Relevant G1: Cost Analysis in a Variety of Situations
Barker Company has a single product called a Zet. The company normally produces and
sells 80,000 Zets each year at a selling price of $40 per unit. The company's unit costs at this level
of activity are given below:
Direct materials
$ 9.50
Direct labor
10.00
Variable manufacturing overhead
2.80
Fixed manufacturing overhead
total)
5.00 ($400,000
Variable selling expenses
1.70
Fixed selling expenses
4,50 ($360,000 total)
Total cost per unit.
$33.50
A number of questions relating to the production and sale of Zets are given below. Each
question is independent.
Required:
1. Assume that Barker Company has sufficient capacity to produce 100,000 Zets each year
without any increase in fixed manufacturing overhead costs. The company could increase sales by
25% above the present 80,000 units each year if it were willing to increase the fixed selling
expenses by $150,000. Would the increased fixed selling expenses be justified?
2. Assume again that Barker Company has sufficient capacity to produce 100,000 Zets each year.
The company has an opportunity to sell 20,000 units in an overseas market. Import duties, foreign
permits, and other special costs associated with the order would total $14,000. The only selling
costs that would be associated with the order would be $1.50 per unit shipping cost. Compute the
per unit break-even price on this order.
3. One of the materials used in the production of Zets is obtained from a foreign supplier. Civil
unrest in the supplier's country has caused a cutoff in material shipments that is expected to last
for three months. Barker Company has enough material on hand to operate at 25% of normal
1
levels for the three-month period. As an alternative, the company could close the plant down
entirely for the three months. Closing the plant would reduce fixed manufacturing overhead costs
by 40% during the three-month period and the fixed selling expenses would continue at twothirds of their normal level. What would be the impact on profits of closing the plant for the
three-month period?
4. The company has 500 Zets on hand that were produced last month and have small blemishes.
Due to the blemishes, it will be impossible to sell these units at the normal price. If the company
wishes to sell them through regular distribution channels, what unit cost figure is relevant for
setting a minimum selling price? Explain.
5. An outside manufacturer has offered to produce Zets and ship them directly to Barker's
customers. If Barker Company accepts this offer, the facilities that it uses to produce Zets would
be idle; however, fixed manufacturing overhead costs would continue at 30%. Since the outside
manufacturer would pay for all shipping costs the variable selling expenses would be reduced by
60%. Compute the unit cost that is relevant for comparison to the price quoted by the outside
manufacturer.
2
G2: Ethics and the Manager; Shut Down or Continue Operations
Marvin Braun had just been appointed vice president of the Great Basin Region of the
Financial Services Corporation (FSC). The company provides check processing services for small
banks. The banks send checks presented for deposit or payment to FSC, which then records the
data on each check in a computerized database. FSC sends the data electronically to the nearest
Federal Reserve Bank check-clearing center where the appropriate transfers of funds are made
between banks. The Great Basin Region consists of three check processing centers in Eastern
IdahoPocatello, Idaho Falls, and Ashton. Prior to his promotion to vice president, Mr. Braun
had been manager of a check processing center in Indiana.
Immediately upon assuming his new position, Mr. Braun requested a complete financial
report for the just-ended fiscal year from the region's controller, Lance Whiting. Mr. Braun
specified that the financial report should follow the standardized format required by corporate
headquarters for all regional performance reports. That report appears below:
Financial Performance
Great Basin Region
Check Processing Centers
Total
Pocatello
Idaho Falls
Ashton
$20,000,000
$7,000,000
$8,000,000
$5,000,000
12,200,000
4,400,000
4,700,000
3,100,000
400,000
150,000
160,000
90,000
Equipment depreciation
2,100,000
700,000
800,000
600,000
Facility expenses
2,000,000
600,000
500,000
900,000
450,000
150,000
180,000
120,000
400,000
140,000
160,000
100,000
1,600,000
560,000
640,000
400,000
Revenues
Operating expenses:
Direct labor
Variable overhead
Local administrative expenses*
Regional administrative
expenses*
Corporate administrative
expenses*
3
Total operating expense
19,150,000
6,700,000
7,140,000
5,310,000
Net operating income
$ 850,000
$ 300,000
$ 860,000
$ (310,000)
*Local administrative expenses are the administrative expenses incurred at the check processing
centers.
