Managerial accounting 13th E
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Managerial accounting 13th E

Course Number: ACCT 3001, Spring 2012

College/University: Minnesota

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Page gar79611_fm_i-xxi.indd i 12/24/08 9:42:20 PM user-s180 Managerial Accounting /Users/user-s180/Desktop/Dhiru 24-12-08/New/MHBR094-FM gar79611_fm_i-xxi.indd gar79611_fm_i-xxi.indd Page ii 12/24/08 9:42:21 PM user-s180 /Users/user-s180/Desktop/Dhiru 24-12-08/New/MHBR094-FM gar79611_fm_i-xxi.indd Page iii 12/24/08 9:42:23 PM user-s180 /Users/user-s180/Desktop/Dhiru 24-12-08/New/MHBR094-FM Managerial Accounting Thirteenth Edition Ray H. Garrison, D.B.A., CPA Professor Emeritus Brigham Young University Eric W. Noreen, Ph.D., CMA Professor Emeritus University of Washington Peter C. Brewer, Ph.D., CPA Miami UniversityOxford, Ohio Boston Burr Ridge, IL Dubuque, IA Madison, WI New York San Francisco St. Louis Bangkok Bogot Caracas Kuala Lumpur Lisbon London Madrid Mexico City Milan Montreal New Delhi Santiago Seoul Singapore Sydney Taipei Toronto gar79611_fm_i-xxi.indd Page iv 1/8/09 3:21:34 PM user /Users/user/Desktop Dedication To our families and to our many colleagues who use this book. MANAGERIAL ACCOUNTING Published by McGraw-Hill/Irwin, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue of the Americas, New York, NY, 10020. Copyright 2010, 2008, 2006, 2003, 2000, 1997, 1994, 1991, 1988, 1985, 1982, 1979, 1976 by The McGraw-Hill Companies, Inc. All rights reserved. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of The McGraw-Hill Companies, Inc., including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning. Some ancillaries, including electronic and print components, may not be available to customers outside the United States. This book is printed on acid-free paper. 1 2 3 4 5 6 7 8 9 0 DOW/DOW 0 9 ISBN MHID 978-0-07-337961-6 0-07-337961-1 Vice president and editor-in-chief: Brent Gordon Editorial director: Stewart Mattson Publisher: Tim Vertovec Developmental editor: Emily A. Hatteberg Marketing manager: Kathleen Klehr Lead project manager: Pat Frederickson Senior production supervisor: Debra R. Sylvester Lead designer: Matthew Baldwin Senior photo research coordinator: Lori Kramer Photo researcher: Keri Johnson Senior media project manager : Susan Lombardi Cover design: Kay Lieberherr Cover Photo: Mark Bertieri, Creative Photo Designs Typeface: 10.5/12 Times Roman Compositor: Aptara, Inc. Printer: R. R. Donnelley Library of Congress Cataloging-in-Publication Data Garrison, Ray H. Managerial accounting / Ray H. Garrison, Eric W. Noreen, Peter C. Brewer.13th ed. p. cm. Includes index. ISBN-13: 978-0-07-337961-6 (alk. paper) ISBN-10: 0-07-337961-1 (alk. paper) 1. Managerial accounting. I. Noreen, Eric W. II. Brewer, Peter C. III. Title. HF5657.4.G37 2010 658.1511dc22 2008054773 www.mhhe.com gar79611_fm_i-xxi.indd Page v 12/24/08 9:42:28 PM user-s180 /Users/user-s180/Desktop/Dhiru 24-12-08/New/MHBR094-FM About the Authors Ray H. Garrison is emeritus professor of accounting at Brigham Young University, Provo, Utah. He received his BS and MS degrees from Brigham Young University and his DBA degree from Indiana University. As a certified public accountant, Professor Garrison has been involved in management consulting work with both national and regional accounting firms. He has published articles in The Accounting Review, Management Accounting, and other professional journals. Innovation in the classroom has earned Professor Garrison the Karl G. Maeser Distinguished Teaching Award from Brigham Young University. Eric W. Noreen has held appointments at institutions in the United States, Europe, and Asia. He is emeritus professor of accounting at the University of Washington. He received his BA degree from the University of Washington and MBA and PhD degrees from Stanford University. A Certified Management Accountant, he was awarded a Certificate of Distinguished Performance by the Institute of Certified Management Accountants. Professor Noreen has served as associate editor of The Accounting Review and the Journal of Accounting and Economics. He has numerous articles in academic journals including: the Journal of Accounting Research; the Accounting Review; the Journal of Accounting and Economics; Accounting Horizons; Accounting, Organizations and Society; Contemporary Accounting Research; the Journal of Management Accounting Research; and the Review of Accounting Studies. Professor Noreen has won a number of awards from students for his teaching. Managerial Accounting Thirteenth Edition v gar79611_fm_i-xxi.indd Page vi 12/24/08 9:42:30 PM user-s180 /Users/user-s180/Desktop/Dhiru 24-12-08/New/MHBR094-FM About the Authors Peter C. Brewer is a professor in the Department of Accountancy at Miami University, Oxford, Ohio. He holds a BS degree in accounting from Penn State University, an MS degree in accounting from the University of Virginia, and a PhD from the University of Tennessee. He has published more than 30 articles in a variety of journals including: Management Accounting Research, the Journal of Information Systems, Cost Management, Strategic Finance, the Journal of Accountancy, Issues in Accounting Education, and the Journal of Business Logistics. Professor Brewer is a member of the editorial boards of Issues in Accounting Education and the Journal of Accounting Education. His article Putting Strategy into the Balanced Scorecard won the 2003 International Federation of Accountants Articles of Merit competition and his articles Using Six Sigma to Improve the Finance Function and Lean Accounting: Whats It All About? were awarded the Institute of Management Accountants Lybrand Gold and Silver Medals in 2005 and 2006. He has received Miami Universitys Richard T. Farmer School of Business Teaching Excellence Award and has been recognized on two occasions by the Miami University Associated Student Government for making a remarkable commitment to students and their educational development. He is a leading thinker in undergraduate management accounting curriculum innovation and is a frequent presenter at various professional and academic conferences. Prior to joining the faculty at Miami University, Professor Brewer was employed as an auditor for Touche Ross in the firms Philadelphia office. He also worked as an internal audit manager for the Board of Pensions of the Presbyterian Church (U.S.A.). He frequently collaborates with companies such as Harris Corporation, Ghent Manufacturing, Cintas, Ethicon Endo-Surgery, Schneider Electric, Lenscrafters, and Fidelity Investments in a consulting or case writing capacity. vi Garrison Noreen Brewer gar79611_fm_i-xxi.indd Page vii 12/24/08 9:42:30 PM user-s180 /Users/user-s180/Desktop/Dhiru 24-12-08/New/MHBR094-FM G ARRISON NOREEN BREWER Let Garrison be Your Guide For centuries, the lighthouse has provided guidance and safe passage for sailors. Similarly, Garrison/Noreen/Brewer has successfully guided millions of students through managerial accounting, helping them sail smoothly through the course. Decades ago, lighthouses were still being operated manually. In these days of digital transformation, lighthouses are run using automatic lamp changers and other modern devices. In much the same way, Garrison/ Noreen/Brewer has evolved over the years. Today, the Garrison book not only guides studentsaccounting majors and non-majors alike safely through the course, but is enhanced by new forms of media and technology to augment student learning and increase student motivation. McGraw-Hill Connect Accounting allows instructors to build assignments and tests from static and algorithmic versions of the end-of-chapter material and testbank problems. Integrated iPod content allows students to download lecture presentations, videos, and self-quizzes to their MP3 playergiving them a portable learning tool. Just as the lighthouse continues to provide reliable guidance to seafarers, the Garrison/Noreen/Brewer book continues its tradition of helping students sail successfully through managerial accounting by always focusing on three important qualities: relevance, accuracy, and clarity. Managerial Accounting Thirteenth Edition vii gar79611_fm_i-xxi.indd gar79611_fm_i-xxi.indd Page viii 12/24/08 9:42:34 PM user-s180 /Users/user-s180/Desktop/Dhiru 24-12-08/New/MHBR094-FM RELEVANCE. Every effort is made to help students Garrison is THE classic managerial accounting text. Angela Sandberg, Jacksonville State University A well-written, well-explained text with terrific in chapter examples and excellent end of chapter materials. Charles Tony Wain, Babson College I love the text. Pam Meyer, University of Louisiana at Lafayette The seminal text on managerial accounting. Dr. Reed W. Easton, Seton Hall University viii relate the concepts in this book to the decisions made by working managers. With insightful chapter openers, the popular Managerial Accounting in Action segments within the chapters, and stimulating end-of-chapter exercises, a student reading Garrison should never have to ask Why am I learning this? ACCURACY. The Garrison book continues to set the standard for accurate and reliable material in its thirteenth edition. With each revision, the authors evaluate the book and its supplements in their entirety, working diligently to ensure that the end-of-chapter material, solutions manual, and test bank, are consistent, current, and accurate. CLARITY. Generations of students have praised Garrison for the friendliness and readability of its writing, but thats just the beginning. Technical discussions have been simplified, material has been reordered, and the entire book carefully retuned to make teachingand learningfrom Garrison as easy as it can be. In addition, the key supplements were written by Garrison, Noreen, and Brewer, ensuring that students and professors will work with clear, well-written supplements that employ consistent terminology. The authors steady focus on these three core elements has led to tremendous results. Managerial Accounting has consistently led the market, being used by over two million students and earning a reputation for reliability that other texts aspire to match. Garrison Noreen Brewer gar79611_fm_i-xxi.indd Page ix 12/24/08 9:42:34 PM user-s180 /Users/user-s180/Desktop/Dhiru 24-12-08/New/MHBR094-FM Garrisons Managerial Accounting is full of pedagogy designed to make studying productive and hassle free. On the following pages, youll see the kind of engaging, helpful pedagogical features that have made Garrison a beacon for over two million students. gar79611_ch10_417-449.indd Page 417 12/22/08 5:01:32 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-10/upload Opening Vignette Flexible Budgets and Performance Analysis The Inevitability of Forecasting Errors BUSINESS FOCUS This textbook is one of the best written, best illustrated textbooks that we have used for the managerial course. 10 Chapter Each chapter opens with a Business Focus feature that provides a real-world example for students, allowing them to see how the chapters information and insights apply to the world outside the classroom. Learning Objectives alert students to what they should expect as they progress through the chapter. While companies derive numerous benefits from planning for the future, they must be able to respond when actual results deviate from the plan. For example, just two months after telling Wall Street analysts that it would breakeven for the first quarter of 2005, General Motors (GM) acknowledged that its actual sales were far less than its original forecast and the company would lose $850 million in the quarter. For the year, GM acknowledged that projected earnings would be 80% lower than previously indicated. The companys stock price dropped by $4.71. When a companys plans deviate from its actual results, managers need to understand the reasons for the deviations. How much is caused by the fact that actual sales differ from budgeted sales? How much is caused by the actions of managers? In the case of GM, the actual level of sales is far less than the budget, so some actual costs are likely to be less than originally budgeted. These lower costs do not signal managerial effectiveness. This chapter explains how to analyze the sources of discrepancies between budgeted and actual results. Source: Alex Taylor III, GM Hits the Skids, Fortune, April 4, 2005, pp. 7174. LEARNING OBJECTIVES After studying Chapter 10, you should be able to: LO1 Prepare a flexible budget. LO2 Prepare a report showing activity variances. LO3 Prepare a report showing revenue and spending variances. LO4 Prepare a performance report that combines activity variances and revenue and spending variances. LO5 Prepare a flexible budget with more than one cost driver. LO6 Understand common errors made in preparing performance reports based on budgets and actual results. Bonnie McQuitter Banks, Alabama A&M University 417 Managerial Accounting Thirteenth Edition ix gar79611_fm_i-xxi.indd Page x 12/24/08 9:42:36 PM user-s180 /Users/user-s180/Desktop/Dhiru 24-12-08/New/MHBR094-FM Powerful Pedagogy IN BUSINESS COST OVERRUNS INCREASE THE BREAK-EVEN POINT When Airbus launched the A380 555-seat jetliner in 2000 the company said it would need to sell 250 units to break even on the project. By 2006, Airbus was admitting that more than $3 billion of cost overruns had raised the projects break-even point to 420 airplanes. Although Airbus has less than 170 orders for the A380, the company remains optimistic that it will sell 751 units over the next 20 years. Given that Airbus rival Boeing predicts the total market size for all airplanes with more than 400 seats will not exceed 990 units, it remains unclear if Airbus will ever break even on its investment in the A380 aircraft. These helpful boxed features offer a glimpse into how real companies use the managerial accounting concepts discussed within the chapter. Each chapter contains from three to fourteen of these current examples. Source: Daniel Michaels, Embattled Airbus Lifts Sales Target for A380 to Prot, The Wall Street Journal, October 20, 2006, p. A6. gar79611_ch05_188-232.indd Page 202 12/24/08 5:25:17 AM user-s176 202 Its the best text currently available. Its thorough and complete and written in a style that students understand. Rebecca J. Oatsvall, Meredith College x In Business Boxes /broker/MH-BURR/MHBR094/MHBR094-05/upload/MHBR094-05 Chapter 5 where no past experience is available concerning activity and costs. In addition, it is sometimes used together with other methods to improve the accuracy of cost analysis. Account analysis works best when analyzing costs at a fairly aggregated level, such as the cost of serving patients in the emergency room (ER) of Cook County General Hospital. The costs of drugs, supplies, forms, wages, equipment, and so on, can be roughly classied as variable or xed and a mixed cost formula for the overall cost of the emergency room can be estimated fairly quickly. However, this method does not recognize that some of the accounts may have both xed and variable cost elements. For example, the cost of electricity for the ER is a mixed cost. Most of the electricity is a xed cost because it is used for heating and lighting. However, the consumption of electricity increases with activity in the ER because diagnostic equipment, operating theater lights, debrillators, and so on, all consume electricity. The most effective way to estimate the xed and variable elements of such a mixed cost may be to analyze past records of cost and activity data. These records should reveal whether electrical costs vary signicantly with the number of patients and if so, by how much. The remainder of this section explains how to conduct such an analysis of past cost and activity data. M ANAGERIAL ACCOUNTING IN ACTION The Issue Dr. Derek Chalmers, the chief executive ofcer of Brentline Hospital, motioned Kinh Nguyen, the chief nancial ofcer of the hospital, into his ofce. Derek: I wanted to talk to you about our maintenance expenses. They seem to be bouncing around a lot. Over the last half year or so they have been as low as $7,400 and as high as $9,800 per month. Kinh: That type of variation is normal for maintenance expenses. Derek: But we budgeted a constant $8,400 a month. Cant we do a better job of predicting what these costs are going to be? And how do we know when weve spent too much in a month? Shouldnt there be some explanation for these variations? Kinh: Now that you mention it, we are in the process of tightening up our budgeting process. Our rst step is to break all of our costs down into xed and variable components. Derek: How will that help? Kinh: Well, it will permit us to predict what the level of costs will be. Some costs are xed and shouldnt change much. Other costs go up and down as our activity goes up and down. The trick is to gure out what is driving the variable component of the costs. Derek: What about the maintenance costs? Kinh: My guess is that the variations in maintenance costs are being driven by our overall level of activity. When we treat more patients, our equipment is used more intensively, which leads to more maintenance expense. Derek: How would you measure the level of overall activity? Would you use patientdays? Kinh: I think so. Each day a patient is in the hospital counts as one patient-day. The greater the number of patient-days in a month, the busier we are. Besides, our budgeting is all based on projected patient-days. Derek: Okay, so suppose you are able to break the maintenance costs down into xed and variable components. What will that do for us? Kinh: Basically, I will be able to predict what maintenance costs should be as a function of the number of patient-days. Derek: I can see where that would be useful. We could use it to predict costs for budgeting purposes. Kinh: We could also use it as a benchmark. Based on the actual number of patient-days for a period, I can predict what the maintenance costs should have been. We can compare this to the actual spending on maintenance. Derek: Sounds good to me. Let me know when you get the results. Managerial Accounting in Action Vignettes These highly praised vignettes depict cross-functional teams working together in real-life settings, working with the products and services that students recognize from their own lives. Students are shown step-by-step how accounting concepts are implemented in organizations and how these concepts are applied to solve everyday business problems. First, The Issue is introduced through a dialogue; the student then walks through the implementation process; finally, The Wrap-up summarizes the big picture. Garrison Noreen Brewer gar79611_fm_i-xxi.indd Page xi 12/24/08 9:42:38 PM user-s180 /Users/user-s180/Desktop/Dhiru 24-12-08/New/MHBR094-FM Utilizing the Icons To To reflect our service-based economy, the text is is replete with examples from service-based bu businesses. A helpful icon distinguishes se service-related examples in the text. Ethics assignments and examples serve as a reminder that good conduct is vital in business. Icons call out content that relates to ethical behavior for students. M Media integrated icons throughout the text lin content back to chapter-specific quizzes, link au lectures, and visual presentations; all of audio w which can be downloaded to an MP3 player. Th gives students access to a portable, This el electronic learning option to support their cla classroom instruction. The writing icon denotes problems that require students to use critical thinking as well as writing skills to explain their decisions. An Excel icon alerts students that spreadsheet An templates are available for use with select tem problems and cases. pr IFRS Comprehensive, current book that is easy to read and follow. Rafik Elias, California State University, Los Angeles The Cadillac of the industryBest of the managerial accounting texts. Joe Gerard, University of WisconsinWhitewater The best managerial accounting book I have found. You can trust the accuracy of the text material as well as the accuracy of end of chapter exercises/problems. Claudia M. Gilbertson, North Hennepin Community College The IFRS icon highlights content that may be affected by the impending change to IFRS and possible convergence between U.S. GAAP and IFRS. Managerial Accounting Thirteenth Edition xi gar79611_fm_i-xxi.indd Page xii 12/24/08 9:42:46 PM user-s180 /Users/user-s180/Desktop/Dhiru 24-12-08/New/MHBR094-FM gar79611_ch02_030-087.indd Page 64 12/8/08 9:08:25 PM user-s180 gar79611_ch02_030-087.indd Page 59 12/8/08 9:08:22 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-02/upload /broker/MH-BURR/MHBR094/MHBR094-02/upload End-of-Chapter Material Multiple-choice questions are provided on the text website at www.mhhe.com/garrison13e. Managerial Accounting has earned a reputation for the best end-of-chapter review f and discussion material of any text a o the market. Our problem and case on m material continues to conform to AACSB recommendations and makes a great starting point for class discussions and g group projects. When Ray Garrison first c created the Managerial Accounting text, h started with the end-of-chapter material he t then wrote the narrative in support of it This unique approach to textbook it. a authoring not only ensured consistency b between the practice material and text c content, but also underscored Garrisons f fundamental belief in the importance of a applying theory through practice. It is not e enough for students to read, they must also understand. To this day, the guiding principle of that first edition remains and Garrisons superior end-of-chapter material continues to provide accurate, current, and relevant practice for students. Exercises EXERCISE 21 The Work of Management and Managerial and Financial Accounting [LO1] A number of terms that relate to organizations, the work of management, and the role of managerial accounting are listed below: Budgets Controller Directing and motivating ect ot vat Feedback eedbac Directing and motivating Feedback Financial accounting Managerial accounting Performance report Planning gar79611_ch02_030-087.indd Page 73 12/8/08 9:08:31 PM user-s180 Precision Timeliness /broker/MH-BURR/MHBR094/MHBR094-02/upload Problems PROBLEM 213 Cost Classication [LO3, LO6, LO7] 4. Listed below are costs found in various organizations. 1. Property taxes, factory. 2. Boxes used for packaging detergent produced by the company. 3. Salespersons commissions. 4. Supervisors salary, factory. 5. Depreciation, executive autos. 6. Wages of workers assembling computers. 7. Insurance, nished goods warehouses. 8. Lubricants for production equipment. 9. Advertising costs. 10. Microchips used in producing calculators. 10. Microchips used in producing calculators. 1 goods sold is computed. 11. Shipping costs merchandise sold. of 1. Shipping costs on merchandise sold. 12. Magazine subscriptions, factory lunchroom. 12. Magazine subscriptions, factory lunchroom. tail how the cost Do you agree that the insurance company owes Solar Technology, Inc., $226,000? Explain your answer. RESEARCH AND APPLICATION 228 [LO2, LO3, LO6, LO7] The questions in this exercise are based on Dell, Inc. To answer the questions, you will need to download Dells 2005 Form 10-K by going to www.sec.gov/edgar/searchedgar/companysearch.html. Input CIK code 826083 and hit enter. In the gray box on the right-hand side of your computer screen dene the scope of your search by inputting 10-K and then pressing enter. Select the 10-K with a ling date of March 8, 2005. You do not need to print this document in order to answer the questions. Required: 1. 2. 3. 4. 5. 6. 7. 8. What is Dells strategy for success in the marketplace? Does the company rely primarily on a customer intimacy, operational excellence, or product leadership customer value proposition? What evidence supports your conclusion? What business risks does Dell face that may threaten its ability to satisfy stockholder expectations? What are some examples of control activities that the company could use to reduce these risks? (Hint: Focus on pages 710 of the 10-K.) How has the Sarbanes-Oxley Act of 2002 explicitly affected the disclosures contained in Dells 10-K report? (Hint: Focus on pages 3435, 59, and 7678.) Is Dell a merchandiser or a manufacturer? What information contained in the 10-K supports your answer? What are some examples of direct and indirect inventoriable costs for Dell? Why has Dells gross margin (in dollars) steadily increased from 2003 to 2005, yet the gross margin as a percent of net revenue has only increased slightly? What is the inventory balance on Dells January 28, 2005 balance sheet? Why is the inventory balance so small compared to the other current asset balances? What competitive advantage does Dell derive from its low inventory levels? Page 27 of Dells 10-K reports a gure called the cash conversion cycle. The cash conversion cycle for Dell has consistently been negative. Is this a good sign for Dell or a bad sign? Why? Describe some of the various types of operating expenses incurred by Dell. Why are these expenses treated as period costs? List four different cost objects for Dell. For each cost object, mention one example of a direct cost and an indirect cost. Research and Application Cases using 10-K data from companies such as Whole Foods Market, Dell, FedEx, and Target offer end-of-chapter learning opportunities for students to identify strategy and business risks and evaluate managerial accounting concepts within a real world context. xii Garrison Noreen Brewer gar79611_fm_i-xxi.indd Page xiii 1/6/09 5:17:02 PM user Author-Written Supplements Unlike other managerial accounting texts, Garrison, Noreen, and Brewer write all of the texts major supplements, ensuring a perfect fit between text and supplement. For more information on Managerial Accountings supplements package, see page xviii. A solid, well-balanced introductory text book which I recommend for accounting and non-accounting majors. Pamela Ondeck, University of Pittsburgh at Greensburg Instructors Manual Test bank Solutions Manual Workbook/Study Guide Garrisons Managerial Accounting is, in my opinion, the best introductory managerial accounting textbook on the market. It is pedagogically sound and has sufficient breadth in end-of-chapter materials to accommodate a variety of teaching styles. This is a well-written text for both accounting and general business majors. It does an excellent job of incorporating real-world examples throughout every chapter. The online learning center is terrific and would be beneficial to all students. Kathleen M. Metcalf, Muscatine Community College Dr. G. Todd Jackson, Northeastern State University Managerial Accounting Thirteenth Edition xiii gar79611_fm_i-xxi.indd Page xiv 12/24/08 9:42:56 PM user-s180 xiv /Users/user-s180/Desktop/Dhiru 24-12-08/New/MHBR094-FM New to the Contents Thirteenth Edition Faculty feedback helps us continue to improve Managerial Accounting. In response to reviewer suggestions we have: Reordered variances in Chapters 10 and 11. Both chapters have been completely rewritten to follow a more logical flow. Streamlined Variable Costing coverage in Chapter 7, making it even more user-friendly. Moved the coverage of balanced scorecard from Chapter 10 to Chapter 12, where it more naturally belongs. Added International Financial Reporting Standards (IFRS) icons throughout the text to highlight topics that may be affected should the U.S. adopt IFRS in the future. Other major changes include: Chapter 1 Chapter 7 In Business boxes have been updated throughout Materials dealing with the distinction between nancial and managerial accounting have been moved to Chapter 2 The section on Technology in Business has been eliminated. New material on Corporate Social Responsibility has been added. The Schedule of Cost of Goods Manufactured has been simplied by eliminating the list of the elements of Manufacturing Overhead. This removes a discrepancy that existed between the coverage of the Schedule of Cost of Goods Manufactured in Chapters 2 and 3. The exercises and problems for the appendices have been moved so that they follow those appendices. Chapter 3 Portions of the chapter have been rewritten to enhance clarity. The appendix has been rewritten to highlight its assumptions. The exercises and problems for the appendix have been moved so that they follow the appendix. The chapter has been extensively revised to make the material more user-friendly. Tables have been simplied and computing cost of goods sold has been stream-lined. Chapter 8 Chapter 2 Prot graphs are covered in addition to CVP graphs. The exercises and problems for the appendices have been moved so that they follow those appendices. Chapter 10 This chapter has been completely rewritten to follow a logical path leading from budgeting to performance evaluation, comparing budgets to actual results and then on to standard cost analysis. Flexible budgets are used to prepare performance reports with activity variances and revenue and spending variances. Chapter 11 This chapter now covers all standard cost variancesincluding xed manufacturing overhead variances in an appendix. The material in this chapter has been extensively rewritten, particularly the materials dealing with manufacturing overhead. Chapter 4 Chapter 12 Preparing the Cost Reconciliation Report is now a Learning Objective. The exercises and problems for the appendices have been moved so that they follow those appendices. Chapter 6 The basic equations used in target prot analysis and break-even analysis have been revised to be more intuitive. Break-even analysis has been moved to follow target prot analysis because break-even analysis is a special case of target prot analysis. xiv Garrison Noreen Brewer The Balanced Scorecard has been moved to this chapter, where it more naturally belongs. Chapter 15 The denition of free cash ow has been added to the chapter. The exercises and problems for the appendix have been moved so that they follow the appendix. gar79611_fm_i-xxi.indd Page xv 12/24/08 9:42:56 PM user-s180 /Users/user-s180/Desktop/Dhiru 24-12-08/New/MHBR094-FM Contents xv A Market-Leading Book Deserves Market-Leading Technology The wide array of technology assets that come with Managerial Accounting arent add-ons thrown in at the last minute: Theyre extensions of the textbook itself, that work in unison to make managerial accounting as easy as possible to learn. You may be tempted to put aside your CD and registration cards, planning to get to them later; you may even want to discard them outright. Dont do it! These supplements can offer you tremendous help as you go through the course; the sooner you become familiar with them, the sooner you can enjoy the immense benets they have to offer. iPod Content Harness the power of one of the most popular technology tools students use todaythe Apple iPod. Our innovative approach allows students to download audio and video presentations right into their iPod and take learning materials with them wherever they go. Students just need to visit the Online Learning Center at www.mhhe.com/garrison13e to download our iPod content. For each chapter of the book they will be able to download audio narrated lecture presentations, managerial accounting videos, and even selfquizzes designed for use on various versions of iPods. It makes review and study time as easy as putting in headphones. McGraw-Hills Homework Manager McGraw-Hills Homework Manager System is an online homework management solution that contains this textbooks end-of-chapter material as well as the test bank. Instructors have the option to build assignments from static and algorithmic versions of the end-of-chapter material or build self-graded quizzes from the test bank. Features: Assigns book-specic problems/exercises to students. Provides integrated test bank questions for quizzes and tests. Automatically grades assignments and quizzes and stores results in one grade book. Learn more about McGraw-Hills Homework Manager system by referring to the opening pages of this text. McGraw-Hills Homework ManagerPlus McGraw-Hills Homework Manager PLUS system gathers all of M anagerial Accounting s online student resources under one convenient access point, combining the power and flexibility of McGraw-Hills Homework Manager system with the latest interactive learning technology to create a comprehensive, fully integrated online study package. Students using McGraw-Hills Homework Manager PLUS system can access not only McGraw-Hills Homework Manager system itself, but the interactive online textbook as well, allowing students working on an assignment to click a hotlink and instantly review the appropriate material in the textbook. Students receive full access to McGraw-Hills Homework Manager system when they purchase McGraw-Hills Homework Manager PLUS system. Managerial Accounting Thirteenth Edition xv gar79611_fm_i-xxi.indd gar79611_fm_i-xxi.indd Page xvi 12/25/08 2:10:45 AM user-s180 /Users/user-s180/Desktop McGraw-Hill Connect Accounting The next evolution in online homework management and assessment, McGraw-Hill Connect Accounting is customized to Garrisons Managerial Accounting, 13e. With Connect Accounting, instructors can deliver assignments, quizzes, and tests online. The system allows instructors to assign end-of-chapter material from the text in both static and algorithmic form, providing an endless supply of practice material for students. In addition, instructors can edit existing questions and author entirely new problems. Features: Assignments are graded automatically, and the results are stored in the instructors private gradebook. Instructors can track individual student performance by question, assignment, or in comparison to the rest of the class. Detailed grade reports are easily integrated with Learning Management Systems, such as WebCT and Blackboard. McGraw-Hill Connect Accounting is also available with the interactive online version of the textConnect Accounting Plus. In addition to providing students with online assignments and assessments, Connect Accounting Plus also gives them 24/7 online access to an eBookan identical, electronic edition of the printed textto aid them in successfully completing their work wherever and whenever they choose. In addition to McGraw-Hill Connect Accounting, Garrison 13e can also be purchased with McGraw-Hills Homework Manager system, giving you more than one option to t your course management needs. Online Learning Center (OLC) w ww.mh h e .co m/ga rriso n 13e More and more students are studying online. Thats why we offer an Online Learning Center (OLC) that follows Managerial Accounting chapter by chapter. It doesnt require any building or maintenance on your part. Its ready to go the moment you and your students type in the URL. The Online Learning Center contains: For the Instructor (on a password protected site): Instructors Manual Solutions Manual Test bank Powerpoint Slides Excel Template Solutions Transparency Masters For the Student: Practice Quizzes Powerpoint Slides Excel Templates iPod Content xvi Garrison Noreen Brewer gar79611_fm_i-xxi.indd Page xvii 12/24/08 9:43:07 PM user-s180 /Users/user-s180/Desktop/Dhiru 24-12-08/New/MHBR094-FM CourseSmart CourseSmart is a new way to nd and buy eTextbooks. At CourseSmart you can save up to 50 percent off the cost of a print textbook, reduce your impact on the environment, and gain access to powerful Web tools for learning. CourseSmart has the largest selection of eTextbooks available anywhere, offering thousands of the most commonly adopted textbooks from a wide variety of higher education publishers. CourseSmart eTextbooks are available in one standard online reader with full text search, notes and highlighting, and e-mail tools for sharing notes between classmates. Garrison makes it easy for those students to see the relevance of the material. That makes it easier to learn. Linda K. Whitten, Skyline College Online Course Management No matter what online course management system you use (WebCT, BlackBoard, or eCollege), we have a course cartridge available for Garrison 13e. Our cartridges are specically designed to make it easy to navigate and access content online. They are easier than ever to install on the latest version of the course management system available today. Dont forget that you can count on the highest level of service from McGraw-Hill. Our online course management specialists are ready to assist you with your online course needs. They provide training and will answer any questions you have throughout the life of your adoption. So try our course cartridge for Garrison 13e and make online course content delivery easy. It is an easy to read, logically sequenced, book. It has been the standard of excellence for years. Keith Patterson, Brigham Young UniversityIdaho Apple iPod iQuiz Use our EZ Test Online to help your students prepare to succeed with Apple iPod iQuiz. Using our EZ Test Online you can make test and quiz content available for a students Apple iPod. Students must purchase the iQuiz game application from Apple for 99 in order to use the iQuiz content. It works on the iPOD fth-generation iPODs and better. Instructors need only EZ Test Online to produce iQuiz ready content. Instructors take their existing tests and quizzes and export them to a le that can then be made available to the student to take as a self quiz on their iPods. Its as simple as that. It is an excellent book for class as well as a reference material for all users. Shiv S. Sharma, Robert Morris University McGraw-Hill/Irwin CARES At McGraw-Hill/Irwin, we understand that getting the most from new technology can be challenging. Thats why our services dont stop after you purchase our book. You can e-mail our Product Specialists 24 hours a day, get product training online, or search our knowledge bank of Frequently Asked Questions on our support Website. McGraw-Hill/Irwin Customer Care Contact Information For all Customer Support call (800) 331-5094 Email be_support@mcgraw-hill.com Or visit www.mhhe.com/support One of our Technical Support Analysts will be able to assist you in a timely fashion. Managerial Accounting It is a very well-written, comprehensive textwith outstanding illustrations and relevant real world examples. Michael Tyler, Ph.D., Barry University Thirteenth Edition xvii gar79611_fm_i-xxi.indd Page xviii 12/24/08 9:43:08 PM user-s180 /Users/user-s180/Desktop/Dhiru 24-12-08/New/MHBR094-FM Instructor Supplements Assurance of Learning Ready Instructor CD-ROM Many educational institutions today are focused on the notion of assurance of learning, an important element of some accreditation standards. Managerial Accounting, 13e is designed specically to support your assurance of learning initiatives with a simple, yet powerful, solution. Each test bank question for Managerial Accounting, 13e maps to a specic chapter learning outcome/objective listed in the text. You can use our test bank software, EZ Test, to easily query for learning outcomes/objectives that directly relate to the learning objectives for your course. You can then use the reporting features of EZ Test to aggregate student results in similar fashion, making the collection and presentation of assurance of learning data simple and easy. You can also use our Algorithmic-Diploma Test Bank to do this. MHID 0073359807 ISBN-13 9780073359809 Allowing instructors to create a customized multimedia presentation, this all-in-one resource incorporates the Test bank, PowerPoint Slides, Instructors Manual, and the Solutions Manual. AACSB Statement MHID 0073359726 ISBN-13 9780073359724 Use this test bank to make different versions of the same test, change the answer order, edit and add questions, and conduct online testing. Technical support for this software is available. McGraw-Hill Companies is a proud corporate member of AACSB International. Recognizing the importance and value of AACSB accreditation, we have sought to recognize the curricula guidelines detailed in AACSB standards for business accreditation by connecting selected questions in Managerial Accounting, 13e to the general knowledge and skill guidelines found in the AACSB standards. The statements contained in Managerial Accounting, 13e are provided only as a guide for the users of this text. The AACSB leaves content coverage and assessment clearly within the realm and control of individual schools, the mission of the school, and the faculty. The AACSB does also charge schools with the obligation of doing assessment against their own content and learning goals. While Managerial Accounting, 13e and its teaching package make no claim of any specic AACSB qualication or evaluation, we have, within Managerial Accounting, 13e, labeled selected questions according to the six general knowledge and skills areas. The labels or tags within Managerial Accounting, 13e are as indicated. There are, of course, many more within the test bank, the text, and the teaching package which might be used as a standard for your course. However, the labeled questions are suggested for your consideration. Instructors Manual Available on the Instructor CD and the OLC. Extensive chapter-by-chapter lecture notes help with classroom presentations and contain useful suggestions for presenting key concepts and ideas. This edition has been updated to coordinate the lecture notes closely with the PowerPoint Slides, making lesson planning even easier. Computerized Test Bank Print Test Bank Volume 1: MHID 0073359823 ISBN-13 9780073359823 Volume 2: MHID 007335970X ISBN-13 9780073359700 Over 2,000 questions are organized by chapter and include true/false, multiple-choice, and problems. This edition of the test bank includes worked out solutions and all items have been tied to AACSB-AICPA standards. Microsoft Excel Templates Available on the Instructor CD and the OLC. Prepared by Jack Terry of ComSource Associates, Inc., these Excel templates offer solutions to the student version. EZ Test Available on the Instructors CD Check Figures McGraw-Hills EZ Test is a exible electronic testing program. The program allows instructors to create tests from book-specic items. It accommodates a wide range of question types, plus instructors may add their own questions and sort questions by format. EZ Test can also scramble questions and answers for multiple versions of the same test. These provide key answers for selected problems and cases should you want to make them available for your students. They are available on the texts Web site. xviii Garrison Noreen Brewer gar79611_fm_i-xxi.indd Page xix 12/24/08 9:43:08 PM user-s180 /Users/user-s180/Desktop/Dhiru 24-12-08/New/MHBR094-FM Student Supplements iPod Content Available on the OLC. The online learning center contains course-related videos, chapterspecific quizzes, and audio and visual lecture presentations that tie directly to the text. Icons in the margins of the book direct students to the assets available on the Web site that can offer them additional help in understanding difficult topics. Working Papers Online Learning Center (OLC) When it comes to getting the most out of your textbook, the Online Learning Center is the place to start. The OLC follows Managerial Accounting chapter by chapter, offering all kinds of supplementary help for you as you read. Before you even start reading Chapter 1, go to this address and bookmark it: w w w.mhhe.com/ g ar r is o n 13e Remember, your Online Learning Center was created specifically to accompany Managerial Accountingso dont let this great resource pass you by! Workbook/Study Guide MHID: 0073359858 ISBN-13: 9780073359854 This study aid provides suggestions for studying chapter material, summarizes essential points in each chapter, and tests your knowledge using self-test questions and exercises. Student Lecture Aid MHID: 007335984X ISBN-13: 9780073359847 This booklet offers a hard-copy version of all the Teaching Transparencies. You can annotate the material during the lecture and take notes in the space provided. Managerial Accounting MHID: 0073359866 ISBN-13: 9780073359861 This study aid contains forms that help you organize your solutions to homework problems. Excel Templates Available on the OLC. Prepared by Jack Terry of ComSource Associates, Inc., this spreadsheet-based software uses Excel to solve selected problems and cases in the text. These selected problems and cases are identified in the margin of the text with an appropriate icon. Practice Set MHID: 0073396192 ISBN-13: 9780073396194 Authored by Janice L. Cobb of Texas Christian University, Doing the Job of the Managerial Accountant is a real-world application for the introductory Managerial Accounting student. The case is based on an actual growing, entrepreneurial manufacturing company that is complex enough to demonstrate the decisions management must make, yet simple enough that a sophomore student can easily understand the entire operations of the company. The case requires the student to do tasks they would perform working as the managerial accountant for the company. The required tasks are directly related to the concepts learned in all managerial accounting classes. The practice set can be used by the professor as a teaching tool for class lectures, as additional homework assignments, or as a semester project. Thirteenth Edition xix gar79611_fm_i-xxi.indd Page xx 12/24/08 9:43:08 PM user-s180 /Users/user-s180/Desktop/Dhiru 24-12-08/New/MHBR094-FM Acknowledgments Suggestions have been received from many of our colleagues throughout the world. Each of those who have offered comments and suggestions has our thanks. The efforts of many people are needed to develop and improve a text. Among these people are the reviewers and consultants who point out areas of concern, cite areas of strength, and make recommendations for change. In this regard, the following professors provided feedback that was enormously helpful in preparing the thirteenth edition of Managerial Accounting: Alfonso Oddo, Niagara University Angela Sandberg, Jacksonville State University Ann Ownby Hicks, North Park University Anna Lusher, Slippery Rock University Barbara A. Croteau, Santa Rosa Jr. College Bikki Jaggi, Rutgers University Bonnie McQuitter Banks, Alabama A&M University Brian L. McGuire, University of Southern Indiana Bruce Neumann, University of Colorado-Denver Carla Cabarle, Minot State University Carmen Morgan, Oregon Institute of Technology Cathy Lumbattis, Southern Illinois University Cecil Battiste, Valencia Community College, East Campus Charles Wain, Babson College Cindi Khanlarian, University of Northern Carolina Greensboro Claudia M. Gilbertson, North Hennepin Community College Clayton Sager, University of WisconsinWhitewater Curtis Howell, Georgia Southern State University David Krug, Johnson County Community College Deborah Beard, Southeast Missouri State University Diane Tanner, University of North Florida Donald E. Summers, Naval Postgraduate School G. Todd Jackson, Northeastern State University Gerald A. Thalmann, North Central College James F. White, Boston University Jeanette C. Maier-Lytle, University of Southern Indiana Jerry W. Hanwell, Robert Morris University Joe Gerard, University of WisconsinWhitewater John Hoffer, Stark State College Joseph G. San Miguel, Naval Postgraduate School Juanita M. Rendon, U.S. Naval Postgrad School Kashi Balachandran, New York University Kathleen M. Metcalf, Muscatine Community College Keith Patterson, BYUIdaho Kreag Danvers, Clarion University Larry Devan, Hood College Laurie McWhorter, Mississippi State University Linda J. Benz, Jefferson Comm. & Tech Coll. Linda K. Whitten, Skyline College xx Garrison Noreen Brewer Linda Tarrago, Hillsborough Community College Mahmoud M. Nourayi, Loyola Marymount University Marilyn Brooks-Lewis, Warren County Community College Mark Juffernbruch, Simpson College Martin Rudnick, William Paterson University Mary Michel, Manhattan College Mary Tichich, University of