management accountants play a major role in Six Sigma applications as both the experts on the measurements being used and as full members of the cross-functional teams that lead the efforts. Why do these business process changes affect management accounting? They all directly affect costs, and accountants often measure the actual cost savings, predict anticipated cost savings, and develop costs for products or services that differ for different production environments. For example, one Midwestern factory saved production time by redesigning its plant layout so that the distance products traveled from one operation to the next during production was reduced from 1,384 feet to 350 feet. Accountants measured the cost the company saved by the reduced production time. A British company reduced the time to manufacture a vacuum pump from three weeks to six minutes by switching from long assembly lines to manufacturing cells that accomplish all production steps in quick succession. Again, accountants measured the benefits created by the reduced production time. In general, when companies change their production processes to accomplish economic objectives, accountants predict and measure the economic impact. MAKING MANAGERIAL DECISIONS Suppose you are a manager of a DuPont chemical plant. The plant has just undertaken a business process reengineering project and, as a result, has substantially changed its production process. It is much more automated, with newly acquired equipment replacing laborintensive operations. The plant is also making more use of electronic commerce and moving toward a JIT inventor y policy. You have a meeting with your accountant to discuss possible changes in your accounting system. What types of accounting-system changes might be warranted? Answer Major changes in production processes generally lead to different information needs. The old accounting system may have focused on accounting for labor; the new system should carefully monitor and report on the use of the automated equipment. This will direct attention to the most important costs in the process and make sure that they are not out of control. Problem-solving needs will also be different. Initially, the plant's managers will probably want comparative data on the cost of the new process versus the cost of the old. In the future, they will need information about how best to use a capacity that the plant owns (the equipment) rather than how much labor to use for the planned level of production. Implications of Process Changes for the Study of Management Accounting As you read the remainder of this book, remember that accounting systems change as the world changes. Companies actually apply all the techniques presented in this book. Tomorrow, however, things may be different. To adapt to changes, you must understand why companies are using the techniques, not just how they are using them. We urge you to resist the temptation to memorize rules and techniques. Instead, develop your understandISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 1: Managerial Accounting, the Business Organization, and Professional Ethics 25 ing of the underlying concepts and principles. These will continue to be useful in developing and understanding new techniques for changing environments. Ethical Conduct for Professional Accountants Business processes and accounting systems change. However, the need for accountants to maintain high ethical standards of professional conduct will never change. Integrity has always been important, but after the ethical lapses early in this decade, it has added importance. Accountants must reestablish a stellar reputation for ethics and integrity that the events of recent years have diminished. First we should define ethics. The Institute of Management Accountants says that ethics "deals with human conduct in relation to what is morally good and bad, right and wrong. It is the application of values to decision making. These values include honesty, fairness, responsibility, respect and compassion." We like to think of ethics as simply doing what is right. O B J E C T I V E Appreciate the importance of standards of ethical conduct to professional accountants. ethics The field that deals with human conduct in relation to what is morally good and bad, right and wrong. It is the application of values to decision making. These values include honesty, fairness, responsibility, respect, and compassion. 9 Standards of Ethical Conduct Until recently, public opinion surveys consistently ranked accountants high in terms of their professional ethics. Ethical standards require CPAs and CMAs to adhere to codes of conduct regarding competence, confidentiality, integrity, and credibility. Exhibit 1-7 contains the IMA Statement of Ethical Professional Practice. Professional accounting organizations have procedures for reviewing alleged behavior that is not consistent with the standards. Within organizations, the CFO is often the ethical gatekeeper and company conscience. Not only should CFOs have high personal integrity, often they are also responsible for assuring high ethical conduct throughout the organization. There should be no difference between personal and business ethics. Managers who check their ethical standards at the door when they report to work, rationalizing that "business is business," will eventually lead an organization into trouble. Realizing this, many companies have hiring practices that include ethical profiling--trying to hire only managers with high ethical standards. The ethical organization also has policies in place to motivate ethical actions. Top management sets the tone. Complete integrity and outspoken support for ethical standards by senior managers, in both word and deed, are the greatest motivators of ethical behavior throughout an organization. To use an old clich, top management must "walk the walk" as well as "talk the talk." A code of conduct--a document specifying the ethical standards of an organization--is the centerpiece of most ethics programs. (See the Business First box, "Ethics and Corporate Codes of Conduct," on p. 28.) But having a code is not sufficient. Actual policies and practices influence behavior. This means that managers' evaluations must include an assessment of ethical conduct. Organizations cannot tolerate unethical behavior, even if it leads to great financial performance. Companies should penalize, not reward, an accountant who can hide losses by manipulating the accounting reports. For example, WorldCom, Global Crossing, Qwest, and other companies created accounting entries to make their financial reports look better than their actual performances. Such entries were misleading--and some downright illegal. At first, managers were rewarded for coming up with such innovative schemes. But in the end, their schemes led to their companies' downfall. Once exposed, they revealed the companies' lack of integrity and caused investors and others to question many aspects of the companies' operations. Most companies make ethics a top priority. For example, Starbucks includes ethical principles in the first line of its mission statement: "To establish Starbucks as the premier purveyor of the finest coffee in the world while maintaining our uncompromising principles as we grow." Ben & Jerry's, the ice cream company, has a high reputation for ethics IMA Statement of Ethical Professional Practice A code of conduct developed by the Institute of Management Accountants; this code includes competence, confidentiality, integrity, and credibility. code of conduct A document specifying the ethical standards of an organization. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 26 Part 1: Focus on Decision Making Exhibit 1-7 IMA Statement of Ethical Professional Practice Members of IMA shall behave ethically. A commitment to ethical professional practice includes: overarching principles that express our values and standards that guide our conduct. Principles IMA's overarching ethical principles include: Honesty, Fairness, Objectivity, and Responsibility. Members shall act in accordance with these principles and shall encourage others within their organizations to adhere to them. Standards A member's failure to comply with the following standards may result in disciplinary action. I. Competence Each member has a responsibility to 1. Maintain an appropriate level of professional expertise by continually developing knowledge and skills. 2. Perform professional duties in accordance with relevant laws, regulations, and technical standards. 3. Provide decision support information and recommendations that are accurate, clear, concise, and timely. 4. Recognize and communicate professional limitations or other constraints that would preclude responsible judgment or successful performance of an activity. II. Confidentiality Each member has a responsibility to 1. Keep information confidential except when disclosure is authorized or legally required. 2. Inform all relevant parties regarding appropriate use of confidential information. Monitor subordinates' activities to ensure compliance. 3. Refrain from using confidential information for unethical or illegal advantage. III. Integrity Each member has a responsibility to 1. Mitigate actual conflicts of interest. Regularly communicate with business associates to avoid apparent conflicts of interest. Advise all parties of any potential conflicts. 2. Refrain from engaging in any conduct that would prejudice carrying out duties ethically. 3. Abstain from engaging in or supporting any activity that might discredit the profession. IV. Credibility Each member has a responsibility to 1. Communicate information fairly and objectively. 2. Disclose all relevant information that could reasonably be expected to influence an intended user's understanding of the reports, analyses, or recommendations. 3. Disclose delays or deficiencies in information, timeliness, processing, or internal controls in conformance with organizational policy and/or applicable law. Resolution of Ethical Conflict In applying the Standards of Ethical Professional Practice, you may encounter problems identifying unethical behavior or resolving an ethical conflict. When faced with ethical issues, you should follow your organization's established policies on the resolution of such conflict. If these policies do not resolve the ethical conflict, you should consider the following courses of action: 1. Discuss the issue with your immediate supervisor except when it appears that the supervisor is involved. In that case, present the issue to the next level. If you cannot achieve a satisfactory resolution, submit the issue to the next management level. If your immediate superior is the chief executive officer or equivalent, the acceptable reviewing authority may be a group such as the audit committee, executive committee, board of directors, board of trustees, or owners. Contact with levels above the immediate superior should be initiated only with your superior's knowledge, assuming he or she is not involved. Communication of such problems to ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 1: Managerial Accounting, the Business Organization, and Professional Ethics 27 Exhibit 1-7 authorities or individuals not employed or engaged by the organization is not considered appropriate, unless you believe there is a clear violation of the law. 2. Clarify relevant ethical issues by initiating a confidential discussion with an IMA Ethics Counselor or other impartial advisor to obtain a better understanding of possible courses of action. 3. Consult your own attorney as to legal obligations and rights concerning the ethical conflict. Source: Institute of Management Accountants, Ethical Standards, www.imanet.org/ima/about_ethics_statement.asp. Continued that focuses more on its external social obligations, as recognized in its mission statement: "To operate the Company in a way that actively recognizes the central role that business plays in the structure of society by initiating innovative ways to improve the quality of life of a broad community--local, national, and international." There are many more companies with high ethical standards than there are with large ethical violations. It is unfortunate that the latter receive most of the publicity. To maintain high ethical standards, accountants and others need to recognize situations that create pressures for unethical behavior. Four such temptations, summarized in Financial Executive, are 1. Emphasis on short-term results. This may have been the largest issue in the recent spate of ethical breakdowns. If "making the numbers" is goal number one, accountants may do whatever is necessary to produce the expected profit numbers. 2. Ignoring the small stuff. Most ethical compromises start out small. The first step may seem insignificant, but large misdeeds are often the result of many small steps. Toleration of even small lapses can lead to large problems. 3. Economic cycles. A down market can reveal what an up market conceals. When Enron was flying high, no one seemed to question its financial reports. When the economy took a downward turn, managers made ethical compromises to keep pace with expectations of an up market. The result was a huge crisis when scrutiny revealed the many questionable practices. To prevent disclosure of ethical problems in bad times, companies need to be especially vigilant to prevent ethical lapses in good times. 4. Accounting rules. Accounting rules have become more complex and less intuitive, making abuse of the rules harder to identify. Ethical accountants do not just meet the "letter of the law," they hold a higher standard for full and fair disclosure. They do not try to find loopholes in the regulations. Instead, they seek transparency--conveying to users the real economic performance and financial position of the company. Few organizations are intentionally unethical. Even Arthur Andersen, the accounting firm destroyed by failed audits at Enron, Sunbeam, Global Crossing, and others, had a formal ethical structure, including a partner in charge of ethics. Nevertheless, other pressures, especially the pressure for growing revenues, overrode the ethical controls and caused many bad decisions. Ethical Dilemmas What makes an action by an accountant unethical? An unethical act is one that violates the ethical standards of the profession. The standards, however, leave much room for individual interpretation and judgment. A first step is to ask two questions: Is this action unethical? Would it be unethical not to take this action? If the answers to these questions are clear, then the ethical action is clear. For example, if WorldCom's accountants had asked whether their recording of expenses as assets was unethical, they would have no choice but to have answered "yes." However, a manager's ethical choice becomes more complex ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. ETHICS AND CORPORATE CODES OF CONDUCT The Sarbanes-Oxley Act of 2002 requires companies "to disclose whether or not, and if not, the reason therefore, such issuer has adopted a code of ethics for senior financial officers, applicable to its principal financial officer and comptroller or principal accounting officer, or persons performing similar functions." This has created increased interest in corporate codes of conduct. However, a code of conduct means different things to different companies. Some of the items included in companies' codes of conduct include maintaining a dress code, avoiding illegal drugs, following instructions of superiors, being reliable and prompt, maintaining confidentiality, not accepting personal gifts from stakeholders as a result of company role, avoiding racial or sexual discrimination, avoiding conflict of interest, complying with laws and regulations, not using an organization's property for personal use, and reporting illegal or questionable activity. Even before the Enron and other corporate scandals, over 80% of U.S. companies had a code of conduct, according to a sur vey by the Financial Executives Institute. But the codes differed in type and in level of enforcement. One company had only one rule: "Don't do anything you would be embarrassed to read about in tomorrow's newspaper." Others have detailed lists of dos and don'ts. Some companies use consulting firms to advise them on their codes. Although the codes and their development differ, the goal is generally the same--to motivate employees to act with integrity. To encourage development of codes of conduct, the Financial Executives Institute (FEI) included examples of codes on its Web site. Two extremes among those presented are those of Wiremold and CSX Corporation. Wiremold has a simple, seven-point code: (1) respect others, (2) tell the truth, (3) be fair, (4) try new ideas, (5) ask why, (6) keep your promises, and (7) do your share. In contrast, CSX has 26 paragraphs detailing expectations of employees under the following headings: Employee Relationships and Conflicts of Interest, Political Contributions and Public Service Involvement, Misrepresentations and False Statements, Employee Discrimination and Harassment, Competition, and Safety and the Environment. FEI also lists inquiries about corporate codes of conduct among the questions to expect at shareholder annual meetings. As stated on FEI's Web site: "If there's any single issue that overlays the recent corporate and accounting scandals, it is a deficiency in ethical behavior among some company executives. Corporate governance consultants and academics agree that a company needs to have a code of conduct and ethics in place, by which the entire staff and management should conduct themselves in relation to their business activities. . . . In all probability, shareholders will ask questions relating to board committees or subcommittees focused on ethical matters." While having a code of conduct is important, it is not sufficient. After all, Enron's code of conduct specified that "business is to be conducted in compliance . . . with the highest professional and ethical standards." Top management must set the tone and get out the message. They must recognize and reward honesty and integrity. As Clarence Otis, CFO of Darden Restaurants, says, "Our senior managers care about honesty and integrity and doing things right, and that influences how they do their job." The corporate culture, more than codes of conduct, is the real influence on the ethical climate of an organization. Codes of conduct can be a part, but only a part, of developing a culture of integrity. Sources: Sarbanes-Oxley Act of 2002, HR 3763; RedHawk Productions Web site (http://redhawkproductions.com); Financial Executives Institute Web site (www.fei.org); D. Blank, "A Matter of Ethics," Internal Auditor, February 2003, pp. 2731; Enron Corporation, 2000 Corporate Responsibility Report, p. 3. when there are no legal guidelines or even clear-cut ethical standards. Ethical dilemmas exist when managers must choose an alternative and there are (1) significant value conflicts among differing interests, (2) real alternatives that are both justifiable, and (3) significant consequences on stakeholders in the situation. Suppose you are an accountant whose superior has asked you to supply the company's banker with a profit forecast for the coming year. A badly needed bank loan rides on the prediction. Your superior is absolutely convinced that profits will be at least $500,000-- anything less than that and the loan is not likely to be approved. Your analysis shows that if the planned introduction of a new product goes extraordinarily well, profits will exceed $500,000. The most likely outcome, however, is for a mod- ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 1: Managerial Accounting, the Business Organization, and Professional Ethics 29 estly successful introduction and a $100,000 profit. If the product fails, the company stands to lose $600,000. Without the loan, the new product cannot be taken to the market, and there is no way the company can avoid a loss for the year. Bankruptcy is a real possibility. What forecast would you make? The fundamental issue here is disagreement about the prospects for the new product. If your superior is correct, it would be unethical to make a forecast of less than $500,000, which seems to guarantee financial problems, perhaps even bankruptcy. This would hurt stockholders, management, employees, suppliers, and customers. But if you are correct, a forecast of $500,000 may not be fair and objective. It may mislead the bank. Maybe you are wrong and your superior is right. There is no easy answer to this dilemma. It is one of those gray areas where neither action is without its risks. But remember that a series of gray areas can create a black area. That is, a series of actions that push the boundary of ethical behavior can add up to a clearly unethical situation. Accountants must draw the line someplace, and it is usually better to be conservative than to push the boundary too far. Enron was the champion of pushing the boundaries. If its managers had done this once or twice, providing that they did not do anything clearly unethical, it might have been overlooked. But the accumulation of questionable actions created an environment where ethical considerations were secondary at best. Resolution of Ethical Conflicts Ethical dilemmas sometimes arise when you only observe, rather than possibly commit, the unethical behavior. If you discover unethical behavior in an organization, you are obligated to try to halt that behavior. However, you still have confidentiality issues to confront. The section on Resolution of Ethical Conflict in Exhibit 1-7 provides guidance. Most often you can bring the issue to the attention of your supervisor or a special ethics officer (often called an ombudsperson) in the organization. However, if there is not an ethics officer and you suspect your supervisor is involved in unethical activity, your decision becomes more complex. As was the case for the two whistle-blowers described in the Business First box on p. 9, you may need to go directly to the top levels in the company. Ultimately, the board of directors may become involved. If the case involves legal issues and the board is not responsive, approaching the Securities and Exchange Commission (the body that regulates corporate reporting) or other legal authorities may be necessary. However, rarely is it appropriate to go directly to the media. Summary Problem for Your Review PROBLEM ISBN: 0-536-47129-0 Yang Electronics Company (YEC) developed a high-speed, low-cost copying machine. The company marketed the machine primarily for home use. However, as YEC customers learned how easy and inexpensive it was to make copies with it, its use by small businesses grew. Sales soared as some businesses ordered large numbers of the copiers. However, the heavier use by these companies caused breakdowns in a certain component of the equipment. The copiers were warranted for two years, regardless of the amount of usage. Consequently, YEC experienced high costs for replacing the damaged components. As the quarterly meeting of YEC's board of directors approached, Mark Chua, assistant controller, was asked to prepare a report on the situation. Unfortunately, it was hard to predict the exact effects. However, it seemed that many business customers were starting to switch to more expensive copiers sold by competitors. And it was clear that the increased warranty costs would significantly affect YEC's profitability. Mark summarized the situation as best he could for the board. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 30 Part 1: Focus on Decision Making Alice Martinez, YEC's controller, was concerned about the impact of the report on the board. She did not disagree with the analysis, but she thought it would make management look bad and might even lead the board to discontinue the product. She was convinced from conversations with the head of engineering that the copier could be slightly redesigned to meet the needs of high-volume users, so discontinuing it may pass up a potentially profitable opportunity. Martinez called Chua into her office and asked him to delete that part of his report dealing with the component failures. She said it was all right to mention this orally to the board, noting that engineering is nearing a solution to the problem. However, Chua felt strongly that such a revision in his report would mislead the board about a potentially significant negative impact on the company's earnings. Explain why Martinez's request to Chua is unethical. How should Chua resolve this situation? SOLUTION According to the IMA Statement of Ethical Professional Practice in Exhibit 1-7, Martinez's request violates requirements for competence, integrity, and credibility. It violates competence because she is asking Chua to prepare a report that is not complete and clear, one that omits potentially relevant information. Therefore, the board will not have all the information it should to make a decision about the component failure problem. The request violates integrity because the revised report may subvert the attainment of the organization's objectives to achieve Martinez's objectives. Management accountants are specifically responsible for communicating unfavorable as well as favorable information. Finally, the revised report would not be credible. It would not disclose all relevant information that could be expected to influence the board's understanding of operations and, therefore, its decisions. Chua's responsibility is to discuss this issue with increasingly higher levels of authority within YEC. First, he should let Martinez know about his misgivings. Possibly the issue can be resolved by her withdrawing the request. If not, he should inform her that he intends to take up the matter with her superior and then continue up to higher levels of authority, even to the board, if necessary, until the issue is resolved. So that Chua does not violate the standard of confidentiality, he should not discuss the matter with persons outside of YEC. Highlights to Remember Describe the major users and uses of accounting information. Internal managers use accounting information for making short-term planning and control decisions, for making nonroutine decisions, and for formulating overall policies and long-range plans. External users, such as investors and regulators, use published financial statements to make investment decisions, regulatory rulings, and many other decisions. Managers use accounting information to answer scorekeeping, attention-directing, and problem-solving questions. 1 2 Explain why ethics is important to management accountants. Integrity is essential to accountants because they provide information that users must trust to be right. Users of accounting information cannot directly assess the quality of that information, and if they cannot rely on accountants to produce unbiased information, the information will have little value to the users. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 1: Managerial Accounting, the Business Organization, and Professional Ethics 31 Describe the cost-benefit and behavioral issues involved in designing an accounting system. Companies design management accounting information systems for the benefit of managers. These systems should be judged by a cost-benefit criterion--the benefits of better decisions should exceed the cost of the system. Behavioral factors--how the system affects managers and their decisions--greatly affect the benefit of a system. Explain the role of budgets and performance reports in planning and control. Budgets and performance reports are essential tools for planning and control. Budgets result from the planning process. Managers use them to translate the organization's goals into action. A performance report compares actual results to the budget. Managers use these reports to monitor, evaluate, and reward performance and, thus, exercise control. 3 4 5 6 7 8 9 Discuss the role accountants play in the company's value-chain functions. Accountants play a key role in planning and control. Throughout the company's value chain, accountants gather and report cost and revenue information for decision makers. Contrast the functions of controllers and treasurers. Accountants are staff employees who provide information and advice for line managers. The head of accounting is often called the controller. Unlike the treasurer, who is concerned mainly with financial matters such as raising capital and investing excess funds, the controller measures and reports on operating performance. Explain why accounting is important in a variety of career paths. Accounting skills are useful in many functional areas of an organization. Management accountants often work with managers throughout the company and learn much from them. This exposure makes management accountants prime candidates for promotions to operating and executive positions. Identify current trends in management accounting. Many factors have caused changes in accounting systems in recent years. Most significant are a shift to a service-based economy, increased global competition, advances in technology, and changed business processes. Without continuous adaptation and improvement, accounting systems would soon become obsolete. Appreciate the importance of standards of ethical conduct to professional accountants. Users of accounting information expect both external and internal accountants to adhere to high standards of ethical conduct. Many ethical dilemmas, however, require value judgments, not the simple application of standards. Accounting Vocabulary Vocabulary is an essential and often troublesome phase of the learning process. A fuzzy understanding of terms hampers the learning of concepts and the ability to solve accounting problems. Before proceeding to the assignment material or to the next chapter, be sure you understand the words and terms in the Accounting Vocabulary section of each chapter. Their meaning is explained within the chapter and in the glossary at the end of this book. accounting system, p. 7 attention directing, p. 5 B2B, p. 22 B2C, p. 22 behavioral implications, p. 11 budget, p. 13 business process reengineering, p. 23 certified management accountant (CMA), p. 21 certified public accountant (CPA), p. 21 chartered accountant (CA), p. 21 chief financial officer (CFO), p. 19 code of conduct, p. 25 computer-integrated manufacturing (CIM) systems, p. 23 control, p. 12 controller (comptroller), p. 19 cost-benefit balance, p. 11 decision making, p. 12 electronic commerce, p. 22 enterprise resource planning (ERP) system, p. 22 e-commerce, p. 22 ethics, p. 25 financial accounting, p. 5 Foreign Corrupt Practices Act, p. 7 generally accepted accounting principles (GAAP), p. 7 IMA Statement of Ethical Professional Practice, p. 25 Institute of Management Accountants (IMA), p. 21 internal auditors, p. 8 internal controls, p. 7 International Accounting Education Standards Board, (IAESB), p. 21 just-in-time (JIT) philosophy, p. 23 lean manufacturing, p. 23 line managers, p. 18 management accounting, p. 5 ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 32 Part 1: Focus on Decision Making management audit, p. 8 management by exception, p. 14 performance reports, p. 13 planning, p. 12 problem solving, p. 6 product life cycle, p. 14 Sarbanes-Oxley Act, p. 8 scorekeeping, p. 5 service organizations, p. 10 Six Sigma, p. 23 staff managers, p. 18 total quality management (TQM), p. 23 treasurer, p. 19 variances, p. 13 value chain, p. 15 XBRL, p. 23 Fundamental Assignment Material The assignment material for each chapter is divided into two groups: fundamental and additional. The fundamental assignment material consists of two sets of parallel problems that convey the essential concepts and techniques of the chapter. The additional assignment material covers the chapter in more detail and includes questions, critical thinking exercises, exercises, problems, cases, Excel application exercises, a collaborative learning exercise, and an Internet exercise. 1-A1 Scorekeeping, Attention Directing, and Problem Solving For each of the following activities, identify the function that the accountant is performing--scorekeeping, attention directing, or problem solving--and explain why it fits that category. 1. Preparing a schedule of depreciation for forklift trucks in the receiving department of a General Electric factory in Scotland. 2. Analyzing, for a Sony production superintendent, the impact on costs of purchasing some new assembly equipment. 3. Preparing a scrap report for the finishing department of a Toyota parts factory. 4. Interpreting why the Colville Timber Resource Company did not adhere to its production schedule. 5. Explaining the stamping department's performance report. 6. Preparing a monthly statement of European sales for the Ford Motor Company's vice president of marketing. 7. Preparing, for the manager of production control of a Mittal Steel plant, a cost comparison of two computerized manufacturing control systems. 8. Interpreting variances on the University of Michigan's purchasing department's performance report. 9. Analyzing, for an Airbus manufacturing manager, the desirability of having some airplane parts made in Korea. 10. Preparing the budget for the dermatology department of Providence Hospital. 1-A2 Management by Exception Beta Alpha Psi (BAP), the accounting honorary fraternity, held a homecoming party. The fraternity expected attendance of 70 persons and prepared the following budget: Room rental Food Entertainment Decorations Total $ 140 700 600 220 $1,660 After BAP paid all the bills for the party, the total cost came to $1,835, or $175 over budget. Details are $140 for room rental; $905 for food; $600 for entertainment; and $190 for decorations. Eightyfive persons attended the party. 1. Prepare a performance report for the party that shows how actual costs differed from the budget. That is, include in your report the budgeted amounts, actual amounts, and variances. 2. Suppose the fraternity uses a management-by-exception rule. Which costs deserve further examination? Why? ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 1: Managerial Accounting, the Business Organization, and Professional Ethics 33 1-A3 Professional Ethics Exhibit 1-7 on pages 2627 lists four main categories of ethical standards for management accountants: competence, confidentiality, integrity, and credibility. For each of the following situations, indicate which of these four should influence the manager and what the appropriate action should be: 1. At a dinner party, a guest asked a General Mills manager how a major new cereal was doing. The manager had just read a report that said sales lagged much below expectation. What should he say? 2. Felix just graduated from business school with an accounting major and joined the controller's department of Pioneer Enterprises. His boss asked him to evaluate a market analysis for a potential new product prepared by the marketing department. Felix knows very little about the industry, and he never had a class to teach him how to make a market analysis. Should he just wade in, without asking for help? 3. Mary Sue prepared a budget for a division of Southeastern Electronics. Her supervisor, the division manager, was not happy that she included results for an exciting new product that was to be introduced in a month. He asked her to leave the results for the product out of the budget. That way, the financial results for the product would boost actual profits well above the amount budgeted, resulting in favorable reviews for the division and its managers. What should Mary Sue do? 1-B1 Scorekeeping, Attention Directing, and Problem Solving For each of the following activities, identify the function the accountant is performing--scorekeeping, attention directing, or problem solving. Explain each of your answers. 1. Estimating the operating costs and outputs that could be expected for each of two large metalstamping machines offered for sale by different manufacturers. Only one of these machines is to be acquired by your company. 2. Recording daily material purchase vouchers. 3. Analyzing the costs of acquiring and using each of two alternate types of welding equipment. 4. Preparing a report of overtime labor costs by production department. 5. Estimating the costs of moving corporate headquarters to another city. 6. Interpreting increases in nursing costs per patient-day in a hospital. 7. Analyzing deviations from the budget of the factory maintenance department. 8. Assisting in a study by the manufacturing vice president to determine whether to buy certain parts needed in large quantities for manufacturing products or to acquire facilities for manufacturing these parts. 9. Preparing estimated costs for a new marketing campaign. 10. Recording overtime hours of the product finishing department. 11. Compiling data for a report showing the ratio of advertising expenses to sales for each branch store. 12. Investigating reasons for increased returns and allowances for drugs purchased by a hospital. 13. Preparing a schedule of fuel costs by months and government departments. 14. Posting daily cash collections to customers' accounts. 15. Computing and recording end-of-year adjustments for expired fire insurance on the factory warehouse. 1-B2 Management by Exception The Suquamish Indian tribe sells fireworks for the five weeks preceding July 4. The tribe's stand at the corner of Highway 110 and Eagle Drive had budgeted sales for 20X5 of $75,000. Expected expenses were as follows: Cost of fireworks Labor cost Other costs Total costs ISBN: 0-536-47129-0 $36,000 15,000 8,000 $59,000 Actual sales were $74,860, almost equal to the budget. The tribe spent $39,500 for fireworks, $13,000 for labor, and $8,020 for other costs. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 34 Part 1: Focus on Decision Making 1. Compute budgeted profit and actual profit. 2. Prepare a performance report to help identify those costs that were significantly different from the budget. 3. Suppose the tribe uses a management-by-exception rule. What costs deserve further explanation? Why? 1-B3 Accounting's Position in the Organization: Controller and Treasurer For each of the following activities, indicate whether it is most likely to be performed by the controller or by the treasurer. Explain each answer. 1. 2. 3. 4. 5. 6. 7. 8. Prepare divisional financial statements. Help managers prepare budgets. Advise which alternative action is least costly. Meet with financial analysts from Wall Street. Arrange short-term financing. Prepare tax returns. Arrange insurance coverage. Prepare credit checks on customers. 1-B4 Ethical Code of Conduct According to the Financial Executives Institute, "corporate governance consultants and academics agree that a company needs to have a code of conduct" for its employees. Most companies, even many of those who experienced ethical breakdowns, have such a code. Answer the following questions about corporate codes of conduct. 1. What is a corporate code of conduct? 2. What types of issues are covered in a corporate code of conduct? At what level of detail? 3. In some cases codes of conduct were not effective. What, besides simply having a code, is necessary for a code of conduct to be effeective? Additional Assignment Material Questions 1-1 Who uses information from an accounting system? 1-10 Give three examples of service organizations. What distinguishes them from other types of organizations? 1-2 "The emphases of financial accounting and management accounting differ." Explain. 1-3 "The field is less sharply defined. There is heavier use of economics, decision sciences, and behavioral sciences." Identify the branch of accounting described in the quotation. 1-11 What two major considerations affect the design of all accounting systems? Explain each. 1-12 "The accounting system is intertwined with operating management. Business operations would be in a hopeless tangle without the paperwork that is so often regarded with disdain." Do you agree? Explain, giving examples. 1-4 Distinguish among scorekeeping, attention directing, and problem solving. 1-5 "Generally accepted accounting principles (GAAP) assist the development of management accounting systems." Do you agree? Explain. 1-13 Distinguish among a budget, a performance report, and a variance. 1-14 "Management by exception means abdicating management responsibility for planning and control." Do you agree? Explain. 1-6 "The Foreign Corrupt Practices Act applies to bribes paid outside the United States." Do you agree? Explain. 1-7 Why is the Sarbanes-Oxley act controversial? 1-8 Why is integrity so important to accountants? 1-9 "Integrity is more important for business professionals than it is for business students." Do you agree? Explain. 1-15 Why are accountants concerned about product life cycles? 1-16 Name the six primary business functions (excluding support functions) that make up the value chain, and briefly describe each. ISBN: 0-536-47129-0 1-17 "Accountants in every company should measure and report on every function in the company's value chain." Do you agree? Explain. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 1: Managerial Accounting, the Business Organization, and Professional Ethics 35 1-18 Distinguish between the duties of line managers and staff managers. 1-19 The role of management accountants is changing, especially in companies with a "flatter" organizational structure. What are some of the changes? 1-24 What is the essence of the JIT philosophy? 1-25 Briefly describe how a change in a plant's layout can make its operation more efficient. 1-26 "Six Sigma is an important management philosophy, but it has little effect on management accountants." Do you agree? Explain. 1-20 Does every company have both a controller and a treasurer? Explain. 1-27 Standards of ethical conduct for management accountants have been divided into four major responsibilities. Describe each of the four in 20 words or less. 1-21 Describe the four parts of the qualifying examination for becoming a CMA. 1-22 "The problem with accounting is that accountants never get to become top managers such as CEOs." Do you agree? Explain. 1-28 "Why are there ethical dilemmas? I thought accountants had standards that specified what is ethical behavior." Discuss this quote. 1-23 How are changes in technology affecting management accounting? Critical Thinking Exercises 1-29 Finance and Management Accounting Often there is confusion between the roles played by the controller and treasurer in an organization. In many small companies, a single person performs activities related to both functions. Distinguish between the controller and the treasurer functions by listing typical activities that are associated with each. 1-30 Marketing and Management Accounting A cross-functional team of managers, including the management accountant, performs each of the following activities. However, depending on the nature of the decision to be made, one functional area will take the leadership role. Which of these activities is primarily a marketing decision? What would the management accountant contribute to each of the marketing decisions? 1. Porsche Motor Company must decide whether to buy a part for one of its cars or to make the part at one of its plants. 2. Airbus must decide the price for spare parts it sells over the Internet using its Spare Parts Web site. 3. St. Steven's Hospital must decide how to finance the purchase of expensive new medical analysis equipment. 4. Amazon.com must forecast the impact on video sales of a new advertising program. 5. TexMex Foods, a regional market leader in the production and distribution of tortillas to retail and food service industries, must decide whether to accept a special order for tortilla chips by a large, national retail chain. 6. Target Stores must decide whether to close one of its retail stores that is operating at a loss. 1-31 Production and Management Accounting A cross-functional team of managers, including the management accountant, performed each of the following activities. However, depending on the nature of the decision to be made, one functional area will take the leadership role. Which of these activities is primarily a production decision? What would the management accountant contribute to each of the production decisions? 1. Saab Automobile AB must decide whether to buy a part for one of its cars or to make the part at one of its plants. 2. Boeing Company must decide the price for spare parts it sells over the Internet using its Spare Parts Web site. 3. St. Steven's Hospital must decide how to finance the purchase of expensive new medical analysis equipment. 4. Amazon.com must forecast how a new advertising program will affect DVD sales. 5. TexMex Foods, a regional market leader in the production and distribution of tortillas to retail and food service industries, must decide whether to accept a special order for tortilla chips by a large national retail chain. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 36 Part 1: Focus on Decision Making 6. Kmart must evaluate its overall vision and strategic goals in the light of competitive pressures from Target, Sears, and Wal-Mart. 7. Dell Computers must decide whether to spend money on training workers to perform setups and changeovers faster. This will free up capacity to be used to make more computers without purchasing more equipment. 8. Ford Motor Company must decide whether to keep or replace four-year-old equipment used in one of its Explorer plants. Exercises 1-32 Management Accounting and Financial Accounting Consider the following short descriptions. Indicate whether each description more closely relates to a major feature of financial accounting or management accounting. 1. 2. 3. 4. 5. 6. 7. Field is less sharply defined Provides internal consulting advice to managers Has less flexibility Is characterized by detailed reports Has a future orientation Is constrained by GAAP Behavioral impact is secondary 1-33 Planning and Control, Management by Exception Study the Starbucks store in Exhibit 1-2 on page 12. Suppose that for 2006 a particular store budgeted revenue of $330,000, a 10% increase over the current revenue of $300,000. The actions listed in Exhibit 1-2 resulted in six new budgeted products and a total advertising budget of $30,000. Actual results were New drinks added Advertising Revenues 7 $32,500 $328,000 1. Prepare a performance report for these items using the format of Exhibit 1-3 on page 13. 2. Net income results were not available until several months after the store implemented the plan. The net income results were disappointing to management because profits declined even though revenues increased. Why? Because costs increased by more than revenues. List some factors that might have caused costs to increase so much and that management may not have considered when they formulated the store's plan. 1-34 Line Versus Staff and Value-Chain Responsibility For each of the following, indicate whether the employee has line or staff responsibility and which value-chain business function is most closely related to activities performed by the employee. 1. 2. 3. 4. 5. 6. President District sales manager Market research analyst Cost accountant Head of the legal department Production superintendent 1-35 Microsoft's Value Chain Microsoft is the world's largest software company. For each of the following value-chain functions, discuss briefly what Microsoft managers would do to achieve that function and how important it is to the overall success of Microsoft. R&D Production Distribution Support functions Product (service) and process design Marketing Customer service ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 1: Managerial Accounting, the Business Organization, and Professional Ethics 37 1-36 Objectives of Management Accounting The Institute of Management Accountants (IMA) is composed of nearly 70,000 members. The IMA "Objectives of Management Accounting" states, "The management accountant participates, as part of management, in assuring that the organization operates as a unified whole in its long-run, intermediate, and short-run best interests." Based on your reading in this chapter, prepare a 100-word description of the principal ways that accountants participate in managing an entity. 1-37 Cost-Benefit of the Ethical Environment A poor ethical environment results in costs to the company. Examples include the cost of internal theft and the cost of absenteeism. On the other hand, a good ethical environment creates benefits. Examples include reduced risk of legal fines and sanctions and improved employee morale and productivity. List several additional costs of a poor ethical environment and benefits of a good ethical environment. 1-38 Early Warning Signs of Ethical Conflict The following statements are early warning signs of ethical conflict: "I don't care how you do it, just get it done!" "No one will ever know." List several other statements that are early warning signs of ethical conflict. Problems 1-39 Management and Financial Accounting Lillian Choi, an able mechanical engineer, was informed that she would be promoted to assistant factory manager. Lillian was pleased but uncomfortable. In particular, she knew little about accounting. She had taken one course in financial accounting. Lillian planned to enroll in a management accounting course as soon as possible. Meanwhile, she asked Walt Greenspan, a cost accountant, to state three or four of the principal distinctions between financial and management accounting. Prepare Walt's written response to Lillian. 1-40 Use of Accounting Information in Hospitals Most U.S. hospitals do not derive their revenues directly from patients. Instead, revenues come through third parties, such as insurance companies and government agencies. Until the 1980s, these payments generally reimbursed the hospital's costs of serving patients. Such payments, however, are now generally flat fees for specified services. For example, the hospital might receive $7,000 for an appendectomy or $28,000 for heart surgery--no more, no less. How might the method of payment change the demand for accounting information in hospitals? Relate your answer to the decisions of top management. 1-41 Costs and Benefits Marks & Spencer, a huge retailer in the United Kingdom with sales of almost 8 billion, was troubled by its paper bureaucracy. Looked at in isolation, each document seemed reasonable, but overall a researcher reported that there was substantial effort in each department to verify the information. Basically, the effort seemed out of proportion to any value received, and, eventually, the company simplified or eliminated many of the documents. Describe the rationale that should govern systems design. How should a company such as Marks & Spencer decide what documents it needs and which can be eliminated? 1-42 Importance of Accounting ISBN: 0-536-47129-0 Some companies are run by engineers and other technical specialists. For example, a manager in a division that is now part of ArvinMeritor, an $8.9 billion automotive parts supplier, once said that "there'd be sixty or seventy guys talking technical problems, with never a word on profits." Other companies, especially consumer products companies such as General Mills, fill top management Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 38 Part 1: Focus on Decision Making positions primarily with marketing executives. And still others, like Berkshire Hathaway with Warren Buffett as CEO, have top managers with strong finance skills. How might the role of management accountants differ in these types of companies? 1-43 Changes in Accounting Systems In the last decade, Boeing has made several significant changes to its accounting system. None of these changes were for reporting to external parties. Management believed, however, that the new system gave more accurate costs of the airplanes and other products produced. 1. Boeing had been a very successful company using its old accounting system. What might have motivated it to change the system? 2. When Boeing changed its system, what criteria might its managers have used to decide whether to invest in the new system? 3. Is changing to a system that provides more accurate product costs always a good strategy? Why or why not? 1-44 Value Chain Nike is an Oregon-based company that focuses on the design, development, and worldwide marketing of high-quality sports footwear, apparel, equipment, and accessory products. Nike is the largest seller of athletic footwear and athletic apparel in the world. The company sells its products to more than 18,000 retail accounts in the United States and through a mix of independent distributors, licensees, and subsidiaries in approximately 140 countries around the world. Nike contracts with more than 700 factories around the world to manufacture virtually all the company's products. Nike produces most footwear products outside the United States, while it produces apparel products both in the United States and abroad. 1. Identify one decision that Nike managers make in each of the six value-chain functions. 2. For each decision in requirement 1, identify one piece of accounting information that would aid the manager's decision. 1-45 Role of Controller Juanita Veracruz, newly hired controller of Braxton Industries, had been lured away from a competitor to revitalize the controller's department. Her first day on the job proved to be an eye-opener. One of her first interviews was with Adrian Belton, production supervisor in the Cleveland factory. Belton commented, "I really don't want to talk to anyone from the controller's office. The only time we see those accountants is when our costs go over their budget. They wave what they call a `performance report,' but it's actually just a bunch of numbers they make up. It has nothing to do with what happens on the shop floor. Besides, my men can't afford the time to fill out all the paperwork those accountants want, so I just plug in some numbers and send it back. Now, if you'll let me get back to important matters. . . . " Veracruz left quickly, but she was already planning for her next visit with Belton. 1. Identify some of the problems in the relationship between the controller's department and the production departments (assuming that the Cleveland factory is representative of the production departments). 2. What should Juanita Veracruz do next? 1-46 The Accountant's Role in an Organization The Marmon Group is a collection of more than 100 different operating companies with more than 500 facilities in 45 countries. It has annual revenues of more than $6.4 billion. Its member companies manufacture such diverse products as copper tubing, water purification products, railroad tank cars, and store fixtures, and they provide services such as credit information for banks. The Business First box on page 19 described the role of accountants in Marmon. Others have described accountants as "internal consultants." Using the information in the box, discuss how accountants at Marmon can act as internal consultants. What kind of background and knowledge would an accountant require to be an effective internal consultant? 1-47 Ethics and Accounting Personnel McMillan Shipping Company has an equal opportunity employment policy. This policy has the full support of the company's president, Rosemary Creighton, and is included in all advertisements for employee positions. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 1: Managerial Accounting, the Business Organization, and Professional Ethics 39 Hiring in the accounting department is done by the controller, D. W. "Butch" Brigham. The assistant controller, Jack Merton, also interviews candidates, but Brigham makes all decisions. In the last year, the department hired 5 new people from a pool of 175 applicants. Thirteen had been interviewed, including 4 minority candidates. The 5 hired included 3 sons of Brigham's close friends and no minorities. Merton had felt that at least 2 of the minority candidates were very well qualified and that the 3 sons of Brigham's friends were definitely not among the most qualified. When Merton questioned Brigham concerning his reservations about the hiring practices, he was told that these decisions were Brigham's and not his, so he should not question them. 1. Explain why Brigham's hiring practices were probably unethical. 2. What should Merton do about this situation? 1-48 Ethical Issues Suppose you are controller of a medium-size oil exploration company in west Texas. You adhere to the standards of ethical conduct for management accountants. How would those standards affect your behavior in each of the following situations? 1. Late one Friday afternoon you receive a geologist's report on a newly purchased property. It indicates a much higher probability of oil than had previously been expected. You are the only one to read the report that day. At a party on Saturday night, a friend asks about the prospects for the property. 2. An oil industry stock analyst invites you and your spouse to spend a week in Tahiti free of charge. All she wants in return is to be the first to know about any financial information your company is about to announce to the public. 3. It is time to make a forecast of the company's annual earnings. You know that some additional losses will be recognized before the company prepares final statements. The company's president has asked you to ignore these losses in making your prediction because a lower-than-expected earnings forecast could adversely affect the chances of obtaining a loan that is being negotiated and that will be completed before actual earnings are announced. 4. You do not know whether a particular expense is deductible for income tax purposes. You are debating whether to research the tax laws or simply to assume that the item is deductible. After all, if you are not audited, no one will ever know the difference. If you are audited, you can plead ignorance of the law. 1-49 Hundred Best Corporate Citizens Each year Business Ethics magazine publishes its list of the 100 best corporate citizens. The magazine rates companies on performance in 8 stakeholder categories: (1) shareholders, (2) community, (3) governance, (4) diversity, (5) employees, (6) environment, (7) human rights, and (8) products. In 2006, the top ten corporate citizens were Green Mountain Coffee Roasters, Hewlett-Packard, Advanced Micro Devices, Motorola, Agilent Technologies, Timberland, Salesforce.com, Cisco Systems, Dell, and Texas Instruments. For each of the 8 dimensions on which the magazine rated companies, give a one-sentence description of what you think would make for good corporate citizenship. Based on your knowledge of these 10 companies, however limited that is, predict the top 2 companies in each of the 8 rated categories. Cases 1-50 Line and Staff Authority Fidelity Leasing Company (FLC) leases office equipment to a variety of customers. The company's organization chart is on page 40. The four positions in blue in the chart are described below. J. P. Chen, assistant controller--special projects. Chen works on projects assigned to him by the controller. The most recent project was to design a new accounts payable system. Betty Hodge, leasing contracts manager. Hodge coordinates and implements leasing transactions. Her department handles all transactions after the sales department gets a signed contract. This includes requisitioning equipment from the purchasing department, maintaining appropriate insurance, delivering equipment, issuing billing statements, and seeking renewal of leases. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 40 Part 1: Focus on Decision Making Larry Paperman, chief accountant. Paperman supervises all the accounting functions. He produces reports for the four supervisors in the functional areas. Dawn Shevlin, director of human resources. Shevlin works with all departments of FLC in hiring personnel. Her department advertises all positions and screens candidates, but the individual departments conduct interviews and make hiring decisions. Shevlin also coordinates employee evaluations and administers the company's salary schedule and fringe benefit program. 1. Distinguish between line and staff positions in an organization and discuss why conflicts might arise between line and staff managers. 2. For each of the 4 managers described, identify whether their position is a line or staff position and explain why you classified it that way. Also, indicate any potential conflicts that might arise with other managers in the organization. Chief Executive Officer Vice-President Purchasing Controller Vice-President Marketing Vice-President Administration Assistant Controller-- Special Projects J. P. Chen Chief Accountant Larry Paperman Leasing Contracts Betty Hodge Director of Data Processing Accounts Receivable Advertising Manager Director of Human Resources Dawn Shevlin Accounts Payable Leasing Sales General Accounting 1-51 Professional Ethics and Toxic Waste Alberta Mining Company extracts and processes a variety of ores and minerals. One of its operations is a coal-cleaning plant that produces toxic wastes. For many years, the wastes have been properly disposed of through Canadian Disposal, an experienced company. However, disposal of the toxic wastes is becoming an economic hardship because increasing government regulations caused the cost of such disposal to quadruple in the last 6 years. Rachel O'Casey, director of financial reporting for Alberta Mining, was preparing the company's financial statements for the year ended June 30, 2007. In researching the material needed for preparing a footnote on environmental contingencies, Rachel found the following note scribbled in pencil at ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 1: Managerial Accounting, the Business Organization, and Professional Ethics 41 the bottom of a memo to the general manager of the coal-cleaning plant. The body of the memo gave details on the increases in the cost of toxic waste disposals: Ralph--We've got to keep these costs down or we won't meet budget. Can we mix more of these wastes with the shipments of refuse to the Oak Hill landfill? Nobody seems to notice the coal-cleaning fluids when we mix it in well. Rachel was bothered by the note. She considered ignoring it, pretending that she had not seen it. But after a couple of hours, her conscience would not let her do it. Therefore, she pondered the following three alternative courses of action: Seek the advice of her boss, the vice president of finance for Alberta. Anonymously release the information to the local newspaper. Give the information to an outside member of Alberta's board of directors, whom she knew because he lived in her neighborhood. 1. Discuss why Rachel has an ethical responsibility to take some action about her suspicion of the illegal dumping of toxic wastes. 2. For each of the three alternative courses of action, explain whether the action is appropriate. 3. Assume that Rachel sought the advice of the vice president of finance and discovered that he both knew about and approved of the dumping of toxic wastes. What steps should she take to resolve the conflict in this situation? Nike 10K Problem 1-52 Information in Nike's 10K Report U.S. companies file 10K reports annually with the SEC. These reports contain the company's annual financial reports and much additional information about the company. Examine Nike's 10K report that is presented in Appendix C. Answer the following questions about Nike. 1. 2. 3. 4. What is Nike's principal business activity? How many retail outlets does Nike have in the United States? How many in other countries? Who is Nike's CFO? What is his accounting background? Where does Nike manufacture most of its footwear? What ethical issues might result from this manufacturing philosophy? EXCEL Application Exercise 1-53 Budgets and Performance Evaluation Goal: Create an Excel spreadsheet to prepare a performance report, and use the results to answer questions about your findings. Scenario: Beta Alpha Psi, the accounting honorary fraternity, has asked you to prepare a per formance report about a homecoming party that they recently held. The background data for Beta Alpha Psi's per formance report appears in the Fundamental Assignment Material 1-A2. When you have completed your spreadsheet, answer the following questions: 1. Based on the formatting option used in the exercise, do the negative (red) variances represent amounts that are over or under budget? 2. Which cost/costs changed because the number of attendees increased? 3. Did the fraternity stay within the budgeted amount for food on a per person basis? Step-by-Step: 1. Open a new Excel spreadsheet. 2. In column A, create a bold-faced heading that contains the following: Row 1: Chapter 1 Decision Guideline Row 2: Beta Alpha Psi Homecoming Party Row 3: Performance Report Row 4: Today's Date ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 42 Part 1: Focus on Decision Making 3. Merge and center the date across columns A through D. 4. In Row 7, create the following bold-faced, right-justified column headings: Column B: Budget Column C: Actual Column D: Variance 5. In Column A, create the following row headings: Row 8: Room rental Row 9: Food Row 10: Entertainment Row 11: Decorations Row 12: Total costs Skip a row Row 14: Attendees Skip a row Row 16: Food per person 6. Use the data from Fundamental Assignment Material 1-A2 and enter the budget and actual amounts for room, food, entertainment, decorations, and attendees. 7. Use budget minus actual formulas to generate variances for each of the cost categories. 8. Use the SUM function to generate total costs for the budget, actual, and variance columns. 9. Use a formula to generate the "per person" food amount for the budget and actual columns. 10. Format all amounts as: Number tab: Category: Decimal places: Symbol: Negative numbers: Currency 0 None Red with parentheses 11. Change the format of the food per person amounts to display two decimal places and a dollar symbol. 12. Change the format of the room rental and total cost amounts to display a dollar symbol. 13. Change the format of the total costs data (Row 12) to display as bold-faced. 14. Change the format of the total costs heading to display as indented: Alignment tab: Horizontal: Indent: Left (Indent) 1 15. Save your work to disk, and print a copy for your files. Collaborative Learning Exercise 1-54 The Future Management Accountant Students should gather in groups of four to six each. Half of each group should read the first of the following articles and half should read the second article. (Alternatively, you can do this exercise as a whole class, with half of the class reading one article and half reading the other.) Roth, R. T., "The CFO's Great Balancing Act," Financial Executive, July/August, 2004, pp. 6061. Russell, K., G. Siegel, and C. Kulesza, "Counting More, Counting Less: Transformations in the Management Accounting Profession," Strategic Finance, September 1999, pp. 3944. 1. Individually, write down the three most important lessons you learned from the article you read. 2. As a group, list all the lessons identified in requirement 1. Combine those that are essentially the same. 3. Prioritize the list you developed in requirement 2 in terms of their importance to someone considering a career in management accounting. 4. Discuss whether this exercise has changed your impression of management accounting and, if so, how your impression has changed. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 1: Managerial Accounting, the Business Organization, and Professional Ethics 43 Internet Exercise 1-55 Institute of Management Accountants The Institute of Management Accountants (IMA) is a major professional organization that is geared toward managerial accounting and finance. The IMA has chapters throughout the United States as well as international chapters. The IMA is very concerned about ethics. Log on to www.imanet.org, the Web site for the IMA. 1. Click on About IMA. What is the IMA devoted to? 2. Follow the link that shows the mission statement for the IMA. What is the mission of the IMA? 3. One of the stated missions of the IMA is to help its members' professional development through education. Click on the Professional Development link. What options does the IMA provide to help educate the members? 4. Click on the Ethics Center link under About IMA. Follow the link to code of ethics called the Statement of Ethical Professional Practice. Read the code and comment on its importance to management accountants. 5. The IMA is made up of individual chapters where members can interact with other management accountants. Follow links from Membership and Community to Communities to Chapters and Councils to Find a Chapter to Online IMA Chapter Directory. List the chapters in your state. Does the chapter closest to your school have a Web site? You may wish to contact the chapter to find out about student involvement and scholarships. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Introduction to Cost Behavior and CostVolume Relationships C H A P T E R LEARNING OBJECTIVES When you have finished studying this chapter, you should be able to: 1. Explain how cost drivers affect cost behavior. 2. Show how changes in cost-driver levels affect variable and fixed costs. 3. Calculate break-even sales volume in total dollars and total units. 4. Create a cost-volume-profit graph and understand the assumptions behind it. 5. Calculate sales volume in total dollars and total units to reach a target profit. 6. Differentiate between contribution margin and gross margin. 7. Explain the effects of sales mix on profits (Appendix 2A). 8. Compute cost-volume-profit relationships on an after-tax basis (Appendix 2B). ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. B O E I N G C O M PA N Y In 1915, William Boeing, a Seattle timberman, assembled his first airplane in a boathouse. Today, the Boeing Company produces 30 to 35 commercial jetliners each month and has annual revenues of nearly $55 billion. The company makes planes with 100 to well over 500 seats and has more than half of the world's market share in airplane sales, and that is growing as Boeing successfully competes for the growing demand for airplanes. How will Boeing maintain its competitive edge and profitability margin? With intense competition from Airbus, Boeing knows that it can improve profits more by controlling (reducing) costs than by increasing prices to customers. So, should it build bigger airplanes or more of the existing size but with improvements in features and efficiencies that will lower customers' operating costs? Which alternative has lower costs for Boeing and its customers? To answer these questions, Boeing had to understand its own costs as well as the costs of its customers. The real question to ask is, What do customers value in return for a price in excess of $50 million per airplane? This chapter begins your study of costs so that you, too, can assess the costs that are important to Boeing and other companies, big and small, as they make crucial decisions about their products and production processes. Consider a recent decision Boeing faced regarding development and production of a new airplane. Back in 1999, the company began by starting an R&D program for the Sonic Cruiser, a unique airplane with a delta wing, rear-mounted engines, and two horizontal fins at the back of the airplane instead of the standard horizontal and vertical tail section found on today's jetliners. The Sonic Cruiser emphasized speed--it was designed to reduce travel time by about 20%. An important part of its research was the assessment of its customers' costs--both of operating their existing fleet of planes and The interior of Boeing's new 787-Dreamliner illustrates many variable costs such as the seats, windows, and the body. Each additional 787-Dreamliner produced requires more of these costs. In contrast, the cost of the facility where this plane was built, including heat and lighting costs, is a fixed cost-- it does not depend on the number of airplanes being produced. ISBN: 0-536-47129-0 45 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 46 Part 1: Focus on Decision Making cost behavior How the activities of an organization affect its costs. of the costs of the new Sonic Cruisers. In early 2001, discussions with airlines in North America, Asia, and Europe confirmed the design offered exactly what airlines and passengers are looking for: the ability to fly quickly and directly to their destinations while avoiding time-consuming and costly stops at major hubs--a concept known as point-to-point service. In late 2002, after more than three years of research, the company had completed the design of the new airplane and was faced with the final decision to launch. A decision to launch would involve a huge immediate investment in costly plant and equipment resources. To pay for these assets and make a profit, Boeing had to be confident that its customers would be willing to pay more for the airplane than it cost Boeing to design, produce, and sell it. But production ultimately hinged on whether customers wanted a faster airplane that used the most up-to-date technology both in operating the airplane and producing it. Despite the years of development activities, Boeing decided not to proceed with the Sonic Cruiser. Why? The economic recession and the terrorist attacks of September 11, 2001, had changed the airline industry's needs. According to Alan Mulally, CEO of Boeing Commercial Airplanes, the airlines made it clear that they wanted a cheaper plane rather than a faster plane. Therefore, Boeing management decided to dedicate its resources to developing the 787Dreamliner--a "super-efficient" version of its existing 777 jetliner. Boeing's managers made their decision after a careful analysis of its own production costs and the airlines' operating costs, comparing them to the predicted demands for airline travel in the next decade. Managers need to understand costs. For example, how much would it cost Boeing to produce each Sonic Cruiser? How much for each 787? How much cost does Northwest Airlines incur when it adds one more passenger at the last moment to an existing flight, or when it adds one more flight to the schedule? What does it cost Toyota to develop a new line of luxury autos, as it did with Lexus? How much does it cost to produce one more Lexus? How will an increase in Arizona's population affect the costs needed to run the state's department of motor vehicles? What does it cost Nestl Purina to meet WalMart's specifications for shipments of pet-care products? What activities contribute most to Nestl Purina's cost to serve Wal-Mart stores? These questions are really different forms of one general question: What will happen to financial results if a company or organization changes its level of activity? Although financial results are based on revenues and costs, we will focus primarily on costs in this chapter. As we saw in the case of Boeing, companies usually have more control over their costs than they do over their revenues. One of the main goals of management accounting is controlling (and reducing) costs. But managers cannot control costs unless they understand cost behavior--how the activities of an organization affect its costs. Identifying Resources, Activities, Costs, and Cost Drivers Different types of costs behave in different ways. Consider Boeing's costs of an existing factory that makes the 737-900ER--Boeing's newest single-aisle airplane. As Boeing produces more airplanes, it buys and uses more resources, such as electrical wire, seats, and aluminum. Therefore, each additional airplane requires Boeing to incur more resource costs. In contrast, the cost of some resources such as the factory and salaries of key managers, stay the same, regardless of the number of airplanes made. When we examine how the number of units produced affects costs, we get a traditional view of how costs behave. Most of this chapter focuses on this traditional relationship of costs to units of output. However, to help us control costs on a day-to-day basis, managers also look at how each activity needed to produce an airplane affects costs--an activity-based view of cost behavior. Both views require us to identify cost drivers, outputs of resources or outputs of activities that require the use of resources and thereby cause costs. Exhibit 2-1 shows the traditional and activity-based views of cost behavior. In the traditional view, the most common resource cost driver is units produced. In an activity-based view, cost drivers are outputs of resources and outputs of activities that accountants can measure. O B J E C T I V E Explain how cost drivers affect cost behavior. 1 cost driver Any output measure that causes costs (that is, causes the use of costly resources). ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 2: Introduction to Cost Behavior and Cost-Volume Relationships 47 Traditional View of Cost Behavior Activity-Based View of Cost Behavior Exhibit 2-1 Traditional and Activity-Based Views of Cost Behavior Resource A Cost Driver = Units of Resource Output Resource B Cost Driver = Units of Resource Output Resource A Cost Driver = Units of Resource Output Resource B Cost Driver = Units of Resource Output Activity A Cost Driver = Units of Activity Output Activity B Cost Driver = Units of Activity Output Product or Service Cost Driver = Units of Final Product or Service Product or Service Cost Driver = Output of Final Product or Service ISBN: 0-536-47129-0 For cost control, managers usually focus their efforts on managing the activities companies use to make, sell, and deliver products or services--not necessarily on the products and services themselves. A production manager needs to know how routine activities, such as machine maintenance and repairs, affect costs. Likewise, a sales manager needs to know how activities such as order processing and post-sales support, affect costs. So, these managers focus on the activity-based view of cost behavior to control costs. Consider one of the many activities performed as part of the production function at Boeing's plant--receiving parts that production workers install on an airplane. Of course, managers want to know the cost of the parts they purchase. But they also need to know how the receiving activity affects production costs. For example, the lease payment for renting the equipment used to move parts from the receiving area to the production floor does not change when receiving activity increases or decreases. However, costs such as fuel for the same moving equipment do vary with the level of activity. Actually, we should say that activities such as receiving require resources such as moving equipment and fuel, and these resources cost money. When we refer to a cost, we mean the amount spent for the resources used. To apply the activity-based view, we must identify the resources used by each activity and the cost driver for each resource. For the receiving activity, let's consider two resources, moving equipment (such as fork lifts) and fuel for that equipment. Often managers identify only one cost driver for all the resources used in an activity. For the receiving activity, the cost driver might be "number of parts received" or "weight of parts received." Both of these potential cost drivers measure the volume of the activity, that is, the output of the receiving activity. The best cost driver is one that is closely related to the amount of resources used and that accountants can measure easily. Accountants apply a cost-benefit test when choosing a cost driver, comparing the cost of measuring the cost driver with how accurately it measures the use of resources. Let's assume that they chose "number of parts received" for the receiving activity's cost driver. To identify the cost behavior for the receiving activity, we simply measure how much the cost of each resource changes with changes in the number of parts received. An organization has many cost drivers across the various activities of its value chain. For example, one manufacturer of pet foods has a plant in Denver that has more than 50 production activities and a total of 21 cost drivers. Exhibit 2-2 lists examples of resource costs and potential resource cost drivers for each of the value-chain functions. How well we identify the most appropriate cost drivers determines how well managers understand cost behavior and how well managers can control costs. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 48 Part 1: Focus on Decision Making Exhibit 2-2 Examples of ValueChain Functions, Costs, and Cost Drivers Value-Chain Function and Example Costs Research and development Salaries of marketing research personnel, costs of market surveys Salaries of product and process engineers Design of products, services, and processes Salaries of product and process engineers Cost of computer-aided design equipment used to develop prototype of product for testing Production Labor wages Supervisory salaries Maintenance wages Depreciation of plant and machinery, supplies Energy cost Marketing Cost of advertisements Salaries of marketing personnel, travel costs, entertainment costs Distribution Wages of shipping personnel Transportation costs including depreciation of vehicles and fuel Customer service Salaries of service personnel Costs of supplies, travel Hours spent servicing products Number of service calls Labor hours Weight of items delivered Number of advertisements Sales dollars Labor hours Number of people supervised Number of mechanic hours Number of machine hours Kilowatt hours Number of engineering hours Number of distinct parts per product Number of new product proposals Complexity of proposed products Example Cost Drivers Variable- and Fixed-Cost Behavior O B J E C T I V E Show how changes in costdriver levels affect variable and fixed costs. variable cost A cost that changes in direct proportion to changes in the cost-driver level. fixed cost A cost that is not immediately affected by changes in the cost-driver level. 2 To understand cost behavior, it is important to distinguish variable costs from fixed costs. Accountants classify costs as variable or fixed depending on how much they change as the level of a particular cost driver changes. A variable cost changes in direct proportion to changes in the cost driver. In contrast, changes in the cost driver do not immediately affect a fixed cost. Suppose units of production is the cost driver of interest. A 10% increase in the units of production would produce a 10% increase in variable costs. However, the fixed costs would remain unchanged. Consider some variable costs and the traditional view of cost behavior where the cost driver is the volume of final goods or services produced and sold. Suppose Watkins Products, the 140-year-old health food company, pays its sales personnel a 40% straight commission on sales. The total cost of sales commissions to Watkins is 40% of sales dollars--a variable cost with respect to sales revenues. Or suppose Long Lake Bait Shop buys bags of fish bait for $2 each. The total cost of fish bait is $2 times the number of bags purchased--a variable cost with respect to units (number of bags) purchased. Notice that variable costs do not change per unit, but that the total variable costs change in direct proportion to the cost-driver activity. Now consider a fixed cost. Suppose Sony rents a factory to produce DVD players for $500,000 per year. The number of DVD players produced does not affect the total fixed ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 2: Introduction to Cost Behavior and Cost-Volume Relationships 49 Exhibit 2-3 If Cost-Driver Level Increases (or Decreases) Type of Cost Fixed costs Variable costs Total Cost No change Increase (or decrease) Cost per Unit* Decrease (or increase) No change Cost Behavior of Fixed and Variable Costs *Per unit of activity volume, for example, product units, passenger-miles, orders processed, or sales dollars. cost of $500,000. The unit cost of rent applicable to each DVD player, however, does depend on the total number of DVD players produced. If Sony produces 100,000 DVD players, the unit cost will be $500,000 100,000 = $5. If it produces 50,000 DVD players, the unit cost will be $500,000 50,000 = $10. Therefore, a fixed cost does not change in total, but the per-unit fixed cost becomes progressively smaller as the volume increases. Note carefully from these examples that the "variable" or "fixed" characteristic of a cost relates to its total dollar amount and not to its per-unit amount. Exhibit 2-3 summarizes these relationships. When analyzing costs, you may find these two rules of thumb useful: 1. Think of fixed costs on a total-cost basis. Total fixed costs remain unchanged regardless of changes in the cost-driver. 2. Think of variable costs on a per-unit basis. The per-unit variable cost remains unchanged regardless of changes in the cost-driver. As a result, the total variable cost varies proportionately with the level of the cost-driver. Now consider again the receiving activity at the Boeing plant discussed in the previous section. Exhibit 2-4 shows the relationship between the receiving activity and the costs of the fuel and equipment resources. The receiving activity requires many more resources such as labor and supplies, but we restrict our discussion to just fuel and equip- Exhibit 2-4 FUEL RESOURCE $0.80 PER PART RECEIVED Cost Driver Number of Parts Received Receiving Activity and Resources Used EQUIPMENT RESOURCE $45,000 Cost Driver Number of Parts Received OTHER RESOURCES ISBN: 0-536-47129-0 RECEIVING ACTIVITY Cost Driver Number of Parts Received Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 50 Part 1: Focus on Decision Making ment. We denote an activity by the symbol . We use the symbol to represent a variable-cost resource and the symbol to represent a fixed-cost resource. The total fuel and equipment costs were $24,000 and $45,000, respectively, and the department received 30,000 parts. Notice in Exhibit 2-4 that we apply the two rules of thumb by showing the total fixed lease cost of $45,000 and the per-unit variable fuel cost of $24,000 30,000 = $.80 per part received. Both of these amounts tend to be relatively constant over the wide range of receiving activity. This is an important characteristic because we can use both these numbers to calculate the activity costs for various levels of the cost driver. Suppose we want to know what the total fuel and equipment cost would be if only 27,500 parts were received. We can use Exhibits 2-3, 2-4 and our rules of thumb to find the answer. Total fuel cost is variable with respect to parts received, but the fuel cost per part received does not change. Equipment lease cost in total does not change when the number of parts received decreases. So the total cost of receiving 27,500 parts would be (27,500 $.80) + $45,000 = $67,000. Notice how we used the rules of thumb to answer the question. We used the unit cost of $.80 for variable fuel cost and the total cost of $45,000 for the fixed equipment lease cost. Exhibit 2-5 shows the total cost lines for both resources. These lines can be used to find an estimate of the total costs at any cost-driver level. Exhibit 2-5 Total Fuel and Equipment Lease Costs $30,000 25,000 Fuel Cost 20,000 15,000 10,000 5,000 5,000 10,000 15,000 20,000 25,000 30,000 35,000 Number of Parts Received $50,000 Equipment Lease Costs 45,000 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 5,000 10,000 15,000 20,000 25,000 30,000 35,000 Number of Parts Received ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 2: Introduction to Cost Behavior and Cost-Volume Relationships 51 Summary Problem for Your Review PROBLEM Refer to the previous discussion of the receiving activity at the Boeing plant and Exhibit 2-4. The plant manager is looking at a monthly report of plant costs and notices that the receiving activity costs vary substantially from month to month. He is interested in knowing more about why the total cost and unit costs of the receiving activity changes when the number of parts change. He gives you the data for parts received for the last several months and you note that the range is from 10,000 to 30,000. 1. Prepare a table that shows the cost of each resource, the total cost, and the total cost on a per-part basis. Use increments of 5,000 parts beginning with 10,000. 2. Prepare brief explanations of why the total and unit cost patterns change. SOLUTION 1. The table can be developed by using the two rules of thumb that are based on the relationships shown in Exhibit 2-3. We can also quickly estimate the total costs from the cost lines in Exhibit 2-5. (1) Parts Received 10,000 15,000 20,000 25,000 30,000 (2) Equipment Cost $45,000 45,000 45,000 45,000 45,000 (3) $.80 (1) Fuel Cost $ 8,000 12,000 16,000 20,000 24,000 (4) (2) + (3) Total Cost $53,000 57,000 61,000 65,000 69,000 (5) (4) (1) Cost per Part Received $5.30 3.80 3.05 2.60 2.30 2. Column (4) shows the total cost of the receiving activity. The total cost increases with increases in the number of parts received due to the increase in variable costs. Whenever we see a pattern of increasing total costs, we may initially assume that it is due to variablecost resources responding to increasing levels of the cost driver. Column (5) shows the cost per part received. The decreasing cost pattern is due to the fixed equipment cost being spread over increasing levels of the cost driver - number of parts received. For example, when the number of parts received increases from 10,000 to 15,000 parts, the cost per part decreases by $1.50 from $5.30 to $3.80. This is exactly the amount of the decrease in the equipment cost per part, which is $4.50 ($45,000 10,000) less $3.00 ($45,000 15,000). The variable fuel cost per part stays the same at $0.80. MAKING MANAGERIAL DECISIONS A key factor in helping managers understand cost behavior is distinguishing between variable and fixed costs. Test your understanding by answering the following questions. 1. A producer of premium ice cream uses "gallons of ice cream produced" as a cost driver for the dairy ingredients resource. Is the cost of dairy ingredients a variable or a fixed cost? 2. The same company uses "square feet occupied" as a cost driver for occupancy resource costs, such as building depreciation and insurance. Is occupancy cost variable or fixed? Answer The best way to determine whether the cost of a resource is fixed or variable is to ask the question, "If the level of the cost driver changes, what will happen to the cost?" If the company increases (decreases) its production of ice cream, then the cost of dairy ingredients will also increase (decrease). Thus, the cost of dairy ingredients is variable. If the square feet occupied by a particular unit in an organization increases (decreases), the building depreciation and insurance on the building will not change. Thus, building occupancy costs, such as depreciation and insurance, are fixed costs. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 52 Part 1: Focus on Decision Making Relevant Range Although we have just described fixed costs as unchanging regardless of changes in the given cost driver, this rule of thumb holds true only within reasonable limits. For example, rent costs, which are generally fixed, will rise if increased production requires a larger or additional building--or if the landlord decides to raise the rent. Conversely, rent costs may go down if decreased production causes the company to move to a smaller plant. The relevant range is the limit of cost-driver level within which a specific relationship between costs and the cost driver is valid. Even within the relevant range, though, a fixed cost remains fixed only over a given period of time--usually the budget period. Fixed costs may change from budget year to budget year solely because of changes in insurance and property tax rates, executive salary levels, or rent levels. But these items usually do not change significantly within a given year. For example, suppose that the relevant range for a General Electric lightbulb plant is between 40,000 and 85,000 cases of lightbulbs per month and that total monthly fixed costs within the relevant range are $100,000. Within the relevant range, fixed costs will remain the same. If production falls below 40,000 cases, changes in production processes would slash fixed costs to $60,000 per month. If operations rise above 85,000 cases, rentals of additional facilities would boost fixed costs to $115,000 per month. Exhibit 2-6 shows graphically these assumptions--a given period and a given activity range. It is highly unusual, however, for monthly operations to be outside the relevant range. Therefore, the three-level refinement at the top of Exhibit 2-6 is usually not graphed. Instead, a single horizontal line is typically extended through the plotted activity levels, as at the bottom of the exhibit. Often a dashed line is used outside the relevant range. The basic idea of a relevant range also applies to variable costs. That is, outside a relevant range, some variable costs, such as fuel consumed, may behave differently per unit of cost-driver activity. For example, the variable cost per case for the GE lightbulb plant might increase if production exceeds 85,000 cases per month because of the lower efficiency of the new facilities. relevant range The limit of cost-driver level within which a specific relationship between costs and the cost driver is valid. Exhibit 2-6 Fixed Costs and Relevant Range $115,000 100,000 60,000 Total Monthly Fixed Costs 20 40 60 80 Relevant Range 100 $115,000 100,000 60,000 20 40 60 80 100 ISBN: 0-536-47129-0 Total Cost-Driver Activity in Thousands of Cases per Month Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 2: Introduction to Cost Behavior and Cost-Volume Relationships 53 Difficulties in Classifying Costs Is it difficult to classify a cost as exactly variable or exactly fixed? As you may suspect, it often is. Many complications arise, including the possibility of costs behaving in some nonlinear way (not producing a straight-line graph). For example, tax preparers often become more efficient as they learn to process the new year's tax forms, thus processing more returns per hour. This means that total variable costs may actually behave as in panel A that follows, and not as in panel B. Panel A Total Variable Cost $ Total Variable Cost $ Panel B Cost-Driver Activity Level Cost-Driver Activity Level Moreover, more than one cost driver may simultaneously affect costs. For example, both the weight and the number of units handled may affect the costs of shipping labor at an Amazon.com warehouse. We will investigate various facets of this problem in succeeding chapters; for now, we assume that we can classify every cost as either totally variable or totally fixed. We assume also that only one cost driver affects a given variable cost and that the variable costs change in direct proportion to the cost driver. Whether we classify costs as fixed or variable also depends on the situation. More costs are fixed and fewer are variable when decisions for which we use the cost information involve very short time spans and very small changes in activity level. Suppose a United Airlines plane with several empty seats will depart from its gate in 2 minutes. A potential passenger is running down a corridor bearing a transferable ticket from a competing airline. Unless the gate attendant holds the airplane for an extra 30 seconds, the passenger will miss the departure and will not switch to United for the planned trip. What are the variable costs to United of delaying the departure and placing one more passenger in an otherwise empty seat? Variable costs (for example, one more meal) are negligible. Virtually all the costs in this situation are fixed (for example, flight crew and maintenance crew salaries). Now, in contrast, suppose United's decision is whether to add another flight, acquire another gate, add another city to its routes, or acquire another airplane. Many more costs would be variable and fewer would be fixed. For example, in the case of adding a flight, the salaries of the flight and maintenance crews would now be variable. This example underscores the importance of the decision situation itself in the analysis of cost behavior. Whether costs are really "fixed" or "variable" depends heavily on the relevant range, the length of the planning period in question, and the specific decision situation. Cost-Volume-Profit Analysis Managers often classify costs as fixed or variable when making decisions that affect the volume of output. Consider the decision about how many units of a product to produce in the coming year. Managers realize that many factors in addition to the volume of output will affect costs. Yet, a useful starting point in their decision process is to predict how the choice of production level will affect costs. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 54 Part 1: Focus on Decision Making cost-volume-profit (CVP) analysis The study of the effects of output volume on revenue (sales), expenses (costs), and net income (net profit). The managers of profit-seeking organizations usually study the effects of output volume on revenue (sales), expenses (costs), and net income (net profit). We call this study cost-volume-profit (CVP) analysis. The managers of nonprofit organizations also benefit from the study of CVP relationships. Why? No organization has unlimited resources, and knowledge of how costs fluctuate with changes in volume helps managers to understand how to control costs. For example, administrators of nonprofit hospitals are concerned about the behavior of costs as the volume of patients fluctuates. To apply CVP analysis, managers usually resort to some simplifying assumptions. The major one is that we can classify costs as either variable or fixed with respect to a single measure of the volume of output activity. This chapter focuses on such a simplified relationship. CVP Scenario Amy Winston, the manager of food services for one of Boeing's plants, is trying to decide whether to rent a line of snack vending machines. Although individual snack items have various acquisition costs and selling prices, Winston has decided that an average selling price of $1.50 per unit and an average acquisition cost of $1.20 per unit will suffice for purposes of this analysis. She predicts the following revenue and expense relationships: Per Unit Selling price Variable cost of each item Selling price less variable cost Monthly fixed expenses Rent Wages for replenishing and servicing Other fixed expenses Total fixed expenses per month $1.50 1.20 $ .30 $ 3,000 13,500 1,500 $18,000 Percentage of Sales 100% 80 20% We will now use these data in examining several applications of CVP analysis. Computing the Break-Even Point O B J E C T I V E Calculate break-even sales volume in total dollars and total units. break-even point The level of sales at which revenue equals expenses and net income is zero. 3 The most basic CVP analysis computes the monthly break-even point in number of units and in dollar sales. The break-even point is the level of sales at which revenue equals expenses and net income is zero. The business press frequently refers to break-even points. For example, a news story on hotel occupancy rates in San Francisco stated that "seventy percent [occupancy] is considered a break-even for hoteliers." Another news story stated that "the Big Three auto makers have slashed their sales break-even point in North America from 12.2 million cars and trucks to only 9.1 million this year." Finally, an article on Outboard Marine Corporation reported that, as a result of restructuring, the company's "break-even point [in sales] will be $250 million lower" than it was before the restructuring. When a company's sales begin to fall, it may try to lower its break-even point to avoid losing money. The Business First box on p. 55 describes this situation for some high-tech firms. Some people call the study of cost-volume-profit relationships break-even analysis. However, this term is misleading. Why? Because CVP analysis does much more than compute the break-even point. It is often an important part of a company's planning process. It helps managers to predict how their decisions will affect sales, costs, and net income. Nevertheless, computing a break-even point is one application of CVP analysis. We next illustrate the two basic methods for computing a break-even point: the contribution-margin method and the equation method. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. TECH FIRMS LOWER BREAK-EVEN POINTS In late 2002 and early 2003, many high-technology companies reported on their attempts to achieve profitability in spite of declining sales. They often focused on how their efforts to control costs reduced their break-even points. If a company faces rapidly falling sales, it must restructure its costs to be able to break even at a lower volume. The early twenty-first century was hard on technology companies. After the bursting of the stock-price bubble of the 1990s, demand for most technology products plummeted. Nearly all technology companies experienced declines in sales. Most lost money in 2001 and 2002, but because of restructured operations, many realized a return to profitability in 2003. Consider Alcatel, the French telecommunications company. CEO Serge Tchuruk indicated that the company cut its break-even point, which was 6 billion in the fourth quar ter of 2001, to 4.1 billion by the last quar ter of 2002. It planned to fur ther cut its quar terly break-even point to 3 billion by the end of 2003. One way that Alcatel accomplished this is by outsourcing much of its manufacturing, thus, greatly reducing its fixed costs. Lucent Technologies, a U.S. telecom company, faced a similar situation. Sales in 2002 were only 43% of those in 2000, and Lucent lost nearly $12 billion in 2002. CEO Patricia Russo indicated that the company "intends to lower its break-even point on a quarterly revenue basis to between $2.5 billion and $3 billion," and cited the need to reduce Lucent's break-even point even fur ther as its sales fell to just above $2 billion a quarter in 2003. Like Lucent, Nortel, the Canadian telecom company, had sales in 2002 that were less than half of those at its peak. By mid-2002 it had reduced its quarterly break-even point to about $2.6 billion, but since 2003 sales averaged only $2.5 billion, the company sought a further reduction of its break-even point by more than $100 million. Stockholders responded to these efforts to lower the break-even point. In early 2003, stock prices for Alcatel, Lucent, and Nor tel doubled, tripled, and quadrupled, respectively. The media attributed this to two factors: "First, each company announced staff reductions that promise to lower their quarterly break-even points. Second, demand for telecom equipment no longer appears to be plunging at a neck-snapping rate." The need to cut break-even points was not confined to telecom companies. Sun Microsystems, the developer of products and ser vices for network computing, said it would "bring the group's quar terly break-even point to $3.2 billion$3.3 billion." With quar terly sales running under $3 billion, even that goal would not bring automatic profitability. And Hector de Jesus Ruiz, president and chief executive officer of chip-maker Advanced Micro Devices (AMD), "reaffirmed his goal of reducing expenses to a break-even point of $775 million by the end of the second quarter of 2003." With 2002 sales down 30% and averaging $675 million a quarter, the expense reduction was not enough to avoid a loss for the year. However, by 2004, AMD's sales had rebounded to $1.25 billion a quar ter, and the company returned to profitability. A look at many other cases would reveal the same picture. Technology companies of all types had net losses in 2001 and 2002, and whether they achieved profitability in 2003 depended on their success in reducing their break-even point to a level consistent with realistic sales expectations. Sources: "Alcatel Plans to Lower Break-Even Point to 3 Billion," Europe Information Service, January 30, 2003; "Russo Sees Lower Lucent BreakEven," Financial Post, September 19, 2002; "Nor tel to Slash Costs by $1.25B," Edmonton Journal, October 12, 2002; "AMD Firing 2,000," San Francisco Chronicle, November 15, 2002; 2002 and 2003 annual reports for Alcatel, Lucent, Nortel, Sun Microsystems, and Advanced Micro Devices. Contribution-Margin Method Consider the following common-sense arithmetic approach. Every unit sold generates a unit contribution margin or marginal income, which is the unit sales price minus the variable cost per unit. For the vending machine snack items, the unit contribution margin is $.30: Unit sales price - Unit variable cost = Unit contribution margin ISBN: 0-536-47129-0 unit contribution margin (marginal income) The sales price per unit minus the variable cost per unit. $1.50 -1.20 $ .30 total contribution margin Total number of units sold times the unit contribution margin. When do we reach the break-even point? When we sell enough units to generate a total contribution margin (total number of units sold unit contribution margin) equal to the total fixed costs. Divide the $18,000 in fixed costs by the $.30 unit contribution margin. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 56 Part 1: Focus on Decision Making contribution margin A term used for either unit contribution margin or total contribution margin. The number of units that we must sell to break even is $18,000 $.30 = 60,000 units. The sales revenue at the break-even point is 60,000 units $1.50 per unit, or $90,000. (Note that some managers and accountants use the term contribution margin to mean either unit contribution margin or total contribution margin, assuming that the context makes clear which they mean.) Think about the contribution margin of the snack items. Each unit sold generates extra revenue of $1.50 and extra cost of $1.20. Fixed costs are unaffected. If we sell zero units, we incur a loss equal to the fixed cost of $18,000. Each unit sold reduces the loss by $.30 until sales reach the break-even point of 60,000 units. After that point, each unit sold adds (or contributes) $.30 to profit. The condensed income statement at the break-even point is Total Units Sales Variable costs Contribution margin* Fixed costs Net income *Sales less variable costs. Per Unit $1.50 1.20 $ .30 Percentage 100% 80 20% 60,000 $90,000 72,000 $18,000 18,000 $ 0 Many companies sell multiple products and, therefore, have no single unit price and unit variable cost. For example, a grocery store sells hundreds of products at many different prices. In such a company, it would not be meaningful to compute a break-even point in overall units sold. Instead, we use total sales and total variable costs to calculate the variable cost percentage and the contribution margin percentage: variable-cost percentage Total variable costs divided by total sales. contribution-margin percentage Total contribution margin divided by sales or 100% minus the variable cost percentage. Variable-cost percentage = total variable costs total sales Contribution-margin percentage = total contribution margin total sales = 100% - variable cost percentage Consider our vending machine example: Sales price - Variable expenses as a percentage of dollar sales = Contribution-margin percentage 100% - 80 20% variable-cost ratio Variable cost percentage expressed as a ratio. contribution-margin ratio Contribution margin percentage expressed as a ratio. The variable-cost percentage is 80%, and the contribution-margin percentage is 20%. We can also express these percentages as ratios, the variable-cost ratio and contributionmargin ratio, which are .80 and .20, respectively. Therefore, 20% of each sales dollar is available for the recovery of fixed expenses and the making of net income. Thus, we need $18,000 .20 = $90,000 of sales to break even. Remember that the contribution-margin percentage is a percentage of dollar sales. Using the contribution-margin percentage, we can compute the break-even volume in dollar sales without determining the break-even point in units. Equation Method The equation method is the most general form of analysis, one you can adapt to any conceivable cost-volume-profit situation. You are familiar with a typical income statement. We can express any income statement in equation form, or as a mathematical model, as follows: sales - variable expenses - fixed expenses = net income That is, Unit sales number net number fixed unit price of units - variable cost of units - expen ses = income (1) ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 2: Introduction to Cost Behavior and Cost-Volume Relationships 57 At the break-even point, net income is zero: sales - variable expenses - fixed expenses = 0 Let N = number of units to be sold to break even. Then, for the vending machine example, $ 1 . 50 N - $ 1 . 20 N - $ 18,000 = 0 $. 30 N = $ 18,000 N = $ 18,0 0 0 $. 30 N = 60,000 units Total sales in the equation is a price-times-quantity relationship, which we expressed in our example as $1.50N. To find the dollar sales, multiply 60,000 units by $1.50, which yields the break-even dollar sales of $90,000. You can also solve the equation for break-even sales dollars without computing the unit break-even point by using the relationship of variable costs and profits as a percentage of sales: variable co st per unit $ 1 . 20 variable-cost = = . 80 or 80 % = ratio or percentage sales price per unit 0 $ 1 . 50 Let S = sales in dollars needed to break even. Then S - . 80S - $ 18,000 = 0 . 20S = $ 18,000 S = $ 18,000 . 20 S = $ 90,000 Relationship Between the Two Methods You may have noticed that the contributionmargin method is merely a shortcut version of the equation method. Look at the last three lines in the two solutions given for equation 1. They read Break-Even Volume Units $.30N = $18,000 N = $18,000 $.30 N = 60,000 units Dollars .20S = $18,000 S = $18,000 .20 S = $90,000 From these equations, we can derive the following shortcut formulas: break-even volume in units = break-even volume in dollars = fixed expenses un it contribution margin fixed expenses contribution-margin ratio (2) (3) ISBN: 0-536-47129-0 Which should you use, the equation or the contribution-margin method? Use either. Both yield the same results, so the choice is a matter of personal preference or convenience in a particular case. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 58 Part 1: Focus on Decision Making MAKING MANAGERIAL DECISIONS Managers use CVP analysis to predict effects of changes in sales or costs on the break-even point. Using shortcut formulas (2) and (3), answer the following questions. Remember that the contribution margin per unit equals the sales price per unit minus the variable costs per unit. 1. What would be the effect on the unit and dollar breakeven level if fixed costs increase (and there are no other changes)? 2. What would be the effect on the unit and dollar breakeven level if variable cost per unit decreases (and there are no other changes)? 3. What would be the effect on the unit and dollar breakeven level if sales volume increases (and there are no other changes)? Answers 1. The break-even level in both units and sales dollars would increase if fixed costs increase. 2. The break-even level in both units and sales dollars would decrease if variable cost per unit decreases. 3. Think before answering this question. The actual (or even planned) volume of sales in units has nothing to do with determining the break-even point. This is why unit sales volume does not appear in either equation (2) or (3). O B J E C T I V E Create a cost-volume-profit graph and understand the assumptions behind it. 4 Graphing the Break-Even Point Exhibit 2-7 is a graph of the cost-volume-profit relationship in our vending machine example. If you fully understand the contribution margin or equation method, you do not need to also learn the graphical method. However, most students find that a careful study of the graphical method leads to a better understanding of CVP analysis. Study the graph as you read the procedure for constructing it. 1. Draw the axes. The horizontal axis is the sales volume, and the vertical axis is dollars of cost and revenue. 2. Plot sales volume. Select a convenient sales volume, say, 100,000 units, and plot point A for total sales dollars at that volume: 100,000 $1.50 = $150,000. Draw the revenue (that is, sales) line from point A to the origin, point 0. Exhibit 2-7 Cost-Volume-Profit Graph $150,000 138,000 120,000 90,000 Total Expenses 60,000 Net Loss Area B Fixed Expenses 0 10 20 30 40 50 60 70 80 90 100 ISBN: 0-536-47129-0 A Sales Net Income Area D Variable Expenses C Net Income Break-Even Point 60,000 Units or $90,000 30,000 18,000 Units (In Thousands) Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 2: Introduction to Cost Behavior and Cost-Volume Relationships 59 3. Plot fixed expenses. Draw the line showing the $18,000 fixed portion of expenses. It should be a horizontal line intersecting the vertical axis at $18,000, point B. 4. Plot variable expenses. Determine the variable portion of expenses at a convenient level of activity: 100,000 units $1.20 = $120,000. Add this to the fixed expenses: $120,000 + $18,000 = $138,000. Plot point C for 100,000 units and $138,000. Then draw a line between this point and point B. This is the total expenses line. 5. Locate the break-even point--where the total expenses line crosses the sales line, 60,000 units or $90,000, namely, where total sales revenues exactly equal total costs, point D. The break-even point is only one part of this cost-volume-profit graph. The graph also shows the profit or loss at any rate of activity. At any given volume, the vertical distance between the sales line and the total expenses line measures the net income or net loss. Managers often use break-even graphs because these graphs show potential profits over a wide range of volume more easily than numerical exhibits. Whether you use graphs or other presentations depends largely on your preferences. However, if you need to explain a CVP model to an audience, a graphical approach can be most helpful. Note that the concept of relevant range applies to the break-even graph. Almost all break-even graphs show revenue and cost lines extending back to the vertical axis as shown in Exhibit 2-7. This approach is misleading because the relationships depicted in such graphs are valid only within a particular relevant range of volume. Nevertheless, for presentation purposes, most managers extend revenue and cost lines beyond the relevant range. Regardless of the method used for CVP analysis, it is based on a set of important assumptions. Some of these assumptions follow. 1. We can classify expenses into variable and fixed categories. Total variable expenses vary directly with activity level. Total fixed expenses do not change with activity level. 2. The behavior of revenues and expenses is linear over the relevant range. The principal differences between the accountant's break-even chart and the economist's are that (a) the accountant draws the sales line on the assumption that selling prices do not change with changes in production or sales, while the economist assumes that reduced selling prices are normally associated with increased sales volume; and (b) the accountant usually assumes a constant variable expense per unit, while the economist assumes that variable expense per unit changes with production levels. Within the relevant range, the accountant's and the economist's sales and expense lines are usually close to one another, although the lines may diverge greatly outside the range. 3. We expect no change in efficiency or productivity. 4. The sales mix remains constant. The sales mix is the relative proportions or combinations of quantities of different products that constitute total sales. (See Appendix 2A for more on sales mixes.) 5. The inventory level does not change significantly during the period. That is, the number of units sold equals number of units produced. sales mix The relative proportions or combinations of quantities of products that constitute total sales. Changes in Fixed Expenses Changes in fixed expenses cause changes in the breakeven point. For example, if we double the $3,000 monthly rent of the vending machines, what would be the monthly break-even point in number of units and dollar sales? The fixed expenses would increase from $18,000 to $21,000, so break-even volume in units = ISBN: 0-536-47129-0 fixed expenses un it contribution margin $ 21,000 = $. 30 = 70,000 u nits Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 60 Part 1: Focus on Decision Making break-even volume in dollars = fixed expenses contribution margin ratio $ 21,000 = . 20 = $ 105,0 00 Note that a one-sixth increase in fixed expenses altered the break-even point by onesixth: from 60,000 to 70,000 units and from $90,000 to $105,000. This type of relationship always exists between fixed expenses and the break-even point if everything else remains constant. Companies frequently lower their break-even points by reducing their total fixed costs. For example, closing or selling factories decreases property taxes, insurance, depreciation, and managers' salaries. When demand for Boeing airplanes fell because of the slumping economy and the September 11, 2001, terrorist attacks, the company made structural changes to reduce fixed costs. If Boeing had merely produced fewer airplanes with the same fixed/variable cost structure, its volume would have fallen below its break-even point. By reducing fixed costs, the company lowered its break-even point and remained profitable. Changes in Unit Contribution Margin Changes in variable costs also cause the breakeven point to shift. Companies can reduce their break-even points by increasing their unit contribution margins through either increases in unit sales prices or decreases in unit variable costs, or both. For example, assume that the fixed rent for the vending machines is still $3,000. (1) If the rental charge includes $.03 per unit sold in addition to the fixed rent, find the monthly break-even point in number of units and in dollar sales. (2) If Winston reduces the selling price from $1.50 to $1.35 per unit and the original variable expenses per unit are unchanged, find the monthly break-even point in number of units and in dollar sales. Here's what happens to the break-even point: 1. The variable expenses would increase from $1.20 to 1.23 per unit, the unit contribution margin would decline from $.30 to $.27, and the contribution-margin ratio would become $.27 $1.50 = .18. The original fixed expenses of $18,000 would stay the same, but the denominators would change from those previously used. Thus, $ 18,000 = 66,667 units 7 $. 27 $ 18,000 = $ 100,000 break-even point in dollars = . 18 break-even point in units = 2. If Winston reduces the selling price from $1.50 to $1.35 per unit and the original variable expenses are unchanged, the unit contribution margin would fall from $1.50 - $1.20 = $.30 to $1.35 - $1.20 = $.15, and the break-even point would soar to $18,000 $.15 = 120,000 units. The break-even point in dollars would also change because the selling price per unit and contribution-margin ratio change. The contribution-margin ratio would be $.15 $1.35 = .11111. The break-even point in dollars, would be 120,000 units $1.35 = $162,000 or, using the formula: break-even volume in dollars = $ 18,000 = $ 162, 000 . 11111 ISBN: 0-536-47129-0 You can see that small changes in price or variable costs can lead to large changes in the unit contribution margin and, hence, to large changes in the break-even point. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 2: Introduction to Cost Behavior and Cost-Volume Relationships 61 Target Net Profit and an Incremental Approach Managers also use CVP analysis to determine the total sales, in units and dollars, needed to reach a target profit. For example, in our snack vending example, suppose Winston considers $1,440 per month the minimum acceptable net income. How many units will she have to sell to justify the adoption of the vending machine plan? How does this figure "translate" into dollar sales? To compute the target sales volume in units needed to meet the desired or target net income, we adapt the basic break-even formula (equation 1 on p. 56): target sales - variable expenses - fixed expenses = target net income or target sales volume in units = fixed expenses + target net income unit contribution margin $ 18,000 + $ 1,440 = = 64,800 units $. 30 (4) O B J E C T I V E Calculate sales volume in total dollars and total units to reach a target profit. 5 (5) The only real difference from the normal break-even analysis is that here we use a positive target net income instead of a break-even net income of $0. Another way of getting the same answer is to use your knowledge of the break-even point and adopt an incremental approach. The phrase incremental effect refers to the change in total results (such as revenue, expenses, or income) under a new condition in comparison with some given or known condition. In this case, the given condition is the 60,000-unit break-even point. We would recover all expenses at that volume. Therefore, the change or increment in net income for every unit of sales beyond 60,000 would be equal to the unit contribution margin of $1.50 - $1.20 = $.30. If $1,440 were the target net profit, $1,440 $.30 would show that the target volume must exceed the break-even volume by 4,800 units; it would therefore be 60,000 + 4,800 = 64,800 units. To find the answer in terms of dollar sales, multiply 64,800 units by $1.50 or use the formula target sales volume in dollars = fixed expenses + target net income contribution-margin ratio $ 18,000 + $ 1,440 = = $ 97,200 . 20 incremental effect The change in total results (such as revenue, expenses, or income) under a new condition in comparison with some given or known condition. (6) To solve directly for sales dollars with the incremental approach, we would start at the break-even point in dollar sales of $90,000. Every sales dollar beyond that point contributes $.20 to net profit. Divide $1,440 by $.20. Dollar sales must exceed the break-even volume by $7,200 to produce a net profit of $1,440. Thus, the total dollar sales would be $90,000 + $7,200 = $97,200. The following table summarizes these computations: Break-Even Point Volume in units Sales Variable expenses Contribution margin Fixed expenses Net income 60,000 $90,000 72,000 $18,000 18,000 $ 0 Increment 4,800 $7,200 5,760 $1,440 -- $1,440 New Condition 64,800 $97,200 77,760 $19,440 18,000 $ 1,440 ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 62 Part 1: Focus on Decision Making Multiple Changes in Key Factors So far, we have seen changes in only one CVP factor at a time. In the real world, managers often make decisions about the probable effects of multiple factor changes. For example, Boeing may cut the price of its airplanes to stimulate a larger volume of sales. Mars might decrease the size of its Snickers candy bar, saving variable costs and increasing the unit contribution margin, but also decreasing sales volume. Or Medtronic might automate the production of its insulin infusion pump, replacing variable costs of labor with fixed costs of equipment. Consider our vending-machine example. Suppose Winston is considering locking the vending machines from 6:00 PM to 6:00 AM, which she estimates will save $2,460 in wages monthly. However, the cutback from 24-hour service would hurt volume substantially because many nighttime employees use the machines. (Assume that the cutback will not affect morale; it is strictly a financial decision.) Should the machines remain available 24 hours per day? Assume that monthly sales would decline by 10,000 units from the current sales level. We will perform the analysis assuming two different levels of current sales volume: (1) 62,000 units and (2) 90,000 units. We will consider two approaches. The first is to construct and solve equations for conditions that prevail under each alternative and select the volume level that yields the highest net income. Regardless of the current volume level, be it 62,000 or 90,000 units, if we accept the prediction that sales will decline by 10,000 units, closing from 6:00 PM to 6:00 AM will decrease net income by $540: Decline from 62,000 to 52,000 Units Units Sales Variable expenses Total contribution margin Fixed expenses Net income Change in net income 62,000 $93,000 74,400 $18,600 18,000 $ 600 ($540) 52,000 $78,000 62,400 $15,600 15,540 $ 60 Decline from 90,000 to 80,000 Units 90,000 $135,000 108,000 $ 27,000 18,000 $ 9,000 ($540) 80,000 $120,000 96,000 $ 24,000 15,540 $ 8,460 A second approach--an incremental approach--is quicker and simpler. Simplicity is important to managers because it keeps the analysis from being cluttered by irrelevant and potentially confusing data. What does the insightful manager see in this situation? First, whether the vending machines sell 62,000 or 90,000 units is irrelevant to the decision at hand. The issue is the decline in volume, which is 10,000 units in either case. The essence of this decision is whether the prospective savings in fixed costs exceed the prospective loss in total contribution-margin dollars. Lost total contribution margin, 10,000 units @ $.30 Less savings in fixed expenses Prospective decline in net income $3,000 - 2,460 $ 540 The incremental analysis also shows that locking the vending machines from 6:00 PM to 6:00 AM would cause a $540 decrease in monthly net income. Whichever way you analyze it, locking the machines is not a sound financial decision. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 2: Introduction to Cost Behavior and Cost-Volume Relationships 63 CVP Analysis and Computer-Based Spreadsheets The use of spreadsheets simplifies the examination of multiple changes in key factors in a CVP model. Managers in a variety of organizations use a personal computer and a spreadsheet-based CVP modeling program to study combinations of changes in selling prices, unit variable costs, fixed costs, and desired profits. Many nonprofit organizations also use computerized CVP modeling. For example, some private universities have models that help measure how decisions, such as raising tuition, adding programs, and closing dormitories during winter holidays, will affect financial results. The computer quickly calculates the results of changes and can display them both numerically and graphically. Consider our vending machine example. Exhibit 2-8 is a sample spreadsheet that shows what the sales level would have to be at three different fixed expense levels and three different variable expense levels to reach three different income levels. The computer calculates the 27 different sales levels rapidly and without error. Managers can insert any numbers they want for fixed expenses (column A), variable expense percentage (column B), target net income (row 3 of columns C, D, and E), and the computer will compute the sales level. In addition to speed and convenience, computers allow a more sophisticated approach to CVP analysis than the one illustrated in this chapter. The assumptions we listed on page 59 are necessary to simplify the analysis enough for most managers to construct a CVP model by hand. Computer analysts, however, can construct a model that does not require all the simplifications. Computer models can include multiple cost drivers, nonlinear relationships between costs and cost drivers, varying sales mixes, and analyses that need not be restricted to a relevant range. The use of computer models is a cost-benefit issue. The reliability of these models depends on the accuracy of their underlying assumptions about how revenues and costs will actually be affected. More complex models often require fewer assumptions and, thus, are more reliable. However, sometimes the costs of modeling exceed the value of the improved quality of management decisions. In small organizations, simplified CVP models often are accurate enough; more sophisticated (and more expensive) modeling may be unwarranted. Exhibit 2-8 A 1 2 3 4 5 6 7 8 9 10 11 12 13 Fixed Expenses $4,000 $4,000 $4,000 $6,000 $6,000 $6,000 $8,000 $8,000 $8,000 *(A5 (A6 (A7 C3)/(1 C3)/(1 C3)/(1 B Variable Expense % 0.40 0.44 0.48 0.40 0.44 0.48 0.40 0.44 0.48 B5) B6) B7) ($4,000 ($4,000 ($4,000 C D E Sales Required to Earn Annual Net Income of $ 4,000 $ 6,000 $13,333 $14,286 $15,385 $16,667 $17,857 $19,231 $20,000 $21,429 $23,077 $.40) $.44) $.48) $10,000 $10,714 $11,538 $16,667 $17,857 $19,231 $20,000 $21,429 $23,077 $23,333 $25,000 $26,923 Spreadsheet Analysis of CVP Relationships $2,000 $10,000* $10,714* $11,538* $13,333 $14,286 $15,385 $16,667 $17,857 $19,231 ISBN: 0-536-47129-0 $2,000)/(1 $2,000)/(1 $2,000)/(1 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. DID BLOCKBUSTER VIOLATE DISNEY CONTRACT? ACCOUNTING DISAGREEMENT OR ETHICAL ISSUE? In early 2003, the Walt Disney Company sued Blockbuster, claiming that Blockbuster had violated a 1997 agreement between the two companies. Prior to the agreement, Blockbuster purchased videos from Disney for about $65 each and kept all the rental revenue. Under the pact, Blockbuster agreed to purchase movies from Disney for $7 a copy and then pay the studio a portion of the revenue from each rental. The contract allowed Blockbuster to buy more copies of each video, which led to the guarantee that customers could rely on Blockbuster to have a copy of any movie they wanted or else the rental was free. With this policy, Blockbuster increased its market share of the video rental market from 28% to 40%. Essentially, Blockbuster turned a fixed cost, $65 per tape, into primarily a variable cost, with a small $7 fixed-cost portion and a larger variablecost por tion that depended on how much revenue Blockbuster generated from its rentals. The arrangement was similar to that between the owners of shopping malls and many of their retail store tenants. Each store pays a monthly rental fee plus a percentage of its sales. Just as shopping mall owners rely on their tenants to truthfully report their sales, Disney relied on Blockbuster to correctly account for its video rentals. In addition, Blockbuster and Disney also agreed on when Blockbuster could sell old rental tapes. Since these were so inexpensive for Blockbuster, selling them could be a lucrative business. But Disney did not want these lowcost tapes competing with its own videotape sales. Thus, it placed restrictions on when Blockbuster could sell them. In the suit, Disney claimed that Blockbuster improperly deducted "promotional" credits from its gross rental fees, failed to account for "hundreds of thousands" of missing videos, and sold videos prematurely. Disney had to rely on Blockbuster to correctly account for its rental revenues and inventory of tapes. Blockbuster claimed that its accounting was in accordance with the original agreement. This is an example where good ethics and good accounting are both impor tant. The original agreement promised benefits to both companies--more rental income for Disney on hit movies and more cost-structure flexibility for Blockbuster. But such a contract will not work if each party cannot trust the other. It's not clear who is right in this case, but both companies were hurt by the allegations. At a minimum, both will need to include better monitoring provisions in future contracts because other companies will suspect Disney of trying to get more than it deserves and Blockbuster of playing accounting tricks to minimize its payment to Disney. Source: "Disney Sues Blockbuster Over Contract," New York Times, Januar y 4, 2003; "Disney Sues Top Video Chain," Los Angeles Times, January 3, 2003. Additional Uses of Cost-Volume Analysis Best Cost Structure Analyzing cost-volume-profit relationships is an important management responsibility. Managers are well advised to gain a thorough understanding of the organization's cost structure--the combination of variable- and fixed-cost factors. For example, purchasing automated machinery may raise fixed costs but reduce labor cost per unit. Conversely, it may be wise to reduce fixed costs to obtain a more favorable combination. Thus, a company may decide to compensate its sales force via sales commissions (variable costs) rather than pay them salaries (a fixed cost). Another example of exchanging a fixed cost for a variable cost is a contract Blockbuster signed with Disney and other major studios. Instead of buying video tapes for $65 each, a fixed cost for each tape, Blockbuster paid only a $7 fixed cost and an additional variable cost equal to a percentage of the rental revenues. You can see one result of this contract in the Business First box above. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 2: Introduction to Cost Behavior and Cost-Volume Relationships 65 Generally, companies that spend heavily for advertising are willing to do so because they have high contribution-margin percentages (e.g., airlines, cigarette, and cosmetic companies). Conversely, companies with low contribution-margin percentages usually spend less for advertising and promotion (e.g., manufacturers of industrial equipment). As a result, two companies with the same unit sales volumes at the same unit prices could have different attitudes toward risking an advertising outlay. Assume the following: Perfume Company Unit sales volume Dollar sales at $10 per unit Variable costs Total contribution margin Contribution-margin percentage 200,000 bottles $2,000,000 200,000 $1,800,000 90% Janitorial Service Company 200,000 square feet $2,000,000 1,700,000 $ 300,000 15% Suppose each company can increase sales volume by 10% with the same expenditure for advertising: Janitorial Service Company $200,000 30,000 Perfume Company Increase in sales volume, 20,000 $10 Increase in total contribution margin, 90%, 15% $200,000 180,000 The perfume company would be inclined to increase advertising considerably to boost the total contribution margin by $180,000. In contrast, the janitorial service company would be foolhardy to spend large amounts to increase the total contribution margin by only $30,000. Note that when the contribution margin as a percentage of sales is low, great increases in volume are necessary to generate increases in net profits. On the other hand, decreases in profit are also small as volume decreases. High contribution-margin ratios have the opposite effect--large increases in profits as sales grow but also large decreases in profits if sales fall. Operating Leverage In addition to weighing the varied effects of changes in fixed and variable costs, managers need to consider their firm's ratio of fixed to variable costs, called operating leverage. In highly leveraged companies--those with high fixed costs and low variable costs--small changes in sales volume result in large changes in net income. Changes in sales volume have a smaller effect on companies with less leverage (that is, lower fixed costs and higher variable costs). Exhibit 2-9 shows cost behavior relationships at two firms, one highly leveraged and one with low leverage. The firm with higher leverage has fixed costs of $14,000 and variable cost per unit of $.10. The firm with lower leverage has fixed costs of only $2,000 but variable costs of $.25 per unit. Expected sales at both companies are 80,000 units at $.30 per unit. At this sales level, both firms would have net incomes of $2,000. If sales fall short of 80,000 units, profits drop most sharply for the highly leveraged business. If sales exceed 80,000 units, however, profits also increase most sharply for the highly leveraged concern. operating leverage A firm's ratio of fixed to variable costs. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 66 Part 1: Focus on Decision Making Exhibit 2-9 High versus Low Operating Leverage $ $4,000 24,000 22,000 Revenue Cost, Lower Leverage $2,500 Cost, Higher Leverage Dollars 14,000 $.10 $.25 $1,500 $.30 2,000 70,000 80,000 90,000 Volume in Units The highly leveraged alternative is more risky. Why? Because it provides the highest possible net income and the highest possible net losses. In other words, net income is highly variable, depending on the actual level of sales. The low-leverage alternative is less risky because variations in sales lead to only a small variability in net income. At sales of 90,000 units, net income is $4,000 for the higher-leveraged firm but only $2,500 for the lower-leveraged firm. At sales of 70,000 units, however, the higher-leveraged firm has zero profits, compared to $1,500 for the lower-leveraged firm. Margin of Safety margin of safety The planned unit sales less the break-even unit sales; it shows how far sales can fall below the planned level before losses occur. CVP analysis can also help managers assess risk by providing a measure of the margin of safety. The margin of safety shows how far sales can fall below the planned level of sales before losses occur. It compares the level of planned sales with the break-even point: margin of safety = planned unit sales - break-even unit sales The larger the margin of safety, the less likely it is that the company will have an operating loss, that is, operate below the break-even point. A small margin of safety may indicate a more risky situation. If Amy Winston in our vending-machine example had predicted a sales volume of 80,000 units, the margin of safety would be 20,000 units: margin of safety = 80,000 units - 60,000 units = 20,000 units O B J E C T I V E Differentiate between contribution margin and gross margin. gross margin (gross profit) The excess of sales over the total cost of goods sold. cost of goods sold The cost of the merchandise that a company acquires or produces and then sells. 6 Contribution Margin and Gross Margin This chapter has focused on the contribution margin. However, accountants also use a similar term, gross margin, to mean something quite different. Too often people confuse the terms contribution margin and gross margin. Gross margin, also called gross profit, is the excess of sales over the cost of goods sold. Cost of goods sold is the cost of the merchandise that a company acquires or produces and then sells. Compare the gross margin with the contribution margin: gross margin = sales price - cost of goods sold contribution margin = sales price - all variab le expenses ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 2: Introduction to Cost Behavior and Cost-Volume Relationships 67 Exhibit 2-10 Variable Costs Production or Acquisition Costs Selling & Administrative (Nonproduction) Costs A Variable Production or Acquisition Costs C Variable Selling & Administrative Costs Total Variable Costs Fixed Costs B Fixed Production or Acquisition Costs D Fixed Selling & Administrative Costs Total Fixed Costs Total Production or Acquisition Costs Total Selling & Administrative (Nonproduction) Costs Costs for Gross Margin and Contribution Margin contribution margin = sales total variable costs = sales (A + C) gross margin = sales total production or acquisition cost = sales (A + B) Exhibit 2-10 shows costs divided on two different dimensions. As shown at the bottom of the exhibit, the gross margin uses the division on the production or acquisition cost versus selling and administrative cost dimension, and the contribution margin uses the division based on the variable-cost versus fixed-cost dimension. In our vending-machine illustration, the contribution margin and the gross margin are identical because the cost of goods sold is the only variable cost: Sales Variable costs: acquisition cost of unit sold Contribution margin and gross margin are equal $1.50 1.20 $ .30 Now, suppose the firm had to pay a commission of $.12 per unit sold: Contribution Margin Sales Acquisition cost of unit sold Variable commission Total variable expense Contribution margin Gross margin $1.50 $1.20 .12 1.32 $ .18 $ .30 Gross Margin $1.50 1.20 As the preceding tabulation indicates, contribution margin and gross margin are different. Contribution margin focuses on sales in relation to all variable costs, whereas gross margin focuses on sales in relation to cost of goods sold. For example, consider MascoTech, a Detroit-based auto parts supplier. A newspaper article reported that MascoTech's "gross profit margin on sales is about 21% today, but for each additional sales dollar the contribution margin is more like 30%." Nonprofit Application Consider how cost-volume-profit relationships apply to nonprofit organizations. Suppose a city has a $100,000 lump-sum budget appropriation to conduct a counseling program for drug addicts. The variable costs for counseling are $400 per patient per year. Fixed costs are $60,000 in the relevant range of 50 to 150 patients. If the city spends the entire budget appropriation, how many patients can it serve in a year? ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 68 Part 1: Focus on Decision Making Exhibit 2-11 Graphical Presentation of Nonprofit Application Total Costs Revenue $100,000 90,000 25 60,000 Slope = $400 $10,000 50 75 100 125 150 Volume of Patients, N We can use the break-even equation to solve the problem. Let N be the number of patients, substitute the $100,000 lump-sum budget for sales, and note that sales equals variable expenses plus fixed expenses if the city completely spends its budget. sales = variable expenses + fixed expenses $100,0 00 lump sum = $ 400 N + $ 60,000 $ 400 N = $ 100,000 - $ 6 0,000 N = $ 40,000 $ 400 N = 100 patients The city can serve 100 patients. Now, suppose the city cuts the total budget appropriation for the following year by 10%. Fixed costs will be unaffected, but service will decline. sales = variable expenses + fixed expenses $90,0 0 0 = $ 400 N + $ 60,000 $ 400 N = $ 90,000 - $ 60,000 N = $ 30,000 $ 400 , N = 75 patients The percentage reduction in service is (100 - 75) 100 = 25%, which is more than the 10% reduction in the budget. Unless the city restructures its operations, the service volume must fall by 25% to stay within budget. A graphical presentation of this analysis is in Exhibit 2-11. Note that lump-sum revenue is a horizontal line on the graph. Summary Problem for Your Review PROBLEM A summary of the budgeted income statement of Port Williams Gift Shop follows: ISBN: 0-536-47129-0 Net revenue Less expenses, including $400,000 of fixed expenses Net loss $800,000 880,000 $(80,000) Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 2: Introduction to Cost Behavior and Cost-Volume Relationships 69 The manager believes that an additional outlay of $200,000 for advertising will increase sales substantially. 1. At what sales volume in dollars will the shop break even after spending $200,000 on advertising? 2. What sales volume in dollars will result in a net profit of $40,000 after spending the $200,000 on advertising? SOLUTION 1. Note that all data are in dollars, not units. Most companies have many products, so the overall break-even analysis deals with dollar sales, not units. The variable expenses are $880,000 - $400,000 = $480,000. The variable-cost ratio is $480,000 $800,000 = .60. (Remember to divide variable costs by sales, not by total costs.) Therefore, the contribution-margin ratio is .40. Let S = break-even sales in dollars. Then S - variable expenses - fixed expenses = net profit S - . 60S - ($ 400,000 + $ 200,000) = 0 0 . 40S = $ 600,000 fixed expenses $ 600,000 S= = contribution-margin ratio . 40 S = $ 1,500,000 2. (fixed expenses + target net p rofit) contribution-margin ratio ($ 600,000 + $ 40,000) $ 640,000 l = required sales = . 40 . 40 required sales = $ 1,600,000 required sales = Alternatively, we can use an incremental approach and reason that all dollar sales beyond the $1.5 million break-even point will result in a 40% contribution to net profit. Divide $40,000 by .40. Therefore, sales must be $100,000 beyond the $1.5 million breakeven point to produce a net profit of $40,000. Highlights to Remember Explain how cost drivers affect cost behavior. A cost driver is an output measure that causes the use of costly resources. When the level of an activity changes, the level of the cost driver or output measure will also change, causing changes in costs. 1 2 3 Show how changes in cost-driver levels affect variable and fixed costs. Different types of costs behave in different ways. If the cost of the resource used changes in proportion to changes in the costdriver level, the resource is a variable-cost resource (its costs are variable). If the cost of the resource used does not change because of cost-driver level changes, the resource is a fixed-cost resource (its costs are fixed). ISBN: 0-536-47129-0 Calculate break-even sales volume in total dollars and total units. We can approach CVP analysis (sometimes called break-even analysis) graphically or with equations. To calculate the break-even point in total units, divide the fixed costs by the unit contribution margin. To calculate the break-even point in total dollars (sales dollars), divide the fixed costs by the contribution-margin ratio. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 70 Part 1: Focus on Decision Making Create a cost-volume-profit graph and understand the assumptions behind it. We can create a cost-volume-profit graph by drawing revenue and total cost lines as functions of the cost-driver level. Be sure to recognize the limitations of CVP analysis and that it assumes constant efficiency, sales mix, and inventory levels. 4 5 6 Calculate sales volume in total dollars and total units to reach a target profit. Managers use CVP analysis to compute the sales needed to achieve a target profit or to examine the effects on profit of changes in factors such as fixed costs, variable costs, or cost-driver volume. Differentiate between contribution margin and gross margin. The contribution margin--the difference between sales price and variable costs--is an important concept. Do not confuse it with gross margin, the difference between sales price and cost of goods sold. Appendix 2A: Sales-Mix Analysis O B J E C T I V E Explain the effects of sales mix on profits. 7 To emphasize fundamental ideas, the cost-volume-profit analysis in this chapter focused on a single product. Nearly all companies, however, sell more than one product. Thus, they must be concerned with sales mix, which you will recall from p. 59 is the relative proportions or combinations of quantities of products that comprise total sales. If the proportions of the mix change, the cost-volume-profit relationships also change. Suppose Ramos Company has two products, wallets (W) and key cases (K). The income budget follows: Wallets (W) Sales in units Sales @ $8 and $5 Variable expenses @ $7 and $3 Contribution margins @ $1 and $2 Fixed expenses Net income 300,000 $2,400,000 2,100,000 $ 300,000 Key Cases (K) 75,000 $375,000 225,000 $150,000 Total 375,000 $2,775,000 2,325,000 $ 450,000 180,000 $ 270,000 What is the break-even point for each product? The typical answer assumes a constant mix of 4 units of W for every unit of K. Therefore, let K = number of units of product K to break even, and 4K = number of units of product W to break even: sales - variable expenses - fixed expenses = zero net income [$8(4K ) + $ 5( K )] - [$7(4K ) + $ 3( K )] - $ 1 80,000 = 0 $32K + $5K - $28K - $3K - $ 180,000 = 0 $ 6 K = $ 1 80,000 K = 30,000 4 K = 120,000 = W The break-even point is 30,000K + 120,000W = 150,000 units. This is the only break-even point for a sales mix of four wallets for every key case. Clearly, however, there are other break-even points for other sales mixes. For instance, suppose Ramos Company sells only key cases, and fixed expenses stay at $180,000. break-even point in units = = fixed expenses con tribution margin per unit $ 180,000 $2 = 90,000 key cases 0 If Ramos sells only wallets: break-even point = $ 180,000 = 180,000 wallets $1 ISBN: 0-536-47129-0 We can see that the break-even point could be 180,000 units (of wallets), 90,000 units (of key cases), or 150,000 units (30,000 key cases and 120,000 wallets). Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 2: Introduction to Cost Behavior and Cost-Volume Relationships 71 Managers are not interested in the break-even point for its own sake. Instead, they want to know how changes in a planned sales mix will affect net income. When the sales mix changes, the breakeven point and the expected net income at various sales levels change also. For example, suppose overall actual total sales were equal to the budget of 375,000 units. However, Ramos sold only 50,000 key cases. Wallets (W) Sales in units Sales @ $8 and $5 Variable expenses @ $7 and $3 Contribution margins @ $1 and $2 Fixed expenses Net income 325,000 $2,600,000 2,275,000 $ 325,000 Key Cases (K) 50,000 $250,000 150,000 $100,000 Total 375,000 $2,850,000 2,425,000 $ 425,000 180,000 $ 245,000 The change in sales mix has resulted in a $245,000 actual net income rather than the $270,000 budgeted net income, an unfavorable difference of $25,000. The budgeted and actual sales in number of units were identical, but the proportion of sales of the product bearing the higher unit contribution margin declined. Managers usually want to maximize the sales of all their products. Faced with limited resources and time, however, executives prefer to generate the most profitable sales mix achievable. For example, Clorox Company included the following in the report of its first-quarter 2003 results: "The revised projection reflects benefits from . . . a more favorable mix of products sold during the quarter." U.S. Home Systems had the opposite experience in 2002: "The loss in the third quarter resulted . . . [partly from the] mix of products sold." Profitability of a given product helps guide executives who must decide to emphasize or deemphasize particular products. For example, given limited production facilities or limited time of sales personnel, should we emphasize wallets or key cases? Other factors beyond the contribution margin can affect these decisions. Chapter 5 explores some of these factors, including the importance of the amount of profit per unit of time rather than per unit of product. Appendix 2B: Impact of Income Taxes Thus far we have (as so many people would like to) ignored income taxes. In most nations, however, private enterprises must pay income taxes. Reconsider the vending machine example in this chapter. As part of our CVP analysis, we discussed the sales necessary to achieve a target income before income taxes of $1,440. If Boeing pays income tax at a rate of 40%, the new result would be Income before income tax Income tax Net income $1,440 576 $ 864 100% 40 60% O B J E C T I V E Compute cost-volume-profit relationships on an aftertax basis. 8 Note that net income = income before income taxes - .40 (income before income taxes) net income = .60 (income before income taxes) income before income taxes = or ISBN: 0-536-47129-0 net income .60 target income before income taxes = target after-tax net income 1 - tax rate $ 864 $ 864 = = $ 1, 44 0 target income b efore income taxes = 4 . 60 1 - . 40 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 72 Part 1: Focus on Decision Making Suppose the target net income after taxes was $864. The only change in the general equation approach would be on the right-hand side of the following equation: target sales - variable expenses - fixed expenses = target after-tax net income 1 - tax rate Thus, letting N be the number of units to be sold at $1.50 each with a variable cost of $1.20 each and total fixed costs of $18,000, $ 1 . 50 N - $ 1 . 20 N - $ 18,000 = $ 864 1 - .4 $. 30 N = $ 18,000 + $ 864 .6 $. 18 N = $ 10,800 + $ 864 = 11,664 N = $ 11,664 $ . 18 = 64,800 units Sales of 64,800 units produce an after-tax profit of $864 as shown here and a before-tax profit of $1,440 as shown in the chapter. Suppose the target net income after taxes was $1,440. The volume needed would rise to 68,000 units, as follows: $ 1 . 50 N - $ 1 . 20 N - $ 18,000 = $ 1, 440 1 - .4 $. 30 N = $ 18,0 0 0 + $ 1, 440 .6 $. 18 N = $ 10,800 + $ 1, 440 = 12, 240 N = $ 1 2, 240 $. 18 = 68,000 units As a shortcut to computing the effects of volume on the change in after-tax income, use the formula change in volume contribution margin change in net income = (1 - tax rate) in units per unit In our example, suppose operations were at a level of 64,800 units and $864 after-tax net income. The manager is wondering how much after-tax net income would increase if sales become 68,000 units. change in net income = (68,000 - 64,800) $. 30 (1 - . 4 ) = 3, 200 $. 30 . 60 = 3, 200 $. 18 = $ 576 In brief, each unit beyond the break-even point adds to after-tax net profit at the unit contribution margin multiplied by (1 - income tax rate). Throughout our illustration, the break-even point itself does not change. Why? Because there is no income tax at a level of zero profits. Accounting Vocabulary break-even point, p. 54 contribution margin, p. 56 contribution-margin percentage, p. 56 contribution-margin ratio, p. 56 cost behavior, p. 46 cost driver, p. 46 cost of goods sold, p. 66 cost-volume-profit (CVP) analysis, p. 54 fixed cost, p. 48 gross margin, p. 66 gross profit, p. 66 incremental effect, p. 61 marginal income, p. 55 margin of safety, p. 66 operating leverage, p. 65 relevant range, p. 52 sales mix, p. 59 total contribution margin, p. 55 unit contribution margin, p. 55 variable cost, p. 48 variable-cost percentage, p. 56 variable-cost ratio, p. 56 ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 2: Introduction to Cost Behavior and Cost-Volume Relationships 73 Fundamental Assignment Material 2-A1 Fixed- and Variable-Cost Behavior Consider a particular Boeing plant. Maintaining a clean working environment is important to Boeing. Cleaning the plant is the responsibility of the maintenance department. Two of the resources needed to clean the plant are labor and cleaning supplies. The cost driver for both resources is square feet cleaned. Plant cleaning laborers are paid the same wages regardless of the number of times the plant is cleaned. Cleaning supplies is a variable cost. The 25,000 square foot plant is thoroughly cleaned from four to six times a month depending on the level and stage of production. For the most recent month, March, the plant was cleaned four times. The March cost of labor was $24,000 and cleaning supplies used cost $5,000. The production schedule for the next quarter (April through June) indicates that the plant will need to be cleaned 5, 6, and 8 times respectively. 1. Prepare a table that shows how labor cost, cleaning supplies cost, total cost, and total cost per square feet cleaned changes in response to the square feet cleaned. What is the predicted total cost of plant cleaning for the next quarter? 2. Suppose Boeing can hire an outside cleaning company to clean the plant as needed. The charge rate for cleaning is $5,900 per plant cleaning. If the outside cleaning company is hired, Boeing can lay off the workers who are now cleaning the plant and will spend nothing for cleaning supplies. Will Boeing save money with the outside cleaning company over the next quarter? Prepare a schedule that supports your answer. 2-A2 Cost-Volume-Profit and Vending Machines Angelino Food Services Company operates and services soft drink vending machines located in restaurants, gas stations, and factories in four southwestern states. The machines are rented from the manufacturer. In addition, Angelino must rent the space occupied by its machines. The following expense and revenue relationships pertain to a contemplated expansion program of 40 machines. Fixed monthly expenses follow: Machine rental: 40 machines @ $43.50 Space rental: 40 locations @ $28.80 Part-time wages to service the additional 40 machines Other fixed costs Total monthly fixed costs $1,740 1,152 1,908 200 $5,000 Other data follow: Per Unit Selling price Cost of soft drink Contribution margin $1.00 .80 $ .20 Per $100 of Sales 100% 80 20% These questions relate to the above data unless otherwise noted. Consider each question independently. 1. What is the monthly break-even point in number of units? In dollar sales? 2. If 36,000 units were sold, what would be the company's net income? 3. If the space rental cost was doubled, what would be the monthly break-even point in number of units? In dollar sales? 4. If, in addition to the fixed rent, Angelino Food Services Company paid the vending-machine manufacturer $.02 per unit sold, what would be the monthly break-even point in number of units? In dollar sales? Refer to the original data. 5. If, in addition to the fixed rent, Angelino paid the machine manufacturer $.04 for each unit sold in excess of the break-even point, what would the new net income be if 36,000 units were sold? Refer to the original data. ISBN: 0-536-47129-0 2-A3 Exercises in Cost-Volume-Profit Relationships Mainline Moving Company specializes in hauling heavy goods over long distances. The company's revenues and expenses depend on revenue miles, a measure that combines both weights and mileage. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 74 Part 1: Focus on Decision Making Summarized budget data for next year are based on predicted total revenue miles of 800,000. At that level of volume, and at any level of volume between 700,000 and 900,000 revenue miles, the company's fixed costs are $110,000. The selling price and variable costs are Per Revenue Mile Average selling price (revenue) Average variable expenses $1.50 1.30 1. Compute the budgeted net income. Ignore income taxes. 2. Management is trying to decide how various possible conditions or decisions might affect net income. Compute the new net income for each of the following changes. Consider each case independently. a. b. c. d. e. A 10% increase in sales price. A 10% increase in revenue miles. A 10% increase in variable expenses. A 10% increase in fixed expenses. An average decrease in selling price of $.03 per revenue mile and a 5% increase in revenue miles. Refer to the original data. f. An average increase in selling price of $.05 and a 10% decrease in revenue miles. g. A 10% increase in fixed expenses in the form of more advertising and a 5% increase in revenue miles. 2-B1 Fixed- and Variable-Cost Behavior Outback Steakhouse has 930 restaurants offering steak, chicken, and seafood served in an Australian-themed atmosphere. Maintaining a clean environment for customers is a key success factor at Outback. Each restaurant is cleaned regularly after closing. In addition to regular cleaning, from 5 to 20 times a month, depending on various factors including the amount of business, a special treatment is given to the floors consisting of breaking down the old wax and rewaxing. So the total number of times a restaurant is cleaned varies from 35 to 50 times a month. The two most costly resources needed to clean an Outback restaurant are labor and supplies. The cost driver for both resources is square feet cleaned. Cleaning laborers are paid the same wages regardless of the number of times a restaurant is cleaned. Cleaning supplies is a varaible cost. The cost of supplies used per square foot for regular and special cleaning are about the same. Suppose one of the local Outback restaurants in Denver has 4,000 square feet. In October, the restaurant was cleaned 35 times. The cost of cleaning labor was $18,000 for October, and cleaning supplies used cost $8,400. The months of November and December are typically much busier, so the restaurant manager expects to clean 45 times and 50 times in November and December respectively. 1. Prepare a table that shows how labor cost, cleaning supplies cost, total cost, and total cost per square feet cleaned changes in response to square feet cleaned. Use volumes of 35, 40, 45, and 50 times cleaned. What is the predicted total cost of cleaning for November and December? 2. Suppose Outback can hire an outside cleaning company to clean the restaurant as needed. The charge rate for cleaning is $.17 per square foot. If the outside cleaning company is hired, Outback can lay off the workers who are now cleaning and will spend nothing on cleaning supplies. Will Outback save money with the outside cleaning company over the next two months? Prepare a schedule that supports your answer. What information would you need to make a recommendation about hiring the outside cleaning company on a permanent basis? 2-B2 Basic CVP Exercises Each problem is unrelated to the others. 1. Given: Selling price per unit, $20; total fixed expenses, $5,000; variable expenses per unit, $15. Find break-even sales in units. 2. Given: Sales, $40,000; variable expenses, $30,000; fixed expenses, $7,500; net income, $2,500. Find break-even sales in dollars. 3. Given: Selling price per unit, $30; total fixed expenses, $33,000; variable expenses per unit, $14. Find total sales in units to achieve a profit of $7,000, assuming no change in selling price. 4. Given: Sales, $50,000; variable expenses, $20,000; fixed expenses, $20,000; net income, $10,000. Assume no change in selling price; find net income if activity volume increases 10%. 5. Given: Selling price per unit, $40; total fixed expenses, $80,000; variable expenses per unit, $30. Assume that variable expenses are reduced by 20% per unit, and the total fixed expenses are increased by 10%. Find the sales in units to achieve a profit of $20,000, assuming no change in selling price. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 2: Introduction to Cost Behavior and Cost-Volume Relationships 75 2-B3 Basic CVP Analysis Raef Nadal opened Raef's Corner, a small day care facility, just over two years ago. After a rocky start, Raef's Corner has been thriving. Nadal is now preparing a budget for November 20X7. Monthly fixed costs for Raef's Corner are Rent Salaries Other fixed costs Total fixed costs $ 800 1,400 100 $2,300 The salary is for Ann Quenilla, the only employee, who works with Raef by caring for the children. Nadal does not pay himself a salary, but he receives the excess of revenues over costs each month. The cost driver for variable costs is "child-days." One child-day is one day in day care for one child, and the variable cost is $10 per child-day. The facility is open from 6:00 AM to 6:00 PM weekdays (that is, Monday through Friday), and there are 22 weekdays in November 20X7. An average day has 8 children attending Raef's Corner. State law prohibits Raef's Corner from having more than 14 children, a limit it has never reached. Nadal charges $30 per day per child, regardless of how long the child is at the facility. 1. Suppose attendance for November 20X7 is equal to the average, resulting in 22 8 = 176 childdays. What amount will Nadal have left after paying all his expenses? 2. Suppose both costs and attendance are difficult to predict. Compute the amount Nadal will have left after paying all his expenses for each of the following situations. Consider each case independently. a. b. c. d. Average attendance is 9 children per day instead of 8, generating 198 child-days. Variable costs increase to $11 per child-day. Rent increases by $200 per month. Nadal spends $300 on advertising (a fixed cost) in November, which increases average daily attendance to 9.5 children. e. Nadal begins charging $33 per day on November 1, and average daily attendance slips to 7 children. Additional Assignment Material Questions 2-1 "Cost behavior is simply identification of cost drivers and their relationships to costs." Comment. 2-9 "Classification of costs into variable and fixed categories depends on the decision situation." Explain. 2-2 Give two rules of thumb to use when analyzing cost behavior. 2-3 Give three examples of variable costs and of fixed costs. 2-10 "Contribution margin is the excess of sales over fixed costs." Do you agree? Explain. 2-11 Why is break-even analysis a misnomer? 2-12 "Companies in the same industry generally have about the same break-even point." Do you agree? Explain. 2-4 Why is the word immediately used in the definition of fixed cost and not in the definition of variable cost? 2-5 "It is confusing to think of fixed costs on a per-unit basis." Do you agree? Why or why not? 2-13 "It is essential to choose the right CVP method--equation, contribution margin, or graphical. If you pick the wrong one, your analysis will be faulty." Do you agree? Explain. 2-6 "All costs are either fixed or variable. The only difficulty in cost analysis is determining which of the two categories each cost belongs to." Do you agree? Explain. ISBN: 0-536-47129-0 2-14 Describe three ways of lowering a breakeven point. 2-15 "Incremental analysis is quicker, but it has no other advantage over an analysis of all costs and revenues associated with each alternative." Do you agree? Why or why not? 2-7 "The relevant range pertains to fixed costs, not variable costs." Do you agree? Explain. 2-8 Identify the major simplifying assumption that underlies CVP analysis. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 76 Part 1: Focus on Decision Making 2-16 Suppose a company with high operating leverage is also operating at near capacity for all its fixed-cost resources. How could an increase in sales volume result in decreasing economies of scale for this company? lower than budgeted. What could be the reason for the lower contribution margin? 2-21 Study Appendix 2B. Given a target aftertax net income, present the CVP formula for computing the income before income taxes. 2-17 Explain operating leverage and why a highly leveraged company is risky. 2-18 "The contribution margin and gross margin are always equal." Do you agree? Explain. 2-22 Study Appendix 2B. Present the CVP formula for computing the effects of a change in volume on after-tax income. 2-23 "As I understand it, costs such as the salary of the vice president of transportation operations are variable because the more traffic you handle, the less your unit cost. In contrast, costs such as fuel are fixed because each ton-mile should entail consumption of the same amount of fuel and hence bear the same unit cost." Do you agree? Explain. 2-19 "CVP relationships are unimportant in nonprofit organizations." Do you agree? Explain. 2-20 Study Appendix 2A. A company sold two products. Total budgeted sales and total actual sales in number of units were identical. Actual unit variable costs and sales prices were the same as budgeted. Actual contribution margin was Critical Thinking Exercises 2-24 Marketing Function of Value-Chain and Cost Behavior Refer to Exhibit 2-2. For the two examples of marketing costs given in Exhibit 2-2, describe their cost behavior in relation to the cost driver listed. 2-25 Production Function of Value-Chain and Cost Behavior Refer to Exhibit 2-2. For the labor wages and depreciation of plant and machinery examples of production costs given in Exhibit 2-2, describe their cost behavior in relation to the cost driver listed. 2-26 Tenneco Automotive's Value Chain Tenneco is an auto parts company that makes Walker exhaust systems and Monroe ride-control equipment (shocks, struts) for vehicle manufacturers and the replacement market, with annual revenues in excess of $4 billion. After reporting weak earnings, the company undertook a strategy to reduce its break-even point by 25% by selling excess capacity, reducing head count, and introducing new highcontribution-margin products. The company's senior vice president listed the key elements of the company's strategy, stating, "We are gaining momentum and transforming our North American aftermarket business with new products, new technology, new positioning strategies, and new pricing." For each of these "new" elements of Tenneco's aftermarket business strategy, list the value-chain function that is most applicable. Exercises 2-27 Identifying Cost Drivers The following list identifies several potential cost drivers for a manufacturing company that makes eight products. The company uses a JIT production system so it stores finished product for a very limited time. The 8 products vary substantially in size from small (plastic casings for pens) to large (plastic casings for truck instrument panels). Number of setups Setup time Square feet Cubic feet Cubic feet weeks For each situation described below (activity and related resource), identify the best cost driver from the list and briefly justify your choice. 1. To produce a product, production mechanics must set up machinery. It takes about the same time to set up for a production run regardless of the product being produced. What is the best cost driver for the setup activity? 2. Instead of the situation described in number 1, what driver should the company use for the setup activity if it takes longer to set up for complex products, such as the instrument panel casings, than for simple products, such as pen casings? ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 2: Introduction to Cost Behavior and Cost-Volume Relationships 77 3. What driver should the company use for warehouse occupancy costs (depreciation and insurance)? The company uses the warehouse to store finished product. 4. What driver should the company use for the warehouse occupancy costs if it did not use a JIT system (that is, the company maintains inventories), and upon inspection, one of the products had a thick layer of dust on it? 2-28 Basic Review Exercises Fill in the blanks for each of the following independent cases (ignore income taxes): Sales 1. 2. 3. $900,000 800,000 -- Variable Expenses $500,000 -- 600,000 Contribution Margin $ -- 350,000 340,000 Fixed Expenses $350,000 -- 250,000 Net Income $ -- 80,000 -- 2-29 Basic Review Exercises Fill in the blanks for each of the following independent cases: (a) Selling Price per Unit $25 10 20 30 -- (b) Variable Cost per Unit $-- 6 15 20 9 (c) Total Units Sold 120,000 100,000 -- 70,000 80,000 (d) Total Contribution Margin $720,000 -- 100,000 -- 160,000 (e) Total Fixed Costs $640,000 320,000 -- -- 110,000 Case 1 2 3 4 5 (f) Net Income $ -- -- 15,000 12,000 -- 2-30 Basic Cost-Volume-Profit Graph Refer to Exercise 2-29. Construct a cost-volume-profit graph for Case 2 that depicts the total revenue, total variable cost, total fixed cost, and total cost lines. Estimate the break-even point in total units sold and the net income for 100,000 units sold. 2-31 Basic Cost-Volume-Profit Graph Refer to Exercise 2-29. Construct a cost-volume-profit graph for Case 4 that depicts the total revenue, total variable cost, total fixed cost, and total cost lines. Estimate the break-even point in total units sold and the net income (loss) for 50,000 units sold. 2-32 Basic Cost-Volume Graphs From the two graphs below, construct two graphs that depict the cost behavior on a per-driver-unit basis. Which of the two constructed graphs show fixed-cost behavior? Variable-cost behavior? $30,000 25,000 Labor Cost 20,000 15,000 10,000 5,000 ISBN: 0-536-47129-0 $12,000 Supplies Costs 100,000 125,000 150,000 175,000 200,000 Square Feet 10,000 8,000 6,000 4,000 2,000 100,000 125,000 150,000 175,000 200,000 Square Feet Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 78 Part 1: Focus on Decision Making 2-33 Basic Cost-Volume Graphs From the two graphs below, construct two graphs that depict the cost behavior on a total cost basis. Which of the two constructed graphs show fixed-cost behavior? Variable-cost behavior? Supplies Costs Per Square Foot Labor Costs Per Square Foot $0.07 0.06 0.05 0.04 0.03 0.02 0.01 100,000 125,000 Square Feet 150,000 $0.14 0.12 0.10 0.08 0.06 0.04 0.02 100,000 125,000 Square Feet 150,000 2-34 Hospital Costs and Pricing St. Vincent Hospital has overall variable costs of 30% of total revenue and fixed costs of $42 million per year. 1. Compute the break-even point expressed in total revenue. 2. A patient-day is often used to measure the volume of a hospital. Suppose there are to be 50,000 patient-days next year. Compute the average daily revenue per patient-day necessary to break even. 2-35 Motel Rentals Suppose a particular Motel 6 has annual fixed costs of $3.2 million for its 400-room motel, average daily room rents of $50, and average variable costs of $10 for each room rented. It operates 365 days per year. 1. How much net income on rooms will Motel 6 generate (a) if the motel is completely full throughout the entire year and (b) if the motel is half full? 2. Compute the break-even point in number of rooms rented. What percentage occupancy for the year is needed to break even? 2-36 Variable Cost to Break Even General Mills makes Wheaties, Cheerios, Betty Crocker cake mixes, and many other food products. Suppose the product manager of a new General Mills cereal has determined that the appropriate wholesale price for a carton of the cereal is $48. Fixed costs of the production and marketing of the cereal is $15 million. 1. The product manager estimates that she can sell 800,000 cartons at the $48 price. What is the largest variable cost per carton that General Mills can pay and still achieve a profit of $1 million? 2. Suppose the variable cost is $30 per carton. What profit (or loss) would General Mills expect? 2-37 Sales-Mix Analysis Study Appendix 2A. Findlay Farms produces strawberries and raspberries. Annual fixed costs are $14,400. The cost driver for variable costs is "pints of fruit produced." The variable cost is $.65 per pint of strawberries and $.85 per pint of raspberries. Strawberries sell for $1.00 per pint, raspberries for $1.35 per pint. Two pints of strawberries are produced for every pint of raspberries. ISBN: 0-536-47129-0 1. Compute the number of pints of strawberries and the number of pints of raspberries produced and sold at the break-even point. 2. Suppose only strawberries are produced and sold. Compute the break-even point in pints. 3. Suppose only raspberries are produced and sold. Compute the break-even point in pints. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 2: Introduction to Cost Behavior and Cost-Volume Relationships 79 2-38 Income Taxes Review the illustration in Appendix 2B. Suppose the income tax rate were 20% instead of 40%. How many units would the company have to sell to achieve a target after-tax net income of (1) $864 and (2) $1,440? Show your computations. 2-39 Income Taxes and Cost-Volume-Profit Analysis Study Appendix 2B. Suppose Hernandez Construction Company has a 40% income tax rate, a contribution-margin ratio of 30%, and fixed costs of $440,000. What sales volume is necessary to achieve an after-tax income of $42,000? Problems 2-40 Kroger Grocery Chain, Variable and Fixed Costs Kroger is the nation's number one grocery chain. While Kroger has diversified through acquisitions, adding jewelry and general merchandise to its mix, food stores still account for about 90% of sales. The company operates nearly 3,700 stores, including more than 2,500 supermarkets and multidepartment stores and nearly 800 convenience stores under names such as Quik Stop and Kwik Shop. Kroger's 2006 sales were more than $61 billion. Maintaining a clean shopping environment is a key success factor for Kroger. Cleaning a supermarket is the responsibility of the cleaning department. Three of the most costly resources needed to clean a supermarket are labor, equipment, and cleaning supplies. The cost driver for all these resources is "number of times cleaned." Cleaning laborers (called porters) are paid the same wages regardless of the number of times the supermarket is cleaned. Supplies used for regular daily cleaning and special cleaning are about the same. A typical store has 50,000 square feet. The floor is thoroughly cleaned every day from midnight until 7:00 AM. Special cleaning of floors and fixtures is performed in the various departments as needed. Special cleaning varies from 10 to 30 times a month depending on the amount of traffic through the store. Thus, the number of times a store is cleaned varies from 40 to 60 times a month. Suppose that in one of Kroger's stores in Cleveland, cleaning was performed 60 times during March. For the month, the cost of labor and rent on equipment was $18,000 and cleaning supplies used cost $10,200. The sales budget for the next quarter (April through June) and better weather conditions indicate that the store will need to be cleaned 50, 46, and 35 times in April, May, and June respectively. 1. Prepare a table that shows how labor cost, depreciation, cleaning supplies cost, total cost, and total cost per square foot cleaned changes in response to the number of times the store is cleaned. Show costs for 35, 40, 45, 50, 55, and 60 cleanings. What is the predicted total cost of store cleaning for the next quarter? 2. Prepare a single graph that can be used to predict the fixed, variable, and total cleaning cost of the Kroger store in Cleveland. 3. Suppose the manager of the Kroger store in Cleveland can hire an outside cleaning company to clean the store as needed. The charge rate for cleaning is $540 per cleaning. If the outside cleaning company is hired, Kroger can lay off the workers who are now cleaning the store and eliminate the need for cleaning supplies and equipment rent. Will Kroger save money with the outside cleaning company over the next quarter? Prepare a schedule that supports your answer. 2-41 Fixed Costs and Relevant Range Bridger Canyon Systems Group (BCSG) has a substantial year-to-year fluctuation in billings to clients. Top management has the following policy regarding the employment of key professional personnel: If Gross Annual Billings Are $2,000,000 or less $2,000,0012,400,000 $2,400,0012,800,000 ISBN: 0-536-47129-0 Number of Persons to Be Employed 10 11 12 Key Professional Annual Salaries $1,000,000 $1,100,000 $1,200,000 Top management believes that the group should maintain a minimum of 10 individuals for a year or more even if billings drop drastically below $2 million. For the past 5 years, gross annual billings for BCSG have fluctuated between $2,020,000 and $2,380,000. Expectations for next year are that gross billings will be between $2,100,000 and Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 80 Part 1: Focus on Decision Making $2,300,000. What amount should the group budget for key professional personnel salaries? Graph the relationships on an annual basis, using the two approaches illustrated in Exhibit 2-6 on page 52. Indicate the relevant range on each graph. You need not use graph paper; simply approximate the graphical relationships. 2-42 Comparing Contribution Margin Percentages Below are actual statements of operating income for Microsoft and Procter & Gamble (in millions): Microsoft Revenues Cost of revenue Research and development Sales and Marketing General and administrative Operating income $39,788 6,200 6,184 8,677 4,166 $14,561 Procter & Gamble Net sales Cost of products sold Selling, general, and administrative expenses Operating income $68,222 33,125 21,848 $13,249 Assume that the only variable cost for Microsoft is "cost of revenue" and for Procter & Gamble it is "cost of products sold." 1. Compute the contribution-margin percentage of Microsoft and that of Procter & Gamble. Why do you suppose the percentages are so different? 2. Suppose each company increases its revenue by $10 million. Compute the increase in operating income for each company. 3. Explain how the contribution margin percentage helps you predict the effects on operating income of changes in sales volume. What assumptions do you make in forming such a prediction? 2-43 Movie Manager Malia Mahler is the manager of Stanford's traditional Sunday Flicks. Each Sunday, a film has two showings. The admission price is deliberately set at a very low $3. She sells a maximum of 500 tickets for each showing. The rental of the auditorium is $330 and labor is $435, including $90 for Mahler. Mahler must pay the film distributor a guarantee, ranging from $300 to $900, or 50% of gross admission receipts, whichever is higher. Before and during the show, she sells refreshments; these sales average 12% of gross admission receipts and yield a contribution margin of 40%. 1. On June 3, Mahler screened Little Miss Sunshine. The film grossed $2,250. The guarantee to the distributor was $750, or 50% of gross admission receipts, whichever is higher. What operating income was produced for the Students' Association, which sponsored the showings? 2. Recompute the results if the film grossed $1,400. 3. The "four-wall" concept is increasingly being adopted by movie producers. In this plan, the movie's producer pays a fixed rental to the theater owner for, say, a week's showing of a movie. As a theater owner, how would you evaluate a "four-wall" offer? 2-44 Promotion of a Rock Concert BBT Productions, Ltd., is promoting a rock concert in London. The bands will receive a flat fee of 7 million in cash. The concert will be shown worldwide on closed-circuit television. BBT will collect 100% of the receipts and will return 30% to the individual local closed-circuit theater managers. BBT expects to sell 1.1 million seats at a net average price of 13 each. BBT will also receive 300,000 from the London arena (which has sold out its 19,500 seats, ranging from 150 for box seats to 20 for general admission, for a gross revenue of 1.25 million); BBT will not share the 300,000 with the local promoters. 1. The general manager of BBT Productions is trying to decide what amount to spend for advertising. What is the most BBT could spend and still break even on overall operations, assuming sales of 1.1 million tickets? 2. If BBT desires an operating income of 500,000, how many seats would it have to sell? Assume that the average price is 13 and the total fixed costs (including 2,000,000 in advertising) are 9 million. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 2: Introduction to Cost Behavior and Cost-Volume Relationships 81 2-45 Cost Reduction Program at Boeing Consider the Boeing plant discussed on pages 4647 and 4950. Suppose Boeing has a cost-reduction program for this plant to reduce the costs of activities, such as receiving parts for its airplanes, by 10%. This resulted in a targeted cost of .90 $69,000 = $62,100 for fuel and equipment. At a meeting of the receiving department operating managers and the accounting staff, complaints were made that cost-reduction was not completely the responsibility of the receiving department because some factors were beyond the department's control. Managers pointed out that the total cost of fuel is a function of fuel price per gallon and the gallons used. In addition, total gallons used is affected by the number of hours equipment is operated. Further, neither the price paid for fuel nor the lease cost is controllable by receiving department employees. Managers argue that the factors such as fuel and equipment usage were not explicitly tracked and costed. These operating measures were the ones managers believed to be the ones that should be used as cost drivers. You have been asked to refine the way variable and fixed costs are calculated by using the more relevant cost drivers for fuel and equipment--"gallons" and "hours operated." You have collected the following data for the most recent period. Equipment cost Fuel cost Hours equipment operated Gallons of fuel used Parts received Target cost goal after 10% cost reduction (90% $69,000) $45,000 $24,000 1,500 6,000 30,000 $62,100 1. Draw a diagram similar to Exhibit 2-4 on page 49 that shows the relationships between the receiving activity and the resources used and that incorporates the new cost drivers recommended by operating managers. On the diagram, show the total level of each cost driver, the fuel consumption rate in gallons used per hour, and the productivity rate in parts moved per hour operated. 2. Refer to your answer to requirement 1. If the number of parts received increased from 30,000 to 40,000, which number(s) would most likely change: total gallons used, total hours operated, gallons per hour, parts moved per hour? Derive an equation that calculates total fuel cost as a function of fuel cost per gallon, fuel consumption rate, and productivity rate. Predict the total cost of the receiving activity if the number of parts received is 40,000. 3. The managers in the receiving department have a plan that will improve both fuel and equipment efficiency. What is the predicted total cost of receiving 30,000 parts if the fuel consumption rate is reduced by 15% and the productivity rate improves by 15% (assume fuel costs per gallon will not change)? Will the receiving department achieve Boeing's 10% cost-reduction goal? Why or why not? 4. Comment on the benefits of the new cost-driver model compared to the one based solely on one cost driver--"number of parts received." 2-46 Basic Relationships, Restaurant Jacqui Giraud owns and operates a restaurant. Her fixed costs are $21,000 per month. She serves luncheons and dinners. The average total bill (excluding tax and tip) is $19 per customer. Giraud's present variable costs average $10.60 per meal. 1. How many meals must she serve to attain a profit before taxes of $8,400 per month? 2. What is the break-even point in number of meals served per month? 3. Giraud's rent and other fixed costs rise to a total of $29,925 per month and variable costs also rise to $12.50 per meal. If Giraud increases her average price to $23, how many meals must she serve to make $8,400 profit per month? 4. Assume the same situation described in requirement 3. Giraud's accountant tells her she may lose 10% of her customers if she increases her prices. If this should happen, what would be Giraud's profit per month? Assume that the restaurant had been serving 3,500 customers per month. 5. Assume the same situation described in requirement 4. To help offset the anticipated 10% loss of customers, Giraud hires a pianist to perform for 4 hours each night for $2,000 per month. Assume that this would increase the total monthly meals from 3,150 to 3,450. Would Giraud's total profit change? By how much? ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 82 Part 1: Focus on Decision Making 2-47 Changing Fixed Costs to Variable Costs at Blockbuster Video According to an article in Business Week, when John F. Antioco took charge of Blockbuster Video, he changed the company's strategy. Traditionally, Blockbuster had bought videotapes from the movie studios for an average cost of about $65 each, planning to rent them out often enough to make a profit. Mr. Antioco replaced this strategy with one that allows Blockbuster to purchase videos for an average of $7 per tape and pay the studio 40% of any rental fee received for the tape. With this arrangement, Blockbuster could afford to stock more copies of each tape and guarantee customers that the tape they want will be in stock--or the rental is free. Suppose that Blockbuster rents videotapes for $2 a day. Assume that operating costs are all fixed. 1. Under the traditional strategy, how many days must each tape be rented before Blockbuster will break even on the tape? 2. Under the new strategy, how many days must each tape be rented before Blockbuster will break even on the tape? 3. Suppose customers rented a particular copy of Babel for 50 days. What profit would Blockbuster make on rentals of the tape (considering only the direct costs of the tape, not the costs of operating the rental store) under the traditional strategy? Under the new strategy? 4. Suppose customers rented a particular copy of The Departed for only 6 days. What profit would Blockbuster make on rentals of the tape (considering only the direct costs of the tape, not the costs of operating the rental store) under the traditional strategy? Under the new strategy? 5. Comment on how the new arrangement affects the risks Blockbuster accepts when purchasing an additional copy of a particular videotape. 2-48 CVP and Financial Statements for a Mega-Brand Company Procter & Gamble Company is a Cincinnati-based company that produces household products under brand names such as Gillette, Bounty, Crest, Folgers, and Tide. The company's 2006 income statement showed the following (in millions): Net sales Costs of products sold Selling, general, and administrative expense Operating income $68,222 33,125 21,848 $13,249 Suppose that the cost of products sold is the only variable cost; selling, general, and administrative expenses are fixed with respect to sales. Assume that Procter & Gamble had a 10% increase in sales in 2007 and that there was no change in costs except for increases associated with the higher volume of sales. Compute the predicted 2007 operating income for Procter & Gamble and its percentage increase. Explain why the percentage increase in income differs from the percentage increase in sales. 2-49 Bingo and Leverage Many churches sponsor bingo games, a tradition stemming from the time when only specific nonprofit institutions were allowed to sponsor games of chance. Reverend Justin Olds, the pastor of a new parish in Orange County, is investigating the desirability of conducting weekly bingo nights. The parish has no hall, but a local hotel would be willing to commit its hall for a lump-sum rental of $600 per night. The rent would include cleaning, setting up and taking down the tables and chairs, and so on. 1. A local printer would provide bingo cards in return for free advertising. Local merchants would donate door prizes. The services of clerks, callers, security force, and others would be donated by volunteers. Admission would be $4.00 per person, entitling the player to 1 card; extra cards would be $1.50 each. Many persons buy extra cards so there would be an average of 4 cards played per person. What is the maximum in total cash prizes that the church may award and still break even if 200 persons attend each weekly session? 2. Suppose the total cash prizes are $1,100. What will be the church's operating income if 100 persons attend? If 200 persons attend? If 300 persons attend? Briefly explain the effects of the cost behavior on income. 3. After operating for 10 months, Reverend Olds is thinking of negotiating a different rental arrangement but keeping the prize money unchanged at $1,100. Suppose the rent is $200 per night plus $2 per person. Compute the operating income for attendance of 100, 200, and 300 persons, respectively. Explain why the results differ from those in requirement 2. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 2: Introduction to Cost Behavior and Cost-Volume Relationships 83 2-50 Leverage at eBay In 2005, eBay had $4.6 billion in revenue and net income over $1 billion. eBay's mission is to "provide a global trading platform where practically anyone can trade practically anything." However, business has not always been as profitable for eBay. The company is one of the survivors of the technology collapse in 2001 and 2002. Consider eBay's situation at that time. In the first quarter of 2001, eBay reported revenue of $154 million and operating expenses of $123 million, for an operating profit of $31 million. In the first quarter of 2002, eBay reported that revenue had increased 59%, to $245 million. eBay's fixed costs were $37 million and variable costs vary with the amount of revenue. 1. Compute eBay's operating income for the first quarter of 2002 and its percentage increase in operating income between 2001 and 2002. 2. Explain how eBay managed to increase its income so much with only a 59% increase in revenue. 2-51 Adding a Product Mac's Brew Pub, located near State University, serves as a gathering place for the university's more social scholars. Mac sells draft beer and all brands of bottled beer at a contribution margin of $.60 a beer. Mac is considering also selling hamburgers during selected hours. His reasons are twofold. First, sandwiches would attract daytime customers. A hamburger and a beer are a quick lunch. Second, he has to meet competition from other local bars, some of which provide more extensive menus. Mac analyzed the costs as follows: Per Month Monthly fixed expenses Wages of part-time cook Other Total $1,200 360 $1,560 Per Hamburger Variable expenses Rolls Meat @ $2.80 per pound (7 hamburgers per pound) Other Total $.12 .40 .18 $.70 Mac planned a selling price of $1.20 per hamburger to lure many customers. For all questions, assume a 30-day month. 1. What are the monthly and daily break-even points, in number of hamburgers? 2. What are the monthly and daily break-even points, in dollar sales? 3. At the end of 2 months, Mac finds he has sold 3,600 hamburgers. What is the operating profit per month on hamburgers? 4. Mac thinks that at least 60 extra beers are sold per day because he has these hamburgers available. This means that 60 extra people come to the bar or that 60 buy an extra beer because they are attracted by the hamburgers. How does this affect Mac's monthly operating income? 5. Refer to requirement 3. How many extra beers would have to be sold per day so that the overall effects of the hamburger sales on monthly operating income would be zero? 2-52 Government Organization A social welfare agency has a government budget appropriation for 20X7 of $900,000. The agency's major mission is to help disabled persons who are unable to hold jobs. On the average, the agency supplements each person's income by $5,000 annually. The agency's fixed costs are $290,000. There are no other costs. 1. How many disabled persons were helped during 20X7? 2. For 20X8, the agency's budget appropriation has been reduced by 15%. If the agency continues the same level of monetary support per person, how many disabled persons will be helped in 20X8? Compute the percentage decline in the number of persons helped. 3. Assume a budget reduction of 15%, as in requirement 2. The manager of the agency has discretion as to how much to supplement each disabled person's income. She does not want to reduce the number of persons served. On the average, what is the amount of the supplement that can be given to each person? Compute the percentage decline in the annual supplement. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 84 Part 1: Focus on Decision Making 2-53 Gross Margin and Contribution Margin Eastman Kodak Company is a provider of imaging technology products and services to the photographic, graphic communications, and health-care markets. A condensed 2005 income statement follows (in millions): Sales Costs of goods sold Gross margin Other operating expenses Loss from continuing operations $14,268 10,617 3,651 4,417 $ (766) Assume that $2,400 million of the cost of goods sold is a fixed cost representing depreciation and other production costs that do not change with the volume of production. In addition, $3,000 million of the other operating expenses is fixed. 1. Compute the total contribution margin for 2005 and the contribution margin percentage. Explain why the contribution margin differs from the gross margin. 2. Suppose that sales for Eastman Kodak were predicted to increase by 10% in 2006 and that the cost behavior was expected to continue in 2006 as it did in 2005. Compute the predicted operating income (loss) for 2006. 3. What assumptions were necessary to compute the predicted 2006 operating income in requirement 2? 2-54 Choosing Equipment for Different Volumes MetroCinema owns and operates a nationwide chain of movie theaters. The 500 properties in the chain vary from low-volume, small-town, single-screen theaters to high-volume, big-city, multiscreen theaters. The management is considering installing machines that will make popcorn on the premises. These machines would allow the theaters to sell freshly popped popcorn rather than the prepopped, prebagged corn that it currently sells. This proposed feature would be properly advertised and is intended to increase patronage at the company's theaters. The machines can be purchased in several different sizes. The annual rental costs and operating costs vary with the size of the machines. The machine capacities and costs are as follows: Popper Model Standard Annual capacity Costs Annual machine rental Popcorn cost per box Cost of each box Other variable costs per box 50,000 boxes $8,000 .14 .09 .22 Deluxe 120,000 boxes $11,200 .14 .09 .14 Jumbo 300,000 boxes $20,200 .14 .09 .05 1. Calculate the volume level in boxes at which the standard and deluxe poppers would earn the same operating profit (loss). 2. The management can estimate the number of boxes to be sold at each of its theaters. Present a decision rule that would enable MetroCinema management to select the most profitable machine without having to make a separate cost calculation for each theater. That is, at what anticipated range of unit sales should the theater use the standard model? The deluxe model? The jumbo model? 3. Could the management use the average number of boxes sold per seat for the entire chain and the capacity of each theater to develop this decision rule? Explain your answer. 2-55 Sales Compensation, Variable/Fixed Costs, and Ethics Most companies compensate their sales forces with a combination of a fixed salary and a commission that is a percentage of sales. Consider two companies competing for the same customers--for example, Kellogg's and Post cereals. Suppose that Kellogg's pays its sales force a large fixed salary and a small commission, while Post pays its sales force a small fixed salary and a large commission. The total pay on average was the same for both companies. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 2: Introduction to Cost Behavior and Cost-Volume Relationships 85 1. Compare the sales cost structure of Kellogg's with that of Post. Which has the larger fixed cost? Which has the larger variable cost? How will this affect each company's risk? (Focus on how the company's profits change with changes in volume.) 2. What incentives does each pay system provide for the sales force? 3. Might either incentive system create potential ethical dilemmas for the sales personnel? Explain. 2-56 Sales-Mix Analysis Study Appendix 2A. The Rocky Mountain Catering Company specializes in preparing Mexican dinners that it freezes and ships to restaurants in the Denver area. When a diner orders an item, the restaurant heats and serves it. The budget data for 20X5 are Product Chicken Tacos Selling price to restaurants Variable expenses Contribution margin Number of units $5 3 $2 250,000 Beef Enchiladas $7 4 $3 125,000 The company prepares the items in the same kitchens, delivers them in the same trucks, and so forth. Therefore, decisions about the individual products do not affect the fixed costs of $735,000. 1. Compute the planned net income for 20X5. 2. Compute the break-even point in units, assuming that the company maintains its planned sales mix. 3. Compute the break-even point in units if the company sells only tacos and if it sells only enchiladas. 4. Suppose the company sells 78,750 units of enchiladas and 236,250 units of tacos, for a total of 315,000 units. Compute the net income. Compute the new break-even point with this new sales mix. What is the major lesson of this problem? 2-57 Hospital Patient Mix Study Appendix 2A. Hospitals measure their volume in terms of patient-days. We calculate patientdays by multiplying the number of patients by the number of days that the patients are hospitalized. Suppose a large hospital has fixed costs of $54 million per year and variable costs of $600 per patientday. Daily revenues vary among classes of patients. For simplicity, assume that there are two classes: (1) self-pay patients (S) who pay an average of $1,000 per day and (2) nonself-pay patients (G) who are the responsibility of insurance companies and government agencies and who pay an average of $800 per day. Twenty percent of the patients are self-pay. 1. Compute the break-even point in patient-days, assuming that the hospital maintains its planned mix of patients. 2. Suppose that the hospital achieves 225,000 patient-days but that 25% of the patient-days were self-pay (instead of 20%). Compute the net income. Compute the break-even point. 2-58 Income Taxes on Hotels Study Appendix 2B. The Four Winds Hotel in downtown Phoenix has annual fixed costs applicable to rooms of $9.2 million for its 600-room hotel, average daily room rates of $105, and average variable costs of $25 for each room rented. It operates 365 days per year. The hotel is subject to an income tax rate of 40%. 1. How many rooms must the hotel rent to earn a net income after taxes of $720,000? Of $360,000? 2. Compute the break-even point in number of rooms rented. What percentage occupancy for the year is needed to break even? 3. Assume that the volume level of rooms sold is 150,000. The manager is wondering how much income could be generated by adding sales of 15,000 rooms. Compute the additional net income after taxes. ISBN: 0-536-47129-0 2-59 Tax Effects, Multiple Choice Study Appendix 2B. Victor Company is a wholesaler of compact disks. The projected after-tax net income for the current year is $120,000, based on a sales volume of 200,000 CDs. Victor has been selling the CDs at $16 each. The variable costs consist of the $10 unit purchase price and a handling Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 86 Part 1: Focus on Decision Making cost of $2 per unit. Victor's annual fixed costs are $600,000, and the company is subject to a 40% income tax rate. Management is planning for the coming year when it expects that the unit purchase price will increase 30%. 1. Victor Company's break-even point for the current year is (a) 150,000 units, (b) 100,000 units, (c) 50,000 units, (d) 60,000 units, or (e) some amount other than those given. 2. An increase of 10% in projected unit sales volume for the current year would result in an increased after-tax income for the current year of (a) $80,000, (b) $32,000, (c) $12,000, (d) $48,000, or (e) some amount other than those given. 3. The volume of sales in dollars that Victor Company must achieve in the coming year to maintain the same after-tax net income as projected for the current year if unit selling price remains at $16 is (a) $12,800,000, (b) $14,400,000, (c) $11,520,000, (d) $32,000,000, or (e) some amount other than those given. 4. To cover a 30% increase in the unit purchase price for the coming year and still maintain the current contribution-margin ratio, Victor Company must establish a selling price per unit for the coming year of (a) $19.60, (b) $20.00, (c) $20.80, (d) $19.00, or (e) some amount other than those given. Cases 2-60 Hospital Costs Gotham City Hospital is unionized. In 20X6, nurses received an average annual salary of $45,000. The hospital administrator is considering changes in the contract with nurses for 20X7. In turn, the hospital may also change the way it charges nursing costs to each department. The hospital holds each department accountable for its financial performance, and it allocates revenues and expenses to departments. Consider the expenses of the obstetrics department in 20X6. Variable expenses (based on 20X6 patient-days) are Meals Laundry Laboratory Pharmacy Maintenance Other Total $ 610,000 260,000 900,000 850,000 150,000 530,000 $3,300,000 Fixed expenses (based on number of beds) are Rent General administrative services Janitorial Maintenance Other Total $3,000,000 2,200,000 200,000 150,000 350,000 $5,900,000 Management assigns nurses to departments on the basis of annual patient-days as follows: Volume Level in Patient-Days 10,00012,000 12,00116,000 Number of Nurses 30 35 ISBN: 0-536-47129-0 Total patient-days are the number of patients multiplied by the number of days they are hospitalized. The hospital charges each department for the salaries of the nurses assigned to it. During 20X6, the obstetrics department had a capacity of 60 beds, billed each patient an average of $810 per day, and had revenues of $12.15 million. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 2: Introduction to Cost Behavior and Cost-Volume Relationships 87 1. Compute the 20X6 volume of activity in patient-days. 2. Compute the 20X6 patient-days that would have been necessary for the obstetrics department to recoup all fixed expenses except nursing expenses. 3. Compute the 20X6 patient-days that would have been necessary for the obstetrics department to break even including nurses' salaries as a fixed cost. 4. Suppose obstetrics must pay $200 per patient-day for nursing services. This plan would replace the two-level, fixed-cost system employed in 20X6. Compute what the break-even point in patient-days would have been in 20X6 under this plan. 2-61 CVP in a Modern Manufacturing Environment A division of Hewlett-Packard Company changed its production operations from one where a large labor force assembled electronic components to an automated production facility dominated by computer-controlled robots. The change was necessary because of fierce competitive pressures. Improvements in quality, reliability, and flexibility of production schedules were necessary just to match the competition. As a result of the change, variable costs fell and fixed costs increased, as shown in the following assumed budgets: Old Production Operation Unit variable cost Material Labor Total per unit Monthly fixed costs Rent and depreciation Supervisory labor Other Total per month $ $ .88 1.22 2.10 New Production Operation $ $ .88 .22 1.10 $450,000 80,000 50,000 $580,000 $ 875,000 175,000 90,000 $1,140,000 Expected volume is 600,000 units per month, with each unit selling for $3.10. Capacity is 800,000 units. 1. Compute the budgeted profit at the expected volume of 600,000 units under both the old and the new production environments. 2. Compute the budgeted break-even point under both the old and the new production environments. 3. Discuss the effect on profits if volume falls to 500,000 units under both the old and the new production environments. 4. Discuss the effect on profits if volume increases to 700,000 units under both the old and the new production environments. 5. Comment on the riskiness of the new operation versus the old operation. 2-62 Multiproduct Break-Even in a Restaurant Study Appendix 2A. An article in Washington Business included an income statement for La Brasserie, a French restaurant in Washington, D.C. A simplified version of the statement follows: Revenues Cost of sales, all variable Gross profit Operating expenses Variable Fixed Administrative expenses, all fixed Net income $2,098,400 1,246,500 851,900 222,380 170,940 451,500 $ 7,080 ISBN: 0-536-47129-0 The average dinner tab at La Brasserie is $40, and the average lunch tab is $20. Assume that the variable cost of preparing and serving dinner is also twice that of a lunch. The restaurant serves twice as many lunches as dinners. Assume that the restaurant is open 305 days a year. 1. Compute the daily break-even volume in lunches and dinners for La Brasserie. Compare this to the actual volume reflected in the income statement. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 88 Part 1: Focus on Decision Making 2. Suppose that an extra annual advertising expenditure of $15,000 would increase the average daily volume by three dinners and six lunches, and that there is plenty of capacity to accommodate the extra business. Prepare an analysis for the management of La Brasserie, explaining whether this would be desirable. 