*Regional administrative expenses are allocated to the check processing centers based on
revenues.
*Corporate administrative expenses represent a standard 8 charge against revenues.
Upon seeing this report. Mr. Braun summoned Lance Whiting for an explanation.
Braun: What's the story on Ashton? It didn't have a loss the previous year, did it?
Whiting: No, the Ashton facility has had a nice profit every year since it was opened six years
ago. But Ashton lost a big contract this year.
Braun: Why?
Whiting: One of our national competitors entered the local market and bid very aggressively on
the contract. We couldn't afford to meet the bid. Ashtons costs--particularly their facility
expenses--are just too high. When Ashton lost the contract, we had to lay off a lot of
employees, but we could not reduce the fixed costs of the Ashton facility.
Braun: Why is Ashton's facility expense so high? It-s a smaller facility than either Pocatello or
Idaho Falls and yet its facility expense is higher.
Whiting: The problem is that we are able to rent suitable facilities very cheaply at Pocatello and
Idaho Falls. No such facilities were available at Ashton, so we had them built. Unfortunately,
there were big cost overruns. The contractor we hired was inexperienced at this kind of work
and in fact went bankrupt before the project was completed. After hiring another contractor to
finish the work, we were way over budget. The large depreciation charges on the facility didn't
matter at first because we didnt have much competition at the time and could charge premium
prices.
Braun: Well, we can't do that anymore. The Ashton facility will obviously have to be shut down.
Its business can be shifted to the other two check processing centers in the region.
Whiting: I would advise against that. The $900,000 in depreciation charges at the Ashton facility
are misleading. That facility should last indefinitely with proper maintenance. And it has no
resale value; there is no other commercial activity around Ashton.
Braun: What about the other costs at Ashton?
Whiting: It we shifted Ashton's business over to the other two processing centers in the region,
we wouldnt save anything on direct labor or variable overhead costs. We might save $60,000
4
or so in local administrative expenses, but we would not save any regional administrative
expense. And corporate headquarters would still charge us 8% of our revenues as corporate
administrative expenses.
In addition we would have to rent more space in Pocatello and Idaho Falls to handle the
work transferred from Ashton: that would probably cost us at least $400,000 a year. And don't
forget that it will cost us something to move the equipment from Ashton to Pocatello and Idaho
Falls. And the move will disrupt service to customers.
Braun: I understand all of that, but a money-losing processing center on my performance report
is completely unacceptable.
Whiting: And if you do shut down Ashton. You are going to throw some loyal employees out of
work.
Braun: That's unfortunate, but we have to face hard business realities.
Whiting: And you would have to write off the investment in the facilities at Ashton.
Braun: I can explain a write-off to corporate headquarters; hiring an inexperienced contractor to
build the Ashton facility was my predecessor's mistake. But they'll have my head at
headquarters if I show operating losses every year at one of my processing centers. Ashton has
to go. At the next corporate board meeting, I am going to recommend that the Ashton facility
be closed.
Required:
1. From the standpoint of the company as a whole, should the Ashton processing center be shut
down and its work redistributed to the other processing centers in the region? Explain.
2. Do you think Marvin Braun's decision to shut down the Ashton facility is ethical? Explain.
3. What influence should the depreciation on the facilities at Ashton have on prices charged by
Ashton for its services?
5
G3: Relevant Costs; Pricing
Jenco Incorporated's only product is a combination fertilizer-weed killer called Fertikil.
Fertikil is sold nationwide through normal marketing channels to retail nurseries and garden
stores.
Taylor Nursery plans to sell a similar fertilizer weed killer compound through its regional
nursery chain under its own private label. Taylor does not have manufacturing facilities of its
own, so it has asked Jenco (and several other companies) to submit a bid for manufacturing and
delivering a 25,000 pound order of the private brand compound to Taylor. While the chemical
composition of the Taylor compound differs from that of Fertikil, the manufacturing processes
are very similar.