WisconsinRiver Falls Michael Tyler, Barry University Mike Thiry, Harper College Nat Briscoe, Northwestern State University Noel McKeon, Florida Community CollegeJacksonville, Downtown Campus Pam Meyer, University of Louisiana@Lafayette Pamela Ondeck, University of Pittsburgh/Greensburg Patricia C. Douglas, Loyola Marymount University Patricia Fedje, Minot State University Paul Fisher, Rogue Community College Priscilla R. Reis, Idaho State University Rafik Elias, California State University, Los Angeles Ray Wilson, Boston University Rebecca J. Oatsvall, Meredith College Reed W. Easton, Seton Hall University Rubik Atamian, The University of Texas, Pan Am Russell Calk, New Mexico State University Sandra Copa, North Hennepin Community College Scott Martens, University of Minnesota Sharon T. Walters, Morehead State University Shirly A. Kleiner, Johnson County Community College Shiv S. Sharma, Robert Morris University Terry Glen Elliott, Morehead State University Thomas Buckhoff, Georgia Southern University Wayne C. Ingalls, University of Maine William Lloyd, Lock Haven University Helen Adams, University of Washington Jorja Bradford, Alabama State University Rob Clarke, Brigham Young University Bob Conway, University of WisconsinPlatteville Hubert Gill, University of North Florida Judy Harris, Nova Southeastern University Susan Hass, Simmons College School of Management gar79611_fm_i-xxi.indd Page xxi 12/24/08 9:43:08 PM user-s180 /Users/user-s180/Desktop/Dhiru 24-12-08/New/MHBR094-FM Margaret Hicks, Howard University Chip Hines, Western Michigan University Randy D. Johnston, Michigan State University Celina Jozsi, University of South Florida Harold Little, Western Kentucky University Michelle McEacharn, University of Louisiana at Monroe Brian McGuire, University of Southern Indiana Michael Newman, University of Houston Mike Slaubaugh, Indiana University Scott Stroher, Glendale Community College Jane Wiese, Valencia Community College Kathy Crusto-Way, Tarrant County College South East Ray Elson, Valdosta State University Ralph Fritzsch, Midwestern State University Mahmud Hossain, University Of Memphis Shondra Johnson, Bradley University Susan Kattelus, Eastern Michigan University Debbie Madden, Morehead State University Loretta Manktelow, James Madison University Richard McDermott, Weber State University Robert Morse, Ivy Tech Community College of Indiana Janet OTousa, University of Notre Dame Ronald Reed, University of Northern Colorado Yehia Salama, University of IllinoisChicago Tony Scott, Norwalk Community College Doris Warmflash, Westchester Community College Mary Ann Welden, Wayne State University We are grateful for the outstanding support from McGraw-Hill. In particular, we would like to thank Stewart Mattson, Editorial Director; Tim Vertovec, Publisher; Emily Hatteberg, Developmental Editor; Kathleen Klehr, Marketing Manager; Pat Frederickson, Lead Project Manager; Debra Sylvester, Production Supervisor; Matthew Baldwin, Lead Designer; Susan Lombardi, Media Project Manager; and Lori Kramer, Photo Research Coordinator. Finally, we would like to thank Beth Woods and Helen Roybark for working so hard to ensure an error-free thirteenth edition. The authors also wish to thank Linda and Michael Bamber for inspiring the creation of the 10-K Research and Application exercises that are included in the end-of-chapter materials throughout the book. We are grateful to the Institute of Certified Management Accountants for permission to use questions and/or unofficial answers from past Certificate in Management Accounting (CMA) examinations. Likewise, we thank the American Institute of Certified Public Accountants, the Society of Management Accountants of Canada, and the Chartered Institute of Management Accountants (United Kingdom) for permission to use (or to adapt) selected problems from their examinations. These problems bear the notations CPA, SMA, and CIMA respectively. Ray H. Garrison Eric Noreen Peter Brewer Garrison is the premier M[anagerial] A[ccounting] text. Very comprehensive, very readable and understandable. The end of chapter problems are very well done, allowing teachers to find excellent examples of a variety of topics and difficulty. Head and shoulders above anything else I have seen or used. Ray Wilson, Boston University Managerial Accounting Thirteenth Edition xxi gar79611_fm_xxii-xxxi.indd Page xxii 1/6/09 5:12:35 PM user-s176 /broker/MH-BURR/MHBR094/MHBR094-FM/upload/MHBR094-FM Brief Contents Chapter One Managerial Accounting and the Business Environment Chapter Two Managerial Accounting and Cost Concepts Chapter Three Systems Design: Job-Order Costing 1 30 88 Chapter Four Systems Design: Process Costing 148 Chapter Five Cost Behavior: Analysis and Use 188 Chapter Six Cost-Volume-Prot Relationships 233 Chapter Seven Variable Costing: A Tool for Management Chapter Eight Activity-Based Costing: A Tool to Aid Decision Making Chapter Nine Prot Planning Chapter Ten 279 307 368 Flexible Budgets and Performance Analysis 417 Chapter Eleven Standard Costs and Operating Performance Measures Chapter Twelve Segment Reporting, Decentralization, and the Balanced Scorecard Chapter Thirteen Relevant Costs for Decision Making Chapter Fourteen Capital Budgeting Decisions 450 578 627 Chapter Fifteen How Well Am I Doing? Statement of Cash Flows Chapter Sixteen How Well Am I Doing? Financial Statement Analysis Appendix A Appendix B x xii Pricing Products and Services Protability Analysis 777 761 687 723 507 gar79611_fm_xxii-xxxi.indd Page xxiii 12/24/08 5:31:34 PM user-s180 /Users/user-s180/Desktop/Dhiru 24-12-08/New/MHBR094-FM Contents 1 Chapter Chapter 2 Managerial Accounting and the Business Environment 1 Managerial Accounting and Cost Concepts 30 Globalization 2 Strategy 4 Organizational Structure 5 Decentralization 5 The Functional View of Organizations 5 The Work of Management and the Need for Managerial Accounting Information 31 Planning 31 Directing and Motivating 32 Controlling 32 The End Results of Managers Activities 33 The Planning and Control Cycle 33 Process Management 7 Lean Production 8 The Lean Thinking Model 8 The Theory of Constraints 10 Six Sigma 11 The Importance of Ethics in Business 12 Code of Conduct for Management Accountants 14 Company Codes of Conduct 14 Codes of Conduct on the International Level 17 Corporate Governance 17 The Sarbanes-Oxley Act of 2002 18 Enterprise Risk Management 19 Identifying and Controlling Business Risks Corporate Social Responsibility 21 The Certied Management Accountant (CMA) 22 Summary 23 Glossary 24 Questions 25 Exercises 25 Problems 26 Research and Application 29 19 Comparison of Financial and Managerial Accounting 33 Emphasis on the Future 34 Relevance of Data 34 Less Emphasis on Precision 35 Segments of an Organization 35 Generally Accepted Accounting Principles (GAAP) Managerial AccountingNot Mandatory 35 35 General Cost Classications 36 Manufacturing Costs 36 Direct Materials 36 Direct Labor 37 Manufacturing Overhead 37 Nonmanufacturing Costs 38 Product Costs versus Period Costs 38 Product Costs 38 Period Costs 39 Prime Cost and Conversion Cost 39 Cost Classications on Financial Statements 41 The Balance Sheet 41 The Income Statement 42 Schedule of Cost of Goods Manufactured 44 Product Cost Flows 45 Inventoriable Costs 46 An Example of Cost Flows 46 x xiii gar79611_fm_xxii-xxxi.indd Page xxiv 12/24/08 5:31:36 PM user-s180 x xiv /Users/user-s180/Desktop/Dhiru 24-12-08/New/MHBR094-FM Contents Cost Classications for Predicting Cost Behavior Variable Cost 48 Fixed Cost 49 46 Cost Classications for Assigning Costs to Cost Objects 51 Direct Cost 51 Indirect Cost 51 Cost Classications for Decision Making Differential Cost and Revenue 52 Opportunity Cost 53 Sunk Cost 54 52 Summary 54 Review Problem 1: Cost Terms 55 Review Problem 2: Schedule of Cost of Goods Manufactured and Income Statement 56 Glossary 57 Questions 58 Exercises 59 Problems 64 Cases 71 Research and Application 73 Appendix 2A: Further Classication of Labor Costs 73 Appendix 2B: Cost of Quality 76 Chapter 3 Systems Design: Job-Order Costing 88 Process and Job-Order Costing Process Costing 89 Job-Order Costing 89 89 Job-Order CostingAn Overview 90 Measuring Direct Materials Cost 91 Job Cost Sheet 92 Measuring Direct Labor Cost 93 Applying Manufacturing Overhead 94 Using the Predetermined Overhead Rate 95 The Need for a Predetermined Rate 95 Choice of an Allocation Base for Overhead Cost 96 Computation of Unit Costs 98 Summary of Document Flows 98 Job-Order CostingThe Flow of Costs 98 The Purchase and Issue of Materials 98 Issue of Direct and Indirect Materials 100 Labor Cost 100 Manufacturing Overhead Costs 101 Applying Manufacturing Overhead 102 The Concept of a Clearing Account 103 Nonmanufacturing Costs 104 Cost of Goods Manufactured 104 Cost of Goods Sold 105 Summary of Cost Flows 105 Problems of Overhead Application 109 Underapplied and Overapplied Overhead 109 Disposition of Underapplied or Overapplied Overhead Balances 110 Closed Out to Cost of Goods Sold 111 Allocated between Accounts 112 Which Method Should Be Used for Disposing of Underapplied or Overapplied Overhead? 112 A General Model of Product Cost Flows 112 Multiple Predetermined Overhead Rates 113 Job-Order Costing in Service Companies Use of Information Technology 114 Summary 116 Review Problem: Job-Order Costing Glossary 119 Questions 119 Exercises 120 Problems 127 Cases 138 Research and Application 140 113 116 Appendix 3A: The Predetermined Overhead Rate and Capacity 141 Chapter 4 Systems Design: Process Costing 148 Comparison of Job-Order and Process Costing Similarities between Job-Order and Process Costing 149 Differences between Job-Order and Process Costing 149 149 gar79611_fm_xxii-xxxi.indd Page xxv 12/24/08 5:31:38 PM user-s180 /Users/user-s180/Desktop/Dhiru 24-12-08/New/MHBR094-FM Contents Cost Flows in Process Costing 150 Processing Departments 150 The Flow of Materials, Labor, and Overhead Costs 151 Materials, Labor, and Overhead Cost Entries 152 Materials Costs 152 Labor Costs 152 Overhead Costs 152 Completing the Cost Flows 153 Equivalent Units of Production 153 Weighted-Average Method 155 Compute and Apply Costs 157 Cost per Equivalent UnitWeighted-Average Method 157 Applying CostsWeighted-Average Method 158 Cost Reconciliation Report 159 Operation Costing 159 Summary 160 Review Problem: Process Cost Flows and Costing Units 160 Glossary 163 Questions 163 Exercises 163 Problems 168 Cases 171 Appendix 4A: FIFO Method 172 Appendix 4B: Service Department Allocations Discretionary Fixed Costs 196 The Trend toward Fixed Costs 197 Is Labor a Variable or a Fixed Cost? 197 Fixed Costs and the Relevant Range 198 Mixed Costs 199 The Analysis of Mixed Costs 200 Diagnosing Cost Behavior with a Scattergraph Plot The High-Low Method 206 The Least-Squares Regression Method 208 Multiple Regression Analysis 210 5 Cost Behavior: Analysis and Use 188 Types of Cost Behavior Patterns 189 Variable Costs 189 The Activity Base 190 Extent of Variable Costs 191 True Variable versus Step-Variable Costs 192 True Variable Costs 192 Step-Variable Costs 192 The Linearity Assumption and the Relevant Range 194 Fixed Costs 194 Types of Fixed Costs 196 Committed Fixed Costs 196 203 The Contribution Format Income Statement 210 Why a New Income Statement Format? 211 The Contribution Approach 211 Summary 212 Review Problem 1: Cost Behavior 212 Review Problem 2: High-Low Method 213 Glossary 214 Questions 215 Exercises 215 Problems 219 Cases 224 Research and Application 225 Appendix 5A: Least-Squares Regression Computations 226 180 Chapter Chapter x xv 6 Cost-Volume-Prot Relationships 233 The Basics of Cost-Volume-Prot (CVP) Analysis 234 Contribution Margin 235 CVP Relationships in Equation Form 237 CVP Relationships in Graphic Form 238 Preparing the CVP Graph 238 Contribution Margin Ratio (CM Ratio) 240 Some Applications of CVP Concepts 242 Change in Fixed Cost and Sales Volume 242 Change in Variable Costs and Sales Volume 243 Change in Fixed Cost, Sales Price, and Sales Volume 244 Change in Variable Cost, Fixed Cost, and Sales Volume 245 Change in Selling Price 246 gar79611_fm_xxii-xxxi.indd Page xxvi 12/24/08 5:31:39 PM user-s180 x xvi /Users/user-s180/Desktop/Dhiru 24-12-08/New/MHBR094-FM Contents Target Prot and Break-Even Analysis 246 Target Prot Analysis 246 The Equation Method 246 The Formula Method 246 Target Prot Analysis in Terms of Sales Dollars Break-Even Analysis 248 Break-Even in Unit Sales 248 Break-Even in Sales Dollars 249 The Margin of Safety 250 CVP Considerations in Choosing a Cost Structure Cost Structure and Prot Stability 251 Operating Leverage 253 Structuring Sales Commissions 255 Sales Mix 256 The Denition of Sales Mix 256 Sales Mix and Break-Even Analysis 256 Assumptions of CVP Analysis Chapter 251 Summary 291 Review Problem: Contrasting Variable and Absorption Costing 292 Glossary 294 Questions 294 Exercises 294 Problems 298 Cases 304 Chapter 258 Summary 259 Review Problem: CVP Relationships Glossary 262 Questions 262 Exercises 263 Problems 268 Cases 276 Research and Application 278 247 Decision Making 288 External Reporting and Income Taxes 289 Advantages of Variable Costing and the Contribution Approach 289 Variable Costing and the Theory of Constraints 290 Impact of Lean Production 291 259 Activity-Based Costing: An Overview 308 How Costs Are Treated under Activity-Based Costing 309 Nonmanufacturing Costs and Activity-Based Costing 309 Manufacturing Costs and Activity-Based Costing 309 Cost Pools, Allocation Bases, and Activity-Based Costing 309 7 Designing an Activity-Based Costing (ABC) System 312 Steps for Implementing Activity-Based Costing Step 1: Dene Activities, Activity Cost Pools, and Activity Measures 315 Variable Costing: A Tool for Management 279 Overview of Absorption and Variable Costing Absorption Costing 280 Variable Costing 280 Selling and Administrative Expense 280 Summary of Differences 280 Absorption Costing Income Statement 282 Variable Costing Contribution Format Income Statement 283 8 Activity-Based Costing: A Tool to Aid Decision Making 307 280 Reconciliation of Variable Costing with Absorption Costing Income 284 Choosing a Costing Method 287 The Impact on the Manager 287 CVP Analysis and Absorption Costing 288 314 The Mechanics of Activity-Based Costing 316 Step 2: Assign Overhead Costs to Activity Cost Pools 316 Step 3: Calculate Activity Rates 319 Step 4: Assign Overhead Costs to Cost Objects 321 Step 5: Prepare Management Reports 323 Comparison of Traditional and ABC Product Costs 326 Product Margins Computed Using the Traditional Cost System 326 The Differences between ABC and Traditional Product Costs 328 gar79611_fm_xxii-xxxi.indd Page xxvii 12/24/08 5:31:42 PM user-s180 /Users/user-s180/Desktop/Dhiru 24-12-08/New/MHBR094-FM x xvii Contents Targeting Process Improvements 331 Activity-Based Costing and External Reports 332 The Limitations of Activity-Based Costing 333 Summary 334 Review Problem: Activity-Based Costing 334 Glossary 336 Questions 337 Exercises 337 Problems 345 Research and Application 348 Appendix 8A: ABC Action Analysis 349 Summary 355 Review Problem: Activity Analysis Report Glossary (Appendix 8A) 357 393 10 Chapter 356 Appendix 8B: Using a Modied Form of Activity-Based Costing to Determine Product Costs for External Reports 360 Chapter Summary 393 Review Problem: Budget Schedules Glossary 395 Questions 396 Exercises 397 Problems 401 Cases 413 Research and Application 415 9 Prot Planning 368 The Basic Framework of Budgeting 369 Advantages of Budgeting 369 Responsibility Accounting 369 Choosing a Budget Period 370 The Self-Imposed Budget 371 Human Factors in Budgeting 372 The Budget Committee 373 The Master Budget: An Overview 374 Preparing the Master Budget 376 The Sales Budget 377 The Production Budget 378 Inventory PurchasesMerchandising Company 380 The Direct Materials Budget 380 The Direct Labor Budget 382 The Manufacturing Overhead Budget 383 The Ending Finished Goods Inventory Budget 384 The Selling and Administrative Expense Budget 385 The Cash Budget 387 The Budgeted Income Statement 390 The Budgeted Balance Sheet 391 Flexible Budgets and Performance Analysis 417 Flexible Budgets 418 Characteristics of a Flexible Budget 418 Deciencies of the Static Planning Budget How a Flexible Budget Works 421 418 Flexible Budget Variances 421 Activity Variances 422 Revenue and Spending Variances 423 A Performance Report Combining Activity and Revenue and Spending Variances 424 Performance Reports in Nonprot Organizations 426 Performance Reports in Cost Centers 427 Flexible Budgets with Multiple Cost Drivers Some Common Errors 429 427 Summary 430 Review Problem: Variance Analysis Using a Flexible Budget 431 Glossary 432 Questions 433 Exercises 433 Problems 441 Cases 446 11 Chapter Standard Costs and Operating Performance Measures 450 Standard CostsManagement by Exception 452 Who Uses Standard Costs? 453 gar79611_fm_xxii-xxxi.indd Page xxviii 12/24/08 5:31:42 PM user-s180 x xviii Contents 12 Setting Standard Costs 453 Ideal versus Practical Standards 454 Setting Direct Materials Standards 455 Setting Direct Labor Standards 456 Setting Variable Manufacturing Overhead Standards 457 A General Model for Variance Analysis Price and Quantity Variances 457 Chapter Segment Reporting, Decentralization, and the Balanced Scorecard 507 457 Using Standard CostsDirect Materials Variances 458 Materials Price VarianceA Closer Look 460 Isolation of Variances 461 Responsibility for the Variance 461 Materials Quantity VarianceA Closer Look 462 Using Standard CostsDirect Labor Variances 463 Labor Rate VarianceA Closer Look 464 Labor Efciency VarianceA Closer Look 464 Using Standard CostsVariable Manufacturing Overhead Variances 465 Manufacturing Overhead VariancesA Closer Look 466 Variance Analysis and Management by Exception 468 International Uses of Standard Costs 469 Evaluation of Controls Based on Standard Costs 470 Advantages of Standard Costs 470 Potential Problems with the Use of Standard Costs 470 Operating Performance Measures 471 Delivery Cycle Time 471 Throughput (Manufacturing Cycle) Time 471 Manufacturing Cycle Efciency (MCE) 472 Summary 473 Review Problem: Standard Costs Glossary 476 Questions 477 Exercises 477 Problems 480 Cases 487 /Users/user-s180/Desktop/Dhiru 24-12-08/New/MHBR094-FM 474 Appendix 11A: Predetermined Overhead Rates and Overhead Analysis in a Standard Costing System 489 Appendix 11B: Journal Entries to Record Variances 501 Decentralization in Organizations 508 Advantages and Disadvantages of Decentralization 508 Responsibility Accounting 509 Cost, Prot, and Investment Centers 509 Cost Center 509 Prot Center 509 Investment Center 511 An Organizational View of Responsibility Centers 511 Decentralization and Segment Reporting 511 Building a Segmented Income Statement 512 Levels of Segmented Statements 514 Sales and Contribution Margin 516 Traceable and Common Fixed Costs 516 Identifying Traceable Fixed Costs 516 Activity-Based Costing 517 Traceable Costs Can Become Common Costs 517 Segment Margin 518 Segmented Financial Information in External Reports 520 Hindrances to Proper Cost Assignment 520 Omission of Costs 520 Inappropriate Methods for Assigning Traceable Costs among Segments 521 Failure to Trace Costs Directly 521 Inappropriate Allocation Base 521 Arbitrarily Dividing Common Costs among Segments 521 Evaluating Investment Center PerformanceReturn on Investment 522 The Return on Investment (ROI) Formula 522 Net Operating Income and Operating Assets Dened 523 Understanding ROI 523 Criticisms of ROI 526 Residual Income 526 Motivation and Residual Income 528 Divisional Comparison and Residual Income 529 gar79611_fm_xxii-xxxi.indd Page xxix 12/24/08 5:31:43 PM user-s180 /Users/user-s180/Desktop/Dhiru 24-12-08/New/MHBR094-FM x xix Contents Balanced Scorecard 529 Common Characteristics of Balanced Scorecards 530 A Companys Strategy and the Balanced Scorecard 533 Tying Compensation to the Balanced Scorecard 535 Advantages of Timely and Graphic Feedback 535 Summary 536 Review Problem 1: Segmented Statements 537 Review Problem 2: Return on Investment (ROI) and Residual Income 538 Glossary 539 Questions 539 Exercises 540 Problems 546 Cases 555 Research and Application 557 Research and Application 558 Appendix 12A: Transfer Pricing Review Problem 3: Transfer Pricing Glossary (Appendix 12A) 566 Glossary (Appendix 12B) Joint Product Costs and the Contribution Approach 598 The Pitfalls of Allocation 599 Sell or Process Further Decisions 600 Activity-Based Costing and Relevant Costs Summary 602 Review Problem: Relevant Costs Glossary 604 Questions 604 Exercises 603 Problems 612 Cases 620 558 564 Appendix 12B: Service Department Charges 570 Capital Budgeting Decisions 627 Capital BudgetingPlanning Investments 628 Typical Capital Budgeting Decisions 628 The Time Value of Money 628 Relevant Costs for Decision Making 578 583 Adding and Dropping Product Lines and Other Segments 586 An Illustration of Cost Analysis 586 A Comparative Format 588 Beware of Allocated Fixed Costs 588 The Make or Buy Decision 589 Strategic Aspects of the Make or Buy Decision 590 An Example of Make or Buy 590 592 602 Chapter 13 Cost Concepts for Decision Making 579 Identifying Relevant Costs and Benets 579 Different Costs for Different Purposes 580 An Example of Identifying Relevant Costs and Benets 581 Reconciling the Total and Differential Approaches Why Isolate Relevant Costs? 585 602 14 574 Chapter Opportunity Cost Special Orders 593 Utilization of a Constrained Resource 594 Contribution Margin per Unit of the Constrained Resource 595 Managing Constraints 596 The Problem of Multiple Constraints 598 Discounted Cash FlowsThe Net Present Value Method 629 The Net Present Value Method Illustrated 629 Emphasis on Cash Flows 631 Typical Cash Outows 631 Typical Cash Inows 631 Recovery of the Original Investment 632 Simplifying Assumptions 633 Choosing a Discount Rate 633 An Extended Example of the Net Present Value Method 634 Discounted Cash FlowsThe Internal Rate of Return Method 635 The Internal Rate of Return Method Illustrated 635 Salvage Value and Other Cash Flows 636 Using the Internal Rate of Return 636 The Cost of Capital as a Screening Tool 636 gar79611_fm_xxii-xxxi.indd Page xxx 12/24/08 5:31:44 PM user-s180 x xx /Users/user-s180/Desktop/Dhiru 24-12-08/New/MHBR094-FM Contents Comparison of the Net Present Value and Internal Rate of Return Methods 637 Expanding the Net Present Value Method The Total-Cost Approach 638 The Incremental-Cost Approach 638 Least-Cost Decisions 640 Uncertain Cash Flows An Example 641 Real Options 642 638 15 Chapter How Well Am I Doing? Statement of Cash Flows 687 The Basic Approach to a Statement of Cash Flows 689 Denition of Cash 689 Constructing the Statement of Cash Flows Using Changes in Noncash Balance Sheet Accounts 689 641 Preference DecisionsThe Ranking of Investment Projects 643 Internal Rate of Return Method 643 Net Present Value Method 644 An Example of a Simplied Statement of Cash Flows 691 Constructing a Simplied Statement of Cash Flows The Need for a More Detailed Statement 693 Other Approaches to Capital Budgeting Decisions 645 The Payback Method 645 Evaluation of the Payback Method 646 An Extended Example of Payback 647 Payback and Uneven Cash Flows 649 The Simple Rate of Return Method 649 Criticisms of the Simple Rate of Return 651 Organization of the Full-Fledged Statement of Cash Flows 694 Operating Activities 695 Investing Activities 695 Financing Activities 695 Postaudit of Investment Projects Other Issues in Preparing the Statement of Cash Flows 696 Cash Flows: Gross or Net? 696 Operating Activities: Direct or Indirect Method? 696 651 Summary 652 Review Problem: Comparison of Capital Budgeting Methods 653 Glossary 654 Questions 655 Exercises 655 Problems 659 Cases 668 Appendix 14A: The Concept of Present Value Glossary (Appendix 14A) 671 671 Appendix 14B: Present Value Tables 677 Appendix 14C: Income Taxes in Capital Budgeting Decisions 679 Glossary (Appendix 14C) 675 691 An Example of a Full-Fledged Statement of Cash Flows 697 Eight Basic Steps to Preparing the Statement of Cash Flows 697 Setting Up the Worksheet (Steps 1 4) 698 Adjustments to Reect Gross, Rather than Net, Amounts (Step 5) 700 Classifying Entries as Operating, Investing, or Financing Activities (Step 6) 701 The Completed Statement of Cash Flows (Steps 7 and 8) 702 Interpretation of the Statement of Cash Flows 703 Depreciation, Depletion, and Amortization 704 Free Cash Flow 704 Summary 705 Review Problem 706 Glossary 708 Questions 709 Exercises 709 Problems 712 Research and Application 718 Appendix 15A: The Direct Method of Determining the Net Cash Provided by Operating Activities 718 gar79611_fm_xxii-xxxi.indd Page xxxi 1/6/09 5:12:14 PM user-s176 /broker/MH-BURR/MHBR094/MHBR094-FM/upload/MHBR094-FM x xxi Contents 16 Chapter How Well Am I Doing? Financial Statement Analysis Appendix A Pricing Products and Services 723 Limitations of Financial Statement Analysis Comparison of Financial Data 724 The Need to Look beyond Ratios 724 724 Statements in Comparative and Common-Size Form 724 Dollar and Percentage Changes on Statements 725 Common-Size Statements 728 Ratio AnalysisThe Common Stockholder 730 Earnings per Share 730 Price-Earnings Ratio 731 Dividend Payout and Yield Ratios 731 The Dividend Payout Ratio 731 The Dividend Yield Ratio 732 Return on Total Assets 732 Return on Common Stockholders Equity 733 Financial Leverage 733 Book Value per Share 733 Ratio AnalysisThe Short-Term Creditor Working Capital 735 Current Ratio 735 Acid-Test (Quick) Ratio 736 Accounts Receivable Turnover 736 Inventory Turnover 737 738 Introduction 762 The Economists Approach to Pricing Elasticity of Demand 762 The Prot-Maximizing Price 763 Target Costing 769 Reasons for Using Target Costing 769 An Example of Target Costing 770 Summary Glossary Questions Exercises Problems 770 771 771 771 772 Appendix B Protability Analysis 777 Summary of Ratios and Sources of Comparative Ratio Data 739 Summary 741 Review Problem: Selected Ratios and Financial Leverage 741 Glossary 744 Questions 744 Exercises 744 Problems 749 Case 759 Research and Application 759 762 The Absorption Costing Approach to Cost-Plus Pricing 766 Setting a Target Selling Price Using the Absorption Costing Approach 766 Determining the Markup Percentage 767 Problems with the Absorption Costing Approach 768 735 Ratio AnalysisThe Long-Term Creditor Times Interest Earned Ratio 738 Debt-to-Equity Ratio 738 761 Introduction 778 Absolute Protability 778 Relative Protability 779 Volume Trade-Off Decisions 781 Managerial Implications 782 Summary 785 Glossary 785 Questions 785 Exercises 786 Problems 787 Case 789 Index 793 gar79611_ch01_001-029.indd Page 1 12/5/08 12:16:23 AM user-s176 1 Chapter Managerial Accounting and the Business Environment /broker/MH-BURR/MHBR094/MHBR094-01/upload/MHBR094-01 B US IN ESS FOCU S Management Accounting: Its More Than Just Crunching Numbers Creating value through values is the credo of todays management accountant. It means that management accountants should maintain an unwavering commitment to ethical values while using their knowledge and skills to influence decisions that create value for organizational stakeholders. These skills include managing risks and implementing strategy through planning, budgeting and forecasting, and decision support. Management accountants are strategic business partners who understand the financial and operational sides of the business. They not only report and analyze financial measures, but also nonfinancial measures of process performance and corporate social performance. Think of these responsibilities as profits (financial statements), process (customer focus and satisfaction), people (employee learning and satisfaction), and planet (environmental stewardship). LEARNING OBJECTIVES After studying Chapter 1, you should be able to: LO1 Understand the role of management accountants in an organization. LO2 Understand the basic concepts underlying Lean Production, the Theory of Constraints (TOC), and Six Sigma. LO3 Understand the importance of upholding ethical standards. Source: Conversation with Jeff Thomson, president and CEO of the Institute of Management Accountants. 1 gar79611_ch01_001-029.indd gar79611_ch01_001-029.indd Page 2 12/5/08 12:16:31 AM user-s176 2 /broker/MH-BURR/MHBR094/MHBR094-01/upload/MHBR094-01 Chapter 1 T hroughout this book you will study how management accounting functions within organizations. However, before embarking on the study of management accounting, you need to develop an appreciation for the larger business environment within which it operates. This chapter is divided into nine sections: (1) globalization, (2) strategy, (3) organizational structure, (4) process management, (5) the importance of ethics in business, (6) corporate governance, (7) enterprise risk management, (8) corporate social responsibility, and (9) the Certied Management Accountant (CMA). Other business classes provide greater detail on many of these topics. Nonetheless, a broad discussion of these topics is useful for placing management accounting in its proper context. Globalization The world has become much more intertwined over the last 20 years. Reductions in tariffs, quotas, and other barriers to free trade; improvements in global transportation systems; explosive expansion in Internet usage; and increasing sophistication in international markets have created a truly global marketplace. Exhibit 11 illustrates this tremendous growth in international trade from the standpoint of the United States and some of its key trading partners. Panel A of the exhibit shows the dollar value of imports (stated in billions of dollars) into the United States from six countries; Panel B shows the dollar value of exports from the United States to those same six countries. As you can see, the increase in import and export activity from 1995 to 2007 was huge. In particular, trade with China expanded enormously as did trade with Mexico and Canada, which participate in the North American Free Trade Agreement (NAFTA). In a global marketplace, a company that has been very successful in its local market may suddenly nd itself facing competition from halfway around the globe. For example, in the 1980s American automobile manufacturers began losing market share to Japanese competitors who offered American consumers higher quality cars at lower prices. For consumers, heightened international competition promises a greater variety of goods and services, at higher quality and lower prices. However, heightened international competition threatens companies that may have been quite protable in their own local markets. Although globalization leads to greater competition, it also means greater access to new markets, customers, and workers. For example, the emerging markets of China, India, Russia, and Brazil contain more than 2.5 billion potential customers and workers.1 Many companies such as FedEx, McDonalds, and Nike are actively seeking to grow their sales by investing in emerging markets. In addition, the movement of jobs from the United States and Western Europe to other parts of the world has been notable in recent years. For example, one study estimates that by the end of the decade more than 825,000 nancial services and high-tech jobs will transfer from Western Europe to less expensive labor markets such as India, China, Africa, Eastern Europe, and Latin America.2 The Internet fuels globalization by providing companies with greater access to geographically dispersed customers, employees, and suppliers. While the number of Internet users continues to grow, as of 2008, more than 78% of the worlds population was still not connected to the Internet. This suggests that the Internets impact on global business has yet to fully develop. 1 2 The Economist: Pocket World in Figures 2004, Prole Books Ltd., London, U.K. Job Exports: Europes Turn, BusinessWeek, April 19, 2004, p. 50. gar79611_ch01_001-029.indd Page 3 12/5/08 12:16:31 AM user-s176 /broker/MH-BURR/MHBR094/MHBR094-01/upload/MHBR094-01 Managerial Accounting and the Business Environment E X H I B I T 11 United States Global Trade Activity (in billions of U.S. dollars) Panel A: Imports to the United States (billions of dollars) $400 Imports to the US (billions) $350 $300 $250 Canada China Germany Japan Mexico United Kingdom $200 $150 $100 $50 $0 1995 2000 2005 2007 Panel B: Exports from the United States (billions of dollars) Exports from the US (billions) $300 $250 $200 Canada China Germany Japan Mexico United Kingdom $150 $100 $50 $0 1995 2000 2005 2007 Source: U.S. Census Bureau, Foreign Trade Division, Data Dissemination Branch, Washington, D.C. 20233. www.census.gov/foreign-trade/balance. 3 gar79611_ch01_001-029.indd gar79611_ch01_001-029.indd Page 4 12/5/08 12:16:32 AM user-s176 4 /broker/MH-BURR/MHBR094/MHBR094-01/upload/MHBR094-01 Chapter 1 IN BUSINESS THE IMPLICATIONS OF GLOBALIZATION International competition goes hand-in-hand with globalization. Chinas entrance into the global marketplace has highlighted this stark reality for many U.S. companies. For example, from 2000 to 2003, Chinas wooden bedroom furniture exports to the United States increased by more than 233% to a total of $1.2 billion. During this same time, the number of workers employed by U.S. furniture manufacturers dropped by about a third, or a total of 35,000 workers. However, globalization means more than international competition. It brings opportunities for companies to enter new markets. FedEx has pushed hard to be an important player in the emerging Asian cargo market. FedEx makes 622 weekly ights to and from Asian markets, including service to 224 Chinese cities. FedEx currently has 39% of the U.S.China express market and it plans to pursue continuous growth in that region of the world. Sources: Ted Fishman, How China Will Change Your Business, Inc. magazine, March 2005, pp. 7084; Matthew Boyle, Why FedEx is Flying High, Fortune, November 1, 2004, pp. 145150. Strategy Even more than in the past, companies that now face global competition must have a viable strategy for succeeding in the marketplace. A strategy is a game plan that enables a company to attract customers by distinguishing itself from competitors. The focal point of a companys strategy should be its target customers. A company can only succeed if it creates a reason for customers to choose it over a competitor. These reasons, or what are more formally called customer value propositions, are the essence of strategy. Customer value propositions tend to fall into three broad categoriescustomer intimacy, operational excellence, and product leadership. Companies that adopt a customer intimacy strategy are in essence saying to their target customers, You should choose us because we understand and respond to your individual needs better than our competitors. Ritz-Carlton, Nordstrom, and Starbucks rely primarily on a customer intimacy value proposition for their success. Companies that pursue the second customer value proposition, called operational excellence, are saying to their target customers, You should choose us because we can deliver products and services faster, more conveniently, and at a lower price than our competitors. Southwest Airlines, Wal-Mart, and The Vanguard Group are examples of companies that succeed rst and foremost because of their operational excellence. Companies pursuing the third customer value proposition, called product leadership, are saying to their target customers, You should choose us because we offer higher quality products than our competitors. BMW, Cisco Systems, and W.L. Gore (the creator of GORE-TEX fabrics) are examples of companies that succeed because of their product leadership. Although one company may offer its customers a combination of these three customer value propositions, one usually outweighs the others in terms of importance.3 Next we turn our attention to how businesses create organizational structures to help accomplish their strategic goals. 3 These three customer value propositions were dened by Michael Treacy and Fred Wiersema in Customer Intimacy and Other Value Disciplines, Harvard Business Review, Volume 71 Issue 1, pp. 8493. gar79611_ch01_001-029.indd gar79611_ch01_001-029.indd Page 5 12/5/08 12:16:33 AM user-s176 /broker/MH-BURR/MHBR094/MHBR094-01/upload/MHBR094-01 5 Managerial Accounting and the Business Environment OPERATIONAL EXCELLENCE COMES TO THE DIAMOND BUSINESS IN BUSINESS An average engagement ring purchased from Blue Nile, an Internet diamond retailer, costs $5,200 compared to $9,500 if purchased from Tiffany & Co., a bricks-and-mortar retailer. Why is there such a difference? There are three reasons. First, Blue Nile allows wholesalers to sell directly to customers using its website. In the brick-and-mortar scenario, diamonds change hands as many as seven times before being sold to a customerpassing through various cutters, wholesalers, brokers, and retailers, each of whom demands a prot. Second, Blue Nile carries very little inventory and incurs negligible overhead. Diamonds are shipped directly from wholesalers after they have been purchased by a customerno retail outlets are necessary. Bricks-and-mortar retailers tie up large amounts of money paying for the inventory and employees on their showroom oors. Third, Blue Nile generates a high volume of transactions by selling to customers anywhere in the world; therefore, it can accept a lower prot margin per transaction than local retailers, who complete fewer transactions with customers within a limited geographic radius. Perhaps you are wondering why customers are willing to trust an Internet retailer when buying an expensive item such as a diamond. The answer is that all of the diamonds sold through Blue Niles website are independently certied by the Gemological Institute of America in four categoriescarat count, type of cut, color, and clarity. In essence, Blue Nile has turned diamonds into a commodity and is using an operational excellence customer value proposition to generate annual sales of $154 million. Source: Victoria Murphy, Romance Killer, Forbes, November 29, 2004, pp. 97101. Organizational Structure Our discussion of organizational structure is divided into two parts. First, we highlight the fact that presidents of all but the smallest companies cannot execute their strategies alone. They must seek the help of their employees by empowering them to make decisionsthey must decentralize. Next, we describe the most common formal decentralized organizational structure in use todaythe functional structure. Decentralization Decentralization is the delegation of decision-making authority throughout an organization by giving managers the authority to make decisions relating to their area of responsibility. Some organizations are more decentralized than others. For example, consider Good Vibrations, an international retailer of music CDs with shops in major cities scattered across the Pacic Rim. Because of Good Vibrations geographic dispersion and the peculiarities of local markets, the company is highly decentralized. Good Vibrations president (often synonymous with the term chief executive ofcer, or CEO) sets the broad strategy for the company and makes major strategic decisions such as opening stores in new markets; however, much of the remaining decision-making authority is delegated to managers at various levels throughout the organization. Each of the companys numerous retail stores has a store manager as well as a separate manager for each music category such as international rock and classical/jazz. In addition, the company has support departments such as a central Purchasing Department and a Personnel Department. The Functional View of Organizations Exhibit 12 shows Good Vibrations organizational structure in the form of an organization chart. The purpose of an organization chart is to show how responsibility is divided among managers and to show formal lines of reporting and communication, or chain of command. Each box depicts an area of management responsibility, and the lines between the boxes show the lines of formal authority between managers. The chart tells us, for example, that L EARNING OBJECTIVE 1 Understand the role of management accountants in an organization. gar79611_ch01_001-029.indd Page 6 12/5/08 12:16:34 AM user-s176 6 /broker/MH-BURR/MHBR094/MHBR094-01/upload/MHBR094-01 Chapter 1 E X H I B I T 12 Organization Chart, Good Vibrations, Inc. Board of Directors President Purchasing Department Personnel Department Vice President Operations Chief Financial Officer Treasurer Manager Hong Kong Store Manager Intnl Rock Controller Manager Tokyo Store Manager Classical/Jazz Manager Intnl Rock Manager CantoPop Manager Classical/Jazz Manager Karaoke Other Stores the store managers are responsible to the operations vice president. In turn, the operations vice president is responsible to the company president, who in turn is responsible to the board of directors. Following the lines of authority and communication on the organization chart, we can see that the manager of the Hong Kong store would ordinarily report to the operations vice president rather than directly to the president of the company. An organization chart also depicts line and staff positions in an organization. A person in a line position is directly involved in achieving the basic objectives of the organization. A person in a staff position, by contrast, is only indirectly involved in achieving those basic objectives. Staff positions provide assistance to line positions or other parts of the organization, but they do not have direct authority over line positions. Refer again to the organization chart in Exhibit 12. Because the basic objective of Good Vibrations is to sell recorded music at a prot, those managers whose areas of responsibility are directly related to selling music occupy line positions. These positions, which are shown in a darker color in the exhibit, include the managers of the various music departments in each store, the store managers, the operations vice president, the president, and the board of directors. By contrast, the managers of the central Purchasing Department and the Personnel Department occupy staff positions, because their departments support other departments rather than carry out the companys basic missions. The chief nancial ofcer is a member of the top management team who also occupies a staff position. The chief nancial ofcer (CFO) is responsible for providing timely and relevant data to support planning and control activities and for preparing nancial statements for external users. In the United States, a manager known as the controller often runs the accounting department and reports directly to the CFO. More than ever, the accountants who work under the gar79611_ch01_001-029.indd gar79611_ch01_001-029.indd Page 7 12/5/08 12:16:34 AM user-s176 /broker/MH-BURR/MHBR094/MHBR094-01/upload/MHBR094-01 7 Managerial Accounting and the Business Environment CFO are focusing their efforts on supporting the needs of co-workers in line positions as one report concluded: Growing numbers of management accountants spend the bulk of their time as internal consultants or business analysts within their companies. Technological advances have liberated them from the mechanical aspects of accounting. They spend less time preparing standardized reports and more time analyzing and interpreting information. Many have moved from the isolation of accounting departments to be physically positioned in the operating departments with which they work. Management accountants work on cross-functional teams, have extensive face-to-face communications with people throughout their organizations, and are actively involved in decision making. . . . They are trusted advisors.4 IN BUSINESS WHAT DOES IT TAKE? A controller at McDonalds describes the characteristics needed by its most successful management accountants as follows: [I]ts a given that you know your accounting cold. Youre expected to know the tax implications of proposed courses of action. You need to understand cost ows and information ows. You have to be very comfortable with technology and be an expert in the companys business and accounting software. You have to be a generalist. You need a working knowledge of what people do in marketing, engineering, human resources, and other departments. You need to understand how the processes, departments, and functions work together to run the business. Youll be expected to contribute ideas at planning meetings, so you have to see the big picture, keep a focus on the bottom line, and think strategically. Source: Gary Siegel, James E. Sorensen, and Sandra B. Richtermeyer, Becoming a Business Partner: Part 2, Strategic Finance, October 2003, pp. 3741. Used with permission from the Institute of Management Accountants (IMA), Montvale, N.J., USA, www.imanet.org. Process Management As global competition intensies, companies are realizing that they must complement the functional view of their operations with a cross-functional orientation that seeks to improve the business processes that deliver customer value. A business process is a series of steps that are followed in order to carry out some task in a business. It is quite common for the linked set of steps comprising a business process to span departmental boundaries. The term value chain is often used when we look at how the functional departments of an organization interact with one another to form business processes. A value chain, as shown in Exhibit 13, consists of the major business functions that add value to a companys products and services. The customers needs are most effectively met by coordinating the business processes that span these functions. L EARNING OBJECTIVE 2 Understand the basic concepts underlying Lean Production, the Theory of Constraints (TOC), and Six Sigma. E X H I B I T 13 Business Functions Making Up the Value Chain Research and Development 4 Product Design Manufacturing Marketing Distribution Gary Siegel Organization, Counting More, Counting Less: Transformations in the Management Accounting Profession, The 1999 Practice Analysis of Management Accounting, Institute of Management Accountants, Montvale, NJ, August 1999, p. 3. Customer Service gar79611_ch01_001-029.indd gar79611_ch01_001-029.indd Page 8 12/5/08 12:16:36 AM user-s176 8 /broker/MH-BURR/MHBR094/MHBR094-01/upload/MHBR094-01 Chapter 1 This section discusses three different approaches to managing and improving business processesLean Production, the Theory of Constraints (TOC), and Six Sigma. Although each is unique in certain respects, they all share the common theme of focusing on managing and improving business processes. Lean Production Traditionally, managers in manufacturing companies have sought to maximize production so as to spread the costs of investments in equipment and other assets over as many units as possible. In addition, managers have traditionally felt that an important part of their jobs was to keep everyone busy on the theory that idleness wastes money. These traditional views, often aided and abetted by traditional management accounting practices, resulted in a number of practices that have come under criticism in recent years. In a traditional manufacturing company, work is pushed through the system in order to produce as much as possible and to keep everyone busyeven if products cannot be immediately sold. This almost inevitably results in large inventories of raw materials, work in process, and nished goods. Raw materials are the materials that are used to make a product. Work in process inventories consist of units of product that are only partially complete and will require further work before they are ready for sale to a customer. Finished goods inventories consist of units of product that have been completed but have not yet been sold to customers. The push process in traditional manufacturing starts by accumulating large amounts of raw material inventories from suppliers so that operations can proceed smoothly