3. La Brasserie uses only premium food, and the cost of food makes up 25% of the restaurant's total variable costs. Use of average rather than premium ingredients could cut the food cost by 20%. Assume that La Brasserie uses average-quality ingredients and does not change its prices. How much of a drop-off in volume could it endure and still maintain the same net income? What factors in addition to revenue and costs would influence the decision about the quality of food to use? 2-63 Effects of Changes in Costs, Including Tax Effects Study Appendix 2B. Pacific Fish Company is a wholesale distributor of salmon. The company services grocery stores in the Chicago area. Small but steady growth in sales has been achieved by Pacific Fish over the past few years, while salmon prices have been increasing. The company is formulating its plans for the coming fiscal year. Presented next are the data used to project the current year's after-tax net income of $128,250. Average selling price per pound Average variable costs per pound Cost of salmon Shipping expenses Total Annual fixed costs Selling Administrative Total Expected annual sales volume (390,000 pounds) Tax rate $ $ $ 5.00 2.50 .50 3.00 $ 210,000 356,250 $ 566,250 $1,950,000 40% Fishing companies have announced that they will increase prices of their products by an average of 15% in the coming year, owing mainly to increases in labor costs. Pacific Fish Company expects that all other costs will remain at the same rates or levels as in the current year. 1. What is Pacific Fish Company's break-even point in pounds of salmon for the current year? 2. What selling price per pound must Pacific Fish Company charge to cover the 15% increase in the cost of salmon and still maintain the current contribution-margin ratio? 3. What volume of sales in dollars must the Pacific Fish Company achieve in the coming year to maintain the same net income after taxes as projected for the current year if the selling price of salmon remains at $5 per pound and the cost of salmon increases 15%? 4. What strategies might Pacific Fish Company use to maintain the same net income after taxes as projected for the current year? Nike 10-K Problem 2-64 Operating Leverage Examine Nike's 10K report in Appendix C. 1. Do a search for the word leverage. How many times is this term used? Is there a common theme? 2. The following quote is from the Selling and Administrative Expense section of Management's Discussion and Analysis of Financial Condition and Results of Operations. In fiscal 2006, selling and administrative expenses decreased as a percentage of revenues by 80 basis points for the year driven by operating overhead leverage. ISBN: 0-536-47129-0 What was the percent change in revenue from 2005 to 2006? What was the percent change in selling and administrative expenses? How can operating leverage help to explain this difference? 3. Would you expect Nike's operating leverage to be high or low? Explain. Which assets do you think contribute to Nike's ability to leverage operating overhead? Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 2: Introduction to Cost Behavior and Cost-Volume Relationships 89 EXCEL Application Exercise 2-65 CVP and Break-Even Goal: Create an Excel spreadsheet to perform CVP analysis and show the relationship between price, costs, and break-even points in terms of units and dollars. Use the results to answer questions about your findings. Scenario: Phonetronix is a small manufacturer of telephone and communications devices. Recently, company management decided to investigate the profitability of cellular phone production. They have three different proposals to evaluate. Under all the proposals, the fixed costs for the new phone would be $110,000. Under proposal A, the selling price of the new phone would be $99 and the variable cost per unit would be $55. Under proposal B, the selling price of the phone would be $129 and the variable cost would remain the same. Under proposal C, the selling price would be $99 and the variable cost would be $49. When you have completed your spreadsheet, answer the following questions: 1. What are the break-even points in units and dollars under proposal A? 2. How did the increased selling price under proposal B impact the break-even points in units and dollars compared to the break-even points calculated under proposal A? 3. Why did the change in variable cost under proposal C not impact the break-even points in units and dollars as significantly as proposal B did? Step-by-Step: 1. Open a new Excel spreadsheet. 2. In column A, create a bold-faced heading that contains the following: Row 1: Chapter 2 Decision Guideline Row 2: Phonetronix Row 3: Cost-Volume-Profit (CVP) Analysis Row 4: Today's Date 3. Merge and center the four heading rows across columns A through D. 4. In Row 7, create the following bold-faced, right-justified column headings: Column B: Proposal A Column C: Proposal B Column D: Proposal C Note: Adjust cell widths when necessary as you work. 5. In Column A, create the following row headings: Row 8: Selling price Row 9: Variable cost Row 10: Contribution margin Row 11: Contribution margin ratio Skip a row Row 13: Fixed cost Skip a row Row 15: Break-even in units Skip a row Row 17: Break-even in dollars 6. Use the scenario data to fill in the selling price, variable cost, and fixed cost amounts for the three proposals. 7. Use the appropriate formulas from this chapter to calculate contribution margin, contribution margin ratio, break-even in units, and break-even in dollars. 8. Format all amounts as: Number tab: Category: Decimal places: Symbol: Negative numbers: Currency 0 None Red with parenthesis ISBN: 0-536-47129-0 9. Change the format of the selling price, contribution margin, fixed cost, and break-even in dollars amounts to display a dollar symbol. 10. Change the format of both contribution margin headings to display as indented: Alignment tab: Horizontal: Indent: Left (Indent) 1 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 90 Part 1: Focus on Decision Making 11. Change the format of the contribution margin amount cells to display a top border, using the default line style. Border tab: Icon: Top Border 12. Change the format of the contribution margin ratio amounts to display as a percentage with two decimal places. Number tab: Category: Decimal places: Percentage 2 13. Change the format of all break-even headings and amounts to display as bold-faced. 14. Activate the ability to use heading names in formulas under Tools Options: Calculation tab: Check the box: Accept labels in formulas 15. Replace the cell-based formulas with "word-based" equivalents for each formula used in Proposal A. Example: Contribution margin for proposal B would be: = (`Selling price' `Proposal B') - (`Variable cost' `Proposal B') Note: The tic marks used in the example help avoid naming errors caused by data having similar titles (i.e., "contribution margin" and "contribution margin ratio"). The parentheses help clarify groupings. Help: Ask the Answer Wizard about "Name cells in a workbook." Select "Learn about labels and names in formulas" from the right-hand panel. 16. Save your work to a disk, and print a copy for your files. Collaborative Learning Exercise 2-66 CVP for a Small Business Form into groups of 2 to 6 students. Each group should select a very simple business, one with a single product or one with approximately the same contribution margin percentage for all products. Some possibilities are A child's lemonade stand A retail video rental store An espresso cart A retail store selling compact disks An athletic shoe store A cookie stand in a mall However, you are encouraged to use your imagination rather than just select one of these examples. The following tasks might be split up among the group members: 1. Make a list of all fixed costs associated with running the business you selected. Estimate the amount of each fixed cost per month (or per day or per year, if one of them is more appropriate for your business). 2. Make a list of all variable costs associated with making or obtaining the product or service your company is selling. Estimate the cost per unit for each variable cost. 3. Given the fixed and variable costs you have identified, compute the break-even point for your business in either units or dollar sales. 4. Assess the prospects of your business making a profit. Internet Exercise 2-67 Cost Behavior at Southwest Airlines It is critical that managers understand how costs and revenues behave. One company that is affected by changes in costs and may not have the capability to rapidly change revenues because of competition is Southwest Airlines. Let's take a closer look at SWA and its costs and revenues. Log on to SWA's Web site at www.southwest.com. This Web site serves many purposes for the airline, such as providing flight schedules, making reservations and selling tickets, and displaying vacation and airfare specials. 1. Click on the book travel icon. How many cities does SWA serve? What is the closest city served by SWA to your current location? Click on that city as the departure city and then select any city ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 2: Introduction to Cost Behavior and Cost-Volume Relationships 91 2. 3. 4. 5. you like for the arrival city. Now select a date about a month from now for leaving and one for returning. Click to continue to the next screen. What types of fares are available? Why do you think that there are different types of fares offered? Click on one of the fare-type captions to see if Southwest places any restrictions on this fare. If there are any restrictions, what purpose do they serve? Return to the reservations screen and select a departure date that is less than a week away. What types of fare choices are available now? Are the rates the same as those that you found for a trip more than a month away? Why do you think that the choices remaining are for the most part the higher-priced ones? Is there any advantage to the fare(s) still available? Who is the most likely user of a ticket purchased at the last minute? Now that you have looked at the revenue side, let's focus on the expense side. Individuals on the same flight may pay different prices for the ticket. Do you think that the cost of flying a passenger differs due to the price that they pay for the ticket? Why or why not? Return to SWA's home page. Take a look at the costs that SWA actually incurs. Click on the "About SWA" icon and then click on "Investor Relations." Click on the "Annual Reports" icon and then select the most recent annual report. Open the annual report using Adobe Acrobat Reader. When you have located the annual report, notice the summary information that the company has provided in the "Consolidated Highlights" section. Give the most recent year's operating revenues and operating expenses. How much has each changed over the prior year? What does this imply for Southwest's profitability? Now find "Management's Discussion and Analysis of Financial Condition and Results of Operations" that is included in the report. Examine the table that shows "Operating Expenses per ASM." (ASM stands for available seat miles, a measure of capacity.) Which of these costs is primarily fixed with respect to ASM? Which is primarily variable? What other cost drivers might be important causes of costs for Southwest? ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Measurement of C H A P T E R Cost Behavior LEARNING OBJECTIVES When you have finished studying this chapter, you should be able to: 1. Explain step- and mixed-cost behavior. 2. Explain management influences on cost behavior. 3. Measure and mathematically express cost functions and use them to predict costs. 4. Describe the importance of activity analysis for measuring cost functions. 5. Measure cost behavior using the engineering analysis, account analysis, high-low, visual-fit, and least-squares regression methods. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. AMERICA WEST US Airways and America West came together in 2006 to create the fifth largest domestic airline. US Airways, US Airways Shuttle, and US Airways Express operate approximately 4,000 flights per day and serve more than 225 communities in the United States, Canada, Europe, the Caribbean, and Latin America. Before its merger with US Airways, America West rode the wave of a booming economy to increased revenues in the late 1990s. As a result, management decided to expand by introducing service to new destinations including Acapulco, Miami, and Detroit, and by adding more daily flights to existing markets including Las Vegas, Mexico City, and Boston. To accomplish this, the company had to expand its labor force, add new aircraft, and spend more than $40 million on new technology. Management did not take lightly the decision to invest large amounts of money in aircraft and equipment. They knew that their decision would have a significant influence on costs, and thus profits, for many years. They also knew that most of the costs would be fixed but the revenues would fluctuate with the economy. When the economy is bad, revenues may not cover these costs. How does an airline protect itself against losses when the economy experiences a downturn? According to Richard Goodmanson, former president and chief executive officer of America West, "management has a goal to have from 5% to 10% of the fleet of aircraft leased and thus subject to annual renewal. This enhances the company's ability to decrease capacity (and related costs) in the event of an industry downturn." This example illustrates that understanding how costs behave, as well as how managers' decisions can influence costs, helped the airline improve its cost control. US Airways and America West Airlines flights preparing for departure. US Airways serves the low-cost, full-service market at more than 225 destinations in the United States, Canada, Europe, the Caribbean, and Latin America. Understanding its costs is an important factor in developing the company's competitive strategy, so managers carefully measure cost behavior. ISBN: 0-536-47129-0 93 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 94 Part 1: Focus on Decision Making measurement of cost behavior Understanding and quantifying how activities of an organization affect its levels of costs. Chapter 2 demonstrated the importance of understanding the cost structure of an organization and the relationships between an organization's activities and its costs, revenues, and profits. This chapter focuses on measurement of cost behavior, which means understanding and quantifying how activities of an organization affect its levels of costs. Recall that activities use resources, and these resources have costs. We measure the relationship between activity and cost using cost drivers. Understanding relationships between costs and their cost drivers allows managers in all types of organizations--profit-seeking, nonprofit, and government--to Evaluate strategic plans and operational improvement programs (Chapter 4) Make proper short-run pricing decisions (Chapter 5) Make short-run operating decisions (Chapter 6) Plan or budget the effects of future activities (Chapters 7 and 8) Design effective management control systems (Chapters 9 and 10) Make proper long-run decisions (Chapter 11) Design accurate and useful product costing systems (Chapters 12 to 14) As you can see, understanding cost behavior is fundamental to management accounting. There are numerous real-world cases in which managers have made very poor decisions to drop product lines, close manufacturing plants, or bid too high or too low on jobs because they had erroneous cost-behavior information. This chapter, therefore, deserves careful study. Cost Drivers and Cost Behavior linear-cost behavior Activity that can be graphed with a straight line because costs are assumed to be either fixed or variable. Accountants and managers often assume that cost behavior is linear over some relevant range of activity levels or cost-driver levels. We can graph linear-cost behavior with a straight line because we assume each cost to be either fixed or variable. Recall that the relevant range specifies the limits of cost-driver activity within which a specific relationship between a cost and its cost driver will be valid. Managers usually define the relevant range based on their previous experience operating the organization at different levels of activity and cost. In this chapter, we focus on those costs for which the volume of a product produced or service provided is the primary driver. These costs are easy to identify with, or trace to, products or services. Examples of volume-driven costs include the costs of printing labor, paper, ink, and binding to produce all the copies of this textbook. The number of copies printed affects the total printing labor, paper, ink, and binding costs. We could easily trace the use of these resources to the number of copies of the text printed by using schedules, payroll records, and other documents that show how much of each resource was used to produce the copies of this text. Activities not directly related to volume also affect costs. Such costs often have multiple cost drivers. For example, the wages and salaries of the editorial staff of the publisher of this textbook are not easy to identify with or trace to outputs. These editorial personnel produce many different textbooks, and it would be very difficult to determine exactly what portion of their wages and salaries went into a specific book, such as Introduction to Management Accounting. Understanding and measuring costs that are difficult to trace to outputs can be especially challenging. In practice, many organizations use a linear relationship with a single cost driver to describe each cost, even though many costs have multiple causes. This approach is easier and less expensive than using nonlinear relationships or multiple cost drivers. If we use it carefully, this method often provides cost estimates that are accurate enough for most decisions. It may seem at odds with reality and economic theory, but the ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 3: Measurement of Cost Behavior 95 Exhibit 3-1 Linear-Cost Behavior Relevant Range Linear Cost Behavior Cost Activity or Resource Cost Driver Level added benefit of understanding "true" cost behavior may be less than the cost of determining it. Accountants often describe cost behavior in visual or graphical terms. Exhibit 3-1 shows linear-cost behavior, the relevant range, and an activity or resource cost driver. Note the similarity to the CVP graphs of Chapter 2. Step- and Mixed-Cost Behavior Patterns Chapter 2 described two patterns of cost behavior: variable costs and fixed costs. Recall that a purely variable cost changes in proportion to changes in its cost driver's activity, while changes in the cost-driver level do not immediately affect a fixed cost. In addition to these pure versions of costs, two additional types of costs combine characteristics of both fixed- and variable-cost behavior. These are step costs and mixed costs. O B J E C T I V E Explain step- and mixedcost behavior. step costs Costs that change abruptly at different intervals of activity because the resources and their costs come in indivisible chunks. 1 Step Costs Step costs change abruptly at different intervals of activity because the resources and their costs are only available in indivisible chunks. If the individual chunks of cost are relatively large and apply to a specific, broad range of activity, we consider the cost a fixed cost over that range of activity. An example is in panel A of Exhibit 3-2, which Exhibit 3-2 A. Lease Cost of Drilling Equipment B. Supermarket Checker Wage Cost Step-Cost Behavior Relevant Range Relevant Range Lease Cost Actual Cost Behavior Fixed Cost Approximation Wage Cost Actual Cost Behavior Variable Cost Approximation ISBN: 0-536-47129-0 Oil and Gas Exploration Activity 40 Shoppers per Hour 440 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 96 Part 1: Focus on Decision Making shows the cost of leasing oil and gas drilling equipment. When oil and gas exploration activity reaches a certain level in a given region, the company must lease an entire additional rig. One level of oil and gas rig leasing, however, will support all volumes of exploration activity within a relevant range of drilling. Within each relevant range, this step cost behaves as a fixed cost. The total step cost at a level of activity is the amount of fixed cost appropriate for the range containing that activity level. In contrast, accountants often describe step costs as variable when the individual chunks of costs are relatively small and apply to a narrow range of activity. Panel B of Exhibit 3-2 shows the wage cost of cashiers at a supermarket. Suppose one cashier can serve an average of 20 shoppers per hour and that within the relevant range of shopping activity, the number of shoppers can range from 40 per hour to 440 per hour. The corresponding number of cashiers would range between 2 and 22. Because the steps are relatively small, this step cost behaves much like a variable cost, and we could use it as such for planning with little loss of accuracy. mixed costs Costs that contain elements of both fixed- and variable-cost behavior. Mixed Costs Mixed costs contain elements of both fixed- and variable-cost behavior. The fixed-cost element is unchanged over a range of cost-driver activity levels. The variable-cost element of the mixed cost is a purely variable cost that varies proportionately with cost-driver activity within the relevant range. You might think of the fixed cost as the cost of having available the capacity necessary to operate at any volume within the relevant range and the variable cost as the additional cost of using that capacity to produce outputs. Many costs are mixed costs. For example, consider the monthly facilities maintenance department cost of the Parkview Medical Center, shown in Exhibit 3-3. Salaries of the maintenance personnel and costs of equipment are fixed at $10,000 per month. In addition, cleaning supplies and repair materials vary at a rate of $5 per patient-day1 delivered by the hospital. The chief administrator at Parkview Medical Center used knowledge of the facilities maintenance department cost behavior to 1. Plan costs: In May, the hospital expected to service 4,000 patient-days. May's predicted facilities maintenance department costs are $10,000 fixed costs plus the variable cost of $20,000 (4,000 patient-days times $5 per patient-day) for a total of $30,000. Exhibit 3-3 Mixed-Cost Behavior Relevant Range Facilities Maintenance Department Cost $5.00 per Patient-Day Total Variable Cost $10,000 Fixed Cost 1,000 5,000 Number of Patient-Days per Month ISBN: 0-536-47129-0 1A patient-day is one patient spending 1 day in the hospital. One patient spending 5 days in the hospital is 5 patient-days of service. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 3: Measurement of Cost Behavior 97 2. Provide feedback to managers: In May, the actual facilities maintenance costs were $34,000 in a month when 4,000 patient-days were serviced as planned. The administrator wanted to know why the hospital overspent by $4,000 ($34,000 less the planned $30,000) so that managers could take corrective action. 3. Make decisions about the most efficient use of resources: For example, managers might weigh the long-run trade-offs of increased fixed costs of highly automated floor cleaning equipment against the variable costs of extra hours needed to clean floors manually. We can see that managers not only passively measure how costs behave, they also take actions that influence the cost structure of an organization. Let's explore in more detail how managers influence cost behavior. Management Influence on Cost Behavior In addition to measuring and evaluating current cost behavior, managers can influence cost behavior through decisions about such factors as product or service attributes, capacity, technology, and policies to create incentives to control costs. O B J E C T I V E Explain management influences on cost behavior. 2 Product and Service Decisions and the Value Chain Throughout the value chain, managers influence cost behavior. This influence occurs through their choices of process and product design, quality levels, product features, distribution channels, and so on. Each of these decisions contributes to the organization's performance, and managers should consider the costs and benefits of each decision. For example, Hertz, the car rental company, would add a feature to its services only if the cost of the feature--for example, free mileage--could be more than recovered in profit from increased business. Capacity Decisions Strategic decisions about the scale and scope of an organization's activities generally result in fixed levels of capacity costs. Capacity costs are the fixed costs of being able to achieve a desired level of production or to provide a desired level of service while maintaining product or service attributes, such as quality. Most companies make a capacity decision infrequently. They consider capacity decisions as strategic because large amounts of resources are involved. An incorrect capacity decision can have serious consequences for the competitiveness of a company. However, some companies make capacity decisions so frequently that they almost become routine operating decisions, such as opening a new Starbucks or McDonald's. In this case, the decision to open a new Starbucks is still strategic, but it becomes highly structured. Companies in industries with long-term variations in demand must be careful when making capacity decisions. Companies cannot recover fixed capacity costs when demand falls during an economic downturn. Consider the dilemma facing automakers such as Ford and General Motors. Demand for new cars in the auto industry varies substantially over time. It is not unusual for an assembly or production plant to operate at ranges of capacity from 60% to 100%. During boom times--such as in the mid-1990s--Ford was operating at full capacity. To meet demand, employees worked overtime, and Ford even outsourced some of its auto production. Ford had to choose either to build new plants and assembly lines or to continue to pay premiums for overtime and outsourced production. Building new plants would enable Ford to produce cars at lower cost, but it would not be able to reduce the fixed capacity costs if production volumes were to fall. Overtime and capacity costs The fixed costs of being able to achieve a desired level of production or to provide a desired level of service while maintaining product or service attributes, such as quality. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 98 Part 1: Focus on Decision Making outsourcing production were expensive, but Ford could eliminate these variable costs during any business downturn when it did not need the extra cars. What did Ford do? Ford chose not to build expensive new plants. According to executives at Ford, it was worth it to keep costs under control: "Sooner or later there's going to be a downturn and we'll be running down days and short weeks even with the capacity we have." Ford's decision to limit its fixed costs even in the face of higher variable costs helped the company to endure the business downturn in the early 2000s. Ford was better able to reduce its costs as demand for autos fell. Capacity decisions also entail an ethical commitment to a company's employees. Most companies try to keep a stable employment policy so that they do not need to fire or lay off employees unless there are huge shifts in demand. In the economic downturn of the early 2000s, news stories about companies "downsizing" (or, using a term that became more politically correct, "rightsizing") abounded. But other companies managed the decrease in demand without imposing large emotional costs on their employees. Companies that plan their capacity to allow flexibility in meeting demand generally survive economic hard times better, without the emotional upheaval caused by widespread firings and layoffs. Committed Fixed Costs Even if, like Ford, a company has chosen to minimize fixed capacity costs, every organization has some costs to which it is committed, perhaps for quite a few years. Committed fixed costs usually arise from the possession of facilities, equipment, and a basic organization. They include mortgage or lease payments, interest payments on longterm debt, property taxes, insurance, and salaries of key personnel. Only major changes in the philosophy, scale, or scope of operations could change these committed fixed costs in future periods. Recall the example of the facilities maintenance department for the Parkview Medical Center. The capacity of the facilities maintenance department was a management decision, and in this case the decision determined the magnitude of the equipment cost. Suppose Parkview Medical Center were permanently to increase its patient-days per month beyond the relevant range of 5,000 patient-days. Because Parkview would need more capacity, the committed equipment cost would rise to a new level per month. committed fixed costs Costs arising from the possession of facilities, equipment, and a basic organization. Discretionary Fixed Costs discretionary fixed costs Costs determined by management as part of the periodic planning process in order to meet the organization's goals. They have no obvious relationship with levels of capacity or output activity. Some costs are fixed at certain levels only because management decided to incur these levels of cost to meet the organization's goals. These discretionary fixed costs have no obvious relationship to levels of capacity or output activity. Companies determine them as part of the periodic planning process. Each planning period, management will determine how much to spend on discretionary items such as advertising and promotion costs, public relations, research and development costs, charitable donations, employee training programs, and purchased management consulting services. These costs then become fixed until the next planning period. Managers can alter discretionary fixed costs easily--up or down--even within a budget period, if they decide that different levels of spending are desirable. Conceivably, managers could eliminate such discretionary costs almost entirely for a given year in dire times, whereas they could not reduce committed costs. Discretionary fixed costs may be essential to the long-run achievement of the organization's goals, but managers can vary spending levels broadly in the short run. Consider Marietta Corporation, which is experiencing financial difficulties. Sales for its major products are down, and Marietta's management is considering cutting back on costs temporarily. Marietta's management must determine which of the following fixed costs it can reduce or eliminate and how much money each would save: ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 3: Measurement of Cost Behavior 99 Fixed Costs Advertising and promotion Depreciation Employee training Management salaries Mortgage payment Property taxes Research and development Total Planned Amounts $ 30,000 400,000 100,000 800,000 250,000 600,000 1,500,000 $3,680,000 Can Marietta reduce or eliminate any of these fixed costs? The answer depends on Marietta's long-run outlook. Marietta could reduce costs but also greatly reduce its ability to compete in the future if it cuts fixed costs carelessly. Rearranging these costs by categories of committed and discretionary costs yields the following analysis: Fixed Costs Committed Depreciation Mortgage payment Property taxes Total committed Discretionary (potential savings) Advertising and promotion Employee training Management salaries Research and development Total discretionary Total committed and discretionary Planned Amounts $ 400,000 250,000 600,000 $1,250,000 30,000 100,000 800,000 1,500,000 $2,430,000 $3,680,000 $ Eliminating all discretionary fixed costs would save Marietta $2,430,000 per year. However, Marietta would be unwise to cut all discretionary costs completely. This would severely impair the company's long-run prospects. Nevertheless, distinguishing committed and discretionary fixed costs would be the company's first step in identifying where costs could be reduced. Technology Decisions One of the most critical decisions that managers make is choosing the type of technology the organization will use to produce its products or deliver its services. Choice of technology (for example, labor-intensive versus robotic manufacturing, traditional banking services versus automated tellers, or e-commerce versus in-store or mail-order sales) positions the organization to meet its current goals and to respond to changes in the environment (for example, changes in customer needs or actions by competitors). The use of high-technology methods rather than labor usually means a much greater fixed-cost component to the total cost. This type of cost behavior creates greater risks for companies with wide variations in demand. Cost-Control Incentives Finally, the incentives that management creates for employees can affect future costs. Managers use their knowledge of cost behavior to set cost expectations, and employees may receive compensation or other rewards that are tied to meeting these expectations. For example, the administrator of Parkview Medical Center could give the supervisor of the facilities maintenance department a favorable evaluation if the supervisor maintained quality of service and kept department costs below the expected amount for the actual level of patient-days. This feedback motivated the supervisor to watch department costs carefully and to find ways to reduce costs without reducing quality of service. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 100 Part 1: Focus on Decision Making Cost Functions As a manager, you will use cost functions often as a planning and control tool. A few of the reasons why cost functions are important are listed here. 1. Planning and controlling the activities of an organization require accurate and useful estimates of future fixed and variable costs. 2. Understanding relationships between costs and their cost drivers allows managers in all types of organizations--profit-seeking, nonprofit, and government--to make better operating, marketing, and production decisions, to plan and evaluate actions, and determine appropriate costs for short-run and long-run decisions. cost measurement Estimating or predicting costs as a function of appropriate cost drivers. The first step in estimating or predicting costs is cost measurement--measuring cost behavior as a function of appropriate cost drivers. The second step is to use these cost measures to estimate future costs at expected levels of cost-driver activity. We begin by looking at the form of cost functions and the criteria for choosing the most appropriate cost drivers. Form of Cost Functions O B J E C T I V E Measure and mathematically express cost functions and use them to predict costs. cost function An algebraic equation used by managers to describe the relationship between a cost and its cost driver(s). 3 To describe the relationship between a cost and its cost driver(s), managers often use an algebraic equation called a cost function. When there is only one cost driver, the cost function is similar to the algebraic CVP relationships discussed in Chapter 2. Consider the mixed cost graphed in Exhibit 3-3 on page 96, the facilities maintenance department cost: monthly facilities monthly fixed monthly v ariable maintenance = + maintenance cost maintenance cost department costs t = Let Y F V X = monthly facilities maintenance department cost = monthly fixed maintenance cost = variable cost per patient-day = cost-driver activity in number of patient-days per month variable cost per n u mber of patient-days monthly fixed + maintenance cost patient-day in the month We can rewrite the mixed-cost function as Y = F + VX or Y = $10,000 + $5.00X This mixed-cost function has the familiar form of a straight line--it is called a linear cost function. When we graph a cost function, F is the intercept, the point on the vertical axis where the cost function begins. In Exhibit 3-3, the intercept is the $10,000 fixed cost per month. V, the variable cost per unit of activity, is the slope of the cost function. In Exhibit 3-3, the cost function slopes upward at the rate of $5 for each additional patient-day. In our example, we use the cost driver patient-days. How did we choose this cost driver? Why not use number of patients or number of operations? In general, how do we develop cost functions? (1) ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 3: Measurement of Cost Behavior 101 Developing Cost Functions Managers should apply two criteria to obtain accurate and useful cost functions: plausibility and reliability. 1. The cost function must be plausible, that is, believable. Personal observation of costs and activities, when it is possible, provides the best evidence of a plausible relationship between a resource cost and its cost driver. Some cost relationships, by nature, are not directly observable, so the cost analyst must be confident that the proposed relationship is sound. Many costs may move together with a number of cost drivers, but no cause-andeffect relationships may exist. A cause-and-effect relationship (that is, the cost driver causes the resource cost) is desirable for cost functions to be accurate and useful. For example, consider three possible cost drivers for the total cost of a US Airways round-trip flight from Phoenix to San Diego: miles flown, number of passengers, and passenger-miles (number of passengers times miles flown). Which of these possible cost drivers makes most sense? The answer is passenger-miles--the cost driver used by almost all airlines. 2. In addition to being plausible, a cost function's estimates of costs at actual levels of activity must reliably conform with actually observed costs. We assess reliability in terms of "goodness of fit"--how well the cost function explains past cost behavior. If the fit is good and conditions do not change, the cost function should be a reliable predictor of future costs. Managers use these criteria together in choosing a cost function. Each is a check on the other. Knowledge of operations and the way accountants record costs is helpful in choosing a plausible and reliable cost function that links cause and effect. For example, companies often perform maintenance when output is low because that is when they can take machines out of service. Lower output does not cause increased maintenance costs, however, nor does increased output cause lower maintenance costs. A more plausible explanation is that over a longer period increased output causes higher maintenance costs, but daily or weekly recording of maintenance costs and outputs may make it appear otherwise. Understanding the nature of maintenance costs should lead managers to a reliable, long-run cost function. MAKING MANAGERIAL DECISIONS A cost function is a mathematical expression of the components of a par ticular cost. However, an intuitive understanding of cost functions is just as impor tant as being able to write the mathematical formula. Suppose you have been using a cost function to predict total orderprocessing activity costs. The cost function is total costs = $25,000 + $89 (number of orders processed). This formula is based on data that are in the range of 500 to 700 orders processed. Now, you need to predict the total cost for 680 orders. You have a few questions to answer before you are comfor table using the cost function in this situation. Why is it impor tant to know the relevant range? What does it mean when a cost function is linear? Why do managers want to know whether a cost is linear? ISBN: 0-536-47129-0 Answer As long as the operating conditions that existed when the data were collected have not changed significantly, then knowing that the number of orders processed is within the relevant range--500 to 700, in this case--gives you confidence in the predicted total cost. A linear cost function means that there are two parts to the cost. One part is fixed--that is, it's independent of the cost driver. The other part varies in proportion to the cost driver--that is, if the cost driver increases by X%, this par t of the cost also increases by X%. Knowing that a cost is linear allows a manager to separate the cost into fixed and variable components--a simplification that helps you understand how decisions will affect costs. Incidentally, the predicted total cost for 680 orders is $25,000 + ($89 680) = $85,520. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 102 Part 1: Focus on Decision Making Choice of Cost Drivers: Activity Analysis O B J E C T I V E Describe the importance of activity analysis for measuring cost functions. activity analysis The process of identifying appropriate cost drivers and their effects on the costs of making a product or providing a service. 4 How do managers choose reliable and plausible cost functions? Well, you cannot have a good cost function without knowing the right cost drivers, so choosing a cost function starts with choosing cost drivers--the X in equation (1) on page 100. Managers use activity analysis to identify appropriate cost drivers and their effects on the costs of making a product or providing a service. The final product or service may have several cost drivers because production may involve many separate activities. The greatest benefit of activity analysis is that it directs management accountants to the appropriate cost drivers for each cost. Consider Northwestern Computers, which makes two products for personal computers: a plug-in music board (Mozart-Plus) and a hard-disk drive (Powerdrive). In the past, most of the work on Northwestern's products was done by hand. Thus, most costs other than the cost of materials were related to (driven by) labor cost. On average, support costs were twice as much as labor costs. Northwestern has just finished upgrading the production function. Now the company uses computer-controlled assembly equipment, which has increased the costs of support activities, such as engineering and maintenance, and has reduced labor cost. Labor cost is now only 5% of the total costs at Northwestern. Furthermore, activity analysis has shown that most of today's support costs are driven by the number of components added to products (a measure of product complexity), not by labor cost. Mozart-Plus has five component parts, and Powerdrive has nine. Suppose Northwestern wants to predict how much support cost it will incur in producing one Mozart-Plus and how much for one Powerdrive. Using the old cost driver, labor cost, the prediction of support costs would be Mozart-Plus Labor cost Support cost 2 direct labor cost $ 8.50 $17.00 Powerdrive $130.00 $260.00 Using the more appropriate cost driver, the number of components added to products, the predicted support costs are Mozart-Plus Support cost at $20 per component $20 5 components $20 9 components Difference in predicted support cost $100.00 $ 83.00 higher $180.00 $ 80.00 lower Powerdrive By using an appropriate cost driver, Northwestern can predict its support costs much more accurately. Managers will make better decisions with this more accurate information. For example, they can relate prices charged for products more closely to the costs of production. To see how an actual organization uses activity analysis, see the Business First box on page 103. One major question remains in our discussion of the measurement of cost behavior-- how are the estimates of fixed costs and variable cost per cost-driver unit determined? Equation (1) on page 100 denotes these amounts by F = monthly fixed maintenance cost and V = variable cost per patient-day. In practice, organizations use several methods of measuring cost functions. Let's look at each of these methods. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. ACTIVITY ANALYSIS FOR A HOSPICE Manufacturing companies were the first organizations to use activity analysis. However, its use has spread to many ser vice industries and nonprofit organizations. A recent article described how a health-care organization, Hospice and Palliative Care of Central Kentucky (HCK), undertook an activity analysis to better understand its costs. HCK is a Medicare/Medicaid-certified program providing medical care to the terminally ill in 10 counties in central Kentucky. In addition to seeing to the medical needs of its patients, HCK has social workers, home health aides, volunteers, and chaplains. It also provides an 18-month bereavement program for families of patients. Many of HCK's costs were related directly to patients, and understanding these costs posed no problems. However, suppor t costs were large, and HCK had little information about what caused these costs. Before undertaking an activity analysis, HCK simply assumed that the patient-day was the only cost driver for all support costs. All that HCK knew about support costs was that they were $35.53 per patient-day. Because HCK felt the squeeze of increasing costs and constant payments from HMOs and insurance companies, management at HCK wanted better cost information to make various decisions. To do this, the organization undertook an activity analysis to determine the appropriate cost drivers for support costs. This consisted of two basic tasks: (1) identify the activities being performed and (2) select a cost driver for each activity. To identify the activities and the costs related to each activity, HCK formed a cross-functional team. Identifying the activities takes a thorough understanding of all the operations of the hospice, so a team of only finance or accounting professionals would not be knowledgeable enough for this task. The team included the director of operations, the bereavement coordinator, the billing coordinator, a nurse, and a representative of the community service program. Among them they knew all aspects of the hospice's operations. The team identified 14 activities. The next step was to select a cost driver for each activity. Some of the activities and their related cost drivers are Activity Referral Admission Bereavement Accounting/finance Billing Volunteer services Cost Driver Number of (indexed) referrals Number of admissions Number of deaths Number of (indexed) patient-days Number of billings Number of volunteers Using the cost information from the activity analysis, management was able to learn how much each different activity cost and could recognize that patients requiring use of expensive activities were more expensive to treat. Management could then tr y to reduce the costs of activities that were not wor th the amount being spent for them, and they could better negotiate contracts so that HMOs and insurance companies would provide more suppor t for patients that required the most expensive activities. Sources: Adapted from Sidney J. Baxendale and Victoria Dornbusch, "Activity-Based Costing for a Hospice," Strategic Finance, March 2000, pp. 6570; Hospice and Palliative Care of Central Kentucky's Web site (www.hospices.org). Methods of Measuring Cost Functions After determining the most plausible drivers behind different costs, managers can choose from a broad selection of methods of approximating cost functions. These methods include (1) engineering analysis, (2) account analysis, (3) high-low analysis, (4) visual-fit analysis, and (5) least-squares regression analysis. These methods are not mutually exclusive; managers frequently use two or more together to avoid major errors in measuring cost behavior. The first two methods rely primarily on logical analysis, whereas the last three involve analysis of past costs. O B J E C T I V E Measure cost behavior using the engineering analysis, account analysis, high-low, visual-fit, and least-squares regression methods. 5 ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 104 Part 1: Focus on Decision Making Engineering Analysis engineering analysis The systematic review of materials, supplies, labor, support services, and facilities needed for products and services; measuring cost behavior according to what costs should be, not by what costs have been. The first method, engineering analysis, measures cost behavior according to what costs should be, not by what costs have been. It entails a systematic review of materials, supplies, labor, support services, and facilities needed for products and services. Analysts can even use engineering analysis successfully for new products and services, as long as the organization has had experience with similar costs. Why? Because they can base measures on information from personnel who are directly involved with the product or service. In addition to actual experience, analysts learn about new costs from experiments with prototypes, accounting and industrial engineering literature, the experience of competitors, and the advice of management consultants. From this information, cost analysts determine what future costs should be. If the cost analysts are experienced and understand the activities of the organization, then their engineering cost predictions may be quite reliable and useful for decision making. The disadvantages of engineering cost analysis are that the efforts are costly and often not timely. Weyerhaeuser Company, producer of wood products, used engineering analysis to determine the cost functions for its 14 corporate service departments. These cost functions measure the cost of corporate services used by three main business groups. For example, accounts payable costs for each division are a function of three cost drivers: the number of hours spent on each division, number of documents, and number of invoices. Nearly any service organization could use this approach to measuring cost behavior. At Parkview Medical Center, introduced earlier, an assistant to the hospital administrator interviewed facilities maintenance personnel and observed their activities on several random days for a month. From these data, she confirmed that the most plausible cost driver for facilities maintenance cost is the number of patient-days. She also estimated from current department salaries and equipment charges that monthly fixed costs approximated $10,000 per month. Using interviews and observing supplies usage during the month, she estimated that variable costs are $5 per patient-day. She gave this information to the hospital administrator but cautioned that the cost measures may be wrong because 1. The month observed may be abnormal. 2. The facilities maintenance personnel may have altered their normal work habits because the assistant was observing them. 3. The facilities maintenance personnel may not have told the complete truth about their activities because of their concerns about the use of the information they revealed. However, if we assume the observed and estimated information is correct, we could predict facilities maintenance costs in any month by first forecasting that month's expected patient-days and then entering that figure into the following algebraic, mixedcost function: Y = $10,000 per month + ($5 patient-days) For example, if the administrator expects 4,000 patient-days next month, the prediction of facilities maintenance costs would be Y = $10,000 + ($5 4,000 patient-days) = $30,000 Account Analysis account analysis Classifying each account as a variable cost or as a fixed cost with respect to a selected cost driver. In contrast to engineering analysis, users of account analysis look to the accounting system for information about cost behavior. The simplest method of account analysis classifies each account as a variable or fixed cost with respect to a selected cost driver. The cost analyst then looks at each cost account balance and estimates either the variable cost per unit of cost-driver activity or the periodic fixed cost. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 3: Measurement of Cost Behavior 105 To illustrate this approach to account analysis, let's return to the facilities maintenance department at Parkview Medical Center and analyze costs for a recent month. The table below shows costs recorded in a month with 3,700 patient-days: Monthly Cost Supervisor's salary and benefits Hourly workers' wages and benefits Equipment depreciation and rentals Equipment repairs Cleaning supplies Total facilities maintenance cost January Amount $ 3,800 14,674 5,873 5,604 7,472 $37,423 Recall that the most plausible and reliable driver for these costs is the number of patient-days serviced per month. Next, the analyst determines which costs may be fixed and which may be variable. Assume that the analyst has made the following judgments: Monthly Cost Supervisor's salary and benefits Hourly workers' wages and benefits Equipment depreciation and rentals Equipment repairs Cleaning supplies Total facilities maintenance costs Amount $ 3,800 14,674 5,873 5,604 7,472 $37,423 Fixed $3,800 $14,674 5,873 5,604 7,472 $27,750 Variable $9,673 Measuring total facilities maintenance cost behavior, then, requires only simple arithmetic. Add all the fixed costs to get the total fixed cost per month. Divide the total variable costs by the units of cost-driver activity to get the variable cost per unit of cost driver. Fixed cost per month = $ 9, 673 Variable cost per patient-day = $ 27, 750 3, 700 patient-days = $ 7 . 50 per patient-day The algebraic, mixed-cost function, measured by account analysis, is Y = $9,673 per month + ($7.50 patient-days) Account-analysis methods are less expensive to conduct than engineering analyses, but they require recording of relevant cost accounts and cost drivers. In addition, like engineering analysis, account analysis is subjective because the analysts decide whether each cost is variable or fixed based on their own judgment. Summary Problem for Your Review PROBLEM ISBN: 0-536-47129-0 The Reliable Insurance Company processes a variety of insurance claims for losses, accidents, thefts, and so on. Account analysis using one cost driver has estimated the variable cost of processing the claims for each automobile accident at 0.5% (.005) of the dollar value of all claims related to a particular accident. This estimate seemed reasonable because high-cost claims often involve more analysis before settlement. To control processing costs better, however, Reliable conducted an activity analysis of claims processing. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 106 Part 1: Focus on Decision Making The analysis suggested that there are three main cost drivers for the costs of processing claims for automobile accidents. The drivers and cost behavior are 0.2% of Reliable Insurance policyholders' p roperty claims +0.6% of other parties' prop erty claims +0.8% of total personal injury claims Data from two recent automobile accident claims follow: Automobile Claim No. 607788 Policyholder claim Other party claim Personal injury claim Total claim amount $ 4,500 0 12,400 $16,900 Automobile Claim No. 607991 $23,600 3,400 0 $27,000 1. Estimate the cost of processing each claim using data from (a) the single-cost-driver analysis and (b) the three-cost-driver analysis. 2. How would you recommend that Reliable Insurance estimate the cost of processing claims? SOLUTION 1. Costs are summarized in the table here. Automobile Claim No. 607788 Claim Amount Using single-cost-driver analysis Total claim amount Estimated processing cost at 0.5% Using three-cost-driver analysis Policyholder claim Estimated processing cost at 0.2% Other party claim Estimated processing cost at 0.6% Personal injury claim Estimated processing cost at 0.8% Total estimated processing cost $16,900 $ 84.50 $ 4,500 $ 9.00 0 0 12,400 99.20 $108.20 0 0 $ 67.60 3,400 20.40 $23,600 $ 47.20 Processing Cost Automobile Claim No. 607991 Claim Amount $27,000 $135.00 Processing Cost 2. The three-cost-driver analysis estimates of processing costs are considerably different from those using a single cost driver. If the activity analyses are reliable, then automobile claims that include personal injury losses are more costly to process than property damage claims. If these estimates are relatively inexpensive to keep current and to use, then it seems reasonable to adopt the three-cost-driver approach. Reliable will have more accurate cost estimates and will be better able to plan its claims processing activities. Reliable processes many different types of claims, however. Extending activity analysis to identify multiple cost drivers for all types of claims would result in a complicated system for predicting costs--much more complex (and costly) than simply using the total dollar value of claims. Whether to undertake an activity analysis for all types of policies depends on cost-benefit considerations. Managers can address such considerations by first adopting activity analysis for one type of claim and assessing the usefulness and cost of the more accurate information. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 3: Measurement of Cost Behavior 107 High-Low, Visual-Fit, and Least-Squares Methods When enough cost data are available, we can use historical data to measure the cost function mathematically. Three popular methods that use such data are the high-low, visualfit, and least-squares methods. All three of these methods are more objective than the engineering-analysis and account analysis methods. Each is based on hard evidence as well as on judgment, and they use more than one period's cost and activity information. Account analysis and engineering analysis will probably remain primary methods of measuring cost behavior because the three mathematical methods require more past cost data. Products, services, technologies, and organizations are changing rapidly in response to increased global competition and technological advances. In some cases, by the time enough historical data are collected to support these analyses, the data are obsolete--the organization has changed, the production process has changed, or the product has changed. The cost analyst must be careful that the historical data are from a past environment that still closely resembles the future environment for which a manager wants to predict costs. Another concern is that historical data may hide past inefficiencies that the company could reduce if it could identify them. Data for Illustration In discussing the high-low, visual-fit, and least-squares regression methods, we will continue to use the Parkview Medical Center's facilities maintenance department costs. The following table shows monthly data collected on facilities maintenance department costs and on the number of patient-days serviced over the past year: Facilities Maintenance Department Data Month January February March April May June July August September October November December Facilities Maintenance Department Cost (Y) $37,000 23,000 37,000 47,000 33,000 39,000 32,000 33,000 17,000 18,000 22,000 20,000 Number of Patient-Days (X) 3,700 1,600 4,100 4,900 3,300 4,400 3,500 4,000 1,200 1,300 1,800 1,600 ISBN: 0-536-47129-0 High-Low Method When sufficient cost data are available, the cost analyst may use historical data to measure the cost function mathematically. The simplest of the three methods to measure a linear-cost function from past cost data is the high-low method shown in Exhibit 3-4. The first step in the high-low method is to plot the historical data points on a graph. This visual display helps the analyst see whether there are obvious errors in the data. Even though many points are plotted, the focus of the high-low method is normally on the highest- and lowest-activity points. However, if one of these points is an outlier that seems in error or nonrepresentative of normal operations, we will need to use the next-highest or next-lowest activity point. For example, you should not use a point from a period with abnormally low activity caused by a labor strike or fire. Why? Because that point is not representative of a normal relationship between the cost and the cost driver. After selecting the representative high and low points, we can draw a line between them, extending the line to the vertical (Y) axis of the graph. Note that this extension in high-low method A simple method for measuring a linear-cost function from past cost data, focusing on the highest-activity and lowestactivity points and fitting a line through these two points. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 108 Part 1: Focus on Decision Making Exhibit 3-4 High-Low Method 50 Facilities Maintenance Department Costs (Thousands) 45 40 35 30 25 20 15 10 5 0 0 1,000 2,000 3,000 4,000 5,000 6,000 Number of Patient-Days 3,700 "Low" Point Slope = $30,000/3,700 = (1,200; 17,000) $8.108 per Patient-Day Intercept, F = $7,270 30,000 "High" Point (4,900; 47,000) Facilities Maintenance Department Costs and Number of Patient-Days Exhibit 3-4 is a dashed line, as a reminder that costs may not be linear outside the range of activity for which we have data (the relevant range). Also, managers usually are concerned with how costs behave within the relevant range, not with how they behave either at zero activity or at impossibly high activity levels. Measurements of costs within the relevant range probably are not reliable measures or predictors of costs outside the relevant range. The point at which the line intersects the Y-axis is the intercept, F, or estimate of fixed cost. The slope of the line measures the variable cost, V, per patient-day. The clearest way to measure the intercept and slope with the high-low method is to use algebra: Facilities Maintenance Department Cost (Y) $47,000 17,000 $30,000 Number of Patient-Days (X) 4,900 1,200 3,700 Month High: April Low: September Difference Variable cost per patient-day, V= change in costs $ 47, 000 - $ 17, 000 = change in activity 4, 900 - 1, 200 patient-days $ 30, 000 V= = $ 8 . 1081 per patient-day 3, 700 Fixed cost per month, F = total mixed cost less total variable cost At X (high): F = $ 47, 000 - ($ 8 . 1081 4, 900 patien t-days) = $47,000 - $39,730 = $ 7, 270 per month At X (low): F = $ 17, 000 - ($ 8 . 1081 1, 200 patien t-days) = $ 17, 000 - $ 9, 730 = $ 7, 270 per month ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 3: Measurement of Cost Behavior 109 Therefore, the facilities maintenance department cost function, measured by the high-low method, is Y = $7,270 per month + ($8.1081 patient-days) The high-low method is easy to apply and illustrates mathematically how a change in a cost driver can change total cost. The cost function that resulted in this case is plausible. Before the widespread availability of computers, managers often used the high-low method to measure a cost function quickly. Today, however, the high-low method is not used as often because it makes inefficient use of information, basing the cost function on only two periods' cost experience, regardless of how many relevant data points have been collected. Summary Problem for Your Review PROBLEM The Reetz Company has its own photocopying department. Reetz's photocopying costs include costs of copy machines, operators, paper, toner, utilities, and so on. We have the following cost and activity data: Month 1 2 3 4 5 Total Photocopying Cost $25,000 29,000 24,000 23,000 28,000 Number of Copies 320,000 390,000 300,000 310,000 400,000 1. Use the high-low method to measure the cost behavior of the photocopy department in formula form. 2. What are the benefits and disadvantages of using the high-low method for measuring cost behavior? SOLUTION 1. The lowest and highest activity levels are in months 3 (300,000 copies) and 5 (400,000 copies). change in cost $ 28, 000 - $ 24, 000 = chang e in activity 400, 000 - 300, 00 0 0 $ 4, 000 = = $ 0 . 04 per copy 100, 000 Fixed cost p er month = total cost less variable cost at 4 00,000 copies: $ 28, 000 - ($ 0 . 04 400, 000) = $ 1 2, 000 per month at 300,000 copies: $ 24, 000 - ($ 0 . 04 300, 000) = $ 12, 000 per month Variable cost per copy = ISBN: 0-536-47129-0 Therefore, the photocopy cost function is Y (total cost) = $12,000 per month + ($0.04 number of copies) Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 110 Part 1: Focus on Decision Making 2. The benefits of using the high-low method are The method is easy to use. Not many data points are needed. The disadvantages of using the high-low method are The choice of the high and low points is subjective. The method does not use all available data. The method may not be reliable. visual-fit method A method in which the cost analyst visually fits a straight line through a plot of all the available data. Visual-Fit Method Because it uses all the available data instead of just two points, the visual-fit method is more reliable than is the high-low method. In the visual-fit method, we draw a straight line through a plot of all the available data, using judgment to fit the line as close as possible to all the plotted points. If the cost function for the data is linear, it is possible to draw a straight line through the scattered points that comes reasonably close to most of them and thus captures the general tendency of the data. We can extend that line back until it intersects the vertical axis of the graph. Exhibit 3-5 shows this method applied to the facilities maintenance department cost data for the past 12 months. By measuring where the line intersects the cost axis, we can estimate the monthly fixed cost--in this case, about $10,000 per month. To find the variable cost per patient-day, select any activity level (for example 1,000 patient-days) and find the total cost at that activity level ($17,000). Then, divide the variable cost (which is total cost less fixed cost) by the units of activity. Variable cost per patient-day = ($ 17, 000 - $ 10, 0 00) 1, 000 patient-days = $ 7 per patient-day The linear-cost function measured by the visual-fit method is Y = $10,000 per month + ($7 patient-days) Although the visual-fit method uses all the data, the placement of the line and the measurement of the fixed and variable costs are subjective. This subjectivity is the main reason that many companies with sufficient data prefer to use least-squares regression analysis rather than the visual-fit method. Exhibit 3-5 Visual-Fit Method Facilities Maintenance Department Costs and Number of Patient-Days 50 Facilities Maintenance Department Costs (Thousands) 45 40 35 30 25 20 15 10 5 0 0 1,000 2,000 3,000 4,000 5,000 6,000 ISBN: 0-536-47129-0 $7,000 Slope, V = $7,000/1,000 = $7.00 per Patient-Day Intercept, F = $10,000 per Month Number of Patient-Days Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 3: Measurement of Cost Behavior 111 Least-Squares Regression Method Least-squares regression (or simply regression analysis) measures a cost function more objectively than does the visual-fit method. Least-squares regression analysis uses statistics rather than human eyesight to fit a cost function to all the historical data. A simple regression uses one cost driver to measure a cost function while a multiple regression uses two or more cost drivers. We will discuss only simple regression analysis in this chapter. Appendix 3 presents some statistical properties of regression analysis and shows how to use computer regression software. In addition to measuring cost behavior more reliably than other cost measurement methods, regression analysis yields important statistical information about the reliability of cost estimates. These statistics allow analysts to assess their confidence in the cost measures and thereby select the best cost driver. One such measure of reliability, or goodness of fit, is the coefficient of determination, R2 (or R-squared), which measures how much of the fluctuation of a cost is explained by changes in the cost driver. Appendix 3 explains R2 and discusses how to use it to select the best cost driver. Exhibit 3-6 shows the linear, mixed-cost function for facilities maintenance costs as measured by simple regression analysis. The fixed-cost measure is $9,329 per month. The variable-cost measure is $6.951 per patient-day. The linear-cost function is facilities maintenance department cost = $9,329 per month + ($6.951 number of patient-days) or Y = $9,329 + ($6.951 patient-days) Compare the cost measures produced by each of the five approaches: Fixed Cost per Month $10,000 9,673 7,270 10,000 9,329 Variable Cost per Patient-Day $5.000 7.500 8.108 7.000 6.951 least-squares regression (regression analysis) Measuring a cost function objectively by using statistics to fit a cost function to all the data. coefficient of determination (R 2) A measurement of how much of the fluctuation of a cost is explained by changes in the cost driver. Method Engineering analysis Account analysis High-low Visual-fit Regression Exhibit 3-6 Facilities Maintenance Department Costs and Number of Patient Days Least-Squares Regression Method 50 Facilities Maintenance Department Costs (Thousands) 45 40 35 30 25 20 15 10 5 0 0 ISBN: 0-536-47129-0 Slope, V = $6.951 per Patient-Day Intercept, F = $9,329 per Month 1,000 2,000 3,000 4,000 5,000 6,000 Number of Patient-Days Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 112 Part 1: Focus on Decision Making To see the differences in results between methods, we will use account-analysis and regression-analysis measures to predict total facilities maintenance department costs at 1,000 and 5,000 patient-days, the approximate limits of the relevant range: Account Analysis 1,000 patient-days: Fixed cost Variable costs $7.500 1,000 $6.951 1,000 Predicted total cost 5,000 patient-days: Fixed cost Variable costs $7.500 5,000 $6.951 5,000 Predicted total cost $ 9,673 7,500 $17,173 $ 9,673 37,500 $47,173 34,755 $44,084 2,745 $3,089 6,951 $16,280 $ 9,329 549 $ 893 $ 344 Regression Analysis $ 9,329 Difference $ 344 At lower levels of patient-day activity the difference between cost predictions is small. At higher levels of patient-day activity, however, the account-analysis cost function predicts much higher costs. The difference between the predicted total costs is due primarily to the higher variable cost per patient-day (approximately $0.55 more) measured by account analysis. Because of their grounding in statistical analysis, the regression-cost measures are probably more reliable than those obtained from the other methods. Thus, managers would have more confidence in cost predictions from the regression-cost function. Highlights to Remember Explain step- and mixed-cost behavior. Cost behavior refers to how costs change as levels of an organization's activities change. Costs can behave as fixed, variable, step, or mixed costs. Step and mixed costs both combine aspects of variable- and fixed-cost behavior. Step costs form graphs that look like steps. Costs will remain fixed within a given range of activity or cost-driver level, but then will rise or fall abruptly when the cost-driver level is outside this range. Mixed costs involve a fixed element and a variable element of cost behavior. Unlike step costs, mixed costs have a single fixed cost at all levels of activity, and in addition have a variable cost element that increases proportionately with activity. 1 2 3 4 5 Explain management influences on cost behavior. Managers can affect the costs and cost behavior patterns of their companies through the decisions they make. Decisions on product and service features, capacity, technology, and cost-control incentives, for example, can all affect cost behavior. Measure and mathematically express cost functions and use them to predict costs. The first step in estimating or predicting costs is measuring cost behavior. This is done by finding a cost function. This is an algebraic equation that describes the relationship between a cost and its cost driver(s). To be useful for decision-making purposes, cost functions should be plausible and reliable. Describe the importance of activity analysis for measuring cost functions. Activity analysis is the process of identifying the best cost drivers to use for cost estimation and prediction and determining how they affect the costs of making a product or service. This is an essential step in understanding and predicting costs. ISBN: 0-536-47129-0 Measure cost behavior using the engineering analysis, account analysis, high-low, visual-fit, and least-squares regression methods. Once analysts have identified cost drivers, they can use one of several methods to determine the cost function. Engineering analysis focuses on what costs should be by systematically reviewing the materials, supplies, labor, support services, and facilities needed for a given Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 3: Measurement of Cost Behavior 113 level of production. Account analysis involves examining all accounts in terms of an appropriate cost driver and classifying each account as either fixed or variable with respect to the driver. The cost function consists of the variable cost per cost-driver unit multiplied by the amount of the cost driver plus the total fixed cost. The high-low, visual-fit, and least-squares methods all use historical data to determine cost functions. Of these three methods, high-low is the easiest, although least-squares is the most reliable. Appendix 3: Use and Interpretation of Least-Squares Regression We can apply regression analysis of historical cost data with no more than a simple calculator. It would be unusual, however, to find cost analysts doing regression analysis by hand--computers are much faster and less prone to error. Therefore, we focus on using a computer to perform regression analysis and on interpretation of the results. This appendix is not a substitute for a good statistics class. More properly, think of it as a motivator for studying statistics so that you can provide and interpret top-quality cost estimates. Assume that there are two potential cost drivers for the costs of the facilities maintenance department in Parkview Medical Center: (1) number of patient-days and (2) total value of hospital room charges. Regression analysis helps to determine which activity is the better cost driver. Exhibit 3-7 shows the past 12 months' cost and cost-driver data for the facilities maintenance department. Regression Analysis Procedures Most spreadsheet software available for PCs offers basic regression analysis in the Data Analysis or Tools commands. We will use these spreadsheet commands to illustrate regression analysis because many readers will be familiar already with spreadsheet software. Entering Data First, create a spreadsheet with the historical cost data in rows and columns. Each row should be data from one period. Each column should be a cost category or a cost driver. For ease of analysis, all the potential cost drivers should be in adjacent columns. Each row and column should be complete (no missing data) and without errors. Plotting Data There are two main reasons why the first step in regression analysis should be to plot the cost against each of the potential cost drivers: (1) Plots may show obvious nonlinear trends in the data; if so, linear regression analysis may not be appropriate for the entire range of the data. (2) Plots help Exhibit 3-7 Facilities Maintenance Cost (Y) $37,000 23,000 37,000 47,000 33,000 39,000 32,000 33,000 17,000 18,000 22,000 20,000 Number of Patient-Days (X1) 3,700 1,600 4,100 4,900 3,300 4,400 3,500 4,000 1,200 1,300 1,800 1,600 Value of Room Charges (X2) $2,183,000 2,735,000 2,966,000 2,846,000 2,967,000 2,980,000 3,023,000 2,352,000 1,825,000 1,515,000 1,547,000 2,117,000 Facilities Maintenance Department Data Month January February March April May June July August September October November December ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 114 Part 1: Focus on Decision Making identify outliers--costs that are in error or are otherwise obviously inappropriate. There is little agreement about what to do with any outliers that are not the result of data-entry errors or nonrepresentative cost and activity levels (e.g., periods of labor strikes or natural catastrophes). After all, if the data are not in error and are representative, the process that is being studied generated them. Even so, some analysts recommend removing outliers from the data set. Leaving these outliers in the data makes regression analysis statistically less appealing because data far removed from the rest of the data set will not fit the line well. The most conservative action is to leave all data in the data set unless you discover uncorrectable errors or unless you know the data to be not representative of the process. Plotting with spreadsheets uses Graph commands on the columns of cost and cost-driver data. These Graph commands typically offer many optional graph types (such as bar charts and pie charts), but the most useful plot for regression analysis usually is called the XY graph. This graph is the type shown earlier in this chapter--the X-axis is the cost driver, and the Y-axis is the cost. The XY graph should be displayed without lines drawn between the data points (called data symbols)-- an optional command. (Consult your spreadsheet manual for details because each spreadsheet program is different.) Regression Output The format of the regression output is different for each software package. However, every package will identify the cost to be explained ("dependent variable") and the cost driver(s) ("independent variable[s]"). Producing regression output with spreadsheets is simple: Just select the Regression command, specify (or highlight) the X-dimension[s] (the cost driver[s]), and specify the Y-dimension or "series" (the cost). Next, specify a blank area on the spreadsheet where the output will be displayed, and select Go. Below is a regression analysis of facilities maintenance department costs using one of the two possible cost drivers, number of patient-days, X1. Facilities Maintenance Department Cost Explained by Number of Patient-Days Regression Output Constant R2 X coefficient(s) 9,329 0.955 6.951 Interpretation of Regression Output The fixed-cost measure, labeled "constant" or "intercept" by most programs, is $9,329 per month. The variable cost measure, labeled "X coefficient(s)" (or something similar in other spreadsheets), is $6.951 per patient-day. The linear cost function is Y = $9,329 per month + ($6.951 patient-days) Typically, the computer output gives a number of statistical measures that indicate how well each cost driver explains the cost and how reliable the cost predictions are likely to be. A full explanation of the output is beyond the scope of this text. One of the most important statistics, the coefficient of determination, or R2, is very important to assessing the goodness of fit of the cost function to the actual cost data. What the visual-fit method tries to do with eyesight, regression analysis accomplishes more reliably. In general, the better a cost driver is at explaining a cost, the closer the data points will lie to the line, and the higher will be the R2, which varies between 0 and 1. An R2 of 0 would mean that the cost driver does not explain variability in the cost data, whereas an R2 of 1 would mean that the cost driver explains the variability perfectly. The R2 of the relationship measured with number of patient-days as the cost driver is 0.955, which is quite high. This value indicates that number of patient-days explains facilities maintenance department cost extremely well. In fact, the number of patient-days explains 95.5% of the past fluctuations in facilities maintenance department cost. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 3: Measurement of Cost Behavior 115 In contrast, performing a regression analysis on the relationship between facilities maintenance department cost and value of hospital room charges produces the following results: Facilities Maintenance Department Cost Explained by Value of Hospital Room Charges Regression Output Constant R2 X coefficient(s) $ 924 0.511 0.012 The R2 value, 0.511, indicates that the cost function using value of hospital room charges does not fit facilities maintenance department cost as well as the cost function using number of patient-days. To use the information generated by regression analysis fully, an analyst must understand the meaning of the statistics and must be able to determine whether the statistical assumptions of regression are satisfied by the cost data. Indeed, one of the major reasons why cost analysts study statistics is to understand the assumptions of regression analysis better. With this understanding, analysts can provide their organizations with top-quality estimates of cost behavior. Summary Problem for Your Review PROBLEM Comtell makes computer peripherals (disk drives, tape drives, and printers). Until recently, managers predicted production scheduling and control (PSC) costs to vary in proportion to labor costs according to the following cost function: PSC costs = 200% of labor cost or Y = 2 labor cost Because PSC costs have been growing at the same time that labor cost has been shrinking, Comtell is concerned that its cost estimates are neither plausible nor reliable. Comtell's controller has just completed activity analysis to determine the most appropriate drivers of PSC costs. She obtained two cost functions using different cost drivers: Y = 2 labor cost R 2 = 0 . 233 and Y = $ 10, 000 per month + (11 number of components used) s R 2 = 0 . 782 1. What would be good tests of which cost function better predicts PSC costs? 2. During a subsequent month, Comtell's labor costs were $12,000, and it used 2,000 product components. Actual PSC costs were $31,460. Using each of the preceding cost functions, prepare reports that show predicted and actual PSC costs and the difference or variance between the two. 3. What is the meaning and importance of each cost variance? ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 116 Part 1: Focus on Decision Making SOLUTION 1. A statistical test of which function better explains past PSC costs compares the R2 of each function. The second function, based on the number of components used, has a considerably higher R2, so it better explains the past PSC costs. If the environment is essentially unchanged in the future, the second function probably will predict future PSC costs better than the first. A useful predictive test would be to compare the cost predictions of each cost function with actual costs for several months that were not used to measure the cost functions. The function that more closely predicted actual costs is probably the more reliable function. 2. Note that more actual cost data would be desirable for a better test, but the procedure would be the same. PSC cost predicted on a labor-cost basis follows: Predicted Cost 2 $12,000 = $24,000 Actual Cost $31,460 Variance $7,460 underestimate PSC cost predicted on a component basis follows: Predicted Cost $10,000 + ($11 2,000) = $32,000 Actual Cost $31,460 Variance $540 overestimate 3. The cost function that relies on labor cost underestimated PSC cost by $7,460. The cost function that uses the number of components closely predicted actual PSC costs (off by $540). Planning and control decisions would have been based on more accurate information using this prediction than using the labor cost-based prediction. An issue is whether the benefits of collecting data on the number of components used exceeded the added cost of so doing. Accounting Vocabulary account analysis, p. 104 activity analysis, p. 102 capacity costs, p. 97 coefficient of determination (R2), p. 111 committed fixed costs, p. 98 cost function, p. 100 cost measurement, p. 100 discretionary fixed costs, p. 98 engineering analysis, p. 104 high-low method, p. 107 least-squares regression, p. 111 linear-cost behavior, p. 94 measurement of cost behavior, p. 94 mixed costs, p. 96 regression analysis, p. 111 step costs, p. 95 visual-fit method, p. 110 Fundamental Assignment Material 3-A1 Types of Cost Behavior Identify the following planned costs as (a) purely variable costs, (b) discretionary fixed costs, (c) committed fixed costs, (d) mixed costs, or (e) step costs. For purely variable costs and mixed costs, indicate the most likely cost driver. 1. Public relations employee compensation to be paid by Intel. 2. Crew supervisor in a Lands' End mail-order house. A new supervisor is added for every 12 workers employed. 3. Sales commissions based on revenue dollars. Payments to be made to advertising salespersons employed by radio station WCCO, Minneapolis. 4. Jet fuel costs of Southwest Airlines. 5. Total costs of renting trucks by the city of Nashville. Charge is a lump sum of $300 per month plus $.20 per mile. 6. Straight-line depreciation on desks in the office of an attorney. 7. Advertising costs, a lump sum, planned by ABC, Inc. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 3: Measurement of Cost Behavior 117 8. Rental payment by the Internal Revenue Service on a five-year lease for office space in a private office building. 9. Advertising allowance granted to wholesalers by 7-Up Bottling on a per-case basis. 10. Compensation of lawyers employed internally by Microsoft. 11. Total repairs and maintenance of a university classroom building. 3-A2 Activity Analysis Evergreen Signs makes customized wooden signs for businesses and residences. These signs are made of wood, which the owner glues and carves by hand or with power tools. After carving the signs, she paints them or applies a natural finish. She has a good sense of her labor and materials cost behavior, but she is concerned that she does not have good measures of other support costs. Currently, she predicts support costs to be 60% of the cost of materials. Close investigation of the business reveals that $40 times the number of power tool operations is a more plausible and reliable support cost relationship. Consider estimated support costs of the following two signs that Evergreen Signs is making: Sign A Materials cost Number of power tool operations Support cost $300 2 ? Sign B $150 6 ? 1. Prepare a report showing the support costs of both signs using each cost driver and showing the differences between the two. 2. What advice would you give Evergreen Signs about predicting support costs? 3-A3 Division of Mixed Costs into Variable and Fixed Components Martina Fernandez, president of Evert Tool Co., has asked for information about the cost behavior of manufacturing support costs. Specifically, she wants to know how much support cost is fixed and how much is variable. The following data are the only records available: Month May June July August September Machine Hours 850 1,300 1,000 1,250 1,750 Support Costs $ 9,000 12,500 7,900 11,400 13,500 1. Find monthly fixed support cost and the variable support cost per machine-hour by the high-low method. 2. Explain how your analysis for requirement 1 would change if new October data were received and machine-hours were 1,700 and support costs were $15,800. 3. A least-squares regression analysis gave the following output: Regression equation: Y = $3,355 + $6.10X What recommendations would you give the president based on these analyses? 3-B1 Identifying Cost Behavior Patterns At a seminar, a cost accountant spoke on identification of different kinds of cost behavior. Tammy Li, a hospital administrator who heard the lecture, identified several hospital costs of concern to her. After her classification, Li presented you with the following list of costs and asked you to (1) classify their behavior as one of the following: variable, step, mixed, discretionary fixed, committed fixed, and (2) to identify a likely cost driver for each variable or mixed cost. 1. 2. 3. 4. 5. 6. 7. 8. Operating costs of X-ray equipment ($95,000 a year plus $3 per film) Health insurance for all full-time employees Costs incurred by Dr. Rath in cancer research Repairs made on hospital furniture Training costs of an administrative resident Straight-line depreciation of operating room equipment Costs of services of King Hospital Consulting Nursing supervisors' salaries (a supervisor is needed for each 45 nursing personnel) ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 118 Part 1: Focus on Decision Making 3-B2 Activity Analysis Nampa Technology, an Idaho manufacturer of printed circuit boards, has always estimated the support cost of its circuit boards with a 100% "markup" over its material costs. An activity analysis suggests that support costs are driven primarily by the number of manual operations performed on each board, estimated at $4 per manual operation. Compute the estimated support costs of two typical circuit boards below using the traditional markup and the activity analysis results: Board Z15 Material cost Manual operations $30.00 16 Board Q52 $55.00 6 Why are the cost estimates different? 3-B3 Division of Mixed Costs into Variable and Fixed Components The president and the controller of Monterrey Transformer Company (Mexico) have agreed that refinement of the company's cost measurements will aid planning and control decisions. They have asked you to measure the function for mixed-cost behavior of repairs and maintenance from the following sparse data. Currency is the Mexican peso (P). Monthly Activity in Machine Hours 8,000 12,000 Monthly Repair and Maintenance Cost P200,000,000 P260,000,000 Additional Assignment Material Questions 3-1 What is a cost driver? Give three examples of costs and their possible cost drivers. 3-13 Why is it important for managers and accountants to measure cost functions? 3-14 Explain plausibility and reliability of cost functions. Which is preferred? Explain. 3-15 What is activity analysis? 3-16 What is engineering analysis? Account analysis? 3-2 Explain linear-cost behavior. 3-3 "Step costs can be fixed or variable, depending on your perspective." Explain. 3-4 Explain how mixed costs are related to both fixed and variable costs. 3-5 How do management's product and service choices affect cost behavior? 3-17 Describe the methods for measuring cost functions using past cost data. 3-6 Why are fixed costs also called capacity costs? 3-18 How could account analysis be combined with engineering analysis? 3-19 Explain the strengths and weaknesses of the high-low and visual-fit methods. 3-7 How do committed fixed costs differ from discretionary fixed costs? 3-20 In the high-low method, does the high and low refer to cost-driver levels or to total cost levels? Explain. 3-8 Why are committed fixed costs the most difficult of the fixed costs to change? 3-9 What are the primary determinants of the level of committed costs? Discretionary costs? 3-10 "Planning is far more important than dayto-day control of discretionary costs." Do you agree? Explain. 3-21 Why is regression analysis usually preferred to the high-low method? 3-11 How can a company's choice of technology affect its costs? 3-12 Explain the use of incentives to control cost. 3-22 "You never know how good your fixedand variable-cost measures are if you use account analysis or if you visually fit a line on a data plot. That's why I like least-squares regression analysis." Explain. 3-23 (Appendix 3) Why should an analyst always plot cost data in addition to applying least-squares regression analysis? ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 3: Measurement of Cost Behavior 119 3-24 (Appendix 3) What can we learn from R2, the coefficient of determination? 3-25 At a conference, a consultant stated, "Before you can control, you must measure." An executive complained, "Why bother to measure when work rules and guaranteed employment provisions in labor contracts prevent discharging workers, using part-time employees, and using overtime?" Evaluate these comments. Critical Thinking Exercises 3-26 Mixed Costs and the Sales Force Wysocki Company pays its sales force a fixed salary plus a 5% commission on all sales. Explain why sales force costs would be considered a mixed cost. 3-27 Committed and Discretionary Fixed Costs in Manufacturing Among the fixed costs of Howarth Company are depreciation and research and development (R&D). Using these two costs as examples, explain the difference between committed and discretionary fixed costs. 3-28 Cost Functions and Decision Making Why is it important that decision makers in a corporation know the cost function for producing the companies' products? 3-29 Statistical Analysis and Cost Functions What advantages does using regression analysis have over the visual-fit method for determining cost functions? Exercises 3-30 Step Costs Which of the following are step costs? Why? a. Rent on a warehouse that is large enough for all anticipated orders. b. Teachers for a private elementary school. One teacher is needed for every 15 students. c. Sheet steel for a producer of machine parts. Steel is purchased in carload shipments, where each carload contains enough steel for 1,000 parts. 3-31 Mixed Costs The following cost function is a mixed cost. Explain why it is a mixed cost and not a fixed, variable, or step cost. Total cost = $5,000 + $45 units produced 3-32 Various Cost-Behavior Patterns In practice, there is often a tendency to simplify approximations of cost-behavior patterns, even though the "true" underlying behavior is not simple. Choose from graphs A through H on the top of page 120, the one that matches the numbered items. Indicate by letter which graph best fits each of the situations described. Next to each number-letter pair, identify a likely cost driver for that cost. The vertical axes of the graphs represent total dollars of costs incurred, and the horizontal axes represent levels of cost driver activity during a particular time period. The graphs may be used more than once. 1. Cost of machining labor that tends to decrease as workers gain experience 2. Price of an increasingly scarce raw material as the quantity used increases 3. Guaranteed annual wage plan, whereby workers get paid for 40 hours of work per week even at zero or low levels of production that require working only a few hours weekly 4. Water bill, which entails a flat fee for the first 10,000 gallons used and then an increasing unit cost for every additional 10,000 gallons used 5. Availability of quantity discounts, where the cost per unit falls as each price break is reached 6. Depreciation of office equipment 7. Cost of sheet steel for a manufacturer of farm implements 8. Salaries of supervisors, where one supervisor is added for every 12 phone solicitors 9. Natural gas bill consisting of a fixed component, plus a constant variable cost per thousand cubic feet after a specified number of cubic feet are used ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 120 Part 1: Focus on Decision Making A B C D E F G H 3-33 Plotting Data The following graph was constructed and data plotted to apply the visual-fit method. Then, the predicted total order-department costs for processing 90 orders was computed. Comment on the accuracy of the analysis. Do your own analysis and explain any differences. Assume the data in parentheses are accurate in thousands of dollars and number of orders. $500 (100, 450) Order Department Costs (Thousands) (20, 280) (10, 240) (40, 240) 200 Fixed cost = 200 50 25 10 20 40 70 80 100 Total cost = 450 so variable cost = 450 200 = 250 or 250/100 orders = 2.50 per order. (80, 420) (70, 320) The total cost function is TC = 200 + 2.50 # Orders Processed Orders Processed TC[90 Orders] = 200,000 + 2.50 90 = $200,225 3-34 Cost Function for Expedia Expedia provides travel services on the Internet. 2002 was an important year for Expedia as it reported positive operating income after three years of operating losses. In the first quarter of 2001, Expedia reported an operating loss of $19 million on sales revenue of $57 million. In the first quarter of 2002, sales revenue had more than doubled to $116 million, and Expedia had operating income of $18 million. Assume that fixed costs were the same in 2002 as in 2001. 1. Compute the operating expenses for Expedia in the first quarter of 2001. In the first quarter of 2002. 2. Determine the cost function for Expedia, that is, the total fixed cost and the variable cost as a percentage of sales revenue. Use the same form as equation (1) on page 100. 3. Explain how Expedia's operating income could increase by $37 million with an increase in sales of $59 million, while it had an operating loss of $19 million on its $57 million of sales in the first quarter of 2001. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 3: Measurement of Cost Behavior 121 3-35 Predicting Costs Given the following four cost behaviors and expected levels of cost-driver activity, predict total costs: 1. Fuel costs of driving vehicles, $0.20 per mile, driven 17,000 miles per month 2. Equipment rental cost, $6,000 per piece of equipment per month for seven pieces for three months 3. Ambulance and EMT personnel cost for a soccer tournament, $1,200 for each 250 tournament participants; the tournament is expecting 2,400 participants 4. Purchasing department cost, $7,500 per month plus $4 per material order processed at 4,000 orders in one month 3-36 Identifying Discretionary and Committed Fixed Costs Identify and compute total discretionary fixed costs and total committed fixed costs from the following list prepared by the accounting supervisor for Huang Building Supply: Advertising Depreciation Health insurance for the company's employees Management salaries Payment on long-term debt Property tax Grounds maintenance Office remodeling Research and development $19,000 47,000 15,000 85,000 50,000 32,000 9,000 21,000 36,000 3-37 Cost Effects of Technology Recreational Sports, an outdoor sports retailer, is planning to add a Web site for online sales. The estimated costs of two alternative approaches are as follows: Alternative 1 Annual fixed cost Variable cost per order Expected number of orders $200,000 $8 70,000 Alternative 2 $400,000 $4 70,000 At the expected level of orders, which online approach has the lower cost? What is the indifference level of orders, or the "break-even" level of orders? What is the meaning of this level of orders? 3-38 Mixed Cost, Choosing Cost Drivers, and High-Low and Visual-Fit Methods Cedar Rapids Implements Company produces farm implements. Cedar Rapids is in the process of measuring its manufacturing costs and is particularly interested in the costs of the manufacturing maintenance activity, since maintenance is a significant mixed cost. Activity analysis indicates that maintenance activity consists primarily of maintenance labor setting up machines using certain supplies. A setup consists of preparing the necessary machines for a particular production run of a product. During setup, machines must still be running, which consumes energy. Thus, the costs associated with maintenance include labor, supplies, and energy. Unfortunately, Cedar Rapid's cost accounting system does not trace these costs to maintenance activity separately. Cedar Rapids employs two fulltime maintenance mechanics to perform maintenance. The annual salary of a maintenance mechanic is $25,000 and is considered a fixed cost. Two plausible cost drivers have been suggested: "units produced" and "number of setups." Data had been collected for the past 12 months and a plot made for the cost driver--units of production. The maintenance cost figures collected include estimates for labor, supplies, and energy. Cory Fielder, controller at Cedar Rapids, noted that some types of activities are performed each time a batch of goods is processed rather than each time a unit is produced. Based on this concept, he has gathered data on the number of setups performed over the past 12 months. The plots of monthly maintenance costs versus the two potential cost drivers follow on page 122. 1. Find monthly fixed maintenance cost and the variable maintenance cost per driver unit using the visual-fit method based on each potential cost driver. Explain how you treated the April data. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 122 Part 1: Focus on Decision Making 2. Find monthly fixed maintenance cost and the variable maintenance cost per driver unit using the high-low method based on each potential cost driver. 3. Which cost driver best meets the criteria for choosing cost functions? Explain. Maintenance Department Costs Cost drivers: Production Units & Setups $30 25 20 15 10 5 0 0 1 2 3 4 Units Produced (Thousands) Plant Closed Three Weeks in April Due to Storm Damage Maintenance Costs (Thousands) Maintenance Costs (Thousands) $30 25 20 15 10 5 0 0 5 10 15 20 25 30 Number of Setups Plant Closed Three Weeks in April Due to Storm Damage 3-39 Account Analysis Custom Computers is a company started by two engineering students to assemble and market personal computers to faculty and students. The company operates out of the garage of one of the students' homes. From the following costs of a recent month, compute the total cost function and total cost for the month: Telephone Utilities Advertising Insurance Materials Labor $ 50, fixed 260: fixed, 25% attributable to the garage, 75% to the house 75, fixed 80, fixed 7,500, variable, for five computers 1,800: $1,300 fixed plus $500 for hourly help for assembling five computers 3-40 Linear Cost Functions Let Y = total costs, X1 = production volume, and X2 = number of setups. Which of the following are linear cost functions? Which are mixed cost functions? ISBN: 0-536-47129-0 a. b. c. d. Y = $1,500 Y = $8X1 Y = $5,000 + $4X1 Y = $3,000 + $6X1 + $30X2 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 3: Measurement of Cost Behavior 123 e. Y = $9,000 + $3(X1 X2) 2 f. Y = $8,500 + $1.50 X 1 3-41 High-Low Method Manchester Foundry produced 45,000 tons of steel in March at a cost of 1,150,000. In April, the foundry produced 35,000 tons at a cost of 950,000. Using only these two data points, determine the cost function for Manchester. 3-42 Economic Plausibility of Regression Analysis Results The head of the Warehousing Division of Lachton Co. was concerned about some cost behavior information given to him by the new assistant controller, who was hired because of his recent training in cost analysis. His first assignment was to apply regression analysis to various costs in the department. One of the results was presented as follows: A regression on monthly data was run to explain building maintenance cost as a function of direct labor hours as the cost driver. The results are Y = $7,810 + $.47X I suggest that we use the building as intensively as possible to keep the maintenance costs down. The department head was puzzled. How could increased use cause decreased maintenance cost? Explain this counterintuitive result to the department head. What step(s) did the assistant controller probably omit in applying and interpreting the regression analysis? Problems 3-43 Controlling Risk, Capacity Decisions, Technology Decisions Consider the earlier discussion of Ford Motor on pages 9798. Ford had been outsourcing production to Mazda and using overtime for as much as 20% of production--Ford's plants and assembly lines were running at 100% of capacity and demand was sufficient for an additional 20%. Ford had considered increasing its capacity by building new, highly automated assembly lines and plants. However, the investment in high technology and capacity expansion was rejected. Assume that all material and labor costs are variable with respect to the level of production and that all other costs are fixed. Consider one of Ford's plants that makes the Mustang model. The increase in annual fixed costs to convert the plant to use fully automated assembly lines is $20 million. The resulting labor costs would be significantly reduced and there would be no need for overtime or outsourced production. The annual costs, in millions of dollars, of the build option and the existing costs that include outsourcing and overtime are given in the tables below: Build Option Percent of current capacity Material costs Labor costs Other costs Total costs 60 $18 6 40 $64 100 $30 10 40 $80 120 $36 12 40 $88 Ford's Existing Costs Using Outsourcing/Overtime Percent of current capacity Material costs Labor costs Other costs Total costs ISBN: 0-536-47129-0 60 $18 18 20 $56 100 $30 30 20 $80 120 $ 36 44 20 $100 1. Prepare a line graph showing total costs for the two options: (a) build new assembly lines, and (b) continue to use overtime and outsource production of Mustangs. Give an explanation of the cost behavior of the two options. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 124 Part 1: Focus on Decision Making 2. Which option enables Ford's management to control risk better? Explain. Assess the cost-benefit trade-offs associated with each option. 3. A solid understanding of cost behavior is an important prerequisite to effective managerial control of costs. Suppose you are an executive at Ford. Currently the production (and sales) level is approaching the 100% level of capacity, and the economy is expected to remain strong for at least one year. While sales and profits are good now, you are aware of the cyclical nature of the automobile business. Would you recommend committing Ford to building automated assembly lines in order to service potential near-term increases in demand, or would you recommend against building, looking to the likely future downturn in business? Discuss your reasoning. 3-44 Step Costs Algona Beach Jail requires a staff of at least one guard for every 4 prisoners. The jail will hold 48 prisoners. Algona Beach attracts numerous tourists and transients in the spring and summer. However, the town is rather sedate in the fall and winter. The jail's fall-winter population is generally between 12 and 16 prisoners. The numbers in the spring and summer can fluctuate from 12 to 48, depending on the weather, among other factors (including phases of the moon, according to some longtime residents). Algona Beach has four permanent guards, hired on a year-round basis at an annual salary of $36,000 each. When additional guards are needed, they are hired on a weekly basis at a rate of $600 per week. (For simplicity, assume that each month has exactly four weeks.) 1. Prepare a graph with the weekly planned cost of jail guards on the vertical axis and the number of prisoners on the horizontal axis. 2. What would be the budgeted amount for jail guards for the month of January? Would this be a fixed or a variable cost? 3. Suppose the jail population of each of the four weeks in July was 25, 38, 26, and 43, respectively. The actual amount paid for jail guards in July was $19,800. Prepare a report comparing the actual amount paid for jail guards with the amount that would be expected with efficient scheduling and hiring. 4. Suppose Algona Beach treated jail-guard salaries for nonpermanent guards as a variable expense of $150 per week per prisoner. This variable cost was applied to the number of prisoners in excess of 16. Therefore, the weekly cost function was Weekly jail-guard cost = $3,000 + $150 (total prisoners - 16) Explain how this cost function was determined. 5. Prepare a report similar to that in requirement 3 except that the cost function in requirement 4 should be used to calculate the expected amount of jail-guard salaries. Which report, this one or the one in requirement 3, is more accurate? Is accuracy the only concern? 3-45 Government Service Cost Analysis Auditors for the Internal Revenue Service (IRS) scrutinize income tax returns after they have been prescreened with the help of computer tests for normal ranges of deductions claimed by taxpayers. The IRS uses an expected cost of $7 per tax return, based on measurement studies that allow 20 minutes per return. Each agent has a workweek of 5 days of 8 hours per day. Twenty auditors are employed at a salary of $830 each per week. The audit supervisor has the following data regarding performance for the most recent 4-week period, when 8,000 returns were processed: Actual Cost of Auditors $66,400 Expected Cost for Processing Returns ? Difference or Variance ? 1. Compute the planned cost and the variance. 2. The supervisor believes that audit work should be conducted more productively and that superfluous personnel should be transferred to field audits. If the foregoing data are representative, how many auditors should be transferred? 3. List some possible reasons for the variance. 4. Describe some alternative cost drivers for processing income tax returns. ISBN: 0-536-47129-0 3-46 Cost Analysis at US Airways US Airways is one of the nation's leading commercial air carriers, with hubs in Phoenix and Las Vegas. Listed below are some of the costs incurred by US Airways. For each cost, select an appropri- Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 3: Measurement of Cost Behavior 125 ate cost driver and indicate whether the cost is likely to be fixed, variable, or mixed in relation to your cost driver. a. b. c. d. e. f. g. Airplane fuel Flight attendants' salaries Baggage handlers' salaries In-flight meals Pilots' salaries Airplane depreciation Advertising 3-47 Separation of Drug Testing Laboratory Mixed Costs into Variable and Fixed Components A staff meeting has been called at SportsLab, a drug-testing facility retained by several professional and college sports leagues and associations. The chief of testing, Dr. Hyde, has demanded an acrossthe-board increase in prices for a particular test because of the increased testing and precision that are now required. The administrator of the laboratory has asked you to measure the mixed-cost behavior of this particular testing department and to prepare a short report she can present to Dr. Hyde. Consider the following limited data: Average Test Procedures per Month Monthly averages, 20X6 Monthly averages, 20X7 Monthly averages, 20X8 500 600 700 Average Monthly Cost of Test Procedures $ 60,000 70,000 144,000 3-48 University Cost Behavior Lakeview School, a private high school, is preparing a planned income statement for the coming academic year ending August 31, 20X7. Tuition revenues for the past 2 years ending August 31 were 20X6: $820,000, and 20X5: $870,000. Total expenses for 20X6 were $810,000 and in 20X5 were $830,000. No tuition rate changes occurred in 20X5 or 20X6, nor are any expected to occur in 20X7. Tuition revenue is expected to be $810,000 for 20X7. What net income should be planned for 20X7, assuming that the implied cost behavior remains unchanged? 3-49 Activity Analysis Des Moines Software develops and markets computer software for the agriculture industry. Because support costs are a large portion of the cost of software development, the director of cost operations of Des Moines, Leslie Paton, is especially concerned with understanding the effects of support cost behavior. Paton has completed a preliminary activity analysis of one of Des Moines's primary software products: FertiMix (software to manage fertilizer mixing). This product is a software template that is customized for specific customers, who are charged for the basic product plus customizing costs. The activity analysis is based on the number of customized lines of FertiMix code. Currently, support cost estimates are based on a fixed rate of 50% of the basic cost. Data are shown for 2 recent customers: Customer West Acres Plants Basic cost of FertiMix Lines of customized code Estimated cost per line of customized code ISBN: 0-536-47129-0 Beautiful Blooms $13,000 180 $22 $13,000 490 $22 1. Compute the support cost of customizing FertiMix for each customer using each cost-estimating approach. 2. If the activity analysis is reliable, what are the pros and cons of adopting it for all Des Moines's software products? Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 126 Part 1: Focus on Decision Making 3-50 High-Low, Regression Analysis On November 15, 2007, Sandra Cook, a newly hired cost analyst at Demgren Company, was asked to predict overhead costs for the company's operations in 2008, when 510 units are expected to be produced. She collected the following quarterly data: Production in Units 76 79 72 136 125 128 125 133 124 129 115 84 84 122 90 Overhead Costs $ 721 715 655 1,131 1,001 1,111 1,119 1,042 997 1,066 996 957 835 1,050 991 Quarter 1/04 2/04 3/04 4/04 1/05 2/05 3/05 4/05 1/06 2/06 3/06 4/06 1/07 2/07 3/07 1. Using the high-low method to estimate costs, prepare a prediction of overhead costs for 2008. 2. Sandy ran a regression analysis using the data she collected. The result was Y = $337 + $5.75X Using this cost function, predict overhead costs for 2008. 3. Which prediction do you prefer? Why? 3-51 Interpretation of Regression Analysis Study Appendix 3. The Tent Division of Arizona Outdoor Equipment Company has had difficulty controlling its use of supplies. The company has traditionally regarded supplies as a purely variable cost. Nearly every time production was above average, however, the division spent less than predicted for supplies; when production was below average, the division spent more than predicted. This pattern suggested to Yuki Li, the new controller, that part of the supplies cost was probably not related to production volume, or was fixed. She decided to use regression analysis to explore this issue. After consulting with production personnel, she considered 2 cost drivers for supplies cost: (1) number of tents produced, and (2) square feet of material used. She obtained the following results based on monthly data. Cost Driver Number of Tents Constant Variable coefficient R2 2,300 .033 .220 Square Feet of Material Used 1,900 .072 .686 1. Which is the preferred cost function? Explain. 2. What percentage of the fluctuation of supplies cost depends on square feet of materials? Do fluctuations in supplies cost depend on anything other than square feet of materials? What proportion of the fluctuations is not explained by square feet of materials? 3-52 Regression Analysis ISBN: 0-536-47129-0 Study Appendix 3. Mr. Liao, CEO of a manufacturer of fine china and stoneware, is troubled by fluctuations in productivity and wants to compute how manufacturing support costs are related to the various sizes of batches of output. The following data show the results of a random sample of 10 batches of one pattern of stoneware: Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 3: Measurement of Cost Behavior 127 Sample 1 2 3 4 5 6 7 8 9 10 Batch Size, X 15 12 20 17 12 25 22 9 18 30 Support Costs, Y $180 140 230 190 160 300 270 110 240 320 1. 2. 3. 4. Plot support costs, Y, versus batch size, X. Using regression analysis, measure the cost function of support costs and batch size. Predict the support costs for a batch size of 25. Using the high-low method, repeat requirements 2 and 3. Should the manager use the high-low or regression method? Explain. 3-53 Choice of Cost Driver Study Appendix 3. Richard Ellis, the director of cost operations of American Micro Devices, wishes to develop an accurate cost function to explain and predict support costs in the company's printed circuit board assembly operation. Mr. Ellis is concerned that the cost function that he currently uses-- based on direct labor costs--is not accurate enough for proper planning and control of support costs. Mr. Ellis directed one of his financial analysts to obtain a random sample of 25 weeks of support costs and three possible cost drivers in the circuit-board assembly department: direct labor hours, number of boards assembled, and average cycle time of boards assembled. (Average cycle time is the average time between start and certified completion--after quality testing--of boards assembled during a week.) Much of the effort in this assembly operation is devoted to testing for quality and reworking defective boards, all of which increase the average cycle time in any period. Therefore, Mr. Ellis believes that average cycle time will be the best support cost driver. Mr. Ellis wants his analyst to use regression analysis to demonstrate which cost driver best explains support costs. Circuit Board Assembly Support Costs, Y $66,402 56,943 60,337 50,096 64,241 60,846 43,119 63,412 59,283 60,070 53,345 65,027 58,220 65,406 35,268 46,394 71,877 61,903 50,009 49,327 44,703 45,582 43,818 62,122 52,403 Direct Labor Hours, X1 7,619 7,678 7,816 7,659 7,646 7,765 7,685 7,962 7,793 7,732 7,771 7,842 7,940 7,750 7,954 7,768 7,764 7,635 7,849 7,869 7,576 7,557 7,569 7,672 7,653 Number of Boards Completed, X2 2,983 2,830 2,413 2,221 2,701 2,656 2,495 2,128 2,127 2,127 2,338 2,685 2,602 2,029 2,136 2,046 2,786 2,822 2,178 2,244 2,195 2,370 2,016 2,515 2,942 Average Cycle Time (Hours), X3 186.44 139.14 151.13 138.30 158.63 148.71 105.85 174.02 155.30 162.20 142.97 176.08 150.19 194.06 100.51 137.47 197.44 164.69 141.95 123.37 128.25 106.16 131.41 154.88 140.07 Week 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 128 Part 1: Focus on Decision Making 1. Plot support costs, Y, versus each of the possible cost drivers, X1, X2, and X3. 2. Use regression analysis to measure cost functions using each of the cost drivers. 3. According to the criteria of plausibility and reliability, which is the best cost driver for support costs in the circuit board assembly department? 4. Interpret the economic meaning of the best cost function. 3-54 Use of Cost Functions for Pricing Study Appendix 3. Read the previous problem. If you worked this problem, use your measured cost functions. If you did not work the previous problem, assume the following measured cost functions: Y = $9,000/week + ($6 direct labor hours); R 2 = .1 0 1 Y = $20,000/week + ($14 number of boards comp leted); R 2 = .40 p Y = $5,000/week + ($350 average cycle time); R 2 = .80 1. Which of the support cost functions would you expect to be the most reliable for explaining and predicting support costs? Why? 2. Assume that American Micro Devices prices its products by adding a percentage markup to its product costs. Product costs include assembly labor, components, and support costs. Using each of the cost functions, compute the circuit board portion of the support cost of an order that used the following resources: a. b. c. d. Effectively used the capacity of the assembly department for three weeks Assembly labor hours: 20,000 Number of boards: 6,000 Average cycle time: 180 hours 3. Which cost driver would you recommend that American Micro Devices use? Why? 4. Assume that the market for this product is extremely cost competitive. What do you think of American Micro Devices's pricing method? 3-55 Review of Chapters 2 and 3 Madison Musical Education Company (MME) provides instrumental music education to children of all ages. Payment for services comes from 2 sources: (1) a contract with Country Day School to provide private music lessons for up to 150 band students a year (where a year is 9 months of education) for a fixed fee of $150,000, and (2) payment from individuals at a rate of $100 per month for 9 months of education each year. In the 20032004 school year, MME made a profit of $5,000 on revenues of $295,000: Revenues: Country Day School contract Private students Total revenues Expenses: Administrative staff Teaching staff Facilities Supplies Total expenses Profit $150,000 145,000 $295,000 $ 75,000 81,000 93,500 40,500 290,000 $ 5,000 MME conducted an activity analysis and found that teaching staff wages and supplies costs are variable with respect to student-months. (A student-month is one student educated for one month.) Administrative staff and facilities costs are fixed within the range of 2,000 to 3,000 student-months. At volumes between 3,000 and 3,500 student-months, an additional facilities charge of $8,000 would be incurred. During the last year, a total of 2,700 student-months of education were provided, 1,450 of which were for private students and 1,250 of which were offered under the contract with Country Day School. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 3: Measurement of Cost Behavior 129 1. Compute the following using cost information from year 20032004 operations: Fixed cost per year Variable cost per student-month 2. Suppose that in 20042005 Country Day School decreased its use of MME to 120 students (that is, 1,080 student-months). The fixed contract price of $150,000 was still paid. If everything else stayed as it was in 20032004, what profit or loss would be made in 20042005? 3. Suppose that at the beginning of 20042005 Country Day School decided not to renew its contract with MME, and the management of MME decided to try to maintain business as usual with only private students. How many students (each signing up for 9 months) would MME require to continue to make a profit of $5,000 per year? Cases 3-56 Government Health Cost Behavior Dr. Stephanie White, the chief administrator of Uptown Clinic, a community mental health agency, is concerned about the dilemma of coping with reduced budgets in the next year and into the foreseeable future, despite increasing demand for services. In order to plan for reduced budgets, she first must identify where costs can be cut or reduced and still keep the agency functioning. Below are some data from the past year: Program Area Administration Salaries Administrator Assistant Two secretaries Supplies Advertising and promotion Professional meetings, dues, and literature Purchased services Accounting and billing Custodial and maintenance Security Consulting Community mental health services Salaries (two social workers) Transportation Outpatient mental health treatment Salaries Psychiatrist Two social workers Costs $60,000 35,000 42,000 35,000 9,000 14,000 15,000 13,000 12,000 10,000 46,000 10,000 86,000 70,000 1. Identify which costs you think are likely to be discretionary or committed costs. 2. One possibility is to eliminate all discretionary costs. How much would be saved? What do you think of this recommendation? 3. How would you advise Dr. White to prepare for reduced budgets? 3-57 Activity Analysis The costs of the Systems Support (SS) department (and other service departments) of Southeast Pulp and Paper have always been charged to the three business divisions (Forest Management, Lumber Products, and Paper Products) based on the number of employees in each division. This measure is easy to obtain and update, and until recently none of the divisions had complained about the charges. The Paper Products division has recently automated many of its operations and has reduced the number of its employees. At the same time, however, to monitor its new process, Paper Products has increased its requests for various reports provided by the SS department. The other divisions have begun to complain that they are being charged more than their fair share of SS department costs. Based on activity analysis of possible cost drivers, cost analysts have suggested using the number of reports prepared as a means of charging for SS costs and have gathered the following information: ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 130 Part 1: Focus on Decision Making Forest Management 2006 number of employees 2006 number of reports 2006 SS costs: $300,000 2007 number of employees 2007 number of reports 2007 SS costs: $385,000 762 410 751 412 Lumber Products 457 445 413 432 Paper Products 502 377 131 712 1. Discuss the plausibility and probable reliability of each of the cost drivers--number of employees or number of reports. 2. What are the 2006 and 2007 SS costs per unit of cost driver for each division using each cost driver? Do the Forest Management and Lumber Products divisions have legitimate complaints? Explain. 3. What are the incentives that are implied by each cost driver? 4. Which cost driver should Southeast Pulp and Paper use to charge its divisions for SS services? For other services? Why? 3-58 Identifying Relevant Data eComp.com manufactures personal digital assistants (PDAs). Because these very small computers compete with laptops that have more functions and flexibility, understanding and using cost behavior is very critical to eComp.com's profitability. eComp.com's controller, Kelly Hudson, has kept meticulous files on various cost categories and possible cost drivers for most of the important functions and activities of eComp.com. Because most of the manufacturing at eComp.com is automated, labor cost is relatively fixed. Other support costs comprise most of eComp.com's costs. Partial data that Hudson has collected over the past 25 weeks on one of these support costs, logistics operations (materials purchasing, receiving, warehousing, and shipping), follow: Logistics Costs, Y $23,907 18,265 24,208 23,578 22,211 22,862 23,303 24,507 17,878 18,306 20,807 19,707 23,020 20,407 20,370 20,678 21,145 20,775 20,532 20,659 20,430 20,713 20,256 21,196 20,406 Number of Orders, X 1,357 1,077 1,383 1,486 1,292 1,425 1,306 1,373 1,031 1,020 1,097 1,069 1,444 733 413 633 711 228 488 655 722 373 391 734 256 ISBN: 0-536-47129-0 Week 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 1. Plot logistics costs, Y, versus number of orders, X. What cost behavior is evident? What do you think happened in week 14? 2. What is your recommendation to Kelly Hudson regarding the relevance of the past 25 weeks of logistics costs and number of orders for measuring logistics cost behavior? Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 3: Measurement of Cost Behavior 131 3. Hudson remarks that one of the improvements that eComp.com has made in the past several months was to negotiate JIT deliveries from its suppliers. This was made possible by substituting an automated ordering system for the previous manual (labor-intensive) system. Although fixed costs increased, the variable cost of placing an order was expected to drop greatly. Do the data support this expectation? Do you believe that the change to the automated ordering system was justified? Why or why not? Nike 10-K Problem 3-59 Step- and Mixed Costs and Cost Drivers Refer to Nike's 10-K in Appendix C and "Item 1. Business." Nike's contract manufacturers make the vast majority of Nike's footwear. Assume these costs are variable to Nike. Nike's largest fixed costs are associated with its distribution system. Consider one of Nike's three distribution and customer service facilities in the United States. List several examples of step-fixed costs and mixed costs at these centers. For each of the following activities at a distribution center, list one plausible cost driver. 1. 2. 3. 4. 5. 6. Receiving activity Unpacking incoming cases of footwear Picking and packing cases of footwear for shipment to retail accounts Processing orders from retail accounts Providing customer service to retail accounts Processing order changes from retail accounts EXCEL Application Exercise 3-60 Fixed and Variable Cost Data Goal: Create an Excel spreadsheet to calculate fixed and variable cost data for evaluating alternative approaches. Use the results to answer questions about your findings. Scenario: Recreational Sports has asked you to evaluate two alternative cost approaches for their new Web site. They would like you to calculate fixed and variable costs at different numbers of orders. The background data for your analysis appear in exercise 337. When you have completed your spreadsheet, answer the following questions: 1. At what number of orders are the Total Costs for the two approaches the same? What does this mean? 2. Which alternative should be selected if the expected number of orders is less than the break-even level of orders? If the expected number of orders is greater than the breakeven level of orders? 3. What conclusion regarding cost predictions can be drawn from your analysis? Step-by-Step: 1. Open a new Excel spreadsheet. 2. In column A, create a bold-faced heading that contains the following: Row 1: Chapter 3 Decision Guideline Row 2: Recreational Sports Row 3: Analysis of Alternative Cost Approaches Row 4: Today's Date 3. Merge and center the four heading rows across columns A through K. 4. In row 7, create the following bold-faced, right-justified column headings: Column A: Number of Orders Column B: Alternative 1 Column C: Alternative 2 Note: Adjust column widths as necessary. ISBN: 0-536-47129-0 5. In column A, Rows 8 through 12, enter order levels from 40,000 to 80,000 in 10,000unit increments. 6. Use the Scenario data to create formulas in columns B and C for calculating the total costs (fixed plus variable costs) for each alternative at the order level in column A. 7. Format all amounts as Number tab: Category: Decimal places: Use 1000 Separator (,): Number 0 Checked Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 132 Part 1: Focus on Decision Making 8. Modify the Page Setup by selecting File, Page Setup. Page tab: Margins tab: Orientation: Top: Bottom: Landscape .5 .5 9. Select the data in columns A through C, Rows 7 through 12, and start the Chart Wizard either by inserting a chart (Insert, Chart) or by clicking the Chart Wizard icon on the toolbar. Step 1 of 4--Chart Type a. Custom Types tab: b. Chart Type: c. Click "Next >" button Note: List is alphabetical. Smooth Lines Step 2 of 4--Chart Source Data d. Data Range tab: e. Modify Data range to: =SheetName!$B$7:$C$12 f. Series in: Columns g. Series tab: h. Category (X) axis labels: =SheetName!$A$8:$A$12 i. Click "Next >" button Step 3 of 4--Chart Options j. Titles tab: k. Chart Title: l. Category (X) axis: m. Value (Y) axis: n. Gridlines tab: o. Category (X) axis: p. Value (Y) axis: q. Click "Next >" button Analysis of Alternative Cost Approaches Number of Orders Total Costs Major Gridlines (checked) Major Gridlines (checked) Step 4 of 4--Chart Location r. As object in SheetName Checked s. Click "Finish" button 10. Move the chart so the upper-left corner is on the left margin, row 14. Left-mouse click the upper-left handle and drag it to the designated location. 11. Resize the chart so the lower-right corner fills cell K37. Left-mouse click the lower-right handle and drag it to the designated location. 12. Format the Y-axis amounts (Total Costs) to display a dollar symbol by doing the following: Double-click any cost amount on the Y-axis to open the "Format Axis" dialog box. Scale tab: Number tab: Minimum: Category: Decimal Places: Symbol: 300,000 Currency 0 $ 4. Save your work to disk, and print a copy for your files. Note: Select cell A8 before printing if you want both the data and the chart to print. If you want only the chart to print, ignore the "Select cell A8" instruction. Print your spreadsheet using landscape in order to ensure that all columns appear on one page. Collaborative Learning Exercise 3-61 Cost-Behavior Examples Select about 10 students to participate in a "cost-behavior bee." The game proceeds like a spelling bee--when a participant is unable to come up with a correct answer, he or she is eliminated from the game. The last one in the game is the winner. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 3: Measurement of Cost Behavior 133 The object of the game is to identify a type of cost that fits a particular cost-behavior pattern. The first player rolls a die.2 If a 1 or a 6 comes up, the die passes to the next player (and the roller makes it to the next round). If a 2, 3, 4, or 5 comes up, the player has to identify one of the following types of costs: If a 2 is rolled, identify a variable cost. If a 3 is rolled, identify a fixed cost. If a 4 is rolled, identify a mixed cost. If a 5 is rolled, identify a step cost. A scribe should label four columns on the board, one for each type of cost, and list the costs that are mentioned for each category. Once a particular cost has been used, it cannot be used again. Each player has a time limit of 10 seconds to produce an example. (For a tougher game, make the time limit 5 seconds.) The instructor is the referee, judging if a particular example is acceptable. It is legitimate for the referee to ask a player to explain why he or she thinks the cost mentioned fits the category before making a judgment. After each player has had a turn, a second round begins with the remaining players taking a turn in the same order as in the first round. The game continues through additional rounds until all but one player has failed to give an acceptable answer within the time limit. The remaining player is the winner. Internet Exercise 3-62. Cost Behavior at Southwest Airlines In this exercise, we will look at some costs and see if we can determine the type of behavior associated with those costs. While firms are concerned about trying to label costs as either variable or fixed to help in planning, very few costs are completely variable or fixed. The information provided by firms to external users also often precludes a user from determining specifics about the cost behaviors-- they don't want to give the competitors too much information! Log on to the Southwest Airlines Web site at www.iflyswa.com. Click on the information icon "About Southwest," and then click on "Investor Relations." This will take you to the site where you can then access the financial information. 1. Click on the "Annual Reports" icon and then select the most recent annual report. Looking at the table of contents, find the page where the 10-year summary starts. Go to this section of the report. What type of information do you find there? 2. When you look at the operating revenue information, what do you see? Look at the information provided concerning operating expenses. Is it categorized in the same manner as the revenues? If the information is not in the same categories, why do you think Southwest did not match it up in the same manner? 3. Now look at the section on consolidated operating statistics. Southwest measures activity in Revenue Passenger Miles (RPMs) and capacity in Available Seat Miles (ASMs). Which of these is larger? How are the RPM and ASM determined? Is it possible for the two numbers to be the same? What information is provided for each of these items in the consolidated operating statistics section? 4. Compute the total operating expense per RPM. 5. Using data from the most recent year and 3 years earlier, use the high-low method to compute the variable operating expense per RPM. Compare the total operating expense per RPM and the variable expense per RPM. Is this relationship what you expected? Why or why not? 6. Airlines are often considered to be high-fixed-cost companies. Is this consistent with your findings in requirement 5? Explain why the high-low method over this time might overestimate the amount of variable costs. ISBN: 0-536-47129-0 2Instead of rolling a die, players could draw one of the four cost categories out of a hat (or similar container) or from a deck of four 3 5 cards. This eliminates the chance element that can let some players proceed to a later round without having to give an example of a particular cost behavior. However, the chance element can add to the enjoyment of the game. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Cost Management Systems and Activity-Based Costing C H A P T E R LEARNING OBJECTIVES When you have finished studying this chapter, you should be able to: 1. Describe the purposes of cost management systems. 2. Explain the relationship among cost, cost object, cost accumulation, and cost assignment. 3. Distinguish between direct and indirect costs. 4. Explain the major reasons for allocating costs. 5. Identify the main types of manufacturing costs: direct materials, direct labor, and indirect production costs. 6. Explain how the financial statements of merchandisers and manufacturers differ because of the types of goods they sell. 7. Understand the main differences between traditional and activity-based costing (ABC) systems and why ABC systems provide value to managers. 8. Use activity-based management (ABM) to make strategic and operational control decisions. 9. Describe the steps in designing an activity-based costing system (Appendix 4). ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. AT & T Until the early 1980s, AT&T dominated the telecommunications industry. A survey at that time asked 1,000 adults for their choice of a "really good company." The company named most often was AT&T. However, the following years were not good to AT&T as it struggled to compete in a rapidly changing industry. Revenues peaked in 2000 and fell to under $45 billion by 2005. However, through a series of strategic moves, AT&T is again emerging as a major force in the telecommunications industry. In the last couple decades, AT&T has had to reinvent itself to remain competitive. The old AT&T provided local and long-distance phone service. Today, we communicate using wireless cell phones and voice-over-Internet, we communicate more data than voice, and a variety of companies have come and gone in the telecommunications industry. While AT&T no longer dominates the industry, it has survived by undertaking three major reorganizations and finally, in 2006, merging with SBC Communications and then acquiring BellSouth. The restructured company calls itself AT&T and is again the largest telecommunications company in the country. However, it is far different from the phone company we knew 30 years ago. How has AT&T managed to change as the telecommunications marketplace evolved? The company began with people, technology, brand, market presence, and financial strength--which proved to be both a blessing and a curse. The combination of these resources that was successful in the past no longer provided AT&T with a competitive edge. Managers have had to mold these resources into new forms to meet the challenge posed by smaller but more nimble competitors. Like any other AT&T Wireless Services customers can use their cell phones in more than 5,500 locations across the United States and Canada, as well as in Europe, Asia, and Australia. People are able to call cell phone users nearly anywhere on earth by dialing the recipient's local wireless number. It is important to AT&T Wireless managers to know the cost of serving its customers. ISBN: 0-536-47129-0 135 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 136 Part 1: Focus on Decision Making company, AT&T's managers, from top executives to local service managers, must understand their customers, their competitors, and their costs. This understanding is a common theme among all successful businesses. Understanding the costs of products and services is especially crucial in highly competitive industries. As new companies emerged to provide innovative telecommunications services and as global competition infringed on AT&T's traditional business, managers needed better information about the costs of products and services. Consider AT&T's Business Communication Services (BCS) unit. BCS was responsible for domestic and international voice and data communications services. To keep the unit's competitive edge, management began using a new cost accounting system. The old system gathered mainly financial data useful to top management and accountants. It provided little useful data to line managers. The new cost accounting system at BCS focused on measuring the costs of the key business processes in the BCS and the costs of the activities that the unit performs to support its various services. Like all good cost accounting systems, it gave managers the information they needed to make decisions about products, services, and customers that would allow AT&T to remain competitive. Cost Management Systems O B J E C T I V E Describe the purposes of cost management systems. cost management system (CMS) A collection of tools and techniques that identify how management's decisions affect costs. 1 To support managers' decisions, accountants go beyond simply determining the cost of products and services; they develop cost management systems. A cost management system (CMS) is a collection of tools and techniques that identify how management's decisions affect costs. A cost management system provides 1. cost information for strategic management decisions, 2. cost information for operational control, and 3. measures of inventory value and cost of goods sold for financial reporting to investors, creditors, and other external stakeholders. Both external parties, such as investors and creditors, and internal managers use cost information. External users need aggregate measures of inventory value and the cost of goods sold. In contrast, managers need more detailed cost information on individual products or services for strategic and operational decisions. The management uses of information drive the need for sophisticated cost management systems. Managers need accurate and timely cost information for strategic reasons, such as deciding on the optimal product and customer mix, choosing the value-chain functions to receive special focus or to outsource, and making investment decisions. For these decisions, managers want to know the costs of individual products, services, customers, and processes associated with value-chain functions. For example, until the last decade or so, AT&T focused primarily on one product--long-distance voice service. Management realized that increased competition and new calling alternatives such as wireless, online chat, and e-mail would result in declining revenue. So, from 1998 to 2001, AT&T invested more than $35 billion to expand its core products and to transform AT&T from a domestic longdistance company to a global communications and information services company. To make this strategic decision, AT&T management needed detailed information concerning the costs of the various new services. Managers must also strive for efficiency by controlling costs. To assess process improvement efforts and other operational cost control programs, managers need accurate and timely feedback on costs. Consider the billing center at AT&T Business Communication Services. The accounting system reported the costs of various activities performed in the center, including the costs of investigating incorrect bills. The cost was so high that BCS managers started a process improvement program to reduce the number of incorrect bills. The result was annual cost savings of about $500,000. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 4: Cost Management Systems and Activity-Based Costing 137 Often, companies make strategic and operational control decisions simultaneously. AT&T made the strategic decision to change from a traditional paper-based system of billing customers to e-billing. It made this decision primarily to serve its customers better (faster)--a strategic decision. Yet, this change also had a dramatic effect on AT&T's costs. With a paper-based billing system, some large corporate customers received more than 17,000 pages in invoices over the course of a year. Paper and postage accounted for nearly 75% of the cost of billing. AT&T's strategic decision to change how it billed customers also helped the company meet its environmental impact goals. In total, AT&T saves 3,000,000 sheets of paper each year--equivalent to 260 trees and 6,000 gallons of oil! Throughout this text, we describe many CMS tools and techniques that help managers make decisions. Examples are the contribution margin technique and cost-volume-profit analysis from Chapter 2. The usefulness of a report that lists the contribution margins for the products of AT&T depends on the accuracy of the cost data that it uses. Clearly, inaccurate cost data could lead AT&T managers to make incorrect decisions. This chapter focuses on cost accounting, that part of the cost management system that measures costs for the purposes of management decision making and financial reporting. Cost Accounting Systems We define cost as a sacrifice or giving up of resources for a particular purpose. Consider the cost of labor resources. An organization pays (gives up) cash or its equivalent to employees in exchange for their work. We measure the cost of labor resources by the monetary units (for example, dollars, yen, or euros) paid to obtain the labor resources. However, managers generally want more from their accountants than simply the cost of the resources used. They often want to know the cost of something in particular, such as a product or a service. Anything for which decision makers desire a separate measurement of costs is a cost object (or cost objective). Although managers most often want to know the cost of a product or service, there are many other possible cost objects. Examples include customers, departments, territories, and activities such as processing orders or moving materials. For example, one large manufacturer of pet food products recently changed its cost management system to report both the cost of products it makes and the cost to serve the company's major retail customers such as Wal-Mart and PETCO. It discovered that all its products were profitable, but the cost to sell to and service some customers was greater than the profit margin on the products sold to these customers. Knowing this, the company was able to develop a strategy to improve the profitability of these customers. The cost data that managers use for decision making come from the cost accounting system--the techniques used to determine the cost of a product, service, customer, or other cost object. The cost accounting system is the most fundamental component of a cost management system. It supports all other cost management system tools and techniques. Cost accounting systems need to provide accurate and timely cost information to help managers make decisions. Without accurate and timely cost information, many decisions can be downright harmful. For example, a large U.S. grocery chain, A&P, ran into profit difficulties and began retrenching by closing many stores. Management's lack of adequate cost information about individual store operations made the closing program a hit-or-miss affair. A news story reported the following: Because of the absence of detailed profit-and-loss statements, and a [cost accounting] system that did not reflect true costs, A&P's strategists could not be sure whether an individual store was really unprofitable. For example, distribution costs were shared equally among all the stores in a marketing area without regard to such factors as a store's distance from the warehouse. Says one close observer of the company: "When they wanted to close a store, they had to wing it. They could not make rational decisions, because they did not have a fact basis." cost accounting That part of the cost management system that measures costs for the purposes of management decision making and financial reporting. cost A sacrifice or giving up of resources for a particular purpose. cost object (cost objective) Anything for which decision makers desire a separate measurement of costs. Examples include departments, products, activities, and territories. cost accounting systems The techniques used to determine the cost of a product, service, customer, or other cost object. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 138 Part 1: Focus on Decision Making All kinds of organizations--manufacturing firms, service companies, and nonprofit organizations--need some form of cost accounting. Managers rely on accountants to design a cost accounting system that measures costs to meet each of the three purposes of a CMS. Consider the following commentaries on the modern role of management accountants and cost accounting systems. We (management accountants) have to understand what the numbers mean, relate the numbers to business activity, and recommend alternative courses of action. Finally, we have to evaluate alternatives and make decisions to maximize business efficiency. --South Central Bell Because the [cost accounting] system now mirrors the manufacturing process, the engineers and production staff believe the cost data produced by the cost accounting system. Engineering and production regularly ask accounting to help find the product design combination that will optimize costs. . . . The accountants now participate in product design decisions. They help engineering and production understand how costs behave. . . . The system makes the professional lives of the accountants more rewarding. --Hewlett-Packard Company The cost accounting system typically includes two processes: cost accumulation Collecting costs by some natural classification, such as activities performed, labor, or materials. cost assignment Attaching costs to one or more cost objects, such as activities, departments, customers, or products. 1. Cost accumulation: Collecting costs by some "natural" classification, such as materials or labor, or by activities performed such as order processing or machine processing. 2. Cost assignment: Attaching costs to one or more cost objects, such as activities, processes, departments, customers, or products. Exhibit 4-1 is a simple illustration of these two basic processes for materials costs. First, the system collects the costs of all materials. Then, it assigns these costs to the departments that use the materials and further to the specific activities performed in these departments. Last, the system assigns the accumulated costs to the products made--cabinets, tables, and desks. The total materials cost of a particular product is the sum of the materials costs assigned to it in the various departments. For example, the cost of a finished desk would include the following materials costs: Metal top, sides, and legs produced by the various activities in the machining department Bolts, brackets, screws, drawers, handles, and knobs pieced together by finishing department activities A company's cost accounting system can have a great influence on managers' decisions. Any manager who makes a decision based on financial data relies on the accuracy of the cost accounting system. In today's business environment, characterized by highlycompetitive global markets and complex production processes, designing cost accounting systems that provide accurate and useful information is a key success factor for all types of organizations. The financial vice president of a major manufacturing firm recently told one of the authors that the company's main competitive advantage was its financial information system, not its manufacturing or distribution capabilities. This chapter describes some major types of cost accounting systems. However, before describing the systems, we need to develop an understanding of the various cost terms that managers and accountants commonly use. O B J E C T I V E Explain the relationship among cost, cost object, cost accumulation, and cost assignment. 2 ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 4: Cost Management Systems and Activity-Based Costing 139 Exhibit 4-1 Cost Accumulation Material Costs (e.g., Metals) Cost Accumulation and Assignment Cost Assignment to Cost Objects 1. Departments* 2. Activities ACTIVITY ACTIVITY ACTIVITY ACTIVITY MACHINING DEPARTMENT ACTIVITY ACTIVITY FINISHING DEPARTMENT ACTIVITY ACTIVITY CABINETS CABINETS 3. Products DESKS DESKS TABLES TABLES *Purpose: to evaluate performance of manufacturing departments. Purpose: to measure and evaluate the efficiency of various activities Purpose: to obtain costs of various products for valuing inventory, determining income, and judging product profitability. Cost Terms Used for Strategic Decision Making and Operational Control Purposes Accountants seem to have their own language laced with jargon. As a manager, you will need to understand the basics of this language. This section focuses on three terms that are crucial to understanding cost accounting systems and the cost measures they produce: direct costs, indirect costs, and cost allocation. Direct Costs, Indirect Costs, and Cost Allocation A major characteristic of a cost is its relationship to a particular cost object. The most basic classification of a cost is whether it is direct or indirect with respect to a particular cost object. Accountants can identify direct costs specifically and exclusively with a given cost object in an economically feasible way. Parts and materials included in a product are the most common types of direct cost. For example, to determine the cost of parts assembled into a Dell laptop computer, Dell's accountants simply look at the purchase orders for the specific parts used. A key characteristic of direct costs is that accountants can physically identify the amount of the cost that relates exclusively to a particular cost object. We often call this tracing the direct cost to the cost object. In contrast, for indirect costs, accountants cannot specifically and exclusively identify the amount of cost related to a given cost object in an economically feasible way. Examples of indirect costs include facilities rental costs, depreciation on equipment, and many staff salaries. Consider whether the cost of labor is direct or indirect to the products being made. Some employees work specifically on particular products. Their costs are direct to those products because accountants can trace the costs to the products. Others, such as supervisors, general managers, accountants, and legal staff, do not work on individual products. Because accountants cannot trace their costs to the products, they are indirect costs. A O B J E C T I V E Distinguish between direct and indirect costs. direct costs Costs that accountants can identify specifically and exclusively with a given cost object in an economically feasible way. tracing Physically identifying the amount of a direct cost that relates exclusively to a particular cost object. indirect costs Costs that accountants cannot identify specifically and exclusively with a given cost object in an economically feasible way. 3 ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 140 Part 1: Focus on Decision Making cost allocation Assigning indirect costs to cost objects in proportion to the cost object's use of a particular cost-allocation base. cost-allocation base A measure of input or output that determines the amount of cost to be allocated to a particular cost object. An ideal costallocation base would measure how much of the particular cost is caused by the cost object. century ago, a large proportion of labor costs were direct. Why? Because most companies had a labor-intensive production process where a majority of the workers had hands-on involvement with producing their company's products. To produce 10% more units of a particular product, a company typically needed about 10% more workers. Today the situation is different. Automated production processes have eliminated many hands-on jobs, and more employees just oversee an automated process that makes many different products. The costs of such labor are indirect. Why? Because it is not economically feasible to trace their costs to the individual products. Just because a cost is indirect does not mean it is unimportant. Companies cannot continue to make products without facilities, equipment, supervisors, and even accountants. One of the most challenging tasks of a cost accounting system is to assign indirect costs to cost objects. Because the proportion of indirect costs in most companies today is far greater than 50% of total costs, accurate assignment of indirect costs is crucial. Decision makers who ignore indirect costs or receive inaccurate measures of indirect costs often make poor decisions. In addition to knowing that a cost is indirect, managers also want to know whether it is fixed or variable--that is, whether it varies in proportion to production. Some indirect costs are variable. Examples are supplies such as tacks and glue in a furniture-making company and the cost of ink in a printing company. Others, such as most depreciation and supervisors' salaries, are fixed. Managers need to distinguish between variable and fixed indirect costs to make informed decisions. To assign indirect costs to cost objects, we use cost allocation, which assigns indirect costs to cost objects in proportion to the cost object's use of a particular cost-allocation base. A cost-allocation base is some measure of input or output that determines the amount of cost to be allocated to a particular cost object. An ideal cost-allocation base would measure how much of the particular cost is caused by the cost object. Note the similarity of this definition to that of a cost driver--an output measure that causes costs. Therefore, most cost-allocation bases are cost drivers. Consider how much assemblyequipment depreciation, an indirect cost, Dell's accountants should assign to a particular model of laptop. They might allocate this indirect cost to Dell's various products based on the allocation base "machine hours." In a sense, machine hours measures the amount of assembly equipment used to make a particular computer. If making a Latitude laptop uses twice as many machine hours as making an Inspiron laptop, then Dell would allocate twice as much machine depreciation cost to the Latitude. Whenever an accountant uses the term allocated, we know the related cost is an indirect cost assigned to a cost object using a cost-allocation base. Decision makers should be careful in using allocated indirect costs. When the allocation base measures how much cost is caused by the cost objects, allocated costs will be relevant for many decisions. When the allocation is not related to the cause of the costs, allocated costs are irrelevant for many decisions. Because cost allocations are so important to cost measurement in today's companies, let's look more deeply into why and how companies allocate their indirect costs. Purposes of Cost Allocation O B J E C T I V E Explain the major reasons for allocating costs. 4 What logic should we use for allocating costs? The answer depends on the purpose(s) of the cost allocation. In short, there are no firm rules that we can rely on--there is no "best cost-allocation system." There are nearly as many schemes for allocation as there are companies. We focus on general concepts that provide guidance when managers design these systems. Recall that cost allocations support a company's CMS--the system providing cost measurements for strategic decision making, operational control, and external reporting. We list four purposes of cost allocation here; the first two support strategic decision ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 4: Cost Management Systems and Activity-Based Costing 141 making and operational control. The third supports external reporting. The last one supports elements of all three. 1. To predict the economic effects of strategic and operational control decisions: Major strategic decisions include setting the optimal product and customer mix, establishing pricing policy, and setting policy about which value-chain functions to develop as core competencies. Managers also need to predict the economic effects--both benefits and costs--of process improvement efforts. Managers within an organizational unit should be aware of all the consequences of their decisions, even consequences outside of their unit. Examples are the addition of a new course in a university that causes additional work in the registrar's office, the addition of a new flight or an additional passenger on an airline that requires reservation and booking services, and the addition of a new specialty in a medical clinic that produces more work for the medical records department. 2. To provide desired motivation and to give feedback for performance evaluation: Companies often include cost allocations in the total costs for which managers are accountable. Therefore, cost allocations influence management behavior and motivate managers to make decisions that are in the company's best interests. For example, some organizations do not allocate the costs of legal or internal auditing services or internal management consulting services because top management wants to encourage their use. Other organizations allocate the costs of such items to spur managers to make sure the benefits of the specified services exceed the costs. 3. To compute income and asset valuations for financial reporting: Companies allocate costs to products and projects to measure inventory costs for their balance sheets and cost of goods sold for their income statements. 4. To justify costs or obtain reimbursement: Sometimes prices are based directly on costs. For example, government contracts often specify a price that includes reimbursement for costs plus some profit margin. In these instances, cost allocations become substitutes for the usual working of the marketplace in setting prices. Ideally, a single cost allocation would serve all four purposes simultaneously. But thousands of managers and accountants will testify that most systems fail to achieve this ideal. Instead, cost allocations are often a major source of discontent and confusion to the affected parties. Allocating fixed costs usually causes the greatest problems. Why? Because it is often hard to find a cost-allocation base that accurately measures the amount of a fixed cost resource used by a cost object. When a system cannot meet all purposes simultaneously, managers and accountants need to identify which of the purposes dominate the particular situation at hand. Often external reporting rules for measuring inventory and cost of goods sold dominate by default because they are externally imposed. Generally accepted accounting principles (GAAP) require a company to assign all production-related costs and only production-related costs to its products. Often these are not the costs managers want assigned to products for their decision-making purposes. For example, managers may prefer not to allocate all production-related indirect fixed costs. If a particular management decision does not affect such costs, it can be misleading to include them as part of the cost of the product. In addition, managers may want to allocate costs from nonproduction parts of the value chain, such as R&D, marketing, or administrative expenses. Management decisions might have a major effect on such costs, and allocating them can make managers more aware of this effect. Thus, when managers need individual product or customer costs for decision making and performance evaluation, they often have to adjust the GAAP allocations used to satisfy inventory-costing purposes. Generally, the added benefit of using allocations for planning and control that differ from those used for inventorycosting purposes is much greater than the added cost. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 142 Part 1: Focus on Decision Making Methods of Cost Allocation Now let's turn to the question of how companies allocate costs. Because final products or services are important cost objects to nearly all organizations, we focus on how companies trace direct costs and allocate indirect costs to these cost objects. Examine Exhibit 4-2 to see the difference between assigning direct costs (tracing) and indirect costs (allocation) to final products. Physically tracing the direct costs is usually straightforward. For example, the cost accounting system can measure the amount and cost of each material added to a product. Workers can record the time spent on each product and the system can value each hour at the worker's appropriate wage rate. Systems to accurately measure direct costs have been available for decades, even centuries. Allocating indirect costs is more complex, and accountants have more chance to influence the resulting costs by the allocation choices they make. Because of the growth in indirect costs for most companies, allocating indirect costs is especially important. Allocation is a 5-step process: 1. Accumulate indirect costs for a period of time, for example one month, into one or more cost pools. A cost pool is a group of individual costs that a company allocates to cost objects using a single cost-allocation base. Many simple cost accounting systems place all indirect production costs in a single cost pool. 2. Select an allocation base for each cost pool, preferably a cost driver, that is, a measure that causes the costs in the cost pool. Companies that have a single cost pool for indirect production costs often use direct labor hours or direct labor cost as the costallocation base. 3. Measure the units of the cost-allocation base used for each cost object (for example, a product) and compute the total units used for all cost objects (for example, all products). 4. Determine the percentage of total cost-allocation base units used for each cost object. 5. Multiply the percentage in step 4 by the total costs in the cost pool to determine the cost allocated to each cost object. Consider the depreciation on Dell's assembly equipment mentioned on page 140. How would Dell's accountants allocate this cost to Inspiron and Latitude laptop computers? Suppose the depreciation cost, $400,000 for July, is the only cost in a particular cost pool. The cost-allocation base is machine hours. Dell used 2,000 machine hours in July to make Inspiron laptops and 3,000 machine hours to make Latitude laptops, for a total of 5,000 cost pool A group of individual costs that a company allocates to cost objects using a single cost-allocation base. Exhibit 4-2 Assignment of Direct and Indirect Costs to Products, Services, Customers, or Activities Costs Cost Assignment Method Cost Objects Physically Traced Direct Costs Products/ Services/ Customers/ Activities Allocated Using a Indirect Costs Cost-Allocation Base Products/ Services/ Customers/ Activities ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 4: Cost Management Systems and Activity-Based Costing 143 machine hours. This means that Dell used 2,000 5,000 = 40% of the machine hours for Inspiron, and the depreciation cost allocated to Inspiron is 40% $400,000 = $160,000. The company used 3,000 5,000 = 60% of the machine hours for Latitude, for an allocation of 60% 400,000 = $240,000. Another way of calculating this allocation is to compute the depreciation cost per machine hour or $400,000 (3,000 + 2,000) = $80. Then the allocation to Inspiron is $80 2,000 = $160,000 and the allocation to Latitude is $80 3,000 = $240,000. The allocation can be depicted using symbols as follows: Assembly Equipment Depreciation $400,000 Cost-Allocation Base: Machine Hours Inspiron Laptops 2,000 Machine Hours Used $160,000 Latitude Laptops 3,000 Machine Hours Used $240,000 Companies also use cost allocation to assign indirect costs to cost objects other than products or services. Suppose we are allocating costs to departments. A logical cost-allocation base for allocating rent costs to departments is the square feet that each department occupies. Other logical cost-allocation bases include cubic feet for allocating depreciation of heating and air conditioning equipment and total direct cost for allocating general administrative expense. Some individual indirect costs are important enough that a company might allocate them as a separate cost pool using obvious cost-allocation bases. For example, law firms might allocate the cost of professional labor to departments, jobs, and projects based on labor hours used. They then pool the other costs that are not important enough to justify being allocated individually and allocate them together in another cost pool. They might include building rent, utilities cost, and janitorial services in the same cost pool because a company allocates all of them on the basis of square footage of space occupied. Or a university could pool all the operating costs of its registrar's office and allocate them to its colleges on the basis of the number of students in each college. Also note the varying terminology you will see in practice. Accountants use many different terms to describe cost allocation. You may encounter terms such as allocate, apply, absorb, attribute, reallocate, assign, distribute, redistribute, load, burden, apportion, and reapportion being used interchangeably to describe the allocation of indirect costs to cost objects. Unallocated Costs ISBN: 0-536-47129-0 There are some costs for which we have difficulty identifying any relationship to a cost object. Often it is best to leave such costs unallocated. Unallocated costs are costs that an accounting system records but does not allocate to any cost object. They might include unallocated costs Costs that an accounting system records but does not allocate to any cost object. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 144 Part 1: Focus on Decision Making research and development (R&D), process design, legal expenses, accounting, information services, and executive salaries. Keep in mind, though, that an unallocated cost for one company may be an allocated cost or even a direct cost for another. Why? Because businesses vary considerably in their value chains and operating processes. For example, product design is a critical success factor for some businesses, and therefore, managers are willing to spend the time and effort to deploy sophisticated accounting systems to allocate or even directly trace product design costs. For other companies, this cost is not important enough to warrant special treatment. Consider the statement of operating income for Li Company in panel A of Exhibit 4-3. It represents a manufacturing company that makes cabinets, tables, and chairs. Each item in panel A represents accumulated totals for all products sold for an entire reporting period. To help make a strategic decision regarding which of the three products to emphasize, it would be useful to "unbundle" these totals to find the profitability amounts for individual products. How can we do this? Consider cost of goods sold. Most companies, like Li Company, find that it is easy to trace material costs to individual products. Other manufacturing costs, including labor for Li Company, are more difficult to trace directly. These costs are indirect, and we allocate them to products. It is not unusual for the amount of indirect costs to be a large component of total company costs. As a result, many companies develop sophisticated cost allocation systems for these indirect costs. The complexity of the cost allocation system depends on the complexity of the associated production system. Let's assume that Li Company uses machine hours to allocate the indirect manufacturing costs. If the use of machine hours is closely related to the amount of indirect costs incurred, managers responsible for each of the products would be satisfied that the cost of goods sold and gross profit amounts in Exhibit 4-3 are accurately measured. Last year 9,000, 6,000, and 7,000 machine hours were used to make cabinets, tables, and chairs, Panel A Statement of Operating Income [External Reporting Purpose] Cabinets Sales Cost of goods sold: Direct material Indirect manufacturing $470,000 120,000 110,000 230,000 240,000 47,000 30,000 77,000 163,000 $280,000 50,000 45,000 95,000 185,000 28,000 12,000 40,000 $145,000 Panel B Contribution to Corporate Costs and Profit [Internal Strategic Decision-Making Purpose] Tables Chairs Cost Type, Assignment Method $100,000 $90,000 30,000 30,000 60,000 40,000 10,000 8,000 18,000 40,000 35,000 75,000 15,000 9,000 10,000 19,000 Direct, direct trace Indirect, allocation based on weight Direct, direct trace Indirect, allocation based on machine hours Gross profit Selling expenses: Sales salaries Distribution Total selling expenses Contribution to corporate expenses and profit Corporate expenses (unallocated): Administrative salaries Other administrative Total unallocated expenses Operating income $ 22,000 $(4,000) 40,000 60,000 100,000 $ 63,000 ISBN: 0-536-47129-0 Exhibit 4-3 Direct, Indirect, and Unallocated Costs for Li Company Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 4: Cost Management Systems and Activity-Based Costing 145 ISBN: 0-536-47129-0 respectively, a total of 22,000 machine hours. So we would calculate the allocation of the $110,000 indirect manufacturing costs to cabinets as $110,000 (9,000 22,000) = $45,000. Exhibit 4-3 shows all three allocations of the indirect manufacturing costs. In our example, we can directly trace sales salaries to individual products because the company pays its sales force on a strictly commission basis. In addition, we can allocate the expenses for the distribution of products to warehouses in a fair manner based on weight. Last year, shipments of cabinets, tables, and chairs weighed 6,000, 4,000, and 5,000 pounds, respectively, for a total of 15,000 pounds. We would calculate the allocation of the $30,000 total distribution costs to cabinets as $30,000 (6,000 15,000) = $12,000. Exhibit 4-3 shows all three allocations of the distribution costs. So, while the managers in charge of chairs may not be happy with the reported loss of $4,000, they would feel that it is a reasonable measure of profitability. Top management would also have useful financial information to aid in their strategic decision regarding the most profitable product mix. In Li Company, the managers could find no reasonable means to allocate administrative salaries or other administrative expenses. Therefore, these corporate-level expenses remain unallocated. Why not allocate the administrative salaries and other administrative expenses to the products by using some simple measure, such as "percent of total revenue generated" or "number of units sold"? Because managers generally want allocations to be a fair measure of the costs incurred on their behalf. If allocations are arbitrary, managers will not trust them and will make decisions based on other less relevant information. In Li Company, the work performed by the administrative personnel was not a simple function of the volume of units sold or revenue generated. If a company cannot find such a measure, it often chooses not to allocate. Often managers must use judgment to decide whether to treat a cost as direct, indirect, or unallocated. Such judgments are based on the type of cost, its magnitude, and how expensive it is to implement a system to trace or allocate the cost. If it is not too expensive, managers prefer costs to be direct rather than indirect. This gives them greater confidence in the reported costs of products, services, or other cost objects. However, the cost of a system for tracing costs to cost objects should not be greater than its expected benefits. For example, a system for tracing the exact cost of steel and fabric (direct cost) to a specific lot of desk chairs may be worth its cost. However, it may be too expensive to trace the exact cost of rivets or thread (indirect costs) to the chairs, even though such a tracing is technically possible. Another factor that influences whether we treat a cost as direct, indirect, or unallocated is the particular cost object. For example, suppose the manager of a local telephone company is faced with two decisions: what price to charge for installing new phone service and what amount of costs to use for the installation department's budget. Among the various costs relevant to both decisions is the salary of a supervisor in the installation department. The supervisor oversees both phone installations and routine service calls. For the pricing decision, the supervisor's salary is an indirect cost. Why? Because accountants cannot physically trace this cost to the phone installations or service calls and therefore must allocate the cost. However, for the department budget, the supervisor's salary is a direct cost. Why? Because accountants can physically identify 100% of the cost as belonging to the department. In general, many more costs are direct when the cost object is a department than when it is a product or service, such as a telephone installation or service call. Frequently, managers want to know the costs of more than one cost object, such as departments, products, services, activities, or resources. In these cases, companies allocate costs to more than one cost object. Thus, a particular cost may simultaneously be direct and indirect. As you have just seen, a supervisor's salary can be both direct with respect to a department and indirect with respect to the department's individual products or services. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 146 Part 1: Focus on Decision Making Cost Terms Used for External Reporting Purposes While this text focuses mostly on costs used by managers for strategic and operational control purposes, it is important to recognize that cost accounting systems also support the financial reporting process. One of the four purposes of cost management systems is to provide aggregate measures of inventory value and cost of goods manufactured for external reporting to investors, creditors, and other external stakeholders. We will discuss four attributes of these costs: manufacturing costs, product versus period costs, costs on the balance sheet, and costs on the income statement. Categories of Manufacturing Costs O B J E C T I V E Identify the main types of manufacturing costs: direct materials, direct labor, and indirect production costs. 5 Manufacturing companies differ from merchandising companies in the way they accumulate and report the cost of inventories. In manufacturing operations, which transform materials into other goods through the use of labor and factory facilities, products are frequently the cost object. Manufacturing companies classify production costs that they assign to products as either (1) direct material, (2) direct labor, or (3) indirect production costs. 1. Direct-material costs include the acquisition costs of all materials that a company identifies as a part of the manufactured goods and that it can trace to the manufactured goods in an economically feasible way. Examples are iron castings, lumber, aluminum sheets, and subassemblies. Direct materials often do not include minor items, such as tacks or glue, because the costs of tracing these items are greater than the possible benefits of having more precise product costs. Such items, often called supplies or indirect materials, are a part of indirect production costs. 2. Direct-labor costs include the wages (and, in some companies, related benefits) paid to employees that a company can trace specifically and exclusively to the manufactured goods in an economically feasible way. Examples are the wages of machine operators and assemblers. In highly automated factories with a flexible workforce, there may be no direct labor costs. Why? Because all workers may spend time overseeing numerous products, which makes it economically infeasible to physically trace any labor cost directly to specific products. 3. Indirect production costs (also called indirect manufacturing costs, factory overhead, factory burden, or manufacturing overhead) include all costs associated with the production process that a company cannot trace to the goods or services produced in an economically feasible way. Accountants consider many labor costs, such as that of janitors, forklift truck operators, plant guards, and storeroom clerks, to be indirect labor because it is impossible or economically infeasible to trace such activity to specific products. Other examples of factory overhead costs are power, supplies, supervisory salaries, property taxes, rent, insurance, and depreciation. Computer technology allows modern cost systems to physically trace more costs to products at a reasonable cost. Thus, costs that were previously indirect costs have become direct costs. For example, meters wired to computers can monitor the electricity used to produce each product, and managers can trace the costs of setting up a batch production run to the items produced in the run. In general, the more manufacturing costs we can trace directly to products, the more accurate the product cost. In addition to direct-material, direct-labor, and indirect production costs, all manufacturing companies also incur nonproduction costs, generally costs associated with the other value-chain functions (research and development, design, marketing, distribution, and customer service). Accounting information systems accumulate these costs by departments, such as R&D, advertising, and sales. Most firms' financial statements report these direct-material costs The acquisition costs of all materials that a company identifies as a part of the manufactured goods and traces to the manufactured goods in an economically feasible way. direct-labor costs The wages of all labor that a company can trace specifically and exclusively to the manufactured goods in an economically feasible way. indirect production costs (indirect manufacturing costs, factory burden, factory overhead, manufacturing overhead) All costs associated with the production process that a company cannot trace to the goods or services produced in an economically feasible way. Usually all production costs except direct materials and direct labor. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 4: Cost Management Systems and Activity-Based Costing 147 costs as selling and administrative expenses. In short, these costs do not become a part of the reported inventory cost of the manufactured products for financial reporting purposes. Product Costs and Period Costs Regardless of the type of cost accounting system a company uses for internal decisionmaking purposes, its production costs must appear in its financial statements for external financial reporting purposes. The costs appear both on the income statement, as cost of goods sold, and on the balance sheet, as inventory amounts. When preparing income statements and balance sheets, accountants frequently distinguish between product costs and period costs. Product costs are costs identified with goods produced or purchased for resale. Product costs first become part of the inventory on hand; thus, we sometimes call them inventoriable costs. These inventoriable costs become expenses in the form of cost of goods sold only when the company sells the inventory. In contrast, period costs become expenses during the current period without becoming part of inventory. For example, look at the top half of Exhibit 4-4. A merchandising company, such as a retailer or wholesaler, acquires goods for resale without changing their basic form. The only product cost is the purchase cost of the merchandise. The company holds unsold goods as merchandise inventory and shows their costs as an asset on a balance sheet. As the company sells the goods, their costs become expenses (often referred to as expiration) in the form of "cost of goods sold." A merchandising company also has a variety of selling and administrative expenses. These costs are period costs because the company deducts them from revenue as expenses without ever being regarded as a part of inventory. The bottom half of Exhibit 4-4 illustrates product and period costs in a manufacturing company. Note that the company transforms direct materials into salable items with the help of direct-labor and indirect manufacturing costs. You can see that the balance sheets of manufacturers and merchandisers differ with respect to inventories. Instead of one inventory account, a manufacturing concern has three inventory accounts that help managers trace all product costs through the production process to the time of sales. These accounts are Direct-material inventory: Material on hand and awaiting use in the production process. Work-in-process inventory: Goods undergoing the production process but not yet fully completed. Costs include appropriate amounts of the three major manufacturing costs: direct material, direct labor, and indirect production costs. Finished-goods inventory: Goods fully completed but not yet sold. Notice that, although merchandising and manufacturing companies differ in how they account for product costs, they account for period costs the same. Regardless of the type of company, period costs never become part of inventory. Be sure you are clear on the differences between merchandising accounting and manufacturing accounting for such costs as insurance, depreciation, and wages. In merchandising accounting, all such items are period costs and are expenses of the current period. In manufacturing accounting, many of these items are related to production activities and, thus, as indirect manufacturing costs, are product costs that appear initially on the balance sheet as inventory. These costs become expenses on the income statement in the form of cost of goods sold when the company sells the inventory. In both merchandising and manufacturing accounting, selling and administrative costs are period costs. Thus, the inventory cost of a manufactured product excludes sales salaries, sales commissions, advertising, legal, public relations, and the president's salary. Manufacturing overhead is part of finished-goods inventory cost, but selling expenses and general administrative expenses are not. product costs (inventoriable costs) Costs identified with goods produced or purchased for resale. period costs Costs that become expenses during the current period without becoming part of inventory. direct-material inventory Material on hand and awaiting use in the production process. work-in-process inventory Goods undergoing the production process but not yet fully completed. finished-goods inventory Goods fully completed but not yet sold. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 148 Part 1: Focus on Decision Making Exhibit 4-4 Relationships of Product Costs and Period Costs Balance Sheet Income Statement Sales Merchandising Company (Retailer or Wholesaler) Minus Merchandise Inventory Expiration Cost of Goods Sold (Expense) Equals Gross Margin Minus Selling Expenses and Administrative Expenses Equals Operating Income Product (Inventoriable) Costs Merchandise Purchases Period Costs Manufacturing Company Direct Material Purchases Product (Inventoriable) Costs Direct Labor Indirect Manufacturing* Direct Material Inventory Work-inProcess Inventory Expiration Sales Minus Cost of Goods Sold (Expense) Equals Gross Margin Minus Selling Expenses and Administrative Expenses Equals Operating Income Finished Goods Inventory Period Costs *Examples: indirect labor, factory supplies, insurance on inventories, and depreciation on plant. Examples: insurance on salespersons' cars, depreciation on salespersons' cars, salespersons' salaries. Examples: insurance on corporate headquarters building, depreciation on office equipment, clerical salaries. Note particularly that when insurance and depreciation relate to the manufacturing function, they are inventoriable, but when they relate to selling and administration, they are not inventoriable. O B J E C T I V E Explain how the financial statements of merchandisers and manufacturers differ because of the types of goods they sell. 6 Balance Sheet and Income Statement Presentation of Costs How do published balance sheets and income statements of merchandising and manufacturing companies differ in presenting costs? Would the basic structure of these financial statements be different for a merchandising company such as Sears compared to a manufacturing company such as Goodyear? Let's take a closer look at how these two primary financial statements differ between manufacturing and merchandising organizations. First, let's examine balance sheets: ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 4: Cost Management Systems and Activity-Based Costing 149 Current Asset Sections of Balance Sheets Manufacturer Cash Receivables Finished goods Work in process Direct material Total inventories Other current assets Total current assets $ $32,000 22,000 23,000 77,000 1,000 $107,000 Merchandise inventories Other current assets Total current assets 77,000 1,000 $107,000 4,000 25,000 Retailer or Wholesaler Cash Receivables $ 4,000 25,000 The difference between the balance sheet of a manufacturer and that of a retailer or wholesaler is apparent from the inventory accounts from the 2005 annual reports of Goodyear and Sears (in millions): Goodyear Tire & Rubber Company Raw materials Work in process Finished goods Total $ 639 137 2,086 $2,862 Sears, Roebuck and Co. Merchandise inventories $10,750 Now consider income statements. We have already mentioned that the reporting of selling and administrative expenses is typically the same for manufacturing and merchandising organizations. What about the cost of goods sold? In published financial statements you will generally see one line for cost of goods sold regardless of the type of company. Only the way the companies calculate the cost of goods sold differs, as follows: Manufacturer Manufacturing cost of goods produced and then sold, usually composed of the three major categories of cost: direct material, direct labor, and indirect manufacturing costs. Retailer or Wholesaler Merchandise cost of goods sold, usually composed of the purchase cost of items, including freight in, that are acquired and then resold. The following shows how manufacturers and retailers or wholesalers calculate their cost of goods sold (numbers assumed): Cost of Goods Sold Section of the Income Statement Manufacturer Beginning finished goods inventory Cost of goods manufactured: Direct materials used Direct labor Indirect manufacturing Cost of goods available for sale Ending finished goods inventory Cost of goods sold ISBN: 0-536-47129-0 Retailer or Wholesaler $ 4,000 $20,000 12,000 8,000 Beginning merchandise inventory Purchases $ 4,000 40,000 40,000 44,000 8,000 $36,000 Cost of goods available for sale Ending merchandise inventory Cost of goods sold 44,000 8,000 $36,000 Sometimes confusion arises because accountants and managers use the terms costs and expenses loosely. Cost is a broad term that describes the amount paid for an activity, product, or service. Expenses specifically denote all costs deducted from revenue in a given period. All costs eventually become expenses, but they are not expenses until Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 150 Part 1: Focus on Decision Making accountants deduct them from revenue in the income statement. Thus, manufacturing costs become an expense on an income statement (called cost of goods sold) via the multistep inventory procedure shown earlier in Exhibit 4-4. In contrast, selling and administrative costs become expenses immediately in all types of companies. Now that we understand cost classifications, let's turn our attention to the types of cost accounting systems that accumulate and report costs. There are many different types of cost accounting systems, but we can describe most of the important features of these systems by looking at two general types--traditional and activity-based cost accounting systems. Traditional and Activity-Based Cost Accounting Systems O B J E C T I V E Understand the main differences between traditional and activitybased costing (ABC) systems and why ABC systems provide value to managers. 7 traditional costing systems Accounting systems that do not accumulate or report costs of activities or processes. They often use a single cost pool for all indirect manufacturing costs with a labor-based cost-allocation base. activity-based costing (ABC) systems A system that first accumulates indirect resource costs for each of the activities of the area being costed, and then assigns the costs of each activity to the products, services, or other cost objects that require that activity. Companies adopt cost accounting systems that are consistent with their management philosophies and their production and operating technologies. Changes in philosophies or technologies often prompt corresponding changes in cost accounting systems. For example, when BorgWarner's Automotive Chain Systems Operation transformed its manufacturing operation to a just-in-time manufacturing system with work cells, it also changed its cost accounting system. This change in the way BorgWarner operated made the existing cost accounting system obsolete. According to management, the new cost accounting system, coupled with the new production systems, "improved the overall reporting, controls, and efficiency dramatically." In recent years, because of increased global competition, many companies recognized the need to improve the accuracy and usefulness of their cost information. The accounting profession responded by developing new types of cost accounting systems that improve the accuracy of costs and thereby enhance their value to managers who use this information for decision-making purposes. During most of the 1900s, almost all companies used traditional costing systems-- those that do not accumulate or report costs of activities or processes. Traditional costing systems often use a single cost pool for all indirect manufacturing costs with labor cost or labor hours as a cost-allocation base. Such systems work well with simple production and operating systems. Consider a company that makes only a few products for which directmaterial and direct-labor costs are a high percentage of total costs. Indirect manufacturing costs are a small percentage of total costs so the system combines them into one cost pool and allocates them to products using only one cost allocation base, for example directlabor hours. Such a company can achieve a high level of accuracy of product costs with a traditional costing system. As companies grow and their operations become more complex, they often need to refine their traditional costing systems to maintain the accuracy of product or service costs. They often do this by accumulating indirect costs into multiple cost pools, often one for each department. Consider a company that has two operating departments, assembly and finishing. The resources in the assembly department are dominated by large, expensive machines. The finishing department has only a few machines but many employees. Because operations within each department are relatively simple, the company might choose a traditional costing system that uses machine hours as an allocation base for the manufacturing overhead in the assembly department and labor hours as an allocation base for manufacturing overhead in the finishing department. But what about a more complex situation where a company makes hundreds or thousands of different products and indirect production costs are a large percentage of total costs? What if the many different products consume resources at widely varying rates? Achieving a high level of cost accuracy in such an operating environment requires a more elaborate cost accounting system. A popular elaborate cost accounting system is an activity-based costing (ABC) system--a system that first accumulates indirect resource costs for each of the activities of a particular plant, department, value-chain function or organization and then assigns the cost of each activity to the products, services, or other ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 4: Cost Management Systems and Activity-Based Costing 151 cost objects that require that activity. Most ABC systems provide highly accurate product or customer costs that a company can use for strategic decisions. Further, accumulating and reporting costs by activities helps managers to understand the cause-effect relationships between day-to-day activities and product or customer costs and thereby aids the operational control purpose of cost management systems. Many managers believe that ABC systems help them better manage their organizations. The Business First box on page 152 reports on a survey listing reasons why some companies use ABC. Comparing Activity-Based and Traditional Costing Let's take a closer look at how ABC differs from traditional costing. One of the most important differences between traditional and ABC systems is the extent of allocation across the value chain. Traditional systems generally assign only production costs to the products. These are the only costs that GAAP allows companies to include in the inventory value of a product for financial reporting purposes. Traditional systems often focus on simply measuring such inventory values. They normally do not allocate the costs of other value-chain functions because these are not appropriate costs to include in inventory. ABC systems, in contrast, focus on the costs that are important to decision makers. They often expand the allocation of costs beyond production to processes such as design, marketing, order processing, and customer service. As a result, ABC systems are more complex but promise more accurate costs that are more useful for decision making. Activity-based costing also causes managers to look closely at the relationships among resources, activities, and cost objects--essentially analyzing the unit's production process. Many ABC teams find it useful to develop a process map--a schematic diagram with symbols that captures the interrelationships between cost objects, activities, and resources. These maps can be an efficient method to enhance managers' understanding of operations. Let's see how managers draw process maps. Exhibit 4-5 contains two examples to show the basic concepts for drawing process maps. We depict resources by a symbol. When the cost object is the product, service, or customer of the company, we will use the symbol. When it is an activity we use a . process map A schematic diagram capturing interrelationships between cost objects, activities, and resources. Exhibit 4-5 RESOURCE A Cost Driver 1 RESOURCE B Basic Concepts for Process Maps ACTIVITY 1 ACTIVITY 2 Cost Driver 2 ACTIVITY 3 Cost Driver 3 PRODUCT T PRODUCT U PRODUCT V PRODUCT W Example 1: Resource A is an indirect cost with respect to activities and products. Example 2: Resource B is a direct cost with respect to activity 3 but an indirect cost with respect to both products. ISBN: 0-536-47129-0 LEGEND Flow of Costs Activity or Process Product or Customer Resource Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. ACTIVITY-BASED COSTING: WHO USES IT AND WHY? Why do managers use ABC? The most frequent applications are for product and ser vice costing, process and activity analysis, and per formance measurement. These are the primary purposes of strategic decision making and operational control that we discussed at the beginning of this chapter. A recent survey asked companies that use ABC to indicate how many managers routinely used the ABC system. The vast majority, 62%, indicated that from 10 to 24 managers used ABC; 23% of the companies repor ted that between 25 and 99 managers used ABC information. BlueCross BlueShield of Florida (BCBSF) is an example of one company that uses ABC. BCBSF's major customers include local groups (persons in companies with headquarters in Florida), direct pay (individuals), national and corporate accounts (persons in companies with headquarters outside Florida), and government programs (persons 65 years or older with Medicare benefits). During the early 1990s, BCBSF faced increased competition for its health-care products and services. But its cost management system did not adequately meet the needs of managers. The primar y goal of BCBSF's management was to develop a new cost management system that would help identify opportunities for increased operating control and cost reduction in administrative expenses. Administrative expenses are all the costs of doing business other than claims payments. In 1996, they were $588 million, or 20% of total revenue. The company goal was to reduce administrative costs from 20% of revenue to less than 10%. The cost-management-system technique BCBSF used was an ABC system. This new cost accounting system provided more accurate and timely measurements of 1. customer and product profitability--a strategic purpose, 2. activities that provided the most value to managers and customers--an operational control purpose, and 3. costs of non-value-added activities--an operational control purpose. Sources: Mohan Nair, "Activity-Based Costing: Who's Using It and Why?" Management Accounting Quarterly, Spring 2000, pp. 2933; K. Thurston, D. Keleman, and J. MacArthur, "Cost for Pricing at BlueCross BlueShield of Florida," Management Accounting Quarterly, Spring 2000, pp. 413. When a resource supports only one activity or an activity applies to only one product, the cost of the resource or activity is direct. In Exhibit 4-5, the costs of Resource B and Activity 1 are direct to Activity 3 and Product T, respectively. When a resource supports two or more activities or an activity applies to two or more products, we must divide the cost among the activities or products. If we can physically trace the costs, they are direct. Otherwise we need to allocate them. In Exhibit 4-5 we assume that we allocate the costs of Resource A, Activity 2, and Activity 3, each to two cost objects. The process map identifies the cost driver on the arrow between the resource or activity cost and the cost object. An Illustration of Traditional and ABC Systems Now let's look at a simple example that demonstrates the main differences between traditional and ABC systems and the reasons why many managers prefer ABC systems. Lopez Plastics Company makes just two product lines, plastic casings for pens and plastic casings for cell phones. The company had an operating loss last quarter of $64,500. Management needs to take immediate actions to improve profitability. You are the vice president of operations. You have to decide which of the two product lines to emphasize to improve profitability. You also wish to reduce costs--especially in the production function of the value chain. Lopez Plastics currently uses a traditional cost accounting system, but you are considering deploying an ABC system to support strategic decision making and operational control. Exhibit 4-6 shows the company's traditional cost accounting system in panel A and the related two financial reports for the most recent quarter in panel B. Notice the three types of costs: direct, indirect, and unallocated, in ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 4: Cost Management Systems and Activity-Based Costing 153 Panel A Process Map of Lopez Plastics Company's Traditional Cost System All Indirect Manufacturing Costs $220,000 All Unallocated Value Chain Costs $100,000 Panel B Lopez Plastics Company Statement of Operating Income Traditional Cost Allocation System Statement of Operating Income [External Reporting Purpose] Contribution to Corporate Costs and Profit [Internal Strategic Decision-Making Purpose] Cost Driver [Direct Labor Hours] Pen Casings Sales Cost of Goods Sold: Direct Material Direct Labor Indirect Manufacturing Cost of Goods Sold 34,500 150,000 220,000 404,500 35,500 22,500 135,000 $440,000 $360,000 Cell Phone Casings $80,000 12,000 15,000 22,000 49,000 198,000* 355,500 Direct Materials for Pen Casings $22,500 Direct Labor for Pen Casings $135,000 Direct Materials for Cell Phone Casings $12,000 Direct Labor for Cell Phone Casings $15,000 Gross Profit Corporate Expenses (Unallocated) Operating Loss $ 4,500 $31,000 100,000 ($64,500) 1.25% 38.75% UNALLOCATED $100,000 SALES $360,000 SALES $80,000 Gross Profit Margin 8.07% *$220,000 $220,000 (4,500 5,000) $198,000 (500 5,000) $22,000 Exhibit 4-6 Lopez Plastics Company's Traditional Costing System and Statement of Operating Income ISBN: 0-536-47129-0 Lopez Plastics' traditional cost accounting system. In the traditional costing system, the portion of total indirect manufacturing costs ($220,000) allocated to a product depends on the proportion of total direct-labor hours consumed in making the product. Last period, the company used 4,500 and 500 direct-labor hours to make pen casings and cell phone casings, respectively, for a total of 5,000 hours. So it allocated (4,500 5,000) = 90% of the indirect costs to pen casings and (500 5,000) = 10% to cell phone casings. The gross profit and gross profit margin lines for both products, shown at the bottom of panel B, indicate that cell phone casings is the more profitable product line. As is the case for Lopez Plastics, many traditional systems use only one cost driver as a basis for allocating indirect manufacturing costs. When does a traditional costing system provide accurate product costs? When there is a plausible and reliable relationship between the single cost driver and all the indirect resource costs being allocated. In today's complex business environments, this is rare. Let's take a careful look at Lopez Plastics' production requirements to see if the traditional cost accounting system is providing the costing accuracy required for strategic decision making and operational control. Pen casings have a simple design and, thus, require a simple production process. The company produces them in high volumes, using 90% of its direct-labor time. Pen Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 154 Part 1: Focus on Decision Making two-stage ABC system A costing system with two stages of allocation to get from the original indirect resource cost to the final product or service cost. The first stage allocates indirect resource costs to activity-cost pools. The second stage allocates activity costs to products or services. casings rarely require special customer support or engineering work. This means that indirect production-support costs, such as design engineering of the pen casings, will be small. On the other hand, cell phone casings have a more complex design, and the company produces them in small volumes, accounting for only 10% of its direct labor time. Customers who buy cell phone casings have specific design requirements that cause much production engineering work. We have learned that most of the engineering work performed at Lopez Plastics supports the production of cell phones. So, common sense tells us that we should allocate most of the costs of engineering to the cell phone casings. How significant is the cost of engineering-related work? Of the $220,000 total indirect cost, engineering-related costs are $40,000. But Lopez Plastics uses a traditional cost system. It does not separately identify or report the indirect costs of the engineering activity. Instead, the $40,000 of resources used for engineering activity--such as engineer labor and depreciation of computeraided design (CAD) equipment--is part of the single indirect resource cost pool. The company allocates all $40,000 of these indirect costs using the cost driver direct-labor time as the cost-allocation base. Thus, it allocates only 10% of the engineering costs to the cell-phone casings. This simply does not make sense. We conclude that the traditional system probably does not provide the level of costing accuracy needed. How can we improve Lopez Plastics' costing accuracy? How can we change the design of the company's cost accounting system to better support strategic decision making and operational control? We could use an ABC system to accumulate all indirect resource costs into cost pools for each of the most critical production activities performed--including engineering activityand then allocate these activity-cost pools to products using plausible and reliable cost drivers as allocation bases. Exhibit 4-7 depicts a fairly simple two-stage ABC system, which uses two stages of allocation to get from the original indirect resource cost to the final product or service cost. The first stage allocates indirect resource costs to activity-cost pools, in this case two activities, processing activity and production-support activity. The second stage allocates activity costs to the products or services. In essence, the cost objects in the first stage are the activities, and the cost objects in the second stage are the products. You will find a more detailed example of a two-stage ABC system in Appendix 4 on pages 162172. In two-stage ABC systems, the first-stage allocation often uses estimated percentages as the allocation base. Suppose Lopez Plastics has only two indirect resources, (1) engineers and CAD equipment, and (2) plant and machinery, and only two activities, (1) processing and (2) production support, as shown in Exhibit 4-7. The cost of engineers and CAD equipment depends mainly on the amount of time engineers spend on a product. Engineers generally spend, on average, about 48 minutes each hour performing production-support activities, such as designing casings. They spend the other 12 minutes supervising the processing activity. Thus, we allocate (48 60) = 80% and (12 60) = 20% of engineering salaries to the production-support and processing activities, respectively. The cost of plant and machinery depends mostly on the square feet of space used. Processing uses 75% of the space and production support uses 25%, so processing gets 75% of the plant and machinery cost and production support gets 25%. This gives us a total cost of the processing activity of $143,000 and a total cost of the production-support activity of $77,000. Now consider the second-stage allocation. It allocates the costs of the two activities, processing and production support, to the two products, pen casings and cell-phone casings. There are several possible cost drivers for the production-support activity costs, including "number of customer-generated engineering changes" and "number of distinct parts." The cost-allocation base should be whichever is a better measure of the consump- ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 4: Cost Management Systems and Activity-Based Costing 155 Exhibit 4-7 Plant and Machinery $180,000 Engineers and CAD Equipment Resource $40,000 All Unallocated Value-Chain Costs $100,000 Lopez Plastics Company's ABC System 20% 75% 25% 80% Processing Activity $135,000 + $ 8,000 $143,000 Production Support Activity $45,000 + $32,000 $77,000 Cost Driver [Direct Labor Hours] Cost Driver [Distinct Parts] Direct Materials for Pen Casings $22,500 Direct Labor for Pen Casings $135,000 Direct Materials for Cell Phone Casings $12,000 Direct Labor for Cell Phone Casings $15,000 UNALLOCATED $100,000 SALES $360,000 SALES $80,000 ISBN: 0-536-47129-0 tion of production-support activity. Let's assume this is "number of distinct parts." Suppose pen casings have only 5 distinct parts compared to 20 for cell-phone casings. We would allocate 20 (20 + 5) $77,000 = $61,600 of the production-support activity costs to cell phone casings and the remaining $15,400 to pen casings. This allocation better measures the use of engineering services than does the allocation based on the traditional system. Why? Because cell phone casings cause most of the production-support activity costs, but the traditional system allocates only 10% of all indirect manufacturing costs, including production-support activity costs, to cell phone casings. In contrast, the ABC system allocates 80% of the production-support activity costs to cell phone casings. We will continue this example in the Summary Problem for Your Review on page 156, but first let's consider one more advantage of ABC systems. In many companies, managers try to gain cost savings by efficiently managing activities. If Lopez Plastics wants its managers to reduce the cost of producing cell phone casings, the managers will probably focus on possible cost savings in either processing or production support. They may also redesign the product to use less direct materials or reengineer the production process to reduce direct labor. But often the largest savings are in the indirect costs. By carrying out activities more efficiently, they reduce the costs of the products that use those activities. What information do managers need to examine the efficiency of activities? They need the cost of each activity. Traditional systems do not generate this cost information, while ABC systems do. Therefore, in addition to providing better costing activity, ABC systems can also promote better operating efficiency. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 156 Part 1: Focus on Decision Making MAKING MANAGERIAL DECISIONS Suppose you have been asked to attend a meeting of top management. When the meeting begins, you are asked to explain in general terms the main differences and similarities in traditional and ABC systems. You have only Exhibits 4-6 and 4-7 as a guide, so you quickly draw these exhibits on a white board and, after taking a deep breath, begin to talk. List as many similarities and differences as you can between the two systems, based on Exhibits 4-6 and 4-7. Answer 1. Traditional costing systems are much simpler than ABC systems and are usually less costly to maintain. 2. Traditional systems and ABC systems both have all three types of costs: direct, indirect, and unallocated. 3. ABC systems unbundle indirect resources into many subgroups, each being assigned to consuming activities. 4. ABC systems assign indirect resource costs to cost objects in two stages of allocation, where the first stage allocates costs to activities and the second stage allocates activity costs to cost objects. Traditional systems normally assign indirect resource costs to cost objects in just one stage. Both traditional and ABC systems use average prices and consumption rates for product lines. Prices and costs within each product line do not vary significantly so the accuracy of product and customer costs is maintained. ABC systems accumulate and report activity costs in several activity-cost pools. ABC systems require many more cost-allocation bases than do traditional systems. When these costallocation bases are both plausible and reliable cost drivers, the overall accuracy of product, ser vice, or customer cost is improved. ABC systems provide more operational information on the costs of activities, which can be used to reduce costs by improving operating efficiencies. 5. 6. 7. 8. We now are in a position to complete our ABC analysis and answer our strategic issue regarding our product mix strategy. We do this in the following Summary Problem for Your Review. It is important for you to carefully work this problem to gain a clear understanding of the basic concepts and value of an ABC system. Summary Problem for Your Review PROBLEM Refer to the Lopez Plastics illustration, especially the financial reports based on the traditional cost accounting system in panel B of Exhibit 4-6. Based on these reports, the marketing department manager has proposed a plan that emphasizes cell phone casings due to their large gross profit margin (38.75%) compared to that of pen casings (1.25%). Now, management implements the ABC system shown in Exhibit 4-7. The first stage of the two-stage ABC system has been completed, and the results are the activity-costpool figures given in Exhibit 4-7--processing activity costs of $143,000 and productionsupport activity costs of $77,000. You need to perform the second-stage allocations to determine the profitability of each product line. The cost allocation base for processing activity is direct-labor hours and the cost allocation base for production-support activity is distinct parts. Data on the use of these cost allocation bases for the last quarter is: ISBN: 0-536-47129-0 Pen Casings Direct labor hours Distinct parts 4,500 5 Cell Phone Casings 500 20 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 4: Cost Management Systems and Activity-Based Costing 157 Calculate the gross profit and gross profit margin for both products based on ABC. Do your results differ significantly from those based on the traditional cost accounting system? Explain. Evaluate marketing's plan. Propose a product-mix strategy for the company. SOLUTION The table that follows shows the gross profit for each product using ABC costs. Financial Reports for Lopez Plastics Company Activity-Based Cost Allocation System Panel A Statement of Operating Income [External Reporting Purpose] Sales Cost of goods sold: Direct material Direct labor Processing activity Production-support activity Cost of goods sold Gross profit Corporate expenses (Unallocated): Operating loss Gross profit margin $440,000 34,500 150,000 143,000 77,000 404,500 35,500 100,000 $ (64,500) 8.07% Panel B Contribution to Corporate Costs and Profit [Internal Strategic Decision-Making and Operational-Control Purposes] Pen Casings $360,000 22,500 135,000 128,700* 15,400 301,600 $ 58,400 Cell Phone Casings $ 80,000 12,000 15,000 14,300 61,600 102,900 $ (22,900) 16.22% (28.63%) * The cost driver is direct-labor hours. The company used 4,500 (4,500 + 500) = 90% of direct-labor hours to produce pen casings. Thus, the allocation is $143,000 .90 = $128,700. The cost driver is distinct parts. The company used 5 (20 + 5) = 20% of distinct parts to make pen casings. Thus, the allocation is $77,000 .20 = $15,400. ISBN: 0-536-47129-0 The ABC system gives results that are dramatically different from those of the traditional cost allocation system. Pen casings are generating substantial profits for the company, while cell phone casings are losing money. Why is there such a dramatic difference between the two cost accounting systems? It's because of differences in the production process for each of the two products. Only the cell phone casings require large amounts of the production-support activity. The ABC system correctly allocates most of this cost to the cell phone casings, while the traditional system allocates most of it to the pen casings. The ABC system first separates the processing-related costs from the production-support costs. Then, it allocates each activity cost to the products based on the proportion of the activity used by each product. Marketing's plan most likely will result in significantly lower profitability, assuming that the ABC results are accurate. The company's top management should probably make the strategic decision to emphasize the pen casings product line due to its large gross profit margin. The cell phone casings are losing money, and that product line needs to be carefully evaluated. Possible actions include raising prices, changing the design by reducing the number of distinct parts, working with suppliers to reduce the cost of direct materials, improving the efficiency of direct labor, or dropping the product line. The ABC system generated information for the management of Lopez Plastics Company that allowed them to make better decisions. For a real-world example of a company that benefited similarly, see the Business First box about Reichhold on page 158. Next, we will take a closer look at how ABC can add value by helping managers make better decisions. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. REICHHOLD DESIGNS COST ACCOUNTING SYSTEM TO MEET ITS COST MANAGEMENT OBJECTIVES Reichhold is a leading global supplier of polyester and performance resins used in products such as boats, bowling balls, paints, and car coatings. The company has manufacturing facilities in 11 countries in the Americas and Europe and employs 2,500 workers. Reichhold recently made a major change in its organizational structure moving from a product-line focused, divisional structure to a team-based structure. At the same time, it changed its marketing strategy to emphasize specialty products with high gross margins. With a new organizational structure and new product family, management needed more accurate cost information to determine the most profitable product mix and to control production costs. Reichhold's management chose an activity-based cost accounting system. The figure that follows compares the traditional and activity-based cost accounting systems. For example, two products consumed the same number of reactor hours and so received the same allocation of indirect costs. But managers knew that one of these products consumed much more time in the thin-tank and filtration processes and had much higher waste disposal costs. The new allocation system, as shown, captures such differences in the rate of consumption of resources. The company's activity-based costing system has just five major activities or processes, but the information provided for cost control was much more useful. With the new ABC system, the cost of the product that consumed more time in the thin-tank and filtrations processes increased from $13 per unit to $18 per unit, reflecting its consumption of costly resources. This new ABC information suppor ted improvements in cost control. Reichhold now produces items with high waste disposal costs in larger batches by Traditional Cost Accounting System Preprocess Preparation Activity PREPARATION HOURS Activity-Based Cost Accounting System Reactor Processing Activity PROCESSING HOURS Thin-tank Processing Activity PROCESSING HOURS Filtration Process Activity PROCESSING HOURS Waste Disposal Activity Maintenance Costs Shipping Costs Shipping Costs Administrative Costs Quality Control Costs BATCHES P R T F W REACTOR HOURS P R T F W P R T F W 1 20 1 20 Products 1 20 Products 1 20 The company had used a traditional cost accounting system where it allocated all indirect production costs to its products based on one cost driver, "number of reactor hours." Company managers believed the traditional system was not providing accurate product costs for strategic or operational control purposes. combining orders. Overall, the new ABC system improved capacity management, analysis of product profitability, and strategic pricing decisions. Source: Adapted from E. Blocher, B. Wong, and C. McKittrick, "Making Bottom-Up ABC Work at Reichhold, Inc.," Strategic Finance, April 2002, pp. 5155. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 4: Cost Management Systems and Activity-Based Costing 159 Activity-Based Management: A Cost Management System Tool As we mentioned previously, ABC systems not only develop more accurate costs, they also aid in the control of costs. Recall that managers' day-to-day focus is on managing activities, not costs. Because ABC systems also focus on activities, they are a very useful tool in cost management systems. Activity-based management (ABM) is using the output of an activity-based cost accounting system to aid strategic decision making and to improve operational control of an organization. The strategic decision to emphasize the pen casing products at Lopez Plastics is an example of ABM. In the broadest terms, ABM aims to improve the value received by customers and to improve profits by identifying opportunities for improvements in strategy and operations. One of the most useful applications of ABM is distinguishing between value-added costs and non-value-added costs. A value-added cost is the cost of an activity that a company cannot eliminate without affecting a product's value to the customer. Valueadded costs are necessary (as long as the activity that drives such costs is performed efficiently). In contrast, companies try to minimize non-value-added costs, costs that a company can eliminate without affecting a product's value to the customer. Activities such as handling and storing inventories, transporting partly finished products from one part of the plant to another, and changing the setup of production-line operations to produce a different model of the product are all non-value-adding activities. A company can often reduce, if not eliminate, them by careful redesign of the plant layout and the production process. Another ABC-related technique is benchmarking, the continuous process of comparing products, services, and activities to the best industry standards. Benchmarking is a tool to help an organization measure its competitive posture. Benchmarks can come from within the organization, from competing organizations, or from other organizations having similar processes. Consider the billing center at AT&T's Business Communication Services (BCS) unit discussed in the chapter opening vignette. Unit costs for key activities provided the basis for benchmarking the work groups within the billing center as well as between different billing centers in the AT&T system. AT&T used the cost drivers for key activities--for example, the time to process a work order--as operational benchmarks. The most efficient work groups and centers shared their ideas for process improvements with other groups and centers. Companies must exercise caution when benchmarking, especially when using financial benchmarks. Consider a California bank with branches located in Chico and several in San Francisco. The bank's benchmarking system uses the financial measure cost per deposit as a benchmark for the deposit-processing efficiency. A small branch located in Chico, a small city in the north central part of the state, has constantly set the benchmark. The San Francisco branches cannot come close to matching this benchmark. Why? There can be numerous reasons, but we point out two that are fairly common. First, costs differ in various parts of the country and especially in different parts of the world. The most obvious reason for the difference in Chico and San Francisco costs is the salaries of tellers. Tellers in metropolitan areas receive much higher wages because of the higher cost of living. The higher costs are reflected in the numerator of the benchmark measure. A second reason is the difference in the scope of the ABC system. Tellers at the Chico branch use the same processing equipment as other branches. Chico's ABC system does not allocate the costs of the equipment to the deposit-processing activity; these costs are unallocated. In contrast, the costs of processing equipment at the San Francisco branches is captured by their ABC systems and allocated to the processing O B J E C T I V E Use activity-based management (ABM) to make strategic and operational control decisions. activity-based management (ABM) Using the output of an activity-based cost accounting system to aid strategic decision making and to improve operational control of an organization. value-added cost The necessary cost of an activity that cannot be eliminated without affecting a product's value to the customer. non-value-added costs Costs that a company can eliminate without affecting a product's value to the customer. benchmarking The continuous process of comparing products, services, and activities against the best industry standards. 8 ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 160 Part 1: Focus on Decision Making activity. This will cause the numerator of the benchmark measure to be higher at the San Francisco branches. As a result, even if the tellers process deposits faster and more accurately at the San Francisco branches, their performance will not appear to be as good as the tellers at the Chico branch. Perhaps a better measure of the deposit process would be the time to process a deposit, a strictly nonfinancial benchmark. Benefits of Activity-Based Costing and Activity-Based Management Activity-based costing systems are more complex and costly than traditional systems. So companies that have relatively simple operating systems may not realize sufficient benefits to warrant using ABC systems. But more organizations in both manufacturing and nonmanufacturing industries are adopting activity-based costing systems for a variety of reasons: Fierce competitive pressure has resulted in shrinking profit margins. Companies may know their overall margin, but they often do not have confidence in the accuracy of the margins for individual products or services. Some are winners and some are losers-- but which ones? Accurate costs are essential for answering this question. Consider Taylor Corporation, one of the largest specialty printers in the United States with annual sales of more than $1.3 billion. Its products include wedding invitations, company stationery, Post-it notes, greeting cards, and calendars. One of its operating divisions implemented an ABC system to provide better information on the profitability of more than 3,500 products. Managers used the ABC information to set an optimal product mix and to estimate the profit margins of new products. Greater diversity in the types of products and services as well as customer classes results in greater business operating complexity. Often in such situations the consumption of a company's shared resources also varies substantially across products and customers--a condition that adds to the value of ABC systems. New production techniques have increased the proportion of indirect costs. That is, indirect costs are far more important in today's automated world-class manufacturing environment than they have been in the past. In many industries, automated equipment is replacing direct labor. Indirect costs are sometimes more than 50% of total cost. Because ABC systems focus on indirect costs, they are more common in companies with automated production processes. The rapid pace of technological change has shortened product life cycles. Hence, companies do not have time to make price or cost adjustments once they discover costing errors. The accurate costs produced by ABC systems are essential. The costs associated with bad decisions that result from inaccurate cost determinations are substantial. Examples include bids lost due to overcosted products, hidden losses from undercosted products, and failure to detect activities that are not cost effective. Companies with accurate ABC product costs have a huge advantage over those with inaccurate costs. Computer technology has reduced the costs of developing and operating ABC systems. While many companies throughout the world are adopting ABC systems, some German companies, including Deutsche Telekom and DaimlerChrysler, have gone a step further. They are using a cost accounting system called Grenzplankostenrechnung (GPK). Most GPK systems use between 400 and 2,000 cost pools to allocate indirect manufacturing costs. The Business First box on p. 161 summarizes some of the characteristics of GPK. GPK A German cost accounting system, called Grenzplankostenrechnung, that goes a step further than ABC systems. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. GPK AND ABC: SUPPORT FOR SHORT-TERM AND LONG-TERM DECISIONS Many companies throughout the world have developed sophisticated cost accounting systems. In the United States, many companies have adopted ABC. Meanwhile, companies in many northern European countries, such as France, Norway, Sweden, the Netherlands, and Germany, are increasingly using GPK, a system first developed 50 years ago in Germany. Among the GPK companies are Porsche, Stihl, Deutsche Telekom, and DaimlerChrysler. An interesting note on the latter is that the Daimler side of the company (in Germany) uses a sophisticated GPK system, while the Chrysler side (in the United States) doesn't use GPK at all. Advances in computer technology have made widespread use of these cost accounting systems more practical. When companies adopt Enterprise Resource Planning (ERP) systems that include software for ABC and GPK, they can upgrade their cost accounting systems without a huge additional investment. The ERP system of SAP, a German software company that helped pioneer such systems, offers the framework for GPK as part of its management accounting module, a main factor in the expanding use of GPK. ABC and GPK embody different approaches to developing cost accounting information. The main difference is that GPK separates fixed and variable costs and applies only variable costs to products or services. Although the ABC approach could do the same, most ABC systems focus on applying all production-related costs (and, often, some nonproduction value-chain costs). Thus, GPK systems measure profitability on a contribution-margin basis, while ABC systems generally produce full-cost margins. Another difference between ABC and GPK is how they define cost pools for allocation. ABC companies focus on activities, with only a few major identified activities. In contrast, GPK companies focus on cost centers and may have thousands of cost centers. Deutsche Telekom has about 20,000, although Porsche has only 450, and most companies have between 400 and 2,000. Most cost centers are work units of only a few people, often 10 workers or less. In both systems, the cost center or activity is the focus of day-to-day cost control. The GPK systems bring this focus down to a much lower level than do most ABC systems. Which is best, ABC or GPK? Like many management accounting issues, the answer is "it depends." Because GPK focuses on contribution margins, it provides information that is more relevant for short-term decisions. In contrast, ABC starts with a long-term perspective, information more suited to strategic decisions. However, GPK systems can add a full-cost calculation for long-term decision purposes, and many ABC systems can separate fixed and variable costs for short-term decisions. Further, the difference between cost-center and activity-based cost pools may not be especially significant because underlying cost pools and cost drivers can be similar in both systems. Although there remain basic philosophical differences related to allocation of fixed costs and definitions of cost pools, in practice companies that use a combination of GPK and ABC principles may find the best of both worlds. Sources: G. Frield, H. Kupper, and B. Pedell, "Relevance Added: Combining ABC with German Cost Accounting," Strategic Finance, June 2005, pp. 5661; K. Krumwiede, "Rewards and Realities of German Cost Accounting," Strategic Finance, April 2005, pp. 2734; P. Sharman and B. Mackie, "Grenzplankostenrechnung (GPK): German Cost Accounting, Flexible Planning and Control," IMA Web site, www.imanet.org/pdf/ 3202.pdf#search=%22Grenzplankostenrechnung%22. Highlights to Remember Explain the relationship among cost, cost object, cost accumulation, and cost assignment. Cost accounting systems provide cost information about various types of objects--products, customers, activities, and so on. To do this, a system first accumulates resource costs by natural classifications, such as materials, labor, and energy. Then, it assigns these costs to cost objects, either tracing them directly or assigning them indirectly through allocation. ISBN: 0-536-47129-0 1 2 3 Describe the purposes of cost management systems. Cost management systems provide cost information for external financial reporting, for strategic decision making, and for operational cost control. Distinguish between direct and indirect costs. Accountants can specifically and exclusively identify direct costs with a cost object in an economically feasible way. When this is not possible, accountants may allocate costs to cost objects using a cost driver. Such costs are called indirect costs. The greater the proportion of direct costs, the greater the accuracy of the cost system. When the Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 162 Part 1: Focus on Decision Making proportion of indirect costs is significant, accountants must take care to find the most appropriate cost drivers. Explain the major reasons for allocating costs. The four main purposes of cost allocation are to predict the economic effects of planning and control decisions, to motivate managers and employees, to measure the costs of inventory and cost of goods sold, and to justify costs for pricing or reimbursement. Some costs are unallocated because the accountants can determine no plausible and reliable relationship between resource costs and cost objects. 4 5 6 7 8 9 Identify the main types of manufacturing costs: direct materials, direct labor, and indirect production costs. The main types of manufacturing costs are direct materials, direct labor, and indirect production costs. Accountants can trace direct materials and direct labor to most cost objects, and they allocate the indirect production costs using a cost allocation base. Explain how the financial statements of merchandisers and manufacturers differ because of the types of goods they sell. The primary difference between the financial statements of a merchandiser and a manufacturer is the reporting of inventories. A merchandiser has only one type of inventory whereas a manufacturer has three types of inventory--raw materials, work-in-process, and finished goods. Understand the main differences between traditional and activity-based costing systems and why ABC systems provide value to managers. Traditional systems usually allocate only the indirect costs of the production function. ABC systems allocate many (and sometimes all) of the costs of the value-chain functions. Traditional costing accumulates costs using categories such as direct material, direct labor, and production overhead. ABC systems accumulate costs by activities required to produce a product or service. The key value of ABC systems is in their increased costing accuracy and better information provided that can lead to process improvements. Use activity-based management (ABM) to make strategic and operational control decisions. Activity-based management is using ABC information to improve operations. A key advantage of an activity-based costing system is its ability to aid managers in decision making. ABC improves the accuracy of cost estimates, including product and customer costs and the costs of value-added versus nonvalue-added activities. ABC also improves managers' understanding of operations. Managers can focus their attention on making strategic decisions, such as product mix, pricing, and process improvements. Describe the steps in designing an activity-based costing system (Appendix 4). Designing and implementing an activity-based costing system involves four steps. First, managers determine the cost objects, key activities, and resources used, and they identify cost drivers (output measures) for each resource and activity. Second, they determine the relationship among cost objects, activities, and resources. The third step is collecting cost and operating data. The last step is to calculate and interpret the new activitybased information. Often, this last step requires the use of a computer due to the complexity of many ABC systems. Appendix 4: Detailed Illustration of Traditional and Activity-Based Cost Accounting Systems As we mentioned in the chapter, ABC systems are much more complex than traditional systems. In this appendix, we go a bit further in depth than the Lopez Plastics Company example. You will notice, however, that the main concepts are exactly the same--only the details will change. Suppose the billing department of one of AT&T's smaller customer care centers requires accurate and useful information about the cost of providing account inquiry and bill printing services for its 120,000 residential and 20,000 commercial customer accounts. A local service bureau has offered to provide all the services currently performed by the billing department at $4.30 per residential account and $8.00 per commercial account. To make informed decisions, AT&T's managers need accurate estimates of the department's own cost per residential account and cost per commercial account. They also need to know the costs of the key activities performed in the department to determine whether they can achieve cost savings through better control of their activities. Exhibit 4-8 depicts the residential and commercial customer classes (cost objects) and the resources used to support the billing department. All the costs incurred in the billing department are indirect. There are no direct costs or unallocated costs. The billing department currently uses a traditional costing system that allocates all indirect production costs based on the number of account inquiries. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 4: Cost Management Systems and Activity-Based Costing 163 Current Costing Based on One Overall Rate--Total Cost $687,500 Telecommunications $58,520 Computer $178,000 Supervisors $33,600 Paper $7,320 Occupancy $47,000 Account Inquiry Labor $173,460 Printing Machines $55,000 20,000 (80%) Billing and Verification Labor $67,500 5,000 (20%) Other Resouces $67,100 Cost Driver: Number of Inquiries Residential Accounts $550,000 Commercial Accounts $137,500 Cost/Inquiry $687,500/25,000 Number of Inquiries Total Cost Number of Accounts Cost/Account Residential Commercial $27.50 $27.50 20,000 5,000 $550,000 $137,500 120,000 20,000 $4.58 $6.88 Exhibit 4-8 Traditional Costing System at the Billing Department ISBN: 0-536-47129-0 Exhibit 4-8 shows that the resources used in the billing department last month cost $687,500. The traditional cost accounting system is very simple. It adds together all indirect costs and then allocates them based on the number of inquiries the department receives from each customer class. The billing department received 25,000 account inquiries during the month, so the cost per inquiry was $687,500 25,000 = $27.50. There were 20,000 residential account inquiries, 80% of the total. Thus, we assign 80% of the indirect production cost to residential accounts and 20% to commercial accounts. The resulting cost per account is ($687,500 .8) 120,000 = $4.58 and ($687,500 .2) 20,000 = $6.88 for residential and commercial accounts, respectively. Does this traditional cost accounting system provide managers with accurate estimates of the cost to serve residential and commercial customers? If the answer is yes, the billing department management would accept the service bureau's proposal to service residential accounts because of the apparent savings of $4.58 - $4.30 = $.28 per account. The billing department would continue to service its commercial accounts because its costs are $8.00 - $6.88 = $1.12 less than the service bureau's bid. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 164 Part 1: Focus on Decision Making MAKING MANAGERIAL DECISIONS Suppose AT&T's management retains its traditional cost accounting system but believes that a more plausible and reliable cost driver is "number of printed lines." Each residential bill averages 12 lines and each commercial bill averages 50 lines. What would be the new cost per account for residential and commercial customers based on number of lines per bill? How would this new cost accounting information affect the outsourcing decision? Instead of allocating 80% of total costs to residential customers, we would allocate only (12 120,000) [(12 120,000) + (50 20,000)] = 59% of total costs to residential customers and the other 41% to commercial accounts. The cost per account for residential customers would then be (59% $687,500) 120,000 = $3.38, and the cost per commercial account would be (41% $687,500) 20,000 = $14.09. The outsourcing decision would likely change. We would outsource commercial accounts but not residential accounts. A key issue is how much confidence management has in the costs it uses for decision making. Poor cost data can lead to poor decisions. Answer The total costs would be the same, but the allocation of the total cost to each customer class would change. Now suppose you are the billing department manager and you know that billing employees spend much of their time verifying the accuracy of commercial bills and very little time verifying residential bills. Yet the traditional cost accounting system allocates 80% of the costs of this work to residential customers. Does this make sense to you? Do you have some doubt about the accuracy of the cost-peraccount data? You also know that commercial accounts average 50 lines or two pages per bill, compared with only 12 lines or one page for residential accounts. This means that the billing department uses much more paper, computer time, and printing machine time for each commercial account. Again, this does not agree with the percentage of allocations based on number of inquiries. In addition, you believe that the actual consumption of support resources for commercial accounts is much greater than 20% because of their complexity. As the billing department manager, you are also concerned about activities such as verification of commercial bills, inquiries from customers, and correspondence resulting from customer inquiries. These activities consume costly resources but do not add value to AT&T's services from the customer's perspective. To reduce these costs, management needs a more thorough understanding of the relationships among key activities and resource costs. In summary, you would probably conclude that AT&T needs to improve the billing department's traditional cost accounting system because it is not providing managers with useful information for strategic decisions or operational control. This is exactly what AT&T's management concluded. So, let's see how we might design an activity-based costing system for the billing department. Design of an Activity-Based Cost Accounting System How do managers actually design ABC systems? At the billing department of AT&T's customer-care center, a team of managers from the billing department and AT&T's regional controller used the following four-step procedure to design their new cost accounting system. Step 1: Determine the Key Components of the Activity-Based Cost Accounting System O B J E C T I V E Describe the steps in designing an activitybased costing system. 9 The key components of an activity-based cost accounting system are cost objects, key activities, resources, and related cost drivers. These components, together with the purpose of the new system, determine the scope of the ABC system. Management at AT&T wanted the system to (1) determine the billing department cost per account for each customer class to better support the strategic decision regarding outsourcing accounts to the local service bureau, and (2) enhance the managers' understanding of key billing department activities to support operational cost control. Because the bid from the local service bureau includes performing all the activities of the department, the ABC system must include all department costs. Further, because management wants to understand the key activities and related costs, the team designed an activity-based system. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 4: Cost Management Systems and Activity-Based Costing 165 Through interviews with the department supervisors, management identified the following activities and related cost drivers to use as cost-allocation bases for the billing department. Activity Account billing Bill verification Account inquiry Correspondence Other activities Cost Driver Number of printed pages Number of accounts verified Number of inquiries Number of letters Number of printed pages The four key billing department activities are account billing, bill verification, account inquiry, and correspondence. These activities require the vast majority of the work done in the billing department. There are other activities performed in the billing department, such as routine printer and computer maintenance, training, and preparing monthly reports. Management did not identify these as individual activities. Instead, the team lumped them together and labeled them "other activities." Why? Because the cost of the resources used for each of these individual activities was relatively small, the team could not find plausible and reliable cost drivers for them, or the cost of collecting data was too high. The cost-allocation base selected for the "other activities" cost pool is number of printed pages because most of the other activities, such as maintenance and training, are associated in some way with the printing function. Exhibit 4-8 shows the resources used by the billing department. MAKING MANAGERIAL DECISIONS Billing department managers debated whether they should allocate the "other activities" cost pool to the two customer classes or leave it unallocated. Although the plausibility and reliability of the cost-allocation base--number of printed pages--was not as high as normally desired, management accepted it because they wanted to allocate all costs to the two customer classes in order to compare full unit costs to the costs bid by the local service bureau. What would be the impact on the costs per account if the billing department did not allocate the "other activities" cost pool? Answer The computed costs per account would be less if the billing department did not allocate the other activities cost pool. This may lead to a bad decision by management to reject the ser vice bureau's offer if it is higher than the computed cost only because the computed cost does not include the cost of other activities. This is a common managerial issue--the trade-off between the need for comparability of cost data and the need for plausible and reliable cost drivers used to generate the cost data. Step 2: Determine the Relationships Among Cost Objects, Activities, and Resources An important phase of any activity-based analysis is identifying the relationships among key activities and the resources consumed. The management team does this by interviewing personnel and analyzing various internal data. AT&T interviewed all employees as part of its ABC study. For example, they asked supervisors how they spend their time. Based on time records, the supervisors estimated that they spend most of their time (40%) supervising account inquiry activity. They also estimated that they spend about 30% of their time supervising billing activity and about 10% of their time reviewing and signing correspondence. They spend the remaining 20% of their time on all other department activities. Exhibit 4-9 shows the results of the interviews. Implementing an ABC system requires a careful study of operations. As a result, managers often discover that they can trace directly to cost objects some previously indirect or even unallocated costs, thus improving the accuracy of product or service costs. During interviews with the billing department supervisors, the ABC team learned that several of the billing employees work exclusively on verification of commercial bills. Thus, the team could trace their salaries--$11,250--directly to the verification activity. Further, because the billing department performs verification activity for only commercial accounts, they could also trace this cost pool directly to the commercial customer cost object. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 166 Part 1: Focus on Decision Making Activity Performed Resource Used to Perform Activity Supervisor Account inquiry labor Billing labor Verification labor Paper Computer Telecommunications Occupancy Printing machines All other department resources Account Inquiry Activity 40% 90 Correspondence Activity 10% 10 Billing Activity 30% 30 100 35 15 90 70 100 10 5 10 20 5 100 Verification Activity All Other Activities 20% Total 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 45 90 65 5 5 Exhibit 4-9 Analysis of Interviews with Supervisors from the Billing Department Look at the computer resource row in Exhibit 4-9. The supervisor indicated that 45% of this resource supports account inquiry, 5% supports correspondence, and so on. How did the supervisor determine these percentages? Initially, he might simply estimate them. Later, he might gather data to support his estimates. Now consider the occupancy resource row. The percentages used to allocate this resource might be based on the square feet used by the various employees for each activity compared to the total square feet in the department. Next, the team determined which activities were needed by each cost object. The supervisors indicated that residential customers needed account inquiry, correspondence, and billing activities. Commercial customers needed account inquiry, correspondence, billing, and verification activities. Both also need other activities. MAKING MANAGERIAL DECISIONS From Exhibit 4-9, suggest output measures that the billing department might use to determine the percentage of the telecommunications, printing machines, and paper resource costs to allocate to the indicated activities. Which of these costs is a direct cost with respect to the related activity but an indirect cost with respect to the customer cost objects? Answer There are several reasonable output measures for each resource. Accountants often use minutes or hours to allocate telecommunication costs. They can use machine time, lines printed, or pages printed to allocate printing machine costs. Paper is a direct cost to the printing activity so a cost-allocation base is not necessar y. Note that the paper resource is an indirect cost with respect to the final cost objective--customers. It will be part of the printing activity cost pool to be allocated based on pages printed. The process map in Exhibit 4-10 depicts in a concise manner the same information that was gathered from interviews. We allocate the costs of the 10 resources to the 5 activities. For example, account inquiry activity consumes 65% of occupancy costs, 90% of telecommunication resources, 45% of computer resources, 40% of supervisor resources, and 90% of account inquiry labor. Then, we allocate the costs of the five activities to the two customer cost objects--residential and commercial. For example, commercial accounts require account inquiry, correspondence, billing, verification, and other activities. We allocate the activity costs based on a measure of the amount of activity that each ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 4: Cost Management Systems and Activity-Based Costing 167 Supervisor Expenses $33,600 S Account Inquiry Labor Expenses $173,460 A Billing Labor Expenses $56,250 B Verification Labor $11,250 V Paper Expense $7,320 P Determined by breaking down accounts in the general ledger. Telecommunication Expense $58,520 Printer Depreciation Expense $55,000 PD Determined through interviews with operating managers. S A C T O S A C PD S B P C O PD B V C S C T O PD OR Computer Expense $178,000 Occupancy Expenses $47,000 O Other Resources $67,100 OR C T 40% 90% 45% 90% 65% ACCOUNT INQUIRY ACTIVITY COST POOL 10% 10% 5% 5% 30% 30% 100% 35% 15% 90% 70% 100% 10% 20% 5% 10% 20% 5% 100% Inquiries Letters Printed Pages Accounts Verified Printed Pages Residential Accounts 20,000 Inquiries 1,800 Letters 120,000 Printed Pages 120,000 Accounts Commercial Accounts 5,000 Inquiries 1,000 Letters 40,000 Printed Pages 20,000 Accounts Exhibit 4-10 Two-Stage Cost Allocation for Billing Department Operations customer uses. For example, we allocate the account inquiry activity cost pool based on the number of inquiries received from residential and commercial accounts. Process maps can be a key tool for managers to gain an understanding of operations. For example, AT&T's managers considered this process map critical because it revealed how AT&T conducted business. Managers were able to see how operating activities consume costly resources. Normally, we do not collect the cost data and the cost driver data shown in Exhibit 4-10 until we have drawn the process map and identified the resources and cost drivers. The ABC team uses the process map as a guide for the next step in designing the ABC system--data collection. Step 3: Collect Relevant Data Concerning Costs and the Physical Flow of the CostDriver Units Among Resources and Activities Using the process map as a guide, billing departISBN: 0-536-47129-0 ment managers collected the required cost and operational data by further interviews with relevant personnel. Sources of data include the accounting records, special studies, and sometimes "best estimates of managers." They collected resource cost information from the general ledger (Exhibit 4-8) and data on the flow of cost drivers from various operational reports (Exhibits 4-9 and 4-11). Exhibit 4-10 shows the data collected. Management can now use the completed process map to determine costs for the strategic and operational decisions that they must make. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 168 Part 1: Focus on Decision Making Exhibit 4-11 Number of Cost Driver Units for the Billing Department Number of Cost Driver Units Activity Account inquiry Correspondence Billing Verification Other activities Cost Driver Units Inquiries Letters Printed pages Accounts verified Printed pages Residential 20,000 1,800 120,000 120,000 Commercial 5,000 1,000 40,000 20,000 40,000 Total 25,000 2,800 160,000 20,000 160,000 Step 4: Calculate and Interpret the New Activity-Based Cost Information After collecting all required financial and operational data, we can calculate the new activity-based information. Exhibit 4-12 summarizes stage 1 allocations. It shows the total traceable costs for the five activity cost pools. Notice that the total traceable costs of $332,872 + $32,356 + $153,125 + $68,425 + $100,722 = $687,500 in Exhibit 4-12 equals the total indirect costs in Exhibit 4-8. Now we can determine the activity-based cost per account for each customer class (stage 2 allocations) from the data in step 3. Exhibit 4-13 shows the computations. Examine the last two rows in Exhibit 4-13. Notice that traditional costing overcosted the highvolume residential accounts and substantially undercosted the low-volume, complex commercial accounts. The cost per account for residential accounts using ABC is $3.98, which is $0.60 (or 13%) less than the $4.58 cost generated by the traditional costing system. The cost per account for commercial accounts is $10.50, which is $3.62 (or 53%) more than the $6.88 cost from the traditional costing system. The analysis confirms management's belief that the traditional system undercosted commercial accounts. AT&T's management now has more accurate cost information for strategic decisionmaking and cost control purposes. Results like these are common when companies perform activitybased costing studies. Traditional systems generally overcost high-volume cost objects with simple processes. Which system makes more sense--the traditional allocation system that "spreads" all support costs to customer classes based solely on the number of inquiries, or the ABC system that identifies key activities and assigns costs based on the consumption of units of cost drivers for each key activity? For AT&T, the probable benefits of the new ABC system appear to outweigh the costs of implementing and maintaining the new cost system. Activity Cost Pool Resource Supervisors Account inquiry labor Billing labor Verification labor Paper Computer Telecommunication Occupancy Printers Other resources Total traceable cost Cost (from Exhibit 4-8) $ 33,600 173,460 56,250 11,250 7,320 178,000 58,520 47,000 55,000 67,100 $687,500 Account Inquiry $ 13,440* 156,114 Correspondence $ 3,360** 17,346 16,875 7,320 62,300 7,050 49,500 $39,375 11,250 17,800 8,900 5,852 9,400 2,750 67,100 $100,722 $ Billing 10,080*** Verification $ Other 6,720**** 80,100 52,668 30,550 8,900 2,750 $332,872 $32,356 $153,125 $68,425 * From Exhibits 4-9 and 4-10, account inquiry activity uses 40% of the supervisor resource. So the allocation is 40% $33,600 = $13,440. ** 10% $33,600 *** 30% $33,600 **** 20% $33,600 ISBN: 0-536-47129-0 Exhibit 4-12 Total Traceable Cost of Activities in the Billing Department Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 4: Cost Management Systems and Activity-Based Costing 169 Driver Costs Traceable Costs (from Exhibit 4-12) (1) $332,872 $ 32,356 $153,125 $ 68,425 $100,722 Total Number of Driver Units (From Exhibit 4-11) (2) 25,000 Inquiries 2,800 Letters 160,000 Printed pages 20,000 Accounts verified 160,000 Printed pages Cost per Driver Unit (1) (2) $13.314880 $11.555714 $ 0.957031 $ 3.421250 $ 0.629513 Activity (Driver Units) Account inquiry (inquiries) Correspondence (letters) Account billing (printed pages) Bill verification (accounts verified) Other activities (printed pages) Cost per Customer Class Residential Commercial Cost per Driver Unit Account inquiry Correspondence Account billing Bill verification Other activities Total cost Number of accounts Cost per account Cost per account, traditional system from Exhibit 4-8 $13.314880 $11.555714 $ 0.957031 $ 3.421250 $ 0.629513 Number of Driver Units 20,000 Inquiries 1,800 Letters 120,000 Pages 120,000 Pages Cost $266,298 20,800 114,844 75,541 $477,483 120,000 $ 3.98 $ 4.58 Number of Driver Units 5,000 Inquiries 1,000 Letters 40,000 Pages 20,000 Accts. 40,000 pages Cost $ 66,574 11,556 38,281 68,425 25,181 $210,017 20,000 $ 10.50 $ 6.88 Exhibit 4-13 Key Results of Activity-Based Costing Study Strategic Decisions, Operational Cost Control, and ABM Now let's see how billing department managers can use the ABC system to improve their strategic decisions and operational cost control. Suppose that the billing department needed to find a way to increase its capacity to handle more accounts due to an expected large increase in demand from a new housing development and a business center. Managers proposed a strategic action--outsource certain customer accounts to a local service bureau. Billing department managers were also interested in reducing the operating costs of the department while not impairing the quality of the service it provided to its customers. To address both of these issues, they used the ABC information from Exhibit 4-13 to identify non-value-added activities that had significant costs. Account inquiry and bill verification activities are non-value-added and costly so management asked for ideas for cost reductions. The new information provided by the ABC system generated the following ideas. Use the service bureau for commercial accounts because of the significant cost savings. From Exhibit 4-13, the service bureau's bid is $8.00 per account, compared to the billing department's activity-based cost of $10.50, a potential savings of $2.50 per account! In addition, department managers would try to eliminate or reduce bill verification, commercial account inquiry, and commercial account correspondence activities, all non-value-adding activities. Suppose AT&T outsourced commercial customers to the service bureau. Would actual costs immediately decrease by $50,000 ($2.50 for each of 20,000 commercial accounts)? No. Only the variable portion of resource costs, such as paper, variable telecommunication charges, variable computer charges, and overtime or part time labor, would decrease immediately. The fixed cost portion of all these resources would not change without some specific management actions. For example, suppose billing labor used for verification is a fixed-cost resource. Then, the time formerly required for verification is idle time, but the company must still pay wages. Management would have to decide whether to lay off billing employees or to keep them in anticipation of the increase in printing activity due to the expected increase in residential customers. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 170 Part 1: Focus on Decision Making Exhibit 4-13 indicates that account inquiry activity is very costly, accounting for a significant portion of total billing department costs. A benchmarking analysis showed the cost per inquiry of $13.31 was unusually high compared to similar measures at other customer care centers. The billing department managers developed ideas for process improvements at meetings with the managers from centers that had significantly lower activity cost rates. One idea that resulted from these meetings was to implement a Web-based inquiry system to handle routine questions about bills. The billing department, like so many companies that have adopted ABC and ABM, improved both strategic and operational decisions. Summary Problem for Your Review PROBLEM Refer to the billing department illustration. Suppose that management at AT&T's Youngstown area customer care center is implementing an ABC system. The center has 98,000 residential customers and 25,000 commercial customers. An ABC team has collected the data shown in Exhibit 4-14. Management has decided not to allocate the other resource costs. 1. Using the same format as Exhibits 4-12 and 4-13, prepare schedules to determine the cost per driver unit for each activity and the activity-based cost per account for each customer type. 2. Consider the verification activity. Suppose the cost per account verified is $0.45. The center verifies 50% of residential and commercial bills. Given that there are, on average, 50 lines on each commercial bill and only 12 lines on each residential bill, criticize the use of accounts verified as a cost driver and suggest a more plausible and reliable cost driver. Percent of Resource Used in Activity Resource Supervisors Account inquiry labor Billing labor Paper Computers Telecommunications Occupancy Printers Other Total Monthly Cost $ 30,500 102,000 45,000 5,800 143,000 49,620 56,000 75,000 59,000 $565,920 Billing 40% 70 100 30 15 80 Account Inquiry 35% 85 Correspondence 8% 15 30 48 85 70 7 10 5 15 15 15 100 Verification Other 17% 5 Monthly Number of Cost Driver Units Activity Billing Account inquiry Correspondence Verification Cost Driver Lines Inquiries Letters Accounts verified Residential 1,176,000 9,800 1,960 49,000 Commercial 1,250,000 7,500 2,500 12,500 Total 2,426,000 17,300 4,460 61,500 ISBN: 0-536-47129-0 Exhibit 4-14 First Stage Percentage Allocations and Monthly Number of Cost Driver Units Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 4: Cost Management Systems and Activity-Based Costing 171 Activity Resource Supervisors Account inquiry labor Billing labor Paper Computer Telecommunication Occupancy Printers Other resources Total traceable cost * 40% $30,500 ** 35% $30,500 *** 8% $30,500 **** 17% $30,500 Cost (from Exhibit 4-14) $ 30,500 102,000 45,000 5,800 143,000 49,620 56,000 75,000 59,000 $565,920 Billing Account Inquiry Correspondence $ 2,440*** 15,300 Verification Other $ 5,185**** $ 12,200* $ 10,675** $ 86,700 31,500 5,800 42,900 68,640 42,177 8,400 39,200 60,000 $160,800 $247,392 $13,500 10,010 14,300 7,150 7,443 8,400 11,250 59,000 $98,428 3,750 $31,500 $27,800 Exhibit 4-15 Total Traceable Cost of Activities in the Billing Department SOLUTION 1. Exhibit 4-15 is a schedule showing the traceable cost of each activity of the billing department. From this we can determine the cost per driver unit and the activity-based cost per account for each customer class, as shown in Exhibit 4-16. 2. The ABC system allocates 49,000 (49,000 + 12,500) = 79.7% of verification costs to residential accounts based on the number of accounts verified. However, the work Driver Costs Traceable Costs (From Exhibit 4 - 15) Activity (Driver Units) Account inquiry (inquiries) Correspondence (letters) Account billing (lines) Bill verification (accounts verified) (1) $247,392 $ 31,500 $160,800 $ 27,800 Residential Cost per Driver Unit Account inquiry Correspondence Account billing Bill verification Total cost Number of accounts Cost per account ISBN: 0-536-47129-0 Total Number of Driver Units (From Exhibit 4 - 14) (2) 17,300 Inquiries 4,460 Letters 2,426,000 Lines 61,500 Accounts Verified Cost per Driver Unit (1) (2) $14.300116 $ 7.062780 $ 0.066282 $ 0.452033 Cost per Customer Class Commercial Cost $140,141 13,843 77,947 22,149 $254,081 98,000 $ 2.59 Number of Driver Units 7,500 Inquiries 2,500 Letters 1,250,000 Lines 12,500 Accounts Cost $107,251 17,657 82,853 5,650 $213,411 25,000 $ 8.54 Number of Driver Units 9,800 Inquiries 1,960 Letters 1,176,000 Lines 49,000 Accounts $14.300116 $ 7.062780 $ 0.066282 $ 0.452033 Exhibit 4-16 Cost Per Driver Unit and Activity-Based Cost Per Account Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 172 Part 1: Focus on Decision Making performed to verify a bill is probably closely related to the number of lines on the bill. Using accounts verified assumes that employees expend the same amount of effort verifying residential accounts and commercial accounts, even though there are many fewer lines on residential bills. Thus, the cost driver "lines verified" is more plausible and reliable. The number of lines verified for commercial accounts are 50 lines per account 12,500 accounts = 625,000 lines and for residential accounts are 12 lines per account 49,000 accounts = 588,000 lines. Thus, we would allocate 588,000 (588,000 + 625,000) = 48.5% of verification costs to residential accounts based on lines verified. ABC teams should always exercise care when choosing cost drivers to use as allocation bases. The Youngstown team might also want to investigate the plausibility and reliability of the "number of inquiries" cost driver because this assumes that residential and commercial customer inquiries require the same amount of work. Accounting Vocabulary Activity-based costing (ABC) systems, p. 150 activity-based management (ABM), p. 159 benchmarking, p. 159 cost, p. 137 cost accounting, p. 137 cost accounting systems, p. 137 cost accumulation, p. 138 cost allocation, p. 140 cost-allocation base, p. 140 cost assignment, p. 138 cost management system (CMS), p. 136 cost object, p. 137 cost objective, p. 137 cost pool, p. 142 direct costs, p. 139 direct-labor costs, p. 146 direct-material costs, p. 146 direct-material inventory, p. 147 factory burden, p. 146 factory overhead, p. 146 finished-goods inventory, p. 147 GPK, p. 160 indirect costs, p. 139 indirect manufacturing costs, p. 146 indirect production costs, p. 146 inventoriable costs, p. 147 manufacturing overhead, p. 146 non-value-added costs, p. 159 period costs, p. 147 process map, p. 151 product costs, p. 147 tracing, p. 139 traditional costing systems, p. 150 two-stage ABC system, p. 154 unallocated costs, p. 143 value-added cost, p. 159 work-in-process inventory, p. 147 Fundamental Assignment Material 4-A1 Direct, Indirect, and Unallocated Costs, Process Map Beltran Door Company makes and sells three product lines--custom detailed doors, large standard doors, and small standard doors. The statement of operating income for the most recent period is shown below. Beltran Door Company Statement of Operating Income Total Sales Cost of goods sold Direct material Indirect manufacturing Gross profit Selling and administrative expenses: Commissions Distribution to warehouses Income before unallocated expenses Unallocated expenses Administrative salaries Other administrative expenses Operating income before taxes $150,000 $40,000 41,000 81,000 69,000 15,000 10,400 25,400 43,600 ISBN: 0-536-47129-0 8,000 4,000 12,000 $ 31,600 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 4: Cost Management Systems and Activity-Based Costing 173 Indirect Manufacturing Costs $41,000 Administrative $8,000 Salaries Distribution Costs $10,400 Other Administrative Costs $4,000 Machine Hours Kilograms Material $5,000 Commissions $1,500 Material $15,000 Commissions $3,500 Material $20,000 Commissions $10,000 Custom Detailed 1,400 Machine Hours 25,000 Kilograms 1,000 Frames Sold at $30/Unit Large Standard 250 Machine Hours 75,000 Kilograms 5,000 Frames Sold at $8/Unit Small Standard 400 Machine Hours 160,000 Kilograms 20,000 Frames Sold at $4/Unit Unallocated Costs $12,000 Exhibit 4-17 Process Map for Beltran Door Company's Traditional Cost Allocation System Beltran uses a traditional cost accounting system. A process map developed to describe this system is shown in Exhibit 4-17. To aid in the company's analysis of its product mix strategy, you have been asked to determine operating income (loss) for each product line. Use a format similar to Exhibit 4-3 on page 144 in the text. 4-A2 Financial Statements for Manufacturing and Merchandising Companies Base One Equipment (BOE) and Camping Supplies International (CSI) both sell tents. BOE purchases its tents from a manufacturer for $96 each and then sells them for $180. It purchased 10,000 tents in 20X4. CSI produces its own tents. In 20X4 CSI produced 10,000 tents. Costs were as follows: Direct materials purchased Direct materials used Direct labor Indirect manufacturing: Depreciation Indirect labor Other Total cost of production $570,000 $520,000 290,000 $50,000 60,000 40,000 150,000 $960,000 Assume that CSI had no beginning inventory of direct materials. There was no beginning inventory of finished tents, but ending inventory consisted of 1,000 finished tents. Ending work-in-process inventory was negligible. Each company sold 9,000 tents for $1,620,000 in 20X4 and incurred the following selling and administrative costs: Sales salaries and commissions Depreciation on retail store Advertising Other Total selling and administrative cost $105,000 40,000 25,000 15,000 $185,000 ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 174 Part 1: Focus on Decision Making 1. Prepare the inventories section of the balance sheet for December 31, 20X4, for BOE. 2. Prepare the inventories section of the balance sheet for December 31, 20X4, for CSI. 3. Using the cost of goods sold format on page 149 as a model, prepare an income statement for the year 20X4 for BOE. 4. Using the cost of goods sold format on page 149 as a model, prepare an income statement for the year 20X4 for CSI. 5. Summarize the differences between the financial statements of BOE, a merchandiser, and CSI, a manufacturer. 6. What purpose of a cost management system is being served by reporting the items in requirements 1 through 4? 4-A3 Activities, Resources, Cost Drivers, and the Banking Industry First Bank is a retail branch of an established banking corporation; it is located in a residential area, and it services mostly individuals and local businesses. First Bank's four main services are transaction processing (withdrawals, checks, currency exchange), loans, simple investments (individual clients), and complex investments (portfolios of large businesses). To support these activities, First Bank employs 10 front-office staff, 12 back-office staff dealing with loan applications and investments, and two people to consult with customers and manage complex portfolio investments. A team of three supervisors manages the overall operations of the bank. As part of First Bank's implementation of activity-based costing, it needed to identify activities, resources, and cost drivers. The following table summarizes the cost drivers First Bank has chosen for its activities and resources: Cost Driver number of investments number of applications number of loans number of person hours number of minutes number of computer transactions number of square feet number of loan inquiries number of transactions number of schedules number of securities For each brief description below, indicate whether it is an activity (A) or a resource (R). For each activity or resource, choose the most appropriate cost driver from the list above and indicate for each resource whether it is a fixed-cost (F) or variable-cost (V) resource. The first item is completed as a guide. a. b. c. d. e. f. g. h. i. j. k. l. Contract maintenance of building and insurance (R; number of square feet; F) Staff for front-line customer service External service bureau providing customer credit checks for loan applications Preparing investment documents for customers Research to evaluate a loan application Overtime by back-office staff Telephones/facsimile Staff for service and background research Establish customer collateral for approved loans External computing services Development of repayment schedules Staff for consulting with customers and arranging the portfolios ISBN: 0-536-47129-0 4-A4 Traditional and ABC Cost Accounting, Activity-Based Management Refer to the text discussion of Lopez Plastics Company on pages 152155. Assume that the company has the traditional cost accounting system described in Exhibit 4-6. The top management team wants to reverse the pattern of quarterly losses. The company president, Angie Oaks, has emphasized the Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 4: Cost Management Systems and Activity-Based Costing 175 importance of profit improvement by linking future pay raises of the two product-line managers to their respective gross profit margins. She is concerned about the profitability of the pen casing product line while pleased with the profitability of the cell phone casing line. She also believes that the unallocated costs of the company are too high compared to those of competitors. The office of controller, whose costs are included in the unallocated costs, is responsible for vendor relations and purchasing of direct materials. The controller presents the following idea: We should use more standard parts in cell phone casings, which will dramatically reduce the purchasing department's work required for purchasing. I believe this should cut our office's costs by as much as $25,000 per quarter. In addition, using standard parts eliminates the need to purchase several expensive resins. The larger volume of purchases of less costly resin from fewer vendors will cut the cell phone casing direct material cost by 10%. Product engineering agrees that this idea is not only feasible but, if implemented, would improve the overall quality of cell phone casings. The controller and marketing manager provided the following summary of actions and related effects: Action Reduce prices of cell phone casings 25%. Use standard parts wherever possible in cell phone casings. Expected effects The vice president of sales estimates that the improved quality of cell phone casings combined with the price reduction will yield a 100% increase in demand for cell phone casings per quarter. Total number of parts for each cell phone casing will not change, but the direct material cost per casing will be reduced by 10% due to volume discounts from preferred vendors. The use of fewer suppliers will reduce vendor-relations work by the purchasing department. This will result in unallocated costs decreasing by $25,000. Processing time, measured in direct-labor hours, will increase by 500 hours due to expected 100% increase in sales and production of cell phone casings, but there is adequate capacity of labor and machine time. Direct-labor costs are fixed as are all of the indirect manufacturing costs. Quality of cell phone casings will improve due to reduced complexity of processing. 1. Evaluate this idea using the traditional cost allocation system shown in Exhibit 4-6 on page 153. What would be the predicted profitability for each product line and the company as a whole? What would be the most likely level of support for the controller's idea by the product managers of the pen casing product line and the cell phone casing product line? What would be the level of support by the president? 2. Assume that you have the ABC system described in Exhibit 4-7 on page 155 with the gross profit margins shown in the table on page 157. Often, managers with ABC systems can anticipate more effects of improvement ideas because of their increased understanding of the operating system. In this case, although the total number of parts would not change, the idea would reduce the number of distinct parts for cell phone casings from 20 to 9. Evaluate the controller's idea using the ABC system described in Exhibit 4-7. What would be the predicted profitability for each product line and the company as a whole? What would be the most likely level of support for the controller's idea by the product managers of the pen casing product line and the cell phone casing product line? What would be the level of support by the president? 3. As vice president, you have expressed concern about the traditional cost-allocation system's product-cost accuracy and its ability to provide relevant information for operational control. Does the new ABC system satisfy your concerns? Explain. ISBN: 0-536-47129-0 4-B1 Direct, Indirect, and Unallocated Costs Des Moines Implements is a supplier that assembles purchased parts into components for three distinct markets--farm tractor implements, lawn mower parts, and hand tool parts. The statement of operating income for the most recent period is shown on the following page. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 176 Part 1: Focus on Decision Making Des Moines Implements: Statement of Operating Income Total Sales Cost of goods sold Direct material Indirect manufacturing (allocated based on machine hours) Gross profit Selling and administrative expenses: Commissions Distribution to warehouses (allocated based on weight in kilograms) Income before unallocated expenses Unallocated expenses Corporate salaries Other general expenses Operating income before taxes $1,010,000 400,000 94,000 494,000 516,000 55,000 150,000 205,000 311,000 11,000 17,000 28,000 $ 283,000 Des Moines Implements uses a traditional cost accounting system. Operating data used in the cost accounting system are as follows: Tractor Implements Purchase cost of parts assembled Machine hours Weight of parts shipped to distributors (kilograms) Sales commissions per unit Units assembled and sold Sales price per unit $175,000 8,500 100,000 $ 5.00 5,000 $ 70.00 Lawn Mower Parts $125,000 1,750 400,000 $ 0.80 25,000 $ 16.00 Hand Tool Parts $100,000 1,500 250,000 $ 0.20 50,000 $ 5.20 You have been asked to determine operating income (loss) for each product line. Use a format similar to Exhibit 4-3 in the text. 4-B2 Allocation, Department Rates, and Direct-Labor Hours Versus Machine Hours The Felski Manufacturing Company has two producing departments, machining and assembly. Mr. Felski recently automated the machining department. The installation of a CAM system, together with robotic workstations, drastically reduced the amount of direct labor required. Meanwhile, the assembly department remained labor intensive. The company had always used one firmwide rate based on direct-labor hours as the cost-allocation base for applying all costs (except direct materials) to the final products. Mr. Felski was considering two alternatives: (1) continue using direct-labor hours as the only cost-allocation base, but use different rates in machining and assembly, and (2) using machine hours as the cost-allocation base in the machining department while continuing with direct-labor hours in assembly. Budgeted data for 20X5 are Machining Total cost (except direct materials) Machine hours Direct-labor hours *Not applicable. Assembly $450,000 * 30,000 Total $1,035,000 105,000 45,000 $585,000 97,500 15,000 1. Suppose Felski continued to use one firmwide rate based on direct-labor hours to apply all manufacturing costs (except direct materials) to the final products. Compute the cost-application rate that would be used. 2. Suppose Felski continued to use direct-labor hours as the only cost-allocation base but used different rates in machining and assembly. a. Compute the cost-application rate for machining. b. Compute the cost-application rate for assembly. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 4: Cost Management Systems and Activity-Based Costing 177 3. Suppose Felski changed the cost accounting system to use machine hours as the cost-allocation base in machining and direct-labor hours in assembly. a. Compute the cost-application rate for machining. b. Compute the cost-application rate for assembly. 4. Three products use the following machine hours and direct-labor hours. Machine Hours in Machining Product A Product B Product C 10.0 17.0 14.0 Direct-Labor Hours in Machining 1.0 1.5 1.3 Direct-Labor Hours in Assembly 14.0 3.0 8.0 a. Compute the manufacturing cost of each product (excluding direct materials) using one firmwide rate based on direct-labor hours. b. Compute the manufacturing cost of each product (excluding direct materials) using directlabor hours as the cost-allocation base, but with different cost-application rates in machining and assembly. c. Compute the manufacturing cost of each product (excluding direct materials) using a costapplication rate based on direct-labor hours in assembly and machine hours in machining. d. Compare and explain the results in requirements 4a, 4b, and 4c. 4-B3 Traditional Costing and ABC, Activity-Based Management Refer to the text discussion of Lopez Plastics Company on pages 152155. Assume that the company has the traditional cost accounting system described in Exhibit 4-6. The top management team wants to reverse the pattern of quarterly losses. The company president, Angie Oaks, has emphasized the importance of profit improvement by linking future pay raises of the two product-line managers to their respective gross profit margins. She is concerned about the profitability of the pen casing product line while pleased with the profitability of the cell phone casing line. She also believes that the unallocated costs of the company are too high compared to competitors. The office of controller, whose costs are included in the unallocated costs, is responsible for vendor relations and purchasing of direct materials. The controller and head of the engineering department present the following idea: We should use more standard parts in cell phone casings, which will dramatically reduce the purchasing department's work required for purchasing. I believe this should cut our office's costs by as much as $20,000 per quarter. Product engineering agrees that this idea is not only feasible but, if implemented, would substantially reduce the design work required for cell phone casings. Quality would also improve. The controller, marketing manager, and head of the engineering department provided the following summary of actions and related effects. Action Reduce prices of cell phone casings 25%. Use standard parts wherever possible in cell phone casings. Related effects The vice president of sales estimates that the improved quality of cell phone casings combined with the price reduction will yield a 100% increase in demand for cell phone casings per quarter. The use of fewer suppliers will reduce vendor-relations work by the purchasing department. This will result in unallocated costs decreasing by $20,000. One of the two engineers can be let go at an annual cost savings of $80,000. Less of the plant and machinery will be used by production support so the allocation percentages will change from 75% and 25% to 80% and 20%. Much less engineer and CAD equipment costs will be needed for production support so these percentages will change from 80% and 20% to 50% and 50%. Processing time, measured in direct-labor hours, will increase by 500 hours due to expected 100% increase in sales and production of cell phone casings, but there is adequate capacity of labor and machine time. Direct-labor costs are fixed as are all of the indirect manufacturing costs. Quality of cell phone casings will improve due to reduced complexity of processing. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 178 Part 1: Focus on Decision Making 1. Evaluate this idea using the traditional cost allocation system shown in Exhibit 4-6 on page 153. What would be the predicted profitability for each product line and the company as a whole? What would be the most likely level of support for the controller's idea by the product managers of the pen casing product line and the cell phone casing product line? What would be the level of support by the president? 2. Assume that you have the ABC system described in Exhibit 4-7 on page 155 with the gross margin percentages as shown in the table on page 157. Often, managers with ABC systems can anticipate more effects of improvement ideas because of their increased understanding of the operating system. In this case, although the total number of parts used would not change, the idea would reduce the number of distinct parts for cell phone casings from 20 to 11. Evaluate the controller's idea using the ABC system described in Exhibit 4-7. What would be the predicted profitability for each product line and the company as a whole? What would be the most likely level of support for the controller's idea by the product managers of the pen casing product line and the cell phone casing product line? What would be the level of support by the president? 3. As vice president, you have expressed concern about the traditional cost-allocation system's product-cost accuracy and its ability to provide relevant information for operational control. Does the new ABC system satisfy your concerns? Explain. 4-B4 Activity-Based Costing in an Electronics Company The cordless phone manufacturing division of a Dallas-based consumer electronics company uses activity-based costing. For simplicity, assume that its accountants have identified only the following three activities and related cost drivers for indirect production costs: Activity Materials handling Engineering Power Cost Driver Direct-materials cost Engineering change notices Kilowatt hours Three types of cell phones are produced: Slim, RAZ, and Tex. Direct costs and cost-driver activity for each product for a recent month are as follows: Slim Direct-materials cost Direct-labor cost Kilowatt hours Engineering change notices $25,000 $ 4,000 50,000 13 RAZ $ 50,000 $ 1,000 200,000 5 Tex $125,000 $ 3,000 150,000 2 Indirect production cost for the month was Materials handling Engineering Power Total indirect production cost $10,000 20,000 16,000 $46,000 1. Compute the indirect production cost allocated to each product with the ABC system. 2. Suppose all indirect production costs had been allocated to products in proportion to their directlabor costs. Compute the indirect production costs allocated to each product. 3. In which product costs, those in requirement 1 or those in requirement 2, do you have the most confidence? Why? Additional Assignment Material Questions 4-1 Define a cost management system and give its three purposes. order to compare it to a target cost established as part of a process improvement program. b. Top management wants to identify the profitability of several product lines to establish the optimum product mix. c. Financial managers want to know the manufactured cost of inventory to appear on the balance sheet of the annual report. 4-2 Cost management systems have three primary purposes. For each of the decisions listed below, indicate the purpose of the CMS being applied. a. A production manager wants to know the cost of performing a setup for a production run in ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 4: Cost Management Systems and Activity-Based Costing 179 4-3 Name four cost objects. 4-4 "Departments are not cost objects or objects of costing." Do you agree? Explain. costs are most likely direct, indirect, and unallocated with respect to the products manufactured. 4-5 What is the major purpose of detailed cost accounting systems? 4-6 What are the two major processes performed by a cost accounting system? 4-18 "For a furniture manufacturer, glue or tacks become an integral part of the finished product, so they would be direct material." Do you agree? Explain. 4-19 "Depreciation is a period expense for financial statement purposes." Do you agree? Explain. 4-7 Why are cost accounting systems critically important to managers? 4-8 Distinguish between direct, indirect, and unallocated costs. 4-20 Distinguish between costs and expenses. 4-21 Distinguish between manufacturing and merchandising companies. 4-9 "The same cost can be direct and indirect." Do you agree? Explain. 4-10 How does the idea of economic feasibility relate to the distinction between direct and indirect costs? 4-11 What are four purposes for cost allocation? 4-12 Why do companies assign all production costs and only production costs to products for external reporting purposes? 4-22 Why is there no direct-labor inventory account on a manufacturing company's balance sheet? 4-23 In two-stage ABC systems, percentages are commonly used to allocate resource costs to activity cost pools. Are these percentages cost drivers? 4-24 "ABC systems are always more accurate than traditional costing systems." Do you agree? Explain. 4-25 Contrast activity-based costing (ABC) with activity-based management (ABM). 4-13 "A cost pool is a group of costs that is physically traced to the appropriate cost objective." Do you agree? Explain. 4-14 List five terms that are sometimes used as substitutes for the word allocate. 4-26 Explain how the layout of a plant's production equipment can reduce non-value-added costs. 4-15 "The typical traditional accounting system does not allocate costs associated with valuechain functions other than production to units produced." Do you agree? Explain. 4-27 Why do managers want to distinguish between value-added activities and non-valueadded activities? 4-16 "It is better not to allocate some costs than to use a cost driver that does not make any sense." Do you agree? Explain. 4-28 What is benchmarking? 4-29 Why should caution be exercised when comparing company performance to benchmarks? 4-30 Why are more organizations adopting ABC systems? 4-17 Production equipment maintenance, sales commissions, and process design costs are part of a company's costs. Identify which of these 4-31 (Appendix 4) Name four steps in the design and implementation of an ABC system. Critical Thinking Exercises 4-32 Marketing and Capacity Planning A company has just completed its marketing plan for the coming year and the management accountant has input the increases in sales volume into the process model. The result is that several key resource capacities have been exceeded. What are the three alternative courses of action to solve this dilemma? 4-33 ABC and ABM Compared During seminars on ABM, participants often ask what the difference is between ABC and ABM. Explain briefly. 4-34 Cost Management Systems and Activity-Based Allocation Many managers are confused regarding the value of activity-based allocation. A typical comment is, "Activity-based allocation is useful for product costing, but not for operational control." Do you agree? Explain. ISBN: 0-536-47129-0 4-35 ABC and Cost Management Systems Cost management systems have three primary purposes. Two of these are providing information for strategic and operational purposes. ABC systems are often adopted to increase the accuracy of cost information used by managers for strategic and operational decisions. Suppose a company produces Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 180 Part 1: Focus on Decision Making only one product. This means that 100% of its costs are direct with respect to the product cost object. The accurate product unit cost is simply all costs incurred divided by the total units produced. Why would this company be interested in an ABC system? 4-36 ABC and Benchmarking Suppose that AT&T used benchmarking to compare the activity-based costs among its various divisions. As part of its benchmarking efforts, AT&T compared the activity cost per driver unit for similar activities and cost per customer for its billing departments in various geographic regions. For example, AT&T compared the costs at the Youngstown area billing department with the similar costs in the Los Angeles area. Are these meaningful comparisons? Why or why not? Exercises 4-37 Classification of Manufacturing Costs Classify each of the following as direct (D) or indirect (I) with respect to traceability to product and as variable (V) or fixed (F) with respect to whether the cost fluctuates in total as activity or volume changes over wide ranges of activity. You will have two answers, D or I and V or F, for each of the 10 items. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. Cement for a road builder Supervisor training program Abrasives (e.g., sandpaper) Cutting bits in a machinery department Food for a factory cafeteria Factory rent Salary of a factory storeroom clerk Workers' compensation insurance in a factory Steel scrap for a blast furnace Paper towels for a factory washroom 4-38 Confirm Your Understanding of the Classification of Manufacturing Costs Classify each of the following as direct or indirect with respect to traceability to product and as variable or fixed with respect to whether the costs fluctuate in total as volume of production changes over wide ranges. Explain your classifications. 1. 2. 3. 4. The wages of machine operators who work on only one product. The cost of components that are assembled into a final product. The cost of supplies consumed when maintenance is performed on machines. The cost of training mechanics who service processing machinery. 4-39 Variable Costs and Fixed Costs; Manufacturing and Other Costs For each of the numbered items, choose the appropriate classifications from the lettered items for a manufacturing company. If in doubt about whether the cost behavior is basically variable or fixed, decide on the basis of whether the total cost will fluctuate substantially over a wide range of volume. Most items have two answers among the following possibilities. a. b. c. d. e. f. g. Manufacturing costs, direct Manufacturing costs, indirect General and administrative cost Selling cost Fixed cost Variable cost Other (specify) Examples: ISBN: 0-536-47129-0 Direct material President's salary Bond interest expense a, f c, e e, g (financial expense) Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 4: Cost Management Systems and Activity-Based Costing 181 Items for your consideration: 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. Welding supplies Salespersons' commissions Salespersons' salaries Factory power for machines Fire loss Sandpaper Supervisory salaries, production control Supervisory salaries, assembly department Supervisory salaries, factory storeroom Company picnic costs Overtime premium, punch press Idle time, assembly Freight out Property taxes Paint for finished products Heat and air conditioning, factory Materials-handling labor, punch press Straight-line depreciation, salespersons' automobiles 4-40 Direct, Indirect, and Unallocated Costs Refer to the Lopez Plastics Company example on pages 152155 and to Exhibit 4-7. The following list gives various resources used by Lopez Plastics Company. Use the letters D, I, and U to indicate how the cost of each resource cost would be classified; D = direct, I = indirect, and U = unallocated. 1. 2. 3. 4. 5. 6. 7. 8. Salary of plant manager Salaries of cost accountants Depreciation on computers used by engineers to design cell phone casings Depreciation of the plant Resin used to make pen casings Salaries of engineers Salaries of operating labor processing pen casings Travel costs of purchasing agent while investigating potential new suppliers of resin 4-41 Cost Allocation in ABC Refer to the Lopez Plastics Company illustration on pages 152155 and to Exhibit 4-7. Also see the table on page 157. Based on new information, management has adjusted the percentages that apply to the first stage of the ABC system as shown below. Prepare a schedule that shows the gross margins for both products. Indirect Resource Percent of Resource Used In Processing activity Production support activity Plant and Machinery 90% 10% Engineers and CAD Equipment 40% 60% 4-42 Activity-Based Costing The Wellington Company makes a variety of souvenirs for visitors to New Zealand. The Queenstown Division manufactures stuffed kiwi birds using a highly automated operation. A recently installed ABC system has four activity centers: Activity Center ISBN: 0-536-47129-0 Cost Driver Kilograms of materials Number of setups Number of units Number of orders Cost per Driver Unit $1.20 per kg $60 per setup $.40 per unit $10 per order Materials receiving and handling Production setup Cutting, sewing, and assembly Packing and shipping Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 182 Part 1: Focus on Decision Making Two products are called "standard kiwi" and "giant kiwi." They require .20 and .40 kg of materials, respectively, at a materials cost of $1.40 for standard kiwis and $2.20 for giant kiwis. One computercontrolled assembly line makes all products. When a production run of a different product is started, a setup procedure is required to reprogram the computers and make other changes in the process. Normally, 600 standard kiwis are produced per setup, but only 240 giant kiwis. Products are packed and shipped separately so a request from a customer for, say, three different products is considered three different orders. Suppose the Te Papa Tongarewa Gift Shop just placed an order for 100 standard kiwis and 50 giant kiwis. 1. Compute the cost of the products shipped to the Te Papa Tongarewa Gift Shop. 2. Suppose the products made for the Te Papa Tongarewa Gift Shop required "Te Papa" to be printed on each kiwi. Because of the automated process, printing the letters takes no extra time or materials, but it requires a special production setup for each product. Compute the cost of the products shipped to the Te Papa Tongarewa Gift Shop. 3. Explain how the activity-based-costing system helps Wellington Company to measure costs of individual products or orders better than a traditional system that allocates all nonmaterials costs based on direct labor. 4-43 Two-Stage Activity-Based Costing--Stage One The Eden Prairie branch of FirstStar Bank is a retail branch in a rapidly growing residential area. It services individuals and local businesses. To support its services, the branch employs 14 tellers, 3 retail sales managers (RSMs), and the branch managing officer. The branch services about 2,900 customers. Each of the 70 branches of FirstStar Bank is implementing ABC in order to improve profitability. FirstStar Bank's branch managing officers have been given the responsibility to implement activity-based costing. The managing officer at the Eden Prairie branch decided to implement a twostage ABC system. Exhibit 4-18 depicts the two-stage ABC system. The Eden Prairie branch has the following cost data for the last year: Teller wages RSM salaries and benefits Managing officer salary and benefits Other bank costs Total $ 330,000 210,000 100,000 430,000 $1,070,000 The "other bank costs" include depreciation on the facility including furniture, building, equipment, insurance, rentals of computers, contracted computer services, telecommunications, and utilities. These costs cannot be directly or indirectly related to routine bank activities, such as processing new accounts or processing deposits or withdrawals, and, thus, are unallocated. There are no costs that can be traced directly to customers so the Eden Prairie branch has just two types of costs--indirect and unallocated. All employees have been interviewed as part of the ABC study. For example, tellers were asked how they spent their time. Three major activities were identified. They said that they spent most of their time (60%) processing deposits and withdrawals. They also estimated that they spent about 10% of their time processing new accounts and about 20% of their time processing other transactions. The remaining 10% of their time was spent on all other banking activities. The results of the interviews appear below. Internal Activity Analysis Open New Accounts Teller wages Retail sales manager salary Managing officer salary 10% 10% 0% Process Deposits and Withdrawals 60% 20% 10% Process Other Transactions 20% 30% 30% All Other Banking Activities 10% 40% 60% Total 100% 100% 100% ISBN: 0-536-47129-0 Determine the total traceable cost of the three major activities conducted at the Eden Prairie branch of FirstStar Bank. Use Exhibit 4-18 as a guide. (Note that this represents the first stage in the two-stage ABC method.) Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 4: Cost Management Systems and Activity-Based Costing 183 Exhibit 4-18 Two-Stage ABC Two-Stage ABC at the Eden Prairie Branch of FirstStar Bank OTHER RESOURCES (UNALLOCATED) TELLERS $350,000 RETAIL SALES MANAGERS $210,000 MANAGING OFFICER $100,000 $430,000 T R M O T 10% R 10% T R M T R M OPEN NEW ACCOUNTS No. of ONA New Accounts 60% 20% 10% PROCESS DEPOSITS AND WITHDRAWALS 20% 30% 30% PROCESS OTHER TRANSACTIONS No. of POT Transactions No. of PDW Deposits and Withdrawals Activity-Consumption Rate The number of new accounts opened for each retail customer account equals .20, or, for every 100 retail customer accounts, 20 new accounts are opened. ONA .20 PDW POT ONA .10 PDW POT T R M O 30 10 RETAIL CUSTOMERS 2,500 ACCOUNTS 220 60 COMMERCIAL CUSTOMERS 400 ACCOUNTS 10% 40% 60% 100% UNALLOCATED RESOURCE COSTS 4-44 Two-Stage Activity-Based Costing, Banking, Benchmarking. (This exercise is a continuation of Exercise 4-43 and should be assigned only if Exercise 4-43 is also assigned.) A part of the activity analysis conducted at the Eden Prairie branch of FirstStar Bank was identifying potential cost drivers for each major activity. The following cost drivers were chosen because they were both plausible and reliable and data were available: Activity Process new accounts Process deposits and withdrawals Process other transactions Cost Driver Number of new accounts Number of deposits and withdrawals Number of other transactions Annual Flow of Cost Driver 540 163,000 49,000 ISBN: 0-536-47129-0 Of the 2,900 customers of the branch, only 400 are local businesses. The business-customer class generated 40 new accounts, 88,000 deposits and withdrawals, and 24,000 other transactions. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 184 Part 1: Focus on Decision Making The implementation of ABC at all branches of FirstStar Bank provided sufficient data for internal benchmarking. The following are the lowest activity costs among all branches implementing twostage ABC systems: Activity Open new accounts Process deposits and withdrawals Process other transactions Customer Class Retail Commercial Lowest Activity Cost per Driver Unit $81.67 per new account $ .75 per deposit or withdrawal $ 3.05 per transaction Lowest Customer Cost per Account $ 88 $508 1. Determine the allocated (indirect) cost per account for retail and commercial accounts. Use Exhibit 4-18 as a guide. 2. Under what conditions would benchmarking between the Eden Prairie branch of FirstStar Bank and the other branches be inappropriate? 3. What do the results of the ABC study suggest? 4-45 Direct, Indirect, and Unallocated Costs Listed below are several activities and related costs that have been observed at Santana Company, a manufacturing company. The company makes a variety of products and currently uses a traditional costing system that allocates only production overhead based on direct-labor hours. It is implementing an ABC system for the design, production, and distribution functions of its value chain. You have been asked to complete the table below by indicating for each activity whether the related cost is direct, indirect, or unallocated. For each indirect cost, indicate one appropriate cost driver (more than one cost driver may be appropriate). The first two items have been completed for you. Activity Supervising production Related Cost Supervisor salaries Traditional Indirect (direct-labor hours) Unallocated ABC Indirect (people supervised) Indirect (number of parts) Designing a prototype for new product Setting up for a production run Purchasing materials and parts to be used in products Shipping sold products to customers (distributors) Market research study conducted by marketing staff to assess demand for potential new product Production scheduling Purchasing materials and parts to be used in products Order processing of customer orders Preparing cost analyses Designing a new product Depreciation of computers Mechanic wages Materials and parts cost Fuel used on company's fleet of trucks Salaries of market research staff Salaries of production scheduling managers Salaries of purchasing agents Salaries of order processing staff Cost accountant salary Salaries of design engineers that are fully dedicated to this new product Salary of executive ISBN: 0-536-47129-0 Managing overall operations of company Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 4: Cost Management Systems and Activity-Based Costing 185 Problems 4-46 Cost Accumulation and Allocation Zhang Manufacturing Company has two departments, machining and finishing. For a given period, the following costs were incurred by the company as a whole: direct material, $150,000; direct labor, $75,000; and indirect manufacturing, $80,000. The grand total was $305,000. The machining department incurred 70% of the direct-material costs, but only 331/3 of the directlabor costs. As is commonplace, indirect manufacturing costs incurred by each department were allocated to products in proportion to the direct-labor costs of products within the departments. Three products were produced. Product Alpha Beta Gamma Total for the machining department Alpha Beta Gamma Total added by finishing department Direct Material 40% 30% 30% 100% 331/3% 331/3% 331/3% 100% Direct Labor 30% 30% 40% 100% 40% 40% 20% 100% The indirect manufacturing costs incurred by the machining and finishing departments and allocated to all products therein amounted to machining, $38,000 and finishing, $42,000. 1. Compute the total costs incurred by the machining department and added by the finishing department. 2. Compute the total costs of each product that would be shown as finished-goods inventory if all the products were transferred to finished stock on completion. (There were no beginning inventories.) 4-47 Hospital Allocation Base Hector Liriano, the administrator of Cook Community Hospital, has become interested in obtaining more accurate cost allocations on the basis of cause and effect. The $192,000 of laundry costs had been allocated on the basis of 600,000 pounds processed for all departments, or $.32 per pound. Liriano is concerned that government health care officials will require weighted statistics to be used for cost allocation. He asks you, "Please develop a revised base for allocating laundry costs. It should be better than our present base, but not be overly complex either." You study the situation and find that the laundry processes a large volume of uniforms for student nurses and physicians and for dietary, housekeeping, and other personnel. In particular, the coats or jackets worn by personnel in the radiology department take an unusual amount of handwork. A special study of laundry for radiology revealed that 7,500 of the 15,000 pounds were jackets and coats that were five times as expensive to process as regular laundry items. Several reasons explained the difference, but it was principally because of handwork involved. Assume that no special requirements were needed in departments other than radiology. Revise the cost-allocation base and compute the new cost-allocation rate. Compute the total cost charged to radiology using pounds and using the new base. 4-48 Cost of Passenger Traffic Southern Pacific Railroad (SP) has a commuter operation that services passengers along a route between San Jose and San Francisco. Problems of cost allocation were highlighted in a news story about SP's application to the Public Utilities Commission (PUC) for a rate increase. The PUC staff claimed that the "avoidable annual cost" of running the operation was $700,000, in contrast to SP officials' claim of a loss of $9 million. PUC's estimate was based on what SP would be able to save if it shut down the commuter operation. The SP loss estimate was based on a "full-allocation-of-costs" method, which allocates a share of common maintenance and overhead costs to the passenger service. If the PUC accepted its own estimate, a 25% fare increase would have been justified, whereas SP sought a 96% fare increase. The PUC stressed that commuter costs represent less than 1% of the systemwide costs of SP and that 57% of the commuter costs are derived from some type of allocation method--sharing the costs of other operations. SP's representative stated that "avoidable cost" is not an appropriate way to allocate costs for calculating rates. He said that "it is not fair to include just so-called above-the-rail costs" because there ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 186 Part 1: Focus on Decision Making are other real costs associated with commuter service. Examples are maintaining smoother connections and making more frequent track inspections. 1. As public utilities commissioner, what approach toward cost allocation would you favor for making decisions regarding fares? Explain. 2. How would fluctuations in freight traffic affect commuter costs under the SP method? 