The Taylor compound would be produced in 1.000 pound lots. Each lot would require 30
direct labor-hours and the following chemicals:
Chemicals
Quantity in Pounds
CW-3
400
JX-6
300
MZ-8
200
BE-7
100
The first three chemicals (CW-3, JX-6, and MZ-8) are all used in the production of
Fertikil. BE-7 was used in another compound that Jenco discontinued several months ago. The
supply of BE-7 that Jenco had on hand when the other compound was discontinued was not
discarded. Jenco could sell its supply of BE-7 at the prevailing market price less $0.10 per pound
selling and handling expenses.
Jenco also has on hand a chemical called CN-5, which was manufactured for use in
another product that is no longer produced. CN-5, which cannot be used in Fertikil, can be
substituted for CW-3 on a one-for-one basis without affecting the quality of the Tavlor
compound. The CN-5 in inventory has a salvage value of $500.
Inventory and cost data for the chemicals that can be used to produce the Taylor
compound are as shown below:
Row Material
Actual Price/Pound
22,000
Current Market
When Purchased
CW-3
Pounds in Inventory
Price/Pound
$0.80
6
$0.90
JX-6
5,000
0.55
0.60
MZ-8
8,000
1.40
1.60
BE-7
4,000
0.60
0.65
CN-5
5,500
0.75
(Salvage)
The current direct labor rate is $14 per hour. The predetermined overhead rate is based on
direct labor-hours (DLH). The predetermined overhead rate for the current year, based on a twoshift capacity of 400,000 total DLH with no overtime, is as follows:
Variable manufacturing overhead
$ 4.50 per DLH
Fixed manufacturing overhead
7.50 per DLH
Combined rate
$12.00 per DLH
Jenco's production manager reports that the present equipment and facilities are adequate
to manufacture the Taylor compound. Therefore, the order would have no effect on total fixed
manufacturing overhead costs. However, Jenco is within 400 hours of its two-shift capacity this
month. Any additional hours beyond 400 hours must be done in overtime. If need be, the Taylor
compound could be produced on regular time by shifting a portion of Fertikil production to
overtime. Jenco's rate for overtime hours is 1.5 times the regular pay rate, or $21 per hour. There
is no allowance for any overtime premium in the predetermined overhead rate.
Required:
1. Jenco, has decided to submit a bid for a 25,000 pound order of Taylor Nursery's new
compound. The order must be delivered by the end of the current month. Taylor Nursery
has indicated that this is a one-time order that will not be repeated. Calculate the lowest
price that Jenco could bid for the order without reducing its net operating income.
2. Refer to the original data. Assume that Taylor Nursery plans to place regular orders for 25,000
pound lots of the new compound during the coming year. Jenco expects the demand for Fertikil to
remain strong. Therefore, the recurring orders from Taylor Nursery would put Jenco over its twoshift capacity. However, production could be scheduled so that 60% of each Taylor Nursery order
could be completed during regular hours. As another option, some Fertikil production could be
shifted temporarily to overtime so that the Taylor Nursery orders could be produced on regular
time. Current market prices are the best available estimates of future market prices.
7
Jenco's standard markup policy for new products is 40% of the full manufacturing cost, including
fixed manufacturing overhead. Calculate the price that Jenco would quote Taylor Nursery for
each 25,000 pound lot of the new compound, assuming that it is to be treated as a new product
and this pricing policy is followed.
8
G4: Make or Buy; Utilization of a Constrained Resource
Storage Systems, Inc., sells a wide range of drums, bins, boxes, and other containers that
are used in the chemical industry. One of the company's products is a heavy-duty corrosionresistant metal drum, called the XSX drum, used to store toxic wastes. Production is constrained
by the capacity of an automated welding machine that is used to make precision welds. A total of
2,000 hours of welding time are available annually on the machine. Since each drum requires 0.8
hours of welding time, annual production is limited to 2,500 drums. At present, the welding
machine is used exclusively to make the XSX drums.
The accounting department has provided the following financial data concerning the
XSX drums.
XSX Drums
Selling price per drum
$154.00
Cost per drum:
Direct materials
$44.50
Direct labor ($18 per hour)
4.50
Manufacturing overhead
3.15
Selling and administrative expense
15.40
Margin per drum
67.55
$ 86.45
Management believes 3.000 XSX drums could be sold each year if the company had
sufficient manufacturing capacity. As an alternative to adding another welding machine,
management has looked into the possibility of buying additional drums from an outside supplier.