even if unanticipated disruptions occur. Next, enough materials are released to workstations to keep everyone busy. When a workstation completes its tasks, the partially completed goods (i.e., work in process) are pushed forward to the next workstation regardless of whether that workstation is ready to receive them. The result is that partially completed goods stack up, waiting for the next workstation to become available. They may not be completed for days, weeks, or even months. Additionally, when the units are nally completed, customers may or may not want them. If nished goods are produced faster than the market will absorb, the result is bloated nished goods inventories. Although some may argue that maintaining large amounts of inventory has its benets, it clearly has its costs. In addition to tying up money, maintaining inventories encourages inefcient and sloppy work, results in too many defects, and dramatically increases the amount of time required to complete a product. For example, when partially completed goods are stored for long periods of time before being processed by the next workstation, defects introduced by the preceding workstation go unnoticed. If a machine is out of calibration or incorrect procedures are being followed, many defective units will be produced before the problem is discovered. And when the defects are nally discovered, it may be very difcult to track down the source of the problem. In addition, units may be obsolete or out of fashion by the time they are nally completed. Large inventories of partially completed goods create many other problems that are best discussed in more advanced courses. These problems are not obviousif they were, companies would have long ago reduced their inventories. Managers at Toyota are credited with the insight that large inventories often create many more problems than they solve. Toyota pioneered what is known today as Lean Production. The Lean Thinking Model The lean thinking model is a ve-step management approach that organizes resources such as people and machines around the ow of business processes and that pulls units through these processes in response to customer orders. The result is lower inventories, fewer defects, less wasted effort, and quicker customer response times. Exhibit 14 (page 9) depicts the ve stages of the lean thinking model. The rst step is to identify the value to customers in specic products and services. The second step is to identify the business process that delivers this value to customers.5 5 The Lean Production literature uses the term value stream rather than business process. gar79611_ch01_001-029.indd gar79611_ch01_001-029.indd Page 9 12/5/08 12:16:36 AM user-s176 /broker/MH-BURR/MHBR094/MHBR094-01/upload/MHBR094-01 9 Managerial Accounting and the Business Environment E X H I B I T 14 The Lean Thinking Model Step 1: Identify value in specific products/services Step 2: Identify the business process that delivers value Step 3: Organize work arrangements around the flow of the business process Step 4: Create a pull system that responds to customer orders Step 5: Continuously pursue perfection in the business process Source: This exhibit is adapted from James P. Womack and Daniel T. Jones, Lean Thinking: Banish Waste and Create Wealth in Your Corporation, Revised and Updated, 2003, Simon & Schuster, New York, NY. As discussed earlier, the linked set of steps comprising a business process typically span the departmental boundaries that are specied in an organization chart. The third step is to organize work arrangements around the ow of the business process. This is often accomplished by creating what is known as a manufacturing cell. The cellular approach takes employees and equipment from departments that were previously separated from one another and places them side-by-side in a work space called a cell. The equipment within the cell is aligned in a sequential manner that follows the steps of the business process. Each employee is trained to perform all the steps within his or her own manufacturing cell. The fourth step in the lean thinking model is to create a pull system where production is not initiated until a customer has ordered a product. Inventories are reduced to a minimum by purchasing raw materials and producing units only as needed to meet customer demand. Under ideal conditions, a company operating a pull system would purchase only enough materials each day to meet that days needs. Moreover, the company would have no goods still in process at the end of the day, and all goods completed during the day would be shipped immediately to customers. As this sequence suggests, work takes place just-intime in the sense that raw materials are received by each manufacturing cell just in time to go into production, manufactured parts are completed just in time to be assembled into products, and products are completed just in time to be shipped to customers. This facet of the lean thinking model is often called just-in-time production, or JIT for short. The change from push to pull production is more profound than it may appear. Among other things, producing only in response to a customer order means that workers will be idle whenever demand falls below the companys production capacity. This can be an extremely difcult cultural change for an organization. It challenges the core beliefs of many managers and raises anxieties in workers who have become accustomed to being kept busy all of the time. The fth step of the lean thinking model is to continuously pursue perfection in the business process. In a traditional company, parts and materials are inspected for defects when they are received from suppliers, and assembled units are inspected as they progress along the production line. In a Lean Production system, the companys suppliers are responsible for the quality of incoming parts and materials. And instead of using quality inspectors, the companys production workers are directly responsible for spotting defective units. A worker who discovers a defect immediately stops the ow of production. Supervisors and other workers go to the cell to determine the cause of the problem and correct it before any further defective units are produced. This procedure ensures that problems are quickly identied and corrected. The lean thinking model can also be used to improve the business processes that link companies together. The term supply chain management is commonly used to refer to the coordination of business processes across companies to better serve end consumers. For example Procter & Gamble and Costco coordinate their business processes to ensure that Procter & Gambles products, such as Bounty, Tide, and Crest, are on Costcos gar79611_ch01_001-029.indd gar79611_ch01_001-029.indd Page 10 12/5/08 12:16:36 AM user-s176 10 /broker/MH-BURR/MHBR094/MHBR094-01/upload/MHBR094-01 Chapter 1 IN BUSINESS LEAN SUPPLY CHAIN MANAGEMENT Tesco, a grocery retailer in Britain, used lean thinking to improve its replenishment process for cola products. Tesco and Britvic (its cola supplier) traced the cola delivery process from the checkout counter of the grocery store through Tescos regional distribution center (RDC), Britvics RDC, the warehouse at the Britvic bottling plant, the lling lines for cola destined for Tesco, and the warehouse of Britvics can supplier. Each step of the process revealed enormous waste. Tesco implemented numerous changes such as electronically linking its point-of-sale data from its grocery stores to its RDC. This change let customers pace the replenishment process and it helped increase store delivery frequency to every few hours around the clock. Britvic also began delivering cola to Tescos RDC in wheeled dollies that could be rolled directly into delivery trucks and then to point-ofsale locations in grocery stores. These changes reduced the total product touches from 150 to 50, thereby cutting labor costs. The elapsed time from the suppliers lling line to the customers cola purchase dropped from 20 days to 5 days. The number of inventory stocking locations declined from ve to two, and the suppliers distribution center was eliminated. Source: Ghostwriter, Teaching the Big Box New Tricks, Fortune, November 14, 2005, pp. 208B208F. shelves when customers want them. Both Procter & Gamble and Costco realize that their mutual success depends on working together to ensure Procter & Gambles products are available to Costcos customers. The Theory of Constraints (TOC) A constraint is anything that prevents you from getting more of what you want. Every individual and every organization faces at least one constraint, so it is not difcult to nd examples of constraints. You may not have enough time to study thoroughly for every subject and to go out with your friends on the weekend, so time is your constraint. United Airlines has only a limited number of loading gates available at its busy Chicago OHare hub, so its constraint is loading gates. Vail Resorts has only a limited amount of land to develop as homesites and commercial lots at its ski areas, so its constraint is land. The Theory of Constraints (TOC) is based on the insight that effectively managing the constraint is a key to success. As an example, long waiting periods for surgery are a chronic problem in the National Health Service (NHS), the government-funded provider of health care in the United Kingdom. The diagram in Exhibit 15 illustrates a simplied version of the steps followed by a surgery patient. The number of patients who can be processed through each step in a day is indicated in the exhibit. For example, appointments for outpatient visits can be made for as many as 100 referrals from general practitioners in a day. E X H I B I T 15 Processing Surgery Patients at an NHS Facility (simplied)* General practitioner referral Outpatient visit Add to surgery waiting list Surgery Follow-up visit Discharge 100 patients per day * Appointment made 100 patients per day 50 patients per day 150 patients per day 15 patients per day 60 patients per day 140 patients per day This diagram originally appeared in the February 1999 issue of the U.K. magazine Health Management. gar79611_ch01_001-029.indd gar79611_ch01_001-029.indd Page 11 12/5/08 12:16:37 AM user-s176 /broker/MH-BURR/MHBR094/MHBR094-01/upload/MHBR094-01 11 Managerial Accounting and the Business Environment The constraint, or bottleneck, in the system is determined by the step that has the smallest capacityin this case surgery. The total number of patients processed through the entire system cannot exceed 15 per daythe maximum number of patients who can be treated in surgery. No matter how hard managers, doctors, and nurses try to improve the processing rate elsewhere in the system, they will never succeed in driving down wait lists until the capacity of surgery is increased. In fact, improvements elsewhere in the systemparticularly before the constraintare likely to result in even longer waiting times and more frustrated patients and health care providers. Thus, to be effective, improvement efforts must be focused on the constraint. A business process, such as the process for serving surgery patients, is like a chain. If you want to increase the strength of a chain, what is the most effective way to do this? Should you concentrate your efforts on strengthening the strongest link, all the links, or the weakest link? Clearly, focusing your effort on the weakest link will bring the biggest benet. The procedure to follow to strengthen the chain is clear. First, identify the weakest link, which is the constraint. In the case of the NHS, the constraint is surgery. Second, do not place a greater strain on the system than the weakest link can handleif you do, the chain will break. In the case of the NHS, more referrals than surgery can accommodate lead to unacceptably long waiting lists. Third, concentrate improvement efforts on strengthening the weakest link. In the case of the NHS, this means nding ways to increase the number of surgeries that can be performed in a day. Fourth, if the improvement efforts are successful, eventually the weakest link will improve to the point where it is no longer the weakest link. At that point, the new weakest link (i.e., the new constraint) must be identied, and improvement efforts must be shifted over to that link. This simple sequential process provides a powerful strategy for optimizing business processes. WATCH WHERE YOU CUT COSTS At one hospital, the emergency room became so backlogged that its doors were closed to the public and patients were turned away for over 36 hours in the course of a single month. It turned out, after investigation, that the constraint was not the emergency room itself; it was the housekeeping staff. To cut costs, managers at the hospital had laid off housekeeping workers. This created a bottleneck in the emergency room because rooms were not being cleaned as quickly as the emergency room staff could process new patients. Thus, laying off some of the lowest paid workers at the hospital had the effect of forcing the hospital to idle some of its most highly paid staff and most expensive equipment! Source: Tracey Burton-Houle, AGI Continues to Steadily Make Advances with the Adaptation of TOC into Healthcare, www.goldratt.com/toctquarterly/august2002.htm. Six Sigma Six Sigma is a process improvement method that relies on customer feedback and factbased data gathering and analysis techniques to drive process improvement. Motorola and General Electric are closely identied with the Six Sigma movement. Technically, the term Six Sigma refers to a process that generates no more than 3.4 defects per million opportunities. Because this rate of defects is so low, Six Sigma is sometimes associated with the term zero defects. The most common framework used to guide Six Sigma process improvement efforts is known as DMAIC (pronounced: du-may-ik), which stands for Dene, Measure, Analyze, Improve, and Control. As summarized in Exhibit 16, the Dene stage of the process focuses on dening the scope and purpose of the project, the ow of the current process, and the customers requirements. The Measure stage is used to gather baseline performance data concerning the existing process and to narrow the scope of the project to the most important problems. The Analyze stage focuses on identifying the root causes IN BUSINESS gar79611_ch01_001-029.indd gar79611_ch01_001-029.indd Page 12 12/5/08 12:16:47 AM user-s176 12 /broker/MH-BURR/MHBR094/MHBR094-01/upload/MHBR094-01 Chapter 1 E X H I B I T 16 The Six Sigma DMAIC Framework Stage Goals Dene Establish the scope and purpose of the project. Diagram the ow of the current process. Establish the customers requirements for the process. Measure Gather baseline performance data related to the existing process. Narrow the scope of the project to the most important problems. Analyze Identify the root cause(s) of the problems identied in the Measure stage. Improve Develop, evaluate, and implement solutions to the problems. Control Ensure that problems remain xed. Seek to improve the new methods over time. Source: Peter C. Brewer and Nancy A. Bagranoff, Near Zero-Defect Accounting with Six Sigma, Journal of Corporate Accounting and Finance, January-February 2004, pp. 6772. of the problems that were identied during the Measure stage. The Analyze stage often reveals that the process includes many activities that do not add value to the product or service. Activities that customers are not willing to pay for because they add no value are known as non-value-added activities and such activities should be eliminated wherever possible. During the Improve stage potential solutions are developed, evaluated, and implemented to eliminate non-value-added activities and any other problems uncovered in the Analyze stage. Finally, the objective in the Control stage is to ensure that the problems remain xed and that the new methods are improved over time. Managers must be very careful when attempting to translate Six Sigma improvements into nancial benets. There are only two ways to increase protsdecrease costs or increase sales. Cutting costs may seem easylay off workers who are no longer needed because of improvements such as eliminating non-value-added activities. However, if this approach is taken, employees quickly get the message that process improvements lead to job losses and they will understandably resist further improvement efforts. If improvement is to continue, employees must be convinced that the end result of improvement will be more secure rather than less secure jobs. This can only happen if management uses tools such as Six Sigma to generate more business rather than to cut the workforce. The Importance of Ethics in Business L EARNING OBJECTIVE 3 Understand the importance of upholding ethical standards. A series of major nancial scandals involving Enron, Tyco International, HealthSouth, Adelphia Communications, WorldCom, Global Crossing, Rite Aid, and other companies have raised deep concerns about ethics in business. The managers and companies involved in these scandals have suffered mightilyfrom huge nes to jail terms and nancial collapse. And the recognition that ethical behavior is absolutely essential for the functioning of our economy has led to numerous regulatory changessome of which we will discuss in a later section on corporate governance. But why is ethical behavior so important? This is not a matter of just being nice. Ethical behavior is the lubricant that keeps the economy running. Without that lubricant, the economy would operate much less efcientlyless would be available to consumers, quality would be lower, and prices would be higher. Take a very simple example. Suppose that dishonest farmers, distributors, and grocers knowingly tried to sell wormy apples as good apples and that grocers refused to take back wormy apples. What would you do as a consumer of apples? Go to another grocer? But what if all grocers acted this way? What would you do then? You would probably either stop buying apples or you would spend a lot of time inspecting apples before buying them. So would everyone else. Now notice what has happened. Because farmers, distributors, and grocers could not be trusted, sales of apples would plummet and those gar79611_ch01_001-029.indd gar79611_ch01_001-029.indd Page 13 12/5/08 12:16:48 AM user-s176 /broker/MH-BURR/MHBR094/MHBR094-01/upload/MHBR094-01 13 Managerial Accounting and the Business Environment who did buy apples would waste a lot of time inspecting them minutely. Everyone loses. Farmers, distributors, and grocers make less money; consumers enjoy fewer apples; and consumers waste time looking for worms. In other words, without fundamental trust in the integrity of businesses, the economy would operate much less efciently. James Surowiecki summed up this point as follows: [F]lourishing economies require a healthy level of trust in the reliability and fairness of everyday transactions. If you assumed every potential deal was a rip-off or that the products you were buying were probably going to be lemons, then very little business would get done. More important, the costs of the transactions that did take place would be exorbitant because youd have to do enormous work to investigate each deal and youd have to rely on the threat of legal action to enforce every contract. For an economy to prosper, whats needed is not a Pollyannaish faith that everyone else has your best interests at heartcaveat emptor [buyer beware] remains an important truthbut a basic condence in the promises and commitments that people make about their products and services.6 NO TRUSTNO ENRON Jonathan Karpoff reports on a particularly important, but often overlooked, aspect of the Enron debacle: As we know, some of Enrons reported prots in the late 1990s were pure accounting ction. But the rm also had legitimate businesses and actual assets. Enrons most important businesses involved buying and selling electricity and other forms of energy. [Using Enron as an intermediary, utilities that needed power bought energy from producers with surplus generating capacity.] Now when an electric utility contracts to buy electricity, the managers of the utility want to make darned sure that the seller will deliver the electrons exactly as agreed, at the contracted price. There is no room for fudging on this because the consequences of not having the electricity when consumers switch on their lights are dire. . . . This means that the rms with whom Enron was trading electricity . . . had to trust Enron. And trust Enron they did, to the tune of billions of dollars of trades every year. But in October 2001, when Enron announced that its previous nancial statements overstated the rms profits, it undermined such trust. As everyone recognizes, the announcement caused investors to lower their valuations of the rm. Less understood, however, was the more important impact of the announcement; by revealing some of its reported earnings to be a house of cards, Enron sabotaged its reputation. The effect was to undermine even its legitimate and (previously) profitable operations that relied on its trustworthiness. This is why Enron melted down so fast. Its core businesses relied on the rms reputation. When that reputation was wounded, energy traders took their business elsewhere. . . . Energy traders lost their faith in Enron, but what if no other company could be trusted to deliver on its commitments to provide electricity as contracted? In that case, energy traders would have nowhere to turn. As a direct result, energy producers with surplus generating capacity would be unable to sell their surplus power. As a consequence, their existing customers would have to pay higher prices. And utilities that did not have sufcient capacity to meet demand on their own would have to build more capacity, which would also mean higher prices for their consumers. So a general lack of trust in companies such as Enron would ultimately result in overinvestment in energygenerating capacity and higher energy prices for consumers. Source: Jonathan M. Karpoff, Regulation vs. Reputation in Preventing Corporate Fraud, UW Business, Spring 2002, pp. 2830. 6 James Surowiecki, A Virtuous Cycle, Forbes, December 23, 2002, pp. 248256. Reprinted by Permission of Forbes Magazine2006 Forbes Inc. IN BUSINESS gar79611_ch01_001-029.indd gar79611_ch01_001-029.indd Page 14 12/5/08 12:16:49 AM user-s176 14 /broker/MH-BURR/MHBR094/MHBR094-01/upload/MHBR094-01 Chapter 1 Thus, for the good of everyoneincluding prot-making companiesit is vitally important that business be conducted within an ethical framework that builds and sustains trust. The Institute of Management Accountants (IMA) of the United States has adopted an ethical code called the Statement of Ethical Professional Practice that describes in some detail the ethical responsibilities of management accountants. Even though the standards were specically developed for management accountants, they have much broader application. Code of Conduct for Management Accountants The IMAs Statement of Ethical Professional Practice consists of two parts that are presented in full in Exhibit 17 (page 15). The rst part provides general guidelines for ethical behavior. In a nutshell, a management accountant has ethical responsibilities in four broad areas: rst, to maintain a high level of professional competence; second, to treat sensitive matters with condentiality; third, to maintain personal integrity; and fourth, to disclose information in a credible fashion. The second part of the standards species what should be done if an individual nds evidence of ethical misconduct. We recommend that you stop at this point and read all of Exhibit 17. The ethical standards provide sound, practical advice for management accountants and managers. Most of the rules in the ethical standards are motivated by a very practical considerationif these rules were not generally followed in business, then the economy and all of us would suffer. Consider the following specic examples of the consequences of not abiding by the standards: Suppose employees could not be trusted with condential information. Then top managers would be reluctant to distribute such information within the company and, as a result, decisions would be based on incomplete information and operations would deteriorate. Suppose employees accepted bribes from suppliers. Then contracts would tend to go to suppliers who pay the highest bribes rather than to the most competent suppliers. Would you like to y in aircraft whose wings were made by the subcontractor who paid the highest bribe? Would you y as often? What would happen to the airline industry if its safety record deteriorated due to shoddy workmanship on contracted parts and assemblies? Suppose the presidents of companies routinely lied in their annual reports and nancial statements. If investors could not rely on the basic integrity of a companys nancial statements, they would have little basis for making informed decisions. Suspecting the worst, rational investors would pay less for securities issued by companies and may not be willing to invest at all. As a consequence, companies would have less money for productive investmentsleading to slower economic growth, fewer goods and services, and higher prices. As these examples suggest, if ethical standards were not generally adhered to, everyone would sufferbusinesses as well as consumers. Essentially, abandoning ethical standards would lead to a lower standard of living with lower-quality goods and services, less to choose from, and higher prices. In short, following ethical rules such as those in the Statement of Ethical Professional Practice is absolutely essential for the smooth functioning of an advanced market economy. Company Codes of Conduct Many companies have adopted formal ethical codes of conduct. These codes are generally broad-based statements of a companys responsibilities to its employees, its customers, its suppliers, and the communities in which the company operates. Codes rarely spell out specic dos and donts or suggest proper behavior in a specic situation. Instead, they give broad guidelines. For example, Exhibit 18 (page 16) shows Johnson & Johnsons code of ethical conduct, which it refers to as a Credo. Johnson & Johnson created its Credo in 1943 gar79611_ch01_001-029.indd Page 15 12/5/08 12:16:49 AM user-s176 /broker/MH-BURR/MHBR094/MHBR094-01/upload/MHBR094-01 15 Managerial Accounting and the Business Environment 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 IMAs 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 members 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 condential except when disclosure is authorized or legally required. 2. Inform all relevant parties regarding appropriate use of condential information. Monitor subordinates activities to ensure compliance. 3. Refrain from using condential information for unethical or illegal advantage. III. INTEGRITY Each member has a responsibility to: 1. Mitigate actual conicts of interest. Regularly communicate with business associates to avoid apparent conicts of interest. Advise all parties of any potential conicts. 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 inuence an intended users understanding of the reports, analyses, or recommendations. 3. Disclose delays or deciencies in information, timeliness, processing, or internal controls in conformance with organization policy and/or applicable law. RESOLUTION OF ETHICAL CONFLICT In applying the Standards of Ethical Professional Practice, you may encounter problems identifying unethical behavior or resolving an ethical conict. When faced with ethical issues, you should follow your organizations established policies on the resolution of such conict. If these policies do not resolve the ethical conict, 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 ofcer 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 superiors knowledge, assuming he or she is not involved. Communication of such problems to 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 condential 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 conict. E X H I B I T 17 IMA Statement of Ethical Professional Practice gar79611_ch01_001-029.indd gar79611_ch01_001-029.indd Page 16 12/5/08 12:16:50 AM user-s176 16 /broker/MH-BURR/MHBR094/MHBR094-01/upload/MHBR094-01 Chapter 1 IN BUSINESS WHO IS TO BLAME? Don Keough, a retired Coca-Cola executive, recalls that, In my time, CFOs [Chief Financial Ofcers] were basically tough, smart, and mean. Bringing good news wasnt their function. They were the truthtellers. But that had changed by the late 1990s in some companies. Instead of being truth-tellers, CFOs became corporate spokesmen, guiding stock analysts in their quarterly earnings estimates and then making sure those earnings estimates were beaten using whatever means necessary, including accounting tricks and in some cases outright fraud. But does the buck stop there? A survey of 179 CFOs published in May 2004 showed that only 38% of those surveyed believed that pressure to use aggressive accounting techniques to improve results had lessened relative to three years earlier. And 20% of those surveyed said the pressure had increased over the past three years. Where did the respondents say the pressure was coming from? Personal greed, weak boards of directors, and overbearing Chief Executive Ofcers (CEOs) topped the list. Who is to blame? Perhaps that question is less important than focusing on what is neededgreater personal integrity and less emphasis on meeting quarterly earnings estimates. Sources: Jeremy Kahn, The Chief Freaked Out Ofcer, Fortune, December 9, 2002, pp. 197202, and Don Durfee, After the Scandals: Its Better (and Worse) Than You Think, CFO, May 2004, p. 29. and today it is translated into 36 languages. Johnson & Johnson surveys its employees every two to three years to obtain their impressions of how well the company adheres to its ethical principles. If the survey reveals shortcomings, corrective actions are taken.7 It bears emphasizing that establishing a code of ethical conduct, such as Johnson & Johnsons Credo, is meaningless if employees, and in particular top managers, do not E X H I B I T 18 The Johnson & Johnson Credo Johnson & Johnson Credo We believe our rst responsibility is to the doctors, nurses and patients, to mothers and fathers and all others who use our products and services. In meeting their needs everything we do must be of high quality. We must constantly strive to reduce our costs in order to maintain reasonable prices. Customers orders must be serviced promptly and accurately. Our suppliers and distributors must have an opportunity to make a fair prot. We are responsible to our employees, the men and women who work with us throughout the world. Everyone must be considered as an individual. We must respect their dignity and recognize their merit. They must have a sense of security in their jobs. Compensation must be fair and adequate, and working conditions clean, orderly and safe. We must be mindful of ways to help our employees fulll their family responsibilities. Employees must feel free to make suggestions and complaints. There must be equal opportunity for employment, development and advancement for those qualied. We must provide competent management, and their actions must be just and ethical. We are responsible to the communities in which we live and work and to the world community as well. We must be good citizenssupport good works and charities and bear our fair share of taxes. We must encourage civic improvements and better health and education. We must maintain in good order the property we are privileged to use, protecting the environment and natural resources. Our nal responsibility is to our stockholders. Business must make a sound prot. We must experiment with new ideas. Research must be carried on, innovative programs developed and mistakes paid for. New equipment must be purchased, new facilities provided and new products launched. Reserves must be created to provide for adverse times. When we operate according to these principles, the stockholders should realize a fair return. 7 www.jnj.com/our_company/our_credo gar79611_ch01_001-029.indd gar79611_ch01_001-029.indd Page 17 12/5/08 12:16:51 AM user-s176 /broker/MH-BURR/MHBR094/MHBR094-01/upload/MHBR094-01 17 Managerial Accounting and the Business Environment adhere to it when making decisions. If top managers continue to say, in effect, that they will only be satised with bottom-line results and will accept no excuses, they are building a culture that implicitly coerces employees to engage in unethical behavior to get ahead. This type of unethical culture is contagious. In fact, one survey showed that [t]hose who engage in unethical behavior often justify their actions with one or more of the following reasons: (1) the organization expects unethical behavior, (2) everyone else is unethical, and/or (3) behaving unethically is the only way to get ahead.8 IN BUSINESS WHERE WOULD YOU LIKE TO WORK? Nearly all executives claim that their companies maintain high ethical standards; however, not all executives walk the talk. Employees usually know when top executives are saying one thing and doing another and they also know that these attitudes spill over into other areas. Working in companies where top managers pay little attention to their own ethical rules can be extremely unpleasant. Several thousand employees in many different organizations were asked if they would recommend their company to prospective employees. Overall, 66% said that they would. Among those employees who believed that their top management strives to live by the companys stated ethical standards, the number of recommenders jumped to 81%. But among those who believed top management did not follow the companys stated ethical standards, the number was just 21%. Source: Jeffrey L. Seglin, Good for Goodness Sake, CFO, October 2002, pp. 7578. Codes of Conduct on the International Level The Code of Ethics for Professional Accountants, issued by the International Federation of Accountants (IFAC), governs the activities of all professional accountants throughout the world, regardless of whether they are practicing as independent CPAs, employed in government service, or employed as internal accountants.9 In addition to outlining ethical requirements in matters dealing with integrity and objectivity, resolution of ethical conicts, competence, and condentiality, the IFACs code also outlines the accountants ethical responsibilities in other matters such as those relating to taxes, independence, fees and commissions, advertising and solicitation, the handling of monies, and cross-border activities. Where cross-border activities are involved, the IFAC ethical requirements must be followed if they are stricter than the ethical requirements of the country in which the work is being performed. Corporate Governance Effective corporate governance enhances stockholders condence that a company is being run in their best interests rather than in the interests of top managers. Corporate governance is the system by which a company is directed and controlled. If properly implemented, the corporate governance system should provide incentives for the board of directors and top management to pursue objectives that are in the interests of the companys owners and it should provide for effective monitoring of performance.10 Unfortunately, history has repeatedly shown that unscrupulous top managers, if unchecked, can exploit their power to defraud stockholders. This unpleasant reality became all too clear in 2001 when the fall of Enron kicked off a wave of corporate scandals. These 8 Michael K. McCuddy, Karl E. Reichardt, and David Schroeder, Ethical Pressures: Fact or Fiction? Management Accounting 74, no. 10, pp. 5761. 9 A copy of this code can be obtained on the International Federation of Accountants website www.ifac.org. 10 This denition of corporate governance was adapted from the 2004 report titled OECD Principles of Corporate Governance published by the Organization for Economic Co-Operation and Development. gar79611_ch01_001-029.indd gar79611_ch01_001-029.indd Page 18 12/5/08 12:16:51 AM user-s176 18 /broker/MH-BURR/MHBR094/MHBR094-01/upload/MHBR094-01 Chapter 1 scandals were characterized by nancial reporting fraud and misuse of corporate funds at the very highest levelsincluding CEOs and CFOs. While this was disturbing in itself, it also indicated that the institutions intended to prevent such abuses werent working, thus raising fundamental questions about the adequacy of the existing corporate governance system. In an attempt to respond to these concerns, the U.S. Congress passed the most important reform of corporate governance in many decadesThe Sarbanes-Oxley Act of 2002. IN BUSINESS SPILLED MILK AT PARMALAT Corporate scandals have not been limited to the United States. In 2003, Parmalat, a publicly traded dairy company in Italy, went bankrupt. The CEO, Calisto Tanzi, admitted to manipulating the books for more than a decade so that he could skim off $640 million to cover losses at various of his family businesses. But the story doesnt stop there. Parmalats balance sheet contained $13 billion in nonexistent assets, including a $5 billion Bank of America account that didnt exist. All in all, Parmalat was the biggest nancial fraud in European history. Source: Gail Edmondson, David Fairlamb, and Nanette Byrnes, The Milk Just Keeps on Spilling, BusinessWeek, January 26, 2004, pp. 5458. The Sarbanes-Oxley Act of 2002 The Sarbanes-Oxley Act of 2002 was intended to protect the interests of those who invest in publicly traded companies by improving the reliability and accuracy of corporate nancial reports and disclosures. We would like to highlight six key aspects of the legislation.11 First, the Act requires that both the CEO and CFO certify in writing that their companys nancial statements and accompanying disclosures fairly represent the results of operationswith possible jail time if a CEO or CFO certies results that they know are false. This creates very powerful incentives for the CEO and CFO to ensure that the nancial statements contain no misrepresentations. Second, the Act established the Public Company Accounting Oversight Board to provide additional oversight over the audit profession. The Act authorizes the Board to conduct investigations, to take disciplinary actions against audit rms, and to enact various standards and rules concerning the preparation of audit reports. Third, the Act places the power to hire, compensate, and terminate the public accounting rm that audits a companys nancial reports in the hands of the audit committee of the board of directors. Previously, management often had the power to hire and re its auditors. Furthermore, the Act species that all members of the audit committee must be independent, meaning that they do not have an afliation with the company they are overseeing, nor do they receive any consulting or advisory compensation from the company. Fourth, the Act places important restrictions on audit rms. Historically, public accounting rms earned a large part of their prots by providing consulting services to the companies that they audited. This provided the appearance of a lack of independence because a client that was dissatised with an auditors stance on an accounting issue might threaten to stop using the auditor as a consultant. To avoid this possible conict of interests, the Act prohibits a public accounting rm from providing a wide variety of nonauditing services to an audit client. Fifth, the Act requires that a companys annual report contain an internal control report. Internal controls are put in place by management to provide assurance to investors 11 A summary of the Sarbanes-Oxley Act of 2002 can be obtained from the American Institute of Certied Public Accountants (AICPA) website http://thecaq.aicpa.org/Resources/Sarbanes+Oxley. gar79611_ch01_001-029.indd gar79611_ch01_001-029.indd Page 19 12/5/08 12:16:52 AM user-s176 /broker/MH-BURR/MHBR094/MHBR094-01/upload/MHBR094-01 19 Managerial Accounting and the Business Environment that nancial disclosures are reliable. The report must state that it is managements responsibility to establish and maintain adequate internal controls and it must contain an assessment by management of the effectiveness of its internal control structure. The internal control report is accompanied by an opinion from the companys audit rm as to whether management has maintained effective internal control over its nancial reporting process. Finally, the Act establishes severe penalties of as many as 20 years in prison for altering or destroying any documents that may eventually be used in an ofcial proceeding and as many as 10 years in prison for managers who retaliate against a so-called whistleblower who goes outside the chain of command to report misconduct. Collectively, these six aspects of the Sarbanes-Oxley Act of 2002 should help reduce the incidence of fraudulent nancial reporting. IN BUSINESS SARBANES-OXLEY TAKES ITS TOLL ON CFOs Bank of Americas stock price rose 13% while Alvaro DeMolina was its Chief Financial Ofcer (CFO). Yet, after 18 months DeMolina resigned from his job because it was suffocating and less fun. DeMolina is one of many CFOs who attribute their job dissatisfaction to The Sarbanes-Oxley Act of 2002 (SOX). A survey of 237 CFOs showed that 75% of them believe SOX signicantly increased their workload and 49% feel that SOX makes their job less satisfying. The turnover rate among CFOs of $1 billion companies increased from 7% in 2002 to 21% in 2005. Thanks to SOX, CFOs are spending too much time certifying stacks of documents and responding to tedious inquiries from the board of directors, and less time on the strategic and creative endeavors of managing internal operations. Source: Telis Demos, CFO: All Pain, No Gain, Fortune, February 5, 2007, pp. 1819; Ghostwriter, Sore About Sarbox, BusinessWeek, March 13, 2006, p. 13. Enterprise Risk Management Businesses face risks every day. Some risks are foreseeable. For example, a company could reasonably be expected to foresee the possibility of a natural disaster or a re destroying its centralized data storage facility. Companies respond to this type of risk by maintaining off-site backup data storage facilities. Other risks are unforeseeable. For example, in 1982 Johnson & Johnson never could have imagined that a deranged killer would insert poison into bottles of Tylenol and then place these tainted bottles on retail shelves, ultimately killing seven people.12 Johnson & Johnsonguided by the rst line of its Credo (see page 16)responded to this crisis by acting to reduce the risks faced by its customers and itself. First, it immediately recalled and destroyed 31 million bottles of Tylenol with a retail value of $100 million to reduce the risk of additional fatalities. Second, it developed the tamper-resistant packaging that we take for granted today to reduce the risk that the same type of crime could be repeated in the future. Every business strategy or decision involves risks. Enterprise risk management is a process used by a company to proactively identify and manage those risks. Identifying and Controlling Business Risks Companies should identify foreseeable risks before they occur rather than react to unfortunate events that have already happened. The left-hand column of Exhibit 19 (page 20) provides 12 examples of business risks. This list is not exhaustive, rather its purpose is to 12 Tamara Kaplan, The Tylenol Crisis: How Effective Public Relations Saved Johnson & Johnson, in Glen Broom, Allen Center, and Scott Cutlip, Effective Public Relations, Prentice Hall, Upper Saddle River, NJ. gar79611_ch01_001-029.indd gar79611_ch01_001-029.indd Page 20 12/5/08 12:16:53 AM user-s176 20 /broker/MH-BURR/MHBR094/MHBR094-01/upload/MHBR094-01 Chapter 1 E X H I B I T 19 Identifying and Controlling Business Risks Examples of Controls to Reduce Business Risks Examples of Business Risks Intellectual assets being stolen from computer les Products harming customers Losing market share due to the unforeseen actions of competitors Poor weather conditions shutting down operations A website malfunctioning A supplier strike halting the ow of raw materials A poorly designed incentive compensation system causing employees to make bad decisions Financial statements inaccurately reporting the value of inventory An employee stealing assets An employee accessing unauthorized information Inaccurate budget estimates causing excessive or insufcient production Failing to comply with equal employment opportunity laws Create rewalls that prohibit computer hackers from corrupting or stealing intellectual property Develop a formal and rigorous new product testing program Develop an approach for legally gathering information about competitors plans and practices Develop contingency plans for overcoming weather-related disruptions Thoroughly test the website before going live on the Internet Establish a relationship with two companies capable of providing needed raw materials Create a balanced set of performance measures that motivates the desired behavior Count the physical inventory on hand to make sure that it agrees with the accounting records Segregate duties so that the same employee does not have physical custody of an asset and the responsibility of accounting for it Create password-protected barriers that prohibit employees from obtaining information not needed to do their jobs Implement a rigorous budget review process Create a report that tracks key metrics related to compliance with the laws illustrate the diverse nature of business risks that companies face. Whether the risks relate to the weather, computer hackers, complying with the law, employee theft, nancial reporting, or strategic decision making, they all have one thing in common. If the risks are not managed effectively, they can infringe on a companys ability to meet its goals. IN BUSINESS MANAGING WEATHER RISK The National Oceanic and Atmospheric Administration claims that the weather inuences one-third of the U.S. gross domestic product. In 2004, the word unseasonable was used by more than 120 publicly traded companies to explain unfavorable nancial performance. Indeed, it would be easy to conclude that the weather poses an uncontrollable risk to businesses, right? Wrong! Weather risk management is a growing industry with roughly 80 companies offering weather risk management services to clients. For example, Planalytics is a weather consulting rm that helps Wise Metal Group, a manufacturer of aluminum can sheeting, to manage its natural gas purchases. Wises $3 million monthly gas bill uctuates sharply depending on the weather. Planalytics software helps Wise plan its gas purchases in advance of changing temperatures. Beyond inuencing natural gas purchases, the weather can also delay the boats that deliver Wises raw materials and it can affect Wises sales to the extent that cooler weather conditions lead to a decline in canned beverage sales. Source: Abraham Lustgarten, Getting Ahead of the Weather, Fortune, February 7, 2005, pp. 8794. gar79611_ch01_001-029.indd gar79611_ch01_001-029.indd Page 21 12/5/08 12:16:54 AM user-s176 /broker/MH-BURR/MHBR094/MHBR094-01/upload/MHBR094-01 21 Managerial Accounting and the Business Environment Once a company identies its risks, it can respond to them in various ways such as accepting, avoiding, or reducing the risk. Perhaps the most common risk management tactic is to reduce risks by implementing specic controls. The right-hand column of Exhibit 19 provides an example of a control that could be implemented to help reduce each of the risks mentioned in the left-hand column of the exhibit. In conclusion, a sophisticated enterprise risk management system cannot guarantee that all risks are eliminated. Nonetheless, many companies understand that managing risks is a superior alternative to reacting, perhaps too late, to unfortunate events. Corporate Social Responsibility Companies are responsible for producing nancial results that satisfy stockholders. However, they also have a corporate social responsibility to serve other stakeholderssuch as customers, employees, suppliers, communities, and environmental and human rights advocates whose interests are tied to the companys performance. Corporate social responsibility (CSR) is a concept whereby organizations consider the needs of all stakeholders when making decisions. CSR extends beyond legal compliance to include voluntary actions that satisfy stakeholder expectations. Numerous companies, such as Procter & Gamble, 3M, Eli Lilly and Company, Starbucks, Microsoft, Genentech, Johnson & Johnson, Baxter International, Abbott Laboratories, KPMG, National City Bank, Deloitte, Southwest Airlines, and Caterpillar, prominently describe their corporate social performance on their websites. Exhibit 110 presents examples of corporate social responsibilities that are of interest to six stakeholder groups. Many companies are paying increasing attention to these types of broadly dened responsibilities for four reasons. First, socially responsible investors control more than $2.3 trillion of investment capital. Companies that want access to this capital Companies should provide customers with: Safe, high-quality products that are fairly priced. Competent, courteous, and rapid delivery of products and services. Full disclosure of product-related risks. Easy-to-use information systems for shopping and tracking orders. Companies should provide suppliers with: Fair contract terms and prompt payments. Reasonable time to prepare orders. Hassle-free acceptance of timely and complete deliveries. Cooperative rather than unilateral actions. Companies should provide stockholders with: Competent management. Easy access to complete and accurate nancial information. Full disclosure of enterprise risks. Honest answers to knowledgeable questions. Companies and their suppliers should provide employees with: Safe and humane working conditions. Nondiscriminatory treatment and the right to organize and le grievances. Fair compensation. Opportunities for training, promotion, and personal development. Companies should provide communities with: Payment of fair taxes. Honest information about plans such as plant closings. Resources that support charities, schools, and civic activities. Reasonable access to media sources. Companies should provide environmental and human rights advocates with: Greenhouse gas emissions data. Recycling and resource conservation data. Child labor transparency. Full disclosure of suppliers located in developing countries. E X H I B I T 110 Examples of Corporate Social Responsibilities gar79611_ch01_001-029.indd gar79611_ch01_001-029.indd Page 22 12/5/08 12:41:16 AM user-s176 22 /broker/MH-BURR/MHBR094/MHBR094-01/upload/MHBR094-01 Chapter 1 must excel in terms of their social performance. Second, a growing number of employees want to work for a company that recognizes and responds to its social responsibilities. If companies hope to recruit and retain these highly skilled employees, then they must offer fullling careers that serve the needs of broadly dened stakeholders. Third, many customers seek to purchase products and services from socially responsible companies. The Internet enables these customers to readily locate competing products, thereby making it even easier to avoid doing business with undesirable companies. Fourth, nongovernment organizations (NGOs) and activists are more capable than ever of tarnishing a companys reputation by publicizing its environmental or human rights missteps. The Internet has enabled these environmental and human rights advocacy groups to better organize their resources, spread negative information, and take coordinated actions against offending companies.13 It is important to understand that a companys social performance can impact its nancial performance. For example, if a companys poor social performance alienates customers, then its revenues and prots will suffer. This reality explains why companies use enterprise risk management, as previously described, to meet the needs of all stakeholders. IN BUSINESS SKILL-BASED VOLUNTEERISM GROWS IN POPULARITY Ernst & Young, a Big 4 public accounting rm, paid one of its managers to spend 12 weeks in Buenos Aires providing free accounting services to a small publishing company. UPS paid one of its logistics supervisors to help coordinate the Susan G. Komen Breast Cancer Foundations annual Race for the Cure event. Why are these companies paying their employees to work for other organizations? A survey of 1,800 people ages 1325 revealed that 79% intend to seek employment with companies that care about contributing to societyunderscoring the value of skill-based volunteerism as an employee recruiting and retention tool. Furthermore, enabling employees to apply their skills in diverse business contexts makes them more effective when they return to their regular jobs. Source: Sarah E. Needleman, The Latest Ofce Perk: Getting Paid to Volunteer, The Wall Street Journal, April 29, 2008, pp. D1 and D5. The Certied Management Accountant (CMA) An individual who possesses the necessary qualications and who passes a rigorous professional exam earns the right to be known as a Certied Management Accountant (CMA). In addition to the prestige that accompanies a professional designation, CMAs are often given greater responsibilities and higher compensation than those who do not have such a designation. Information about becoming a CMA and the CMA program can be accessed on the Institute of Management Accountants (IMA) website www.imanet.org or by calling 1-800-638-4427. To become a Certied Management Accountant, the following four steps must be completed: 1. File an Application for Admission and register for the CMA examination. 