4-49 Activity-Based Costing and Activity-Based Management, Automotive Supplier Rayburn Auto Products (RAP) is an automotive component supplier. RAP has been approached by General Motors to consider expanding its production of part X120 to a total annual quantity of 2,000 units. This part is a low-volume, complex product with a high gross margin that is based on a proposed (quoted) unit sales price of $7.50. RAP uses a traditional costing system that allocates indirect manufacturing costs based on direct-labor costs. The rate currently used to allocate indirect manufacturing costs is 400% of direct-labor cost. This rate is based on the $3,200,000 annual factory overhead cost divided by $800,000 annual direct-labor cost. To produce 2,000 units of X120 requires $5,000 of direct materials and $1,000 of direct labor. The unit cost and gross margin percentage for part X120 based on the traditional cost system are computed as follows: Per Unit (2,000) $2.50 .50 2.00 $5.00 7.50 $2.50 33.3% Total Direct material Direct labor Indirect manufacturing: (400% direct labor) Total cost Sales price quoted Gross margin Gross margin percentage $ 5,000 1,000 4,000 $10,000 The management of RAP decided to examine the effectiveness of their traditional costing system versus an activity-based costing system. The following data have been collected by a team consisting of accounting and engineering analysts: Activity Center Quality Production scheduling Setup Shipping Shipping administration Production Total indirect manufacturing cost Activity Center: Cost Drivers Quality: Number of pieces scrapped Production scheduling and set up: Number of setups Shipping: Number of containers shipped Shipping administration: Number of shipments Production: Number of machine hours Traceable Factory Overhead Costs (Annual) $ 700,000 50,000 600,000 300,000 50,000 1,500,000 $3,200,000 Annual Cost-Driver Quantity 10,000 500 60,000 1,000 10,000 The accounting and engineering team has performed activity analysis and provides the following estimates for the total quantity of cost drivers to be used to produce 2,000 units of part X120: Cost Driver Pieces scrapped Setups Containers shipped Shipments Machine hours Cost-Driver Consumption 120 4 10 5 15 ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 4: Cost Management Systems and Activity-Based Costing 187 1. Prepare a schedule calculating the unit cost and gross margin of part X120 using the activitybased costing approach. 2. Based on the ABC results, which course of action would you recommend regarding the proposal by General Motors? List the benefits and costs associated with implementing an ABC system at RAP. 4-50 Library Research in Activity-Based Costing or Activity-Based Management Select an article from Strategic Finance, Cost Management (available in most libraries), or Management Accounting Quarterly (an online journal) that describes a particular company's application of either (a) an activity-based costing system, or (b) activity-based management. Prepare a summary of 300 words or less that includes the following: Name of the company (if given) Industry of the company Description of the particular application Assessment of the benefits the company received from the application Any difficulties encountered in implementation 4-51 Review of Chapters 2, 3, and 4 The Chavez Tools Company provides you with the following miscellaneous data regarding operations in 20X6: Gross profit Net loss Sales Direct material used Direct labor Fixed manufacturing overhead Fixed selling and administrative expenses $ 20,000 (5,000) 100,000 35,000 25,000 15,000 12,000 There are no beginning or ending inventories. Compute (a) variable selling and administrative expenses, (b) contribution margin in dollars, (c) variable manufacturing overhead, (d) break-even point in sales dollars, and (e) manufacturing cost of goods sold. 4-52 Review of Chapters 2, 3, and 4 K. Y. Kim Corporation provides you with the following miscellaneous data regarding operations for 20X1(in thousands of South Korean won, W ): Break-even point Direct material used Gross profit Contribution margin Direct labor Sales Variable manufacturing overhead W 84,000 29,000 20,000 25,000 28,000 100,000 5,000 There are no beginning or ending inventories. Compute (a) the fixed manufacturing overhead, (b) variable selling and administrative expenses, and (c) fixed selling and administrative expenses. 4-53 Review of Chapters 2, 3, and 4 Yamamoto Company manufactured and sold 1,000 sabres during November. Selected data for this month follow: Sales Direct materials used Direct labor Variable manufacturing overhead Fixed manufacturing overhead Variable selling and administrative expenses Fixed selling and administrative expenses Contribution margin Operating income $100,000 21,000 16,000 13,000 11,000 ? ? 40,000 22,000 ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 188 Part 1: Focus on Decision Making There were no beginning or ending inventories. 1. 2. 3. 4. What were the variable selling and administrative expenses for November? What were the fixed selling and administrative expenses for November? What was the cost of goods sold during November? Without prejudice to your earlier answers, assume that the fixed selling and administrative expenses for November amounted to $4,000. a. What was the break-even point in units for November? b. How many units must be sold to earn a target operating income of $14,000? c. What would the selling price per unit have to be if the company wanted to earn an operating income of $22,500 on the sale of 900 units? Cases 4-54 Multiple Allocation Bases The Manchester Company produces three types of circuit boards; call them X, Y, and Z. The cost accounting system used by Manchester until 2006 applied all costs except direct materials to the products using direct-labor hours as the only cost driver. In 2006, the company undertook a cost study. The study determined that there were six main factors that incurred costs. A new system was designed with a separate cost pool for each of the six factors. The factors and the costs associated with each are as follows: 1. 2. 3. 4. Direct-labor hours--direct-labor cost and related fringe benefits and payroll taxes Machine hours--depreciation and repairs and maintenance costs Pounds of materials--materials receiving, handling, and storage costs Number of production setups--labor used to change machinery and computer configurations for a new production batch 5. Number of production orders--costs of production scheduling and order processing 6. Number of orders shipped--all packaging and shipping expenses The company is now preparing a budget for 2008. The budget includes the following predictions: Board X Units to be produced Direct-materials cost Direct-labor hours Machine hours Pounds of materials Number of production setups Number of production orders Number of orders shipped 10,000 70/unit 4/unit 7/unit 3/unit 100 300 1,000 Board Y 800 88/unit 18/unit 15/unit 4/unit 50 200 800 Board Z 5,000 45/unit 9/unit 7/unit 2/unit 50 70 2,000 The total budgeted cost for 2008 is 3,752,250, of which 995,400 was direct-materials cost, and the amount in each of the six cost pools defined above is Cost Pool* 1 2 3 4 5 6 Total *Identified by the cost driver used. ISBN: 0-536-47129-0 Cost 1,391,600 936,000 129,600 160,000 25,650 114,000 2,756,850 1. Prepare a budget that shows the total budgeted cost and the unit cost for each circuit board. Use the new system with six cost pools (plus a separate direct application of direct-materials cost). 2. Compute the budgeted total and unit costs of each circuit board if the old direct-labor-hour system had been used. 3. How would you judge whether the new system is better than the old one? Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 4: Cost Management Systems and Activity-Based Costing 189 4-55 ABC and Customer Profitability in Financial Services To increase its share of the checking account market, Columbia City Bank in Seattle took two actions: It established a customer call center to respond to customer inquiries about account balances, checks cleared, fees charged, etc., and it paid year-end bonuses to branch managers who met their branch's target increase in the number of customers. While 80% of the branch managers met the target increase in the number of customers, Columbia City Bank's profits continued to decline. John Diamond, the CEO, didn't understand why profits were declining, even though the bank was serving more customers. The Pierce County branch manager, Rose Perez, noticed that while small retail customers flocked to the bank, the number of business customers was declining. Columbia City Bank's costing system, developed back in 1988, is straightforward. No costs are traced directly to customers. The bank simply assigns the total indirect costs to customer lines (retail customer line or business customer line) based on the total number of checks processed. Perez suspected that Columbia City Bank's cost system might be part of the problem. Perez learned about ABC in school, but the applications involved manufacturing firms. She wonders whether Columbia City Bank could develop an ABC system, with the customer-line as the primary cost object. Rose's boss was skeptical. ("Our profits are going down the tubes and you want me to spend money developing a new accounting system?") However, Rose persuaded her boss to allow a pilot ABC study, using the three Tacoma branches for the pilot test. The ABC implementation team included Perez, the managers of each of the three Tacoma branches, a bank teller, and a customer service representative from the customer call center. The team began by identifying the following three activities: Check payments Teller withdrawals and deposits Customer service call center The ABC team then scrutinized the Tacoma branches' total indirect cost of $2,850,000. They classified the components of this total indirect cost into the appropriate activity pool, coming up with the following estimates (in thousands of dollars): Estimated Total Costs for Tacoma Branches $ 440 700 1,200 450 60 $2,850 Cost Salaries of check-processing personnel Depreciation on check-processing equipment Teller salaries Salaries of customer representatives at call center Toll-free phone lines at customer call center Total indirect costs Activity Cost Pool to Which Cost Is Assigned Check payments Check payments Teller withdrawals and deposits Customer service call center Customer service call center The team then identified the following cost drivers for each activity cost pool: Activity Cost Pool Check payments Teller withdrawals and deposits Customer service call center Activity Cost Driver number of checks processed number of teller transactions number of calls The ABC team estimated that for the Tacoma branches, the retail customer line and the business customer line would require the following total resources (in thousands): Number of Units of Activity Cost Driver Used by Retail Customers 2,280 320 95 150 Number of Units of Activity Cost Driver Used by Business Customers 9,120 80 5 50 Activity Cost Driver ISBN: 0-536-47129-0 Total 11,400 400 100 200 Checks processed Teller transactions Customer calls to call center Checking accounts Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 190 Part 1: Focus on Decision Making That is, the retail customers have 320,000 teller transactions, make 95,000 calls to the customer service center, and so on. On average, Columbia City Bank earns revenue from each type of account (from interest earned on checking account balances) as follows: Average revenue per retail customer account Average revenue per business customer account 1. Using the original (old) cost system: a. Compute the indirect cost allocation rate. b. Determine the total indirect cost assigned to the retail customer line and the business customer line. c. Compute the proportion of the total indirect cost assigned to the retail customer line and the business customer line. d. Determine the indirect cost per retail account and the indirect cost per business account. e. Assuming that there are no direct costs, compute the average profit per account for retail customers and for business customers. f. Assess the likely business strategy that might be adopted by managers using data from this original cost system. 2. What are the signs that Columbia City Bank's original cost system was broken or in need of refinement? 3. Using the new activity-based costing system: a. Compute the indirect cost allocation rates for each of the three activities: Check payments Teller withdrawals and deposits Customer call center b. Use the schedule below to compute the total indirect cost allocated to each customer line: $10 $40 Activity Check payments Teller withdrawals and deposits Customer call center Total indirect costs Total Indirect Cost Assigned to Retail Customer Line Total Indirect Cost Assigned to Business Customer Line c. What proportion of each activity's resources are used by the retail customer line and the business customer line? d. Using the ABC data from requirement 3b, compute the indirect cost per retail customer account and the indirect cost per business customer account. e. Explain why the results in requirement 1d and requirement 3d differ in the direction they do. Be precise and specific. f. Using the new ABC data, compute the average profit per account for both retail and business customers. Assess the likely business strategy that might be adopted by managers using data from this ABC cost system. 4. Be prepared to discuss the following questions: a. Was Columbia City Bank's bonus-based incentive plan to increase the number of checking account customers a wise strategy? Would you suggest any change in the strategy based on the ABC analysis? b. What benefits can Columbia City Bank reap from the ABC analysis? c. Why might Rose Perez have suspected that the benefits of ABC would likely outweigh the costs of implementing ABC at Columbia City Bank? d. Why is it important for nonaccounting managers to understand ABC? ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 4: Cost Management Systems and Activity-Based Costing 191 4-56 Identifying Activities, Resources, and Cost Drivers in Manufacturing International Plastics is a multinational, diversified organization. One of its manufacturing divisions, Northeast Plastics Division, has become less profitable due to increased competition. The division produces three major lines of plastic products within its single plant. Product Line A is high-volume, simple pieces produced in large batches. Product Line B is medium-volume, more complex pieces. Product Line C is low-volume, small-order, highly complex pieces. Currently, the division allocates indirect manufacturing costs based on direct labor cost. The vice president of manufacturing is uncomfortable using the traditional cost figures. He thinks the company is underpricing the more complex products. He decides to conduct an ABC analysis of the business. Interviews were conducted with the key managers in order to identify activities, resources, cost drivers, and their interrelationships. INTERVIEWEE: PRODUCTION MANAGER Q1. What activities are carried out in your area? A1. All products are manufactured using three similar, complex, and expensive molding machines. Each molding machine can be used in the production of the three product lines. Each setup takes about the same time irrespective of the product. Q2. Who works in your area? A2. Last year, we employed 30 machine operators, 2 maintenance mechanics, and 2 supervisors. Q3. How are the operators used in the molding process? A3. It requires nine operators to support a machine during the actual production process. Q4. What do the maintenance mechanics do? A4. Their primary function is to perform machine setups. However, they were also required to provide machine maintenance during the molding process. Q5. Where do the supervisors spend their time? A5. They provide supervision for the machine operators and the maintenance mechanics. For the most part, the supervisors appear to spend the same amount of time with each of the employees that they supervise. Q6. What other resources are used to support manufacturing? A6. The molding machines use energy during the molding process and during the setups. We put meters on the molding machines to get a better understanding of their energy consumption. We discovered that for each hour that a machine ran, it used 6.3 kilowatts of energy. The machines also require consumable shop supplies (e.g., lubricants, hoses, and so on). We have found a direct correlation between the amount of supplies used and the actual processing time. Q7. How is the building used, and what costs are associated with it? A7. We have a 100,000-square-foot building. The total rent and insurance costs for the year were $675,000. These costs are allocated to production, sales, and administration based on square footage. 1. Identify the activities and resources for the division. For each activity, suggest an appropriate cost driver. 2. For each resource identified in requirement 1, indicate its cost behavior with respect to the activities it supports (assume a planning period of 1 month). Nike 10-K Problem 4-57 Nike's Cost Accounting System Examine the inventory account in the balance sheet in Nike's 10-K in Appendix C. Note especially footnote 2, "Inventories." What does the explanation of Nike's inventory imply about the company's manufacturing operations? Is Nike primarily a manufacturer or merchandiser? Can you confirm this elsewhere in the 10-K? Nike describes its properties in Item 2 of the 10-K. One of the properties is a distribution and customer service facility in Wilsonville, Oregon. Suppose Nike wanted to set up an ABC system for this facility. Based on your understanding of Nike's operations from the descriptions in the 10-K, what major activities might they identify (at least three)? Identify two resources used by each activity and a possible cost-allocation base for assigning each resource cost to the activity. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 192 Part 1: Focus on Decision Making EXCEL Application Exercise 4-58 Traditional Costing Versus Activity-Based Costing Goal: Create an Excel spreadsheet to compare traditional costing versus activity-based costing. Use the results to answer questions about your findings. Scenario: Circuitech Corporation is one of Dell's circuit board suppliers. Circuitech currently uses traditional costing for making business decisions. At the urging of Dell, however, the company has decided to move to activity-based costing for circuit board production related to products LP-7310 and PC-33. As one of the company's accountants, you have been asked to prepare a spreadsheet comparing the two costing methods for the next company board meeting. Your supervisor has given you the following quarterly data: Total Indirect Costs for the Quarter: Assembly Soldering Inspection $630,000 $270,000 $160,000 LP-7310 Direct costs (materials, labor) Machine hours (assembly) Number of units produced (soldering) Testing hours (inspection) $162,400 480 6,000 6,000 PC-33 $178,240 1,080 4,000 8,000 When you have completed your spreadsheet, answer the following questions: a. What is the total manufacturing cost per unit using traditional costing for LP-7310? For PC-33? b. What is the total manufacturing cost per unit using activity-based costing for LP-7310? For PC-33? c. What conclusions can be drawn from your spreadsheet results? Step-by-Step: 1. Open a new Excel spreadsheet. 2. In column A, create a bold-faced heading that contains the following: Row 1: Chapter 4 Decision Guideline Row 2: Circuitech Corporation Row 3: Traditional Versus Activity-Based Costing Row 4: Today's Date Note: Adjust column widths as follows: Column A (41.57), Columns B, C, and D (21.0). Column D is for check figures only. The column widths have been designed to ensure that Column D will not print on the final version of the spreadsheet if only page 1 is printed. 3. Merge and center the four heading rows across columns A through C. 4. In Column A, create the following row headings: Row 7: Raw Data Row 8: Indirect costs for the quarter: Row 9: Assembly Row 10: Soldering Row 11: Inspection Row 12: Total indirect costs Skip 2 rows Row 15: Direct costs (Materials, labor) Row 16: Machine hours (Assembly) Row 17: Number of units produced (Soldering) Row 18: Testing hours (Inspection) Skip 2 rows Row 21: Traditional costing system Row 22: Indirect cost driver (machine hours) Row 23: Allocated indirect costs ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 4: Cost Management Systems and Activity-Based Costing 193 Skip a row Row 25: Cost per product Row 26: Direct costs Row 27: Manufacturing overhead Row 28: Total manufacturing costs per product Skip a row Row 30: Number of units Row 31: Total manufacturing costs per unit Skip 2 rows Row 34: Activity-based costing system Row 35: Assembly cost driver (machine hours) Row 36: Allocated assembly cost Row 37: Soldering cost driver (units) Row 38: Allocated soldering cost Row 39: Inspection cost driver (testing hours) Row 40: Allocated inspection cost Skip a row Row 42: Cost per product Row 43: Direct costs Row 44: Manufacturing overhead Row 45: Assembly Row 46: Soldering Row 47: Inspection Row 48: Total manufacturing costs per product Skip a row Row 50: Number of units Row 51: Total manufacturing costs per unit 5. Change the format of Raw Data (Row 7), Traditional costing system (Row 21), and Activity-based costing system (Row 34) to bold-faced headings. Hint: Use the control key for highlighting multiple cells or rows when making changes. 6. Change the format of Cost per product (Rows 25 and 42) to underlined headings. 7. In Rows 14, 21, 25, 34, and 42 create the following bold-faced, right-justified column headings: Column B: LP-7310 Column C: PC-33 8. In Rows 21 and 34 create the following bold-faced, right-justified column headings: Column D: Total 9. Use the scenario data to fill in the Raw Data section. Use the SUM function to calculate Total indirect costs (Row 12). 10. Traditional costing system: Fill in rows 26 and 30 with information from the Raw Data section. Use appropriate formulas from this chapter to calculate the cost driver and allocated costs. Use the SUM function to calculate the Total column for manufacturing overhead costs. Complete the remainder of the Cost per product data using formulas and calculations. Calculate the Total manufacturing costs per product. 11. Activity-based costing system: Fill in Rows 43 and 50 with information from the Raw Data section. Use appropriate formulas from this chapter to calculate the cost drivers and allocated costs. Use the SUM function to calculate the Total columns for all allocated costs. Complete the remainder of the Cost per product data using formulas and calculations. Calculate the Total manufacturing costs per product. Hint: If using the SUM function to calculate Total manufacturing costs, verify range. 12. Format all amounts as: ISBN: 0-536-47129-0 Number tab: Category: Decimal places: Symbol: Negative numbers: Currency 2 None Red with parentheses Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 194 Part 1: Focus on Decision Making 13. Change the format of hours and units in rows 1618, 30, and 50 to display no decimal places. 14. Change the format of the amounts in rows 9, 12, 15, 23, 26, 28, 31, 36, 38, 40, 43, 48, and 51 to display a dollar symbol. 15. Change the format of the row headings in rows 911, 1518, 23, 36, 38, 40, and 4547 to display as indented. Alignment tab: Horizontal: Indent: Left (Indent) 1 16. Change the format of the amounts in rows 12, 28, and 48 to display a top border, using the default Line Style. Border tab: Icon: Top Border 17. Change the format of the cost driver calculations in rows 22, 35, 37, and 39 to display as left-justified percentages with two decimal places. Number tab: Alignment tab: Category: Decimal places: Horizontal: Indent: Percentage 2 Left (Indent) 0 18. Accentuate the Cost per product information for each costing method by applying cellshading to columns A, B, and C of rows 2531 and 4251. Patterns tab: Color: Lightest grey 19. Save your work to disk, and print a copy for your files. Note: The final version of the spreadsheet will be on page 1. You do not need to print page 2 as it should contain only the check figures. Collaborative Learning Exercise 4-59 Internet Research, ABC, and ABM Form groups of three to five people each. Each member of the group should pick one of the following industries: Manufacturing Insurance Health care Government Service Each person should explore the Internet for an example of a company that implemented activity-based costing and activity-based management. One way to do this is to go to the Web site www.Hyperion.com and choose one company from the industry chosen. Prepare and give a briefing for your group. Do this by completing the following: 1. 2. 3. 4. Describe the company and its business. What was the scope of the ABC/ABM project? What were the goals for the ABC/ABM project? Summarize the results of the project. After each person has briefed the group on his or her company, discuss within your group the commonalities between the ABC/ABM applications. Internet Exercise 4-60. Vermont Teddy Bear Factory Costs are very important to any manager. Managers focus on trying to keep costs as low as possible. There are many ways to report costs, such as the total amount that is often seen on the income statement or an individual cost for a particular component part. 1. Go to the home page of Vermont Teddy Bear at www.vermontteddybear.com. When you click onto the Web site, what does it suggest that you should do? What is the current headline offering on the site? ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 4: Cost Management Systems and Activity-Based Costing 195 2. Click to learn more about what a Bear-Gram gift is and what it contains. 3. What is unique about a Vermont Teddy Bear? What color can a teddy bear be? Can you choose what type of outfit you would like your bear to sport? What do you notice about the accessories? 4. Take a tour of the factory. Click on "Online Factory Tour" near the bottom of the left-hand side of the home page. Take the online tour. List several activities shown in the tour. What are some resources that are consumed by these activities? For one of the activities you listed, give at least one fixed-cost and one variable-cost resource. Suggest a cost driver for one of the activities you listed. 5. Do you think that the Vermont Teddy Bear factory would be a good candidate for using activitybased costing? Explain. 6. Find the company's most recent financial statements by clicking "investor relations" at ir.vtbearcompany.com and, under SEC Filings, find the most recent 10-K. What information can you find about the types of inventory accounts that the company has? Where did you find this information? What was the value of the inventory accounts for the past year? Is this amount increasing or decreasing? 7. Would you say the firm is a manufacturer or merchandiser, based on the financial statements? Does the income statement provided give you a clue as to the type of firm this is? Explain. In the chapter, we discussed the differences in the financial statements for a manufacturer and a merchandiser--do these differences really show up in the annual report? ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Relevant Information for Decision Making with a Focus on Pricing Decisions C H A P T E R LEARNING OBJECTIVES When you have finished studying this chapter, you should be able to: 1. Discriminate between relevant and irrelevant information for making decisions. 2. Apply the decision process to make business decisions. 3. Construct absorption and contribution-margin income statements, and identify their relevance for decision making. 4. Decide to accept or reject a special order using the contribution-margin technique. 5. Explain why pricing decisions depend on the characteristics of the market. 6. Identify the factors that influence pricing decisions in practice. 7. Compute a target sales price by various approaches, and compare the advantages and disadvantages of these approaches. 8. Use target costing to decide whether to add a new product. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. G R A N D C A N Y O N R A I L WAY While you are on vacation, the last thing you want to worry about is transportation. For visitors to Grand Canyon National Park, the Grand Canyon Railway provides a relaxing alternative to driving to the canyon. Why drive when you can sit back and enjoy the scenery across 65 miles of beautiful Arizona countryside from the comfort of a fully reconditioned steam-powered train? Strolling musicians serenade you, and western characters stage attacks and holdups that offer a glimpse into what train travel might have been like for old-west loggers, miners, and ranchers at the turn of the century. The Grand Canyon Railway offers a ride not only to the canyon itself but into the past as well. Rides into the past aren't exactly cheap. Tracks for the narrow-gauge train as well as the authentic steam engines and passenger cars cost a lot to buy new or to recondition. The company spent upward of $20 million before opening. Recovering that initial investment while earning a profit is not easy. According to the company controller, Kevin Call, "Pricing is really the key in running a successful operation." The railway offers 5 different classes of service, and setting the pricing on each one determines the company's profit and return on investment. To set prices, management uses the contribution-margin technique introduced in Chapter 2. Among the influences on pricing discussed in this chapter, costs and customer demands are the most important to the railway. The prices charged must not only ensure a reasonable profit, but they also must be attractive to the customer. Costs are important in the pricing decisions of many types of companies. What price should a Safeway store charge for a pound of hamburger? What should Boeing charge for a 777 airplane? Should a clothing manufacturer accept a special order from Wal-Mart? Managers rely on accounting information to answer these questions The Grand Canyon Railway offers classic train rides to the southern rim of the Grand Canyon. The train departs from the railway's Williams, Arizona, depot for the 65-mile trip. Managers use relevant cost and revenue information to set prices for the various classes of passenger service. ISBN: 0-536-47129-0 197 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 198 Part 1: Focus on Decision Making and to make important decisions on a daily basis. For example, it would be impossible for a firm to determine a pricing strategy without accounting information. However, not all accounting information applies to each type of decision. In this chapter, we'll focus on identifying relevant information for decision making and apply what we learn to pricing decisions. The ability to separate relevant from irrelevant information is often the difference between success and failure in modern business.1 The Concept of Relevance What information is relevant? That depends on the decision being made. Decision making is essentially choosing among several courses of action. Decision makers identify the available actions by an often time-consuming formal or informal search and screening process, perhaps carried out by a company team that includes engineers, accountants, and operating executives. Accountants play an important role in the decision-making process, not as decision makers but as collectors, reporters, and analyzers of relevant information. Although many managers want the accountant to recommend the proper decision, the final choice always rests with the operating executive. The accountant's role in decision making is primarily that of a technical expert on financial analysis who helps managers focus on the relevant information that will lead to the best decision. What Is Relevance? O B J E C T I V E Discriminate between relevant and irrelevant information for making decisions. relevant information The predicted future costs and revenues that will differ among alternative courses of action. 1 Making business decisions requires managers to compare two or more alternative courses of action. Accountants should use two criteria to determine whether information is relevant: (1) Information must be an expected future revenue or cost, and (2) it must have an element of difference among the alternatives. That is, relevant information is the predicted future costs and revenues that will differ among the alternatives. Note that relevant information is a prediction of the future, not a summary of the past. Historical (past) information has no direct bearing on a decision. Such information can have an indirect bearing on a decision because it may help in predicting the future. But past figures, in themselves, are irrelevant to the decision itself. Why? Because the decision cannot change the past. Decisions affect the future. Nothing can alter what has already happened. Of the expected future information, only data that will differ from alternative to alternative are relevant to the decision. Any item that will remain the same regardless of the alternative selected is irrelevant. For instance, if a department manager's salary will be the same regardless of the products produced, the salary is irrelevant to the selection of products. Here are some examples to help you clarify the sharp distinctions between relevant and irrelevant information. Suppose you always buy gasoline from either of two nearby gasoline stations. Yesterday you noticed that one station was selling gasoline at $3.00 per gallon. The other was selling it at $2.90. Your automobile needs gasoline today, and in making your choice of stations, you assume that these prices have not changed. The relevant costs are $3.00 and $2.90, the expected future costs that will differ between the alternatives. You use your past experience (that is, what you observed yesterday) for predicting today's price. Note that the relevant cost is not what you paid in the past, or what you observed yesterday, but what you expect to pay when you drive in to get gasoline. This cost meets our two criteria: (1) It is the expected future cost, and (2) it differs between the alternatives. 1Throughout ISBN: 0-536-47129-0 this and the next chapter, to concentrate on the fundamental ideas, we shall ignore the time value of money and income taxes (discussed in Chapter 11). Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 5: Relevant Information for Decision Making with a Focus on Pricing Decisions 199 You may also plan to have your car lubricated. The recent price at each station was $15, and this is what you anticipate paying. This expected future cost is irrelevant because it will be the same under either alternative. It does not meet our second criterion. On a business level, consider the following decision. A food container manufacturer is thinking of using aluminum instead of tin in making a line of large cans. The cost of direct material will decrease from $.30 to $.20 per can if the manufacturer uses aluminum. The cost of tin used for this comparison probably came from historical cost records on the amount paid most recently for tin, but the relevant cost in the foregoing analysis is the expected future cost of tin compared with the expected future cost of aluminum. Suppose the direct-labor cost will continue to be $.70 per unit regardless of the material used. It is irrelevant because our second criterion--an element of difference between the alternatives--is not met. Aluminum Direct material Direct labor $.20 .70 Tin $.30 .70 Difference $.10 -- Therefore, we can safely exclude direct labor from the comparison of alternatives. A Decision Model Exhibit 5-1 illustrates this simple decision process, and it serves to show the appropriate framework for more complex decisions. Box 1(A) represents historical data from the accounting system. Box 1(B) represents other data, such as price indices or industry statistics, gathered from outside the accounting system. Regardless of their source, the data in step 1 help the formulation of predictions in step 2. (Remember that, although historical data may act as a guide to predicting, they are irrelevant to the decision itself.) In step 3, these predictions become inputs to the decision model. A decision model is any method used for making a choice. Such models sometimes require elaborate quantitative procedures, such as a petroleum refinery's mathematical method for choosing what products to manufacture for any given day or week. A decision model, however, may also be simple. It may be confined to a single comparison of costs for choosing between two materials, as in the previous example of the tin versus aluminum cans. In this example, our decision model is to compare the predicted unit costs and, assuming that everything else is equal, select the alternative with the lower cost. We will be referring to Exhibit 5-1 frequently because it illustrates the main concept in this chapter. This decision process applies to all business decisions, no matter how simple or complicated they may be. By using this process, you will be able to focus squarely on the relevant information--the predicted future differences between alternatives--in any decision. In the rest of this chapter, we will use this decision process to apply the concept of relevance to several specific pricing decisions. O B J E C T I V E Apply the decision process to make business decisions. 2 decision model Any method for making a choice, sometimes requiring elaborate quantitative procedures. Accuracy and Relevance In the best of all possible worlds, the information managers use for decision making would be both perfectly relevant and precisely accurate. However, in reality, such information is often too difficult or too costly to obtain. Accountants are sometimes forced to choose between more relevance and more accuracy. Precise but irrelevant information is worthless for decision making. For example, a university president's salary may be $340,000 per year, to the penny, but may have no bearing on the question of whether to buy or rent data-processing equipment. However, imprecise but relevant information can be useful. For example, sales predictions for a new product may be subject to error, but they still are helpful in deciding whether to ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 200 Part 1: Focus on Decision Making Exhibit 5-1 Decision Process and Role of Information (A) (1) Historical Information Other Information (B) (2) Prediction Method Predictions as Inputs to Decision Model (3) Decision Model Decisions by Managers with the Aid of the Decision Model (4) Implementation and Evaluation Feedback manufacture the product. Relevant information must be reasonably accurate but not precisely so. The degree to which information is relevant or precise often depends on the degree to which it is qualitative or quantitative. Qualitative aspects are those for which measurement in dollars and cents is difficult and imprecise; quantitative aspects are those for which measurement is easy and precise. Accountants, statisticians, and mathematicians try to express as many decision factors as feasible in quantitative terms. Why? Because this approach reduces the number of qualitative (subjective) factors they need to consider. Just as we noted that relevance is more crucial than precision in decision making, so qualitative aspects may easily carry more weight than quantitative (financial) impacts in many decisions. For example, the extreme opposition of a militant union to new labor-saving machinery may cause a manager to forgo installation of such machinery even if it would save money. In a similar way, a company may pass up the opportunity to purchase a component from the supplier at a price below the cost of producing it themselves to avoid a long-range dependence on a particular supplier. Likewise, managers sometimes introduce new technology (for example, advanced computer systems or automated equipment) even though the expected quantitative ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 5: Relevant Information for Decision Making with a Focus on Pricing Decisions 201 results seem unattractive. Managers defend such decisions on the grounds that failure to keep abreast of new technology will surely bring unfavorable financial results in the long run. The Relevance of Alternative Income Statements In many cases, income statement information is relevant to decision making because it specifies how alternative choices impact income. Additionally, since executives use income statements to evaluate performance, managers need to know how their decisions will affect income as reported on the statements. Some income statements track fixed and variable costs using the contribution approach, whereas others adopt the absorption approach used in reporting to external parties. Let's examine the relevance of contribution and absorption income statements. To highlight the different effects of these approaches, consider the Cordell Company. Suppose Cordell makes and sells 1,000,000 units of seat covers for seats on airplanes, buses, and railroad passenger cars. Cordell sells these to companies such as America West and the Grand Canyon Railway Company. The total manufacturing cost of making 1,000,000 seat covers is $30,000,000. The unit manufacturing cost of the product is $30,000,000 1,000,000, or $30 per unit. We will assume that in 2007 the Cordell Company has direct-materials costs of $14 million and direct-labor costs of $6 million. Assume also that the company incurs the indirect manufacturing costs illustrated in Exhibit 5-2 and the selling and administrative expenses illustrated in Exhibit 5-3. Total sales are predicted at $40 million. Finally, assume that Cordell Company produces the same number of units that it sells. There are no beginning or ending inventories. Note that Exhibits 5-2 and 5-3 subdivide costs as variable or fixed. Most companies do not make such subdivisions in their income statements for external reporting. Nevertheless, to align income statements with the information managers should use in decision making, many companies report the extent to which their costs are variable or fixed, even though they must sometimes make arbitrary decisions about whether a given cost is variable, fixed, or partially fixed (for example, repairs). O B J E C T I V E Construct absorption and contribution-margin income statements, and identify their relevance for decision making. 3 Absorption Approach Exhibit 5-4 presents Cordell's income statement using the absorption approach (or absorption costing), the approach used by companies for external financial reporting. Firms that take this approach consider all direct and indirect manufacturing costs (both absorption approach A costing approach that considers all indirect manufacturing costs (both variable and fixed) to be product (inventoriable) costs that become an expense in the form of manufacturing cost of goods sold only as sales occur. Exhibit 5-2 Schedule 1: Variable Costs Supplies (lubricants, expendable tools, coolants, sandpaper) Materials-handling labor (forklift operators) Repairs on manufacturing equipment Power for factory Schedule 2: Fixed Costs Managers' salaries in factory Factory employee training Factory picnic and holiday party Factory supervisory salaries Depreciation, plant and equipment Property taxes on plant Insurance on plant Total indirect manufacturing costs Cordell Company $ 600 2,800 400 200 $ 400 180 20 1,400 3,600 300 100 Schedules of Predicted Indirect Manufacturing Costs for the Year Ended December 31, 2007 (thousands of dollars) $ 4,000 ISBN: 0-536-47129-0 6,000 $10,000 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 202 Part 1: Focus on Decision Making Exhibit 5-3 Cordell Company Schedules of Predicted Selling and Administrative Expenses for the Year Ended December 31, 2007 (thousands of dollars) Schedule 3: Selling Expenses Variable Sales commissions Shipping expenses for products sold Fixed Advertising Sales salaries Other Total selling expenses Schedule 4: Administrative Expenses Variable Some clerical wages Computer time rented Fixed Office salaries Other salaries Depreciation on office facilities Public-accounting fees Legal fees Other Total administrative expenses $1,400 600 $1,400 2,000 600 $2,000 4,000 $6,000 $ 160 40 $ 200 400 200 80 200 720 $ 200 1,800 $2,000 variable and fixed) to be product (inventoriable) costs that become an expense in the form of manufacturing cost of goods sold only as sales occur. Note in Exhibit 5-4 that gross profit or gross margin is the difference between sales and the manufacturing cost of goods sold. Note too that the primary classifications of costs on the income statement are by three major management functions: manufacturing, selling, and administrative. contribution approach A method of internal (management accounting) reporting that emphasizes the distinction between variable and fixed costs for the purpose of better decision making. Contribution Approach In contrast, Exhibit 5-5 presents Cordell's income statement using the contribution approach (also called variable costing or direct costing). Authorities do not allow the contribution approach for external financial reporting. However, many companies use this approach for internal decision-making purposes and an absorption format for external Exhibit 5-4 Cordell Company Predicted Absorption Income Statement for the Year Ended December 31, 2007 (thousands of dollars) Sales Less: Manufacturing costs of goods sold Direct materials Direct labor Indirect manufacturing (Schedules 1 plus 2)* Gross margin or gross profit Selling expenses (Schedule 3) Administrative expenses (Schedule 4) Total selling and administrative expenses Operating income $40,000 $14,000 6,000 10,000 $ 6,000 2,000 8,000 $ 2,000 ISBN: 0-536-47129-0 30,000 $10,000 *Schedules 1 and 2 are in Exhibit 5-2. Schedules 3 and 4 are in Exhibit 5-3. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 5: Relevant Information for Decision Making with a Focus on Pricing Decisions 203 purposes. Why? Because they expect the benefits of making better decisions using the contribution approach to exceed the extra costs of using two different reporting systems simultaneously. For decision purposes, the major difference between the contribution approach and the absorption approach is that the former emphasizes the distinction between variable and fixed costs. Its primary classifications of costs is by variable- and fixed-cost behavior patterns, not by business functions. The contribution income statement provides a contribution margin--revenue less all variable costs including variable selling and administrative costs. This approach makes it easier to understand the impact of changes in sales demand on operating income. It also dovetails neatly with the cost-volume-profit (CVP) analysis illustrated in Chapter 2 and the decision analyses in this chapter and the next. A major benefit of the contribution approach is that it stresses the role of fixed costs in operating income. Before a company can earn income, its total contribution margin must exceed the fixed costs it has incurred for manufacturing and other value-chain functions. This highlighting of contribution margin and total fixed costs focuses management attention on cost behavior and control in making both short-run and long-run plans. Remember that advocates of the contribution approach do not maintain that fixed costs are unimportant or irrelevant. They do stress, however, that the distinctions between behaviors of variable and fixed costs are crucial for certain decisions. Decisions usually affect fixed costs in a different way than they affect variable costs. The difference between the gross margin (from the absorption approach) and the contribution margin (from the contribution approach) is striking in manufacturing companies. Why? Because absorption-costing systems regard fixed manufacturing costs as a part of cost of goods sold, and these fixed costs reduce the gross margin accordingly. However, fixed manufacturing costs do not reduce the contribution margin, which is simply the difference between revenues and variable costs. Comparing Contribution and Absorption Approaches In essence, the contribution-margin approach separates costs based on the primary distinction of cost behavior pattern. It deducts variable costs from sales to compute a contribution margin and then deducts fixed costs to measure profit. In contrast, the absorption approach separates costs based on the primary distinction of manufacturing versus nonmanufacturing costs. It deducts manufacturing costs from sales to compute a gross margin and then deducts nonmanufacturing costs to measure profit. Both formats can be relevant for decision making, depending on the type of decision being contemplated. In situations where cost behavior patterns are most important, such as the short-run pricing decisions we will discuss in this chapter, the contribution-margin approach will yield great value. In contrast, the absorption approach is well suited for long-run pricing decisions, where it is important that the prices over a product's life cover all manufacturing costs. Pricing Special Sales Orders Before considering more general approaches to pricing, it is helpful to examine how a manager might approach a specific pricing decision--whether to accept a proposed price for a special sales order. We will highlight the value of the contribution approach in such a decision. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 204 Part 1: Focus on Decision Making Exhibit 5-5 Cordell Company Predicted Contribution Income Statement for the Year Ended December 31, 2007 (thousands of dollars) Sales Less: Variable expenses Direct materials Direct labor Variable indirect manufacturing costs (Schedule 1)* Total variable manufacturing cost of goods sold Variable selling expenses (Schedule 3) Variable administrative expenses (Schedule 4) Total variable expenses Contribution margin Less: fixed expenses Manufacturing (Schedule 2) Selling (Schedule 3) Administrative (Schedule 4) Operating income $40,000 $14,000 6,000 4,000 $24,000 2,000 200 26,200 $13,800 $ 6,000 4,000 1,800 11,800 $ 2,000 * Note: Schedules 1 and 2 are in Exhibit 5-2. Schedules 3 and 4 are in Exhibit 5-3. Illustrative Example In our illustration, we'll focus again on the Cordell Company. Suppose Branson Gray Line Tours offered Cordell $26 per unit for a 100,000-unit special order of seat covers that (1) would not affect Cordell's regular business in any way, (2) would not raise any antitrust issues concerning price discrimination, (3) would not affect total fixed costs, (4) would not require any additional variable selling and administrative expenses, and (5) would use some otherwise idle manufacturing capacity. Should Cordell sell the 100,000 seat covers for the price of $26 each? Perhaps we should state the question more succinctly: What is the difference in the short-run financial results between not accepting and accepting? As usual, the key question is, What are the differences between alternatives? Exhibit 5-5 presents the income statement of the Cordell Company without the special order, using the contributionmargin approach. Let's see how Cordell's operating income would change if it accepts the special order. Correct Analysis--Focus on Relevant Information and Cost Behavior O B J E C T I V E Decide to accept or reject a special order using the contribution-margin technique. 4 The correct analysis focuses on determining relevant information and cost behavior. It employs the contribution-margin technique. As Exhibit 5-6 shows, this particular order affects only variable manufacturing costs, at a rate of $24 per unit. All other variable costs and all fixed costs are unaffected and, thus, irrelevant. Therefore, a manager may safely ignore them in making this special-order decision. Note how the contribution-margin technique's distinction between variable- and fixed-cost behavior patterns aids the necessary cost analysis. Total short-run income will increase by $200,000 if Cordell accepts the order--despite the fact that the unit selling price of $26 is less than the total unit manufacturing cost of $30. Why did we include fixed costs in Exhibit 5-6? After all, they are irrelevant. We included them because management often focuses on the bottom line--operating income. Both the contribution margin and the operating income increase by $200,000 so we could ignore the fixed costs and come to the same conclusion. However, management may prefer to justify decisions by their effect on operating income, so we include the irrelevant fixed costs in the presentation. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 5: Relevant Information for Decision Making with a Focus on Pricing Decisions 205 MAKING MANAGERIAL DECISIONS Suppose you are at a meeting of Cordell Company managers and someone asked the following questions. Some of the answers given by your colleagues follow. Q: What will be the change in the contribution margin if we accept this order? A: The contribution margin will increase to $14,000,000. Q: In your analysis [Exhibit 5-6], you show that fixed costs do not change if we accept the order. Are these costs relevant? A: No. Fixed costs are not relevant. Q: OK. But do fixed costs that we incur have an effect on the bottom line of our company? A: Certainly. That is why we deduct fixed costs from the contribution margin to get operating income. Q: Well, if fixed costs affect the bottom line, how can you say they are not relevant? Comment on your colleague's answers, and answer the last question. Answer Your colleague's answer to the first question is technically incorrect. The question asks for change, not the new total contribution margin. The correct answer to this question is that contribution margin will increase by $200,000 (and therefore to $14,000,000). We need to be ver y careful when answering questions to be sure to differentiate between terms that imply totals and terms that imply changes. In this case, $14,000,000 is the answer to "What is the new total contribution margin if we accept the order?" Your colleague's responses to the second and third questions are correct. The fixed costs of Cordell are not relevant for this par ticular special order situation. Nevertheless, the bottom line includes all costs or total costs and revenues. Do not confuse this with the relevant costs--a term we associated with this specific decision. In a decision situation, relevant costs include only those future costs that will differ if we accept the order. If a manager wants to know the "bottom line" after accepting the order, we would need to include the fixed cost. However, the fixed costs do not affect the difference between the preorder bottom line and the bottom line after accepting the order. The difference is the same $200,000 amount by which the contribution margin increases. Without Special Order, 1,000,000 Units Sales Less: variable expenses Manufacturing Selling and administrative Total variable expenses Contribution margin Less: fixed expenses Manufacturing Selling and administrative Total fixed expenses Operating income ISBN: 0-536-47129-0 Effect of Special Order 100,000 Units Total Per Unit $2,600,000 $2,400,000 -- $2,400,000 $ 200,000 -- -- -- $ 200,000 $26 $24 -- $24 $ 2 -- -- -- $ 2 With Special Order, 1,100,000 Units $42,600,000 $26,400,000 2,200,000 $28,600,000 $14,000,000 $ 6,000,000 5,800,000 $11,800,000 $ 2,200,000 $40,000,000 $24,000,000 2,200,000 $26,200,000 $13,800,000 $ 6,000,000 5,800,000 $11,800,000 $ 2,000,000 Exhibit 5-6 Cordell Company Comparative Predicted Income Statements, Contribution-Margin Technique for Year Ended December 31, 2007 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 206 Part 1: Focus on Decision Making Analysis--Misuse of Unit Cost Faulty cost analysis sometimes occurs because of misinterpreting unit fixed costs, especially with an absorption approach. For instance, Cordell's managers might erroneously use the $30 per-unit total manufacturing cost under the absorption approach ($30,000,000 1,000,000 units per Exhibit 5-4) to make the following prediction for the year: Without Special Order 1,000,000 Units $40,000,000 30,000,000 10,000,000 8,000,000 $ 2,000,000 Incorrect Effect of Special Order 100,000 Units $2,600,000 3,000,000 (400,000) -- $ (400,000) With Special Order 1,100,000 Units $42,600,000 33,000,000 9,600,000 8,000,000 $ 1,600,000 Incorrect Analysis Sales Less: manufacturing cost of goods sold @ $30 Gross margin Selling and administrative expenses Operating income The incorrect prediction of a $3 million increase in costs results from multiplying 100,000 units by $30. The fallacy in this approach is that it treats a fixed cost (fixed manufacturing cost) as if it were variable. Avoid the temptation to use total unit costs as a basis for predicting how total costs will behave. Unit costs are useful for predicting variable costs, but unit costs are generally misleading when used to predict fixed costs. Confusion of Variable and Fixed Costs Consider the relationship between total fixed manufacturing costs and a fixed manufacturing cost per unit of product (per Exhibit 5-5): total fixed manufacturing costs fixed manufacturing cost = per unit of product t some selected volume level as the denominator $ 6,000,000 , = = $ 6 per unit 1,000,000 units As we noted in Chapter 1, the typical cost accounting system serves two purposes simultaneously: planning and control and product costing. We can graph the total fixed cost for budgetary planning and control purposes as a lump sum: Total Fixed Manufacturing Costs Budgetary Control Purpose $6,000,000 ISBN: 0-536-47129-0 500,000 1,000,000 Volume in Units Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 5: Relevant Information for Decision Making with a Focus on Pricing Decisions 207 For product-costing purposes, however, using the total unit manufacturing cost implies that these fixed costs have a variable-cost behavior pattern, which is contrary to fixed-cost behavior: Total Fixed Manufacturing Costs Budgetary Control Purpose $6,000,000 Product-Costing Purpose @ $6 per Unit 500,000 1,000,000 Volume in Units The addition of 100,000 units will not add any fixed costs as long as total output is within the relevant range. The incorrect analysis, however, includes 100,000 $6 = $600,000 of additional fixed cost in the predictions of increases in total costs. In short, we should compute the increase in manufacturing costs by multiplying 1,000,000 units by $24, not by $30. The $30 includes a $6 component that will not affect the total manufacturing costs as volume changes. Alternatively, one could entirely avoid this pitfall of unitizing fixed costs by using the contribution-margin approach as in Exhibit 5-6. MAKING MANAGERIAL DECISIONS We have presented two key lessons so far in this chapter: relevant information and misuse of unit costs. We cannot stress enough how important it is to clearly understand the definition and concept of relevant information. It is also impor tant to understand why the use of unit fixed costs can lead to an incorrect analysis. Suppose you are a manager in a company that makes small appliances. You are deciding whether to accept or reject a special order for 1,000 units. (Assume there is suf ficient excess capacity available for the order.) 1. Which of the following costs are relevant: (a) parts for the order, (b) supervisor's salary, (c) assembly equipment depreciation, (d) power to operate the assembly equipment? 2. Suppose the total unit manufacturing cost for the 1,000 units is $100 per unit. We determined this amount by dividing the total cost by 1,000 units. If the customer decided to double the order to 2,000 units, which costs listed in number 1 would change? Which ISBN: 0-536-47129-0 costs per unit would change? Would the total cost of the order double? Answers 1. Relevant costs and revenues are predicted future costs and revenues that differ among alternative courses of action. In this case, the cost of parts and power would increase if management accepts the order, and, thus, they are relevant. The other costs are fixed costs that would not change because excess capacity is available. 2. Only the relevant costs, in this case, the variable costs, would change: par ts and power. Fixed costs would be unaffected. In contrast, the fixed cost per unit will change, whereas the variable cost per unit will stay the same. For example, fixed super visor y salaries will be divided by 2,000 units instead of by only 1,000 units, and hence per-unit supervisory cost will decrease. The parts cost per unit would stay the same, as would the power cost per unit. So, the total unit cost would fall, and the total cost of the order would not double. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 208 Part 1: Focus on Decision Making Activity-Based Costing, Special Orders, and Relevant Costs To identify relevant costs affected by a special order (or by other special decisions), more firms are going a step beyond simply identifying fixed and variable costs. As we pointed out in Chapters 3 and 4, a company's operations include many different activities. Businesses that have identified all their significant activities and related cost drivers can produce more detailed relevant information to predict the effects of special orders more accurately. Suppose the Cordell Company examined its $24 million of variable manufacturing costs very closely and identified two significant activities and related cost drivers: $21 million of processing activity that varies directly with units produced ($14 million in direct materials, $6 million in direct labor, and $1 million of variable manufacturing overhead) at a rate of $21 per unit and $3 million of setup activity (the remainder of variable manufacturing overhead) that varies with the number of production setups. Normally, Cordell produces 2,000 units per setup. Therefore, for processing 1,000,000 units, Cordell has 500 setups at a cost of $6,000 per setup. Additional sales generally require a proportional increase in the number of setups. Now suppose the special order is for 100,000 units that vary only slightly in production specifications. Instead of the normal 50 setups, Cordell will need only 5 setups. So processing 100,000 units will take only $2,130,000 of additional variable manufacturing cost: Additional unit-based variable manufacturing cost, 100,000 $21 Additional setup-based variable manufacturing cost, 5 $6,000 Total additional variable manufacturing cost $2,100,000 30,000 $2,130,000 Instead of the original estimate of 100,000 $24 = $2,400,000 additional variable manufacturing cost, the special order will cost only $2,130,000, or $270,000 less than the original estimate. Therefore, activity-based costing (ABC) allows managers to realize that the special order is $270,000 more profitable than predicted from the simple unit-based assessment of variable manufacturing cost. A special order may also be more costly than predicted by a simple fixed- and variablecost analysis. Suppose the 100,000-unit special order called for a variety of models and colors delivered at various times so that it requires 100 setups. The variable cost of the special order would be $2.7 million, $300,000 more than the original estimate of $2.4 million. Additional unit-based variable manufacturing cost, 100,000 $21 Additional setup-based variable manufacturing cost, 100 $6,000 Total additional variable manufacturing cost $2,100,000 600,000 $2,700,000 ABC systems provide much useful operating information for special-order decisions, but the fundamental concepts remain the same--focus your attention on future costs and revenues that differ because of the special order. Also, be careful to recognize and use terms such as impact, change, and total properly. The summary problem for your review that follows gives you more practice at analyzing a special order. Summary Problem for Your Review PROBLEM 1. Suppose Nike produces and sells 500,000 units of the LeBron James "Witness" basketball shirt. The selling price is $35, and there is excess capacity to produce an additional 300,000 shirts. The costs are as follows for the 500,000 shirts currently being produced and sold: The absorption cost is $10,000,000 500,000, or $20 per shirt, ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 5: Relevant Information for Decision Making with a Focus on Pricing Decisions 209 consisting of variable manufacturing costs of $7,000,000 ($7,000,000 500,000 or $14 per shirt) and fixed manufacturing costs of $3,000,000 ($3,000,000 500,000 or $6 per shirt). Variable selling and administrative costs are $3 per shirt, and fixed selling and administrative costs are $2,000,000. Assume Nike receives a special order for 100,000 shirts from the Sports Authority that had the following terms: Selling price would be $18.00 per shirt, and if Nike accepts the order it would not incur any additional variable selling and administrative costs, but it would have to pay a flat fee of $80,000 to a manufacturer's agent who had obtained the potential order. Should Nike accept the special order? 2. What if the order was for 250,000 units at a selling price of $13.00 and there was no $80,000 agent's fee? One manager argued for acceptance of such an order as follows: "Of course, we will lose $1.00 each on the variable manufacturing costs ($13 - $14), but we will gain $2.00 per unit by spreading our fixed manufacturing costs over 750,000 shirts instead of 500,000 shirts. Consequently, we should take the offer because it represents an advantage of $1.00 per shirt." The manager's analysis follows: Old fixed manufacturing cost per unit, $3,000,000 500,000 New fixed manufacturing cost per unit, $3,000,000 750,000 "Savings" in fixed manufacturing cost per unit Loss on variable manufacturing cost per unit, $13.00 - $14.00 Net savings per unit in manufacturing cost $6.00 4.00 $2.00 1.00 $1.00 Explain why this is faulty thinking. SOLUTION 1. Focus on relevant information--the differences in revenues and costs. In this problem, in addition to the difference in variable costs, there is a difference in fixed costs between the two alternatives. Additional revenue, 100,000 units @ $18.00 per shirt Less additional costs Variable costs, 100,000 units @ $14 per unit Fixed costs, agent's fee Increase in operating income from special order $1,800,000 1,400,000 80,000 $ 320,000 So, from a strictly financial perspective, Nike should accept the special order. 2. The faulty thinking comes from attributing a "savings" to the decrease in unit fixed costs. Regardless of how we "unitize" the fixed manufacturing costs or "spread" them over the units produced, the special order will not change the total of $3 million. Remember that we have a negative contribution margin of $1.00 per unit on this special order. Thus, there is no way we can cover any amount of fixed costs! Fixed costs are not relevant to this decision. Basic Principles for Pricing Decisions One of the major decisions managers face is pricing. Actually, pricing can take many forms. In addition to pricing special orders, managers make the following pricing decisions: ISBN: 0-536-47129-0 1. Setting the price of a new or refined product. 2. Setting the price of products sold under private labels. 3. Responding to a new price of a competitor. 4. Pricing bids in both sealed and open bidding situations. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 210 Part 1: Focus on Decision Making Pricing decisions are so important that we will spend the rest of the chapter discussing the many aspects of pricing. Let us now take a look at some of the basic concepts behind pricing. The Concept of Pricing O B J E C T I V E Explain why pricing decisions depend on the characteristics of the market. perfect competition A market in which a firm can sell as much of a product as it can produce, all at a single market price. marginal cost The additional cost resulting from producing and selling one additional unit. marginal revenue The additional revenue resulting from the sale of an additional unit. 5 imperfect competition A market in which the price a firm charges for a unit will influence the quantity of units it sells. Pricing decisions depend on the characteristics of the market a firm faces. In perfect competition, all competing firms sell the same type of product at the same price. Thus, a firm can sell as much of a product as it can produce, all at a single market price. If it charges more, no customer will buy. If it charges less, it sacrifices profits. Therefore, every firm in such a market will charge the market price, and the only decision for managers to make is how much to produce. Although costs do not directly influence prices in perfect competition, they do affect the production decision. Consider the marginal cost curve in Exhibit 5-7. The marginal cost is the additional cost resulting from producing and selling one additional unit--for the Grand Canyon Railway, one additional passenger; for General Motors, one additional car. With a fixed set of production facilities, the marginal cost often decreases as production increases up to a point because of efficiencies created by larger volumes. At some point, however, marginal costs begin to rise with increases in production because facilities become overcrowded or overused, resulting in inefficiencies. Exhibit 5-7 also includes a marginal revenue curve. The marginal revenue is the additional revenue resulting from the sale of an additional unit. In perfect competition, the marginal revenue curve is a horizontal line equal to the price per unit at all volumes of sales. As long as the marginal cost is less than the marginal revenue (price), additional production and sales are profitable. When marginal cost exceeds price, however, the firm loses money on each additional unit. Therefore, the profit-maximizing volume is the quantity at which marginal cost equals price. In Exhibit 5-7, the firm should produce V0 units. Producing fewer units passes up profitable opportunities, and producing more units reduces profit because each additional unit costs more to produce than it generates in revenue. In imperfect competition, the price a firm charges for a unit will influence the quantity of units it sells. At some point, the firm must reduce prices to generate additional sales. Exhibit 5-8 contains a demand curve (also called the average revenue curve) for Exhibit 5-7 Marginal Revenue and Cost in Perfect Competition Marginal Cost Dollars per Unit Marginal Revenue = Price V0 Volume in Units ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 5: Relevant Information for Decision Making with a Focus on Pricing Decisions 211 Exhibit 5-8 Marginal Cost Marginal Revenue and Cost in Imperfect Competition Price Dollars per Unit Demand = Average Revenue Marginal Revenue V0 Volume in Units imperfect competition that shows the volume of sales at each possible price. To sell additional units, the firm must reduce the price of all units sold. Therefore, the marginal revenue curve, also shown in Exhibit 5-8, is below the demand curve. That is, the marginal revenue for selling one additional unit is less than the price at which the company sells it because the price of all other units falls as well. For example, suppose a firm can sell 10 units for $50 per unit. However, the firm must drop the price to $49 per unit to sell 11 units, to $48 to sell 12 units, and to $47 to sell 13 units. The fourth column of Exhibit 5-9 shows the marginal revenue for units 11 through 13. Notice that the marginal revenue decreases as volume increases. To estimate marginal revenue, managers must predict the price elasticity--the effect of price changes on sales volume. If small price increases cause large volume declines, demand is highly elastic. If prices have little or no effect on volume, demand is highly inelastic. For the marginal costs shown in the fifth column of Exhibit 5-9, the optimal production and sales level is 12 units. The last column of that exhibit illustrates that the eleventh unit adds $4 to profit, and the twelfth adds $1, but production and sale of the thirteenth unit would decrease profit by $2. In general, firms should produce and sell units until the marginal revenue equals the marginal cost, represented by volume V0 in Exhibit 5-8. The optimal price charged will be the amount that creates a demand for V0 units. Notice that the marginal cost is relevant for pricing decisions. In managerial accounting, marginal cost is essentially the variable cost. What is the major difference between price elasticity The effect of price changes on sales volume. Units Sold 10 11 12 13 ISBN: 0-536-47129-0 Price per Unit $50 49 48 47 Total Revenue 10 $50 = $500 11 49 = 539 12 48 = 576 13 47 = 611 Marginal Revenue $539 - $500 = $39 576 - 539 = 37 611 - 576 = 35 Marginal Cost $35 36 37 Profit from Production and Sale of Additional Unit $39 - $35 = $4 37 - 36 = 1 35 - 37 = (2) Exhibit 5-9 Profit Maximization in Imperfect Competition Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 212 Part 1: Focus on Decision Making marginal cost and variable cost? Accountants assume that variable cost is constant within a relevant range of volume, whereas marginal cost may change with each unit produced. Within large ranges of production volume, however, changes in marginal cost are often small. Therefore, variable cost can be a reasonable approximation of marginal cost in many situations. Pricing and Accounting Accountants seldom compute marginal revenue curves and marginal cost curves. Instead, they use estimates based on judgment to predict the effects of additional production and sales on profits. In addition, they examine selected volumes, not the whole range of possible volumes. Such simplifications are justified because the cost of a more sophisticated analysis would exceed the benefits. Consider a division of General Electric (GE) that makes microwave ovens. Suppose market researchers estimate that GE can sell 700,000 ovens at $200 per unit and 1,000,000 ovens at $180. The variable cost of production is $130 per unit at production levels of both 700,000 and 1,000,000. Both volumes are also within the relevant range so that changes in volume do not affect fixed costs. Which price should GE charge? GE's accountant would determine the relevant revenues and costs. The additional revenue and additional costs of the 300,000 additional units of sales at the $180 prices are Additional revenue: (1,000,000 $180) - (700,000 $200) = Additional costs: 300,000 $130 = Additional profit $40,000,000 39,000,000 $ 1,000,000 So the $180 price is optimal since it generates $1,000,000 more profit. Alternatively, the accountant could compare the total contribution for each alternative: Contribution at $180: ($180 - $130) 1,000,000 = Contribution at $200: ($200 - $130) 700,000 = Difference $50,000,000 49,000,000 $ 1,000,000 Notice that comparing the total contributions is essentially the same as computing the additional revenues and costs--both use the same relevant information. Further, both approaches correctly ignore fixed costs, which are unaffected by this pricing decision. General Influences on Pricing in Practice O B J E C T I V E Identify the factors that influence pricing decisions in practice. 6 Several factors interact to shape the market in which managers make pricing decisions. Legal requirements, competitors' actions, and customer demands all influence pricing. Legal Requirements Managers must consider constraints imposed by U.S. and international laws when making pricing decisions. These laws often protect consumers, but they also help protect competing companies from predatory and discriminatory pricing. Predatory pricing means setting prices so low that they drive competitors out of the market. The predatory pricer then has no significant competition and can raise prices dramatically. For example, lawsuits have accused Wal-Mart of predatory pricing--selling at low cost to drive out local competitors. However, in a 4-to-3 vote, The Arkansas Supreme Court ruled in favor of Wal-Mart. Courts in the United States have generally ruled that pricing is predatory only if companies set prices below their average variable cost and actually lose money in order to drive their competitors out of business. predatory pricing Establishing prices so low that they drive competitors out of the market. The predatory pricer then has no significant competition and can raise prices dramatically. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 5: Relevant Information for Decision Making with a Focus on Pricing Decisions 213 Discriminatory pricing is charging different prices to different customers for the same product or service. For example, a large group of retail druggists and big drugstore chains sued several large drug companies, alleging that their practice of allowing discounts, some as large as 40%, to mail-order drug companies, health maintenance organizations, and other managed-care entities constitutes discriminatory pricing. However, pricing is not discriminatory if it reflects a cost differential incurred in providing the good or service. When the companies settled the class-action suit, it did not require the drug companies to alter their pricing practices. Both predatory and discriminatory pricing practices are not only illegal but unethical business practices. Management accountants have an ethical obligation to perform their duties in accordance with relevant laws and to refrain from engaging in or supporting any activity or practice that would discredit the profession. discriminatory pricing Charging different prices to different customers for the same product or service. Competitors' Actions Competitors usually react to the price changes of their rivals. Many companies will gather information regarding a rival's capacity, technology, and operating policies. In this way, managers make more informed predictions of competitors' reactions to a company's prices. The study of game theory, for which two economists won a Nobel Prize, focuses on predicting and reacting to competitors' actions. A manager's expectations of competitors' reactions and of the overall effects of price changes on the total industry demand for the good or service in question heavily influence pricing policies. For example, an airline might cut prices even if it expects price cuts from its rivals, hoping that total customer demand for the tickets of all airlines will increase sufficiently to offset the reduction in the price per ticket. In contrast, they might avoid price reductions if they expect competitors to follow and do not expect an increase in overall industry demand. Competition is becoming increasingly international. Overcapacity in some countries often causes aggressive pricing policies for a company's exported goods. For example, companies might "dump" products by selling them at a low price in a foreign market that is isolated from its other markets. As you can imagine, when companies' markets expand globally, their pricing policies become more complex. Customer Demands More than ever before, managers are recognizing the needs of customers. Pricing is no exception. If customers believe a price is too high, they may turn to other sources for the product or service, substitute a different product, or decide to produce the item themselves. As the controller for the Grand Canyon Railway states, ". . . prices charged must be attractive to the customer." If not, they can simply drive their own car to the Grand Canyon or choose to ride a bus. Cost-Plus Pricing Accounting influences pricing by providing costs. The exact role costs play in pricing decisions depends on both the market conditions and the company's approach to pricing. This section discusses cost-plus pricing, the most common use of costs in pricing decisions. What Is Cost-Plus Pricing? ISBN: 0-536-47129-0 Many managers say that they set prices by "cost-plus" pricing. For example, Grand Canyon Railway sets its prices by computing an average cost and then adding a desired markup--the amount by which price exceeds cost--that will generate a desired level of income. The key, however, is the "plus" in cost plus. Instead of being a fixed markup, the markup The amount by which price exceeds cost. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 214 Part 1: Focus on Decision Making "plus" will usually depend on both costs and the demands of customers. For example, the railway has a standard (rack rate) price that does not change during the year, but it often offers discounts during the slow winter season. Prices are most directly related to costs in industries where revenue is based on cost reimbursement. Cost-reimbursement contracts generally specify how to measure costs and what costs are allowable. For example, the government reimburses only coach-class (not first-class) airfares for business travel on defense contracts. Ultimately, though, the market sets prices. Why? Because companies inevitably adjust the price as set by a cost-plus formula "in light of market conditions." The maximum price a company can charge is the one that does not drive the customer away. The minimum price might be considered to be zero (for example, companies may give out free samples to gain entry into a market). A more practical guide is that, in the short run, the minimum price sales personnel should quote on an order is the marginal cost that the company incurs if it gets the order-- often all variable costs of producing, selling, and distributing the good or service. However, in the long run, the price must be high enough to cover all costs, including fixed costs. Therefore, many companies add allocated fixed unit costs to the variable costs to get a minimum price they want to achieve in the long run. They acknowledge that market conditions sometimes dictate sales at a price lower than this long-run minimum price. Yet, to continue to produce and sell such a product, there must be a prospect of eventually achieving a price at or above the long-run minimum. Cost Bases for Cost-Plus Pricing O B J E C T I V E Compute a target sales price by various approaches, and compare the advantages and disadvantages of these approaches. 7 full cost The total of all manufacturing costs plus the total of all selling and administrative costs. To set a desired price or target price for products or services, managers often add a markup to some measure of costs--thus, the term cost plus. The size of the "plus" depends on the definition of cost and the target (desired) operating income. Target prices can be based on a host of different markups that are in turn based on a host of different definitions of cost. Thus, there are many ways to arrive at the same target price. Exhibit 5-10 displays the relationships of costs to target selling prices, assuming a target operating income of $1 million on a volume of 1 million units. The percentages there represent four popular markup formulas for pricing: (1) as a percentage of variable manufacturing costs, (2) as a percentage of total variable costs, (3) as a percentage of total manufacturing cost, and (4) as a percentage of full costs. Notice that the first two formulas are consistent with the contribution-margin approach and the latter two are based on absorption costing numbers. Note also that full cost means the total of all manufacturing costs plus the total of all selling and administrative costs. As noted in earlier chapters, we use "selling and administrative" to include all value-chain functions other than production. To achieve the same prices, the percentages in Exhibit 5-10 differ for each definition of cost. For instance, the markup on variable manufacturing costs is 66.67%, and on full costs it is only 5.26%. Regardless of the formula used, the pricing decision maker will be led toward the same target price. For a volume of 1 million units, assume that the target selling price is $20 per unit. If the decision maker is unable to obtain such a price consistently, the company will not achieve its $1 million operating income objective. We have seen that managers can base prices on various types of cost information, from variable manufacturing costs to full costs. Each of these costs can be relevant to the pricing decision. Each approach has advantages and disadvantages. Advantages of the Contribution-Margin Approach in Cost-Plus Pricing ISBN: 0-536-47129-0 Prices based on variable costs represent a contribution approach to pricing, as we showed earlier in the chapter. When used intelligently, the contribution-margin approach has some advantages over the total-manufacturing-cost and full-cost approaches because the latter two often fail to highlight different cost behavior patterns. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 5: Relevant Information for Decision Making with a Focus on Pricing Decisions 215 Exhibit 5-10 Alternative Markup Percentages to Achieve Same Target Sales Price Target sales price Variable cost: (1) Manufacturing Selling and administrative* (2) Unit variable costs Fixed costs: Manufacturing Selling and administrative Unit fixed costs (3) Full costs Target operating income $20.00 $12.00 1.10 $13.10 $ 3.00 2.90 $ 5.90 $19.00 $ 1.00 ($20.00 - $12.00) $12.00 = 66.67% ($20.00 - $13.10) $13.10 = 52.67% Relationships of Costs to Same Target Selling Price ($20.00 - $19.00) $19.00 = 5.26% * Selling and administrative costs include costs of all value chain functions other than production. (4) A frequently used formula is based on total manufacturing costs: [$20.00 - ($12.00 + $3.00)] $15.00 = 33.33%. The contribution-margin approach offers more detailed information because it displays variable- and fixed-cost behavior patterns separately. Because the contribution-margin approach is sensitive to cost-volume-profit relationships, it is a helpful basis for developing pricing formulas. As a result, this approach allows managers to prepare price schedules at different volume levels. The correct analysis in Exhibit 5-11 shows how changes in volume affect operating income. The contribution-margin approach helps managers with pricing decisions by readily displaying the interrelationships among variable costs, fixed costs, and potential changes in selling prices. In contrast, target pricing with full costing presumes a given volume level. When the volume changes, the unit cost used at the original planned volume may mislead managers. Managers sometimes erroneously assume that they can compute the change in total costs by multiplying any change in volume by the full unit cost. Correct Analysis Volume in units Sales @ $20.00 Unit variable costs @ $13.10* Contribution margin Fixed costs Full costs @ $19.00* Operating income 900,000 $18,000,000 1,000,000 $20,000,000 1,100,000 $22,000,000 900,000 $18,000,000 Incorrect Analysis 1,000,000 $20,000,000 1,100,000 $22,000,000 11,790,000 6,210,000 5,900,000 13,100,000 6,900,000 5,900,000 14,410,000 7,590,000 5,900,000 17,100,000 19,000,000 $ 1,000,000 20,900,000 $ 1,100,000 $ 310,000 $ 1,000,000 $3,000,000 2,900,000 $5,900,000 $ 1,690,000 $ 900,000 ISBN: 0-536-47129-0 *From Exhibit 5-10. Fixed manufacturing costs Fixed selling and administrative costs Total fixed costs Exhibit 5-11 Analyses of Effects of Changes in Volume on Operating Income Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 216 Part 1: Focus on Decision Making The incorrect analysis in Exhibit 5-11 shows how using the $19 full cost per unit (based on a volume of 1,000,000 units from Exhibit 5-10) to predict effects of volume changes on operating income can mislead managers. Suppose a manager uses the $19 figure to predict an operating income of $900,000 if the company sells 900,000 instead of 1,000,000 units. If actual operating income is $310,000 instead, as the correct analysis predicts, that manager may be stunned--and possibly looking for a new job. Notice the only volume where the incorrect analysis is actually correct is at the 1 million unit volume level, which is also the only volume where the $19 full cost per unit is valid. The contribution-margin approach also offers insight into the short-run versus longrun effects of cutting prices on special orders. For example, assume the same cost behavior patterns as in the Cordell Company example in Exhibit 5-6 (page 205). The 100,000unit order added $200,000 to operating income at a selling price of $26, which was $14 below the target selling price of $40 and $4 below the total manufacturing cost of $30. Given all the stated assumptions, accepting the order appeared to be the better choice. As you saw earlier, the contribution-margin approach generated the most relevant information. Consider the contribution and total-manufacturing-cost approaches. Contribution Margin Technique Sales, 100,000 units @ $26 Variable manufacturing costs @ $24 Total manufacturing costs @ $30 Apparent change in operating income $2,600,000 2,400,000 $ 200,000 TotalManufacturing-Cost Approach $2,600,000 3,000,000 ($ 400,000) Under the total-manufacturing-cost approach, the offer is definitely unattractive because the price of $26 is $4 below total manufacturing costs. Under the contribution-margin approach, a manager sees a short-run advantage of $200,000 from accepting the offer. Fixed costs will be unaffected by whatever decision the manager makes, and operating income will increase by $200,000. However, the manager should also consider long-run effects. Will acceptance of the offer undermine the long-run price structure? In other words, is the short-run advantage of $200,000 more than offset by highly probable long-run financial disadvantages? The manager may think so and, thus, reject the offer. But--and this is important--by doing so the manager is, in effect, forgoing $200,000 now to protect certain long-run market advantages. Generally, the manager can assess problems of this sort by asking whether the probability of long-run benefits is worth an "investment" equal to the forgone contribution margin ($200,000, in this case). Under full-cost approaches, the manager must ordinarily conduct a special study to find the immediate effects. Under the contribution-margin approach, the manager has a system that will routinely and more surely provide such information. Advantages of Absorption-Cost Approaches in Cost-Plus Pricing Frequently, companies do not employ a contribution-margin approach because they fear that managers will indiscriminately substitute variable costs for full costs and will, therefore, lead to suicidal price cutting. This problem should not arise if managers use the data wisely. However, if top managers perceive a pronounced danger of underpricing when they reveal variable-cost data, they may justifiably prefer an absorption-cost approach (either total-manufacturing-costs or full-costs) for guiding pricing decisions. Actually, absorption costs are far more widely used in practice than is the contributionmargin approach. Why? In addition to the reasons we have already mentioned, managers have cited the following: 1. In the long run, a firm must recover all costs to stay in business. Sooner or later, fixed costs do indeed fluctuate as volume changes. Therefore, it is prudent to assume that all costs are variable (even if some are fixed in the short run). ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 5: Relevant Information for Decision Making with a Focus on Pricing Decisions 217 2. Computing target prices based on absorption cost may indicate what competitors might charge, especially if they have approximately the same level of efficiency as you and also aim at recovering all costs in the long run. 3. Absorption-cost formula pricing meets the cost-benefit test. It is too expensive to conduct individual cost-volume tests for the many products (sometimes thousands) that a company offers. 4. There is much uncertainty about the shape of the demand curves and the correct priceoutput decisions. Absorption-cost pricing copes with this uncertainty by not encouraging managers to take too much marginal business. 5. Absorption-cost pricing tends to promote price stability. Managers prefer price stability because it eases their professional lives, primarily because it makes planning more dependable. 6. Absorption-cost pricing provides the most defensible basis for justifying prices to all interested parties including government antitrust investigators. 7. Absorption-cost pricing provides convenient reference (target) points to simplify hundreds or thousands of pricing decisions. Using Multiple Approaches To say that either a contribution-margin approach or an absorption-cost approach provides the "best" guide to pricing decisions is a dangerous oversimplification of one of the most perplexing issues in business. Lack of understanding and judgment can lead to unprofitable pricing regardless of the kind of cost data available or cost accounting system used. Basically, no single method of pricing is always best. Most executives who were interviewed for a study on their pricing methods said that their companies often use both fullcost and variable-cost information in pricing decisions. The history of accounting reveals that most companies have gathered costs via some form of absorption-cost system because this is what authorities require for financial reporting. Modern accounting systems, such as ERP systems, often identify variable and fixed costs. However, when companies implement such a system, managers often regard this information as an addition to the existing absorption-cost information. That is, many managers insist on having information regarding both variable costs per unit and the allocated fixed costs per unit before setting selling prices. This allows assessment of both short-run and long-run effects. Most ERP systems can easily provide both variable-cost and full-cost information. In contrast, most older systems focus on absorption-cost and do not organize their data collection to distinguish between variable and fixed costs. When using such older systems, special studies or educated guessing must be used to designate costs as variable or fixed. Managers are especially reluctant to focus on variable costs and ignore allocated fixed costs when their performance evaluations, and possibly their bonuses, are based on income shown in published financial statements. Why? Because most companies base such statements on full costing, and thus allocations of fixed costs affect reported income. Formats for Pricing Exhibit 5-10 showed how to compute alternative general markup percentages that would produce the same selling prices if used day after day. In practice, the format and arithmetic of quote sheets, job proposals, or similar records vary considerably. Exhibit 5-12 is from an actual quote sheet used by the manager of a small job shop that bids on welding machinery orders in a highly competitive industry. The approach in Exhibit 5-12 is a tool for informed pricing decisions. Notice that the maximum price is not a matter of cost at all. It is what you think you can obtain. The minimum price is the total variable cost. The manager will rarely bid the minimum price. Businesses do need to make a profit. Still, the manager wants to know the effect of a job on the company's total variable costs. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 218 Part 1: Focus on Decision Making Exhibit 5-12 Quote Sheet for Pricing Direct materials, at cost Direct labor and variable manufacturing overhead, 600 direct labor hours $30 per hour Sales commission (varies with job) Total variable costs -- minimum price* Add fixed costs allocated to job, 600 direct labor hours $20 per hour Total costs Add desired markup Selling price -- maximum price that you think you can obtain* $25,000 18,000 2,000 45,000 12,000 57,000 30,000 $87,000 *This sheet shows two prices, maximum and minimum. Any amount you can get above the minimum price provides contribution margin. Occasionally, a company will bid near or even below that minimum price to establish a presence in new markets or with a new customer, especially when cost reductions can be achieved in the future or when the new product is tied to other products that generate profits for the firm, as in the Business First box on page 219 regarding Microsoft's Xbox. Note that Exhibit 5-12 classifies costs specifically for the pricing task. More than one person may make pricing decisions in a particular company. The accountant's responsibility is to prepare an understandable format that requires a minimum of computations. Exhibit 5-12 combines direct labor and variable manufacturing overhead. It lumps together all fixed costs, whether manufacturing, selling, or administrative, and applies them to the job using a single fixed-overhead rate per direct labor hour. If the company wants more accuracy, it could formulate many more detailed cost items and overhead rates. To obtain the desired accuracy, many companies are turning to activity-based costing. Some managers, particularly in construction and in service industries, such as auto repair, compile separate categories of costs of (1) direct materials, parts, and supplies and (2) direct labor. These managers then use different markup rates for each category. They use these rates to provide enough revenue to cover both indirect and unallocated costs and operating profit. For example, an automobile repair shop might have the following format for each job: Billed to Customers Auto parts ($200 cost plus 40% markup) Direct labor (Cost is $20 per hour. Bill at 300% to recover indirect and unallocated costs and provide for operating profit. Billing rate is $20 300% = $60 per hour. Total billed for 10 hours is $60 10 = $600) Total billed to customer $280 600 $880 Another example is an Italian printing company in Milan that wants to price its jobs so that each one generates a margin of 28% of revenues--14% to cover selling and administrative expenses and 14% for profit. To achieve this margin, the manager uses a pricing formula of 140% times predicted materials cost plus 25 per hour of production time. The latter covers labor and overhead costs of 18 per hour. For a product with 400 of materials cost and 30 hours of production time, the price would be 1,310: Cost Materials Labor and overhead Total 400 540 940 Price 560 750 1,310 Profit ISBN: 0-536-47129-0 160 210 370 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. XBOX PRICING Despite all the hype surrounding the new Xbox 360 video game console, Microsoft won't make any money on the machine itself. A tear-down analysis by market researcher iSuppli of the high-end Xbox 360 found that the materials (e.g., hard drive, computer chip, cables, etc.) cost Microsoft $525 before assembly. The console sells at retail for $399, for a loss of $126 per unit. iSuppli analyst Chris Crotty says efficiency gains should shave $50 off chip costs, which, with other reductions over time, could get Microsoft closer to breakeven. Microsoft expects that, including sales of its own game software, the Xbox line should start out "gross margin neutral"--breakeven--and turn a profit in 2007. Will this classic razor-and-blade strategy work? It hasn't so far: In the year ended June 30, 2005, Microsoft's home entertainment division lost $391 million on sales of $3.3 billion. Source: Arik Kesseldahl, "For Every Xbox, A Big Fat Loss," Business Week, December 5, 2005. The profit of 370 is approximately 40% of the cost of 940 and 28% of the price of 1,310. Thus, there are numerous ways to compute selling prices. However, some general words of caution are appropriate here. Managers are better able to understand their options and the effects of their decisions on profits if they know their costs. That is, it is more informative to pinpoint costs first, before adding markups, than to have a variety of markups already embedded in the "costs" used as guides for setting selling prices. For example, if materials cost $1,000, a price quotation guide should show them at $1,000, not at, for example, a marked-up $1,400 because that is what the seller hopes to get. Summary Problem for Your Review PROBLEM Custom Graphics is a Chicago printing company that bids on a wide variety of design and printing jobs. The owner of the company, Janet Solomon, prepares the bids for most jobs. Her cost budget for 20X7 follows. Materials Labor Overhead Variable Fixed Total production cost of jobs Selling and administrative expenses* Variable Fixed Total costs ISBN: 0-536-47129-0 $ 350,000 250,000 $300,000 150,000 450,000 1,050,000 $ 75,000 125,000 200,000 $1,250,000 *These expenses include costs of all value chain functions other than production. Solomon has a target profit of $250,000 for 20X7. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 220 Part 1: Focus on Decision Making Compute the average target markup percentage for setting prices as a percentage of 1. Materials plus labor 2. Variable production cost of jobs (assume labor is a variable-cost resource) 3. Total production cost of jobs 4. All variable costs 5. All costs SOLUTION The purpose of this problem is to emphasize that many different approaches to pricing might be used that, properly employed, would achieve the same target selling prices. To achieve $250,000 of profit, the desired revenue for 20X7 is $1,250,000 + $250,000 = $1,500,000. The target markup percentages are 1. Percent of materials and labor = ($ 1,500,000 - $ 600,000) = 150 % $ 600,000 ($ 1,500,000 - $ 900,000) = 66 . 7 % $ 900,000 2. Percent of variable production cost of jobs = 3. Percent of total production cost of jobs = 4. Percent of all variable costs = 5. Percent of all costs = ($ 1,500,000 - $ 1,050,000) = 42 . 9 % $ 1,050,000 ($ 1,500,000 - $ 975,000) = 53 . 8 % $ 975,000 ($ 1,500,000 - $ 1,250,000) = 20 % $ 1,250,000 Target Costing O B J E C T I V E Use target costing to decide whether to add a new product. target costing Taking a product's market price as given and determining the maximum cost the company can spend to make the product and still achieve the desired profitability. 8 The pricing approaches so far have all developed a price based on measures of costs. Another approach to the relationship between costs and prices is to take a product's market price as given and determine the maximum cost the company can spend to make the product and still achieve the desired profitability. We call this target costing. Consider a company that is deciding whether to develop and market a new product. In evaluating the feasibility of the new product, management must predict both the cost to produce the product and the price at which it will sell. The degree to which management actions can affect price and cost determines the most effective approach to use for pricing and cost management purposes. Companies use cost-plus pricing for products where management actions (for example, advertising) can influence the market price. Although cost management is important in this case, there is a strong focus on marketing and the revenue side of the profit equation. But what if the market conditions are such that management cannot influence prices? If a company is to achieve management's desired profit, it must focus on the product's cost. What management needs is an effective tool to reduce costs without reducing value to the customer. A growing number of companies faced with this situation are adopting target costing. Based on the product's predicted price and the company's desired profit, managers set a desired, or target, cost before creating or even designing the product. Managers must then design the product and manufacturing process so that the product's cost does not exceed its target cost. Why focus on the product design phase? Because the design affects a vast majority of costs. For example, the design of the product and the ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 5: Relevant Information for Decision Making with a Focus on Pricing Decisions 221 associated production process largely determines the costs of resources, such as new machinery, materials, parts, and even future refinements. It is not easy to reduce these costs once production begins. So, the emphasis of target costing is on proactive, up-front planning throughout every activity of the new product development process. Target Costing and New Product Development Exhibit 5-13 shows a real company's target costing process for a new product. Based on the existing technology and related cost structure, the new product has three parts, requires direct labor, and has four types of indirect costs. The first step in the target-costing process is to determine the market price. The market sets this price. So why does management have to determine it? Remember that the product is new and has not actually been on the market. So, management has to estimate what the market will pay for the product. There are several tools, such as market focus group studies and surveys, that a firm can use to determine this price. Management also sets a desired gross margin for the new product. The market price less the gross margin is the target cost for the new product. The company determines the existing cost structure for the product by building up costs on an individual component level. This product has two components. Component 1 consists of parts A and B. Component 2 is part C. Both components and the final assembly use direct labor. Finally, the activities necessary to plan and process the product create indirect costs. Marketing plays a large role in target costing. Market research from the marketing department at the beginning of the target costing activity guides the whole product development process by supplying information about customer demands and requirements. One of the key characteristics of successful target costing is a strong emphasis on understanding customer demands. Many companies actively seek customer input on the design of product Target Cost Analysis Existing Cost Structure Price (Set by Market) Gross Margin (Set by Management) Part A Part B Part C Part A Target Product Cost (Price Gross Margin) Direct Labor Cost Reduction Methods Indirect Cost 1* Indirect Cost 2 Indirect Cost 3 Indirect Cost 4 ISBN: 0-536-47129-0 Target Cost Structure Part C Direct Labor Indirect Cost 2 Indirect Cost 3 Indirect Cost 4 Value Engineering (During design and development) Kaizen Costing (During production) Activity-Based Management (During all stages of product life) Exhibit 5-13 The Target Costing Process *Each indirect cost is associated with an indirect activity. Indirect Cost 1 was eliminated in the cost reduction process. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 222 Part 1: Focus on Decision Making value engineering A cost-reduction technique, used primarily during design, that uses information about all value chain functions to satisfy customer needs while reducing costs. kaizen costing The Japanese term for continuous improvement during manufacturing. features. Then, they compare the cost of each feature to its value to determine whether to add it to the product. For example, one of Boeing's customers wanted heated floors in its airplanes. However, the cost of the heated floors was too high, and the customer reconsidered. In the example in Exhibit 5-13, the existing cost is too large to generate the desired profit. Does this mean that the new product is not feasible? Not necessarily. A crossfunctional team consisting of engineers, sales personnel, key suppliers, and accountants now must determine if the company can implement cost reductions large enough to meet the target cost. In the example in Exhibit 5-13, the company reduced the cost of parts by changing the design of the product so that it could use part C in place of part B. The company also asked suppliers of parts A and C to reduce their costs. Design and process engineers were also able to eliminate the activity that generated the first type of indirect cost. These cost reductions resulted from value engineering--a cost-reduction technique, used primarily during the design stage, that uses information about all value-chain functions to satisfy customer needs while reducing costs. In total, the planned cost reductions were adequate to reduce costs to the target. Not all the reductions in cost have to take place before production begins. For example, kaizen costing is the Japanese term for continuous improvement during manufacturing. How do companies apply kaizen costing? They establish kaizen goals each year as part of the planning process. Examples include the continual reduction in setup and processing times due to increased employee familiarity with the procedure. In total, target costing during design and kaizen costing during manufacturing may allow the firm to achieve the target cost over the product's life, even if initial cost predictions look too high. Underlying these cost-reduction methods is the need for accurate cost information. Activity-based costing often provides this information. Companies can then use activitybased management (ABM) to identify and eliminate non-value-added activities, waste, and their related costs. ABM is applied throughout both the design and manufacturing stages of the product's life. For examples of how accountants are using ABC in target costing, see the Business First box on page 223. Illustration of Target Costing Consider the target-costing system used by ITT Automotive--one of the world's largest automotive suppliers. The company designs, develops, and manufactures a broad range of products, including brake systems, electric motors, and lamps. Also, the company is the worldwide market leader in antilock braking systems (ABS), producing 20,000 such systems per day. What pricing approach does ITT Automotive use for the ABS? The pricing process starts when one of ITT's customers, for example Mercedes-Benz, sends an invitation to bid. The market for brake systems is so competitive that very little variance exists in the prices companies can ask (bid). ITT then forms a target-costing group and charges it with determining whether the price and costs allow for enough of a profit margin. This group includes engineers, management accountants, and sales personnel. Factors the group considers in determining the feasibility of earning the desired target profit margin include competitor pricing, inflation rates, interest rates, and potential cost reductions during both the design (target costing) and production (kaizen costing) stages of the ABS product life. ITT purchases many of the component parts that make up the ABS. Thus, the target-costing group works closely with suppliers. After making product and process design improvements and receiving commitments from suppliers, the company has the cost information needed to decide the price to bid. The target-costing system has worked well at ITT Automotive. The company's bid for the ABS resulted in Mercedes-Benz U.S. International selecting ITT Automotive as the developer and supplier of ABS for the automaker's M-Class All-Activity Vehicle. For another illustration of how target-costing teams at DaimlerChrysler and Continental Teves ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. TARGET COSTING, ABC, AND THE ROLE OF MANAGEMENT ACCOUNTING Many companies use target costing together with an ABC system. Target costing requires a company to first determine what a customer will pay for a product and then work backward to design the product and production process that will generate a desired level of profit. ABC provides data on the costs of the various activities needed to produce the product. Knowing the costs of activities allows product and production process designers to predict the effects of their designs on the product's cost. Target costing essentially takes activity-based costs and uses them for strategic product decisions. For example, Culp, a North Carolina textile manufacturer, uses target costing and ABC to elevate cost management into one of the most strategically impor tant areas of the firm. Culp found that 80% of its product costs are predetermined at the design stage, but earlier cost control effor ts had focused only on the other 20%. By shifting cost management efforts to the design stage and getting accurate costs of the various activities involved in production, cost management at Culp evolved into a process of cutting costs when engineers design a product, not identifying costs that are out of line after the production is complete. A basic goal of target costing is to reduce costs before they occur. After all, once a company has incurred costs, it cannot change them. Such a strategy is especially impor tant when product life cycles are shor t. Because most product life cycles are shrinking, use of target costing is expanding. Target costing focuses on reducing costs in the product design and development stages-- when costs can really be affected. For example, target costing heavily influenced DaimlerChrysler's design of the low-priced Neon, and Procter & Gamble's CEO credits target costing for helping eliminate costs that could cause managers to price products too high for the market to bear. "The design process is where you can truly leverage [reduce] your costs," according to Ron Gallaway, CFO of Micrus Semiconductors. What role does management accounting play in target costing? At Micrus, management accountants are responsible for setting final target costs for all components and processes. One sur vey repor ts that 86% of companies using target costing take data directly from their cost systems to estimate product costs during product design. At Eastman Kodak, management accountants are a vital part of the cross-functional team that implements target costing. This team includes design and manufacturing engineers, procurement, and marketing, as well as management accounting. Peter Zampino, director of research at the Consor tium for Advanced Manufacturing-- International, agrees: "It's like anything else; if finance doesn't bless the numbers, they won't have the credibility throughout the organization." Sources: Adapted from R. Banham, "Off Target," CFO, May 2000; J. Bohn, "Chrysler Cuts Costs by Nurturing Links with Suppliers," Automotive Age, January 17, 1994, p. 18; G. Boer and J. Ettlie, "Target Costing Can Boost Your Bottom Line," Strategic Finance, July 1999, pp. 4952; J. Brausch, "Target Costing for Profit Enhancement," Management Accounting, November 1994, pp. 4549; G. Hoffman, "Future Vision," Grocer y Marketing, March 1994, p. 6. are working closely with both customers and suppliers, see the Business First box, "Target Costing and the External Value Chain," on page 224. Target Costing and Cost-Plus Pricing Compared Successful companies understand the market in which they operate and use the most appropriate pricing approach. To see how target costing and cost-plus pricing can lead to different decisions, suppose that ITT Automotive receives an invitation from Ford to bid on the ABS to be used in a new model car. Assume the following data apply: The specifications contained in Ford's invitation lead to an estimated current manufacturing cost (component parts, direct labor, and manufacturing overhead) of $154. ITT Automotive had a desired gross margin rate of 30% on sales, which means that actual cost should make up 70% of the price. Highly competitive market conditions exist and have established a sales price of $200 per unit. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. TARGET COSTING AND THE EXTERNAL VALUE CHAIN The value chain we have defined consists of functions within a company that add value to a product or service. Companies that use target costing often go beyond the internal value chain to involve both customers and suppliers during the design process. DaimlerChrysler's target-costing team worked actively with customers when analyzing the trade-off between cost and value of lighting for interior controls and under the hood. The value analysis resulted in adding the interior control lighting but not the under-the-hood lighting. For many companies, a large percentage of the total cost of a product is from materials and par ts that are purchased from suppliers--approximately 75% for DaimlerChr ysler and Continental Tevesone of largest manufacturers of hydraulic and electronic brake systems, elec- tronic steering systems, and air spring systems. Both of these companies have intercompany teams to meet costreduction goals. At DaimlerChr ysler, each supplier was asked to reduce costs by 5% annually, including improvements that reduce DaimlerChrysler's costs. For example, one supplier suggested changing the front rail system from several pieces to one unit. This improvement reduced DaimlerChr ysler's costs so the supplier received credit. Continental Teves uses a cost-modeling tool to determine the target costs for components it outsources. If a supplier fails to meet its target costs, Continental might send a team to analyze the supplier's operations. Source: Adapted from D. Swenson, S. Ansari, J. Bill, I. Kim, "Best Practices in Target Costing," Management Accounting Quarterly, Winter 2003. If ITT had used cost-plus pricing to bid on the ABS, the bid price would be $154 .7 = $220. Ford would most likely reject this bid because others are likely to bid $200. ITT Automotive's pricing approach would lead to a lost opportunity. Suppose that managers at ITT Automotive recognize that market conditions dictate a set price of $200. If ITT used a target-costing system, what would be its pricing decision? The target cost is $140 (that is, $200 .7) so a required cost reduction of $14 per unit is necessary. The target-costing group would work with product and process engineers and suppliers to determine if they could reduce the average unit cost by $14 over the product's life. Note that it is not necessary to get costs down to the $140 target cost before production begins. The initial unit cost will likely be higher, for example, $145. Continuous improvement over the product's life will result in the final $5 of cost reductions. If the managers receive commitments for cost reductions, they will decide to bid $200 per unit. Note that if ITT Automotive wins the bid, it must carry through with its focus on cost management throughout the life of the product. Target costing originated in Japan and is a common practice there. However, a growing number of companies now use it worldwide, including DaimlerChrysler, Boeing, Eastman Kodak, Honda of America, Mercedes-Benz, Procter & Gamble, Caterpillar, and ITT Automotive. Even some hospitals use target costing. Why the increasing popularity of target costing? With increased global competition in many industries, companies are increasingly limited in influencing market prices. Cost management then becomes the key to profitability. Target costing forces managers to focus on costs to achieve the desired profits. Highlights to Remember ISBN: 0-536-47129-0 Discriminate between relevant and irrelevant information for making decisions. To be relevant to a particular decision, a cost (or revenue) must meet two criteria: (1) It must be an expected future cost (or revenue), and (2) it must have an element of difference among the alternative courses of action. 1 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 5: Relevant Information for Decision Making with a Focus on Pricing Decisions 225 Apply the decision process to make business decisions. All managers make business decisions based on some decision process. The best processes help decision making by focusing the manager's attention on relevant information. 2 3 4 5 6 7 8 Construct absorption and contribution-margin income statements, and identify their relevance for decision making. The major difference between the absorption and contribution-margin formats for the income statement is that the contribution-margin format focuses on cost behavior (fixed and variable), whereas the absorption format reports costs by business functions (manufacturing versus nonmanufacturing). The contribution-margin approach makes it easier for managers to evaluate the effects of changes in volume on income and thus is well suited for shorter-run decision making. Decide to accept or reject a special order using the contribution-margin technique. Decisions to accept or reject a special sales order should use the contribution-margin technique and focus on the additional revenues and additional costs of the order. Explain why pricing decisions depend on the characteristics of the market. Market demand and supply, the degree of competition, and marginal revenue and marginal cost concepts impact market price and must be incorporated into any pricing decision. Identify the factors that influence pricing decisions in practice. Market conditions, the law, customers, competitors, and costs influence pricing decisions. The degree that management actions can affect price and cost determines the most effective approach to use for pricing and cost management purposes. Compute a target sales price by various approaches, and compare the advantages and disadvantages of these approaches. Companies use cost-plus pricing for products when management actions can influence the market price. They can add profit markups to a variety of cost bases including variable manufacturing costs, all variable costs, full manufacturing costs, or all costs. The contributionmargin approach to pricing has the advantage of providing detailed cost behavior information that is consistent with cost-volume-profit analysis. Use target costing to decide whether to add a new product. When market conditions are such that management cannot influence prices, companies must focus on cost control and reduction. They use target costing primarily for new products, especially during the design phase of the value chain. They deduct a desired target margin from the market-established price to determine the target cost. Cost management then focuses on controlling and reducing costs over the product's life cycle to achieve that target cost. Accounting Vocabulary absorption approach, p. 201 contribution approach, p. 202 decision model, p. 199 discriminatory pricing, p. 213 full cost, p. 214 imperfect competition, p. 210 kaizen costing, p. 222 marginal cost, p. 210 marginal revenue, p. 210 markup, p. 213 perfect competition, p. 210 predatory pricing, p. 212 price elasticity, p. 211 relevant information, p. 198 target costing, p. 220 value engineering, p. 222 Fundamental Assignment Material 5-A1 Straightforward Income Statements The Independence Company had the following manufacturing data for the year 2006 (in thousands of dollars). Beginning and ending inventories Direct material used Direct labor Supplies Utilities--variable portion Utilities--fixed portion Indirect labor--variable portion Indirect labor--fixed portion Depreciation Property taxes Supervisory salaries None $400 330 20 40 12 90 40 200 20 50 ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 226 Part 1: Focus on Decision Making Selling expenses were $300,000 (including $60,000 that were variable) and general administrative expenses were $144,000 (including $23,000 that were variable). Sales were $1.8 million. Direct labor and supplies are regarded as variable costs. 1. Prepare two income statements, one using the contribution approach and one using the absorption approach. 2. Suppose that all variable costs fluctuate directly in proportion to sales and that fixed costs are unaffected over a very wide range of sales. What would operating income have been if sales had been $2.0 million instead of $1.8 million? Which income statement did you use to help obtain your answer? Why? 5-A2 Special Order Consider the following details of the income statement of the Manteray Pen Company (MPC) for the year ended December 31, 20X6. Sales Less cost of goods sold Gross margin or gross profit Less selling and administrative expenses Operating income $10,000,000 6,500,000 $ 3,500,000 2,800,000 $ 700,000 MPC's fixed manufacturing costs were $2.9 million and its fixed selling and administrative costs were $2.0 million. Sales commissions of 3% of sales are included in selling and administrative expenses. The division had produced and sold 2 million pens. Near the end of the year, Pizza Hut offered to buy 150,000 pens on a special order. To fill the order, a special Pizza Hut logo would have to be added to each pen. Pizza Hut intended to use the pens in special promotions in an eastern city during early 20X7. Even though MPC had some idle plant capacity, the president rejected the Pizza Hut offer of $660,000 for the 150,000 pens. He said, The Pizza Hut offer is too low. We'd avoid paying sales commissions, but we'd have to incur an extra cost of $.40 per pen to add the logo. If MPC sells below its regular selling prices, it will begin a chain reaction of competitors' price cutting and of customers wanting special deals. I believe in pricing at no lower than 8% above our full costs of $9,300,000 2,000,000 units = $4.65 per unit plus the extra $.40 per pen less the savings in commissions. 1. Using the contribution-margin technique, prepare an analysis similar to that in Exhibit 5-6 on page 207. Use four columns: without the special order, the effect of the special order (one column total and one column per unit), and totals with the special order. 2. By what percentage would operating income increase or decrease if the order had been accepted? Do you agree with the president's decision? Why? 5-A3 Formulas for Pricing Randy Azarski, a building contractor, builds houses in tracts, often building as many as 20 homes simultaneously. Azarski has budgeted costs for an expected number of houses in 20X6 as follows: Direct materials Direct labor Job construction overhead Cost of jobs Selling and administrative costs Total costs $3,500,000 1,000,000 1,500,000 $6,000,000 1,500,000 $7,500,000 The job construction overhead includes approximately $900,000 of fixed costs, such as the salaries of supervisors and depreciation on equipment. The selling and administrative costs include $600,000 of variable costs, such as sales commissions and bonuses that depend fundamentally on overall profitability. Azarski wants an operating income of $1.5 million for 20X6. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 5: Relevant Information for Decision Making with a Focus on Pricing Decisions 227 Compute the average target markup percentage for setting prices as a percentage of 1. 2. 3. 4. 5. Direct materials plus direct labor The full "cost of jobs" The variable "cost of jobs" The full "cost of jobs" plus selling and administrative costs The variable "cost of jobs" plus variable selling and administrative costs 5-A4 Target Costing Lowest Cost Corporation uses target costing to aid in the final decision to release new products to production. A new product is being evaluated. Market research has surveyed the potential market for this product and believes that its unique features will generate a total demand over the product's life of 70,000 units at an average price of $360. The target costing team has members from market research, design, accounting, and production engineering departments. The team has worked closely with key customers and suppliers. A value analysis of the product has determined that the total cost for the various value-chain functions using the existing process technology are as follows: Value-Chain Function Research and development Design Manufacturing (70% outsourced to suppliers) Marketing Distribution Customer service Total cost over product life Total Cost over Product Life $ 2,500,000 950,000 8,000,000 1,800,000 2,400,000 950,000 $16,600,000 Management has a target contribution to profit percentage of 40% of sales. This contribution provides sufficient funds to cover corporate support costs, taxes, and a reasonable profit. 1. Should the new product be released to production? Explain. 2. Approximately 70% of manufacturing costs for this product consists of materials and parts that are purchased from suppliers. Key suppliers on the target-costing team have suggested process improvements that will reduce supplier cost by 20%. Should the new product be released to production? Explain. 3. New process technology can be purchased at a cost of $220,000 that will reduce nonoutsourced manufacturing costs by 25%. Assuming the supplier's process improvements and new process technology are implemented, should the new product be released to production? Explain. 5-B1 Contribution and Absorption Income Statements The following information is taken from the records of the Kingland Manufacturing Company for the year ending December 31, 2006. There were no beginning or ending inventories. Sales Sales commissions Advertising Shipping expenses Administrative executive salaries Administrative clerical salaries (variable) Fire insurance on factory equipment Property taxes on factory equipment $12,000,000 500,000 400,000 300,000 Long-term rent, factory Factory superintendent's salary Factory supervisors' salaries Direct materials used Direct labor Cutting bits used Factory methods research Abrasives for machining Indirect labor Depreciation on factory equipment $ 100,000 30,000 100,000 4,000,000 2,000,000 60,000 40,000 100,000 800,000 100,000 400,000 ISBN: 0-536-47129-0 2,000 10,000 300,000 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 228 Part 1: Focus on Decision Making 1. Prepare a contribution income statement and an absorption income statement. If you are in doubt about any cost behavior pattern, decide on the basis of whether the total cost in question will fluctuate substantially over a wide range of volume. Prepare a separate supporting schedule of indirect manufacturing costs subdivided between variable and fixed costs. 2. Suppose that all variable costs fluctuate directly in proportion to sales, and that fixed costs are unaffected over a wide range of sales. What would operating income have been if sales had been $11 million instead of $12 million? Which income statement did you use to help get your answer? Why? 5-B2 Special Order, Terminology, and Unit Costs Following is the income statement of Danube Company, a manufacturer of men's blue jeans: Danube Company Income Statement for the Year Ended December 31, 20X6 Total Sales Less cost of goods sold Gross margin Less selling and administrative expenses Operating income $40,000,000 24,000,000 $16,000,000 15,000,000 $ 1,000,000 Per Unit $20.00 12.00 $ 8.00 7.50 $ .50 Danube had manufactured 2 million pairs of jeans, which had been sold to various clothing wholesalers and department stores. At the start of 20X6, the president, Rosie Valenzuela, died unexpectedly. Her son, Ricardo, became the new president. Ricardo had worked for 15 years in the marketing phases of the business. He knew very little about accounting and manufacturing, which were his mother's strengths. Ricardo has several questions, including inquiries regarding the pricing of special orders. 1. To prepare better answers, you decide to recast the income statement in contribution form. Variable manufacturing cost was $19 million. Variable selling and administrative expenses, which were mostly sales commissions, shipping expenses, and advertising allowances paid to customers based on units sold, were $9 million. Prepare the revised income statement. 2. Ricardo asks, "I can't understand financial statements until I know the meaning of various terms. In scanning my mother's assorted notes, I found the following pertaining to both total and unit costs: full manufacturing cost, variable cost, full cost, fully allocated cost, gross margin, and contribution margin. Using our data for 20X6, please give me a list of these costs, their total amounts, and their per-unit amounts." 3. "Near the end of 20X6, I brought in a special order from Costco for 100,000 jeans at $17 each. I said I'd accept a flat $20,000 sales commission instead of the usual 6% of selling price, but my mother refused the order. She usually upheld a relatively rigid pricing policy, saying that it was bad business to accept orders that did not at least generate full manufacturing cost plus 80% of full manufacturing cost. "That policy bothered me. We had idle capacity. The way I figured, our manufacturing costs would go up by 100,000 $12 = $1,200,000, but our selling and administrative expenses would go up by only $20,000. That would mean additional operating income of 100,000 ($17 - $12) minus $20,000, or $500,000 minus $20,000, or $480,000. That's too much money to give up just to maintain a general pricing policy. Was my analysis of the impact on operating income correct? If not, please show me the correct additional operating income." 4. After receiving the explanations offered in number 2 and 3, Ricardo said, "Forget that I had the Costco order. I had an even bigger order from Lands' End. It was for 500,000 units and would have filled the plant completely. I told my mother I'd settle for no commission. There would have been no selling and administrative costs whatsoever because Lands' End would pay for the shipping and would not get any advertising allowances. "Lands' End offered $9.20 per unit. Our fixed manufacturing costs would have been spread over 2.5 million instead of 2 million units. Wouldn't it have been advantageous to accept the offer? Our old fixed manufacturing costs were $2.50 per unit. The added volume would reduce that cost more than our loss on our variable costs per unit. "Am I correct? What would have been the impact on total operating income if we had accepted the order?" ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 5: Relevant Information for Decision Making with a Focus on Pricing Decisions 229 5-B3 Cost-Plus Pricing and Target Costing A Fortune 100 company, Caterpillar is the world's leading manufacturer of construction and mining equipment, diesel and natural gas engines, and industrial gas turbines. Caterpillar also manufactures custom piston pins for other manufacturers in the same facility used to make pins for its own heavyduty engines. Piston pins are made with cost effective CNC bar feeders and multispindle barstock machines. This process is a high-output, high-efficiency operation that eliminates the added costs of purchasing special cut-to-length barstock or cutting barstock to specific lengths. The market research department has indicated that a proposed new piston pin for a manufacturer of truck engines would likely sell for $46. A similar piston pin currently being produced has the following manufacturing costs: Direct materials Direct labor Overhead Total $24.00 10.00 16.00 $50.00 Assume that Caterpillar desires a gross margin of 35% of the manufacturing cost. 1. Suppose Caterpillar used cost-plus pricing, setting the price 35% above the manufacturing cost. What price would be charged for the piston pin? Would you produce such a piston pin if you were a manager at Caterpillar? Explain. 2. Caterpillar uses target costing. What price would the company charge for a piston pin? What is the highest acceptable manufacturing cost for which Caterpillar would be willing to produce the piston pin? 3. As a user of target costing, what steps would Caterpillar managers take to try to make production of this product feasible? Additional Assignment Material Questions 5-1 "The distinction between precision and relevance should be kept in mind." Explain. 5-2 Distinguish between the quantitative and qualitative aspects of decisions. 5-3 Describe the accountant's role in decision making. 5-4 "Any future cost is relevant." Do you agree? Explain. 5-5 Why are historical or past data irrelevant to special decisions? 5-6 Describe the role of past or historical costs in the decision process. That is, how do these costs relate to the prediction method and the decision model? 5-7 What is the advantage of the contribution approach as compared with the absorption approach? 5-8 "The primary classifications of costs are by variable and fixed-cost behavior patterns, not by business functions." Name 3 commonly used terms that describe this type of income statement. ISBN: 0-536-47129-0 5-9 "There is a commonality of approach to various special decisions." Explain. 5-10 "Avoidable costs are variable costs." Do you agree? Explain. 5-11 Why are customers one of the factors influencing pricing decisions? 5-12 What is target cost per unit? 5-13 What is value engineering? 5-14 What is kaizen costing? 5-15 "In target costing, prices determine costs rather than vice versa." Explain. 5-16 Many companies that use target costing involve both customers and suppliers in product and process design. Explain why. 5-17 If a target-costing system is used and the existing cost cannot be reduced to the target cost through cost reductions, management should discontinue producing and selling the product. Do you agree? Explain. 5-18 "Basing pricing on only the variable costs of a job results in suicidal underpricing." Do you agree? Why? 5-19 Provide three examples of pricing decisions other than the special order. 5-20 List three popular markup formulas for pricing. 5-21 Describe two long-run effects that may lead to managers' rejecting opportunities to cut prices and obtain increases in short-run profits. 5-22 Give two reasons why full costs are far more widely used than variable costs for guiding pricing. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 230 Part 1: Focus on Decision Making Critical Thinking Exercises 5-23 Fixed Costs and the Sales Function Many sales managers have a good intuitive understanding of costs, but they often are imprecise in how they describe the costs. For example, one manager said the following: "Increasing sales will decrease fixed costs because it spreads them over more units." Do you agree? Explain. 5-24 Income Statements and Sales Managers Suppose Chee Wong is in charge of selling Nantucket Nectars Juice Cocktails. What type of income statement, absorption or contribution, would Wong find most useful for his decisions? Why? 5-25 The Economics of the Pricing Decision Economic theory states that managers should set price equal to marginal cost in perfect competition. Accountants use variable cost to approximate marginal costs. Compare and contrast marginal cost and variable cost, and explain whether using variable costs as an approximation for marginal cost is appropriate for making pricing decisions. 5-26 Pricing Decisions, Ethics, and the Law Managers should base pricing decisions on both cost and market factors. In addition, they must also consider ethical and legal issues. Describe the influence that ethics and the law have on pricing decisions. 5-27 Target Costing and the Value Chain According to Keith Hallin, Program Affordability Manager (Target Costing) for Boeing's MMA Program in Integrated Defense Systems, reaching target costs is a challenge for the company's entire value chain. Explain how managers of the various value-chain functions at Boeing might be involved in the target costing process. Exercises 5-28 Pinpointing Relevant Costs Today you are planning to see a motion picture, and you can attend either of two theaters. You have only a small budget for entertainment so prices are important. You have attended both theaters recently. One charged $5 for admission; the other charged $7. You habitually buy popcorn in the theater--each theater charges $3. The motion pictures now being shown are equally attractive to you, but you are virtually certain that you will never see the picture that you reject today. Identify the relevant costs. Explain your answer. 5-29 Information and Decisions Suppose the historical costs for the manufacture of a calculator by Radio Shack were as follows: direct materials, $5.00 per unit; direct labor, $6.00 per unit. Management is trying to decide whether to replace some materials with different materials. The replacement should cut material costs by 10% per unit. However, direct-labor time will increase by 5% per unit. Moreover, direct-labor rates will be affected by a recent 10% wage increase. Prepare an exhibit like Exhibit 5-1 (p. 200), showing where and how the data about direct material and direct labor fit in the decision process. 5-30 Identification of Relevant Costs Paul and Paula Petroceli were trying to decide whether to go to the symphony or to the baseball game. They already have two nonrefundable tickets to "Pops Night at the Symphony" that cost $40 each. This is the only concert of the season they considered attending because it is the only one with the type of music they enjoy. The baseball game is the last one of the season, and it will decide the league championship. They can purchase tickets to the game for $20 each. The Petrocelis will drive 50 miles round-trip to either event. Variable costs for operating their auto are $.18 per mile, and fixed costs average $.13 per mile for the 15,000 miles they drive annually. Parking at the symphony is free, but it costs $6 at the baseball game. To attend either event, Paul and Paula will hire a babysitter at $7 per hour. They expect to be gone 5 hours to attend the baseball game but only 4 hours to attend the symphony. Compare the cost of attending the baseball game with the cost of attending the symphony. Focus on relevant costs. Compute the difference in cost, and indicate which alternative is more costly to the Petrocelis. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 5: Relevant Information for Decision Making with a Focus on Pricing Decisions 231 5-31 Straightforward Absorption Statement The Pierce Company had the following data (in thousands) for a given period: Sales Direct materials Direct labor Indirect manufacturing costs Selling and administrative expenses $700 200 150 170 150 There were no beginning or ending inventories. Compute the (1) manufacturing cost of goods sold, (2) gross profit, (3) operating income, and (4) conversion cost (total manufacturing cost less materials cost). 5-32 Straightforward Contribution Income Statement Yoko Ltd. had the following data (in millions of yen) for a given period: Sales Direct materials Direct labor Variable factory overhead Variable selling and administrative expenses Fixed factory overhead Fixed selling and administrative expenses 870 290 140 60 100 120 45 There were no beginning or ending inventories. Compute the (a) variable manufacturing cost of goods sold, (b) contribution margin, and (c) operating income. 5-33 Straightforward Absorption and Contribution Statement Anzola Company had the following data (in millions) for a recent period. Fill in the blanks. There were no beginning or ending inventories. a. Sales b. Direct materials used c. Direct labor Indirect manufacturing costs: d. Variable e. Fixed f. Variable manufacturing cost of goods sold g. Manufacturing cost of goods sold Selling and administrative expenses: h. Variable i. Fixed j. Gross profit k. Contribution margin $920 350 210 100 50 -- -- 90 80 -- -- 5-34 Absorption Statement Stein Jewelry had the following data (in thousands of South African Rands, ZAR) for a given period. Assume there are no inventories. Fill in the blanks. Sales Direct materials Direct labor Indirect manufacturing Manufacturing cost of goods sold Gross margin Selling and administrative expenses Operating income Prime cost (direct materials + direct labor) ZAR 370 ISBN: 0-536-47129-0 780 120 20 600 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 232 Part 1: Focus on Decision Making 5-35 Contribution Income Statement Jackson Company had the following data (in thousands) for a given period. Assume there are no inventories. Direct labor Direct materials Variable indirect manufacturing Contribution margin Fixed selling and administrative expenses Operating income Sales $170 210 110 200 100 10 990 Compute the (a) variable manufacturing cost of goods sold, (b) variable selling and administrative expenses, and (c) fixed indirect manufacturing costs. 5-36 Special-Order Decision Belltown Athletic Supply (BAS) makes game jerseys for athletic teams. The F. C. Kitsap soccer club has offered to buy 100 jerseys for the teams in its league for $15 per jersey. The team price for such jerseys normally is $18, an 80% markup over BAS's purchase price of $10 per jersey. BAS adds a name and number to each jersey at a variable cost of $2 per jersey. The annual fixed cost of equipment used in the printing process is $6,000, and other fixed costs allocated to jerseys are $2,000. BAS makes about 2,000 jerseys per year, so the fixed cost is $4 per jersey. The equipment is used only for printing jerseys and stands idle 75% of the usable time. The manager of BAS turned down the offer, saying, "If we sell at $15 and our cost is $16, we lose money on each jersey we sell. We would like to help your league, but we can't afford to lose money on the sale." 1. Compute the amount by which the operating income of BAS would change if it accepted F. C. Kitsap's offer. 2. Suppose you were the manager of BAS. Would you accept the offer? In addition to considering the quantitative impact computed in requirement 1, list two qualitative considerations that would influence your decision--one qualitative factor supporting acceptance of the offer and one supporting rejection. 5-37 Unit Costs and Total Costs You are a CPA who belongs to a downtown business club. Annual dues are $150. You use the club solely for lunches, which cost $9 each. You have not used the club much in recent years, and you are wondering whether to continue your membership. 1. You are confronted with a variable-cost plus a fixed-cost behavior pattern. Plot each on a graph, where the vertical axis is total cost and the horizontal axis is annual volume in number of lunches. Also plot a third graph that combines the previous two graphs. 2. What is the cost per lunch if you pay for your own lunch once a year? Twelve times a year? Two hundred times a year? 3. Suppose the average price of lunches elsewhere is $10. (a) How many lunches must you have at the luncheon club so that the total costs of the lunches would be the same, regardless of where you ate for that number of lunches? (b) Suppose you ate 200 lunches a year at the club. How much would you save in relation to the total costs of eating elsewhere? 5-38 Advertising Expenditures and Nonprofit Organizations Many colleges and universities have been extensively advertising their services. For example, a university in Philadelphia used a biplane to pull a sign promoting its evening program, and one in Mississippi designed bumper stickers and slogans as well as innovative programs. Suppose Wilton College charges a comprehensive annual fee of $14,500 for tuition, room, and board, and it has capacity for 2,500 students. The admissions department predicts enrollment of 2,000 students for 20X7. Costs per student for the 20X7 academic year are ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 5: Relevant Information for Decision Making with a Focus on Pricing Decisions 233 Variable Educational programs Room Board $4,000 1,300 2,600 $7,900 Fixed $4,200 2,200 600 $7,000* Total $ 8,200 3,500 3,200 $14,900 *Based on 2,000 to 2,500 students for the year. The assistant director of admissions has proposed a two-month advertising campaign, however, using radio and television advertisements, together with an extensive direct mailing of brochures. 1. Suppose the advertising campaign will cost $1.65 million. What is the minimum number of additional students the campaign must attract to make the campaign break even? 2. Suppose the admissions department predicts that the campaign will attract 350 additional students. What is the most Wilton should pay for the campaign and still break even? 3. Suppose a three-month (instead of two-month) campaign will attract 450 instead of 350 additional students. What is the most Wilton should pay for the one-month extension of the campaign and still break even? 5-39 Variety of Cost Terms Consider the following data: Variable selling and administrative costs per unit Total fixed selling and administrative costs Total fixed manufacturing costs Variable manufacturing costs per unit Units produced and sold $ 4.00 $2,900,000 $3,500,000 $ 10.00 500,000 1. Compute the following per unit of product: (a) total variable costs, (b) full manufacturing cost, (c) full cost. 5-40 Acceptance of Low Bid The Velasquez Company, a maker of a variety of metal and plastic products, is in the midst of a business downturn and is saddled with many idle facilities. Columbia Health Care has approached Velasquez to produce 300,000 nonslide serving trays. Columbia will pay $1.50 each. Velasquez predicts that its variable costs will be $1.60 each. Its fixed costs, which had been averaging $1 per unit on a variety of other products, will now be spread over twice as much volume, however. The president commented, "Sure we'll lose $.10 each on the variable costs, but we'll gain $.50 per unit by spreading our fixed costs. Therefore, we should take the offer because it represents an advantage of $.40 per unit." Suppose the regular business had a current volume of 300,000 units, sales of $600,000, variable costs of $480,000, and fixed costs of $300,000. Do you agree with the president? Why? 5-41 Pricing by Auto Dealer Many automobile dealers have an operating pattern similar to that of Austin Motors, a dealer in Texas. Each month, Austin initially aims at a unit volume quota that approximates a break-even point. Until the break-even point is reached, Austin has a policy of relatively lofty pricing, whereby the "minimum deal" must contain a sufficiently high markup to ensure a contribution to profit of no less than $400. After the break-even point is attained, Austin tends to quote lower prices for the remainder of the month. What is your opinion of this policy? As a prospective customer, how would you react to this policy? 5-42 Pricing to Maximize Contribution ISBN: 0-536-47129-0 Reynolds Company produces and sells picture frames. One particular frame for 8 10 photos was an instant success in the market, but recently competitors have come out with comparable frames. Reynolds has been charging $12.50 wholesale for the frames, and sales have fallen from 10,000 units last year to 7,000 units this year. The product manager in charge of this frame is considering lowering the price to $10 per frame. He believes sales will rebound to 10,000 units at the lower price, but they Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 234 Part 1: Focus on Decision Making will fall to 6,000 units at the $12.50 price. The unit variable cost of producing and selling the frames is $6, and $60,000 of fixed cost is assigned to the frames. 1. Assuming that the only prices under consideration are $10 and $12.50 per frame, which price will lead to the largest profit for Reynolds? Explain why. 2. What subjective considerations might affect your pricing decision? 5-43 Target Selling Prices Consider the following data from Blackmar Company's budgeted income statement (in thousands of dollars). Target sales Variable costs Manufacturing Selling and administrative Total variable costs Fixed costs Manufacturing Selling and administrative Total fixed costs Total of all costs Operating income $90,000 30,000 6,000 36,000 8,000 6,000 14,000 50,000 $40,000 Compute the following markup percentages that would be used for obtaining the same target sales as a percentage of (1) total variable costs, (2) full costs, (3) variable manufacturing costs. 5-44 Competitive Bids Griffy, Rodriguez, and Martinez, a CPA firm, is preparing to bid for a consulting job. Although Alicia Martinez will use her judgment about the market in finalizing the bid, she has asked you to prepare a cost analysis to help in the bidding. You have estimated the costs for the consulting job to be Materials and supplies, at cost Hourly pay for consultants, 2,000 hours @ $35 per hour Fringe benefits for consultants, 2,000 hours @ $12 per hour Total variable costs Fixed costs allocated to the job Based on labor, 2,000 hours @ $10 per hour Based on materials and supplies, 80% of 30,000 Total cost $ 30,000 70,000 24,000 124,000 20,000 24,000 $168,000 Of the $44,000 allocated fixed costs, $35,000 will be incurred even if the job is not undertaken. Alicia normally bids jobs at the sum of (1) 150% of the estimated materials and supplies cost and (2) $75 per estimated labor hour. 1. Prepare a bid using the normal formula. 2. Prepare a minimum bid equal to the additional costs expected to be incurred to complete the job. 3. Prepare a bid that will cover full costs plus a markup for profit equal to 20% of full cost. 5-45 Target Costing Quality Corporation believes that there is a market for a portable electronic toothbrush that can be easily carried by business travelers. Quality's market research department has surveyed the features and prices of electronic brushes currently on the market. Based on this research, Quality believes that $70 would be about the right price. At this price, marketing believes that about 80,000 new portable brushes can be sold over the product's life cycle. It will cost about $1,000,000 to design and develop the portable brush. Quality has a target profit of 20% of sales. Determine the total and unit target cost to manufacture, sell, distribute, and service each portable brush. ISBN: 0-536-47129-0 5-46 Target Costing Best Cost Corporation has an aggressive R&D program and uses target costing to aid in the final decision to release new products to production. A new product is being evaluated. Market research has Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 5: Relevant Information for Decision Making with a Focus on Pricing Decisions 235 surveyed the potential market for this product and believes that its unique features will generate a total demand of 50,000 units at an average price of $230. Design and production engineering departments have performed a value analysis of the product and have determined that the total cost for the various value-chain functions using the existing process technology are as follows: Value-Chain Function Research and Development Design Manufacturing Marketing Distribution Customer Service Total Cost over Product Life Total Cost over Product Life $ 1,500,000 750,000 5,000,000 800,000 1,200,000 750,000 $10,000,000 Management has a target profit percentage of 20% of sales. Production engineering indicates that a new process technology can reduce the manufacturing cost by 40%, but it will cost $1,100,000. 1. Assuming the existing process technology is used, should the new product be released to production? Explain. 2. Assuming the new process technology is purchased, should the new product be released to production? Explain. Problems 5-47 Pricing, Ethics, and the Law Great Lakes Pharmaceuticals, Inc. (GLPI), produces both prescription and over-the-counter medications. In January, GLPI introduced a new prescription drug, Capestan, to relieve the pain of arthritis. The company spent more than $50 million over the last 5 years developing the drug, and advertising alone during the first year of introduction will exceed $10 million. Production cost for a bottle of 100 tablets is approximately $12. Sales in the first 3 years are predicted to be 500,000, 750,000, and 1,000,000 bottles, respectively. To achieve these sales, GLPI plans to distribute the medicine through three sources: directly to physicians, through hospital pharmacies, and through retail pharmacies. Initially, the bottles will be given free to physicians to give to patients, hospital pharmacies will pay $25 per bottle, and retail pharmacies will pay $40 per bottle. In the second and third year, the company plans to phase out the free distributions to physicians and move all other customers toward a $50-per-bottle sales price. Comment on the pricing and promotion policies of GLPI. Pay particular attention to the legal and ethical issues involved. 5-48 Analysis with Contribution Income Statement The following data have been condensed from LaGrande Corporation's report of 2006 operations (in millions of euros): Variable Manufacturing cost of goods sold Selling and administrative expenses Sales 400 140 Fixed 180 60 Total 580 200 900 1. Prepare the 2006 income statement in contribution form, ignoring income taxes. 2. LaGrande's operations have been fairly stable from year to year. In planning for the future, top management is considering several options for changing the annual pattern of operations. You are asked to perform an analysis of their estimated effects. Use your contribution income statement as a framework to compute the estimated operating income (in millions) under each of the following separate and unrelated assumptions: ISBN: 0-536-47129-0 a. Assume that a 10% reduction in selling prices would cause a 30% increase in the physical volume of goods manufactured and sold. b. Assume that an annual expenditure of 30 million for a special sales promotion campaign would enable the company to increase its physical volume by 10% with no change in selling prices. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 236 Part 1: Focus on Decision Making c. Assume that a basic redesign of manufacturing operations would increase annual fixed manufacturing costs by 80 million and decrease variable manufacturing costs by 15% per product unit, but with no effect on physical volume or selling prices. d. Assume that a basic redesign of selling and administrative operations would double the annual fixed expenses for selling and administration and increase the variable expenses for selling and administration by 25% per product unit, but would also increase physical volume by 20%. Selling prices would be increased by 5%. e. Would you prefer to use the absorption form of income statement for the preceding analyses? Explain. 3. Discuss the desirability of alternatives a through d in number 2. If only one alternative could be selected, which would you choose? Explain. 5-49 Pricing and Contribution-margin Technique The Transnational Trucking Company has the following operating results to date for 20X7: Operating revenues Operating costs Operating income $50,000,000 40,000,000 $10,000,000 A large Boston manufacturer has inquired about whether Transnational would be interested in trucking a large order of its parts to Chicago. Steve Goldmark, operations manager, investigated the situation and estimated that the "fully allocated" costs of servicing the order would be $45,000. Using his general pricing formula, he quoted a price of $50,000. The manufacturer replied, "We'll give you $39,000, take it or leave it. If you do not want our business, we'll truck it ourselves or go elsewhere." A cost analyst had recently been conducting studies of how Transnational's operating costs tended to behave. She found that $30 million of the $40 million could be characterized as variable costs. Goldmark discussed the matter with her and decided that this order would probably generate cost behavior about the same as Transnational's general operations. 1. Using a contribution-margin technique, prepare an analysis for Transnational. 2. Should Transnational accept the order? Explain. 5-50 Cost Analysis and Pricing The budget for the Oxford University Printing Company for 20X7 follows: Sales Direct material Direct labor Overhead Net income 1,100,000 280,000 320,000 400,000 1,000,000 100,000 The company typically uses a so-called cost-plus pricing system. Direct-material and direct-labor costs are computed, overhead is added at a rate of 125% of direct labor costs, and 10% of the total cost is added to obtain the selling price. Edith Smythe, the sales manager, has placed a 22,000 bid on a particularly large order with a cost of 5,600 direct material and 6,400 direct labor. The customer informs her that she can have the business for 18,000, take it or leave it. If Smythe accepts the order, total sales for 20X7 will be 1,118,000. Smythe refuses the order, saying, "I sell on a cost-plus basis. It is bad policy to accept orders at below cost. I would lose 2,000 on the job." The company's annual fixed overhead is 160,000. 1. What would operating income have been with the order? Without the order? Show your computations. 2. Give a short description of a contribution-margin technique to pricing that Smythe might follow. Include a stipulation of the pricing formula that Smythe should routinely use if she hopes to obtain a target operating income of 100,000. ISBN: 0-536-47129-0 5-51 Pricing of Education You are the director of continuing education programs for a state university. Courses for executives are especially popular, and you have developed an extensive menu of one-day and two-day courses that Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 5: Relevant Information for Decision Making with a Focus on Pricing Decisions 237 are presented in various locations throughout the state. The performance of these courses for the current fiscal year, excluding the final course, which is scheduled for the next Saturday, is Tuition revenue Costs of courses Contribution margin General administrative expenses Operating income $2,000,000 800,000 1,200,000 400,000 $ 800,000 The costs of the courses include fees for instructors, rentals of classrooms, advertising, and any other items, such as travel, that can be easily and exclusively identified as being caused by a particular course. The general administrative expenses include your salary, your secretary's compensation, and related expenses, such as a lump-sum payment to the university's central offices as a share of university overhead. The enrollment for your final course of the year is 30 students, who have paid $200 each. Two days before the course is to begin, a city manager telephones your office. "Do you offer discounts to nonprofit institutions?" he asks. "If so, we'll send 10 managers. But our budget will not justify our spending more than $100 per person." The extra cost of including these 10 managers would entail lunches at $20 each and course materials at $30 each. 1. Prepare a tabulation of the performance for the full year including the final course. Assume that the costs of the final course for the 30 enrollees' instruction, travel, advertising, rental of hotel classroom, lunches, and course materials would be $3,000. Show a tabulation in four columns: before final course, final course with 30 registrants, effect of 10 more registrants, and grand totals. 2. What major considerations would probably influence the pricing policies for these courses? For setting regular university tuition in private universities? 5-52 DVD Sales and Rental Markets Is it more profitable to sell your product for $50 or $15? This is a difficult question for many movie studio executives. Consider a movie that cost $60 million to produce and required another $40 million to promote. After its theater release, the studio must determine whether to sell DVDs directly to the public at a wholesale price of about $15 per DVD or to sell to video rental store distributors for about $50 per DVD. The distributors will then sell to about 14,000 video rental stores in the United States. Assume that the variable cost to produce and ship 1 DVD is $3.00. 1. Suppose each video rental store would purchase 10 DVDs of this movie. How many DVDs would need to be sold directly to customers to make direct sales a more profitable option than sales to video store distributors? 2. How does the cost of producing and promoting the movie affect this decision? 3. Walt Disney Co. elected to sell The Lion King directly to consumers, and it sold 30 million copies at an average price of $15.50 per DVD. How many DVDs would each video rental store have to purchase to provide Disney as much profit as the company received from direct sales? Assume that Disney would receive $50 per DVD from the distributors. 5-53 Use of Passenger Jets In a recent year Continental Airlines filled about 50% of the available seats on its flights, a record about 15% below the national average. Continental could have eliminated about 4% of its runs and raised its average load considerably. The improved load factor would have reduced profits, however. Give reasons for or against this elimination. What factors should influence an airline's scheduling policies? When you answer this question, suppose that Continental had a basic package of 3,000 flights per month, with an average of 100 seats available per flight. Also suppose that 52% of the seats were filled at an average ticket price of $200 per flight. Variable costs are about 70% of revenue. Continental also had a marginal package of 120 flights per month, with an average of 100 seats available per flight. Suppose that only 20% of the seats were filled at an average ticket price of $100 per flight. Variable costs are about 50% of this revenue. Prepare a tabulation of the basic package, marginal package, and total package, showing percentage of seats filled, revenue, variable expenses, and contribution margin. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 238 Part 1: Focus on Decision Making 5-54 Effects of Volume on Operating Income The Wittred Division of Melbourne Sports Company manufactures boomerangs, which are sold to wholesalers and retailers. The division manager has set a target of 250,000 boomerangs for next month's production and sales and developed an accurate budget for that level of sales. The manager has also prepared an analysis of the effects on operating income of deviations from the target: Volume in units Sales @ $3.00 Full costs @ $2.50 Operating income 200,000 $600,000 500,000 $100,000 250,000 $750,000 625,000 $125,000 300,000 $900,000 750,000 $150,000 The costs have the following characteristics. Variable manufacturing costs are $.80 per boomerang; variable selling costs are $.50 per boomerang. Fixed manufacturing costs per month are $250,000; fixed selling and administrative costs per month are $50,000. 1. Prepare a correct analysis of the changes in volume on operating income. Prepare a tabulated set of income statements at levels of 200,000, 250,000, and 300,000 boomerangs. Also show percentages of operating income in relation to sales. 2. Compare your tabulation with the manager's tabulation. Why is the manager's tabulation incorrect? 5-55 Pricing at the Grand Canyon Railway Suppose a tour agent approached the general manager of the Grand Canyon Railway with a proposal to offer a special guided tour to the agent's clients. The tour would occur 20 times each summer and be part of a larger itinerary that the agent is putting together. The agent presented two options: (a) a special 65-mile tour with the agent's 30 clients as the only passengers on the train, or (b) adding a car to an existing train to accommodate the 30 clients on an already scheduled 65-mile tour. Under either option, Grand Canyon would hire a tour guide for $200 for the trip. Grand Canyon has extra cars in its switching yard, and it would cost $40 to move a car to the main track and hook it up. The extra fuel cost to pull one extra car is $.20 per mile. To run an engine and a passenger car on the trip would cost $2.20 per mile, and an engineer would be paid $400 for the trip. Depreciation on passenger cars is $5,000 per year, and depreciation on engines is $20,000 per year. Each passenger car and each engine travels about 50,000 miles a year. They are replaced every 8 years. The agent offered to pay $32 per passenger for the special tour and $15 per passenger for simply adding an extra car. 1. Which of the two options is more profitable to Grand Canyon? Comment on which costs are irrelevant to this decision. 2. Should Grand Canyon accept the proposal for the option you found best in number 1? Comment on what costs are relevant for this decision but not for the decision in number 1. 5-56 Pricing of Special Order The Drosselmeier Corporation, located in Munich, makes Christmas nutcrackers and has an annual plant capacity of 2,400 product units. Suppose its predicted operating results (in euros) for the year are Production and sales of 2,000 units, total sales Manufacturing costs Fixed (total) Variable (per unit) Selling and administrative expenses Fixed (total) Variable (per unit) 180,000 70,000 25 30,000 10 Compute the following, ignoring income taxes: 1. If the company accepts a special order for 300 units at a selling price of 40 each, how would the total predicted net income for the year be affected, assuming no effect on regular sales at regular prices? ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 5: Relevant Information for Decision Making with a Focus on Pricing Decisions 239 2. Without decreasing its total net income, what is the lowest unit price for which the Drosselmeier Corporation could sell an additional 100 units not subject to any variable selling and administrative expenses, assuming no effect on regular sales at regular prices? 3. List the numbers given in the problem that are irrelevant (not relevant) in solving number 2. 4. Compute the expected annual net income (with no special orders) if plant capacity can be doubled by adding additional facilities at a cost of 500,000. Assume that these facilities have an estimated life of 4 years with no residual scrap value, and that the current unit selling price can be maintained for all sales. Total sales are expected to equal the new plant capacity each year. No changes are expected in variable costs per unit or in total fixed costs except for depreciation. 5-57 Pricing and Confusing Variable and Fixed Costs Goldwyn Electronics had a fixed factory overhead budget for 20X6 of $10 million. The company planned to make and sell 2 million units of a particular communications device. All variable manufacturing costs per unit were $10. The budgeted income statement contained the following: Sales Manufacturing cost of goods sold Gross margin Deduct selling and administrative expenses Operating income $40,000,000 30,000,000 10,000,000 4,000,000 $ 6,000,000 For simplicity, assume that the actual variable costs per unit and the total fixed costs were exactly as budgeted. 1. Compute Goldwyn's budgeted fixed factory overhead per unit. 2. Near the end of 20X6, a large computer manufacturer offered to buy 100,000 units for $1.3 million on a one-time special order. The president of Goldwyn stated, "The offer is a bad deal. It's foolish to sell below full manufacturing costs per unit. I realize that this order will have only a modest effect on selling and administrative costs. They will increase by a $20,000 fee paid to our sales agent." Compute the effect on operating income if the offer is accepted. 3. What factors should the president of Goldwyn consider before finally deciding whether to accept the offer? 4. Suppose the original budget for fixed manufacturing costs was $10 million, but budgeted units of product were 1 million. How would your answers to numbers 1 and 2 change? Be specific. 5-58 Demand Analysis Zimmerman Manufacturing Limited produces and sells one product, a three-foot Canadian flag. During 20X6, the company manufactured and sold 50,000 flags at $26 each. Existing production capacity is 60,000 flags per year. In formulating the 20X7 budget, management is faced with several decisions concerning product pricing and output. The following information is available: 1. A market survey shows that the sales volume depends on the selling price. For each $1 drop in selling price, sales volume would increase by 10,000 flags. 2. The company's expected cost structure for 20X7 is as follows: a. Fixed cost (regardless of production or sales activities), $360,000 b. Variable costs per flag (including production, selling, and administrative expenses), $15 3. To increase annual capacity from the present 60,000 to 90,000 flags, additional investment for plant, building, equipment, and the like of $500,000 would be necessary. The estimated average life of the additional investment would be 10 years, so the fixed costs would increase by an average of $50,000 per year. (Expansion of less than 30,000 additional units of capacity would cost only slightly less than $500,000.) Indicate, with reasons, what the level of production and the selling price should be for the coming year. Also indicate whether the company should approve the plant expansion. Show your calculations. Ignore income tax considerations and the time value of money. ISBN: 0-536-47129-0 5-59 Target Costing Memphis Electrical makes small electric motors for a variety of home appliances. Memphis sells the motors to appliance makers, who assemble and sell the appliances to retail outlets. Although Memphis Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 240 Part 1: Focus on Decision Making makes dozens of different motors, it does not currently make one to be used in garage-door openers. The company's market research department has discovered a market for such a motor. The market research department has indicated that a motor for garage-door openers would likely sell for $26. A similar motor currently being produced has the following manufacturing costs: Direct materials Direct labor Overhead Total $13.00 6.00 8.00 $27.00 Memphis desires a gross margin of 20% of the manufacturing cost. 1. Suppose Memphis used cost-plus pricing, setting the price 20% above the manufacturing cost. What price would be charged for the motor? Would you produce such a motor if you were a manager at Memphis? Explain. 2. Suppose Memphis uses target costing. What price would the company charge for a garage-dooropener motor? What is the highest acceptable manufacturing cost for which Memphis would be willing to produce the motor? 3. As a user of target costing, what steps would Memphis managers take to try to make production of this product feasible? 5-60 Target Costing and ABM Cleveland Plastics makes plastic parts for other manufacturing companies. Cleveland has an ABC system for its production, marketing, and customer service functions. The company uses target costing as a strategic decision-making tool. One of Cleveland's product lines--consumer products--has over 100 individual products with life cycles of less than 3 years. This means that about 30 to 40 products are discontinued and replaced with new products each year. Cleveland's top management has established the following tool to be used by the target-cost team for evaluating proposed new products: Required Cost Reduction (RCR) as a Percent of Market Price RCR 0% 0 < RCR 5% 5% < RCR 25% RCR > 25% Action Release to production Release to production and set kaizen improvement plan Product and process redesign Abandon subject to top management review and approval The following operational and ABC data are for four proposed new products: Estimated Number of Driver Units over Product Life Cycle Value-Chain Function Production Direct Material Setup/Maintenance Processing Cost per Driver Unit C-200472 2,000 10 20 30 55 2,000 Units $39 C-200473 1,000 4 12 10 35 1,400 28 C-200474 4,000 12 32 50 20 4,000 35 C-200475 800 5 12 16 28 600 50 $1.60 per pound $1,015 per setup $370 per machine hour Marketing $860 per order Customer Service $162 per sales call Estimated Life-Cycle Demand Estimated Market Price per Unit Top management has set a desired contribution to cover unallocated value-chain costs, taxes, and profit of 40% of the estimated market price. Prepare a schedule that shows for each proposed new product, the target cost, estimated cost using existing technology, and any required cost reduction as a percent of the estimated market price. Use the evaluation tool to make a decision regarding the four proposed new products. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 5: Relevant Information for Decision Making with a Focus on Pricing Decisions 241 5-61 Target Costing Over Product Life Cycle Southeast Equipment makes a variety of motor-driven products for homes and small businesses. The market research department recently identified power lawn mowers as a potentially lucrative market. As a first entry into this market, Southeast is considering a riding lawn mower that is smaller and less expensive than those of most of the competition. Market research indicates that such a lawn mower would sell for about $995 at retail and $800 wholesale. At that price, Southeast expects life-cycle sales as follows: Year 2004 2005 2006 2007 2008 2009 2010 Sales 1,000 5,000 10,000 10,000 8,000 6,000 4,000 The production department has estimated that the variable cost of production will be $475 per lawn mower, and annual fixed costs will be $900,000 per year for each of the 7 years. Variable selling costs will be $25 per lawn mower and fixed selling costs will be $50,000 per year. In addition, the product development department estimates that $5 million of development costs will be necessary to design the lawn mower and the production process for it. 1. Compute the expected profit over the entire product life cycle of the proposed riding lawn mower. 2. Suppose Southeast expects pretax profits equal to 10% of sales on new products. Would the company undertake production and selling of the riding lawn mower? 3. Southeast Equipment uses a target costing approach to new products. What steps would management take to try to make a profitable product of the riding lawn mower? Cases 5-62 Use of Capacity St. Tropez S.A. manufactures several different styles of jewelry cases in southern France. Management estimates that during the second quarter of 20X7 the company will be operating at 80% of normal capacity. Because the company desires a higher utilization of plant capacity, it will consider a special order. St. Tropez has received special-order inquiries from two companies. The first is from Lyon, which would like to market a jewelry case similar to one of St. Tropez's cases. The Lyon jewelry case would be marketed under Lyon's own label. Lyon has offered St. Tropez 67.5 per jewelry case for 20,000 cases to be shipped by July 1, 20X7. The cost data for the St. Tropez jewelry case, which would be similar to the specifications of the Lyon special order, are as follows: Regular selling price per unit Costs per unit: Raw materials Direct labor, .5 hour @ 60 Overhead, .25 machine hour @ 40 Total costs 100 35 30 10 75 ISBN: 0-536-47129-0 According to the specifications provided by Lyon, the special-order case requires less expensive raw materials, which will cost only 32.5 per case. Management has estimated that the remaining costs, labor time, and machine time will be the same as those for the St. Tropez jewelry case. The second special order was submitted by the Avignon Co. for 7,500 jewelry cases at 85 per case. These cases would be marketed under the Avignon label and would have to be shipped by July 1, 20X7. The Avignon jewelry case is different from any jewelry case in the St. Tropez line. Its estimated per-unit costs are as follows: Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 242 Part 1: Focus on Decision Making Raw materials Direct labor, .5 hour @ 60 Overhead, .5 machine hour @ 40 Total costs 43 30 20 93 In addition, St. Tropez will incur 15,000 in additional setup costs and will have to purchase a 20,000 special device to manufacture these cases; this device will be discarded once the special order is completed. The St. Tropez manufacturing capabilities are limited by the total machine hours available. The plant capacity under normal operations is 90,000 machine hours per year, or 7,500 machine hours per month. The budgeted fixed overhead for 20X7 amounts to 2.16 million, or 24 per hour. All manufacturing overhead costs are applied to production on the basis of machine hours at 40 per hour. St. Tropez will have the entire second quarter to work on the special orders. Management does not expect any repeat sales to be generated from either special order. Company practice precludes St. Tropez from subcontracting any portion of an order when special orders are not expected to generate repeat sales. Should St. Tropez accept either special order? Justify your answer and show your calculations. (Hint: Distinguish between variable and fixed overhead.) Nike 10-K Problem 5-63 Special Order As discussed in Nike's 10-K, one of the companies they own is Cole Haan. Cole Haan makes a variety of fashion footwear, such as dress shoes. One of these products is a men's loafer. This shoe is in strong demand. Suppose sales on this loafer during the present year, 20X7, are expected to hit the 1,000,000 mark. Full plant capacity is 1,150,000 units, but the 1,000,000 unit mark is considered normal capacity. The following unit price and cost breakdown is applicable in 20X7: Per unit Sales price Less manufacturing costs Materials Direct labor Overhead: Variable Fixed Total manufacturing costs Gross margin Less selling and administrative expenses Selling: Variable Fixed Administrative, fixed Packaging, variable* Total selling and administrative expenses Net profit before taxes $145.00 $ 49.00 22.00 14.00 16.00 $101.00 $ 44.00 5.50 9.00 12.00 3.50 $ 30.00 $ 14.00 $ *Two types of packaging are available: deluxe, $3.50 per unit; and standard, $2.00 per unit. During March, the company received two special-order requests from Nordstrom and Macy's. These orders are not part of the budgeted 1,000,000 unit sales for 20X7, but there is sufficient capacity for possibly one order to be accepted. Orders received and their terms are: Order from Nordstrom: 75,000 loafers @ $136.00 per unit, deluxe packaging Order from Macy's: 90,000 loafers @ $130.00 per unit, standard packaging Since these orders were made directly to Cole Haan, no variable selling costs will be incurred. 1. Analyze the profitability of each of these two special orders. Which special order should be accepted? 2. What other aspects need to be considered in addition to profitability? ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 5: Relevant Information for Decision Making with a Focus on Pricing Decisions 243 EXCEL Application Exercise 5-64 Determining Whether to Accept a Special Order Goal: Create an Excel spreadsheet to determine which special order to accept. Use the results to answer questions about your findings. Scenario: The Ibunez Tool Company has been offered two different special orders: (1) the production of 40,000 plain circular saws or (2) the production of 20,000 professional circular saws. The company has enough excess capacity to accept either offer, but not both. The plain saw sells for $65 and has a variable cost of $50. The professional saw sells for $100 and has a variable cost of $75. When you have completed your spreadsheet, answer the following questions: 1. What is the contribution margin and contribution-margin ratio per unit for the plain circular saw? For the professional circular saw? 2. What is the total contribution margin for the plain circular saw if they fill this special order? For the professional circular saw special order? 3. What general conclusion can you draw from the data illustrated by the Excel problem? Step-by-Step: 1. Open a new Excel spreadsheet. 2. In column A, create a bold-faced heading that contains the following: Row 1: Chapter 5 Decision Guideline Row 2: Ibunez Tool Company Row 3: Special Order Analysis Row 4: Today's Date 3. Merge and center the four heading rows across columns A through E. 4. Adjust column widths as follows: Column A: 17 Column B: 15 Column C: 10 Column D: 15 Column E: 10 5. In row 7, create the following bold-faced column heading: Column B: Products 6. Merge and center the Products heading across columns B through E. 7. In row 8, create the following bold-faced column headings: Column B: Plain Circular Saw Column D: Professional Circular Saw 8. Merge and center the Plain Circular Saw heading across columns B and C. 9. Merge and center the Professional Circular Saw heading across columns D and E. 10. In column A, create the following row headings: Row 9: Selling price Row 10: Variable cost Row 11: Contribution margin Skip 4 rows Row 16: Special order units: Skip 1 row Row 18: Total contribution margin: 11. Merge the headings in rows 16 through 18 across columns A and B, then right-justify. Alignment tab: Horizontal: Right ISBN: 0-536-47129-0 12. Enter the selling price and variable cost for plain and professional saws in columns B and D respectively. 13. In row 11, create formulas to calculate the contribution margin for each type of saw in columns B and D respectively. 14. In row 11, create formulas to calculate the contribution-margin percent for each type of saw in columns C and E, respectively. 15. In row 16, Enter the number of units requested in the special order for each type of saw in columns C and E, respectively. 16. In row 18, create formulas to calculate the total contribution margin for each type of saw in columns C and E, respectively. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 244 Part 1: Focus on Decision Making 17. Format all amounts in columns B and D as Number tab: Category: Decimal places: Symbol: Accounting ($ sign is left-justified) 2 $ 18. Modify the format of the variable cost amounts to exclude the dollar ($) sign. Number tab: Symbol: None 19. Modify the format of the contribution-margin amounts to display a top border, using the default Line Style. Border tab: Icon: Top Border 20. Format the contribution-margin percent in columns C and E as Number tab: Alignment tab: Category: Decimal places: Horizontal: Percentage 0 Center 21. Format the amount in row 16 as Number tab: Category: Decimal places: Use 1000 Separator (,): Alignment tab: Horizontal: Number 0 Checked Center 22. Format total contribution-margin amounts as Number tab: Category: Decimal places: Symbol: Accounting 0 $ 23. Save your work to disk, and print a copy for your files. Collaborative Learning Exercise 5-65 Understanding Pricing Decisions Form teams of three to six students. Each team should contact and meet with a manager responsible for pricing in a company in your area. This might be a product manager or brand manager for a large company or a vice president of marketing or sales for a smaller company. Explore with the manager how his or her company sets prices. Among the questions you might ask are: How do costs influence your prices? Do you set prices by adding a markup to costs? If so, what measure of costs do you use? How do you determine the appropriate markup? How do you adjust prices to meet market competition? How do you measure the effects of price on sales level? Do you use target costing? That is, do you find out what a product will sell for and then try to design the product and production process to make a desired profit on the product? What is your goal in setting prices? Do you try to maximize revenue, market penetration, contribution margin, gross margin, or some combination of these, or do you have other goals when setting prices? After each team has conducted its interview, it would be desirable, if time permits, to get together as a class and share your findings. How many different pricing policies did the groups find? Can you explain why policies differ across companies? Are there characteristics of different industries or different management philosophies that explain the different pricing policies? Internet Exercise ISBN: 0-536-47129-0 5-66 Marketing Decisions at Colgate-Palmolive Managers need information of all types in order to make decisions. Many marketing decisions are strategic, such as setting pricing policies. Managers rely on multiple sources to help locate relevant Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 5: Relevant Information for Decision Making with a Focus on Pricing Decisions 245 information to support these decisions. Managers must know how to use the information that is available and what weight to assign to the information that is deemed to be useful. A firm is not going to give us detailed information about its marketing strategy on its Web site. However, we can view a firm's Web site to look at some of the relevant information that managers might use to help make marketing decisions. Let's look at the Colgate-Palmolive Company to see what information on their site would be relevant for some marketing decisions. 1. Go to Colgate-Palmolive's home page at www.colgate.com. Move your cursor to the heading "For Investors" at the top of the page. Click on "For Investors," then on "Financial Info," then "Annual Reports," and then on the "Dear Colgate Shareholder" in the 2005 annual report. In this section, Colgate shares its worldwide strategy. What types of pricing decisions that are discussed in this chapter are part of Colgate's strategy? What does this strategy reveal about the need for relevant information? 2. Many companies place a high priority on ethics. Examine the section "Living Our Values." Give two examples that show Colgate's commitment to ethical behavior. 3. One area that many companies identify as a key component to strategy is new product development. Visit the News Link under "Our Company" where Colgate highlights its newest products. Based on the information in the News Link, what was the last new product to be released? Is this a "new" product or is it simply a variation of an existing product? 4. Now, look at the products that the firm manufactures. What format is offered for learning about these products? Look at the fabric conditioner products. How many fabric conditioners does the firm offer? From looking at the information provided, can you tell what differentiates the products? Does the Web site provide any information on how or when to use the products? Would you want to make a decision about the "best" fabric conditioner for a specific type of laundry based on the information found on the Web site? Why or why not? 5. Let's look at the most recent annual report again. Is there evidence in the financial statements that Colgate is achieving its worldwide strategy? Is the company improving profitability? ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Relevant Information for Decision Making with a Focus on Operational Decisions C H A P T E R LEARNING OBJECTIVES When you have finished studying this chapter, you should be able to: 1. Use a differential analysis to examine income effects across alternatives and show that an opportunity cost analysis yields identical results. 2. Decide whether to make or to buy certain parts or products. 3. Choose whether to add or delete a product line using relevant information. 4. Compute the optimal product mix when production is constrained by a scarce resource. 5. Decide whether a joint product should be processed beyond the split-off point. 6. Decide whether to keep or replace equipment. 7. Identify irrelevant and misspecified costs. 8. Discuss how performance measures can affect decision making. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. N A N T U C K E T N E C TA R S Starting a beverage business can be a complex maze of decisions. Tom First and Tom Scott should know. After graduating from college, they operated a two-person boat service business off Nantucket Island, provisioning and cleaning yachts during the summer. In 1989, the inspiration for a juice drink made with fresh peaches hit. After a bit of experimentation, the self-proclaimed "juice guys" began bottling and selling their nectar drink from their boat. That first summer, they sold 2,000 bottles at $1.00 each. Today, Nantucket Nectars, owned by Cadbury-Schweppes since 2002, sells millions of cases each year. Product lines include Nantucket Nectars' Organic, 100% fruit juices, juice cocktails, carbonated juice drinks, and not from concentrate teas and lemonades. Getting to this point, however, has been anything but smooth sailing. Their early attempts to sell juice to retailers failed. Profits were nonexistent. They sold half the business to an equity partner for $500,000 to venture into distribution, but ended up losing $1 million the first year. Employees stole caseloads of merchandise from the warehouse. And there have been inevitable product disappointments, such as Bayberry Tea. But the juice guys are quick learners. They got out of distribution, changed their marketing approach, and stopped the flow of red ink. As the company grew, it tackled important operational decisions. For example, should they build and operate their own bottling facilities? What criteria should be used for developing new products? What's the best approach for tracking and analyzing the growing volume of production, distribution, and sales data? After examining the cost of building and operating bottling plants, Nantucket Nectars chose to contract with existing beverage co-packers in Rhode Island, Nevada, Florida, Pennsylvania, and Maryland. This approach gave the company When you relax with a bottle of Nantucket Nectars juice, you do not consider the various costs that go into producing, selling, and distributing the bottle. But these costs are very important to the managers at Nantucket Nectars. ISBN: 0-536-47129-0 247 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 248 Part 1: Focus on Decision Making broader distribution options without the capital expenditure and overhead of multiple plants. Its managers scrutinized unit costs associated with new product ideas emerging from the test kitchen to be sure margins were on target. And they meticulously tracked every detail--from operational costs to pricing promotions--through a computerized enterprise resource planning (ERP) information system from Oracle. Throughout it all, the juice guys never wavered in their determination to produce a top-quality product and satisfy customers. They readily admit they both failed their first accounting course in college, but they have come to appreciate its relevance in decision making as they've weathered stormy periods and sailed smooth seas. As with Nantucket Nectars, managers in other companies must make similar operational decisions. Should Toyota make the tires it mounts on its cars, or should it buy them from suppliers? Should General Mills sell the flour it mills, or should it use the flour to make more breakfast cereal? Should Delta Airlines add routes to use idle airplanes, or should it sell the planes? These decisions all require a good deal of accounting information. But what information will be relevant to each decision? In Chapter 5, we identified relevant information for pricing decisions. We now need to determine relevance in the operational area. The basic framework for identifying relevant information remains the same for operations as it was for pricing. We are still looking only for future costs that differ among alternatives. However, we now expand our analysis by introducing the concepts of opportunity costs and differential costs. O B J E C T I V E Use a differential analysis to examine income effects across alternatives and show that an opportunity cost analysis yields identical results. differential cost The difference in total cost between two alternatives. differential revenue The difference in total revenue between two alternatives. incremental analysis An analysis of the incremental (additional) costs and benefits of a proposed alternative compared with a given alternative. incremental costs The additional costs or reduced benefits generated by the proposed alternative in comparison with a given alternative. incremental benefits The additional revenues or reduced costs generated by the proposed alternative in comparison with a given alternative. 1 Analyzing Relevant Information: Focusing on Futuristic and Differential Attributes Opportunity, Outlay, and Differential Costs and Analysis Management decision making is often a matter of comparing two or more alternative courses of action. (Of course, if there were only one alternative, no decision would be necessary.) Suppose a manager has only two alternatives to compare. The key to determining the financial difference between the alternatives is to identify the differential costs and revenues. Differential cost (differential revenue) is the difference in total cost (revenue) between two alternatives. For example, consider the decision about which of two machines to purchase. Both machines perform the same function. The differential cost is the difference in the price paid for the machines plus the difference in the costs of operating the machines. When managers analyze the differential costs between a given alternative, often the status quo (that is, the existing situation), and a proposed alternative, they often refer to this as incremental analysis. They examine the incremental (additional) costs and benefits of the proposed alternative compared with the given alternative. The incremental costs are additional costs or reduced revenues generated by the proposed alternative. Incremental benefits are the additional revenues or reduced costs generated by the proposed alternative. For instance, suppose Nantucket proposes to increase production of its NectarFizz juice drink from 1,000 bottles to 1,200 bottles per week. The incremental costs of the proposed alternative are the costs of producing the additional 200 bottles each week. The incremental benefits are the additional revenues generated by selling the extra 200 bottles. When there are multiple alternative courses of action, managers often compare one particular action against the entire set of alternatives. For example, Nantucket Nectars might consider introducing a new 100% juice drink, Papaya Mango. There are many alternatives to introducing Papaya Mango, including introducing other new 100% juice dinks, expanding production of existing drinks such as juice cocktails or blended nectars, or producing nonjuice products. Computing the differential costs and revenues between produc- ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 6: Relevant Information for Decision Making with a Focus on Operational Decisions 249 ing Papaya Mango and every alternative could be cumbersome. Thus, Nantucket Nectars managers might use another approach. Introducing Papaya Mango would entail two types of costs, outlay costs and opportunity costs. An outlay cost requires a future cash disbursement. Outlay costs include costs for items such as materials and labor. Opportunity cost applies to a resource that a company already owns or that it has already committed to purchase. It is the maximum available contribution to profit forgone (or passed up) by using such a resource for a particular purpose. The decision regarding Papaya Mango will not affect whether the company acquires such resources, only how it uses them. The opportunity cost of such resources depends on the potential uses for the resources, not on the amount paid for them. Why? Because the decision about Papaya Mango will not affect the amount paid for the resources. Nantucket Nectars has already paid (or committed to pay) that cost. However, the decision to use the resources to produce Papaya Mango precludes using them for other alternatives. The amount that the company would have gained if the resources had been used in their best alternative use (that is, the best use other than using them to produce Papaya Mango) becomes the opportunity cost of the resources. Suppose Nantucket Nectars has a machine for which it paid $100,000 several years ago and is sitting idle. It can use the machine to produce Papaya Mango or to increase the production of The Original Peach 100% Juice. The contribution margin from the additional sales of The Original Peach would be $60,000. A third alternative is selling the machine for $50,000 cash. What is the opportunity cost of the machine when we analyze the Papaya Mango alternative? It is $60,000, the larger of the $50,000 or $60,000, the two possible gains that the company could achieve using the machine in its alternative uses. The $100,000 paid for the machine is a past cost, and we know from our discussion of relevant costs in Chapter 5 that past costs are irrelevant. Now suppose that Nantucket Nectars will have total sales over the life cycle of Papaya Mango 100% Juice of $500,000. The production and marketing costs (outlay costs), excluding the cost of the machine, are $400,000. The net financial benefit from the Papaya Mango is $40,000: Revenues Costs: Outlay costs Financial benefit before opportunity costs Opportunity cost of machine Net financial benefit $500,000 400,000 $100,000 60,000 $ 40,000 outlay cost A cost that requires a future cash disbursement. opportunity cost For a resource that a company already owns or that it has already committed to purchase, the maximum available contribution to profit forgone (or passed up) by using such a resource for a particular purpose. ISBN: 0-536-47129-0 Nantucket Nectars will gain $40,000 more financial benefit using the machine to make Papaya Mango than it would make using it for the next most profitable alternative. An alternative to the opportunity cost analysis is to conduct an incremental analysis. In an incremental analysis, we compare the revenues and outlay costs of the proposed alternative to those of the next best alternative use of the machine. In this case, the revenue less outlay costs for Papaya Mango of $100,000 is $40,000 higher than the predicted contribution margin on The Original Peach. The result of the incremental analysis is equivalent to that of the opportunity-cost approach. To further illustrate this equivalence, consider Maria Morales, a certified public accountant employed by a large accounting firm for a salary of $60,000 per year. She is considering an alternative use of her time, her most valuable resource. The alternative is to have her own independent accounting practice. Maria's practice would have revenues of $200,000; $140,000 more than she would make as an employee of the large firm. However, she would also have to pay $120,000 to rent office space, lease equipment, buy advertising, and cover other out-of-pocket expenses. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 250 Part 1: Focus on Decision Making An incremental analysis follows: Assume Maria opens her own independent practice Incremental benefits, $200,000 - $60,000 of increased revenues Incremental costs, $120,000 - $0 of additional costs Incremental income effects per year $140,000 120,000 $ 20,000 If Maria opens her own practice, her income will be $20,000 higher than it is as an employee of the large firm. Now let's take an opportunity-cost approach. We will look at the alternative of operating an independent practice, essentially comparing it to the alternative uses of Maria's time (which in this case is simply the alternative of working for the large firm). To do this we must consider another cost. Had Maria remained an employee, she would have made $60,000. By starting her own company, Maria will forgo this profit. Thus, the $60,000 is an opportunity cost of starting her own business: Alternative Chosen: Independent Practice Revenue Expenses Outlay costs (operating expenses) Opportunity cost of employee salary Income effects per year $200,000 $120,000 60,000 180,000 $ 20,000 Ponder the two preceding tabulations. Each produces the correct key difference between alternatives, $20,000. The first tabulation does not mention opportunity cost because we measured the differential economic impacts (in the form of differential revenues and differential costs), given the selection of one of the alternatives. The second tabulation mentions opportunity cost because we included the $60,000 annual net-economic impact of the excluded alternative as a cost of the chosen alternative. If we had failed to recognize opportunity cost in the second tabulation, we would have misstated the difference between the alternatives. Why do we use opportunity costs when an incremental analysis produces the same result? When there is only one resource and one alternative opportunity to use that resource, the incremental analysis is more straightforward. However, suppose you were analyzing a project that uses five existing machines each with 10 alternative uses. An incremental analysis would require comparing the project with 105 = 100,000 alternatives--every combination of alternative uses of the five machines. Using opportunity costs allows you to simplify the analysis. You just assess the 10 alternatives for each machine, pick the best one to use in determining each machine's opportunity cost, and add the five opportunity costs to the outlay costs of the project. The opportunity-cost approach is simpler than the incremental approach in such a situation. The major message here is that an incremental analysis is a very valuable approach for making optimal decisions. Additionally, opportunity costs are an important concept as well (and yields identical decisions to an incremental analysis). Consider an automobile owner who has made the final payment on a car loan. While celebrating, the owner says, "It's a wonderful feeling to know that future driving is free of any interest cost!" Many car owners have similar thoughts. Why? Because they will have no future outlay costs for interest. Nevertheless, there is an opportunity cost of continuing to drive the car. After all, an alternative would be to sell the car, place the proceeds in some other investment, and use public transportation. The owner forgoes the interest in the other investment so this forgone interest income becomes an opportunity cost of automobile ownership. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 6: Relevant Information for Decision Making with a Focus on Operational Decisions 251 We will next use the concepts in this section to analyze a variety of operational decisions. Just as we focused on relevant costs for pricing decisions in Chapter 5, we will focus on relevant costs for operational decisions in this chapter. MAKING MANAGERIAL DECISIONS Consider how difficult it is to estimate opportunity costs. There is no sale or purchase to establish an appropriate cost. Further, the opportunity cost depends on the alternatives that are available at a point in time. The same alternatives may not be available at a different time. For example, excess capacity in September does not mean that there will also be excess capacity in October. How might a manager at Mattel, the toy company, estimate the opportunity cost of excess warehouse space in January? Answer The Mattel manager would know that excess warehouse space is a seasonal phenomenon. There is unlikely to be excess space late in the year as Christmas approaches. Therefore, he or she would look for temporar y alternatives, ones that use the space for only a few months. After identifying alternatives, the manager would estimate the value of each. Because most of the alternatives are ones that a company never under takes, estimating their values is a subjective process. The highest valued alternative would establish the oppor tunity cost of the space. Make-or-Buy Decisions Managers often must decide whether to produce a product or service within the firm or purchase it from an outside supplier. If they purchase products or services from an outside supplier, we often call it outsourcing. They apply relevant cost analysis to a variety of outsourcing decisions such as the following: Boeing must decide whether to buy or make many of the tools used in assembling 777 airplanes. IBM must decide whether to develop its own operating system for a new computer or to buy it from a software vendor. The Business First box on page 252 describes outsourcing and its growing popularity. O B J E C T I V E Decide whether to make or to buy certain parts or products. outsourcing Purchasing products or services from an outside supplier. 2 Basic Make-or-Buy Decisions and Idle Facilities A basic make-or-buy question is whether a company should make its own parts that it will use in its final products or buy the parts from vendors. Sometimes the answer to this question is based on qualitative factors. For example, some manufacturers always make parts because they want to control quality. Alternatively, some companies always purchase parts to protect long-run relationships with their suppliers. These companies may deliberately buy from vendors even during slack times to avoid difficulties in obtaining needed parts during boom times, when there may well be shortages of materials and workers, but no shortage of sales orders. What quantitative factors are relevant to the decision of whether to make or buy? The answer, again, depends on the situation. A key factor is whether there are idle facilities. Many companies make parts only when they cannot use their facilities to better advantage. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. AN EXAMPLE OF MAKE OR BUY: OUTSOURCING Make-or-buy decisions (selecting the buy decision is often called outsourcing) apply to ser vices as well as to products. Companies are increasingly deciding to hire ser vice firms to handle some of their internal operations. According to the Outsourcing Institute, outsourcing is "the strategic use of outside resources to per form activities traditionally handled by internal staf f and resources." Companies use outsourcing for many business processes. How do these processes compare to the value-chain functions we have discussed? The companies often outsource the following business functions: What are the key reasons for outsourcing? Over half of the companies in Outsourcing Institute's annual sur vey said they wanted to improve the company's focus and reduce operating costs. According to Todd Ker tley, who manages IBM's outsourcing ser vices, "Corporations increasingly want to focus on their core businesses, not technology." As the complexity of data processing and especially networking has grown, companies have found it harder and harder to keep current with the technology. Instead of investing huge sums in personnel and equipment and diverting attention from the value-added activities of their own businesses, many firms have found out- Business Function Information technology Administration Distribution and logistics Finance Human resources Manufacturing Contact centers/call centers Sales and marketing Percent of Companies Outsourcing 55% 47% 22% 20% 19% 18% 15% 13% Value-Chain Function Corporate support Corporate support Distribution Corporate support Corporate support Production Marketing Marketing The processes listed include almost all the valuechain functions, including suppor t activities. Research and development and design are the two value-chain functions not frequently outsourced. That makes sense because most companies perceive these functions as core business processes. Although companies can outsource many processes, the Internet has driven much of the recent growth in outsourcing. During the 1990s, many companies installed ERP systems to handle all their computing needs. However, by the beginning of the twenty-first centur y, many companies realized that the huge investments necessitated by ERP systems may be unnecessary. They could purchase the required ser vices over the Internet without investing in the systems' purchase and development costs. The formerly expensive process of communication using ser vice providers had become essentially free via the Internet. A new group of computing ser vice providers--called application ser vice providers (ASPs)--arose to provide outsourcing opportunities for a variety of computing applications. sourcing financially attractive. The big stumbling block to outsourcing has been subjective factors, such as control. To make outsourcing attractive, the services must be reliable, be available when needed, and be flexible enough to adapt to changing conditions. Companies that have successful outsourcing arrangements have been careful to include the subjective factors in their decisions. Outsourcing has become so profitable that more than 75% of Fortune 500 companies outsource some aspect of their business suppor t ser vices. The total value of outsourcing contracts in the United States is more than $10 billion. The Outsourcing Institute was formed to provide "objective, independent information on the strategic use of outside resources." Sources: Adapted from T. Kearney, "Why Outsourcing Is In," Strategic Finance, Januar y 2000, pp. 3438; R. E. Dr tina, "The Outsourcing Decision," Management Accounting, March, 1994, pp. 5662; J. Hechinger, "IBM to Take Over Operations of Auto-Parts Maker Visteon," The Wall Street Journal, February 12, 2003; and the Outsourcing Institute (www.outsourcing.com). ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 6: Relevant Information for Decision Making with a Focus on Operational Decisions 253 Assume that Nantucket Nectars reports the following costs: Nantucket Nectars Company Cost of Making 12-Ounce Glass Bottles Total Cost for 1,000,000 Bottles Direct materials Direct labor Variable factory overhead Fixed factory overhead Total costs $ 60,000 20,000 40,000 80,000 $200,000 Cost per Bottle $.06 .02 .04 .08 $.20 Another manufacturer offers to sell Nantucket Nectars the bottles for $.18. Should Nantucket Nectars make or buy the bottles? Although the $.20 unit cost seemingly indicates that the company should buy, the answer is rarely so obvious. The essential question is, "What is the difference in expected future costs between the alternatives?" If the $.08 fixed overhead per bottle consists of costs that will continue regardless of the decision, the entire $.08 becomes irrelevant. Examples of such fixed factory costs include depreciation, property taxes, insurance, and foreman salaries for the plant. Are only the variable costs relevant? No. Perhaps Nantucket Nectars will eliminate $50,000 of the fixed costs if the company buys the bottles instead of making them. For example, the company may be able to release a supervisor with a $50,000 salary. In other words, fixed costs that the company will be able to avoid in the future are relevant. For the moment, suppose the capacity now used to make bottles will become idle if the company purchases the bottles. Further, the $50,000 supervisor's salary is the only fixed cost that the company would eliminate. The relevant computations follow. Make Total Purchase cost Direct materials Direct labor Variable factory overhead Fixed factory overhead that can be avoided by not making (supervisor's salary) Total relevant costs Difference in favor of making $ 60,000 20,000 40,000 Per Bottle $.06 .02 .04 Total $180,000 Buy Per Bottle $.18 50,000* $170,000 $ 10,000 .05* $.17 $.01 $180,000 $.18 *Note that unavoidable fixed costs of $80,000 - $50,000 = $30,000 are irrelevant. Thus, the irrelevant costs per unit are $.08 - $.05 = $.03. The key to wise make-or-buy decisions is identifying and accurately measuring the additional costs for making (or the costs avoided by buying) a part or component. Companies with accurate cost accounting systems, such as ABC systems discussed in Chapter 4, are in a better position to perform make-or-buy analysis. Make or Buy and the Use of Facilities ISBN: 0-536-47129-0 Make-or-buy decisions are rarely as simple as the one in our Nantucket Nectars example. As we said earlier, the use of facilities is a key to the make-or-buy decision. For simplicity, we assumed that the Nantucket Nectars facilities would remain idle if the company chose to buy the bottles. This means that the opportunity cost of the facilities is zero. In Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 254 Part 1: Focus on Decision Making most cases, companies will not leave their facilities idle. Instead, they will often put idle facilities to some other use, and we must consider the financial outcomes of these uses when choosing to make or buy. The value received from the best of these alternative uses is an opportunity cost for the internal production of the parts or components. Suppose Nantucket Nectars can use the released facilities in our example in some other manufacturing activity to produce a contribution to profits of $55,000 or can rent them out for $25,000. We now have four alternatives to consider. The following table is an incremental analysis that summarizes all the costs and revenues that differ among the four alternatives (amounts are in thousands): Buy and Leave Facilities Idle $ -- -- (180) $(180) Buy and Rent Out Facilities $ 25 -- (180) $(155) Buy and Use Facilities for Other Products $ -- 55 (180) $(125) Make Rent revenue Contribution from other products Relevant cost of bottles Net relevant costs $ -- -- (170) $(170) The final column indicates that buying the bottles and using the vacated facilities for the production of other products would yield the lowest net costs in this case, $170,000 - $125,000 = $45,000 less than the cost of making the bottles. We can also analyze this choice using opportunity costs. The opportunity cost of the facilities is $55,000 because that is the benefit Nantucket Nectars could get if it did not use the facilities to make bottles. Add that to the outlay cost, and the total cost of making the bottles is $225,000. This is $45,000 higher than the $180,000 cost of purchasing them. To summarize, the make-or-buy decision should focus on relevant costs in a particular decision situation. In all cases, companies should relate make-or-buy decisions to the long-run policies for the use of capacity. MAKING MANAGERIAL DECISIONS Suppose a company uses its facilities, on average, 80% of the time. However, because of seasonal changes in the demand for its product, the actual demand for the facilities varies from 60% in the off season to over 100% in the peak season when it must outsource production of some par ts. Under what circumstances would the company choose to perform special projects during the off season and continue to outsource production of parts during the peak season--that is, why would the company choose not to expand its capacity? Answer During the off season, the company may decide to perform special projects for other manufacturers (on a subcontract). There is profit on these projects, but it may not be enough to justify expanding the capacity of the facilities. The company will use facilities for these projects only when their opportunity cost is close to zero, that is, when there are no other more profitable uses for the facilities. In contrast, during the peak season, the company meets the high volume by outsourcing the production of some parts. Again, the cost of purchased parts may be higher than the cost to make them in the company's own facilities if there were idle capacity, but purchasing the parts is less costly than buying the facilities to produce them. Additionally, a company may increase production above demand (but below capacity) in the off-season in order to build inventory for the busy season. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 6: Relevant Information for Decision Making with a Focus on Operational Decisions 255 Summary Problem for Your Review PROBLEM Exhibit 6-1 contains data for the Block Company for the year just ended. The company makes industrial power drills. Exhibit 6-1 shows the costs of the plastic housing separately from the costs of the electrical and mechanical components. Answer each of the following questions independently. (Requirement 1 reviews Chapter 5.) 1. During the year, a prospective customer in an unrelated market offered $82,000 for 1,000 drills. The drills would be manufactured in addition to the 100,000 units sold. Block Company would pay the regular sales commission rate on the 1,000 drills. The president rejected the order because "it was below our costs of $97 per unit." What would operating income have been if Block Company had accepted the order? 2. A supplier offered to manufacture the year's supply of 100,000 plastic housings for $13.00 each. What would be the effect on operating income if the Block Company purchased rather than made the housings? Assume that Block Company would avoid $350,000 of the fixed costs assigned to housings if it purchases the housings. 3. Suppose that Block Company could purchase the housings for $13.50 each and use the vacated space for the manufacture of a deluxe version of its drill. Assume that it could make 20,000 deluxe units (and sell them for $130 each in addition to the sales of the 100,000 regular units) at a unit variable cost of $90, exclusive of housings and exclusive of the 10% sales commission. The company could also purchase the 20,000 extra plastic housings for $13.50 each. All the fixed costs pertaining to the plastic housings would continue because these costs relate primarily to the manufacturing facilities used. What would operating income have been if Block had bought the housings and made and sold the deluxe units? A Electrical and Mechanical Components* Sales: 100,000 units, @ $100 Variable costs Direct materials $4,400,000 Direct labor 400,000 Variable factory overhead 100,000 Other variable costs 100,000 Sales commissions, @ 10% of sales 1,000,000 Total variable costs $6,000,000 Contribution margin Total fixed costs $2,220,000 Operating income *Not including the costs of plastic housing (column B). ISBN: 0-536-47129-0 B Plastic Housing A+B Industrial Drills $10,000,000 $ 500,000 300,000 200,000 -- -- $1,000,000 $ 480,000 $ 4,900,000 700,000 300,000 100,000 1,000,000 $ 7,000,000 $ 3,000,000 2,700,000 $ 300,000 Exhibit 6-1 Block Company Cost of Industrial Drills Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 256 Part 1: Focus on Decision Making SOLUTION 1. The costs of filling the special order follow: Direct materials Direct labor Variable factory overhead Other variable costs Sales commission @ 10% of $82,000 Total variable costs Selling price Contribution margin $49,000 7,000 3,000 1,000 8,200 $68,200 82,000 $13,800 Operating income would have been $300,000 + $13,800, or $313,800, if Block Company had accepted the order. In a sense, the decision to reject the offer implies that the Block Company is willing to invest $13,800 in immediate gains forgone (an opportunity cost) in order to preserve the long-run selling price structure. 2. Assuming that Block Company could have avoided $350,000 of the fixed costs by not making the housings and that the other fixed costs would have continued, we can summarize the incremental costs and benefits of buying the housings compared with making them as follows. Incremental cost (Purchase cost of 100,000 $13) Incremental benefits: Variable costs Avoidable fixed costs Net incremental benefit $1,300,000 $1,000,000 350,000 $ 50,000 If the facilities used for plastic housings became idle, the Block Company would prefer to buy the housings. Operating income would increase by $50,000. 3. The effect of purchasing the plastic housings and using the vacated facilities for the manufacture of a deluxe version of its drill follows. Incremental Benefit: Sales increase, 20,000 units, @ $130 Variable costs exclusive of housings increase, 20,000 units, @ $90 Plus: sales commission, 10% of $2,600,000 Contribution margin on 20,000 units Incremental Cost: Housings: 120,000 rather than 100,000 would be needed Buy 120,000 @ $13.50 Versus make 100,000 @ $10 (only the variable costs are relevant) Incremental cost of outside purchase Fixed costs, unchanged Net incremental cost to buying $2,600,000 $1,800,000 260,000 $2,060,000 $ 540,000 $1,620,000 1,000,000 620,000 -- $ 80,000 Operating income would decline to $220,000 ($300,000 - $80,000). The deluxe units bring in a contribution margin of $540,000, but the additional costs of buying rather than making housings is $620,000, leading to a net disadvantage of $80,000. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 6: Relevant Information for Decision Making with a Focus on Operational Decisions 257 Deletion or Addition of Products, Services, or Departments Relevant information also plays an important role in decisions about adding or deleting products, services, or departments. O B J E C T I V E Choose whether to add or delete a product line using relevant information. 3 Avoidable and Unavoidable Costs Often, existing businesses will want to expand or contract their operations to improve profitability. How can a manufacturer decide whether to add or to drop products? The same way a retailer decides whether to add or to drop departments: by examining all the relevant costs and revenues. For example, consider a discount department store that has three major departments: groceries, general merchandise, and drugs. Management is considering dropping the grocery department, which has consistently shown an operating loss. The following table reports the store's present annual operating income (in thousands of dollars): Departments Total Sales Variable cost of goods sold and expenses* Contribution margin Fixed expenses (salaries, depreciation, insurance, property taxes, and so on): Avoidable Unavoidable Total fixed expenses Operating income (loss) $1,900 1,420 $ 480 (25%) Groceries $1,000 800 $ 200 (20%) General Merchandise $800 560 $240 (30%) Drugs $100 60 $ 40 (40%) $ 265 180 $ 445 $ 35 $ 150 60 $ 210 $ (10) $100 100 $200 $ 40 $ 15 20 $ 35 $ 5 *Examples of variable expenses include product, paper shopping bags, and sales commissions. Notice that we have divided the fixed expenses into two categories, avoidable and unavoidable. Avoidable costs--costs that will not continue if an ongoing operation is changed or deleted--are relevant. In our example, avoidable costs include department salaries and other costs that the store could eliminate by not operating the specific department. Unavoidable costs--costs that continue even if a company discontinues an operation--are not relevant in our example because a decision to delete the department does not affect them. Unavoidable costs include many common costs, which are those costs of facilities and services that are shared by users.1 For example, store depreciation, heating, air conditioning, and general management expenses are costs of shared resources used by all departments. For our example, assume first that we will consider only two alternatives, dropping or continuing the grocery department, which shows a loss of $10,000. Assume further that the decision will not affect the total assets invested in the store. The vacated space would be idle, and the unavoidable costs would continue. Which alternative would you recommend? An analysis (in thousands of dollars) follows. concept of avoidable cost is used by government regulators as well as business executives. For example, Amtrak divides its costs into avoidable--costs that "would cease if the route were eliminated"--and fixed--costs that would "remain relatively constant if a single route were discontinued." The U.S. Interstate Commerce Commission then considers the avoidable costs when considering approval of a railroad's request to abandon a route. Similarly, the Canadian government looks at the avoidable cost when determining the amount of subsidy to give to the country's passenger rail system. The Montreal Gazette reported that revenues covered only 35% of the "$7 million in avoidable costs (costs that wouldn't exist if the train disappeared tomorrow--things like staff salaries, food, fuel, and upkeep of train stations)." 1The avoidable costs Costs that will not continue if an ongoing operation is changed or deleted. unavoidable costs Costs that will continue even if a company discontinues an operation. common costs Those costs of facilities and services that are shared by users. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 258 Part 1: Focus on Decision Making Store as a Whole Total Before Change (a) $1,900 1,420 $ 480 265 $ 215 180 35 Effect of Dropping Groceries (b) $1,000 800 $ 200 150 $ 50 -- 50 Total After Change (a) - (b) $900 620 $280 115 $165 180 $ (15) Income Statements Sales Variable expenses Contribution margin Avoidable fixed expenses Profit contribution to common space and other unavoidable costs Common space and other unavoidable costs Operating income (loss) $ $ The preceding analysis shows that matters would be worse, rather than better, if the store drops the groceries department and leaves the vacated facilities idle. In short, as the income statement shows, groceries bring in a contribution margin of $200,000, which is $50,000 more than the $150,000 fixed expenses that the store would save by closing the grocery department. The grocery department showed a loss in the first income statement because of the unavoidable fixed costs charged (allocated) to it. Most companies do not like having space left idle, so perhaps the preceding example was a bit too basic. Assume now that the store could use the space made available by the dropping of groceries to expand the general merchandise department. The space would be occupied by merchandise that would increase sales by $500,000, generate a 30% contribution-margin percentage, and have additional (avoidable) fixed costs of $70,000. The $80,000 increase in operating income of general merchandise more than offsets the $50,000 decline from eliminating groceries, providing an overall increase in operating income of $65,000 - $35,000 = $30,000. The analysis is as follows. Effects of Changes Total Before Change (a) (in thousands of dollars) Sales Variable expenses Contribution margin Avoidable fixed expenses Contribution to common space and other unavoidable costs Common space and other unavoidable costs* Operating income $1,900 1,420 $ 480 265 $ 215 180 35 Drop Groceries (b) $1,000 800 $ 200 150 $ 50 -- 50 Expand General Merchandise (c) $500 350 $150 70 $ 80 -- $ 80 Total After Changes (a) - (b) + (c) $1,400 970 $ 430 185 $ 245 180 65 $ $ $ *Includes the $60,000 of former grocery fixed costs, which were allocations of unavoidable common costs that will continue regardless of how the space is occupied. The purpose of deciding whether to add or drop new products, services, or departments is to obtain the greatest contribution possible. The company will use the contribution to pay the unavoidable costs. The unavoidable costs will remain the same regardless of any decision, so the key is picking the alternative that will contribute the most toward paying off these costs. The following analysis illustrates this concept for our example: ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 6: Relevant Information for Decision Making with a Focus on Operational Decisions 259 Profit Contribution of Given Space (in thousands of dollars) Drop Groceries Sales Variable expenses Contribution margin Avoidable fixed expenses Contribution to common space and other unavoidable costs $1,000 800 $ 200 150 $ 50 Expansion of General Merchandise $500 350 $150 70 $ 80 Difference $500 U 450 F $ 50 U 80 F $ 30 F F = Favorable difference (a benefit) resulting from replacing groceries with general merchandise. U = Unfavorable difference (a cost) resulting from replacing groceries with general merchandise. In our example, the general merchandise will not achieve the dollar sales volume that groceries will, but the higher contribution margin percentage and the lower wage costs (mostly because of the diminished need for stocking and checkout clerks) combine to produce a more favorable bottom line. This example illustrates that relevant costs are not always variable. The key to decision making is not relying on a hard and fast rule about what to include and what to ignore. Rather, you need to analyze all pertinent costs and revenues to determine what is and what is not relevant. In this case, the relevant costs included the avoidable fixed costs. It is also important to remember that nonfinancial information can influence decisions to add or delete products or departments. For example, when deciding to delete a product or to close a plant, there are ethical considerations. What happens to the employees in the area being discontinued? What about customers who might be relying on customer support in the future? What about the community in which a discontinued operation is located? While the nonfinancial impacts of such considerations are hard to determine, they are still factors a company should consider. In addition, a stable, committed workforce and a supportive community can be important assets to a company. This may be a situation where good ethics is good business. Any negative impacts on employees, customers, or communities could create future financial problems for the company that are much larger than short-term cost savings from discontinuing a product or plant. MAKING MANAGERIAL DECISIONS When managers face a decision about whether to add or delete a product, service, or department, it is useful to classify the associated fixed costs as avoidable or unavoidable. Indicate whether the following fixed costs are typically avoidable or unavoidable if a company deletes a product. Assume that the company produces many products in a single plant. 1. Depreciation on equipment used to produce the product. The company will sell the equipment if it discontinues the product. ISBN: 0-536-47129-0 2. Salary of the plant manager. 3. Depreciation on the plant building. 4. Advertising costs for the product. The company places specific ads just for this product. Answer Numbers 1 and 4 are avoidable fixed costs. The company is unlikely to change the salary of the plant manager if it discontinues only one product. Thus, it is unavoidable. The same is true for the plant depreciation. Hence, it is also an unavoidable cost. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 260 Part 1: Focus on Decision Making O B J E C T I V E Compute the optimal product mix when production is constrained by a scarce resource. limiting factor (scarce resource) The item that restricts or constrains the production or sale of a product or service. 4 Optimal Use of Limited Resources: Product-Mix Decisions Suppose a plant makes more than one product and is operating at capacity. If demand for its products exceeds the amount the company can produce, managers must decide which product mix to produce. The product-mix decision requires a focus on each product's contribution margin and its use of capacity. Managers should emphasize the product that makes the largest contribution per unit of the limiting factor. A limiting factor or scarce resource restricts or constrains the production or sale of a product or service. Limiting factors include labor hours and machine hours that limit production (and hence sales) in manufacturing firms, and square feet of floor space or cubic meters of display space that limit sales in department stores. Managers must use the contribution margin technique wisely. They sometimes mistakenly favor those products with the biggest contribution margin or gross margin per sales dollar, without regard to scarce resources. This could lead to incorrect decisions. Consider two different athletic shoes produced by Nike, the Air Court tennis shoe and the Air Max running shoe. Only one facility produces these two shoes, and Nike managers must decide how many shoes of each type to produce. Suppose the capacity of this facility is determined by machine time, and there is a maximum of 10,000 hours of machine time. The facility can produce 10 pairs of Air Court shoes or 5 pairs of Air Max shoes in one hour of machine time. Unit data follow. Air Court Selling price per pair Variable costs per pair Contribution margin per pair Contribution margin ratio $80 60 $20 25% Air Max $120 84 $ 36 30% Which is more profitable, the Air Court or Air Max? On which should Nike spend its resources? The correct answer is, "It depends." Suppose the production facility has excess capacity of 1,000 hours of machine time. Now a sports retailer approaches Nike and wants them to fill a special order for 1,000 pairs of shoes of either type. Which shoe would be most profitable to fill this order, the Air Court or the Air Max? It would be better to produce and sell an Air Max pair contributing $36 than an Air Court pair contributing $20. In this case, Air Max shoes generate more profit per pair. Thus, if the limiting factor is demand, that is, pairs of shoes, the more profitable product is the one with the higher contribution per unit. Now suppose the demand for either shoe would fill the plant's capacity. Capacity is now the limiting factor because there is only one production facility in which to make either the Air Max or the Air Court. In this case, the Air Court shoe is more profitable. Why? Because it generates $2,000,000 of contribution margin from the capacity that is available compared to $1,800,000 for Air Max: Air Court 1. Pairs of shoes from 10,000 hours 2. Contribution margin per pair 3. Contribution margin from 10,000 hours of capacity, (1) (2) Contribution margin per machine hour, (3) 10,000 100,000 $ 20 $2,000,000 $ 200 $ Air Max 50,000 36 $1,800,000 $ 180 ISBN: 0-536-47129-0 Each machine hour used to produce Air Court shoes generates $200 of contribution, while an hour used to produce Air Max shoes generates only $180. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 6: Relevant Information for Decision Making with a Focus on Operational Decisions 261 Now suppose that neither shoe alone has enough demand to fill the entire capacity, but the combined demand will more than fill the capacity. What our analysis tells us is the Air Court shoe is a better use of the production capacity than is the Air Max shoe. Nike would want to make sure there are as many pairs of Air Court shoes available as customers demand, and only after satisfying this demand is it worth producing Air Max shoes. This analysis depends on the relative use of capacity by the two products. Suppose the facility can produce 7 instead of 5 Air Max shoes per hour of machine time. Then, the Air Max would be the most profitable use of plant capacity. It would have a $252 contribution for each machine hour compared with Air Court's $200. Air Court Contribution from 10,000 machine hours Contribution per machine hour Air Max 10,000 10 $20 = $2,000,000 $2,000,000 10,000 = $200 10,000 7 $36 = $2,520,000 $2,520,000 10,000 = $252 Any way we express it, Air Max shoes will have more contribution per unit of capacity-- per hour or per 10,000 hours. Note that each of these financial measures shows that Air Max shoes are 26% more profitable than the Air Court. For example, the contribution from the facility for Air Max is $520,000 more than for Air Court, that is, 26% = $520,000/$2,000,000 more. This issue of optimizing the use of scarce resources is important in non-manufacturing companies as well. In retail sales, the limiting resource is often floor space. Thus, retail stores often focus either on products taking up less space or on using the space for shorter periods of time--greater inventory turnover (number of times the average inventory is sold per year). However, the product that is most profitable when one particular factor limits sales may be the least profitable if a different factor restricts sales. Consider an example of two department stores. The conventional gross profit percentage (gross profit selling price) is an insufficient clue to profitability because, as we said, profits depend on the space occupied and the inventory turnover. Discount department stores, such as Wal-Mart, Target, and Kmart, have succeeded in using lower markups than traditional department stores because they have been able to increase turnover and, thus, increase the contribution to profit per unit of space. Exhibit 6-2 illustrates the same product, taking up the same amount of space, in each of two stores. The contribution margins per unit and per sales dollar are less in the discount store, but faster turnover makes the same product a more profitable use of space in the discount store. In general, retail companies seek faster inventory turnover. A survey of retail shoe stores showed that those with above-average financial performance had an inventory turnover of 2.6 times per year compared to an industry average of 2.0. inventory turnover The number of times the average inventory is sold per year. Exhibit 6-2 Regular Department Store Retail price Cost of merchandise and other variable costs Contribution to profit per unit Units sold per year Total contribution to profit, assuming the same space allotment in both stores $4.00 3.00 $1.00 (25%) 10,000 $10,000 Discount Department Store $3.50 3.00 $.50 (14%) 22,000 $11,000 Effect of Inventory Turnover on Profit ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 262 Part 1: Focus on Decision Making O B J E C T I V E Decide whether a joint product should be processed beyond the split-off point. 5 Joint Product Costs: Sell or Process Further Decisions We now examine another operating decision for which relevant costs are important-- decisions about whether to sell a product as it is or to further process it. In this section, we will examine how joint product costs affect such decisions. Consider ConAgra, which produces meat products with brand names such as Swift, Armour, and Butterball. ConAgra cannot kill a sirloin steak; it has to purchase and slaughter a steer, which supplies various cuts of dressed meat, hides, and trimmings. So how does ConAgra determine the proper allocation of the purchase cost paid for the steer to the various manufactured meat products? When two or more manufactured products (1) have relatively significant sales values and (2) are not separately identifiable as individual products until their split-off point, we call them joint products. The split-off point is that juncture of manufacturing where the joint products become individually identifiable. Any costs beyond that stage are separable costs because they are not part of the joint process and the accounting system can exclusively identify them with individual products. We call the costs of manufacturing joint products prior to the split-off point joint costs. Further examples of joint products include chemicals, lumber, flour, and the products of petroleum refining To illustrate joint costs, suppose Dow Chemical Company produces two chemical products, X and Y, as a result of a particular joint process. The joint processing cost is $100,000. This includes raw material costs and the cost of processing before the joint products X and Y reach the split-off point. At the split-off point, Dow either sells X and Y or processes them further before selling them to the petroleum industry, which uses them as ingredients of gasoline. The relationships follow: joint products Two or more manufactured products that (1) have relatively significant sales values and (2) are not separately identifiable as individual products until their split-off point. split-off point The juncture of manufacturing where the joint products become individually identifiable. separable costs Any cost beyond the split-off point. joint costs The costs of manufacturing joint products prior to the split-off point. 1,000,000 Liters of X @ Selling Price of $.09 Joint-Processing Cost, $100,000 500,000 Liters of Y @ Selling Price of $.06 $90,000 Split-Off Point $30,000 Total Sales Value at Split Off $120,000 Manufacturers that have joint products frequently face the decision to sell or to process further. Let's see how managers develop relevant information to help them decide whether to sell joint products at the split-off point or to process some or all products further. Sell or Process Further Consider again the situation described in the previous section where Dow Chemical has two joint products, X and Y. Suppose Dow can further process the 500,000 liters of Y and sell it to the plastics industry as product YA, an ingredient for plastic sheeting. The additional processing cost would be $.08 per liter for manufacturing and distribution, a total of $40,000 for 500,000 liters. The net sales price of YA would be $.16 per liter, a total of $80,000. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 6: Relevant Information for Decision Making with a Focus on Operational Decisions 263 Exhibit 6-3 Sell at Split-Off as Y Revenues Separable costs beyond split off @ $.08 Income effects $30,000 -- $30,000 Process Further and Sell as YA $80,000 40,000 $40,000 Illustration of Sell or Process Further Difference $50,000 40,000 $10,000 Dow cannot process product X further and will sell it at the split-off point, but management is undecided about product Y. Should the company sell Y at the split-off point, or should it process Y into YA? To answer this question, we need to find the relevant costs involved. Because Dow must incur the joint costs to reach the split-off point, those costs might seem relevant. However, they cannot affect anything beyond the split-off point. They violate both attributes of relevancy; they are neither future costs nor differential across alternatives. Therefore they are completely irrelevant to the question of whether to sell or process further. The only approach that will yield valid results is to concentrate on the separable costs and revenue beyond split-off, as shown in Exhibit 6-3. This analysis shows that it would be $10,000 more profitable to process Y beyond split-off than to sell Y at split-off. Briefly, it is profitable to extend processing or to incur additional distribution costs on a joint product if the additional revenue exceeds the additional expenses. Exhibit 6-4 illustrates another way to compare the alternatives of (1) selling Y at the split-off point and (2) processing Y beyond split-off. It includes the joint costs, which are the same for each alternative and, therefore, do not affect the difference. The allocation of joint costs would not affect the decision, as Exhibit 6-4 demonstrates. In the exhibit, we have not allocated the joint costs, but no matter how we might allocate them, the total income effects would not change. We provide additional coverage of joint costs and inventory valuation in Chapter 12. O B J E C T I V E Keeping or Replacing Equipment We next examine a common decision in business, the replacement of old equipment. One important aspect of such a situation is that the book value of the old equipment is not a relevant consideration in deciding whether to purchase a replacement. Why? Because it is a past cost, not a future cost. When a company purchases equipment, it spreads the cost via a depreciation expense over the future periods in which it will use the equipment. The Decide whether to keep or replace equipment. depreciation The periodic cost of equipment that a company spreads over the future periods in which the company will use the equipment. 6 (1) Alternative One X Revenues Joint costs Separable costs Total costs Income effects $90,000 Y $30,000 Total $120,000 $100,000 -- $100,000 $ 20,000 X $90,000 (2) Alternative Two YA $80,000 40,000 Total $170,000 $100,000 40,000 $140,000 $ 30,000 (3) Differential Effects $50,000 -- 40,000 $40,000 $10,000 ISBN: 0-536-47129-0 Exhibit 6-4 Sell or Process Further Analysis--Firm as a Whole Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 264 Part 1: Focus on Decision Making book value (net book value) The original cost of equipment less accumulated depreciation accumulated depreciation The sum of all depreciation charged to past periods. equipment's book value, or net book value, is the original cost less accumulated depreciation. Accumulated depreciation is the sum of all depreciation charged to past periods. For example, suppose a $10,000 machine with a ten-year life span has depreciation of $1,000 per year. At the end of six years, accumulated depreciation is 6 $1,000 = $6,000, and the book value is $10,000 - $6,000 = $4,000. Consider the following data for a decision whether to replace an old machine: Old Machine Original cost Useful life in years Current age in years Useful life remaining in years Accumulated depreciation Book value Disposal value (in cash) now Disposal value in four years Annual cash operating costs (maintenance, power, repairs, coolants, and so on) $10,000 10 6 4 $ 6,000 $ 4,000 $ 2,500 0 $ 5,000 Replacement Machine $8,000 4 0 4 0 Not acquired yet Not acquired yet 0 $3,000 sunk cost A historical or past cost, that is, a cost that the company has already incurred and, therefore, is irrelevant to the decisionmaking process. Let's prepare a comparative analysis of the two alternatives. Before proceeding, consider some important concepts. The most widely misunderstood facet of replacement decision making is the role of the book value of the old equipment in the decision. We often call the book value a sunk cost, which is really just another term for historical or past cost, a cost that the company has already incurred and, therefore, is irrelevant to the decision-making process. All past costs are down the drain. Nothing can change what has already happened. The Business First box on page 266 illustrates this concept. The irrelevance of past costs for decisions does not mean that knowledge of past costs is useless. Often managers use past costs to help predict future costs. In addition, past costs affect future payments for income taxes (as explained in Chapter 11). However, the past cost itself is not relevant. The only relevant cost is the predicted future cost. In deciding whether to replace or keep existing equipment, we must consider the relevance of four commonly encountered items:2 1. Book value of old equipment: irrelevant because it is a past (historical) cost. Therefore, depreciation on old equipment is irrelevant. 2. Disposal value of old equipment: relevant because it is an expected future inflow that usually differs among alternatives. 3. Gain or loss on disposal: This is the difference between book value and disposal value. It is therefore a meaningless combination of irrelevant and relevant items. The combination form, loss (or gain) on disposal, blurs the distinction between the irrelevant book value and the relevant disposal value. Consequently, it is best to think of each separately. 4. Cost of new equipment: relevant because it is an expected future outflow that will differ among alternatives. Therefore, the initial cost of new equipment (or its allocation in subsequent depreciation charges) is relevant. Exhibit 6-5 shows the relevance of these items in our example. Book value of old equipment is irrelevant regardless of the decision-making technique we use. The "differ2For simplicity, we ignore income-tax considerations and the effects of the interest value of money in this chapter. Book value is irrelevant even if income taxes are considered, however, because the relevant item is then the tax cash flow, not the book value. The book value is essential information for predicting the amount and timing of future tax cash flows (e.g., depreciation charges as well as gains or losses on disposal), but, by itself, the book value is irrelevant. For elaboration, see Chapter 11. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 6: Relevant Information for Decision Making with a Focus on Operational Decisions 265 Exhibit 6-5 Four Years Together Cash operating costs Old equipment (book value) Periodic write-off as depreciation or Lump-sum write-off Disposal value New machine Acquisition cost Total costs Keep $20,000 4,000 Replace $12,000 -- -- -- -- $24,000 4,000* 2,500* 8,000 $21,500 2,500 8,000 $ 2,500 Difference $ 8,000 Cost Comparison-- Replacement of Equipment Including Relevant and Irrelevant Items The advantage of replacement is $2,500 for the four years together. * In a formal income statement, these two items would be combined as "loss on disposal" of $4,000 $2,500 $1,500. In a formal income statement, written off as straight-line depreciation of $8,000 4 $2,000 for each of four years. ence" column in Exhibit 6-5 shows that the $4,000 book value of the old equipment does not differ between alternatives. We should completely ignore it for decision-making purposes. The difference is merely one of timing. The amount written off is still $4,000, regardless of any available alternative. The $4,000 appears on the income statement either as a $4,000 deduction from the $2,500 cash proceeds received to obtain a $1,500 loss on disposal in the first year or as $1,000 of depreciation in each of four years. But how it appears is irrelevant to the replacement decision. In contrast, the $2,000 annual depreciation on the new equipment is relevant because the total $8,000 depreciation is a future cost that we can avoid by not replacing. The three relevant items--operating costs, disposal value, and acquisition cost--give replacement a net advantage of $2,500. MAKING MANAGERIAL DECISIONS It is sometimes difficult to accept the proposition that past or sunk costs are irrelevant to decisions. Consider the ticket you have to a major football game in December. After getting the ticket, you learn that the game will be on TV, and you really prefer to watch the game in the comfort of your warm home. Does your decision about attending the game or watching it on TV depend on whether you were given the ticket for free or you paid $80 for it? What does this tell you about a manager's decision to replace a piece of equipment? you really prefer to watch the game on TV, it may have been a bad decision to pay $80 for a ticket. But you cannot erase that bad decision. All you can do is choose the future action that has the most value to you. You should not suffer through a less pleasant experience just because you paid $80 for the ticket. A manager must make the same analysis regarding the replacement of a piece of equipment. What the company spent for the old equipment is irrelevant. Keeping equipment that is no longer economical is just like using a ticket for an event that you would rather not attend. Additionally, keeping the equipment creates an opportunity cost from forgoing the disposal value of the old equipment, in the same way that keeping the ticket prevents you from reselling it to another fan (which is a relevant item in this scenario). Answer The amount paid, whether it be $0, $80, or $1,000, should make no difference to the decision. You have the ticket, and you have paid for it. That cannot be changed. If ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. SUNK COSTS AND GOVERNMENT CONTRACTS It is easy to agree that--in theor y--managers should ignore sunk costs when making decisions. But in practice, sunk costs often influence important decisions, especially when a decision maker doesn't want to admit that a previous decision to invest funds was a bad decision. Consider two examples from the St. Louis Post Dispatch: (1) Larry O. Welch, the Air Force Chief of Staff, was quoted as saying that "the B-2 already is into production; cancel it and the $17 billion front end investment is lost." (2) Les Aspin, chairman of the House Armed Ser vices Committee, was quoted as stating that "with $17 billion already invested in it, the B-2 is too costly to cancel." The $17 billion already invested in the B-2 is a sunk cost. It is "lost" regardless of whether the government cancels production of the B-2. And whether B-2 production is too costly to continue depends only on the future costs necessary to complete production compared to the value of the completed B-2s. The $17 billion was relevant when the Defense Department made the original decision to begin development of the B-2, but now that the money has been spent, it is no longer relevant. No decision can affect it. Why would intelligent leaders consider the $17 billion relevant to the decision on continuing production of the B-2? Probably because it is difficult to admit that the government would derive no benefit from the $17 billion investment. Those who favor canceling production of the B-2 would consider the outcome of the original investment decision to be unfavorable. With per fect hindsight, they believe the investment should not have been made. It is human nature to find unpleasant the task of admitting that $17 billion was wasted. Yet, it is more important to avoid throwing good money after bad--that is, if the value of the B-2 is not at least equal to the future investment in it, the Defense Department should terminate production, regardless of the amount spent to date. Failure to ignore sunk costs is not unique to the U.S. government. In reference to Russia's store of bomb-grade plutonium, the country's minister of atomic energy stated, "We have spent too much money making this material to just mix it with radioactive wastes and bury it." Burying the plutonium may or may not be the best decision, but the amount already spent is not relevant to the decision. Sources: Adapted from J. Berg, J. Dickhaut, and C. Kanodia, "The Role of Private Information in the Sunk Cost Phenomenon," unpublished paper, November 12, 1991; and M. Wald and M. Gordon, "Russia Treasures Plutonium, but U.S. Wants to Destroy It," New York Times, August 19, 1994, p. A1. Summary Problem for Your Review PROBLEM Exhibit 6-5 looks beyond one year. Examining the alternatives over the equipment's entire life ensures that peculiar nonrecurring items, such as loss on disposal, will not obstruct the long-run view vital to many managerial decisions. However, Exhibit 6-5 presents both relevant and irrelevant items. Prepare an analysis that concentrates on relevant items only. SOLUTION Exhibit 6-6 presents the analysis with relevant items only--the cash operating costs, the disposal value of the old equipment, and the acquisition cost of the new equipment. To demonstrate that the amount of the old equipment's book value will not affect the answer, suppose the book value of the old equipment is $500,000 rather than $4,000. Your final answer will not change. The cumulative advantage of replacement is still $2,500. (If you are in doubt, rework this example, using $500,000 as the book value.) ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 6: Relevant Information for Decision Making with a Focus on Operational Decisions 267 Four Years Together Cash operating costs Disposal value of old machine New machine, acquisition cost Total relevant costs Keep $20,000 -- -- $20,000 Replace $12,000 2,500 8,000 $17,500 Difference $ 8,000 2,500 8,000 $ 2,500 Exhibit 6-6 Cost Comparison--Replacement of Equipment, Relevant Items Only Identify Irrelevant or Misspecified Costs The ability to recognize irrelevant or misspecified costs is sometimes just as important to decision makers as identifying relevant costs. How do we know that past costs, although sometimes good predictors of future costs, are irrelevant in decision making? Let's consider such past costs as obsolete inventory and see why they are irrelevant to decisions. Suppose General Dynamics has 100 obsolete aircraft parts in its inventory. The original manufacturing cost of these parts was $100,000. General Dynamics can (1) remachine the parts for $30,000 and then sell them for $50,000 or (2) scrap them for $5,000. Which should it do? This is an unfortunate situation, yet the $100,000 past cost is irrelevant to the decision to remachine or scrap. The only relevant factors are the expected future revenues and costs: Remachine Expected future revenue Expected future costs Relevant excess of revenue over costs Accumulated historical inventory cost* Net overall loss on project *Irrelevant because it is unaffected by the decision. O B J E C T I V E Identify irrelevant and misspecified costs. 7 Scrap 5,000 -- $ 5,000 100,000 $ (95,000) $ Difference $45,000 30,000 $15,000 -- $15,000 $ 50,000 30,000 $ 20,000 100,000 $ (80,000) ISBN: 0-536-47129-0 As you can see from the fourth line of the preceding table, we can completely ignore the $100,000 historical cost and still arrive at the $15,000 difference, the key figure in the analysis that yields re-machining as the optimal decision. In addition to past costs, some future costs may be irrelevant because they will be the same under all feasible alternatives. These, too, we may safely ignore for a particular decision. The salaries of many members of top management are examples of expected future costs that will be unaffected by the decision at hand. Other irrelevant future costs include fixed costs that will be unchanged by such considerations as whether machine X or machine Y is selected. However, it is not merely a case of saying that fixed costs are irrelevant and variable costs are relevant. Variable costs can be irrelevant, and fixed costs can be relevant. For instance, sales commissions are a variable cost that is irrelevant to a decision on whether to produce a product in plant G or plant H. The rental cost of a warehouse is a fixed cost that is relevant if one alternative requires the warehouse while the other does not. Variable costs are irrelevant whenever they do not differ among the alternatives at hand, and fixed costs are relevant whenever they differ between the alternatives at hand. Finally, it is also critical in decision making to identify misspecified costs. The pricing illustration in Chapter 5 showed that managers should analyze unit costs with care in decision Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 268 Part 1: Focus on Decision Making making. There are two major ways to go wrong: (1) including irrelevant costs, such as the $.03 allocation of unavoidable fixed costs in the Nantucket Nectars make-or-buy example (p. 253) that would result in a unit cost of $.20 instead of the relevant unit cost of $.17 and (2) comparing unit costs not computed on the same volume basis, as the following example demonstrates. Machinery sales personnel often brag about the low unit costs of using the new machines. Sometimes they neglect to point out that the unit costs are based on outputs far in excess of the volume of activity of their prospective customer. Assume that a new $100,000 machine with a five-year life span can produce 100,000 units a year at a variable cost of $1 per unit, as opposed to a variable cost per unit of $1.50 with an old machine. A sales representative claims that the new machine will reduce cost by $.30 per unit. Is the new machine a worthwhile acquisition? The new machine is attractive at first glance. If the customer's expected volume is 100,000 units, unit-cost comparisons are valid, provided that new depreciation is also considered. Assume that the disposal value of the old equipment is zero. Because depreciation is an allocation of historical cost, the depreciation on the old machine is irrelevant. In contrast, the depreciation on the new machine is relevant because the new machine entails a future cost that the customer can avoid by not acquiring it. Old Machine Units Variable costs Straight-line depreciation Total relevant costs Unit relevant costs 100,000 $150,000 -- $150,000 $ 1.50 New Machine 100,000 $100,000 20,000 $120,000 $ 1.20 Apparently, the sales representative is correct. However, if the customer's expected volume is only 30,000 units per year, the unit costs change in favor of the old machine. Old Machine Units Variable costs Straight-line depreciation Total relevant costs Unit relevant costs 30,000 $45,000 -- $45,000 $ 1.50 New Machine 30,000 $30,000 20,000 $50,000 $1.6667 Generally, be wary of unit fixed costs. Use total fixed cost in your analysis, not fixed cost per unit. Why? Because you need to calculate a new fixed cost per unit for every different volume of production--often a cumbersome task--and if you don't recalculate it, your costs will be misspecified. Conflicts Between Decision Making and Performance Evaluation O B J E C T I V E Discuss how performance measures can affect decision making. 8 You should now know how to make good decisions based on relevant data. However, knowing how to make these decisions and actually making them are two different things. Managers might be tempted to make decisions they know are poor--not in the best interests of the company--if the performance measures in place will reward them for those decisions. To motivate managers to make optimal decisions, methods of evaluating managers' performance should be consistent with their appropriate decision model. Let's look at an example of a conflict between the analysis for decision making and the method used to evaluate performance. Consider the replacement decision shown in ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 6: Relevant Information for Decision Making with a Focus on Operational Decisions 269 Exhibit 6-6 on page 267, where replacing the machine had a $2,500 advantage over keeping it. To motivate managers to make the right choice, the method used to evaluate performance should be consistent with the decision model--that is, it should show better performance when managers replace the machine than when they keep it. Assume that top management uses accounting income to measure a manager's performance. The accounting income in the first year after replacement compared with that in years 2, 3, and 4 follows: Year 1 Keep Cash operating costs Depreciation Loss on disposal ($4,000 - $2,500) Total charges against revenue $5,000 1,000 -- $6,000 Replace $3,000 2,000 1,500 $6,500 Years 2, 3, and 4 Keep $5,000 1,000 -- $6,000 Replace $3,000 2,000 -- $5,000 ISBN: 0-536-47129-0 First-year costs will be $6,500 - $6,000 = $500 lower, and first-year income will be $500 higher, if the manager keeps the machine rather than replacing it. Because managers naturally want to make decisions that maximize the measure of their performance, the manager may be inclined to keep the machine. The conflict is especially severe if a company often transfers managers from one position to another. Why? Because the $500 first-year advantage for keeping the machine will be offset by a $1,000 annual advantage of replacing in years 2 to 4. (Note that the net difference of $2,500 in favor of replacement over the four years together is the same as in Exhibit 6-6.) A manager who moves to a new position after the first year, however, bears the entire loss on disposal without reaping the benefits of lower operating costs in years 2 to 4. The decision to replace a machine earlier than planned also reveals a possible error in the original decision to purchase the machine. The company bought the old machine 6 years ago for $10,000. Its expected life span was 10 years. However, if a better machine is now available, then the useful life of the old machine was really 6 years, not 10. This feedback on the actual life of the old machine has two possible effects, the first good and the second bad. First, managers might learn from the earlier mistake. If the manager overestimated the useful life of the old machine, how believable is the prediction that the new machine will have a four-year life span? Feedback can help avoid repeating past mistakes. Second, another mistake might be made to cover up the earlier one. A "loss on disposal" could alert superiors to the incorrect economic-life prediction used in the earlier decision. By avoiding replacement, the manager can spread the $4,000 remaining book value over the future as "depreciation," a more appealing term than "loss on disposal." The superiors may never find out about the incorrect prediction of economic life. The accounting income approach to performance evaluation mixes the financial effects of various decisions, hiding both the earlier misestimation of useful life and the current failure to replace. The conflict between decision making and performance evaluation is a widespread problem in practice. Unfortunately, there are no easy solutions. In theory, accountants could evaluate performance in a manner consistent with decision making. In our equipment example, this would mean predicting year-by-year income effects over the planning horizon of 4 years, noting that the first year would be poor, and evaluating actual performance against the predictions. The trouble is that evaluating performance, decision by decision, is a costly procedure. Therefore, we generally use aggregate measures. For example, an income statement shows the results of many decisions, not just the single decision of buying a machine. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 270 Part 1: Focus on Decision Making Consequently, in many cases like our equipment example, the first-year effects on the income statement may be the major influence on managers' decisions. Thus, managers refrain from taking the longer view that would benefit the company. Chapters 5 and 6 introduced the important topics of relevant information and decision making. Our major focus was on how to determine and use relevant information when faced with various managerial decisions such as pricing, special orders, make or buy, adding or deleting a product line, and equipment replacement. We have emphasized the importance of understanding cost behavior in each of these decision situations. Now, we shift our emphasis from decision-making techniques to planning and control techniques. One of the most important planning techniques you will use as a manager is budgeting-- the major topic in Chapters 7 and 8. Highlights to Remember Use a differential analysis to examine income effects across alternatives, and show that an opportunity cost analysis yields identical results. An incremental analysis is a valuable tool for analyzing decisions; it focuses on the relevant items in the situation. One should always consider opportunity costs when deciding on the use of limited resources. The opportunity cost of a course of action is the maximum profit forgone from other alternative actions. Decision makers may fail to consider opportunity costs because accountants do not report them in the financial accounting system. Decide whether to make or to buy certain parts or products. One of the most important production decisions is the make-or-buy decision. Should a company make its own parts or products or should it buy them from outside sources? Both qualitative and quantitative factors affect this decision. In applying relevant cost analysis to a make-or-buy situation, a key factor to consider is the use of facilities. 1 2 3 4 5 6 7 Choose whether to add or delete a product line using relevant information. Relevant information also plays an important role in decisions about adding or deleting products, services, or departments. Decisions on whether to delete a department or product line require analysis of the revenues forgone and the costs saved from the deletion. Compute the optimal product mix when production is constrained by a scarce resource. When production is constrained by a limiting resource, the key to obtaining the maximum profit from a given capacity is to obtain the greatest possible contribution to profit per unit of the limiting or scarce resource. Decide whether a joint product should be processed beyond the split-off point. Another typical production situation is deciding whether to process further a joint product or sell it at the split-off point. The relevant information for this decision includes the costs that differ beyond the split-off point. Joint costs that occur before split-off are irrelevant. Decide whether to keep or replace equipment. In the decision to keep or replace equipment, the book value of old equipment is irrelevant. This sunk cost is a past or historical cost that a company has already incurred. Relevant costs normally include the disposal value of old equipment, the cost of new equipment, and the difference in the annual operating costs. Identify irrelevant and misspecified costs. In certain production decisions, it is important to recognize and identify irrelevant costs. In the decision to dispose of obsolete inventory, the original cost of the inventory is irrelevant because there is no way to restore the resources used to buy or produce the inventory. Unit fixed costs can be misleading because of the differences in the assumed level of volume on which they are based. The more units a company makes, the lower the unit fixed cost will be. If a salesperson assumes a company will produce 100,000 units and it actually produces only 30,000 units, the unit costs will be understated. You can avoid being misled by unit costs by always using total fixed costs. Discuss how performance measures can affect decision making. If companies evaluate managers using performance measures that are not in line with relevant decision criteria, there could be a conflict of interest. Managers often make decisions based on how the decision affects their performance measures. Thus, performance measures work best when they are consistent with the long-term good of the company. 8 ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 6: Relevant Information for Decision Making with a Focus on Operational Decisions 271 Accounting Vocabulary accumulated depreciation, p. 264 avoidable costs, p. 257 book value, p. 264 common costs, p. 257 depreciation, p. 263 differential cost, p. 248 differential revenue, p. 248 incremental analysis, p. 248 incremental benefits, p. 248 incremental costs, p. 248 inventory turnover, p. 261 joint costs, p. 262 joint products, p. 262 limiting factor, p. 260 net book value, p. 264 opportunity cost, p. 249 outlay cost, p. 249 outsourcing, p. 251 scarce resource, p. 260 separable costs, p. 262 split-off point, p. 262 sunk cost, p. 264 unavoidable costs, p. 257 Fundamental Assignment Material 6-A1 Make or Buy Sunshine State Fruit Company sells premium-quality oranges and other citrus fruits by mail order. Protecting the fruit during shipping is important so the company has designed and produces shipping boxes. The annual cost to make 80,000 boxes is Materials Labor Indirect manufacturing costs Variable Fixed Total $120,000 20,000 16,000 60,000 $216,000 Therefore, the cost per box averages $2.70. Suppose Weyerhaeuser submits a bid to supply Sunshine State with boxes for $2.10 per box. Sunshine State must give Weyerhaeuser the box design specifications, and the boxes will be made according to those specs. 1. How much, if any, would Sunshine State save by buying the boxes from Weyerhaeuser? 2. What subjective factors should affect Sunshine State's decision whether to make or buy the boxes? 3. Suppose all the fixed costs represent depreciation on equipment that was purchased for $600,000 and is just about at the end of its 10-year life. New replacement equipment will cost $800,000 and is also expected to last 10 years. In this case, how much, if any, would Sunshine State save by buying the boxes from Weyerhaeuser? 6-A2 Choice of Products The Ibunez Tool Company has two products: a plain circular saw and a professional circular saw. The plain saw sells for $70 and has a variable cost of $50. The professional saw sells for $100 and has a variable cost of $70. 1. Compute contribution margins and contribution-margin ratios for plain and professional saws. 2. The demand is for more units than the company can produce. There are only 20,000 machine hours of manufacturing capacity available. Two plain saws can be produced in the same average time (1 hour) needed to produce one professional saw. Compute the total contribution margin for 20,000 hours for plain saws only and for professional saws only. Which product is the best use of machine hours? 3. Use two or three sentences to state the major lesson of this problem. 6-A3 Joint Products: Sell or Process Further The Mussina Chemical Company produced three joint products at a joint cost of $117,000. These products were processed further and sold as follows. Chemical Product ISBN: 0-536-47129-0 Sales $230,000 330,000 175,000 Additional Processing Costs $190,000 300,000 100,000 A B C Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 272 Part 1: Focus on Decision Making The company has had an opportunity to sell at split off directly to other processors. If that alternative had been selected, sales would have been A, $54,000; B, $32,000; and C, $54,000. The company expects to operate at the same level of production and sales in the forthcoming year. Consider all the available information, and assume that all costs incurred after split off are variable. 1. Could the company increase operating income by altering its processing decisions? If so, what would be the expected overall operating income? 2. Which products should be processed further and which should be sold at split off? 6-A4 Role of Old Equipment Replacement On January 2, 2007, the S. H. Park Company installed a brand-new $87,000 special molding machine for producing a new product. The product and the machine have an expected life of 3 years. The machine's expected disposal value at the end of 3 years is zero. On January 3, 2007, Kimiyo Lee, a star salesperson for a machine tool manufacturer, tells Mr. Park, "I wish I had known earlier of your purchase plans. I can supply you with a technically superior machine for $99,000. The machine you just purchased can be sold for $16,000. I guarantee that our machine will save $40,000 per year in cash operating costs, although it too will have no disposal value at the end of 3 years." Park examines some technical data. Although he has confidence in Lee's claims, Park contends, "I'm locked in now. My alternatives are clear: (a) Disposal will result in a loss, (b) keeping and using the `old' equipment avoids such a loss. I have brains enough to avoid a loss when my other alternative is recognizing a loss. We've got to use that equipment until we get our money out of it." The annual operating costs of the old machine are expected to be $60,000, exclusive of depreciation. Sales, all in cash, will be $910,000 per year. Other annual cash expenses will be $810,000 regardless of this decision. Assume that the equipment in question is the company's only fixed asset. Ignore income taxes and the time value of money. 1. Prepare statements of cash receipts and disbursements as they would appear in each of the next 3 years under both alternatives. What is the total cumulative increase or decrease in cash for the 3 years? 2. Prepare income statements as they would appear in each of the next 3 years under both alternatives. Assume straight-line depreciation. What is the cumulative increase or decrease in net income for the 3 years? 3. Assume that the cost of the "old" equipment was $1 million rather than $87,000. Would the net difference computed in numbers 1 and 2 change? Explain. 4. As Kimiyo Lee, reply to Mr. Park's contentions. 5. What are the irrelevant items in each of your presentations for numbers 1 and 2? Why are they irrelevant? 6-B1 Make or Buy Suppose a BMW executive in Germany is trying to decide whether the company should continue to manufacture an engine component or purchase it from Frankfurt Corporation for 50 each. Demand for the coming year is expected to be the same as for the current year, 200,000 units. Data for the current year follow: Direct material Direct labor Factory overhead, variable Factory overhead, fixed Total costs 5,000,000 1,900,000 1,100,000 2,500,000 10,500,000 If BMW makes the components, the unit costs of direct material will increase 10%. If BMW buys the components, 30% of the fixed costs will be avoided. The other 70% will continue regardless of whether the components are manufactured or purchased. Assume that variable overhead varies with output volume. 1. Prepare a schedule that compares the make-or-buy alternatives. Show totals and amounts per unit. Compute the numerical difference between making and buying. Assume that the capacity now used to make the components will become idle if the components are purchased. 2. Assume also that the BMW capacity in question can be rented to a local electronics firm for 1,250,000 for the coming year. Prepare a schedule that compares the net relevant costs of the ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 6: Relevant Information for Decision Making with a Focus on Operational Decisions 273 three alternatives: make, buy and leave capacity idle, buy and rent. Which is the most favorable alternative? By how much in total? 6-B2 Unit Costs and Capacity Fargo Manufacturing Company produces two industrial solvents for which the following data have been tabulated. Fixed manufacturing cost is applied to products at a rate of $1.00 per machine hour. Per Unit Selling price Variable manufacturing costs Fixed manufacturing cost Variable selling cost XY-7 $6.00 3.00 .80 2.00 BD-4 $4.00 1.50 .25 2.00 The sales manager has had a $160,000 increase in her budget allotment for advertising and wants to apply the money on the most profitable product. The solvents are not substitutes for one another in the eyes of the company's customers. 1. How many machine hours does it take to produce one XY-7? To produce one BD-4? (Hint: Focus on applied fixed manufacturing cost.) 2. Suppose Fargo has only 100,000 machine hours that can be made available to produce XY-7 and BD-4. If the potential increase in sales units for either product resulting from advertising is far in excess of these production capabilities, which product should be produced and advertised, and what is the estimated increase in contribution margin earned? 6-B3 Dropping a Product Line Hambley's Toy Store is on Regent Street in London. It has a magic department near the main door. Suppose that management is considering dropping the magic department, which has consistently shown an operating loss. The predicted income statements, in thousands of pounds (), follow (for ease of analysis, only three product lines are shown): General Merchandise 5,000 3,500 1,500 (30%) Electronic Products 400 200 200 (50%) Magic Department 600 390 210 (35%) Total Sales Variable expenses Contribution margin Fixed expenses (compensation, depreciation, property taxes, insurance, etc.) Operating income (loss) 6,000 4,090 1,910 (32%) 1,110 800 750 750 50 150 310 (100) ISBN: 0-536-47129-0 The 310,000 of magic department fixed expenses include the compensation of employees of 100,000. These employees will be released if the magic department is abandoned. All of the magic department's equipment is fully depreciated, so none of the 310,000 pertains to such items. Furthermore, disposal values of equipment will be exactly offset by the costs of removal and remodeling. If the magic department is dropped, the manager will use the vacated space for either more general merchandise or more electronic products. The expansion of general merchandise would not entail hiring any additional salaried help, but more electronic products would require an additional person at an annual cost of 25,000. The manager thinks that sales of general merchandise would increase by 300,000; electronic products, by 200,000. The manager's modest predictions are partially based on the fact that she thinks the magic department has helped lure customers to the store and, thus, improved overall sales. If the magic department is closed, that lure would be gone. Should the magic department be closed? Explain, showing computations. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 274 Part 1: Focus on Decision Making 6-B4 Sell or Process Further ConAgra produces meat products with brand names such as Healthy Choice, Armour, and Butterball. Suppose one of the company's plants processes beef cattle into various products. For simplicity, assume that there are only three products: steak, hamburger, and hides, and that the average steer costs $700. The three products emerge from a process that costs $100 per steer to run, and output from one steer can be sold for the following net amounts. Steak (100 pounds) Hamburger (500 pounds) Hide (120 pounds) Total $ 400 600 100 $1,100 Assume that each of these three products can be sold immediately or processed further in another ConAgra plant. The steak can be the main course in frozen dinners sold under the Healthy Choice label. The vegetables and desserts in the 400 dinners produced from the 100 pounds of steak would cost $120, and production, sales, and other costs for the 400 meals would total $350. Each meal would be sold wholesale for $2.15. The hamburger could be made into frozen Salisbury steak patties sold under the Armour label. The only additional cost would be a $200 processing cost for the 500 pounds of hamburger. Frozen Salisbury steaks sell wholesale for $1.70 per pound. The hide can be sold before or after tanning. The cost of tanning one hide is $80, and a tanned hide can be sold for $175. 1. 2. 3. 4. Compute the total profit if all three products are sold at the split-off point. Compute the total profit if all three products are processed further before being sold. Which products should be sold at the split-off point? Which should be processed further? Compute the total profit if your plan in number 3 is followed. 6-B5 Replacing Old Equipment Consider these data regarding Douglas County's photocopying requirements: Proposed Replacement Equipment 3 0 3 $15,000 0 Not acquired yet Not acquired yet 0 8,000 Old Equipment Useful life, in years Current age, in years Useful life remaining, in years Original cost Accumulated depreciation Book value Disposal value (in cash) now Disposal value in 3 years Annual cash operating costs for power, maintenance, toner, and supplies 5 2 3 $25,000 10,000 15,000 7,000 0 14,000 The county administrator is trying to decide whether to replace the old equipment. Because of rapid changes in technology, she expects the replacement equipment to have only a 3-year useful life. Ignore the effects of taxes. 1. Prepare a schedule that compares both relevant and irrelevant items for the next 3 years together. (Hint: See Exhibit 6-5, page 265.) 2. Prepare a schedule that compares all relevant items for the next 3 years together. Which tabulation is clearer, this one or the one in requirement 1? (Hint: See Exhibit 6-6, page 267.) 3. Prepare a simple "shortcut" or direct analysis to support your choice of alternatives. 6-B6 Decision and Performance Models Refer to the preceding problem. ISBN: 0-536-47129-0 1. Suppose the "decision model" favored by top management consisted of a comparison of a 3-year accumulation of cash under each alternative. As the manager of office operations, which alternative would you choose? Why? 2. Suppose the "performance evaluation model" emphasized the minimization of overall costs of photocopying operations for the first year. Which alternative would you choose? Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 6: Relevant Information for Decision Making with a Focus on Operational Decisions 275 Additional Assignment Material Questions 6-1 Distinguish between an opportunity cost and an outlay cost. 6-2 "I had a chance to rent my summer home for two weeks for $800. But I chose to have it idle. I didn't want strangers living in my summer house." What term in this chapter describes the $800? Why? agement decisions regarding whether a product should be sold at the split-off point or processed further." Do you agree? Explain. 6-14 "Inventory that was purchased for $5,000 should not be sold for less than $5,000 because such a sale would result in a loss." Do you agree? Explain. 6-3 "Accountants do not ordinarily record opportunity costs in the formal accounting records." Why? 6-15 "Recovering sunk costs is a major objective when replacing equipment." Do you agree? Explain. 6-16 "Past costs are indeed relevant in most instances because they provide the point of departure for the entire decision process." Do you agree? Why? 6-17 Which of the following items are relevant to replacement decisions? Explain. a. Book value of old equipment b. Disposal value of old equipment c. Cost of new equipment 6-4 Distinguish between an incremental cost and a differential cost. 6-5 "Incremental cost is the addition to costs from the manufacture of one unit." Do you agree? Explain. 6-6 "The differential costs or incremental costs of increasing production from 1,000 automobiles to 1,200 automobiles per week would be the additional costs of producing the additional 200 automobiles." If production were reduced from 1,200 to 1,000 automobiles per week, what would the decline in costs be called? 6-18 "Some expected future costs may be irrelevant." Do you agree? Explain. 6-19 "Variable costs are irrelevant whenever they do not differ among the alternatives at hand." Do you agree? Explain. 6-7 "Qualitative factors generally favor making over buying a component." Do you agree? Explain. 6-8 "Choices are often mislabeled as simply make or buy." Do you agree? Explain. 6-20 There are two major reasons why unit costs should be analyzed with care in decision making. What are they? 6-21 "Machinery sales personnel sometimes erroneously brag about the low unit costs of using their machines." Identify one source of an error concerning the estimation of unit costs. 6-22 Give an example of a situation in which the performance evaluation model is not consistent with the decision model. 6-9 "The key to decisions to delete a product or department is identifying avoidable costs." Do you agree? Explain. 6-10 Give four examples of limiting or scarce factors. 6-11 What are joint products? Name several examples of joint products. 6-12 What is the split-off point, and why is it important in analyzing joint costs? 6-23 "Evaluating performance, decision by decision, is costly. Aggregate measures, such as the income statement, are frequently used." How might the wide use of income statements affect managers' decisions about buying equipment? 6-13 "No technique used to assign the joint cost to individual products should be used for man- Critical Thinking Exercises 6-24 Measurement of Opportunity Cost "Accountants cannot measure opportunity cost. Only managers have the knowledge to measure it." Do you agree with this statement? Why or why not? 6-25 Outsourcing Decisions Decisions on whether to outsource services such as payroll accounting and systems development are much like make-or-buy decisions. What cost factors should influence the decision on whether to outsource payroll functions? ISBN: 0-536-47129-0 6-26 Unitized Costs Suppose you are a manager in a manufacturing company. Your accountant has just presented you with a very detailed cost analysis for a decision whether to outsource or make a component of a product. You have to use this analysis in a meeting with other managers. Since the analysis is shown in totals and your colleagues prefer simple reports and unit costs, you divide the bottom-line amounts by the Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 276 Part 1: Focus on Decision Making total units to be made or bought (outsourced) and present just these in a simple report. Your colleagues are pleased that your report is so easy to understand and simple to use. Then they begin to predict the total cost differences for several other possible number of units to be made or outsourced by simply multiplying the unit costs by the volume to be outsourced. Why should you feel uncomfortable? 6-27 Historical Costs and Inventory Decisions Explain why it is sometimes best to sell inventory for less than the amount paid for it. Exercises 6-28 Opportunity Costs Martina Bridgeman is an attorney employed by a large law firm at a salary of $110,000 per year. She is considering whether to become a sole practitioner, which would probably generate annually $340,000 in operating revenues and $220,000 in operating expenses. 1. Present two tabulations of the annual income effects of these alternatives. The second tabulation should include the opportunity cost of Bridgeman's compensation as an employee. 2. Suppose Bridgeman prefers less risk and chooses to stay an employee. Show a tabulation of the income effects of rejecting the opportunity of independent practice. 6-29 Opportunity Cost of Home Ownership Oliver Kamp has just made the final payment on his mortgage. He could continue to live in the home; cash expenses for repairs and maintenance (after any tax effects) would be $500 monthly. Alternatively, he could sell the home for $200,000 (net of taxes), invest the proceeds in 5% municipal tax-free bonds, and rent an apartment for $12,000 annually. The landlord would then pay for repairs and maintenance. Prepare two analyses of Kamp's alternatives, one showing no explicit opportunity cost and the second showing the explicit opportunity cost of the decision to hold the present home. 6-30 Opportunity Cost at Nantucket Nectars Suppose Nantucket Nectars has a machine for which it paid $160,000 several years ago and is currently not being used. It can use the machine to produce 12 oz. bottles of its Juice Cocktails or 12 oz. bottles of its 100% Juices. The contribution margin from the additional sales of 100% Juices would be $90,000. A third alternative is selling the machine for cash of $75,000. What is the opportunity cost of the machine when we analyze the alternative to produce 12 oz. bottles of Juice Cocktails? 6-31 Hospital Opportunity Cost An administrator at Saint Jude Hospital is considering how to use some space made available when the outpatient clinic moved to a new building. She has narrowed her choices, as follows: a. Use the space to expand laboratory testing. Expected future annual revenue would be $330,000; future costs, $290,000. b. Use the space to expand the eye clinic. Expected future annual revenue would be $500,000; future costs, $480,000. c. The gift shop is rented by an independent retailer who wants to expand into the vacated space. The retailer has offered $11,000 for the yearly rental of the space. All operating expenses will be borne by the retailer. The administrator's planning horizon is unsettled. However, she has decided that the yearly data given will suffice for guiding her decision. Tabulate the total relevant data regarding the decision alternatives. Omit the concept of opportunity cost in one tabulation, but use the concept in a second tabulation. As the administrator, which tabulation would you prefer if you could receive only one? 6-32 Make or Buy Assume that a division of Bose makes an electronic component for its speakers. Its manufacturing process for the component is a highly automated part of a just-in-time production system. All labor is considered to be an overhead cost, and all overhead is regarded as fixed with respect to output volume. Production costs for 100,000 units of the component are as follows: Direct materials Factory overhead Indirect labor Supplies Allocated occupancy cost Total cost $300,000 ISBN: 0-536-47129-0 $80,000 30,000 40,000 150,000 $450,000 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 6: Relevant Information for Decision Making with a Focus on Operational Decisions 277 A small, local company has offered to supply the components at a price of $3.30 each. If the division discontinued its production of the component, it would save two-thirds of the supplies cost and $30,000 of indirect-labor cost. All other overhead costs would continue. The division manager recently attended a seminar on cost behavior and learned about fixed and variable costs. He wants to continue to make the component because the variable cost of $3.00 is below the $3.30 bid. 1. Compute the relevant cost of (a) making and (b) purchasing the component. Which alternative is less costly and by how much? 2. What qualitative factors might influence the decision about whether to make or to buy the component? 6-33 Make or Buy at Nantucket Nectars Assume that Nantucket Nectars reports the following costs to make 17.5 oz. bottles for its Juice Cocktails: Nantucket Nectars Company Cost of Making 17.5-Ounce Bottles Total Cost for 1,000,000 Bottles Direct materials Direct labor Variable factory overhead Fixed factory overhead Total costs $ 80,000 30,000 60,000 85,000 $255,000 Cost per Bottle $.080 .030 .060 .085 $.255 Another manufacturer offers to sell Nantucket Nectars the bottles for $.25. The capacity now used to make bottles will become idle if the company purchases the bottles. Further, one supervisor with a salary of $60,000, a fixed cost, would be eliminated if the bottles were purchased. Prepare a schedule that compares the costs to make and buy the 17.5 oz. bottles. Should Nantucket Nectars make or buy the bottles? 6-34 Make or Buy and the Use of Idle Facilities at Nantucket Nectars Refer to the preceding exercise. Suppose Nantucket Nectars can use the released facilities in another manufacturing activity that makes a contribution to profits of $75,000 or can rent them out for $55,000. Prepare a schedule that compares the four alternative courses of action. Which alternative would yield the lowest net cost? 6-35 Profit per Unit of Space 1. Several successful chains of warehouse stores such as Costco and Sam's Club have merchandising policies that differ considerably from those of traditional department stores. Name some characteristics of these warehouse stores that have contributed to their success. 2. Food chains such as Safeway have typically regarded approximately 20% of selling price as an average target gross profit on canned goods and similar grocery items. What are the limitations of such an approach? Be specific. 6-36 Deletion of Product Line Zurich American School is an international private elementary school. In addition to regular classes, after-school care is provided between 3:00 PM and 6:00 PM at SFR 12 per child per hour. Financial results for the after-school care for a representative month are Revenue, 600 hours @ SFR 12 per hour Less Teacher salaries Supplies Depreciation Sanitary engineering Other fixed costs Operating income (loss) SFR 7,200 SFR 5,200 800 1,300 100 200 ISBN: 0-536-47129-0 7,600 SFR (400) Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 278 Part 1: Focus on Decision Making The director of Zurich American School is considering discontinuing the after-school care services because it is not fair to the other students to subsidize the after-school care program. He thinks that eliminating the program will free up SFR 400 a month to support regular classes. 1. Compute the financial impact on Zurich American School from discontinuing the after-school care program. 2. List three qualitative factors that would influence your decision. 6-37 Sell or Process Further An Exxon petrochemical factory produces two products, L and M, as a result of a particular joint process. Both products are sold to manufacturers as ingredients for assorted chemical products. Product L sells at split off for $.25 per gallon; M, for $.30 per gallon. Data for April follow: Joint processing cost Gallons produced and sold L M $1,600,000 4,000,000 2,500,000 Suppose that in April the 2,500,000 gallons of M could have been processed further into Super M at an additional cost of $210,000. The Super M output would be sold for $.38 per gallon. Product L would be sold at split off in any event. Should M have been processed further in April and sold as Super M? Show your computations. 6-38 Joint Products, Multiple Choice From a particular joint process, Edgerton company produces three products, A, B, and C. Each product may be sold at the point of split off or processed further. Additional processing requires no special facilities, and production costs of further processing are entirely variable and traceable to the products involved. In 2006, all three products were processed beyond split off. Joint production costs for the year were $72,000. Sales values and costs needed to evaluate Edgerton's 2006 production policy follow: Additional Costs and Sales Values if Processed Further Net Realizable Values (Sales Values) at Split Off $25,000 41,000 24,000 Sales Values $42,000 45,000 32,000 Added Costs $ 9,000 7,000 10,000 Product A B C Units Produced 6,000 4,000 2,000 Answer the following multiple-choice questions: 1. For units of C, the unit production cost most relevant to a sell-or-process-further decision is (a) $5, (b) $12, (c) $4, (d) $9. 2. To maximize profits, Edgerton should subject the following products to additional processing: (a) A only, (b) A, B, and C, (c) B and C only, (d) C only. 6-39 Obsolete Inventory The Ohio State bookstore bought more "Buckeye Champs" calendars than it could sell. It was nearly June and 200 calendars remained in stock. The store paid $4.50 each for the calendars and normally sold them for $8.95. Since February, they had been on sale for $6.00, and two weeks ago the price was dropped to $5.00. Still, few calendars were being sold. The bookstore manager thought it was no longer worthwhile using shelf space for the calendars. The proprietor of Hurricane Collectibles offered to buy all 200 calendars for $100. He intended to store them until the 2006 football season was over and then sell them as novelty items. ISBN: 0-536-47129-0 Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 6: Relevant Information for Decision Making with a Focus on Operational Decisions 279 The bookstore manager was not sure she wanted to sell for $.50 calendars that cost $4.50. The only alternative, however, was to scrap them because the publisher would not take them back. 1. Compute the difference in profit between accepting the $100 offer and scrapping the calendars. 2. Describe how the $4.50 200 = $900 paid for the calendars affects your decision. 6-40 Replacement of Old Equipment Three years ago, the Oak Street TCBY bought a frozen yogurt machine for $8,000. A salesman has just suggested to the TCBY manager that she replace the machine with a new, $12,500 machine. The manager has gathered the following data: Old Machine Original cost Useful life in years Current age in years Useful life remaining in years Accumulated depreciation Book value Disposal value (in cash) now Disposal value in 5 years Annual cash operating cost $8,000 8 3 5 $3,000 $5,000 $3,000 0 $4,500 New Machine $12,500 5 0 5 Not acquired yet Not acquired yet Not acquired yet 0 $ 2,000 1. Compute the difference in total costs over the next five years under both alternatives, that is, keeping the original machine or replacing it with the new machine. Ignore taxes. 2. Suppose the Oak Street TCBY manager replaces the original machine. Compute the "loss on disposal" of the original machine. How does this amount affect your computation in number 1? Explain. 6-41 Unit Costs Brandon Company produces and sells a product that has variable costs of $9 per unit and fixed costs of $220,000 per year. 1. Compute the unit cost at a production and sales level of 10,000 units per year. 2. Compute the unit cost at a production and sales level of 20,000 units per year. 3. Which of these unit costs is most accurate? Explain. 6-42 Relevant Investment Roberta Thomas had obtained a new truck with a list price, including options, of $21,000. The dealer had given her a "generous trade-in allowance" of $5,000 on her old truck that had a wholesale price of $3,000. Sales tax was $1,260. The annual cash operating costs of the old truck were $4,200. The new truck was expected to reduce these costs by one-third, to $2,800 per year. Compute the amount of the original investment in the new truck. Explain your reasoning. 6-43 Weak Division Lake Forest Electronics Company paid $7 million in cash 4 years ago to acquire a company that manufactures CD-ROM drives. This company has been operated as a division of Lake Forest and has lost $500,000 each year since its acquisition. The minimum desired return for this division is that, when a new product is fully developed, it should return a net profit of $500,000 per year for the foreseeable future. Recently, the IBM Corporation offered to purchase the division from Lake Forest for $5 million. The president of Lake Forest commented, "I've got an investment of $9 million to recoup ($7 million plus losses of $500,000 for each of four years). I have finally got this situation turned around, so I oppose selling the division now." Prepare a response to the president's remarks. Indicate how to make this decision. Be as specific as possible. ISBN: 0-536-47129-0 6-44 Opportunity Cost Renee Behr, MD, is a psychiatrist who is in heavy demand. Even though she has raised her fees considerably during the past five years, Dr. Behr still cannot accommodate all the patients who wish to see her. Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 280 Part 1: Focus on Decision Making Behr has conducted 6 hours of appointments a day, 6 days a week, for 48 weeks a year. Her fee averages $150 per hour. Her variable costs are negligible and may be ignored for decision purposes. Ignore income taxes. 1. Behr is weary of working a six-day week. She is considering taking every other Saturday off. What would be her annual income (a) if she worked every Saturday and (b) if she worked every other Saturday? 2. What would be her opportunity cost for the year of not working every other Saturday? 3. Assume that Dr. Behr has definitely decided to take every other Saturday off. She loves to repair her sports car by doing the work herself. If she works on her car during half a Saturday when she otherwise would not see patients, what is her opportunity cost? Problems 6-45 Hotel Rooms and Opportunity Costs The Marriott Corporation operates many hotels throughout the world. Suppose one of its Chicago hotels is facing difficult times because of the opening of several new competing hotels. To accommodate its flight personnel, American Airlines has offered Marriott a contract for the coming year that provides a rate of $70 per night per room for a minimum of 50 rooms for 365 nights. This contract would assure Marriott of selling 50 rooms of space nightly, even if some of the rooms are vacant on some nights. Assume zero variable costs. The Marriott manager has mixed feelings about the contract. On several peak nights during the year, the hotel could sell the same space for $150 per room. 1. Suppose the Marriott manager signs the contract. What is the opportunity cost of the 50 rooms on October 20, the night of a big convention of retailers when every nearby hotel room is occupied? What is the opportunity cost on December 28, when only 10 of these rooms would be expected to be rented at an average rate of $100? 2. If the year-round rate per room averaged $110, what percentage of occupancy of the 50 rooms in question would have to be rented to make Marriott indifferent about accepting the offer? 6-46 Extension of Preceding Problem Assume the same facts as in the preceding problem. However, also assume that the variable costs per room, per day are $10. 1. Suppose the best estimate is a 62% general occupancy rate for the 50 rooms at an average $110 room rate for the next year. Should Marriott accept the contract? 2. What percentage of occupancy of the 50 rooms in question would make Marriott indifferent about accepting the offer? 6-47 Make or Buy Dana Corporation, based in Toledo, Ohio, is a global manufacturer of highly engineered products that serve industrial, vehicle, construction, commercial, aerospace, and semiconductor markets. Dana's 2006 sales were $10.3 billion. It frequently subcontracts work to other manufacturers, depending on whether Dana's facilities are fully occupied. Suppose Dana is about to make some final decisions regarding the use of its manufacturing facilities for the coming year. The following are the costs of making part EC113, a key component of an emissions control system: Total Cost for 50,000 Units Direct materials Direct labor Variable factory overhead Fixed factory overhead Total manufacturing costs $ 400,000 300,000 150,000 300,000 $1,150,000 Cost per Unit $ 8 6 3 6 $23 ISBN: 0-536-47129-0 Another manufacturer has offered to sell the same part to Dana for $21 each. The fixed overhead consists of depreciation, property taxes, insurance, and supervisory salaries. All the fixed overhead Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. Chapter 6: Relevant Information for Decision Making with a Focus on Operational Decisions 281 would continue if Dana bought the component except that the cost of $150,000 pertaining to some supervisory and custodial personnel could be avoided. 1. Assume that the capacity now used to make parts will become idle if the parts are purchased. Should Dana buy or make the parts? Show computations. 2. Assume that the capacity now used to make parts will either (a) be rented to a nearby manufacturer for $65,000 for the year or (b) be used to make oil filters that will yield a profit contribution of $200,000. Should Dana buy or make part EC113? Show your computations. 6-48 Relevant-Cost Analysis Following are the unit costs of making and selling a single product at a normal level of 5,000 units per month and a current unit selling price of $90: Manufacturing costs Direct materials Direct labor Variable overhead Fixed overhead (total for the year, $300,000) Selling and administrative expenses Variable Fixed (total for the year, $480,000) $35 12 8 5 15 8 Consider each requirement separately. Label all computations, and present your solutions in a form that will be comprehensible to the company president. 1. This product is usually sold at a rate of 60,000 units per year. It is predicted that a rise in price to $98 will decrease volume by 10%. How much may advertising be increased under this plan without having annual operating income fall below the current level? 2. The company has received a proposal from an outside supplier to make and ship this item directly to the company's customers as sales orders are forwarded. Variable selling and administrative costs would fall 40%. If the supplier's proposal is accepted, the company will use its own plant to produce a new product. The new product would be sold through manufacturer's agents at a 10% commission based on a selling price of $40 each. The cost characteristics of this product, based on predicted yearly normal volume, are as follows: Per Unit Direct materials Direct labor Variable overhead Fixed overhead Manufacturing costs Selling and administrative expenses Variable (commission) Fixed $ 6 12 8 6 $32 10% of selling price $ 2 What is the maximum price per unit that the company can afford to pay to the supplier for subcontracting production of the entire old product? Assume the following: Total fixed factory overhead and total fixed selling expenses will not change if the new product line is added. The supplier's proposal will not be considered unless the present annual net income can be maintained. Selling price of the old product will remain unchanged. All $300,000 of fixed manufacturing overhead will be assigned to the new product. ISBN: 0-536-47129-0 6-49 Hotel Pricing and Use of Capacity A growing corporation in a large city has offered a 200-room Holiday Inn a 1-year contract to rent 40 rooms at reduced rates of $50 per room instead of the regular rate of $86 per room. The corporation Introduction to Management Accounting: Chapters 1-17, Fourteenth Edition, by Charles T. Horngren, Gary L. Sundem, William O. Stratton, David Burgstahler, and Jeff Schatzberg. Published by Prentice Hall. Copyright 2008 by Pearson Education, Inc. 282 Part 1: Focus on Decision Making will sign the contract for 365-day occupancy because its visiting manufacturing and marketing personnel are virtually certain to use all the space each night. Each room occupied has a variable cost of $12 per night (for cleaning, laundry, lost linens, and extra electricity). The hotel manager expects an 85% occupancy rate for the year so she is reluctant to sign the contract. If the contract is signed, the occupancy rate on the remaining 160 rooms will be 95%. 1. Compute the total contribution margin for the year with and without the contract. Is the contract profitable to Holiday Inn? 2. Compute the lowest room rate that the hotel should accept on the contract so that the total contribution margin would be the same with or without the contract. 6-50 Special Air Fares Denver-based Frontier Airlines provides service to 39 cities in the United States and Mexico. Frontier operates a fleet of 37 aircraft including sixteen 134-passenger Boeing 737-300 jets. The manager of operations of Frontier Airlines is trying to decide whether to adopt a new discount fare. Focus on one 134-seat 737 airplane now operating at a 56% load factor. That is, on average the airplane has .56 134 = 75 passengers. The regular fares produce an average revenue of $.12 per passenger mile. Suppose an average 40% fare discount (which is subject to restrictions regarding time of departure and length of stay) will produce three new additional passengers. Also suppose that three of the previously committed passengers accept the restrictions and switch to the discount fare from the regular fare. 1. Compute the total revenue per airplane mile with and without the discount fares. 2. Suppose the maximum allowed allocation to new discount fares is 50 seats. These will be filled. As before, some previously committed passengers will accept the restrictions and switch to the discount fare from the regular fare. How many will have to switch so that the total revenue per mile will be the same either with or without the discount plan? 6-51 Choice of Products Gulf Coast Fashions sells both designer and moderately priced women's wear in Tampa. Profits have been volatile. Top management is trying to decide which product line to drop. Accountants have reported the following data: Per Item Designer Average selling price Average variable expenses Average contribution margin Average contribution-margin percentage $240 120 $120 50% Moderately Priced $150 85 $ 65 43% The store has 8,000 square feet of floor space. If moderately priced goods are sold e