Metal Products, Inc., a supplier of quality products, would be able to provide up to 1,800 XSXtype drums per year at a price of $120 per drum, which Storage Systems would resell to its
customers at its normal selling price after appropriate relabeling.
Jasmine Morita, Storage Systems' production manager, has suggested that the company
could make better use of the welding machine by manufacturing premium mountain bike frames,
which would require only 0.2 hours of welding time per frame. Jasmine believes that Storage
Systems could sell up to 3.500 mountain bike frames per year to mountain hike manufacturers at
a price of $65 per frame. The accounting department has provided the following data concerning
the proposed new product:
9
Mountain Bike Frames
Selling price per frame
$65.00
Cost per frame:
Direct materials
$17.50
Direct labor ($18 per hour)
22.50
Manufacturing overhead
15.75
Selling and administrative expense
6.50
Margin per frame
62.25
$ 2.75
The mountain bike frames could be produced with existing equipment and personnel.
Manufacturing overhead is allocated to products on the basis of direct labor-hours. Most of the
manufacturing overhead consists of fixed common costs such as rent on the factory building, but
some of it is variable. The variable manufacturing overhead has been estimated at $l.05 per XSX
drum and $0.60 per mountain bike frame. The variable manufacturing overhead cost would not be
incurred on drums acquired from the outside supplier.
Selling and administrative expenses are allocated to products on the basis of revenues.
Almost all of the selling and administrative expenses are fixed common costs, but it has been
estimated that variable selling and administrative expenses amount to $0.85 per XSX drum and
would be $0.40 per mountain bike frame. The variable selling and administrative expenses of
$0.85 per drum would be incurred when drums acquired from the outside supplier are sold to the
company's customers. All of the company's employeesdirect and indirectare paid for full 40hour workweeks and the company has a policy of laying off workers only in major recessions.
Required:
1. Given the margins of the two products as indicated in the reports submitted by the accounting
department, does it make any sense to even consider producing the mountain bike frames?
Explain.
2. Compute the contribution margin per unit for:
a. Purchased XSX drums.
b. Manufactured XSX drums.
10
c. Manufactured mountain bike frames.
3. Determine the number of XSX drums (if any) that should be purchased and the number of
XSX drums and/or mountain bike frames (if any) that should be manufactured. What is the
improvement in net income that would result from this plan over current operations?
As soon as your analysis was shown to the top management team at Storage managers Systems,
several got into an argument concerning how direct labor costs should be treated when
making this decision. One manager argued that direct labor is always treated as a variable cost in
textbooks and in practice and has always been considered a variable cost at Storage Systems.
After all, "direct" means you can directly trace the cost to products. If direct labor is not a
variable cost, what is? Another manager argued just as strenuously that direct labor should be
considered a fixed cost at Storage Systems. No one had been laid off in over a decade, and for all
practical purposes, everyone at the plant is on a monthly salary. Everyone classified as direct
labor works a regular 40-hour workweek and overtime has not been necessary since the company
adopted Lean Production techniques. Whether the welding machine is used to make drums or
frames, the total payroll would he exactly the same. There is enough slack, in the form of idle
time, to accommodate any increase in total direct labor time that the mountain bike frames would
require.
4. Redo requirements (2) and (3) above, making the opposite assumption about direct labor from
the one you originally made. In other words, if you treated direct labor as a variable cost, redo the
analysis treating it as a fixed cost. If you treated direct labor as a fixed cost, redo the analysis
treating it as a variable cost.
5. What do you think is the correct way to treat direct labor in this situationas a variable cost
or as a fixed cost?
G5: Sell or Process Further Decision
Midwest Mills has a plant that can mill wheat grain into a cracked wheat cereal and then
further mill the cracked wheat into flour. The company can sell all the cracked wheat cereal that it
can produce at a selling price of $490 per ton. In the past, the company has sold only part of its
cracked wheat as cereal and has retained the rest for further milling into flour. The flour has been
selling for $700 per ton, but recently the price has become unstable and has dropped to $625 per
ton. The costs and revenues associated with a ton of flour follow:
11
Per Ton of Flour
Selling price
$625
Cost to manufacture:
Raw materials:
Enrichment materials
$ 80
Cracked wheat
470
Total raw materials
550
Direct labor
20
Manufacturing overhead
60
Manufacturing profit (loss)
630
$ (5)
Because of the weak price for flour, the sales manager believes that the company should
discontinue milling flour and use its entire milling capacity to produce cracked wheat to sell as
cereal.