2. Pass all four parts of the CMA examination within a three-year period. 3. Satisfy the experience requirement of two continuous years of professional experience in management and/or nancial accounting prior to or within seven years of passing the CMA examination. 4. Comply with the Statement of Ethical Professional Practice. 13 The insights from this paragraph and many of the examples in Exhibit 110 were drawn from Ronald W. Clement, The Lessons from Stakeholder Theory for U.S. Business Leaders, Business Horizons, May/June 2005, pp. 255264; and Terry Leap and Misty L. Loughry, The Stakeholder-Friendly Firm, Business Horizons, March/April 2004, pp. 2732. gar79611_ch01_001-029.indd gar79611_ch01_001-029.indd Page 23 12/5/08 12:16:55 AM user-s176 /broker/MH-BURR/MHBR094/MHBR094-01/upload/MHBR094-01 23 Managerial Accounting and the Business Environment IN BUSINESS HOWS THE PAY? The Institute of Management Accountants has created the following table that allows an individual to estimate what his salary would be as a management accountant. (The table below applies specically to men. A similar table exists for women.) Your Calculation Start with this base amount . . . . . . . . . . . . . . If you are top-level management . . . . . . . . . . OR, if you are entry-level management . . . . . ....... Number of years in the eld If you have an advanced degree . . . . . . . . . . OR, if you have no degree . . . . . . . . . . . . . . . If you hold the CMA . . . . . . . . . . . . . . . . . . . . OR, if you hold the CPA . . . . . . . . . . . . . . . . . OR, if you hold both CMA and CPA . . . . . . . . Your estimated salary level . . . . . . . . . . . . . . ADD SUBTRACT TIMES ADD SUBTRACT ADD ADD ADD $70,449 $25,484 $24,475 $702 $11,473 $27,283 $14,874 $12,320 $18,128 $70,449 For example, if you make it to top-level management in 10 years, have an advanced degree and a CMA, your estimated salary would be $129,300 [$70,449 $25,484 (10 $702) $11,473 $14,874]. Source: David L. Schroeder and Karl E. Reichardt, IMA 2006 Salary Survey, Strategic Finance, June 2007, pp. 2238. Summary Successful companies follow strategies that differentiate themselves from competitors. Strategies often focus on three customer value propositionscustomer intimacy, operational excellence, and product leadership. Most organizations rely on decentralization to some degree. Decentralization is formally depicted in an organization chart that shows who works for whom and which units perform line and staff functions. Lean Production, the Theory of Constraints, and Six Sigma are three management approaches that focus on business processes. Lean Production organizes resources around business processes and pulls units through those processes in response to customer orders. The result is lower inventories, fewer defects, less wasted effort, and quicker customer response times. The Theory of Constraints emphasizes the importance of managing an organizations constraints. Because the constraint is whatever is holding back the organization, improvement efforts usually must be focused on the constraint to be effective. Six Sigma uses the DMAIC (Dene, Measure, Analyze, Improve, and Control) framework to eliminate non-value-added activities and to improve processes. Ethical behavior is the foundation of a successful market economy. If we cannot trust others to act ethically in their business dealings with us, we will be inclined to invest less, scrutinize purchases more, and generally waste time and money trying to protect ourselves from the unscrupulous resulting in fewer goods available to consumers at higher prices and lower quality. Unfortunately, trust in our corporate governance system has been undermined by numerous high-prole nancial reporting scandals. The Sarbanes-Oxley Act of 2002 was passed with the objective of improving the reliability of the nancial disclosures provided by publicly traded companies. All organizations face risks that they should proactively identify and respond to by accepting, avoiding, or reducing the risk. They also have a corporate social responsibility to serve a wide variety of stakeholders including stockholders, customers, employees, suppliers, and communities. gar79611_ch01_001-029.indd gar79611_ch01_001-029.indd Page 24 12/5/08 12:16:56 AM user-s176 24 /broker/MH-BURR/MHBR094/MHBR094-01/upload/MHBR094-01 Chapter 1 Glossary At the end of each chapter, a list of key terms for review is given, along with the denition of each term. (These terms are printed in boldface where they are dened in the chapter.) Carefully study each term to be sure you understand its meaning. The list for Chapter 1 follows. Business process A series of steps that are followed to carry out some task in a business. (p. 7) Chief Financial Ofcer (CFO) The member of the top management team who is responsible for providing timely and relevant data to support planning and control activities and for preparing nancial statements for external users. (p. 6) Constraint Anything that prevents an organization or individual from getting more of what it wants. (p. 10) Controller The member of the top management team who is responsible for providing relevant and timely data to managers and for preparing nancial statements for external users. The controller reports to the CFO. (p. 6) Corporate governance The system by which a company is directed and controlled. If properly implemented it should provide incentives for top management to pursue objectives that are in the interests of the company and it should effectively monitor performance. (p. 17) Corporate social responsibility A concept whereby organizations consider the needs of all stakeholders when making decisions. It extends beyond legal compliance to include voluntary actions that satisfy stakeholder expectations. (p. 21) Decentralization The delegation of decision-making authority throughout an organization by providing managers with the authority to make decisions relating to their area of responsibility. (p. 5) Enterprise risk management A process used by a company to help identify the risks that it faces and to develop responses to those risks that enable the company to be reasonably assured of meeting its goals. (p. 19) Finished goods Units of product that have been completed but have not yet been sold to customers. (p. 8) Just-in-time (JIT) A production and inventory control system in which materials are purchased and units are produced only as needed to meet actual customer demand. (p. 9) Lean thinking model A ve-step management approach that organizes resources around the ow of business processes and that pulls units through these processes in response to customer orders. (p. 8) Line A position in an organization that is directly related to the achievement of the organizations basic objectives. (p. 6) Non-value-added activities Activities that consume resources but do not add value for which customers are willing to pay. (p. 12) Organization chart A diagram of a companys organizational structure that depicts formal lines of reporting, communication, and responsibility between managers. (p. 5) Raw materials Materials that are used to make a product. (p. 8) Sarbanes-Oxley Act of 2002 Legislation enacted to protect the interests of stockholders who invest in publicly traded companies by improving the reliability and accuracy of the disclosures provided to them. (p. 18) Six Sigma A method that relies on customer feedback and objective data gathering and analysis techniques to drive process improvement. (p. 11) Staff A position in an organization that is only indirectly related to the achievement of the organizations basic objectives. Such positions provide service or assistance to line positions or to other staff positions. (p. 6) Strategy A game plan that enables a company to attract customers by distinguishing itself from competitors. (p. 4) Supply chain management A management approach that coordinates business processes across companies to better serve end consumers. (p. 9) Theory of Constraints (TOC) A management approach that emphasizes the importance of managing constraints. (p. 10) Value chain The major business functions that add value to a companys products and services such as research and development, product design, manufacturing, marketing, distribution, and customer service. (p. 7) Work in process Units of product that are only partially complete and will require further work before they are ready for sale to a customer. (p. 8) gar79611_ch01_001-029.indd Page 25 12/22/08 11:24:49 PM user-s176 /broker/MH-BURR/MHBR094/MHBR094-01/upload/MHBR094-01 25 Managerial Accounting and the Business Environment Questions 11 12 13 14 15 16 17 18 19 110 111 112 113 114 115 What is meant by a business strategy? Describe the three broad categories of customer value propositions. Distinguish between line and staff positions in an organization. Describe the basic responsibilities of the Chief Financial Ofcer. What are the three main categories of inventories in a manufacturing company? What are the ve steps in the lean thinking model? What are the major benets from successful implementation of the lean thinking model? Describe what is meant by a pull production system. Where does the Theory of Constraints recommend that improvement efforts be focused? Briey describe Six Sigma. Describe the ve stages in the Six Sigma DMAIC Framework. Why is adherence to ethical standards important for the smooth functioning of an advanced market economy? Describe what is meant by corporate governance. Briey describe what is meant by enterprise risk management. What are the major stakeholder groups whose interests are tied to a companys performance? Multiple-choice questions are provided on the text website at www.mhhe.com/garrison13e. Exercises EXERCISE 11 The Roles of Managers and Management Accountants [LO1] Six terms that relate to organizations, the work of management, and the role of managerial accounting are listed below: Decentralization Line Staff Controller Organization chart Chief Financial Ofcer Choose the term above that most appropriately completes the following statements: 1. A position that is directly related to achieving the basic objectives of an organization is called position. a 2. A diagram that shows how responsibility is divided among managers and shows the formal . lines of reporting and communication is called an position provides service or assistance to other parts of the organization 3. A and does not directly achieve the basic objectives of the organization. 4. The delegation of decision-making authority throughout an organization by allowing managers at various operating levels to make key decisions relating to their area of responsibility is . called . 5. The manager in charge of the accounting department is generally known as the is the member of the top management team who is responsible for 6. The providing timely and relevant data to support planning and control activities and for preparing nancial statements for external users. EXERCISE 12 The Business Environment [LO2] A number of terms are listed below: Six Sigma customer value proposition lean thinking model supply chain management Theory of Constraints non-value-added activity value chain stakeholders pulls business process corporate governance strategy enterprise risk management The Sarbanes-Oxley Act of 2002 nonconstraint constraint corporate social responsibility manufacturing cell Required: Choose the term or terms from the above list that most appropriately completes each of the following statements: gar79611_ch01_001-029.indd gar79611_ch01_001-029.indd Page 26 12/5/08 12:16:57 AM user-s176 26 /broker/MH-BURR/MHBR094/MHBR094-01/upload/MHBR094-01 Chapter 1 1. A(n) is a game plan that enables a company to attract customers by distinguishing itself from competitors. 2. is a method that relies on customer feedback and objective data gathering and analysis techniques to drive process improvement. 3. A(n) is a series of steps that are followed to carry out some task in a business. 4. The system by which a company is directed and controlled is called . 5. The process used by a company to help identify the risks that it faces and to develop responses to those risks so that the company is reasonably assured of meeting its goals is known as . 6. A is a work space that takes employees and equipment from departments that were previously separated from one another and places them side-by-side. 7. The various groups of people, such as employees, customers, and suppliers, whose interests are tied to a companys performance are called . 8. A(n) is anything that prevents an organization or individual from getting more of what it wants. 9. Increasing the rate of output of a(n) as the result of an improvement effort is unlikely to have much effect on prots. 10. A(n) consists of business functions that add value to a companys products and services such as research and development, product design, manufacturing, marketing, distribution, and customer service. 11. is a concept whereby organizations consider the needs of all stakeholders when making decisions. 12. A management approach that coordinates business processes across companies to better serve end consumers is known as . 13. The is a ve-step management approach that organizes resources around the ow of business processes and that units through those processes in response to customer orders. 14. A company can only succeed if it creates a reason for customers to choose it over a competitor; in short, a . 15. was enacted to protect the interests of those who invest in publicly traded companies. 16. A(n) consumes resources but does not add value for which customers are willing to pay. 17. The management approach that emphasizes the importance of managing constraints is known as the . EXERCISE 13 Ethics in Business [LO3] Mary Karston was hired by a popular fast-food restaurant as an order-taker and cashier. Shortly after taking the job, she was shocked to overhear an employee bragging to a friend about shortchanging customers. She confronted the employee who then snapped back: Mind your own business. Besides, everyone does it and the customers never miss the money. Mary didnt know how to respond to this aggressive stance. Required: What would be the practical consequences on the fast-food industry and on consumers if cashiers generally shortchanged customers at every opportunity? Problems PROBLEM 14 Ethics and the Manager [LO3] Richmond, Inc., operates a chain of 44 department stores. Two years ago, the board of directors of Richmond approved a large-scale remodeling of its stores to attract a more upscale clientele. Before nalizing these plans, two stores were remodeled as a test. Linda Perlman, assistant controller, was asked to oversee the nancial reporting for these test stores, and she and other management personnel were offered bonuses based on the sales growth and protability of these stores. While completing the nancial reports, Perlman discovered a sizable inventory of outdated goods that should have been discounted for sale or returned to the manufacturer. She discussed the situation with her management colleagues; the consensus was to ignore reporting this inventory as obsolete because reporting it would diminish the nancial results and their bonuses. gar79611_ch01_001-029.indd gar79611_ch01_001-029.indd Page 27 12/5/08 12:17:04 AM user-s176 /broker/MH-BURR/MHBR094/MHBR094-01/upload/MHBR094-01 Managerial Accounting and the Business Environment Required: 1. 2. According to the IMAs Statement of Ethical Professional Practice, would it be ethical for Perlman not to report the inventory as obsolete? Would it be easy for Perlman to take the ethical action in this situation? (CMA, adapted) PROBLEM 15 Preparing an Organization Chart [LO1] Bristow University is a large private school located in the Midwest. The university is headed by a president who has ve vice presidents reporting to him. These vice presidents are responsible for, respectively, auxiliary services, admissions and records, academics, nancial services (controller), and the physical plant. In addition, the university has managers over several areas who report to these vice presidents. These include managers over central purchasing, the university press, and the university bookstore, all of whom report to the vice president for auxiliary services; managers over computer services and over accounting and nance, who report to the vice president for nancial services; and managers over grounds and custodial services and over plant and maintenance, who report to the vice president for physical plant. The university has four collegesbusiness, humanities, ne arts, and engineering and quantitative methodsand a law school. Each of these units has a dean who is responsible to the academic vice president. Each college has several departments. Required: 1. 2. 3. Prepare an organization chart for Bristow University. Which of the positions on your chart would be line positions? Why would they be line positions? Which would be staff positions? Why? Which of the positions on your chart would have need for accounting information? Explain. PROBLEM 16 Ethics; Just-In-Time (JIT) Purchasing [LO2, LO3] (The situation described below was adapted from a case published by the Institute of Management Accountants Committee on Ethics.*) WIW is a publicly owned corporation that makes various control devices used in manufacturing mechanical equipment. J.B. is the president of WIW, Tony is the purchasing agent, and Diane is J.B.s executive assistant. All three have been with WIW for about ve years. Charlie is WIWs controller and has been with the company for two years. J.B.: Hi, Charlie, come on in. Diane said you had a condential matter to discuss. Whats on your mind? Charlie: J.B., I was reviewing our increased purchases from A-1 Warehouse Sales last week and wondered why our volume has tripled in the past year. When I discussed this with Tony he seemed a bit evasive and tried to dismiss the issue by stating that A-1 can give us one-day delivery on our orders. J.B.: Well, Tony is right. You know we have been trying to implement just-in-time and have been trying to get our inventory down. Charlie: We still have to look at the overall cost. A-1 is more of a jobber than a warehouse. After investigating orders placed with them, I found that only 10% are delivered from their warehouse and the other 90% are drop-shipped from the manufacturers. The average markup by A-1 is 30%, which amounted to about $600,000 on our orders for the past year. If we had ordered directly from the manufacturers when A-1 didnt have an item in stock, we could have saved about $540,000 ($600,000 90%). In addition, some of the orders were late and not complete. J.B.: Now look, Charlie, we get quick delivery on most items, and who knows how much we are saving by not having to stock this stuff in advance or worry about it becoming obsolete. Is there anything else on your mind? Charlie: Well, J.B., as a matter of fact, there is. I ordered a Dun & Bradstreet credit report on A-1 and discovered that Mike Bell is the principal owner. Isnt he your brother-in-law? J.B.: Sure he is. But dont worry about Mike. He understands this JIT approach. Besides, hes looking out for our interests. Charlie (to himself): This conversation has been enlightening, but it doesnt respond to my concerns. Can I legally or ethically ignore this apparent conict of interests? * Neil Holmes, ed., Ethics, Management Accounting 73, no. 8, p. 16. Used with permission from the Institute of Management Accountants (IMA), Montvale, N.J., USA, www.imanet.org. 27 gar79611_ch01_001-029.indd gar79611_ch01_001-029.indd Page 28 12/5/08 12:17:08 AM user-s176 28 /broker/MH-BURR/MHBR094/MHBR094-01/upload/MHBR094-01 Chapter 1 Required: 1. 2. Would Charlie be justied in ignoring this situation, particularly because he is not the purchasing agent? In preparing your answer, consider the IMAs Statement of Ethical Professional Practice. State the specic steps Charlie should follow to resolve this matter. PROBLEM 17 Ethics in Business [LO3] Consumers and attorney generals in more than 40 states accused a prominent nationwide chain of auto repair shops of misleading customers and selling them unnecessary parts and services, from brake jobs to front-end alignments. Lynn Sharpe Paine reported the situation as follows in Managing for Organizational Integrity, Harvard Business Review, Volume 72 Issue 3: In the face of declining revenues, shrinking market share, and an increasingly competitive market . . . management attempted to spur performance of its auto centers. . . . The automotive service advisers were given product-specic sales quotassell so many springs, shock absorbers, alignments, or brake jobs per shiftand paid a commission based on sales. . . . [F]ailure to meet quotas could lead to a transfer or a reduction in work hours. Some employees spoke of the pressure, pressure, pressure to bring in sales. This pressure-cooker atmosphere created conditions under which employees felt that the only way to satisfy top management was by selling products and services to customers that they didnt really need. Suppose all automotive repair businesses routinely followed the practice of attempting to sell customers unnecessary parts and services. Required: 1. 2. How would this behavior affect customers? How might customers attempt to protect themselves against this behavior? How would this behavior probably affect prots and employment in the automotive service industry? PROBLEM 18 Line and Staff Positions [LO1] Special Alloys Corporation manufactures a variety of specialized metal products for industrial use. Most of its revenues are generated by large contracts with companies that have government defense contracts. The company also develops and markets parts to the major automobile companies. It employs many metallurgists and skilled technicians because most of its products are made from highly sophisticated alloys. The company recently signed two large contracts; as a result, the workload of Wayne Washburn, the general manager, has become overwhelming. To relieve some of this overload, Mark Johnson was transferred from the Research Planning Department to the general managers ofce. Johnson, who has been a senior metallurgist and supervisor in the Research Planning Department, was given the title assistant to the general manager. Washburn assigned several resposibilities to Johnson in their rst meeting. Johnson will oversee the testing of new alloys in the Product Planning Department and be given the authority to make decisions as to the use of these alloys in product development; he will also be responsible for maintaining the production schedules for one of the new contracts. In addition to these duties, he will be required to meet with the supervisors of the production departments regularly to consult with them about production problems they may be experiencing. Washburn expects to be able to manage the company much more efciently with Johnsons help. Required: 1. 2. 3. Positions within organization are often described as having (a) line authority or (b) staff authority. Describe what is meant by these two terms. Of the responsibilities assigned to Mark Johnson as assistant to the general manager, which tasks have line authority and which have staff authority? Identify and discuss the conicts Mark Johnson may experience in the production departments as a result of his new responsibilities. (CMA, adapted) gar79611_ch01_001-029.indd Page 29 12/22/08 11:24:58 PM user-s176 /broker/MH-BURR/MHBR094/MHBR094-01/upload/MHBR094-01 Managerial Accounting and the Business Environment RESEARCH AND APPLICATION 19 [LO1, LO3] The questions in this exercise are based on one of the fastest growing food retailers in the United StatesWhole Foods Market, Inc. To answer the questions, you will need to download Whole Foods Markets 2004 annual report at www.wholefoodsmarket.com/company/annualreports.php and its 10-K/A for the scal year ended September 26, 2004 by going to www.sec.gov/ edgar/searchedgar/companysearch.html. Input CIK code 865436 and hit enter. In the gray box on the right-hand side of your computer screen dene the scope of your search by inputting 10-K and then pressing enter. Select the 10-K/A with a ling date of May 18, 2005. In addition, youll need to download the companys mission statement (which it refers to as a Declaration of Interdependence) at www.wholefoodsmarket.com/company/declaration.php and its code of business conduct at www.wholefoodsmarket.com/company/pdfs/codeofconduct.pdf. You do not need to print these documents to answer the questions. Required: 1. 2. 3. 4. 5. What is Whole Foods Markets strategy for success in the marketplace? Does the company rely primarily on a customer intimacy, operational excellence, or product leadership customer value proposition? What evidence supports your conclusion? What business risks does Whole Foods Market face that may threaten its ability to satisfy stockholder expectations? What are some examples of control activities that the company could use to reduce these risks? (Hint: Focus on pages 1115 of the 10-K/A.) Create an excerpt of an organization chart for Whole Foods Market. Do not try to create an organization chart for the entire companyit would be overwhelming! Pick a portion of the company and depict how the company organizes itself. (Hint: Study the 2004 Global All-Stars mentioned in the annual report and refer to page 16 of the 10-K/A.) Mention by name three employees that occupy line positions and three employees that occupy staff positions. Compare and contrast Whole Foods Markets mission statement with the Johnson & Johnson Credo shown on page 16. Compare and contrast Whole Foods Markets mission statement and its code of business conduct. 29 Chapter gar79611_ch02_030-087.indd Page 30 12/8/08 9:07:44 PM user-s180 2 /broker/MH-BURR/MHBR094/MHBR094-02/upload Managerial Accounting and Cost Concepts Understanding Costs Aids the Growth of a Billion Dollar Company Identify the major differences and similarities between financial and managerial accounting. LO2 Identify and give examples of each of the three basic manufacturing cost categories. LO3 Distinguish between product costs and period costs and give examples of each. LO4 Prepare an income statement including calculation of the cost of goods sold. LO5 Prepare a schedule of cost of goods manufactured. LO6 Understand the differences between variable costs and fixed costs. LO7 Understand the differences between direct and indirect costs. Source: Alison Stein Wellner, Gary Heavin Is on a Mission from God, Inc. magazine, October 2006, pp. 116123. LO8 Understand cost classifications used in making decisions: differential costs, opportunity costs, and sunk costs. LO9 (Appendix 2A) Properly account for labor costs associated with idle time, overtime, and fringe benefits. LO10 (Appendix 2B) Identify the four types of quality costs and explain how they interact. LO11 (Appendix 2B) Prepare and interpret a quality cost report. LEARNING OBJECTIVES After studying Chapter 2, you should be able to: 30 BU SIN ES S FO C US LO1 I n 1986, Womens World of Fitness went bankrupt despite having 14 locations and 50,000 members. The companys owner, Gary Heavin, says the fitness centers contained too many costly amenities such as swimming pools, tanning beds, cardio machines, kids programs, juice bars, personal trainers, and aerobics classes. As costs escalated, he attempted to increase revenues by offering memberships to men, which alienated his female members. What did Heavin learn from his experience? In 1992, Heavin founded a new brand of womens fitness centers called Curves. Rather than investing in every conceivable piece of fitness equipment and amenity, Heavin focused on simplicity. He created a simple fitness circuit that uses minimal equipment and is quick and easy for members to complete. Instead of operating almost 24 hours a day, he decided to close his gyms early. Even showers were deemed unnecessary. In short, Heavin eliminated numerous costs that did not provide benefits in the eyes of his customers. With dramatically lower costs, he has been able to maintain his women only approach while building a billion dollar company with nearly 10,000 locations across the United States. gar79611_ch02_030-087.indd gar79611_ch02_030-087.indd Page 31 12/8/08 9:07:50 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-02/upload Managerial Accounting and Cost Concepts T his chapter begins by describing the work of management and the need for managerial accounting information followed by a discussion of the differences and similarities between nancial and managerial accounting. Next, we explain that in managerial accounting, the term cost is used in many different ways. The reason is that there are many types of costs, and these costs are classied differently according to the immediate needs of management. For example, managers may want cost data to prepare external nancial reports, to prepare planning budgets, or to make decisions. Each different use of cost data demands a different classication and denition of costs. For example, the preparation of external nancial reports requires the use of historical cost data, whereas decision making may require predictions about future costs. This notion of different costs for different purposes is a critically important aspect of managerial accounting. The Work of Management and the Need for Managerial Accounting Information Every organizationlarge and smallhas managers. Someone must be responsible for formulating strategy, making plans, organizing resources, directing personnel, and controlling operations. This is true of the Bank of America, the Peace Corps, the University of Illinois, the Red Cross, and the Coca-Cola Corporation, as well as the local 7-Eleven convenience store. In this chapter, we will use a particular organizationGood Vibrations, Inc.to illustrate the work of management. What we have to say about the management of Good Vibrations, however, is very general and can be applied to virtually any organization. Good Vibrations runs a chain of retail outlets that sells a full range of music CDs. The chains stores are concentrated in Pacic Rim cities such as Sydney, Singapore, Hong Kong, Beijing, Tokyo, and Vancouver. The company has found that the best way to generate sales and prots is to create an exciting shopping environment following a customer intimacy strategy. Consequently, the company puts a great deal of effort into planning the layout and decor of its storeswhich are often quite large and extend over several oors in key downtown locations. Management knows that different types of clientele are attracted to different kinds of music. The international rock section is generally decorated with bold, brightly colored graphics, and the aisles are purposely narrow to create a crowded feeling much like one would experience at a popular nightclub on Friday night. In contrast, the classical music section is wood-paneled and fully sound insulated, with the rich, spacious feeling of a country club meeting room. Managers at Good Vibrations like managers everywhere, carry out three major activitiesplanning, directing and motivating, and controlling. Planning involves establishing a basic strategy, selecting a course of action, and specifying how the action will be implemented. Directing and motivating involves mobilizing people to carry out plans and run routine operations. Controlling involves ensuring that the plan is actually carried out and is appropriately modied as circumstances change. Management accounting information plays a vital role in these basic management activitiesbut most particularly in the planning and control functions. Planning An important part of planning is to identify alternatives and then to select from among the alternatives the one that best ts the organizations strategy and objectives. The basic objective of Good Vibrations is to earn prots for the owners of the company by providing superior service at competitive prices in as many markets as possible. To further this strategy, every year top management carefully considers a range of options, or alternatives, for expanding into new geographic markets. This year management is considering opening new stores in Shanghai, Los Angeles, and Auckland. 31 gar79611_ch02_030-087.indd gar79611_ch02_030-087.indd Page 32 12/8/08 9:07:50 PM user-s180 32 /broker/MH-BURR/MHBR094/MHBR094-02/upload Chapter 2 When making this choice, management must balance the potential benets of opening a new store against the costs and demands on the companys resources. Management knows from bitter experience that opening a store in a major new market is a big step that cannot be taken lightly. It requires enormous amounts of time and energy from the companys most experienced, talented, and busy professionals. When the company attempted to open stores in both Beijing and Vancouver in the same year, resources were stretched too thinly. The result was that neither store opened on schedule, and operations in the rest of the company suffered. Therefore, Good Vibrations plans very carefully before entering a new market. Among other data, top management looks at the sales volumes, prot margins, and costs of the companys established stores in similar markets. These data, supplied by the management accountant, are combined with projected sales volume data at the proposed new locations to estimate the prots that would be generated by the new stores. In general, virtually all important alternatives considered by management in the planning process impact revenues or costs, and management accounting data are essential in estimating those impacts. After considering all of the alternatives, Good Vibrations top management decided to open a store in the booming Shanghai market in the third quarter of the year, but to defer opening any other new stores to another year. As soon as this decision was made, detailed plans were drawn up for all parts of the company that would be involved in the Shanghai opening. For example, the Personnel Departments travel budget was increased because it would be providing extensive on-site training to the new personnel hired in Shanghai. As in the case of the Personnel Department, the plans of management are often expressed formally in budgets, and the term budgeting is generally used to describe this part of the planning process. Budgets are usually prepared under the direction of the controller, who is the manager in charge of the Accounting Department. Typically, budgets are prepared annually and represent managements plans in specic, quantitative terms. In addition to a travel budget, the Personnel Department will be given goals in terms of new hires, courses taught, and detailed breakdowns of expected expenses. Similarly, the store managers will be given targets for sales volume, prot, expenses, pilferage losses, and employee training. Good Vibrations management accountants will collect, analyze, and summarize these data in the form of budgets. Directing and Motivating In addition to planning for the future, managers oversee day-to-day activities and try to keep the organization functioning smoothly. This requires motivating and directing people. Managers assign tasks to employees, arbitrate disputes, answer questions, solve on-the-spot problems, and make many small decisions that affect customers and employees. In effect, directing is that part of a managers job that deals with the routine and the here and now. Managerial accounting data, such as daily sales reports, are often used in this type of day-to-day activity. Controlling In carrying out the control function, managers seek to ensure that the plan is being followed. Feedback, which signals whether operations are on track, is the key to effective control. In sophisticated organizations, this feedback is provided by various detailed reports. One of these reports, which compares budgeted to actual results, is called a performance report. Performance reports suggest where operations are not proceeding as planned and where some parts of the organization may require additional attention. For example, the manager of the new Shanghai store will be given sales volume, prot, and expense targets. As the year progresses, performance reports will be constructed that compare actual sales volume, prot, and expenses to the targets. If the actual results fall below the targets, top management will be alerted that the Shanghai store requires more attention. Experienced personnel can be own in to help the new manager, or top management may gar79611_ch02_030-087.indd Page 33 12/8/08 9:07:50 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-02/upload 33 Managerial Accounting and Cost Concepts E X H I B I T 21 The Planning and Control Cycle Formulating long- and short-term plans (Planning) Comparing actual to planned performance (Controlling) Decision Making Implementing plans (Directing and Motivating) Measuring performance (Controlling) conclude that its plans need to be revised. As we shall see in later chapters, one of the central purposes of managerial accounting is to provide this kind of feedback to managers. The End Results of Managers Activities When a customer enters a Good Vibrations store, the results of managements planning, directing and motivating, and controlling activities will be evident in the many details that make the difference between a pleasant and an irritating shopping experience. The store will be clean, fashionably decorated, and logically laid out. Featured artists videos will be displayed on TV monitors throughout the store, and the background rock music will be loud enough to send older patrons scurrying for the classical music section. Popular CDs will be in stock, and the latest hits will be available for private listening on earphones. Specic titles will be easy to nd. Regional music, such as CantoPop in Hong Kong, will be prominently featured. Checkout clerks will be alert, friendly, and efcient. In short, what the customer experiences doesnt simply happen; it is the result of the efforts of managers who must visualize and then t together the processes that are needed to get the job done. The Planning and Control Cycle Exhibit 21 depicts the work of management in the form of the planning and control cycle. The planning and control cycle involves the smooth ow of management activities from planning through directing and motivating, controlling, and then back to planning again. All of these activities involve decision making, which is the hub around which the other activities revolve. Comparison of Financial and Managerial Accounting Managerial accounting is concerned with providing information to managersthat is, the people inside an organization who direct and control its operations. In contrast, nancial accounting is concerned with providing information to stockholders, creditors, and others who are outside the organization. This contrast in orientation results in a number of major differences between nancial and managerial accounting, even though they often rely on the same underlying nancial data. Exhibit 22 (page 34) summarizes these differences. As shown in Exhibit 22, nancial and managerial accounting differ not only in their user orientation but also in their emphasis on the past and the future, in the type of data provided to users, and in several other ways. These differences are discussed in the following paragraphs. LEARNING OBJECTIVE 1 Identify the major differences and similarities between nancial and managerial accounting. gar79611_ch02_030-087.indd Page 34 12/8/08 9:07:50 PM user-s180 34 /broker/MH-BURR/MHBR094/MHBR094-02/upload Chapter 2 E X H I B I T 22 Comparison of Financial and Managerial Accounting Accounting Recording Estimating Organizing Summarizing Financial and Operational Data Managerial Accounting Financial Accounting Reports to those outside the organization: Owners Creditors Tax authorities Regulators Reports to those inside the organization for: Planning Directing and motivating Controlling Performance evaluation Emphasizes financial consequences of past activities. Emphasizes decisions affecting the future. Emphasizes objectivity and verifiability. Emphasizes relevance. Emphasizes precision. Emphasizes timeliness. Emphasizes summary data concerning the entire organization. Emphasizes detailed segment reports about departments, products, and customers. Must follow GAAP. Need not follow GAAP. Mandatory for external reports. Not mandatory. Emphasis on the Future Because planning is such an important part of the managers job, managerial accounting has a strong future orientation. In contrast, nancial accounting primarily summarizes past nancial transactions. These summaries may be useful in planning, but only to a point. The future is not simply a reection of what has happened in the past. Changes are constantly taking place in economic conditions, customer needs and desires, competitive conditions, and so on. All of these changes demand that the managers planning be based in large part on estimates of what will happen rather than on summaries of what has already happened. Relevance of Data Financial accounting data should be objective and veriable. However, for internal uses managers need information that is relevant even if it is not completely objective or veriable. By relevant, we mean appropriate for the problem at hand. For example, it is difcult to verify what the sales volume is going to be for a proposed new store at Good Vibrations, but this is gar79611_ch02_030-087.indd Page 35 12/23/08 1:05:58 AM user-s176 /broker/MH-BURR/MHBR094/MHBR094-02/upload/MHBR094-02 35 Managerial Accounting and Cost Concepts exactly the type of information that is most useful to managers. Managerial accounting should be exible enough to provide whatever data are relevant for a particular decision. Less Emphasis on Precision Making sure that dollar amounts are accurate down to the last dollar or penny takes time and effort. While that kind of accuracy is required for external reports, most managers would rather have a good estimate immediately than wait for a more precise answer later. For this reason, managerial accountants often place less emphasis on precision than nancial accountants do. For example, in a decision involving hundreds of millions of dollars, estimates that are rounded off to the nearest million dollars are probably good enough. In addition to placing less emphasis on precision than nancial accounting, managerial accounting places much more weight on nonmonetary data. For example, data about customer satisfaction may be routinely used in managerial accounting reports. Segments of an Organization Financial accounting is primarily concerned with reporting for the company as a whole. By contrast, managerial accounting focuses much more on the parts, or segments, of a company. These segments may be product lines, sales territories, divisions, departments, or any other categorization that management nds useful. Financial accounting does require some breakdowns of revenues and costs by major segments in external reports, but this is a secondary emphasis. In managerial accounting, segment reporting is the primary emphasis. Generally Accepted Accounting Principles (GAAP) Financial accounting statements prepared for external users must comply with generally accepted accounting principles (GAAP). External users must have some assurance that the reports have been prepared in accordance with a common set of ground rules. These common ground rules enhance comparability and help reduce fraud and misrepresentation, but they do not necessarily lead to the type of reports that would be most useful in internal decision making. For example, if management at Good Vibrations is considering selling land to nance a new store, they need to know the current market value of the land. However, GAAP requires that the land be stated at its original, historical cost on nancial reports. The more relevant data for the decisionthe current market valueis ignored under GAAP. While GAAP continues to shape nancial reporting in the United States, most companies throughout the world are now communicating with their stakeholders using a different set of rules called International Financial Reporting Standards (IFRS). To better align U.S. reporting standards with the global community, the Securities and Exchange Commission (SEC) may eventually require all publicly traded companies in the U.S. to comply with IFRS instead of GAAP.1 Regardless of what the SEC decides to do, it is important to understand that managerial accounting is not bound by GAAP or IFRS. Managers set their own rules concerning the content and form of internal reports. The only constraint is that the expected benets from using the information should outweigh the costs of collecting, analyzing, and summarizing the data. Nevertheless, as we shall see in subsequent chapters, it is undeniably true that nancial reporting requirements have heavily inuenced management accounting practice. Managerial AccountingNot Mandatory Financial accounting is mandatory; that is, it must be done. Various outside parties such as the Securities and Exchange Commission (SEC) and the tax authorities require periodic nancial statements. Managerial accounting, on the other hand, is not mandatory. A company is completely free to do as much or as little as it wishes. No regulatory bodies or 1 The SEC may permit some companies in industries composed mainly of IFRS-reporting entities to adopt IFRS for calendar years ending on or after December 15, 2009. If the SEC decides to mandate IFRS for all publicly traded companies, then the three-year transitional process will begin in 2014. IFRS gar79611_ch02_030-087.indd Page 36 12/8/08 9:07:51 PM user-s180 36 /broker/MH-BURR/MHBR094/MHBR094-02/upload Chapter 2 other outside agencies specify what is to be done, or, for that matter, whether anything is to be done at all. Because managerial accounting is completely optional, the important question is always, Is the information useful? rather than, Is the information required? As explained earlier, the work of management focuses on planning, which includes setting objectives and outlining how to attain these objectives, and control, which includes the steps taken to ensure that objectives are realized. To carry out these planning and control responsibilities, managers need information about the organization. From an accounting point of view, this information often relates to the costs of the organization. In managerial accounting, the term cost is used in many different ways. The reason is that there are many types of costs, and these costs are classied differently according to the immediate needs of management. For example, managers may want cost data to prepare external nancial reports, to prepare planning budgets, or to make decisions. Each different use of cost data may demand a different kind of cost. For example, historical cost data is used to prepare external nancial reports whereas decision making may require current cost data. General Cost Classications We have chosen to start our discussion of cost concepts by focusing on manufacturing companies, because they are involved in most of the activities found in other types of organizations. Manufacturing companies such as Texas Instruments, Ford, and DuPont are involved in acquiring raw materials, producing nished goods, marketing, distributing, billing, and almost every other business activity. Therefore, an understanding of costs in a manufacturing company can be very helpful in understanding costs in other types of organizations. In this chapter, we introduce cost concepts that apply to diverse organizations including fast-food outlets such as Kentucky Fried Chicken, Pizza Hut, and Taco Bell; movie studios such as Disney, Paramount, and United Artists; consulting rms such as Accenture and McKinsey; and your local hospital. The exact terms used in these industries may not be the same as those used in manufacturing, but the same basic concepts apply. With some slight modications, these basic concepts also apply to merchandising companies such as Wal-Mart, The Gap, 7-Eleven, and Nordstrom. With that in mind, lets begin our discussion of manufacturing costs. Manufacturing Costs LEARNING OBJECTIVE 2 Identify and give examples of each of the three basic manufacturing cost categories. Most manufacturing companies separate manufacturing costs into three broad categories: direct materials, direct labor, and manufacturing overhead. A discussion of each of these categories follows. Direct Materials The materials that go into the nal product are called raw materials. This term is somewhat misleading because it seems to imply unprocessed natural resources like wood pulp or iron ore. Actually, raw materials refer to any materials that are used in the nal product; and the nished product of one company can become the raw materials of another company. For example, the plastics produced by Du Pont are a raw material used by Compaq Computer in its personal computers. One study of 37 manufacturing industries found that materials costs averaged about 55% of sales revenues.2 Raw materials may include both direct and indirect materials. Direct materials are those materials that become an integral part of the nished product and whose costs can be conveniently traced to the nished product. This would include, for example, the seats that Airbus purchases from subcontractors to install in its commercial aircraft and the tiny electric motor Panasonic uses in its DVD players. Sometimes it isnt worth the effort to trace the costs of relatively insignicant materials to end products. Such minor items would include the solder used to make electrical 2 Germain Boer and Debra Jeter, Whats New About Modern Manufacturing? Empirical Evidence on Manufacturing Cost Changes, Journal of Management Accounting Research, volume 5, pp. 6183. gar79611_ch02_030-087.indd gar79611_ch02_030-087.indd Page 37 12/8/08 9:07:51 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-02/upload 37 Managerial Accounting and Cost Concepts connections in a Sony TV or the glue used to assemble an Ethan Allen chair. Materials such as solder and glue are called indirect materials and are included as part of manufacturing overhead, which is discussed later in this section. Direct Labor Direct labor consists of labor costs that can be easily (i.e., physically and conveniently) traced to individual units of product. Direct labor is sometimes called touch labor because direct labor workers typically touch the product while it is being made. Examples of direct labor include assembly-line workers at Toyota, carpenters at the home builder Kaufman and Broad, and electricians who install equipment on aircraft at Bombardier Learjet. Labor costs that cannot be physically traced to particular products, or that can be traced only at great cost and inconvenience, are termed indirect labor. Just like indirect materials, indirect labor is treated as part of manufacturing overhead. Indirect labor includes the labor costs of janitors, supervisors, materials handlers, and night security guards. Although the efforts of these workers are essential, it would be either impractical or impossible to accurately trace their costs to specic units of product. Hence, such labor costs are treated as indirect labor. IS SENDING JOBS OVERSEAS ALWAYS A GOOD IDEA? In recent years, many companies have sent jobs from high labor-cost countries such as the United States to lower labor-cost countries such as India and China. But is chasing labor cost savings always the right thing to do? In manufacturing, the answer is no. Typically, total direct labor costs are around 7% to 15% of cost of goods sold. Because direct labor is such a small part of overall costs, the labor savings realized by offshoring jobs can easily be overshadowed by a decline in supply chain efciency that occurs simply because production facilities are located farther from the ultimate customers. The increase in inventory carrying costs and obsolescence costs coupled with slower response to customer orders, not to mention foreign currency exchange risks, can more than offset the benets of employing geographically dispersed low-cost labor. One manufacturer of casual wear in Los Angeles, California, understands the value of keeping jobs close to home in order to maintain a tightly knit supply chain. The company can ll orders for as many as 160,000 units in 24 hours. In fact, the company carries less than 30 days inventory and is considering fabricating clothing only after orders are received from customers rather than attempting to forecast what items will sell and making them in advance. How would they do this? The companys entire supply chainincluding weaving, dyeing, and sewingis located in downtown Los Angeles, eliminating shipping delays. Source: Robert Sternfels and Ronald Ritter, When Offshoring Doesnt Make Sense, The Wall Street Journal, October 19, 2004, p. B8. Major shifts have taken place and continue to take place in the structure of labor costs in some industries. Sophisticated automated equipment, run and maintained by skilled indirect workers, is increasingly replacing direct labor. Indeed, direct labor averages only about 10% of sales revenues in manufacturing. In some companies, direct labor has become such a minor element of cost that it has disappeared altogether as a separate cost category. Nevertheless, the vast majority of manufacturing and service companies throughout the world continue to recognize direct labor as a separate cost category. Manufacturing Overhead Manufacturing overhead, the third element of manufacturing cost, includes all manufacturing costs except direct materials and direct labor. Manufacturing overhead includes items such as indirect materials; indirect labor; maintenance and repairs on production equipment; and heat and light, property taxes, depreciation, and insurance on manufacturing facilities. A company also incurs costs for heat and IN BUSINESS gar79611_ch02_030-087.indd Page 38 12/8/08 9:07:52 PM user-s180 38 /broker/MH-BURR/MHBR094/MHBR094-02/upload Chapter 2 light, property taxes, insurance, depreciation, and so forth, associated with its selling and administrative functions, but these costs are not included as part of manufacturing overhead. Only those costs associated with operating the factory are included in manufacturing overhead. Across large numbers of manufacturing companies, manufacturing overhead averages about 16% of sales revenues.3 Various names are used for manufacturing overhead, such as indirect manufacturing cost, factory overhead, and factory burden. All of these terms are synonyms for manufacturing overhead. Nonmanufacturing Costs Nonmanufacturing costs are often divided into two categories: (1) selling costs and (2) administrative costs. Selling costs include all costs that are incurred to secure customer orders and get the nished product to the customer. These costs are sometimes called order-getting and order-lling costs. Examples of selling costs include advertising, shipping, sales travel, sales commissions, sales salaries, and costs of nished goods warehouses. Administrative costs include all costs associated with the general management of an organization rather than with manufacturing or selling. Examples of administrative costs include executive compensation, general accounting, secretarial, public relations, and similar costs involved in the overall, general administration of the organization as a whole. Nonmanufacturing costs are also often called selling, general, and administrative (SG&A) costs or just selling and administrative costs. Product Costs versus Period Costs LEARNING OBJECTIVE 3 Distinguish between product costs and period costs and give examples of each. In addition to classifying costs as manufacturing or nonmanufacturing costs, there are other ways to look at costs. For instance, they can also be classied as either product costs or period costs. To understand the difference between product costs and period costs, we must rst discuss the matching principle from nancial accounting. Generally, costs are recognized as expenses on the income statement in the period that benets from the cost. For example, if a company pays for liability insurance in advance for two years, the entire amount is not considered an expense of the year in which the payment is made. Instead, one-half of the cost would be recognized as an expense each year. The reason is that both yearsnot just the rst yearbenet from the insurance payment. The unexpensed portion of the insurance payment is carried on the balance sheet as an asset called prepaid insurance. The matching principle is based on the accrual concept that costs incurred to generate a particular revenue should be recognized as expenses in the same period that the revenue is recognized. This means that if a cost is incurred to acquire or make something that will eventually be sold, then the cost should be recognized as an expense only when the sale takes placethat is, when the benet occurs. Such costs are called product costs. Product Costs For nancial accounting purposes, product costs include all costs involved in acquiring or making a product. In the case of manufactured goods, these costs consist of direct materials, direct labor, and manufacturing overhead. Product costs attach to units of product as the goods are purchased or manufactured, and they remain attached as the goods go into inventory awaiting sale. Product costs are initially assigned to an inventory account on the 3 J. Miller, A. DeMeyer, and J. Nakane, Benchmarking Global Manufacturing (Homewood, IL: Richard D. Irwin), Chapter 2. The Boer and Jeter article cited earlier contains a similar nding concerning the magnitude of manufacturing overhead. gar79611_ch02_030-087.indd Page 39 12/8/08 9:07:52 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-02/upload 39 Managerial Accounting and Cost Concepts balance sheet. When the goods are sold, the costs are released from inventory as expenses (typically called cost of goods sold) and matched against sales revenue. Because product costs are initially assigned to inventories, they are also known as inventoriable costs. We want to emphasize that product costs are not necessarily treated as expenses in the period in which they are incurred. Rather, as explained above, they are treated as expenses in the period in which the related products are sold. This means that a product cost such as direct materials or direct labor might be incurred during one period but not recorded as an expense until a following period when the completed product is sold. Period Costs Period costs are all the costs that are not product costs. For example, sales commissions and the rental costs of administrative ofces are period costs. Period costs are not included as part of the cost of either purchased or manufactured goods; instead, period costs are expensed on the income statement in the period in which they are incurred using the usual rules of accrual accounting. Keep in mind that the period in which a cost is incurred is not necessarily the period in which cash changes hands. For example, as discussed earlier, the costs of liability insurance are spread across the periods that benet from the insuranceregardless of the period in which the insurance premium is paid. As suggested above, all selling and administrative expenses are considered to be period costs. Advertising, executive salaries, sales commissions, public relations, and other nonmanufacturing costs discussed earlier are all examples of period costs. They will appear on the income statement as expenses in the period in which they are incurred. Prime Cost and Conversion Cost Two more cost categories are often used in discussions of manufacturing costsprime cost and conversion cost. Prime cost is the sum of direct materials cost and direct labor cost. Conversion cost is the sum of direct labor cost and manufacturing overhead cost. The term conversion cost is used to describe direct labor and manufacturing overhead because these costs are incurred to convert materials into the nished product. Exhibit 23 (page 40) contains a summary of the cost terms that we have introduced so far. PRODUCT COSTS AND PERIOD COSTS: A LOOK ACROSS INDUSTRIES Cost of goods sold and selling and administrative expenses expressed as a percentage of sales differ across companies and industries. For example, the data below summarize the median cost of goods sold as a percentage of sales and the median selling and administrative expense as a percentage of sales for eight different industries. Why do you think the percentages in each column differ so dramatically? Industry Aerospace and Defense . . . . . . . . . . . . . Beverages . . . . . . . . . . . . . . . . . . . . . . . . Computer Software and Services . . . . . . Electrical Equipment and Components . . Healthcare Services . . . . . . . . . . . . . . . . Oil and Gas . . . . . . . . . . . . . . . . . . . . . . . Pharmaceuticals . . . . . . . . . . . . . . . . . . . Restaurants . . . . . . . . . . . . . . . . . . . . . . . Cost of Goods Selling and Administrative Sold Sales Expense Sales 79% 52% 34% 64% 82% 90% 31% 78% 9% 34% 38% 21% 6% 3% 41% 8% Source: Lori Calabro, Controlling the Flow, CFO, February 2005, p. 4650. IN BUSINESS gar79611_ch02_030-087.indd Page 40 12/8/08 9:07:53 PM user-s180 40 /broker/MH-BURR/MHBR094/MHBR094-02/upload Chapter 2 E X H I B I T 23 Summary of Cost Terms Manufacturing Costs (Also called Product Costs or Inventoriable Costs) Direct Materials Direct Labor Materials that can be conveniently traced to a product (such as wood in a table). Manufacturing Overhead Labor cost that can be physically and conveniently traced to a product (such as assembly-line workers in a plant). Direct labor is sometimes called touch labor. Prime Cost All costs of manufacturing a product other than direct materials and direct labor (such as indirect materials, indirect labor, factory utilities, and depreciation of factory buildings and equipment). Conversion Cost Nonmanufacturing Costs (Also called Period Costs or Selling and Administrative Costs) Selling Costs Administrative Costs All costs necessary to secure customer orders and get the finished product or service to the customer (such as sales commissions, advertising, and depreciation of delivery equipment and finished goods warehouses). All costs associated with the general management of the company as a whole (such as executive compensation, executive travel costs, secretarial salaries, and depreciation of office buildings and equipment). IN BUSINESS THE CHALLENGES OF MANAGING CHARITABLE ORGANIZATIONS Charitable organizations, such as Harlem Childrens Zone, Sports4Kids, and Citizen Schools, are facing a difcult situation. Many donorsaware of stories involving charities that spent excessively on themselves while losing sight of their missionhave started prohibiting their charity of choice from using donated funds to pay for administrative costs. However, even the most efcient charitable organizations nd it difcult to expand without making additions to their infrastructure. For example, Sports4Kids nationwide expansion of its sports programs drove up administrative costs from 5.6% to 14.7% of its total budget. The organization claims that this cost increase was necessary to build a more experienced management team to oversee the dramatically increased scale of operations. Many charitable organizations are starting to seek gifts explicitly to fund administrative expenses. Their argument is simplethey cannot do good deeds for other people without incurring such costs. Source: Rachel Emma Silverman and Sally Beatty, Save the Children (But Pay the Bills, Too), The Wall Street Journal, December 26, 2006, pp. D1D2. gar79611_ch02_030-087.indd Page 41 12/8/08 9:08:03 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-02/upload Managerial Accounting and Cost Concepts Cost Classications on Financial Statements In this section of the chapter, we compare the cost classications used on the nancial statements of manufacturing and merchandising companies. The nancial statements prepared by a manufacturing company are more complex than the statements prepared by a merchandising company because a manufacturing company must produce its goods as well as market them. The production process involves many costs that do not exist in a merchandising company, and these costs must be properly accounted for on the manufacturing companys nancial statements. We begin by explaining how these costs are shown on the balance sheet. The Balance Sheet The balance sheet, or statement of nancial position, of a manufacturing company is similar to that of a merchandising company. However, their inventory accounts differ. A merchandising company has only one class of inventorygoods purchased from suppliers for resale to customers. In contrast, manufacturing companies have three classes of inventoriesraw materials, work in process, and nished goods. Raw materials are the materials that are used to make a product. Work in process consists of units of product that are only partially complete and will require further work before they are ready for sale to a customer. Finished goods consist of completed units of product that have not yet been sold to customers. Ordinarily, the sum total of these three categories of inventories is the only amount shown on the balance sheet in external reports. However, the footnotes to the nancial statements often provide more detail. We will use two companiesGraham Manufacturing and Reston Bookstoreto illustrate the concepts discussed in this section. Graham Manufacturing is located in Portsmouth, New Hampshire, and makes precision brass ttings for yachts. Reston Bookstore is a small bookstore in Reston, Virginia, specializing in books about the Civil War. The footnotes to Graham Manufacturings Annual Report reveal the following information concerning its inventories: Graham Manufacturing Corporation Inventory Accounts Beginning Balance Raw materials . . . . . . . . . . . $ 60,000 Work in process . . . . . . . . . . 90,000 Finished goods . . . . . . . . . . 125,000 Ending Balance $ 50,000 60,000 175,000 Total inventory accounts . . . $275,000 $285,000 Graham Manufacturings raw materials inventory consists largely of brass rods and brass blocks. The work in process inventory consists of partially completed brass ttings. The nished goods inventory consists of brass ttings that are ready to be sold to customers. In contrast, the inventory account at Reston Bookstore consists entirely of the costs of books the company has purchased from publishers for resale to the public. In merchandising companies like Reston, these inventories may be called merchandise inventory. The beginning and ending balances in this account appear as follows: Reston Bookstore Inventory Account Beginning Balance Merchandise inventory . . . . . $100,000 Ending Balance $150,000 41 gar79611_ch02_030-087.indd Page 42 12/8/08 9:08:04 PM user-s180 42 /broker/MH-BURR/MHBR094/MHBR094-02/upload Chapter 2 LEARNING OBJECTIVE 4 Prepare an income statement including calculation of the cost of goods sold. The Income Statement Exhibit 24 compares the income statements of Reston Bookstore and Graham Manufacturing. For purposes of illustration, these statements contain more detail about cost of goods sold than you will generally nd in published nancial statements. At rst glance, the income statements of merchandising and manufacturing companies like Reston Bookstore and Graham Manufacturing are very similar. The only apparent difference is in the labels of some of the entries in the computation of the cost of goods sold. In the exhibit, the computation of cost of goods sold relies on the following basic equation for inventory accounts: Basic Equation for Inventory Accounts Beginning balance Additions to inventory Ending balance Withdrawals from inventory The logic underlying this equation, which applies to any inventory account, is illustrated in Exhibit 25. The beginning inventory consists of any units that are in the inventory at the beginning of the period. Additions are made to the inventory during the period. The sum of the beginning balance and the additions to the account is the total amount of E X H I B I T 24 Comparative Income Statements: Merchandising and Manufacturing Companies Merchandising Company Reston Bookstore The cost of merchandise inventory purchased from outside suppliers during the period. Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost of goods sold: Beginning merchandise inventory . . . . . . . . . Add: Purchases . . . . . . . . . . . . . . . . . . . . . . . $100,000 650,000 Goods available for sale . . . . . . . . . . . . . . . . . Deduct: Ending merchandise inventory . . . . . 750,000 150,000 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . Selling and administrative expenses: Selling expense . . . . . . . . . . . . . . . . . . . . . . . Administrative expense . . . . . . . . . . . . . . . . . $1,000,000 600,000 400,000 100,000 200,000 Net operating income . . . . . . . . . . . . . . . . . . . . . 300,000 $ 100,000 Manufacturing Company Graham Manufacturing The manufacturing costs associated with the goods that were nished during the period. (See Exhibit 26 for details.) Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost of goods sold:* Beginning nished goods inventory . . . . . . . . Add: Cost of goods manufactured . . . . . . . . . $125,000 850,000 Goods available for sale . . . . . . . . . . . . . . . . . Deduct: Ending nished goods inventory . . . . 975,000 175,000 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . Selling and administrative expenses: Selling expense . . . . . . . . . . . . . . . . . . . . . . . Administrative expense . . . . . . . . . . . . . . . . . $1,500,000 800,000 700,000 250,000 300,000 Net operating income . . . . . . . . . . . . . . . . . . . . . *Further adjustments will be made to the cost of goods sold for a manufacturing company in the next chapter. 550,000 $ 150,000 gar79611_ch02_030-087.indd Page 43 12/8/08 9:08:05 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-02/upload 43 Managerial Accounting and Cost Concepts E X H I B I T 25 Inventory Flows y tud ic S I Bas ages ti Stra Basic Study Stratiages II y y tud tud ic S II ic S II Bas agesBas ages ti ti Stra Stra Basic Study Stratiages II y y tud tud ic S II II ic S Bas agesBas ages ti ti Stra Stra Ending balance Basic Study Stratiages I Basic Study Stratiages II Basic Study Stratiages II y y tud tud ic S I ic S I B Bas ages as tiages ti Stra Stra Basic Study Stratiages II Basic Study Stratiages I y tud ic S I Bas ages ti Stra Basic Study Stratiages I Basic Study Stratiages II y y y y y y y tud tud tud tud tud tud tud ic S I ic S I ic S I ic S II ic S II ic S II ic S II Bas ages as ages as agesBas agesBas agesBas agesBas ages B B ti ti ti ti ti ti ti Stra Stra Stra Stra Stra Stra Stra Basic Study Stratiages I Withdrawals Basic Study Stratiages II Basic Study Stratiages II Basic Study Stratiages II Basic Study Stratiages II Basic Study Stratiages I Basic Study Stratiages I y y y y tud tud tud tud ic S II ic S II ic S II ic S II Bas agesBas agesBas agesBas ages ti ti ti ti Stra Stra Stra Stra Total available Basic Study Stratiages I Basic Study Stratiages II Additions Basic Study Stratiages II Basic Study Stratiages II y y y tud tud tud ic S I ic S I I ic S Bas ages as ages as ages B B ti ti ti Stra Stra Stra Basic Study Stratiages II Basic Study Stratiages I Basic Study Stratiages I Basic Study Stratiages I Beginning balance y y tud tud ic S II ic S II Bas agesBas ages ti ti Stra Stra inventory available. During the period, withdrawals are made from inventory. The ending balance is whatever is left at the end of the period after the withdrawals. These concepts are used to determine the cost of goods sold for a merchandising company like Reston Bookstore as follows: Cost of Goods Sold in a Merchandising Company Beginning merchandise inventory Purchases Ending merchandise inventory Cost of goods sold or Cost of goods sold Beginning merchandise inventory Purchases Ending merchandise inventory To determine the cost of goods sold in a merchandising company, we only need to know the beginning and ending balances in the Merchandise Inventory account and the purchases. Total purchases can be easily determined in a merchandising company by simply adding together all purchases from suppliers. IN BUSINESS THE FINANCIAL IMPLICATIONS OF RETAIL THEFT Retail theft in the United States reached a record high of more than $37 billion in 2005. To put this amount in perspective, nationwide auto theft losses in 2005 totaled $7.6 billion and burglary and robbery losses totaled about $4 billion. The largest retail theft crime categories were internal theft (e.g., when employees steal from their employers), which accounted for 47% of the losses, and external theft, such as shoplifting, which accounted for 33% of the losses. Merchandisers respond to theft losses, which equate to 1.6 cents per retail sales dollar, in one of two ways. Either they attempt to maintain stable gross margins by passing on their losses to customers in the form of higher prices, or they absorb the losses and report lower gross margins and prots to shareholders. Source: Kerry Clawson, Retail Thefts Stealing the Show in Crime, Akron Beacon Journal, November 23, 2006, pp. D1D2. The cost of goods sold for a manufacturing company like Graham Manufacturing is determined as follows: Cost of Goods Sold in a Manufacturing Company Beginning nished goods inventory Cost of goods manufactured Ending nished goods inventory Cost of goods sold gar79611_ch02_030-087.indd Page 44 12/8/08 9:08:11 PM user-s180 44 /broker/MH-BURR/MHBR094/MHBR094-02/upload Chapter 2 or Cost of goods sold* Beginning nished goods inventory Cost of goods manufactured Ending nished goods inventory * Further adjustments will be made to a manufacturing companys cost of goods sold in the next chapter. To determine the cost of goods sold in a manufacturing company, we need to know the cost of goods manufactured and the beginning and ending balances in the Finished Goods inventory account. The cost of goods manufactured consists of the manufacturing costs associated with goods that were nished during the period. The cost of goods manufactured for Graham Manufacturing is derived in the schedule of cost of goods manufactured shown in Exhibit 26. Schedule of Cost of Goods Manufactured L EARNING OBJECTIVE 5 Prepare a schedule of cost of goods manufactured. At rst glance, the schedule of cost of goods manufactured in Exhibit 26 appears complex and perhaps even intimidating. However, it is all quite logical. The schedule of cost of goods manufactured contains the three elements of product costs that we discussed earlierdirect materials, direct labor, and manufacturing overhead. The direct materials cost of $410,000 is not the cost of raw materials purchased during the periodit is the cost of raw materials used during the period. The purchases of raw materials are added to the beginning balance to determine the cost of the materials available for use. The ending raw materials inventory is deducted from this amount to arrive at the cost of raw materials used in production. The sum of the three manufacturing cost elementsmaterials, direct labor, and manufacturing overheadis the total E X H I B I T 26 Schedule of Cost of Goods Manufactured Direct materials: Beginning raw materials inventory* . . . . . . . $ 60,000 Add: Purchases of raw materials . . . . . . . . 400,000 Raw materials available for use . . . . . . . . . 460,000 Deduct: Ending raw materials inventory . . . 50,000 Raw materials used in production . . . . . . . . Direct materials $410,000 Direct labor Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000 Manufacturing overhead . . . . . . . . . . . . . . . . 350,000 Manufacturing overhead Total manufacturing cost . . . . . . . . . . . . . . . . Add: Beginning work in process inventory . . . 820,000 90,000 910,000 60,000 $850,000 Cost of goods manufactured Deduct: Ending work in process inventory . . . Cost of goods manufactured (see Exhibit 24) *We assume in this example that the Raw Materials inventory account contains only direct materials. gar79611_ch02_030-087.indd Page 45 12/8/08 9:08:11 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-02/upload 45 Managerial Accounting and Cost Concepts manufacturing cost of $820,000. However, youll notice that this is not the same thing as the cost of goods manufactured for the period of $850,000. The subtle distinction between the total manufacturing cost and the cost of goods manufactured is very easy to miss. Some of the materials, direct labor, and manufacturing overhead costs incurred during the period relate to goods that are not yet completed. As stated above, the cost of goods manufactured consists of the manufacturing costs associated with the goods that were nished during the period. Consequently, adjustments need to be made to the total manufacturing cost of the period for the partially completed goods that were in process at the beginning and at the end of the period. The costs that relate to goods that are not yet completed are shown in the work in process inventory gures at the bottom of the schedule. Note that the beginning work in process inventory must be added to the manufacturing costs of the period, and the ending work in process inventory must be deducted, to arrive at the cost of goods manufactured. The $30,000 decline in the Work in Process account during the year ($90,000 $60,000) explains the $30,000 difference between the total manufacturing cost and the cost of goods manufactured. Product Cost Flows Earlier in the chapter, we dened product costs as costs incurred to either purchase or manufacture goods. For manufactured goods, these costs consist of direct materials, direct labor, and manufacturing overhead. It will be helpful at this point to look briey at the ow of costs in a manufacturing company. This will help us understand how product costs move through the various accounts and how they affect the balance sheet and the income statement. Exhibit 27 illustrates the ow of costs in a manufacturing company. Raw materials purchases are recorded in the Raw Materials inventory account. When raw materials are used in production, their costs are transferred to the Work in Process inventory account as direct materials. Notice that direct labor cost and manufacturing overhead cost are added E X H I B I T 27 Cost Flows and Classications in a Manufacturing Company Costs Balance Sheet Product costs Raw materials purchases Raw Materials inventory Direct materials used in production Direct labor Manufacturing overhead Work in Process inventory Goods completed (Cost of Goods Manufactured) Income Statement Cost of Goods Sold Finished Goods inventory Period costs Goods sold Selling and administrative Selling and Administrative Expenses gar79611_ch02_030-087.indd Page 46 12/8/08 9:08:11 PM user-s180 46 /broker/MH-BURR/MHBR094/MHBR094-02/upload Chapter 2 directly to Work in Process. Work in Process can be viewed most simply as products on an assembly line. The direct materials, direct labor, and manufacturing overhead costs added to Work in Process in Exhibit 27 are the costs needed to complete these products as they move along this assembly line. Notice from the exhibit that as goods are completed, their costs are transferred from Work in Process to Finished Goods. Here the goods await sale to customers. As goods are sold, their costs are transferred from Finished Goods to Cost of Goods Sold. At this point the various costs required to make the product are nally recorded as an expense. Until that point, these costs are in inventory accounts on the balance sheet. Inventoriable Costs As stated earlier, product costs are often called inventoriable costs. The reason is that these costs go directly into inventory accounts as they are incurred (rst into Work in Process and then into Finished Goods), rather than going into expense accounts. Thus, they are termed inventoriable costs. This is a key concept because such costs can end up on the balance sheet as assets if goods are only partially completed or are unsold at the end of a period. To illustrate this point, refer again to Exhibit 27. At the end of the period, the materials, labor, and overhead costs that are associated with the units in the Work in Process and Finished Goods inventory accounts will appear on the balance sheet as assets. As explained earlier, these costs will not become expenses until the goods are completed and sold. Selling and administrative expenses are not involved in making a product. For this reason, they are not treated as product costs but rather as period costs that are expensed as they are incurred, as shown in Exhibit 27. An Example of Cost Flows To provide an example of cost ows in a manufacturing company, assume that a companys direct labor cost is $500,000 and its administrative salaries cost is $200,000. As illustrated in Exhibit 28, the direct labor cost is added to Work in Process. As shown in the exhibit, the direct labor cost will not become an expense until the goods that are produced during the year are soldwhich may not happen until the following year or even later. Until the goods are sold, the $500,000 will be part of inventorieseither Work in Process or Finished Goodsalong with the other costs of producing the goods. By contrast, $200,000 of administrative salaries cost will be expensed immediately. Thus far, we have been mainly concerned with classications of manufacturing costs for the purpose of determining inventory valuations on the balance sheet and cost of goods sold on the income statement in external nancial reports. However, costs are used for many other purposes, and each purpose requires a different classication of costs. We will consider several different purposes for cost classications in the remaining sections of this chapter. These purposes and the corresponding cost classications are summarized in Exhibit 29. To help keep the big picture in mind, we suggest that you refer back to this exhibit frequently as you progress through the rest of this chapter. Cost Classications for Predicting Cost Behavior L EARNING OBJECTIVE 6 Understand the differences between variable costs and xed costs. Quite frequently, it is necessary to predict how a certain cost will behave in response to a change in activity. For example, a manager at Qwest, a telephone company, may want to estimate the impact a 5 percent increase in long-distance calls by customers would have on Qwests total electric bill. Cost behavior refers to how a cost reacts to changes in the level of activity. As the activity level rises and falls, a particular cost may rise and fall as wellor it may remain constant. For planning purposes, a manager must be able to anticipate which of these will happen; and if a cost can be expected to change, the manager must be able to estimate how much it will change. To help make such distinctions, costs are often categorized as variable or xed. gar79611_ch02_030-087.indd Page 47 12/8/08 9:08:11 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-02/upload 47 Managerial Accounting and Cost Concepts E X H I B I T 28 An Example of Cost Flows in a Manufacturing Company $500,000 of direct labor cost Balance Sheet Work in Process inventory Direct labor The $500,000 moves slowly into finished goods inventory as units of the product are completed. Finished Goods inventory Income Statement Cost of Goods Sold Selling and administrative The $500,000 moves slowly into cost of goods sold as finished goods are sold. $200,000 of administrative salaries cost Selling and Administrative Expenses Purpose of Cost Classication Cost Classications Preparing external nancial statements Product costs (inventoriable) Direct materials Direct labor Manufacturing overhead Period costs (expensed) Nonmanufacturing costs Selling costs Administrative costs Predicting cost behavior in response to changes in activity Variable cost (proportional to activity) Fixed cost (constant in total) Assigning costs to cost objects such as departments or products Direct cost (can be easily traced) Indirect cost (cannot be easily traced) Making decisions Differential cost (differs between alternatives) Sunk cost (past cost not affected by a decision) Opportunity cost (forgone benet) Cost of quality (Appendix 2B) Prevention costs Appraisal costs Internal failure costs External failure costs E X H I B I T 29 Summary of Cost Classications gar79611_ch02_030-087.indd gar79611_ch02_030-087.indd Page 48 12/8/08 9:08:12 PM user-s180 48 /broker/MH-BURR/MHBR094/MHBR094-02/upload Chapter 2 Variable Cost A variable cost is a cost that varies, in total, in direct proportion to changes in the level of activity. The activity can be expressed in many ways, such as units produced, units sold, miles driven, beds occupied, lines of print, hours worked, and so forth. A good example of a variable cost is direct materials. The cost of direct materials used during a period will vary, in total, in direct proportion to the number of units that are produced. To illustrate this idea, consider the Saturn Division of GM. Each auto requires one battery. As the output of autos increases and decreases, the number of batteries used will increase and decrease proportionately. If auto production goes up 10%, then the number of batteries used will also go up 10%. The concept of a variable cost is shown graphically in Exhibit 210. The graph on the left-hand side of Exhibit 210 illustrates that the total variable cost rises and falls as the activity level rises and falls. This idea is presented below, assuming that a Saturns battery costs $24: Number of Autos Produced Cost per Battery $24 $24 $24 1............. 500 . . . . . . . . . . . . . 