The same milling equipment is used for both products. Milling one ton of cracked wheat
into one ton of flour requires the same capacity as milling one ton of wheat grain into one ton of
cracked wheat. Hence, the choice is between one ton of flour and two tons of cracked wheat.
Current cost and revenue data on the cracked wheat cereal follow:
Per Ton of Cracked Wheat
Selling price
$490
Cost to manufacture:
Wheat grain
$390
Direct labor
20
Manufacturing overhead
60
Manufacturing profit
470
$ 20
The sales manager argues that since the present $625 per ton price for the flour results in
a $5 per ton loss, the milling of flour should not be resumed until the price per ton rises above
$630.
The company assigns manufacturing overhead cost to the two products on the basis of
milling hours. The same amount of time is required to mill either a ton of cracked wheat or a ton
12
of flour. Virtually all manufacturing overhead costs are fixed. Materials and labor costs are
variable.
The company can sell all of the cracked wheat and flour it can produce at the current
market prices.
Required:
1. Do you agree with the sales manager that the company should discontinue milling flour and
use the entire milling capacity to mill cracked wheat if the price of flour remains at $625 per ton?
Support your answer with computations and explanations.
2. What is the lowest price that the company should accept for a ton of flour? Again support your
answer with computations and explanations.
13
G6: Plant Closing Decision
Mobile Seating Corporation manufactures seats for automobiles, vans, trucks, and boats.
The company has a number of plants, including the Greenville Cover Plant, which makes seat
covers.
Miriam Restin is the plant manager at the Greenville Cover Plant but also serves as the
regional production manager for the company. Her budget as the regional manager is charged to
the Greenville Cover Plant.
Restin has just heard that Mobile Seating has received a bid from an outside vendor to
supply the equivalent of the entire annual output of the Greenville Cover Plant for $21 million.
Restin was astonished at the low outside bid because the budget for the Greenville Cover Plant's
operating costs for the coming year was set at $24.3 million. If this bid is accepted, the Greenville
Cover Plant will be closed down.
The budget for the Greenville Cover Plant's operating costs for the conning year is
presented below. Additional facts regarding the plant's operations are as follows:
a. Due to the Greenville Cover Plant's commitment to use high-quality fabrics in all of its
products, the Purchasing Department was instructed to place blanket purchase orders with major
suppliers to ensure the receipt of sufficient materials for the coming year. If these orders are
canceled as a consequence of the plant closing, termination charges would amount to 25% of the
cost of direct materials.
b. Approximately 350 employees will lose their jobs if the plant is closed. This includes all of the
direct laborers and supervisors, management and staff, and the plumbers, electricians, and other
skilled workers classified as indirect plant workers. Some of these workers would have difficulty
finding new jobs. Nearly all the production workers would have difficulty matching the
Greenville Cover Plant's base pay of $12.50 per hour, which is the highest in the area. A clause in
Greenville Cover's contract with the union may help some employees: the company must provide
employment assistance and job training to its former employees for 12 months after a plant
closing. The estimated cost to administer this service would be $0.8 million.
c. Some employees would probably choose early retirement because Mobile Seating Corporation
has an excellent pension plan. In fact, $0.7 million of the annual pension expense would continue
whether the Greenville Cover Plant is open or not.
d. Restin and her regional staff would not be affected by the closing of the Greenville Cover
Plant. They would still be responsible for running three other area plants.
14
e. If the Greenville Cover Plant were closed, the company would realize about $2 million salvage
value for the equipment in the plant. If the plant remains open, there are no plans to make any
significant investments in new equipment or buildings. The old equipment is adequate for the job
and should last indefinitely.
Greenville Cover Plant
Annual Budget for Operating Costs
Materials
$ 8,000,000
Labor:
Direct
$6,700,000
Supervision
400,000
Indirect plant
1,900,000
9,000,000
Overhead:
Depreciationequipment
1,300,000
Depreciationbuilding
2,100,000
Pension expense
1,600,000
Plant manager and staff
600,000
Corporate expenses
1,700,000
Total budgeted costs
7,300,000
$24,300,000
*Fixed corporate expenses allocated to plants and other operating units based on total budgeted
wage and salary costs.
Required:
1. Without regard to costs, identify the advantages to Mobile Seating Corporation of continuing
to obtain covers from its own Greenville Cover Plant.
2. Mobile Seating Corporation plans to prepare a financial analysis that will be used in deciding
whether or not to close the Greenville Cover Plant. Management has asked you to identify:
15
a. The annual budgeted costs that are relevant to the decision regarding closing the plant
(show the dollar amounts).
b. The annual budgeted costs that are not relevant to the decision regarding closing the
plant and explain why they are not relevant (again show the dollar amounts).
c. Any nonrecurring costs that would arise due to the closing of the plant and explain
how they would affect the decision (again show any dollar amounts).
3. Looking at the data you have prepared in (2) above, should the plant be closed? Show
computations and explain your answer.
4. Identify any revenues or costs not specifically mentioned in the problem that Mobile Seating
Corporation should consider before making a decision.
16
G7 Activity-Based Costing and the Flexible Budget Approach
The Munchkin Theater is a nonprofit organization devoted 10 staging theater productions
of plays for children in Toronto, Canada. The theater has a very small full-time professional
administrative staff. Through a special arrangement with the actors' union, actors and directors
rehearse without pay and are paid only for actual performances.
During 2006, The Munchkin Theater had five different productionseach of which was
performed 12 times. The costs of 2006's operations were as follows:
The Munchkin Theater
Cost Report
For the Year Ended 31 December 2006
Number of productions
5
Number of performances of each production
12
Total number of performances
60
Actual costs incurred:
Actors and directors' wages
$144000
Stagehands' wages
27,000
Ticket booth personnel and ushers wages
10,800
Scenery, costumes, and props
43,000
Theater hall rent
45,000
Printed programs
10,500
Publicity
13,000
Administrative expenses
43,200
Total actual cost incurred
$336,500
Some of the costs vary with the number of productions, some with the number of
performances, and some are relatively fixed and depend on neither the number of productions nor
17
the number performances. The costs of scenery, costumes, props, and publicity vary with the
number of productions. It doesnt make any difference how many times Peter the Rabbit is
performed, the cost of the scenery is the same. Likewise, the cost of publicizing a play with
posters and radio commercials is the same whether there are 10, 20, or 30 performances of the
play. On the other hand, the wages of the actors, directors, stagehands, ticket booth personnel,
and ushers vary with the number of performances. The great the number of performances, the
higher the wage costs will be. Similarly, the costs of renting the hall and printing the programs
will vary with the number of performances. Administrative expenses are more difficult to pin
down, but the best estimate is that approximately 75% of these costs are fixed, 15% depend on
the number of productions staged, and the remaining 10% depend on the number of
performances.
At the end of 2006, the board of directors of the theater authorized changing the theaters
program in 2007 to four productions, with 16 performances each. Actual cost for 2007 were
higher than the costs for 2006. (Grants from donors and ticket sales were also correspondingly
higher.) Data concerning 2007's operations appear below:
The Munchkin Theater
Cost Report
For the Year Ended 31 December 2007
Number of productions
4
Number of performances of each production
16
Total number of performances
64
Actual costs incurred:
Actors and directors' wages
$148,000
Stagehands' wages
28,600
Ticket booth personnel and ushers' wages
12,300
Scenery, costumes, and props
39,300
18
Theater hall rent
49,600
Printed programs
10,950
Publicity
12,000
Administrative expenses
41,650
Total actual cost incurred
$342,400
Even though many of the costs above may be considered direct costs rather than
overhead, The flexible budget approach covered in the chapter can be used to evaluate how well
these costs are controlled. The principles are the same whether a cost is a direct cost or is
overhead.
Required:
1. Use the actual results from 2006 to estimate the cost formulas for the flexible budget for the
Munchkin Theater. Keep in mind that the theater has two measures of activitythe number of
productions and the number of performances.