1,000 . . . . . . . . . . . . . Total Variable Cost Batteries $24 $12,000 $24,000 While total variable costs change as the activity level changes, it is important to note that a variable cost is constant if expressed on a per unit basis. For example, the per unit cost of batteries remains constant at $24 even though the total cost of the batteries increases and decreases with activity. There are many examples of costs that are variable with respect to the products and services provided by a company. In a manufacturing company, variable costs include items such as direct materials, shipping costs, and sales commissions and some elements of manufacturing overhead such as lubricants. We will also usually assume that direct labor is a variable cost, although direct labor may act more like a xed cost in some E X H I B I T 210 Variable and Fixed Cost Behavior Variable Cost Behavior Fixed Cost Behavior $24,000 Total cost of rent Total cost of batteries $30,000 $20,000 $10,000 $0 0 250 500 750 1,000 Number of autos produced in a month $16,000 $8,000 $0 0 500 1,000 1,500 2,000 Number of lab tests performed in a month gar79611_ch02_030-087.indd Page 49 12/8/08 9:08:12 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-02/upload 49 Managerial Accounting and Cost Concepts situations as we shall see in a later chapter. In a merchandising company, the variable costs of carrying and selling products include items such as cost of goods sold, sales commissions, and billing costs. In a hospital, the variable costs of providing health care services to patients would include the costs of the supplies, drugs, meals, and perhaps nursing services. When we say that a cost is variable, we ordinarily mean that it is variable with respect to the amount of goods or services the organization produces. However, costs can be variable with respect to other things. For example, the wages paid to employees at a Blockbuster Video outlet will depend on the number of hours the store is open and not strictly on the number of videos rented. In this case, we would say that wage costs are variable with respect to the hours of operation. Nevertheless, when we say that a cost is variable, we ordinarily mean it is variable with respect to the amount of goods and services produced. This could be how many Jeep Cherokees are produced, how many videos are rented, how many patients are treated, and so on. BROWN IS THINKING GREEN United Parcel Service (UPS) truck drivers travel more than 1.3 billion miles annually to deliver more than 4.5 billion packages. Therefore, it should come as no surprise that fuel is a huge variable cost for the company. Even if UPS can shave just a penny of cost from each mile driven, the savings can be enormous. This explains why UPS is so excited about swapping its old diesel powered trucks for diesel-electric hybrid vehicles, which have the potential to cut fuel costs by 50%. Beyond the savings for UPS, the environment would also benet from the switch because hybrid vehicles cut emissions by 90%. As UPS television commercials ask, What can Brown do for you? Thanks to diesel-electric technology, the answer is that Brown can help make the air you breathe a little bit cleaner. Source: Charles Haddad and Christine Tierney, FedEx and Brown Are Going Green, BusinessWeek, August 4, 2003, pp. 6062. Fixed Cost A xed cost is a cost that remains constant, in total, regardless of changes in the level of activity. Unlike variable costs, xed costs are not affected by changes in activity. Consequently, as the activity level rises and falls, total xed costs remain constant unless inuenced by some outside force, such as a price change. Rent is a good example of a xed cost. Suppose the Mayo Clinic rents a machine for $8,000 per month that tests blood samples for the presence of leukemia cells. The $8,000 monthly rental cost will be incurred regardless of the number of tests that may be performed during the month. The concept of a xed cost is shown graphically on the right-hand side of Exhibit 210. Very few costs are completely xed. Most will change if activity changes enough. For example, suppose that the capacity of the leukemia diagnostic machine at the Mayo Clinic is 2,000 tests per month. If the clinic wishes to perform more than 2,000 tests in a month, it would be necessary to rent an additional machine, which would cause a jump in the xed costs. When we say a cost is xed, we mean it is xed within some relevant range. The relevant range is the range of activity within which the assumptions about variable and xed costs are valid. For example, the assumption that the rent for diagnostic machines is $8,000 per month is valid within the relevant range of 0 to 2,000 tests per month. Fixed costs can create confusion if they are expressed on a per unit basis. This is because the average xed cost per unit increases and decreases inversely with changes in activity. In the Mayo Clinic, for example, the average cost per test will fall as the number IN BUSINESS gar79611_ch02_030-087.indd Page 50 12/8/08 9:08:13 PM user-s180 50 /broker/MH-BURR/MHBR094/MHBR094-02/upload Chapter 2 IN BUSINESS FOOD COSTS AT A LUXURY HOTEL The Sporthotel Theresa (http://www.theresa.at/ ), owned and operated by the Egger family, is a four star hotel located in Zell im Zillertal, Austria. The hotel features access to hiking, skiing, biking, and other activities in the Ziller alps as well as its own tness facility and spa. Three full meals a day are included in the hotel room charge. Breakfast and lunch are served buffet-style while dinner is a more formal affair with as many as six courses. A sample dinner menu appears below: Tyrolean cottage cheese with homemade bread *** Salad bar *** Broccoli-terrine with saddle of venison and smoked goose-breast or Chicken-liver parfait with gorgonzola-cheese ravioli and port-wine sauce *** Clear vegetable soup with ne vegetable strips or Whey-yoghurt juice *** Roulade of pork with zucchini, ham and cheese on pesto ribbon noodles and saffron sauce or Roasted let of Irish salmon and prawn with spring vegetables and sesame mash or Fresh white asparagus with scrambled egg, fresh herbs, and parmesan or Steak of Tyrolean organic beef *** Strawberry terrine with homemade chocolate ice cream or Iced Viennese coffee The chef, Stefan Egger, believes that food costs are roughly proportional to the number of guests staying at the hotel; that is, they are a variable cost. He must order food from suppliers two or three days in advance, but he adjusts his purchases to the number of guests who are currently staying at the hotel and their consumption patterns. In addition, guests make their selections from the dinner menu early in the day, which helps Stefan plan which foodstuffs will be required for dinner. Consequently, he is able to prepare just enough food so that all guests are satised and yet waste is held to a minimum. Source: Conversation with Stefan Egger, chef at the Sporthotel Theresa. of tests performed increases because the $8,000 rental cost will be spread over more tests. Conversely, as the number of tests performed in the clinic declines, the average cost per test will rise as the $8,000 rental cost is spread over fewer tests. This concept is illustrated in the table below: Monthly Rental Cost $8,000 . . . . . . . . . $8,000 . . . . . . . . . $8,000 . . . . . . . . . Number of Tests Performed Average Cost per Test 10 500 2,000 $800 $16 $4 gar79611_ch02_030-087.indd Page 51 12/8/08 9:08:19 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-02/upload 51 Managerial Accounting and Cost Concepts Behavior of the Cost (within the relevant range) Cost Variable cost Fixed cost In Total Total variable cost increases and decreases in proportion to changes in the activity level. Total xed cost is not affected by changes in the activity level within the relevant range. Per Unit E X H I B I T 211 Summary of Variable and Fixed Cost Behavior Variable cost per unit remains constant. Fixed cost per unit decreases as the activity level rises and increases as the activity level falls. Note that if the Mayo Clinic performs only 10 tests each month, the rental cost of the equipment will average $800 per test. But if 2,000 tests are performed each month, the average cost will drop to only $4 per test. More will be said later about the misunderstandings created by this variation in average unit costs. Examples of xed costs include straight-line depreciation, insurance, property taxes, rent, supervisory salaries, administrative salaries, and advertising. A summary of both variable and xed cost behavior is presented in Exhibit 211. THE POWER OF SHRINKING AVERAGE FIXED COST PER UNIT IN BUSINESS Intel built ve new computer chip manufacturing facilities that put its competitors on the defensive. Each plant can produce chips using a 12-inch wafer that is imprinted with 90-nanometer circuit lines that are 0.1% of the width of a human hair. These plants can produce 1.25 million chips a day, or about 375 million chips a year. Better yet, these new plants slash Intels production costs in half because each plants volume of output is 2.5 times greater than any of Intels seven older plants. Building a computer chip manufacturing facility is a very expensive undertaking due to the required investment in xed equipment costs. So why are Intels competitors on the defensive? Because they are struggling to match Intels exceptionally low average xed cost per unit of output. Or, in an economists terms, they are struggling to match Intels economies of scale. Source: Cliff Edwards, Intel, BusinessWeek, March 8, 2004, pp. 5664. Cost Classications for Assigning Costs to Cost Objects Costs are assigned to cost objects for a variety of purposes including pricing, preparing protability studies, and controlling spending. A cost object is anything for which cost data are desiredincluding products, customers, jobs, and organizational subunits. For purposes of assigning costs to cost objects, costs are classied as either direct or indirect. Direct Cost A direct cost is a cost that can be easily and conveniently traced to a specied cost object. The concept of direct cost extends beyond just direct materials and direct labor. For example, if Reebok is assigning costs to its various regional and national sales ofces, then the salary of the sales manager in its Tokyo ofce would be a direct cost of that ofce. Indirect Cost An indirect cost is a cost that cannot be easily and conveniently traced to a specied cost object. For example, a Campbell Soup factory may produce dozens of varieties of canned LEARNING OBJECTIVE 7 Understand the differences between direct and indirect costs. gar79611_ch02_030-087.indd Page 52 12/8/08 9:08:20 PM user-s180 52 /broker/MH-BURR/MHBR094/MHBR094-02/upload Chapter 2 soups. The factory managers salary would be an indirect cost of a particular variety such as chicken noodle soup. The reason is that the factory managers salary is incurred as a consequence of running the entire factoryit is not incurred to produce any one soup variety. To be traced to a cost object such as a particular product, the cost must be caused by the cost object. The factory managers salary is called a common cost of producing the various products of the factory. A common cost is a cost that is incurred to support a number of cost objects but cannot be traced to them individually. A common cost is a type of indirect cost. A particular cost may be direct or indirect, depending on the cost object. While the Campbell Soup factory managers salary is an indirect cost of manufacturing chicken noodle soup, it is a direct cost of the manufacturing division. In the rst case, the cost object is chicken noodle soup. In the second case, the cost object is the entire manufacturing division. Cost Classications for Decision Making LEARNING OBJECTIVE 8 Understand cost classications used in making decisions: differential costs, opportunity costs, and sunk costs. IN BUSINESS Costs are an important feature of many business decisions. In making decisions, it is essential to have a rm grasp of the concepts differential cost, opportunity cost, and sunk cost. Differential Cost and Revenue Decisions involve choosing between alternatives. In business decisions, each alternative will have costs and benets that must be compared to the costs and benets of the other available alternatives. A difference in costs between any two alternatives is known as a differential cost. A difference in revenues between any two alternatives is known as differential revenue. A differential cost is also known as an incremental cost, although technically an incremental cost should refer only to an increase in cost from one alternative to another; decreases in cost should be referred to as decremental costs. Differential cost is a broader term, encompassing both cost increases (incremental costs) and cost decreases (decremental costs) between alternatives. The accountants differential cost concept can be compared to the economists marginal cost concept. In speaking of changes in cost and revenue, the economist uses the terms marginal cost and marginal revenue. The revenue that can be obtained from selling one more unit of product is called marginal revenue, and the cost involved in producing one more unit of product is called marginal cost. The economists marginal concept is basically the same as the accountants differential concept applied to a single unit of output. THE COST OF A HEALTHIER ALTERNATIVE McDonalds is under pressure from critics to address the health implications of its menu. In response, McDonalds switched from partially hydrogenated vegetable oil to fry foods to a new soybean oil that cuts trans-fat levels by 48% even though the soybean oil is much more expensive than the partially hydrogenated vegetable oil and it lasts only half as long. What were the cost implications of this change? A typical McDonalds restaurant uses 500 pounds of the relatively unhealthy oil per week at a cost of about $186. In contrast, the same restaurant would need to use 1,000 pounds of the new soybean oil per week at a cost of about $571. This is a differential cost of $385 per restaurant per week. This may seem like a small amount of money until the calculation is expanded to include 13,000 McDonalds restaurants operating 52 weeks a year. Now, the total tab for a more healthy frying oil rises to about $260 million per year. Source: Matthew Boyle, Can You Really Make Fast Food Healthy? Fortune, August 9, 2004, pp. 134139. gar79611_ch02_030-087.indd gar79611_ch02_030-087.indd Page 53 12/8/08 9:08:20 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-02/upload Managerial Accounting and Cost Concepts Differential costs can be either xed or variable. To illustrate, assume that Nature Way Cosmetics, Inc., is thinking about changing its marketing method from distribution through retailers to distribution by a network of neighborhood sales representatives. Present costs and revenues are compared to projected costs and revenues in the following table: Retailer Distribution (present) Sales Differential Representatives Costs and (proposed) Revenues Revenues (Variable) . . . . . . . . . . . . . . . . $700,000 $800,000 $100,000 Cost of goods sold (Variable) . . . . . . . . . Advertising (Fixed) . . . . . . . . . . . . . . . . . Commissions (Variable) . . . . . . . . . . . . . Warehouse depreciation (Fixed) . . . . . . . Other expenses (Fixed) . . . . . . . . . . . . . . 350,000 80,000 0 50,000 60,000 400,000 45,000 40,000 80,000 60,000 50,000 (35,000) 40,000 30,000 0 Total expenses . . . . . . . . . . . . . . . . . . . . 540,000 625,000 85,000 Net operating income . . . . . . . . . . . . . . . $160,000 $175,000 $ 15,000 According to the above analysis, the differential revenue is $100,000 and the differential costs total $85,000, leaving a positive differential net operating income of $15,000 under the proposed marketing plan. The decision of whether Nature Way Cosmetics should stay with the present retail distribution or switch to sales representatives could be made on the basis of the net operating incomes of the two alternatives. As we see in the above analysis, the net operating income under the present distribution method is $160,000, whereas the net operating income with sales representatives is estimated to be $175,000. Therefore, using sales representatives is preferred because it would result in $15,000 higher net operating income. Note that we would have arrived at exactly the same conclusion by simply focusing on the differential revenues, differential costs, and differential net operating income, which also show a $15,000 advantage for sales representatives. In general, only the differences between alternatives are relevant in decisions. Those items that are the same under all alternatives and that are not affected by the decision can be ignored. For example, in the Nature Way Cosmetics example above, the Other expenses category, which is $60,000 under both alternatives, can be ignored because it has no effect on the decision. If it were removed from the calculations, the sales representatives would still be preferred by $15,000. This is an extremely important principle in management accounting that we will revisit in later chapters. Opportunity Cost Opportunity cost is the potential benet that is given up when one alternative is selected over another. To illustrate this important concept, consider the following examples: Example 1 Vicki has a part-time job that pays $200 per week while attending college. She would like to spend a week at the beach during spring break, and her employer has agreed to give her the time off, but without pay. The $200 in lost wages would be an opportunity cost of taking the week off to be at the beach. Example 2 Suppose that Neiman Marcus is considering investing a large sum of money in land that may be a site for a future store. Rather than invest the funds in land, the company could invest the funds in high-grade securities. The opportunity cost of buying the land is the investment income that could have been realized by purchasing the securities instead. Example 3 Steve is employed by a company that pays him a salary of $38,000 per year. He is thinking about leaving the company and returning to school. Because returning to school 53 gar79611_ch02_030-087.indd gar79611_ch02_030-087.indd Page 54 12/8/08 9:08:21 PM user-s180 54 /broker/MH-BURR/MHBR094/MHBR094-02/upload Chapter 2 would require that he give up his $38,000 salary, the forgone salary would be an opportunity cost of seeking further education. Opportunity costs are not usually found in accounting records, but they are costs that must be explicitly considered in every decision a manager makes. Virtually every alternative involves an opportunity cost. Sunk Cost A sunk cost is a cost that has already been incurred and that cannot be changed by any decision made now or in the future. Because sunk costs cannot be changed by any decision, they are not differential costs. And because only differential costs are relevant in a decision, sunk costs can and should be ignored. To illustrate a sunk cost, assume that a company paid $50,000 several years ago for a special-purpose machine. The machine was used to make a product that is now obsolete and is no longer being sold. Even though in hindsight purchasing the machine may have been unwise, the $50,000 cost has already been incurred and cannot be undone. And it would be folly to continue making the obsolete product in a misguided attempt to recover the original cost of the machine. In short, the $50,000 originally paid for the machine is a sunk cost that should be ignored in current decisions. Summary In this chapter, we discussed the work of management and the similarities and differences between nancial and managerial accounting. Managers use managerial accounting reports in their planning and controlling activities. Unlike nancial accounting reports, these managerial accounting reports need not conform to Generally Accepted Accounting Principles and are not mandatory. In particular, managerial accounting places more emphasis on the future and relevance of the data, less emphasis on precision, and focuses more on the segments of the organization than does nancial accounting. We have also looked at some of the ways in which managers classify costs. How the costs will be usedfor preparing external reports, predicting cost behavior, assigning costs to cost objects, or decision makingwill dictate how the costs are classied. For purposes of valuing inventories and determining expenses for the balance sheet and income statement, costs are classied as either product costs or period costs. Product costs are assigned to inventories and are considered assets until the products are sold. At the point of sale, product costs become cost of goods sold on the income statement. In contrast, period costs are taken directly to the income statement as expenses in the period in which they are incurred. In a merchandising company, product cost is whatever the company paid for its merchandise. For external nancial reports in a manufacturing company, product costs consist of all manufacturing costs. In both kinds of companies, selling and administrative costs are considered to be period costs and are expensed as incurred. For purposes of predicting how costs will react to changes in activity, costs are classied into two categoriesvariable and xed. Variable costs, in total, are strictly proportional to activity. The variable cost per unit is constant. Fixed costs, in total, remain at the same level for changes in activity that occur within the relevant range. The average xed cost per unit decreases as the number of units increases. For purposes of assigning costs to cost objects such as products or departments, costs are classied as direct or indirect. Direct costs can be conveniently traced to cost objects. Indirect costs cannot be conveniently traced to cost objects. For purposes of making decisions, the concepts of differential cost and revenue, opportunity cost, and sunk cost are vitally important. Differential costs and revenues are the costs and revenues that differ between alternatives. Opportunity cost is the benet that is forgone when one alternative is selected over another. Sunk cost is a cost that occurred in the past and cannot be altered. Differential costs and opportunity costs should be carefully considered in decisions. Sunk costs are always irrelevant in decisions and should be ignored. These various cost classications are different ways of looking at costs. A particular cost, such as the cost of cheese in a taco served at Taco Bell, could be a manufacturing cost, a product cost, a variable cost, a direct cost, and a differential costall at the same time. Taco Bell is a manufacturer of fast food. The cost of the cheese in a taco is a manufacturing cost and, as such, it would be gar79611_ch02_030-087.indd Page 55 12/8/08 9:08:21 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-02/upload 55 Managerial Accounting and Cost Concepts a product cost as well. In addition, the cost of cheese is variable with respect to the number of tacos served and it is a direct cost of serving tacos. Finally, the cost of the cheese in a taco is a differential cost of making and serving the taco. Review Problem 1: Cost Terms Many new cost terms have been introduced in this chapter. It will take you some time to learn what each term means and how to properly classify costs in an organization. Consider the following example: Chippen Corporation manufactures furniture, including tables. Selected costs are given below: 1. The tables are made of wood that costs $100 per table. 2. The tables are assembled by workers, at a wage cost of $40 per table. 3. Workers making the tables are supervised by a factory supervisor who is paid $38,000 per year. 4. Electrical costs are $2 per machine-hour. Four machine-hours are required to produce a table. 5. The depreciation on the machines used to make the tables totals $10,000 per year. The machines have no resale value and do not wear out through use. 6. The salary of the president of the company is $100,000 per year. 7. The company spends $250,000 per year to advertise its products. 8. Salespersons are paid a commission of $30 for each table sold. 9. Instead of producing the tables, the company could rent its factory space for $50,000 per year. Required: Classify these costs according to the various cost terms used in the chapter. Carefully study the classication of each cost. If you dont understand why a particular cost is classied the way it is, reread the section of the chapter discussing the particular cost term. The terms variable cost and xed cost refer to how costs behave with respect to the number of tables produced in a year. Solution to Review Problem 1 Variable Cost 1. Wood used in a table ($100 per table) . . . . . . . . . . 2. Labor cost to assemble a table ($40 per table) . . . . . 3. Salary of the factory supervisor ($38,000 per year) . . . . . . . . . . . . . . . . . . 4. Cost of electricity to produce tables ($2 per machine-hour) . . . . . . . . . . . 5. Depreciation of machines used to produce tables ($10,000 per year) . . . . . . . . 6. Salary of the company president ($100,000 per year) . . . . . . . . . . . . . . . . . . 7. Advertising expense ($250,000 per year) . . . . . . . . . . . . . . . . . . 8. Commissions paid to salespersons ($30 per table sold) . . . . . . . 9. Rental income forgone on factory space . . . . . . . . . . . . Fixed Cost Period (Selling and Administrative) Cost X Direct Materials Direct Labor Manufacturing Overhead Sunk Cost Opportunity Cost X X X X X X X X X X X* X X X Product Cost X X X *This is a sunk cost because the outlay for the equipment was made in a previous period. This is an opportunity cost because it represents the potential benet that is lost or sacriced as a result of using the factory space to produce tables. Opportunity cost is a special category of cost that is not ordinarily recorded in an organizations accounting records. To avoid possible confusion with other costs, we will not attempt to classify this cost in any other way except as an opportunity cost. gar79611_ch02_030-087.indd Page 56 12/8/08 9:08:21 PM user-s180 56 /broker/MH-BURR/MHBR094/MHBR094-02/upload Chapter 2 Review Problem 2: Schedule of Cost of Goods Manufactured and Income Statement The following information has been taken from the accounting records of Klear-Seal Corporation for last year: Selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . Raw materials inventory, January 1 . . . . . . . . . . . Raw materials inventory, December 31 . . . . . . . . Direct labor cost . . . . . . . . . . . . . . . . . . . . . . . . . . Purchases of raw materials . . . . . . . . . . . . . . . . . Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Administrative expenses . . . . . . . . . . . . . . . . . . . Manufacturing overhead . . . . . . . . . . . . . . . . . . . Work in process inventory, January 1 . . . . . . . . . Work in process inventory, December 31 . . . . . . Finished goods inventory, January 1 . . . . . . . . . . Finished goods inventory, December 31 . . . . . . . $140,000 $90,000 $60,000 $150,000 $750,000 $2,500,000 $270,000 $640,000 $180,000 $100,000 $260,000 $210,000 Management wants these data organized in a better format so that nancial statements can be prepared for the year. Required: 1. Prepare a schedule of cost of goods manufactured as in Exhibit 26. Assume raw materials consists entirely of direct materials. 2. Compute the cost of goods sold as in Exhibit 24. 3. Prepare an income statement. Solution to Review Problem 2 1. Klear-Seal Corporation Schedule of Cost of Goods Manufactured For the Year Ended December 31 Direct materials: Raw materials inventory, January 1 . . . . . . . . . . . . . . . . . . . . . . Add: Purchases of raw materials . . . . . . . . . . . . . . . . . . . . . . . . $ 90,000 750,000 Raw materials available for use . . . . . . . . . . . . . . . . . . . . . . . . . Deduct: Raw materials inventory, December 31. . . . . . . . . . . . . 840,000 60,000 Raw materials used in production . . . . . . . . . . . . . . . . . . . . . . . Direct labor. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Manufacturing overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 780,000 150,000 640,000 Total manufacturing cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Add: Work in process inventory, January 1 . . . . . . . . . . . . . . . . . . 1,570,000 180,000 1,750,000 Deduct: Work in process inventory, December 31 . . . . . . . . . . . . . 100,000 Cost of goods manufactured . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,650,000 2. The cost of goods sold would be computed as follows: Finished goods inventory, January 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Add: Cost of goods manufactured . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 260,000 1,650,000 Goods available for sale. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deduct: Finished goods inventory, December 31. . . . . . . . . . . . . . . . . . . . . . . . . . 1,910,000 210,000 Cost of goods sold* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,700,000 *Further adjustments will be made to cost of goods sold in the next chapter. gar79611_ch02_030-087.indd Page 57 12/8/08 9:08:22 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-02/upload 57 Managerial Accounting and Cost Concepts 3. Klear-Seal Corporation Income Statement For the Year Ended December 31 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost of goods sold (above) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,500,000 1,700,000 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Selling and administrative expenses: Selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800,000 Net operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $140,000 270,000 410,000 $ 390,000 Glossary Administrative costs All executive, organizational, and clerical costs associated with the general management of an organization rather than with manufacturing or selling. (p. 38) Budget A detailed plan for the future, usually expressed in formal quantitative terms. (p. 32) Common cost A cost that is incurred to support a number of cost objects but that cannot be traced to them individually. For example, the wage cost of the pilot of a 747 airliner is a common cost of all of the passengers on the aircraft. Without the pilot, there would be no ight and no passengers. But no part of the pilots wage is caused by any one passenger taking the ight. (p. 52) Control The process of instituting procedures and then obtaining feedback to ensure that all parts of the organization are functioning effectively and moving toward overall company goals. (p. 32) Controller The member of the top management team who is responsible for providing relevant and timely data to managers and for preparing nancial statements for external users. The controller reports to the CFO. (p. 32) Controlling Actions taken to help ensure that the plan is being followed and is appropriately modied as circumstances change. (p. 31) Conversion cost Direct labor cost plus manufacturing overhead cost. (p. 39) Cost behavior The way in which a cost reacts to changes in the level of activity. (p. 46) Cost object Anything for which cost data are desired. Examples of cost objects are products, customers, jobs, and parts of the organization such as departments or divisions. (p. 51) Cost of goods manufactured The manufacturing costs associated with the goods that were nished during the period. (p. 44) Differential cost A difference in cost between two alternatives. Also see Incremental cost. (p. 52) Differential revenue The difference in revenue between two alternatives. (p. 52) Direct cost A cost that can be easily and conveniently traced to a specied cost object. (p. 51) Directing and motivating Mobilizing people to carry out plans and run routine operations. (p. 31) Direct labor Factory labor costs that can be easily traced to individual units of product. Also called touch labor. (p. 37) Direct materials Materials that become an integral part of a nished product and whose costs can be conveniently traced to it. (p. 36) Feedback Accounting and other reports that help managers monitor performance and focus on problems and/or opportunities that might otherwise go unnoticed. (p. 32) Financial accounting The phase of accounting concerned with providing information to stockholders, creditors, and others outside the organization. (p. 33) Finished goods Units of product that have been completed but not yet sold to customers. (p. 41) Fixed cost A cost that remains constant, in total, regardless of changes in the level of activity within the relevant range. If a xed cost is expressed on a per unit basis, it varies inversely with the level of activity. (p. 49) Incremental cost An increase in cost between two alternatives. Also see Differential cost. (p. 52) gar79611_ch02_030-087.indd gar79611_ch02_030-087.indd Page 58 12/8/08 9:08:22 PM user-s180 58 /broker/MH-BURR/MHBR094/MHBR094-02/upload Chapter 2 Indirect cost A cost that cannot be easily and conveniently traced to a specied cost object. (p. 51) Indirect labor The labor costs of janitors, supervisors, materials handlers, and other factory workers that cannot be conveniently traced to particular products. (p. 37) Indirect materials Small items of material such as glue and nails that may be an integral part of a nished product, but whose costs cannot be easily or conveniently traced to it. (p. 37) Inventoriable costs Synonym for product costs. (p. 39) Managerial accounting The phase of accounting concerned with providing information to managers for use within the organization. (p. 33) Manufacturing overhead All manufacturing costs except direct materials and direct labor. (p. 37) Opportunity cost The potential benet that is given up when one alternative is selected over another. (p. 53) Performance report A detailed report comparing budgeted data to actual data. (p. 32) Period costs Costs that are taken directly to the income statement as expenses in the period in which they are incurred or accrued. (p. 39) Planning Selecting a course of action and specifying how the action will be implemented. (p. 31) Planning and control cycle The ow of management activities through planning, directing and motivating, and controlling, and then back to planning again. (p. 33) Prime cost Direct materials cost plus direct labor cost. (p. 39) Product costs All costs that are involved in acquiring or making a product. In the case of manufactured goods, these costs consist of direct materials, direct labor, and manufacturing overhead. Also see Inventoriable costs. (p. 38) Raw materials Any materials that go into the nal product. (pp. 36, 41) Relevant range The range of activity within which assumptions about variable and xed cost behavior are valid. (p. 49) Schedule of cost of goods manufactured A schedule showing the direct materials, direct labor, and manufacturing overhead costs incurred during a period and the portion of those costs that are assigned to Work in Process and Finished Goods. (p. 44) Segment Any part of an organization that can be evaluated independently of other parts and about which the manager seeks nancial data. Examples include a product line, a sales territory, a division, or a department. (p. 35) Selling costs All costs that are incurred to secure customer orders and get the nished product or service into the hands of the customer. (p. 38) Sunk cost A cost that has already been incurred and that cannot be changed by any decision made now or in the future. (p. 54) Variable cost A cost that varies, in total, in direct proportion to changes in the level of activity. A variable cost is constant per unit. (p. 48) Work in process Units of product that are only partially complete. (p. 41) Questions 21 22 23 24 25 26 27 28 29 210 Describe the three major activities of a manager. What are the four steps in the planning and control cycle? What are the major differences between nancial and managerial accounting? What are the three major elements of product costs in a manufacturing company? Dene the following: (a) direct materials, (b) indirect materials, (c) direct labor, (d) indirect labor, and (e) manufacturing overhead. Explain the difference between a product cost and a period cost. Describe how the income statement of a manufacturing company differs from the income statement of a merchandising company. Describe the schedule of cost of goods manufactured. How does it tie into the income statement? Describe how the inventory accounts of a manufacturing company differ from the inventory account of a merchandising company. Why are product costs sometimes called inventoriable costs? Describe the ow of such costs in a manufacturing company from the point of incurrence until they nally become expenses on the income statement. gar79611_ch02_030-087.indd gar79611_ch02_030-087.indd Page 59 12/8/08 9:08:22 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-02/upload 59 Managerial Accounting and Cost Concepts 211 212 213 214 Is it possible for costs such as salaries or depreciation to end up as assets on the balance sheet? Explain. The variable cost per unit varies with output, whereas the xed cost per unit is constant. Do you agree? Explain. Dene the following terms: differential cost, opportunity cost, and sunk cost. Only variable costs can be differential costs. Do you agree? Explain. Multiple-choice questions are provided on the text website at www.mhhe.com/garrison13e. Exercises EXERCISE 21 The Work of Management and Managerial and Financial Accounting [LO1] A number of terms that relate to organizations, the work of management, and the role of managerial accounting are listed below: Budgets Directing and motivating Financial accounting Performance report Precision Controller Feedback Managerial accounting Planning Timeliness Required: Choose the term or terms above that most appropriately complete the following statements. A term may be used more than once or not at all. , managers mobilize people to carry out plans and run 1. When routine operations. 2. The plans of management are expressed formally in . 3. consists of identifying alternatives, selecting from among the alternatives the one that is best for the organization, and specifying what actions will be taken to implement the chosen alternative. 4. Managerial accounting places less emphasis on and more emphasis on than nancial accounting. 5. is concerned with providing information for the use of those who are inside the organization, whereas is concerned with providing information for the use of those who are outside the organization. 6. emphasizes detailed segment reports about departments, customers, products, and customers. 7. must follow GAAP, whereas need not follow GAAP. 8. The accounting and other reports that help managers monitor performance and focus on problems and/or opportunities are a form of . 9. The manager in charge of the accounting department is usually known as the . 10. A detailed report to management comparing budgeted data with actual data for a specic time period is a . EXERCISE 22 Classifying Manufacturing Costs [LO2] The PC Works assembles custom computers from components supplied by various manufacturers. The company is very small and its assembly shop and retail sales store are housed in a single facility in a Redmond, Washington, industrial park. Listed below are some of the costs that are incurred at the company. Required: For each cost, indicate whether it would most likely be classied as direct labor, direct materials, manufacturing overhead, selling, or an administrative cost. 1. The cost of a hard drive installed in a computer. 2. The cost of advertising in the Puget Sound Computer User newspaper. 3. The wages of employees who assemble computers from components. 4. Sales commissions paid to the companys salespeople. 5. The wages of the assembly shops supervisor. 6. The wages of the companys accountant. gar79611_ch02_030-087.indd Page 60 12/8/08 9:08:23 PM user-s180 60 /broker/MH-BURR/MHBR094/MHBR094-02/upload Chapter 2 7. 8. Depreciation on equipment used to test assembled computers before release to customers. Rent on the facility in the industrial park. EXERCISE 23 Classication of Costs as Period or Product Cost [LO3] Suppose that you have been given a summer job as an intern at Issac Aircams, a company that manufactures sophisticated spy cameras for remote-controlled military reconnaissance aircraft. The company, which is privately owned, has approached a bank for a loan to help it nance its growth. The bank requires nancial statements before approving such a loan. You have been asked to help prepare the nancial statements and were given the following list of costs: 1. Depreciation on salespersons cars. 2. Rent on equipment used in the factory. 3. Lubricants used for machine maintenance. 4. Salaries of personnel who work in the nished goods warehouse. 5. Soap and paper towels used by factory workers at the end of a shift. 6. Factory supervisors salaries. 7. Heat, water, and power consumed in the factory. 8. Materials used for boxing products for shipment overseas. (Units are not normally boxed.) 9. Advertising costs. 10. Workers compensation insurance for factory employees. 11. Depreciation on chairs and tables in the factory lunchroom. 12. The wages of the receptionist in the administrative ofces. 13. Cost of leasing the corporate jet used by the companys executives. 14. The cost of renting rooms at a Florida resort for the annual sales conference. 15. The cost of packaging the companys product. Required: Classify the above costs as either product costs or period costs for the purpose of preparing the nancial statements for the bank. EXERCISE 24 Constructing an Income Statement [LO4] Last month CyberGames, a computer game retailer, had total sales of $1,450,000, selling expenses of $210,000, and administrative expenses of $180,000. The company had beginning merchandise inventory of $240,000, purchased additional merchandise inventory for $950,000, and had ending merchandise inventory of $170,000. Required: Prepare an income statement for the company for the month. EXERCISE 25 Prepare a Schedule of Cost of Goods Manufactured [LO5] Lompac Products manufactures a variety of products in its factory. Data for the most recent months operations appear below: Beginning raw materials inventory . . . . . . . . . . . . . Purchases of raw materials . . . . . . . . . . . . . . . . . . Ending raw materials inventory . . . . . . . . . . . . . . . Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Manufacturing overhead . . . . . . . . . . . . . . . . . . . . Beginning work in process inventory . . . . . . . . . . . Ending work in process inventory . . . . . . . . . . . . . $60,000 $690,000 $45,000 $135,000 $370,000 $120,000 $130,000 Required: Prepare a schedule of cost of goods manufactured for the company for the month. EXERCISE 26 Classication of Costs as Fixed or Variable [LO6] Below are costs and measures of activity in a variety of organizations. Required: Classify each cost as variable or xed with respect to the indicated measure of activity by placing an X in the appropriate column. gar79611_ch02_030-087.indd Page 61 12/8/08 9:08:23 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-02/upload Managerial Accounting and Cost Concepts Cost Behavior Cost 1. The cost of X-ray lm used in the radiology lab at Virginia Mason Hospital in Seattle 2. The cost of advertising a rock concert in New York City 3. The cost of renting retail space for a McDonalds restaurant in Hong Kong 4. The electrical cost of running a roller coaster at Magic Mountain 5. Property taxes paid by your local cinema theater 6. The cost of sales commissions paid to salespersons at a Nordstrom store 7. Property insurance on a Coca-Cola bottling plant 8. The costs of synthetic materials used to make a particular model of running shoe 9. The costs of shipping Panasonic televisions to retail stores 10. The cost of leasing an ultrascan diagnostic machine at the American Hospital in Paris Measure of Activity Variable Fixed Number of X-rays taken Number of rock concert tickets sold Total sales at the restaurant Number of times the roller coaster is run Number of tickets sold Total sales at the store Number of cases of bottles produced Number of shoes of that model produced The number of televisions sold The number of patients who are scanned with the machine EXERCISE 27 Identifying Direct and Indirect Costs [LO7] Northwest Hospital is a full-service hospital that provides everything from major surgery and emergency room care to outpatient clinics. Required: For each cost incurred at Northwest Hospital, indicate whether it would most likely be a direct cost or an indirect cost of the specied cost object by placing an X in the appropriate column. Cost Ex. 1. 2. 3. 4. 5. 6. 7. 8. Cost Object Catered food served to patients The wages of pediatric nurses Prescription drugs Heating the hospital The salary of the head of pediatrics The salary of the head of pediatrics Hospital chaplains salary Lab tests by outside contractor Lab tests by outside contractor A particular patient The pediatric department A particular patient The pediatric department The pediatric department A particular pediatric patient A particular patient A particular patient A particular department Direct Cost X Indirect Cost 61 gar79611_ch02_030-087.indd Page 62 12/8/08 9:08:24 PM user-s180 62 /broker/MH-BURR/MHBR094/MHBR094-02/upload Chapter 2 EXERCISE 28 Differential, Opportunity, and Sunk Costs [LO8] Northwest Hospital is a full-service hospital that provides everything from major surgery and emergency room care to outpatient clinics. The hospitals Radiology Department is considering replacing an old inefcient X-ray machine with a state-of-the-art digital X-ray machine. The new machine would provide higher quality X-rays in less time and at a lower cost per X-ray. It would also require less power and would use a color laser printer to produce easily readable X-ray images. Instead of investing the funds in the new X-ray machine, the Laboratory Department is lobbying the hospitals management to buy a new DNA analyzer. Required: For each of the items below, indicate by placing an X in the appropriate column whether it should be considered a differential cost, an opportunity cost, or a sunk cost in the decision to replace the old X-ray machine with a new machine. If none of the categories apply for a particular item, leave all columns blank. Differential Cost Item Ex. 1. 2. 3. 4. 5. 6. 7. 8. Cost of X-ray lm used in the old machine Cost of the old X-ray machine . . . . . . . . . . . . . . . . . . . . . . The salary of the head of the Radiology Department . . . . The salary of the head of the Pediatrics Department . . . . Cost of the new color laser printer . . . . . . . . . . . . . . . . . . . Rent on the space occupied by Radiology . . . . . . . . . . . . . The cost of maintaining the old machine . . . . . . . . . . . . . . Benets from a new DNA analyzer . . . . . . . . . . . . . . . . . . Cost of electricity to run the X-ray machines . . . . . . . . . . . Opportunity Cost Sunk Cost X EXERCISE 29 Denitions of Cost Terms [LO2, LO3, LO6, LO8] Following are a number of cost terms introduced in the chapter: Variable cost Fixed cost Prime cost Opportunity cost Product cost Sunk cost Conversion cost Period cost Required: Choose the term or terms above that most appropriately describe the cost identied in each of the following situations. A cost term can be used more than once. 1. Lake Company produces a popular tote bag. The cloth used to manufacture the tote bag is di. rect materials and for nancial accounting purposes is classied as a(n) . In terms of cost behavior, the cloth could also be described as a(n) 2. The direct labor cost required to produce the tote bags, combined with manufacturing over. head cost, is called 3. The company could have taken the funds that it has invested in production equipment and invested them in interest-bearing securities instead. The interest forgone on the securities is a(n) . 4. Taken together, the direct materials cost and the direct labor cost required to produce tote bags . is called 5. Formerly, the company produced a smaller tote bag that was not very popular. Three hundred of these smaller bags are stored in one of the companys warehouses. The amount invested in . these bags is called a(n) 6. Tote bags are sold through agents who are paid a commission on each bag sold. For nancial . accounting purposes, these commissions are classied as a(n) . In terms of cost behavior, commissions are classied as a(n) 7. For nancial accounting purposes, depreciation on the equipment used to produce tote bags is . However, for nancial accounting purposes, depreciation a(n) on any equipment used by the company in selling and administrative activities is classied as . In terms of cost behavior, depreciation is usually a(n) a(n) . gar79611_ch02_030-087.indd gar79611_ch02_030-087.indd Page 63 12/8/08 9:08:24 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-02/upload Managerial Accounting and Cost Concepts 8. A(n) is also known as an inventoriable cost, because such costs go into the Work in Process inventory account and then into the Finished Goods inventory account before appearing on the income statement as part of Cost of Goods Sold. 9. For nancial accounting purposes, the salary of Lake Companys president is classied as a(n) , because the salary will appear on the income statement as an expense in the time period in which it is incurred. 10. Costs are often classied in several ways. For example, Lake Company pays $5,000 rent each month on its factory building. The rent is part of manufacturing overhead. In terms of cost . The rent can also be behavior, it would be classied as a(n) and as a(n) . classied as a(n) EXERCISE 210 Classication of Costs as Variable or Fixed and as Selling and Administrative or Product [LO3, LO6] Below are listed various costs that are found in organizations. 1. Hamburger buns in a Wendys outlet. 2. Advertising by a dental ofce. 3. Apples processed and canned by Del Monte. 4. Shipping canned apples from a Del Monte plant to customers. 5. Insurance on a Bausch & Lomb factory producing contact lenses. 6. Insurance on IBMs corporate headquarters. 7. Salary of a supervisor overseeing production of printers at Hewlett-Packard. 8. Commissions paid to Encyclopedia Britannica salespersons. 9. Depreciation of factory lunchroom facilities at a General Electric plant. 10. Steering wheels installed in BMWs. Required: Classify each cost as being either variable or xed with respect to the number of units produced and sold. Also classify each cost as either a selling and administrative cost or a product cost. Prepare your answer sheet as shown below. Place an X in the appropriate columns to show the proper classication of each cost. Cost Behavior Cost Item Variable Fixed Selling and Administrative Cost Product Cost EXERCISE 211 Preparing a Schedule of Costs of Goods Manufactured and Cost of Goods Sold [LO2, LO4, LO5] The following cost and inventory data are taken from the accounting records of Mason Company for the year just completed: Costs incurred: Direct labor cost . . . . . . . . . . . . . . . . . . . . . . . . . Purchases of raw materials . . . . . . . . . . . . . . . . Manufacturing overhead . . . . . . . . . . . . . . . . . . Advertising expense . . . . . . . . . . . . . . . . . . . . . . Sales salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation, ofce equipment . . . . . . . . . . . . . $70,000 $118,000 $80,000 $90,000 $50,000 $3,000 Beginning of the Year Inventories: Raw materials . . . . . . . . . . . . . Work in process . . . . . . . . . . . . Finished goods . . . . . . . . . . . . . End of the Year $7,000 $10,000 $20,000 $15,000 $5,000 $35,000 Required: 1. 