2. Prepare a performance report for 2007 using the flexible budget approach and both measures
of activity. Assume inflation was insignificant. (Note: To evaluate administrative expenses, first
determine the flexible budget amounts for the three elements of administrative expenses. Then
compare the total of the three elements to the actual administrative expense of $41,650.)
3. If you were on the board of directors of the theater, would you be pleased with how well costs
were controlled during 2007? Why or why not?
4. The cost formulas provide figures for the average cost per production and average cost per
performance. How accurate do you think these figures would be for predicting the cost of a new
production or of an additional performance of a particular production?
19
G8 Ethics and the Manager; Absorption Costing Income Statements
Michael Lee was hired as chief executive officer (CEO) in late November by the board of
directors of Hunter Electronics, a company that produces a state-of-the-art DVD drive for
personal computers. The previous CEO had been fired by the board due to a series of
questionable business practices including prematurely recording revenues on products that had
not yet been shipped to customers.
Michael felt that his first priority on the job was to restore employee moralewhich had
suffered during the previous CEO's reign. He was particularly anxious to build a sense of trust
between himself and the company's employees His second priority was to prepare the budget for
the coming year, which the board of directors wanted to review in their December 15 meeting.
After hammering out the details in meetings with key managers, Michael was able to put
together a budget that he felt the company could realistically meet during the coming year. That
budget appears below:
Basic Budget Data
Units in beginning inventory
0
Units produced
200,000
Units sold
200,000
Units in ending inventory
0
Variable costs per unit:
Direct materials
$ 50
Direct labor
40
Variable manufacturing overhead
20
Variable selling and administrative
10
Total variable cost per unit
$120
Fixed costs:
Fixed manufacturing overhead
$ 8,400,000
Fixed selling and administrative
3,600,000
Total fixed costs
$12,000,000
20
Hunter Electronics
Budgeted Income Statement
(absorption method)
Sales (200,000 units)
$40,000,000
Cost of goods sold:
Beginning inventory
$
0
Add cost of goods manufactured
(200,000 x $152 per unit)
30,400,000
Goods available for sale
30,400,000
Less ending inventory
0
Gross margin
30,400,000
9,600,000
Selling and administrative expenses:
Variable selling and administrative
2,000,000
Fixed selling and administrative
3,600,000
Net operating income
5,600,000
$ 4,000,000
While the board of directors did not oppose the budget, they made it clear that the budget
was not as ambitious as they had hoped. The most influential member of the board stated that
"managers should have to really stretch to meet profit goals." After some discussion, the board
decided to set a profit goal of $4,800,000 for the coming year. To provide strong incentives and a
win-win situation, the board agreed to pay out bonuses to top managers of $200,000 if this profit
goal was eventually met. Michael's share of the bonus pool would be $50,000. The bonus would
he all-or-nothing. If actual net operating income turned out to be $4,800,000 or more, the bonus
would be paid. Otherwise, no bonus would be allowed.
Required:
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1. Assuming that the company does not build up its inventory (i.e. production equals sales) and
its selling price and cost structure remain the same, how many units of the DVD drive would have
to be sold to meet the target net operating income of $4,800,000?
2. Verify your answer to (1) above by constructing a revised budget and budgeted absorption
costing income statement that yields a net operating income of $4,800,000.
3. Unfortunately, by October of the next year it had become clear that the company would not be
able to make the $4,800.000 target profit. In fact, it looked like the company would wind up the
year as originally planned, with sales of 200,000 units, no ending inventories, and a profit of
$4,000,000.
Several managers who were reluctant to lose their year-end bonuses approached Michael
and suggested that the company could still show a profit of $4,800,000. The managers argued that
at the present rate of sales, there was enough capacity to produce tens of thousands of additional
DVD drives for the warehouse. Overtime costs might have to he incurred, but all of this
additional cost would he assigned to the DVD drives in ending inventory.
If sales are 200.000 units for the year and the selling price and cost structure remain the
same, how many units would have to be produced to show a profit of at least $4,800,000 under
absorption costing? (Round your answer up to the nearest whole unit.)
4. Verify your answer to (3) above by constructing an absorption costing income statement.
5. Do you think Michael Lee should approve the plan to build ending inventories in order to
attain the target profit?
6. What advice would you give to the board of directors concerning how they determine bonuses
in the future?
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