2. Prepare a schedule of cost of goods manufactured. Prepare the cost of goods sold section of Mason Companys income statement for the year. 63 gar79611_ch02_030-087.indd Page 64 12/8/08 9:08:25 PM user-s180 64 /broker/MH-BURR/MHBR094/MHBR094-02/upload Chapter 2 EXERCISE 212 Product Cost Flows; Product versus Period Costs [LO3, LO4] The Devon Motor Company produces motorcycles. During April, the company purchased 8,000 batteries at a cost of $10 per battery. Devon withdrew 7,600 batteries from the storeroom during the month. Of these, 100 were used to replace batteries in motorcycles used by the companys traveling sales staff. The remaining 7,500 batteries withdrawn from the storeroom were placed in motorcycles being produced by the company. Of the motorcycles in production during April, 90% were completed and transferred from work in process to nished goods. Of the motorcycles completed during the month, 30% were unsold at April 30. There were no inventories of any type on April 1. Required: 1. 2. Determine the cost of batteries that would appear in each of the following accounts at April 30: a. Raw Materials. b. Work in Process. c. Finished Goods. d. Cost of Goods Sold. e. Selling Expense. Specify whether each of the above accounts would appear on the balance sheet or on the income statement at April 30. Problems PROBLEM 213 Cost Classication [LO3, LO6, LO7] Listed below are costs found in various organizations. 1. Property taxes, factory. 2. Boxes used for packaging detergent produced by the company. 3. Salespersons commissions. 4. Supervisors salary, factory. 5. Depreciation, executive autos. 6. Wages of workers assembling computers. 7. Insurance, nished goods warehouses. 8. Lubricants for production equipment. 9. Advertising costs. 10. Microchips used in producing calculators. 11. Shipping costs on merchandise sold. 12. Magazine subscriptions, factory lunchroom. 13. Thread in a garment factory. 14. Billing costs. 15. Executive life insurance. 16. Ink used in textbook production. 17. Fringe benets, assembly-line workers. 18. Yarn used in sweater production. 19. Wages of receptionist, executive ofces. Required: Prepare an answer sheet with column headings as shown below. For each cost item, indicate whether it would be variable or xed with respect to the number of units produced and sold; and then whether it would be a selling cost, an administrative cost, or a manufacturing cost. If it is a manufacturing cost, indicate whether it would typically be treated as a direct cost or an indirect cost with respect to units of product. Three sample answers are provided for illustration. Cost Item Direct labor . . . . . . . . . . . . . . . Executive salaries . . . . . . . . . . Factory rent . . . . . . . . . . . . . . . Variable or Fixed V F F Selling Cost Administrative Cost Manufacturing (Product) Cost Direct Indirect X X X gar79611_ch02_030-087.indd Page 65 12/8/08 9:08:25 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-02/upload Managerial Accounting and Cost Concepts PROBLEM 214 Cost Classication [LO2, LO3, LO6, LO8] Wollogong Group Ltd. of New South Wales, Australia, acquired its factory building about 10 years ago. For several years, the company has rented out a small annex attached to the rear of the building. The company has received a rental income of $30,000 per year on this space. The renters lease will expire soon, and rather than renewing the lease, the company has decided to use the space itself to manufacture a new product. Direct materials cost for the new product will total $80 per unit. To have a place to store nished units of product, the company will rent a small warehouse nearby. The rental cost will be $500 per month. In addition, the company must rent equipment for use in producing the new product; the rental cost will be $4,000 per month. Workers will be hired to manufacture the new product, with direct labor cost amounting to $60 per unit. The space in the annex will continue to be depreciated on a straight-line basis, as in prior years. This depreciation is $8,000 per year. Advertising costs for the new product will total $50,000 per year. A supervisor will be hired to oversee production; her salary will be $1,500 per month. Electricity for operating machines will be $1.20 per unit. Costs of shipping the new product to customers will be $9 per unit. To provide funds to purchase materials, meet payrolls, and so forth, the company will have to liquidate some temporary investments. These investments are presently yielding a return of about $3,000 per year. Required: Prepare an answer sheet with the following column headings: Period Product Cost Name (Selling and of the Variable Fixed Direct Direct Manufacturing Administrative) Opportunity Sunk Cost Cost Cost Materials Labor Overhead Cost Cost Cost List the different costs associated with the new product decision down the extreme left column (under Name of the Cost). Then place an X under each heading that helps to describe the type of cost involved. There may be Xs under several column headings for a single cost. (For example, a cost may be a xed cost, a period cost, and a sunk cost; you would place an X under each of these column headings opposite the cost.) PROBLEM 215 Cost Classication [LO6, LO7] Various costs associated with the operation of factories are given below: 1. Electricity to run production equipment. 2. Rent on a factory building. 3. Cloth used to make drapes. 4. Production superintendents salary. 5. Wages of laborers assembling a product. 6. Depreciation of air purication equipment used to make furniture. 7. Janitorial salaries. 8. Peaches used in canning fruit. 9. Lubricants for production equipment. 10. Sugar used in soft-drink production. 11. Property taxes on the factory. 12. Wages of workers painting a product. 13. Depreciation on cafeteria equipment. 14. Insurance on a building used in producing helicopters. 15. Cost of rotor blades used in producing helicopters. Required: Classify each cost as either variable or xed with respect to the number of units produced and sold. Also indicate whether each cost would typically be treated as a direct cost or an indirect cost with respect to units of product. Prepare your answer sheet as shown below: Cost Behavior Cost Item Example: Factory insurance Variable To Units of Product Fixed X Direct Indirect X 65 gar79611_ch02_030-087.indd Page 66 12/8/08 9:08:25 PM user-s180 66 /broker/MH-BURR/MHBR094/MHBR094-02/upload Chapter 2 PROBLEM 216 Schedule of Cost of Goods Manufactured; Income Statement [LO2, LO3, LO4, LO5] Swift Company was organized on March 1 of the current year. After ve months of start-up losses, management had expected to earn a prot during August. Management was disappointed, however, when the income statement for August also showed a loss. Augusts income statement follows: Swift Company Income Statement For the Month Ended August 31 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less operating expenses: Direct labor cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Raw materials purchased . . . . . . . . . . . . . . . . . . . . . . Manufacturing overhead . . . . . . . . . . . . . . . . . . . . . . . Selling and administrative expenses . . . . . . . . . . . . . . $450,000 $ 70,000 165,000 85,000 142,000 Net operating loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 462,000 $ (12,000) After seeing the $12,000 loss for August, Swifts president stated, I was sure wed be protable within six months, but our six months are up and this loss for August is even worse than Julys. I think its time to start looking for someone to buy out the companys assetsif we dont, within a few months there wont be any assets to sell. By the way, I dont see any reason to look for a new controller. Well just limp along with Sam for the time being. The companys controller resigned a month ago. Sam, a new assistant in the controllers ofce, prepared the income statement above. Sam has had little experience in manufacturing operations. Inventory balances at the beginning and end of August were: August 1 Raw materials . . . . . . . . . . . . . . Work in process . . . . . . . . . . . . . Finished goods . . . . . . . . . . . . . August 31 $8,000 $16,000 $40,000 $13,000 $21,000 $60,000 The president has asked you to check over the income statement and make a recommendation as to whether the company should look for a buyer for its assets. Required: 1. 2. 3. As one step in gathering data for a recommendation to the president, prepare a schedule of cost of goods manufactured for August. As a second step, prepare a new income statement for August. Based on your statements prepared in (1) and (2) above, would you recommend that the company look for a buyer? PROBLEM 217 Classication of Salary Cost as a Period or Product Cost [LO3] You have just been hired by Ogden Company to ll a new position that was created in response to rapid growth in sales. It is your responsibility to coordinate shipments of nished goods from the factory to distribution warehouses located in various parts of the United States so that goods will be available as orders are received from customers. The company is unsure how to classify your annual salary in its cost records. The companys cost analyst says that your salary should be classied as a manufacturing (product) cost; the controller says that it should be classied as a selling expense; and the president says that it doesnt matter which way your salary cost is classied. Required: 1. 2. Which viewpoint is correct? Why? From the point of view of the reported net operating income for the year, is the president correct in his statement that it doesnt matter which way your salary cost is classied? Explain. gar79611_ch02_030-087.indd Page 67 12/8/08 9:08:26 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-02/upload Managerial Accounting and Cost Concepts PROBLEM 218 Schedule of Cost of Goods Manufactured; Income Statement; Cost Behavior [LO2, LO3, LO4, LO5, LO6] Various cost and sales data for Meriwell Company for the just completed year appear in the worksheet below: Of the $105,000 of manufacturing overhead, $15,000 is variable and $90,000 is xed. Required: 1. 2. 3. 4. 5. Prepare a schedule of cost of goods manufactured. Prepare an income statement. Assume that the company produced the equivalent of 10,000 units of product during the year just completed. What was the average cost per unit for direct materials? What was the average cost per unit for xed manufacturing overhead? Assume that the company expects to produce 15,000 units of product during the coming year. What average cost per unit and what total cost would you expect the company to incur for direct materials at this level of activity? For xed manufacturing overhead? Assume that direct materials is a variable cost. As the manager responsible for production costs, explain to the president any difference in the average costs per unit between (3) and (4) above. PROBLEM 219 Cost Classication and Cost Behavior [LO3, LO6, LO7] The Dorilane Company specializes in producing a set of wood patio furniture consisting of a table and four chairs. The set enjoys great popularity, and the company has ample orders to keep production going at its full capacity of 2,000 sets per year. Annual cost data at full capacity follow: Factory labor, direct . . . . . . . . . . . . . . . . . . . . . . . . Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Factory supervision . . . . . . . . . . . . . . . . . . . . . . . . Property taxes, factory building . . . . . . . . . . . . . . . Sales commissions . . . . . . . . . . . . . . . . . . . . . . . . Insurance, factory. . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation, administrative ofce equipment . . . . Lease cost, factory equipment . . . . . . . . . . . . . . . . Indirect materials, factory. . . . . . . . . . . . . . . . . . . . Depreciation, factory building . . . . . . . . . . . . . . . . Administrative ofce supplies (billing) . . . . . . . . . . Administrative ofce salaries . . . . . . . . . . . . . . . . . Direct materials used (wood, bolts, etc.) . . . . . . . . Utilities, factory. . . . . . . . . . . . . . . . . . . . . . . . . . . . $118,000 $50,000 $40,000 $3,500 $80,000 $2,500 $4,000 $12,000 $6,000 $10,000 $3,000 $60,000 $94,000 $20,000 67 gar79611_ch02_030-087.indd Page 68 12/23/08 1:08:45 AM user-s176 68 /broker/MH-BURR/MHBR094/MHBR094-02/upload/MHBR094-02 Chapter 2 Required: 1. Prepare an answer sheet with the column headings shown below. Enter each cost item on your answer sheet, placing the dollar amount under the appropriate headings. As examples, this has been done already for the rst two items in the list above. Note that each cost item is classied in two ways: rst, as variable or xed with respect to the number of units produced and sold; and second, as a selling and administrative cost or a product cost. (If the item is a product cost, it should also be classied as either direct or indirect as shown.) Fixed Selling or Administrative Cost $50,000 $50,000 Cost Behavior Cost Item Factory labor, direct . . . . Advertising . . . . . . . . . . . Variable $118,000 Product Cost Direct Indirect* $118,000 *To units of product. 2. 3. 4. Total the dollar amounts in each of the columns in (1) above. Compute the average product cost of one patio set. Assume that production drops to only 1,000 sets annually. Would you expect the average product cost per set to increase, decrease, or remain unchanged? Explain. No computations are necessary. Refer to the original data. The presidents brother-in-law has considered making himself a patio set and has priced the necessary materials at a building supply store. The brother-in-law has asked the president if he could purchase a patio set from the Dorilane Company at cost, and the president agreed to let him do so. a. Would you expect any disagreement between the two men over the price the brother-inlaw should pay? Explain. What price does the president probably have in mind? The brother-in-law? b. Because the company is operating at full capacity, what cost term used in the chapter might be justication for the president to charge the full, regular price to the brother-in-law and still be selling at cost? PROBLEM 220 Classication of Various Costs [LO2, LO3, LO6, LO8] Staci Valek began dabbling in pottery several years ago as a hobby. Her work is quite creative, and it has been so popular with friends and others that she has decided to quit her job with an aerospace company and manufacture pottery full time. The salary from Stacis aerospace job is $3,800 per month. Staci will rent a small building near her home to use as a place for manufacturing the pottery. The rent will be $500 per month. She estimates that the cost of clay and glaze will be $2 for each nished piece of pottery. She will hire workers to produce the pottery at a labor rate of $8 per pot. To sell her pots, Staci feels that she must advertise heavily in the local area. An advertising agency states that it will handle all advertising for a fee of $600 per month. Stacis brother will sell the pots; he will be paid a commission of $4 for each pot sold. Equipment needed to manufacture the pots will be rented at a cost of $300 per month. Staci has already paid the legal and ling fees associated with incorporating her business in the state. These fees amounted to $500. A small room has been located in a tourist area that Staci will use as a sales ofce. The rent will be $250 per month. A phone installed in the room for taking orders will cost $40 per month. In addition, a recording device will be attached to the phone for taking after-hours messages. Staci has some money in savings that is earning interest of $1,200 per year. These savings will be withdrawn and used to get the business going. For the time being, Staci does not intend to draw any salary from the new company. Required: 1. Prepare an answer sheet with the following column headings: Period Product Cost Name (Selling and of the Variable Fixed Direct Direct Manufacturing Administrative) Opportunity Sunk Cost Cost Cost Materials Labor Overhead Cost Cost Cost gar79611_ch02_030-087.indd Page 69 12/23/08 1:08:59 AM user-s176 /broker/MH-BURR/MHBR094/MHBR094-02/upload/MHBR094-02 Managerial Accounting and Cost Concepts 2. List the different costs associated with the new company down the extreme left column (under Name of Cost). Then place an X under each heading that helps to describe the type of cost involved. There may be Xs under several column headings for a single cost. (That is, a cost may be a xed cost, a period cost, and a sunk cost; you would place an X under each of these column headings opposite the cost.) Under the Variable Cost column, list only those costs that would be variable with respect to the number of units of pottery that are produced and sold. All of the costs you have listed above, except one, would be differential costs between the alternatives of Staci producing pottery or staying with the aerospace company. Which cost is not differential? Explain. PROBLEM 221 Schedule of Cost of Goods Manufactured; Income Statement; Cost Behavior [LO2, LO3, LO4, LO5, LO6] Selected account balances for the year ended December 31 are provided below for Superior Company: Selling and administrative salaries . . . . . . . . . . . . Purchases of raw materials . . . . . . . . . . . . . . . . . . Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Advertising expense . . . . . . . . . . . . . . . . . . . . . . . Manufacturing overhead . . . . . . . . . . . . . . . . . . . . Sales commissions . . . . . . . . . . . . . . . . . . . . . . . . $110,000 $290,000 ? $80,000 $270,000 $50,000 Inventory balances at the beginning and end of the year were as follows: Beginning of the Year Raw materials . . . . . . . . . . . . . . Work in process . . . . . . . . . . . . . Finished goods . . . . . . . . . . . . . End of the Year $40,000 ? $50,000 $10,000 $35,000 ? The total manufacturing costs for the year were $683,000; the goods available for sale totaled $740,000; and the cost of goods sold totaled $660,000. Required: 1. 2. 3. 4. Prepare a schedule of cost of goods manufactured and the cost of goods sold section of the companys income statement for the year. Assume that the dollar amounts given above are for the equivalent of 40,000 units produced during the year. Compute the average cost per unit for direct materials used and the average cost per unit for manufacturing overhead. Assume that in the following year the company expects to produce 50,000 units and manufacturing overhead is xed. What average cost per unit and total cost would you expect to be incurred for direct materials? For manufacturing overhead? (Assume that direct materials is a variable cost.) As the manager in charge of production costs, explain to the president the reason for any difference in average cost per unit between (2) and (3) above. PROBLEM 222 Ethics and the Manager [LO3] M. K. Gallant is president of Kranbrack Corporation, a company whose stock is traded on a national exchange. In a meeting with investment analysts at the beginning of the year, Gallant had predicted that the companys earnings would grow by 20% this year. Unfortunately, sales have been less than expected for the year, and Gallant concluded within two weeks of the end of the scal year that it would be impossible to ultimately report an increase in earnings as large as predicted unless some drastic action was taken. Accordingly, Gallant has ordered that wherever possible, expenditures should be postponed to the new yearincluding canceling or postponing orders with suppliers, delaying planned maintenance and training, and cutting back on end-of-year advertising and travel. Additionally, Gallant ordered the companys controller to carefully scrutinize all costs that are currently classied as period costs and reclassify as many as possible as product costs. The company is expected to have substantial inventories of work in process and nished goods at the end of the year. 69 gar79611_ch02_030-087.indd gar79611_ch02_030-087.indd Page 70 12/8/08 9:08:30 PM user-s180 70 /broker/MH-BURR/MHBR094/MHBR094-02/upload Chapter 2 Required: 1. 2. Why would reclassifying period costs as product costs increase this periods reported earnings? Do you believe Gallants actions are ethical? Why or why not? PROBLEM 223 Variable and Fixed Costs; Subtleties of Direct and Indirect Costs [LO6, LO7] Madison Seniors Care Center is a nonprot organization that provides a variety of health services to the elderly. The center is organized into a number of departments, one of which is the meals-on-wheels program that delivers hot meals to seniors in their homes on a daily basis. Below are listed a number of costs of the center and the meals-on-wheels program. example The cost of groceries used in meal preparation. a. The cost of leasing the meals-on-wheels van. b. The cost of incidental supplies such as salt, pepper, napkins, and so on. c. The cost of gasoline consumed by the meals-on-wheels van. d. The rent on the facility that houses Madison Seniors Care Center, including the mealson-wheels program. e. The salary of the part-time manager of the meals-on-wheels program. f. Depreciation on the kitchen equipment used in the meals-on-wheels program. g. The hourly wages of the caregiver who drives the van and delivers the meals. h. The costs of complying with health safety regulations in the kitchen. i. The costs of mailing letters soliciting donations to the meals-on-wheels program. Required: For each cost listed above, indicate whether it is a direct or indirect cost of the meals-on-wheels program, whether it is a direct or indirect cost of particular seniors served by the program, and whether it is variable or xed with respect to the number of seniors served. Use the below form for your answer. Direct or Indirect Cost of the Mealson-Wheels Program Item Description Example The cost of groceries used in meal preparation . . . Direct X Indirect Direct or Indirect Cost of Particular Seniors Served by the Meals-onWheels Program Direct Indirect Variable or Fixed with Respect to the Number of Seniors Served by the Meals-onWheels Program Variable X Fixed X PROBLEM 224 Income Statement; Schedule of Cost of Goods Manufactured [LO2, LO3, LO4, LO5] Visic Corporation, a manufacturing company, produces a single product. The following information has been taken from the companys production, sales, and cost records for the just completed year. Production in units . . . . . . . . . . . . . . . . . . . . . . . Sales in units . . . . . . . . . . . . . . . . . . . . . . . . . . . Ending nished goods inventory in units . . . . . . Sales in dollars . . . . . . . . . . . . . . . . . . . . . . . . . Costs: Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . Raw materials purchased . . . . . . . . . . . . . . . Manufacturing overhead . . . . . . . . . . . . . . . . Selling and administrative expenses . . . . . . . 29,000 ? ? $1,300,000 Beginning of the Year End of the Year $20,000 $50,000 $0 $30,000 $40,000 ? Inventories: Raw materials Work in process Finished goods $90,000 $480,000 $300,000 $380,000 gar79611_ch02_030-087.indd Page 71 12/8/08 9:08:30 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-02/upload 71 Managerial Accounting and Cost Concepts The nished goods inventory is being carried at the average unit production cost for the year. The selling price of the product is $50 per unit. Required: 1. 2. 3. Prepare a schedule of cost of goods manufactured for the year. Compute the following: a. The number of units in the nished goods inventory at the end of the year. b. The cost of the units in the nished goods inventory at the end of the year. Prepare an income statement for the year. PROBLEM 225 Working with Incomplete Data from the Income Statement and Schedule of Cost of Goods Manufactured [LO4, LO5] Supply the missing data in the following cases. Each case is independent of the others. Case 1 2 3 4 Schedule of Cost of Goods Manufactured Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . Direct labor. . . . . . . . . . . . . . . . . . . . . . . . . . . . . Manufacturing overhead . . . . . . . . . . . . . . . . . . Total manufacturing costs . . . . . . . . . . . . . . . . . Beginning work in process inventory . . . . . . . . . Ending work in process inventory . . . . . . . . . . . Cost of goods manufactured . . . . . . . . . . . . . . . $4,500 ? $5,000 $18,500 $2,500 ? $18,000 $6,000 $3,000 $4,000 ? ? $1,000 $14,000 $5,000 $7,000 ? $20,000 $3,000 $4,000 ? $3,000 $4,000 $9,000 ? ? $3,000 ? Income Statement Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Beginning nished goods inventory . . . . . . . . . . Cost of goods manufactured . . . . . . . . . . . . . . . Goods available for sale. . . . . . . . . . . . . . . . . . . Ending nished goods inventory . . . . . . . . . . . . Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . Selling and administrative expenses . . . . . . . . . Net operating income. . . . . . . . . . . . . . . . . . . . . $30,000 $1,000 $18,000 ? ? $17,000 $13,000 ? $4,000 $21,000 $2,500 $14,000 ? $1,500 ? ? $3,500 ? $36,000 ? ? ? $4,000 $18,500 $17,500 ? $5,000 $40,000 $2,000 $17,500 ? $3,500 ? ? ? $9,000 Cases CASE 226 Inventory Computations from Incomplete Data [LO4, LO5] Hector P. Wastrel, a careless employee, left some combustible materials near an open ame in Salter Companys plant. The resulting explosion and re destroyed the entire plant and administrative ofces. Justin Quick, the companys controller, and Constance Trueheart, the operations manager, were able to save only a few bits of information as they escaped from the roaring blaze. What a disaster, cried Justin. And the worst part is that we have no records to use in ling an insurance claim. I know, replied Constance. I was in the plant when the explosion occurred, and I managed to grab only this brief summary sheet that contains information on one or two of our costs. It says that our direct labor cost this year totaled $180,000 and that we purchased $290,000 in raw materials. But Im afraid that doesnt help much; the rest of our records are just ashes. Well, not completely, said Justin. I was working on the year-to-date income statement when the explosion knocked me out of my chair. I instinctively held onto the page I was working on, and from what I can make out, our sales to date this year totaled $1,200,000 and our gross margin was 40% of sales. Also, I can see that our goods available for sale to customers totaled $810,000 at cost. Maybe were not so bad off after all, exclaimed Constance. My sheet says that prime cost totaled $410,000 so far this year and that manufacturing overhead is 70% of conversion cost. Now if we just had some information on our beginning inventories. gar79611_ch02_030-087.indd Page 72 12/8/08 9:08:31 PM user-s180 72 /broker/MH-BURR/MHBR094/MHBR094-02/upload Chapter 2 Hey, look at this, cried Justin. Its a copy of last years annual report, and it shows what our inventories were when this year started. Lets see, raw materials was $18,000, work in process was $65,000, and nished goods was $45,000. Super, yelled Constance. Lets go to work. To le an insurance claim, the company must determine the amount of cost in its inventories as of the date of the re. You may assume that all materials used in production during the year were direct materials. Required: Determine the amount of cost in the Raw Materials, Work in Process, and Finished Goods inventory accounts as of the date of the re. (Hint: One way to proceed would be to reconstruct the various schedules and statements that would have been affected by the companys inventory accounts during the period.) CASE 227 Missing Data; Income Statement; Schedule of Cost of Goods Manufactured [LO2, LO3, LO4, LO5] I was sure that when our battery hit the market it would be an instant success, said Roger Strong, founder and president of Solar Technology, Inc. But just look at the gusher of red ink for the rst quarter. Its obvious that were better scientists than we are businesspeople. At this rate well be out of business within a year. The data to which Roger was referring follow: Solar Technology, Inc. Income Statement For the Quarter Ended March 31 Sales (32,000 batteries) Less operating expenses: Selling and administrative expenses Manufacturing overhead Purchases of raw materials Direct labor $ 960,000 $290,000 410,000 360,000 70,000 Net operating loss 1,130,000 $ (170,000) Solar Technology was organized at the beginning of the current year to produce and market a revolutionary new solar battery. The companys accounting system was set up by Rogers brotherin-law who had taken an accounting course about 10 years ago. We may not last a year if the insurance company doesnt pay the $226,000 it owes us for the 8,000 batteries lost in the warehouse re last week, said Roger. The insurance adjuster says our claim is inated, but hes just trying to pressure us into a lower gure. We have the data to back up our claim, and it will stand up in any court. On April 3, just after the end of the rst quarter, the companys nished goods storage area was swept by re and all 8,000 unsold batteries were destroyed. (These batteries were part of the 40,000 units completed during the rst quarter.) The companys insurance policy states that the company will be reimbursed for the cost of any nished batteries destroyed or stolen. Rogers brother-in-law has determined this cost as follows: $1,130,000 40,000 units Total costs for the quarter Batteries produced during the quarter $28.25 per unit 8,000 batteries $28.25 per unit $226,000 Inventories at the beginning and end of the quarter were as follows: Beginning of the Quarter Raw materials Work in process Finished goods End of the Quarter $0 $0 $0 $10,000 $50,000 ? gar79611_ch02_030-087.indd Page 73 12/8/08 9:08:31 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-02/upload 73 Managerial Accounting and Cost Concepts Required: 1. 2. 3. 4. What conceptual errors, if any, were made in preparing the income statement above? Prepare a schedule of cost of goods manufactured for the rst quarter. Prepare a corrected income statement for the rst quarter. Your statement should show in detail how the cost of goods sold is computed. Do you agree that the insurance company owes Solar Technology, Inc., $226,000? Explain your answer. RESEARCH AND APPLICATION 228 [LO2, LO3, LO6, LO7] The questions in this exercise are based on Dell, Inc. To answer the questions, you will need to download Dells 2005 Form 10-K by going to www.sec.gov/edgar/searchedgar/companysearch.html. Input CIK code 826083 and hit enter. In the gray box on the right-hand side of your computer screen dene the scope of your search by inputting 10-K and then pressing enter. Select the 10-K with a ling date of March 8, 2005. You do not need to print this document in order to answer the questions. Required: 1. 2. 3. 4. 5. 6. 7. 8. What is Dells strategy for success in the marketplace? Does the company rely primarily on a customer intimacy, operational excellence, or product leadership customer value proposition? What evidence supports your conclusion? What business risks does Dell face that may threaten its ability to satisfy stockholder expectations? What are some examples of control activities that the company could use to reduce these risks? (Hint: Focus on pages 710 of the 10-K.) How has the Sarbanes-Oxley Act of 2002 explicitly affected the disclosures contained in Dells 10-K report? (Hint: Focus on pages 3435, 59, and 7678.) Is Dell a merchandiser or a manufacturer? What information contained in the 10-K supports your answer? What are some examples of direct and indirect inventoriable costs for Dell? Why has Dells gross margin (in dollars) steadily increased from 2003 to 2005, yet the gross margin as a percent of net revenue has only increased slightly? What is the inventory balance on Dells January 28, 2005 balance sheet? Why is the inventory balance so small compared to the other current asset balances? What competitive advantage does Dell derive from its low inventory levels? Page 27 of Dells 10-K reports a gure called the cash conversion cycle. The cash conversion cycle for Dell has consistently been negative. Is this a good sign for Dell or a bad sign? Why? Describe some of the various types of operating expenses incurred by Dell. Why are these expenses treated as period costs? List four different cost objects for Dell. For each cost object, mention one example of a direct cost and an indirect cost. Appendix 2A: Further Classication of Labor Costs Idle time, overtime, and fringe benets associated with direct labor workers pose particular problems in accounting for labor costs. Are these costs a part of the costs of direct labor or are they something else? LEARNING OBJECTIVE 9 Properly account for labor costs associated with idle time, overtime, and fringe benets. gar79611_ch02_030-087.indd Page 74 12/8/08 9:08:32 PM user-s180 74 /broker/MH-BURR/MHBR094/MHBR094-02/upload Chapter 2 IN BUSINESS THE BIG THREE WRESTLE WITH FRINGE BENEFITS When companies hire employees they have to pay more than just salaries and wages. Providing fringe benets to employees, such as retirement and medical benets, can be very costly. The Big Three U. S. automobile manufacturers (Ford, General Motors, and Chrysler) understand the costs associated with providing fringe benets all too well. Chryslers retirement and medical costs run $450 per vehicle higher than the likes of Toyota and Honda. Worse yet, the same costs for General Motors are $1,200 higher per vehicle than its Japanese rivals. The Big Three combined have approximately $15 billion in annual health and retirement expenses. Source: David Welch, A Contract the Big Three Can Take to the Bank, BusinessWeek, September 29, 2003, p. 46. Idle Time Machine breakdowns, materials shortages, power failures, and the like result in idle time. The labor costs incurred during idle time may be treated as a manufacturing overhead cost rather than as a direct labor cost. This approach spreads such costs over all the production of a period rather than just the jobs that happen to be in process when breakdowns or other disruptions occur. To give an example of how the cost of idle time may be handled, assume that a press operator earns $12 per hour. If the press operator is paid for a normal 40-hour workweek but is idle for 3 hours during a given week due to breakdowns, labor cost would be allocated as follows: Direct labor ($12 per hour 37 hours) . . . . . . . . . . . . . . . . . . . . . Manufacturing overhead (idle time: $12 per hour 3 hours) . . . . . . Total cost for the week . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $444 36 $480 Overtime Premium The overtime premium paid to factory workers (direct labor as well as indirect labor) is usually considered to be part of manufacturing overhead and is not assigned to any particular order. At rst glance this may seem strange because overtime is always spent working on some particular order. Why not charge that order for the overtime cost? The reason is that it would be considered unfair and arbitrary to charge an overtime premium against a particular order simply because the order happened to fall on the tail end of the daily production schedule. To illustrate, assume that two batches of goods, order A and order B, each take three hours to complete. The production run on order A is scheduled early in the day, but the production run on order B is scheduled late in the afternoon. By the time the run on order B is completed, two hours of overtime have been logged. The necessity to work overtime was a result of the fact that total production exceeded the regular time available. Order B was no more responsible for the overtime than was order A. Therefore, managers feel that all production should share in the premium charge that resulted. This is considered a more equitable way of handling overtime premium because it doesnt penalize one run simply because it happens to occur late in the day. Let us again assume that a press operator in a plant earns $12 per hour. She is paid time and a half for overtime (time in excess of 40 hours a week). During a given week, gar79611_ch02_030-087.indd gar79611_ch02_030-087.indd Page 75 12/8/08 9:08:33 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-02/upload Managerial Accounting and Cost Concepts she works 45 hours and has no idle time. Her labor cost for the week would be allocated as follows: Direct labor ($12 per hour 45 hours) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Manufacturing overhead (overtime premium: $6 per hour 5 hours) . . . . . . . Total cost for the week. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $540 30 $570 Observe from this computation that only the overtime premium of $6 per hour is charged to the overhead accountnot the entire $18 earned for each hour of overtime work ($12 regular rate per hour 1.5 hours $18). Labor Fringe Benets Labor fringe benets are made up of employment-related costs paid by the employer and include the costs of insurance programs, retirement plans, various supplemental unemployment benets, and hospitalization plans. The employer also pays the employers share of Social Security, Medicare, workers compensation, federal employment tax, and state unemployment insurance. These costs often add up to as much as 30% to 40% of base pay. Many companies treat all such costs as indirect labor by adding them to manufacturing overhead. Other companies treat the portion of fringe benets that relates to direct labor as additional direct labor cost. This approach is conceptually superior because the fringe benets provided to direct labor workers clearly represent an added cost of their services. Appendix 2A Exercises and Problems EXERCISE 2A1 Allocations of the Cost of Idle Time [LO9] Mary Adams is employed by Acme Company. Last week she worked 34 hours assembling one of the companys products and was idle 6 hours due to material shortages. Acmes employees are engaged at their workstations for a normal 40-hour week. Ms. Adams is paid $15 per hour. Required: Allocate Ms. Adamss earnings for the week between direct labor and manufacturing overhead. EXERCISE 2A2 Allocations of Overtime Pay [LO9] John Olsen operates a stamping machine on the assembly line of Drake Manufacturing Company. Last week Mr. Olsen worked 45 hours. His basic wage rate is $14 per hour, with time and a half for overtime (time worked in excess of 40 hours per week). Required: Allocate Mr. Olsens earnings for the week between direct labor and manufacturing overhead. EXERCISE 2A3 Classication of Overtime Cost [LO9] Several days ago you took your TV set into a shop to have some repair work done. When you later picked up the set, the bill showed a $75 charge for labor. This charge represented two hours of service time$30 for the rst hour and $45 for the second. When questioned about the difference in hourly rates, the shop manager explained that work on your set was started at 4 oclock in the afternoon. By the time work was completed two hours later at 6 oclock, an hour of overtime had been put in by the repair technician. The second hour therefore contained a charge for an overtime premium because the company had to pay the repair technician time and a half for any work in excess of eight hours per day. The shop manager further explained that the shop was working overtime to catch up a little on its backlog of repairs, but it still needed to maintain a decent prot margin on the technicians time. 75 gar79611_ch02_030-087.indd Page 76 12/23/08 1:09:53 AM user-s176 76 /broker/MH-BURR/MHBR094/MHBR094-02/upload/MHBR094-02 Chapter 2 Required: 1. 2. 3. Do you agree with the shops computation of the service charge on your job? The shop pays its technicians $14 per hour for the rst eight hours worked in a day and $21 per hour for any additional time worked in a day. Show how the cost of the repair technicians time for the day (nine hours) should be allocated between direct labor and general overhead on the shops books. Under what circumstances might the shop be justied in charging an overtime premium for repair work on your set? EXERCISE 2A4 Classication of Labor Costs [LO9] Paul Clark is employed by Aerotech Products where he assembles a component part for one of the companys product lines. He is paid $14 per hour for regular time and time and a half (i.e., $21 per hour) for all work in excess of 40 hours per week. Required: 1. 2. 3. Assume that during a given week Paul is idle for ve hours due to machine breakdowns and that he is idle for four more hours due to material shortages. No overtime is recorded for the week. Allocate Pauls wages for the week between direct labor and manufacturing overhead. Assume that during the following week Paul works a total of 48 hours. He has no idle time for the week. Allocate Pauls wages for the week between direct labor and manufacturing overhead. Pauls company provides an attractive package of fringe benets for its employees. This package includes a retirement program and a health insurance program. Explain two ways that the company could handle the costs of its direct laborers fringe benets in its cost records. PROBLEM 2A5 Allocating Labor Costs [LO9] Mark Hansen is employed by Eastern Products and works on the companys assembly line. Marks basic wage rate is $20 per hour. The companys union contract states that employees are to be paid time and a half (i.e., $30 per hour) for any work in excess of 40 hours per week. Required: 1. 2. 3. 4. Suppose that in a given week Mark works 46 hours. Compute Marks total wages for the week. How much of this amount would be allocated to direct labor? To manufacturing overhead? Suppose in another week that Mark works 48 hours but is idle for 3 hours during the week due to machine breakdowns. Compute Marks total wages for the week. How much of this amount would be allocated to direct labor cost? To manufacturing overhead cost? Eastern Products, Inc., has an attractive package of fringe benets that costs the company $6 for each hour of employee time (either regular time or overtime). During a particular week, Mark works 50 hours but is idle for 2 hours due to material shortages. Compute Marks total wages and fringe benets for the week. If the company treats all fringe benets as part of manufacturing overhead cost, how much of Marks wages and fringe benets for the week would be allocated to direct labor cost? To manufacturing overhead cost? Refer to the data in (3) above. If the company treats that part of fringe benets relating to direct labor as added direct labor cost, how much of Marks wages and fringe benets for the week will be allocated to direct labor cost? To manufacturing overhead cost? Appendix 2B: Cost of Quality A company may have a product with a high-quality design that uses high-quality components, but if the product is poorly assembled or has other defects, the company will have high warranty repair costs and dissatised customers. People who are dissatised with a product are unlikely to buy the product again. They often tell others about their bad experiences. This is the worst possible sort of advertising. To prevent such problems, companies expend a great deal of effort to reduce defects. The objective is to have high quality of conformance. Quality of Conformance A product that meets or exceeds its design specications and is free of defects that mar its appearance or degrade its performance is said to have high quality of conformance. gar79611_ch02_030-087.indd Page 77 12/8/08 9:08:34 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-02/upload 77 Managerial Accounting and Cost Concepts Note that if an economy car is free of defects, it can have a quality of conformance that is just as high as a defect-free luxury car. The purchasers of economy cars cannot expect their cars to be as opulently equipped as luxury cars, but they can and do expect them to be free of defects. Preventing, detecting, and dealing with defects causes costs that are called quality costs or the cost of quality. The use of the term quality cost is confusing to some people. It does not refer to costs such as using a higher-grade leather to make a wallet or using 14K gold instead of gold-plating in jewelry. Instead, the term quality cost refers to all of the costs that are incurred to prevent defects or that result from defects in products. Quality costs can be broken down into four broad groups. Two of these groups known as prevention costs and appraisal costsare incurred in an effort to keep defective products from falling into the hands of customers. The other two groups of costsknown as internal failure costs and external failure costsare incurred because defects occur despite efforts to prevent them. Examples of specic costs involved in each of these four groups are given in Exhibit 2B1. Several things should be noted about the quality costs shown in the exhibit. First, quality costs dont relate to just manufacturing; rather, they relate to all the activities in a company from initial research and development (R&D) through customer service. Second, the number of costs associated with quality is very large; total quality cost can be very high unless management gives this area special attention. Finally, the costs in the four groupings are quite different. We will now look at each of these groupings more closely. LEARNING OBJECTIVE 10 Identify the four types of quality costs and explain how they interact. Prevention Costs Generally, the most effective way to manage quality costs is to avoid having defects in the rst place. It is much less costly to prevent a problem from ever happening than it is to nd and correct the problem after it has occurred. Prevention costs support activities whose purpose is to reduce the number of defects. Companies employ many techniques Prevention Costs Internal Failure Costs Systems development Quality engineering Quality training Quality circles Statistical process control activities Supervision of prevention activities Quality data gathering, analysis, and reporting Quality improvement projects Technical support provided to suppliers Audits of the effectiveness of the quality system Net cost of scrap Net cost of spoilage Rework labor and overhead Reinspection of reworked products Retesting of reworked products Downtime caused by quality problems Disposal of defective products Analysis of the cause of defects in production Re-entering data because of keying errors Debugging software errors Appraisal Costs External Failure Costs Test and inspection of incoming materials Test and inspection of in-process goods Final product testing and inspection Supplies used in testing and inspection Supervision of testing and inspection activities Depreciation of test equipment Maintenance of test equipment Plant utilities in the inspection area Field testing and appraisal at customer site Cost of eld servicing and handling complaints Warranty repairs and replacements Repairs and replacements beyond the warranty period Product recalls Liability arising from defective products Returns and allowances arising from quality problems Lost sales arising from a reputation for poor quality E X H I B I T 2B1 Typical Quality Costs gar79611_ch02_030-087.indd Page 78 12/8/08 9:08:35 PM user-s180 78 /broker/MH-BURR/MHBR094/MHBR094-02/upload Chapter 2 to prevent defects including statistical process control, quality engineering, training, and a variety of other Six Sigma tools. Note from Exhibit 2B1 that prevention costs include activities relating to quality circles and statistical process control. Quality circles consist of small groups of employees that meet on a regular basis to discuss ways to improve quality. Both management and workers are included in these circles. Quality circles are widely used and can be found in manufacturing companies, utilities, health care organizations, banks, and many other organizations. Statistical process control is a technique that is used to detect whether a process is in or out of control. An out-of-control process results in defective units and may be caused by a miscalibrated machine or some other factor. In statistical process control, workers use charts to monitor the quality of units that pass through their workstations. With these charts, workers can quickly spot processes that are out of control and that are creating defects. Problems can be immediately corrected and further defects prevented rather than waiting for an inspector to catch the defects later. Note also from the list of prevention costs in Exhibit 2B1 that some companies provide technical support to their suppliers as a way of preventing defects. Particularly in just-in-time (JIT) systems, such support to suppliers is vital. In a JIT system, parts are delivered from suppliers just in time and in just the correct quantity to ll customer orders. There are no parts stockpiles. If a defective part is received from a supplier, the part cannot be used and the order for the ultimate customer cannot be lled on time. Hence, every part received from a supplier must be free of defects. Consequently, companies that use JIT often require that their suppliers use sophisticated quality control programs such as statistical process control and that their suppliers certify that they will deliver parts and materials that are free of defects. Appraisal Costs Any defective parts and products should be caught as early as possible in the production process. Appraisal costs, which are sometimes called inspection costs, are incurred to identify defective products before the products are shipped to customers. Unfortunately, performing appraisal activities doesnt keep defects from happening again, and most managers now realize that maintaining an army of inspectors is a costly (and ineffective) approach to quality control. The late professor John K. Shank of Dartmouth College once stated, The old-style approach was to say, Weve got great quality. We have 40 quality control inspectors in the factory. Then somebody realized that if you need 40 inspectors, it must be a lousy factory. So now the trick is to run a factory without any quality control inspectors; each employee is his or her own quality control person.1 Employees are increasingly being asked to be responsible for their own quality control. This approach, along with designing products to be easy to manufacture properly, allows quality to be built into products rather than relying on inspection to get the defects out. Internal Failure Costs Failure costs are incurred when a product fails to conform to its design specications. Failure costs can be either internal or external. Internal failure costs result from identifying defects before they are shipped to customers. These costs include scrap, rejected products, reworking of defective units, and downtime caused by quality problems. In some companies, as little as 10% of the companys products make it through the production process without rework of some kind. Of course, the more effective a companys appraisal activities, the greater the chance of catching defects internally and the greater 1 Robert W. Casey, The Changing World of the CEO, PPM World 24, no. 2, p. 31. gar79611_ch02_030-087.indd Page 79 12/8/08 9:08:35 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-02/upload 79 Managerial Accounting and Cost Concepts the level of internal failure costs. This is the price that is paid to avoid incurring external failure costs, which can be devastating. External Failure Costs External failure costs result when a defective product is delivered to a customer. As shown in Exhibit 2B1, external failure costs include warranty repairs and replacements, product recalls, liability arising from legal action against a company, and lost sales arising from a reputation for poor quality. Such costs can decimate prots. In the past, some managers have taken the attitude, Lets go ahead and ship everything to customers, and well take care of any problems under the warranty. This attitude generally results in high external failure costs, customer ill will, and declining market share and prots. THE HIGH COST OF EXTERNAL FAILURES IN HEALTH CARE Poor quality management has plagued the American health-care industry for years. At least 100,000 patients are killed every year due to external failures and $500 billion a year is spent on avoidable medical costs. These alarming statistics fueled $27 billion in malpractice costs in 2003. Fortunately, change appears on the horizon. Some hospitals are beginning to measure performance and issue report cards rather than assuming that their doctors decisions and practices are always correct. For example, when newly created reports informed managers at Utahs Intermountain LDS Hospital that their doctors were frequently prematurely inducing expectant mothers into labor for convenience, they clamped down by requiring more prudent medical practices. The LDS Hospital is also nding that small investments in prevention are reaping huge savings in money and lives. The hospitals annual deaths from congestive heart failure have dropped 22% simply by creating and enforcing the use of a checklist to ensure that all patients receive the proper medications before being discharged from the hospital. Source: Robert Langreth, Fixing Hospitals, Forbes, June 20, 2005, pp. 6876. Distribution of Quality Costs Quality costs for U.S. companies have been found to range between 10% and 20% of total sales, whereas experts say that these costs should be more in the 2% to 4% range. How does a company reduce its total quality cost? The answer lies in how the quality costs are distributed. Refer to the graph in Exhibit 2B2 (page 80), which shows total quality costs as a function of the quality of conformance. The graph shows that when the quality of conformance is low, total quality cost is high and that most of this cost consists of costs of internal and external failure. A low quality of conformance means that a high percentage of units are defective and hence the company has high failure costs. However, as a company spends more and more on prevention and appraisal, the percentage of defective units drops (the percentage of defect-free units increases). This results in lower internal and external failure costs. Ordinarily, total quality cost drops rapidly as the quality of conformance increases. Thus, a company can reduce its total quality cost by focusing its efforts on prevention and appraisal. The cost savings from reduced defects usually swamp the costs of the additional prevention and appraisal efforts. The graph in Exhibit 2B2 has been drawn so that the total quality cost is minimized when the quality of conformance is less than 100%. However, some experts contend that the total quality cost is not minimized until the quality of conformance is 100% and there are no defects. Indeed, many companies have found that the total quality costs seem to keep dropping even when the quality of conformance approaches 100% and defect rates get as low as 1 in a million units. Others argue that total quality cost eventually increases as the quality of IN BUSINESS gar79611_ch02_030-087.indd Page 80 12/8/08 9:08:36 PM user-s180 80 /broker/MH-BURR/MHBR094/MHBR094-02/upload Chapter 2 Costs E X H I B I T 2B2 Effect of Quality Costs on Quality of Conformance Costs of internal and external failure Total quality cost Costs of prevention and appraisal 0 100 Quality of conformance (percent of output without defects) conformance increases. However, in most companies this does not seem to happen until the quality of conformance is very close to 100% and defect rates are very close to zero. As a companys quality program becomes more rened and as its failure costs begin to fall, prevention activities usually become more effective than appraisal activities. Appraisal can only nd defects, whereas prevention can eliminate them. The best way to prevent defects from happening is to design processes that reduce the likelihood of defects and to continually monitor processes using statistical process control methods. Quality Cost Reports L EARNING OBJECTIVE 11 Prepare and interpret a quality cost report. As an initial step in quality improvement programs, companies often construct a quality cost report that provides an estimate of the nancial consequences of the companys current level of defects. A quality cost report details the prevention costs, appraisal costs, and costs of internal and external failures that arise from the companys current quality control efforts. Managers are often shocked by the magnitude of these costs. A typical quality cost report is shown in Exhibit 2B3. Several things should be noted from the data in the exhibit. First, Ventura Companys quality costs are poorly distributed in both years, with most of the costs due to either internal failure or external failure. The external failure costs are particularly high in Year 1 in comparison to other costs. Second, note that the company increased its spending on prevention and appraisal activities in Year 2. As a result, internal failure costs went up in that year (from $2 million in Year 1 to $3 million in Year 2), but external failure costs dropped sharply (from $5.15 million in Year 1 to only $2 million in Year 2). Because of the increase in appraisal activity in Year 2, more defects were caught inside the company before they were shipped to customers. This resulted in more cost for scrap, rework, and so forth, but saved huge amounts in warranty repairs, warranty replacements, and other external failure costs. Third, note that as a result of greater emphasis on prevention and appraisal, total quality cost decreased in Year 2. As continued emphasis is placed on prevention and appraisal gar79611_ch02_030-087.indd Page 81 12/23/08 3:36:14 PM user-s180 /Users/user-s180/Desktop/Dhiru-23-12-08/New/MHBR094-02 81 Managerial Accounting and Cost Concepts E X H I B I T 2B3 Quality Cost Report Ventura Company Quality Cost Report For Years 1 and 2 Year 1 Year 2 Amount Prevention costs: Systems development . . . . . . . . . . . Quality training . . . . . . . . . . . . . . . . . Supervision of prevention activities . . Quality improvement projects . . . . . . Total prevention cost . . . . . . . . . . . . . . Appraisal costs: Inspection . . . . . . . . . . . . . . . . . . . . Reliability testing . . . . . . . . . . . . . . . Supervision of testing and inspection Depreciation of test equipment . . . . . Total appraisal cost . . . . . . . . . . . . . . . Internal failure costs: Net cost of scrap . . . . . . . . . . . . . . . Rework labor and overhead . . . . . . . Downtime due to defects in quality . . Disposal of defective products . . . . . Total internal failure cost . . . . . . . . . . . External failure costs: Warranty repairs . . . . . . . . . . . . . . . . Warranty replacements . . . . . . . . . . Allowances . . . . . . . . . . . . . . . . . . . Cost of field servicing . . . . . . . . . . . . Total external failure cost . . . . . . . . . . . Total quality cost . . . . . . . . . . . . . . . . . Percent* Amount Percent* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 270,000 130,000 40,000 210,000 650,000 0.54% 0.26% 0.08% 0.42% 1.30% $ 400,000 210,000 70,000 320,000 1,000,000 0.80% 0.42% 0.14% 0.64% 2.00% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 560,000 420,000 80,000 140,000 1,200,000 1.12% 0.84% 0.16% 0.28% 2.40% 600,000 580,000 120,000 200,000 1,500,000 1.20% 1.16% 0.24% 0.40% 3.00% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 750,000 810,000 100,000 340,000 2,000,000 1.50% 1.62% 0.20% 0.68% 4.00% 900,000 1,430,000 170,000 500,000 3,000,000 1.80% 2.86% 0.34% 1.00% 6.00% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 900,000 2,300,000 630,000 1,320,000 5,150,000 $9,000,000 1.80% 4.60% 1.26% 2.64% 10.30% 18.00% 400,000 870,000 130,000 600,000 2,000,000 $7,500,000 0.80% 1.74% 0.26% 1.20% 4.00% 15.00% *As a percentage of total sales. In each year sales totaled $50,000,000. in future years, total quality cost should continue to decrease. That is, future increases in prevention and appraisal costs should be more than offset by decreases in failure costs. Moreover, appraisal costs should also decrease as more effort is placed in prevention. EXTERNAL FAILURE; ITS WORSE THAN YOU THINK Venky Nagar and Madhav Rajan investigated quality costs at 11 manufacturing plants of a large U.S. company. They found that total quality costs were about 7% of sales. Moreover, they found that external failure costs as usually measured grossly understate the true impact of external failures on the companys prots. In addition to the obvious costs of repairing defective products that are under warranty, defective products sold to customers negatively impact the companys reputation and hence future sales. Statistical analysis of the data from the manufacturing plants indicated that a $1 increase in external failure costs such as warranty repairs was associated with a $26 decrease in cumulative future sales and a $10.40 cumulative decrease in future prots. Source: Venky Nagar and Madhav V. Rajan, The Revenue Implications of Financial and Operational Measures of Product Quality, The Accounting Review 76, no. 4, October 2001, pp. 495513. IN BUSINESS gar79611_ch02_030-087.indd Page 82 12/8/08 9:08:37 PM user-s180 82 /broker/MH-BURR/MHBR094/MHBR094-02/upload Chapter 2 Quality Cost Reports in Graphic Form As a supplement to the quality cost report shown in Exhibit 2B3, companies frequently prepare quality cost information in graphic form. Graphic presentations include pie charts, bar graphs, trend lines, and so forth. The data for Ventura Company from Exhibit 2B3 are presented in bar graph form in Exhibit 2B4. The rst bar graph in Exhibit 2B4 is scaled in terms of dollars of quality cost, and the second is scaled in terms of quality cost as a percentage of sales. In both graphs, the data are stacked upward. That is, appraisal costs are stacked on top of prevention costs, internal failure costs are stacked on top of the sum of prevention costs plus appraisal costs, and so forth. The percentage gures in the second graph show that total quality cost equals 18% of sales in Year 1 and 15% of sales in Year 2, the same as reported earlier in Exhibit 2B3. Data in graphic form help managers to see trends more clearly and to see the magnitude of the various costs in relation to each other. Such graphs are easily prepared using computer graphics and spreadsheet applications. Uses of Quality Cost Information A quality cost report has several uses. First, quality cost information helps managers see the nancial signicance of defects. Managers usually are not aware of the magnitude of their quality costs because these costs cut across departmental lines and are not normally tracked and accumulated by the cost system. Thus, when rst presented with a quality cost report, managers often are surprised by the amount of cost attributable to poor quality. Second, quality cost information helps managers identify the relative importance of the quality problems faced by their companies. For example, the quality cost report may show that scrap is a major quality problem or that the company is incurring huge warranty costs. With this information, managers have a better idea of where to focus their efforts. Third, quality cost information helps managers see whether their quality costs are poorly distributed. In general, quality costs should be distributed more toward prevention and appraisal activities and less toward failures. 20 9 18 8 7 6 External failure External failure 5 Internal failure 4 3 Internal failure 2 1 0 Appraisal Appraisal 16 14 12 Year Internal failure 8 6 Internal failure 4 Prevention 0 2 External failure External failure 10 2 Prevention 1 Quality cost as a percentage of sales $10 Quality cost (in millions) E X H I B I T 2B4 Quality Cost Reports in Graphic Form Appraisal Appraisal Prevention 1 Year Prevention 2 gar79611_ch02_030-087.indd gar79611_ch02_030-087.indd Page 83 12/8/08 9:08:37 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-02/upload Managerial Accounting and Cost Concepts Counterbalancing these uses, three limitations of quality cost information should be recognized. First, simply measuring and reporting quality costs does not solve quality problems. Problems can be solved only by taking action. Second, results usually lag behind quality improvement programs. Initially, total quality cost may even increase as quality control systems are designed and installed. Decreases in quality costs may not begin to occur until the quality program has been in effect for some time. And third, the most important quality cost, lost sales arising from customer ill will, is usually omitted from the quality cost report because it is difcult to estimate. Typically, during the initial years of a quality improvement program, the benets of compiling a quality cost report outweigh the costs and limitations of the reports. As managers gain experience in balancing prevention and appraisal activities, the need for quality cost reports often diminishes. International Aspects of Quality Many of the tools used in quality management today were developed in Japan after World War II. In statistical process control, Japanese companies borrowed heavily from the work of W. Edwards Deming. However, Japanese companies are largely responsible for quality circles, JIT, the idea that quality is everyones responsibility, and the emphasis on prevention rather than on inspection. In the 1980s, quality reemerged as a pivotal factor in the market. Many companies now nd that it is impossible to effectively compete without a very strong quality program in place. This is particularly true of companies that wish to compete in the European market. The ISO 9000 Standards The International Organization for Standardization (ISO), based in Geneva, Switzerland, has established quality control guidelines known as the ISO 9000 standards. Many companies and organizations in Europe will buy only from ISO 9000-certied suppliers. This means that the suppliers must demonstrate to a certifying agency that: 1. A quality control system is in use, and the system clearly denes an expected level of quality. 2. The system is fully operational and is backed up with detailed documentation of quality control procedures. 3. The intended level of quality is being achieved on a sustained, consistent basis. The key to receiving certication under the ISO 9000 standards is documentation. Its one thing for a company to say that it has a quality control system in operation, but its quite a different thing to be able to document the steps in that system. Under ISO 9000, this documentation must be so detailed and precise that if all the employees in a company were suddenly replaced, the new employees could use the documentation to make the product exactly as it was made by the old employees. Even companies with good quality control systems nd that it takes up to two years of painstaking work to develop this detailed documentation. But companies often nd that compiling this documentation results in improvements in their quality systems. The ISO 9000 standards have become an international measure of quality. Although the standards were developed to control the quality of goods sold in European countries, they have become widely accepted elsewhere as well. Companies in the United States that export to Europe often expect their own suppliers to comply with ISO 9000 standards because these exporters must document the quality of the materials going into their products as part of their own ISO 9000 certication. The ISO program for certication of quality management programs is not limited to manufacturing companies. The American Institute of Certied Public Accountants was 83 gar79611_ch02_030-087.indd Page 84 12/8/08 9:08:38 PM user-s180 84 /broker/MH-BURR/MHBR094/MHBR094-02/upload Chapter 2 the rst professional membership organization in the United States to win recognition under an ISO certication program. IN BUSINESS ISO 9000 STANDARDS: WHERE IS THE PAYOFF? The International Organization for Standardization (ISO) has established over 15,000 standards during its existence. As of 2003, more than 600,000 companies worldwide had received some form of ISO certication. Organizations such as Northrop Grumman, Ford, and some units of the United States government require their suppliers to be ISO certied. Nonetheless, many companies are beginning to question whether the effort expended to become certied is worth it. According to Bill Robinson, who supervised more than 50 ISO certications at Lucent Technologies, ISO certication can help drive a company to a plateau level of performance, but it will keep it at that level and, in fact, stie improvement. Arunas Chesonis, CEO of Paetec Communications in Rochester, New York, is de-emphasizing ISO in favor of Six Sigma because he believes ISO is not one of the better systems for process improvement. Furthermore, research has shown that although ISO 9000 certication may be necessary to maintain current levels of nancial performance (in cases where a companys customers require their suppliers to be certied), it has a very limited effect on improving nancial performance. Source: Stephanie Clifford, So Many Standards to Follow, So Little Payoff, Inc. magazine, May 2005, pp. 2527. Summary (Appendix 2B) Defects cause costs, which can be classied into prevention costs, appraisal costs, internal failure costs, and external failure costs. Prevention costs are incurred to keep defects from happening. Appraisal costs are incurred to ensure that defective products, once made, are not shipped to customers. Internal failure costs are incurred as a consequence of detecting defective products before they are shipped to customers. External failure costs are the consequences (in terms of repairs, servicing, and lost future business) of delivering defective products to customers. Most experts agree that management effort should be focused on preventing defects. Small investments in prevention can lead to dramatic reductions in appraisal costs and costs of internal and external failure. Quality costs are summarized on a quality cost report. This report shows the types of quality costs being incurred and their signicance and trends. The report helps managers understand the importance of quality costs, spot problem areas, and assess the way in which the quality costs are distributed. Glossary (Appendix 2B) Appraisal costs Costs that are incurred to identify defective products before the products are shipped to customers. (p. 78) External failure costs Costs that are incurred when a product or service that is defective is delivered to a customer. (p. 79) Internal failure costs Costs that are incurred as a result of identifying defective products before they are shipped to customers. (p. 78) ISO 9000 standards Quality control requirements issued by the International Organization for Standardization that relate to products sold in European countries. (p. 83) Prevention costs Costs that are incurred to keep defects from occurring. (p. 77) Quality circles Small groups of employees that meet on a regular basis to discuss ways of improving quality. (p. 78) Quality cost Costs that are incurred to prevent defective products from falling into the hands of customers or that are incurred as a result of defective units. (p. 77) gar79611_ch02_030-087.indd gar79611_ch02_030-087.indd Page 85 12/8/08 9:08:38 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-02/upload Managerial Accounting and Cost Concepts Quality cost report A report that details prevention costs, appraisal costs, and the costs of internal and external failures. (p. 80) Quality of conformance The degree to which a product or service meets or exceeds its design specications and is free of defects or other problems that mar its appearance or degrade its performance. (p. 76) Statistical process control A charting technique used to monitor the quality of work being done in a workstation for the purpose of immediately correcting any problems. (p. 78) Appendix 2B Exercises and Problems EXERCISE 2B1 Cost of Quality Terms [LO10] A number of terms relating to the cost of quality and quality management are listed below: Appraisal costs Quality cost report Quality of conformance Internal failure costs Quality circles Prevention costs External failure costs Quality costs Required: Choose the term or terms that most appropriately complete the following statements. The terms can be used more than once and a blank can hold more than one word. . 1. A product that has a high rate of defects is said to have a low 2. All of the costs associated with preventing and dealing with defects once they occur are known as . 3. In many companies, small groups of employees, known as , meet on a regular basis to discuss ways to improve quality. 4. A company incurs and in an effort to keep defects from occurring. 5. A company incurs and because defects have occurred. 6. Of the four groups of costs associated with quality of conformance, are generally the most damaging to a company. 7. Inspection, testing, and other costs incurred to keep defective products from being shipped to customers are known as . 8. are incurred in an effort to eliminate poor product design, defective manufacturing practices, and the providing of substandard service. 9. The costs relating to defects, rejected products, and downtime caused by quality problems are known as . 10. When a product that is defective in some way is delivered to a customer, are incurred. 11. Over time a companys total quality costs should decrease if it redistributes its quality costs by placing its greatest emphasis on and . 12. One way to ensure that management is aware of the costs associated with quality is to summarize such costs on a . EXERCISE 2B2 Classication of Quality Costs [LO10] A number of activities that are a part of a companys quality control system are listed below: a. Product testing. k. Net cost of scrap. b. Product recalls. l. Depreciation of test equipment. c. Rework labor and overhead. m. Returns and allowances arising from poor d. Quality circles. quality. e. Downtime caused by defects. n. Disposal of defective products. f. Cost of eld servicing. o. Technical support to suppliers. g. Inspection of goods. p. Systems development. h. Quality engineering. q. Warranty replacements. i. Warranty repairs. r. Field testing at customer site. j. Statistical process control. s. Product design. 85 gar79611_ch02_030-087.indd Page 86 12/8/08 9:08:39 PM user-s180 86 /broker/MH-BURR/MHBR094/MHBR094-02/upload Chapter 2 Required: 1. 2. Classify the costs associated with each of these activities into one of the following categories: prevention cost, appraisal cost, internal failure cost, or external failure cost. Which of the four types of costs in (1) above are incurred in an effort to keep poor quality of conformance from occurring? Which of the four types of costs in (1) above are incurred because poor quality of conformance has occurred? PROBLEM 2B3 Quality Cost Report [LO10, LO11] In response to intensive foreign competition, the management of Florex Company has attempted over the past year to improve the quality of its products. A statistical process control system has been installed and other steps have been taken to decrease the amount of warranty and other eld costs, which have been trending upward over the past several years. Costs relating to quality and quality control over the last two years are given below: Costs (in thousands) Last Year Inspection. . . . . . . . . . . . . . . . . . . . . . Quality engineering . . . . . . . . . . . . . . Depreciation of test equipment . . . . . Rework labor . . . . . . . . . . . . . . . . . . . Statistical process control . . . . . . . . . Cost of eld servicing. . . . . . . . . . . . . Supplies used in testing . . . . . . . . . . . Systems development . . . . . . . . . . . . Warranty repairs. . . . . . . . . . . . . . . . . Net cost of scrap . . . . . . . . . . . . . . . . Product testing . . . . . . . . . . . . . . . . . . Product recalls . . . . . . . . . . . . . . . . . . Disposal of defective products . . . . . . This Year $750 $420 $210 $1,050 $0 $1,200 $30 $480 $3,600 $630 $810 $2,100 $720 $900 $570 $240 $1,500 $180 $900 $60 $750 $1,050 $1,125 $1,200 $750 $975 Sales have been at over the past few years, at $75,000,000 per year. A great deal of money has been spent in the effort to upgrade quality, and management is anxious to see whether or not the effort has been effective. Required: 1. 2. 3. Prepare a quality cost report that contains data for both this year and last year. Carry percentage computations to two decimal places. Prepare a bar graph showing the distribution of the various quality costs by category. Prepare a written evaluation to accompany the reports you have prepared in (1) and (2) above. This evaluation should discuss the distribution of quality costs in the company, changes in this distribution that you see taking place, the reasons for changes in costs in the various categories, and any other information that would be of value to management. PROBLEM 2B4 Analyzing a Quality Cost Report [LO11] Mercury, Inc., produces cell phones at its plant in Texas. In recent years, the companys market share has been eroded by stiff competition from overseas. Price and product quality are the two key areas in which companies compete in this market. A year ago, the companys cell phones had been ranked low in product quality in a consumer survey. Shocked by this result, Jorge Gomez, Mercurys president, initiated a crash effort to improve product quality. Gomez set up a task force to implement a formal quality improvement program. Included on this task force were representatives from the Engineering, Marketing, Customer Service, Production, and Accounting departments. The broad representation was needed because Gomez believed that this was a companywide program and that all employees should share the responsibility for its success. After the rst meeting of the task force, Holly Elsoe, manager of the Marketing Department, asked John Tran, production manager, what he thought of the proposed program. Tran replied, I have reservations. Quality is too abstract to be attaching costs to it and then to be holding you and me responsible for cost improvements. I like to work with goals that I can see and count! Im gar79611_ch02_030-087.indd gar79611_ch02_030-087.indd Page 87 12/8/08 9:08:40 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-02/upload Managerial Accounting and Cost Concepts nervous about having my annual bonus based on a decrease in quality costs; there are too many variables that we have no control over. Mercurys quality improvement program has now been in operation for one year. The companys most recent quality cost report is shown below. Mercury, Inc. Quality Cost Report (in thousands) Last Year Prevention costs: Machine maintenance Training suppliers Quality circles This Year $ 70 0 0 $ 120 10 20 Total prevention costs 70 150 Appraisal costs: Incoming inspection Final testing 20 80 40 90 Total appraisal costs 100 130 Internal failure costs: Rework Scrap 50 40 130 70 Total internal failure costs 90 200 External failure costs: Warranty repairs Customer returns 90 320 30 80 Total external failure costs 410 110 Total quality cost $ 670 $ 590 Total production cost $4,200 $4,800 As they were reviewing the report, Elsoe asked Tran what he now thought of the quality improvement program. Tran replied. Im relieved that the new quality improvement program hasnt hurt our bonuses, but the program has increased the workload in the Production Department. It is true that customer returns are way down, but the cell phones that were returned by customers to retail outlets were rarely sent back to us for rework. Required: 1. 2. 3. Expand the companys quality cost report by showing the costs in both years as percentages of both total production cost and total quality cost. Carry all computations to one decimal place. By analyzing the report, determine if Mercury, Inc.s quality improvement program has been successful. List specic evidence to support your answer. Do you expect the improvement program as it progresses to continue to increase the workload in the Production Department? Jorge Gomez believed that the quality improvement program was essential and that Mercury, Inc., could no longer afford to ignore the importance of product quality. Discuss how Mercury, Inc., could measure the cost of not implementing the quality improvement program. (CMA, adapted) 87 Chapter gar79611_ch03_088-147.indd Page 88 12/11/08 1:27:34 AM user-s180 3 /broker/MH-BURR/MHBR094/MHBR094-03/upload Systems Design: Job-Order Costing Two College Students Succeeding as Entrepreneurs LEARNING OBJECTIVES After studying Chapter 3, you should be able to: Distinguish between process costing and job-order costing and identify companies that would use each costing method. LO2 Identify the documents used in a job-order costing system. LO3 Compute predetermined overhead rates and explain why estimated overhead costs (rather than actual overhead costs) are used in the costing process. LO4 Understand the flow of costs in a job-order costing system and prepare appropriate journal entries to record costs. LO5 Apply overhead cost to Work in Process using a predetermined overhead rate. LO6 Prepare schedules of cost of goods manufactured and cost of goods sold. LO7 Use T-accounts to show the flow of costs in a job-order costing system. LO8 Compute underapplied or overapplied overhead cost and prepare the journal entry to close the balance in Manufacturing Overhead to the appropriate accounts. LO9 (Appendix 3A) Understand the implications of basing the predetermined overhead rate on activity at capacity rather than on estimated activity for the period. 88 Source: Conversation with Joe Haddad, cofounder of University Tees. B U SI NE SS F OCU S LO1 When the University of Dayton athletic department needed 2,000 customized T-shirts to give away at its first home basketball game of the year, it chose University Tees to provide the shirts. A larger competitor could have been chosen, but University Tees won the order because of its fast customer response time, low price, and high quality. University Tees is a small business that was started in February 2003 by two Miami University seniorsJoe Haddad and Nick Dadas (see the companys website at www.universitytees.com). The company creates the artwork for customized T-shirts and then relies on carefully chosen suppliers to manufacture the product. Accurately calculating the cost of each potential customer order is critically important to University Tees because the company needs to be sure that the price exceeds the cost associated with satisfying the order. The costs include the cost of the T-shirts themselves, printing costs (which vary depending on the quantity of shirts produced and the number of colors printed per shirt), silk screen costs (which also vary depending on the number of colors included in a design), shipping costs, and the artwork needed to create a design. The company also takes into account its competitors pricing strategies when developing its own prices. gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 89 12/11/08 1:27:38 AM user-s180 /broker/MH-BURR/MHBR094/MHBR094-03/upload 89 Systems Design: Job-Order Costing U nderstanding how products and services are costed is vital to managers because the way in which these costs are determined can have a substantial impact on reported prots, as well as on key management decisions. A managerial costing system should provide cost data to help managers plan, direct and motivate, control, and make decisions. Nevertheless, external nancial reporting and tax reporting requirements often heavily inuence how costs are accumulated and summarized on managerial reports. This is true of product costing. In the last chapter and in this chapter we use absorption costing to determine product costs. In absorption costing, all manufacturing costs, both xed and variable, are assigned to units of productunits are said to fully absorb manufacturing costs. In later chapters we look at alternatives to absorption costing such as activity-based costing and variable costing. Most countriesincluding the United Statesrequire some form of absorption costing for both external nancial reports and for tax reports. In addition, the vast majority of companies throughout the world also use absorption costing in their management reports. Because absorption costing is the most common approach to product costing throughout the world, we discuss it rst and then discuss the alternatives in subsequent chapters. Process and Job-Order Costing Under absorption costing, product costs include all manufacturing costs. Some manufacturing costs, such as direct materials, can be directly traced to particular products. For example, the cost of the airbags installed in a Toyota Camry can be easily traced to that particular auto. But what about manufacturing costs like factory rent? Such costs do not change from month to month, whereas the number and variety of products made in the factory may vary dramatically from one month to the next. Since these costs remain unchanged from month to month regardless of what products are made, they are clearly not caused byand cannot be directly traced toany particular product. Therefore, these types of costs are assigned to products and services by averaging across time and across products. The type of production process inuences how this averaging is done. We discuss two different costing systems in the sections that followprocess costing and joborder costing. Process Costing Process costing is used in companies that produce many units of a single product for long periods. Examples include producing paper at Weyerhaeuser, rening aluminum ingots at Reynolds Aluminum, mixing and bottling beverages at Coca- Cola, and making wieners at Oscar Mayer. These are all homogeneous products that ow through the production process on a continuous basis. Process costing systems accumulate costs in a particular operation or department for an entire period (month, quarter, year) and then divide this total cost by the number of units produced during the period. The basic formula for process costing is: Unit product cost Total manufacturing cost Total units produced Because one unit is indistinguishable from any other unit of a product, each unit produced during the period is assigned the same average cost. This costing technique results in a broad, average unit cost gure that applies to homogeneous units owing in a continuous stream out of the production process. Job-Order Costing Job-order costing is used in situations where many different products are produced each period. For example, a Levi Strauss clothing factory would typically make many different L EARNING OBJECTIVE 1 Distinguish between process costing and job-order costing and identify companies that would use each costing method. gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 90 12/23/08 2:30:21 AM user-s176 90 /broker/MH-BURR/MHBR094/MHBR094-03/upload/MHBR094-03 Chapter 3 types of jeans for both men and women during a month. A particular order might consist of 1,000 stonewashed mens blue denim jeans, style number A312. This order of 1,000 jeans is called a job. In a job-order costing system, costs are traced and allocated to jobs and then the costs of the job are divided by the number of units in the job to arrive at an average cost per unit. Other examples of situations where job-order costing would be used include large-scale construction projects managed by Bechtel International , commercial aircraft produced by Boeing, greeting cards designed and printed by Hallmark, and airline meals prepared by LSG SkyChefs. All of these examples are characterized by diverse outputs. Each Bechtel project is unique and different from every otherthe company may be simultaneously constructing a dam in Zaire and a bridge in Indonesia. Likewise, each airline orders a different type of meal from LSG SkyChefs catering service. Job-order costing is also used extensively in service industries. For example, hospitals, law rms, movie studios, accounting rms, advertising agencies, and repair shops all use a variation of job-order costing to accumulate costs. Although the detailed example of job-order costing provided in the following section deals with a manufacturing company, the same basic concepts and procedures are used by many service organizations. In this chapter, we focus on the design of a job-order costing system. In the following chapter, we focus on process costing and also look more closely at the similarities and differences between the two costing methods. IN BUSINESS IS THIS REALLY A JOB? VBT Bicycling Vacations of Bristol, Vermont, offers deluxe bicycling vacations in the United States, Canada, Europe, and other locations throughout the world. For example, the company offers a 10-day tour of the Puglia region of Italythe heel of the boot. The tour price includes international airfare, 10 nights of lodging, most meals, use of a bicycle, and ground transportation as needed. Each tour is led by at least two local tour leaders, one of whom rides with the guests along the tour route. The other tour leader drives a sag wagon that carries extra water, snacks, and bicycle repair equipment and is available for a shuttle back to the hotel or up a hill. The sag wagon also transports guests luggage from one hotel to another. Each specic tour can be considered a job. For example, Giuliano Astore and Debora Trippetti, two natives of Puglia, led a VBT tour with 17 guests over 10 days in late April. At the end of the tour, Giuliano submitted a report, a sort of job cost sheet, to VBT headquarters. This report detailed the on the ground expenses incurred for this specic tour, including fuel and operating costs for the van, lodging costs for the guests, the costs of meals provided to guests, the costs of snacks, the cost of hiring additional ground transportation as needed, and the wages of the tour leaders. In addition to these costs, some costs are paid directly by VBT in Vermont to vendors. The total cost incurred for the tour is then compared to the total revenue collected from guests to determine the gross prot for the tour. Sources: Giuliano Astore and Gregg Marston, President, VBT Bicycling Vacations. For more information about VBT, see www.vbt.com. Job-Order CostingAn Overview L EARNING OBJECTIVE 2 Identify the documents used in a job-order costing system. To introduce job-order costing, we will follow a specic job as it progresses through the manufacturing process. This job consists of two experimental couplings that Yost Precision Machining has agreed to produce for Loops Unlimited, a manufacturer of roller coasters. Couplings connect the cars on the roller coaster and are a critical component in the performance and gar79611_ch03_088-147.indd Page 91 12/23/08 2:30:48 AM user-s176 /broker/MH-BURR/MHBR094/MHBR094-03/upload/MHBR094-03 Systems Design: Job-Order Costing 91 safety of the ride. Before we begin our discussion, recall from the previous chapter that companies generally classify manufacturing costs into three broad categories: (1) direct materials, (2) direct labor, and (3) manufacturing overhead. As we study the operation of a job-order costing system, we will see how each of these three types of costs is recorded and accumulated. Yost Precision Machining is a small company in Michigan that specializes in fabricating precision metal parts that are used in a variety of applications ranging from deep-sea exploration vehicles to the inertial triggers in automobile air bags. The companys top managers gather every morning at 8:00 A.M. in the companys conference room for the daily planning meeting. Attending the meeting this morning are: Jean Yost, the companys president; David Cheung, the marketing manager; Debbie Turner, the production manager; and Marc White, the company controller. The president opened the meeting: Jean: The production schedule indicates well be starting Job 2B47 today. Isnt that the special order for experimental couplings, David? David: Thats right. Thats the order from Loops Unlimited for two couplings for their new roller coaster ride for Magic Mountain. Debbie: Why only two couplings? Dont they need a coupling for every car? David: Yes. But this is a completely new roller coaster. The cars will go faster and will be subjected to more twists, turns, drops, and loops than on any other existing roller coaster. To hold up under these stresses, Loops Unlimiteds engineers completely redesigned the cars and couplings. They want us to make just two of these new couplings for testing purposes. If the design works, then well have the inside track on the order to supply couplings for the whole ride. Jean: We agreed to take on this initial order at our cost just to get our foot in the door. Marc, will there be any problem documenting our cost so we can get paid? Marc: No problem. The contract with Loops stipulates that they will pay us an amount equal to our cost of goods sold. With our job-order costing system, I can tell you the cost on the day the job is completed. Jean: Good. Is there anything else we should discuss about this job at this time? No? Well then lets move on to the next item of business. Measuring Direct Materials Cost Each experimental coupling for Loops Unlimited will require three parts that are classied as direct materials: two G7 Connectors and one M46 Housing. This is a custom product that is being made for the rst time, but if this were one of the companys standard products, it would have an established bill of materials. A bill of materials is a document that lists the type and quantity of each type of direct material needed to complete a unit of product. In this case, there is no established bill of materials, so Yosts production staff determined the materials requirements from the blueprints submitted by the customer. Each coupling requires two connectors and one housing, so to make two couplings, four connectors and two housings are required. When an agreement has been reached with the customer concerning the quantities, prices, and shipment date for the order, a production order is issued. The Production Department then prepares a materials requisition form similar to the form in Exhibit 31. The materials requisition form is a document that species the type and quantity of materials to be drawn from the storeroom and identies the job that will be charged for the cost of the materials. The form is used to control the ow of materials into production and also for making entries in the accounting records. The Yost Precision Machining materials requisition form in Exhibit 31 shows that the companys Milling Department has requisitioned two M46 Housings and four G7 Connectors for the Loops Unlimited job, which has been designated as Job 2B47. A production worker presents the completed form to the storeroom clerk who then issues the specied materials to the worker. The storeroom clerk is not allowed to release materials without a completed and properly authorized materials requisition form. M ANAGERIAL ACCOUNTING IN ACTION The Issue gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 92 12/11/08 1:27:49 AM user-s180 92 /broker/MH-BURR/MHBR094/MHBR094-03/upload Chapter 3 E X H I B I T 31 Materials Requisition Form Materials Requistion Number 14873 Job Number to Be Charged 2B47 Department Milling Description Date March 2 Quantity Unit Cost Total Cost 2 4 $124 $103 $248 412 $660 M46 Housing G7 Connector Authorized Signature Job Cost Sheet After being notied that the production order has been issued, the Accounting Department prepares a job cost sheet like the one presented in Exhibit 32. A job cost sheet is a form prepared for a job that records the materials, labor, and manufacturing overhead costs charged to that job. After direct materials are issued, the Accounting Department records their costs on the job cost sheet. Note from Exhibit 32, for example, that the $660 cost for direct E X H I B I T 32 Job Cost Sheet Job Number 2B47 Department Milling Item Special order coupling JOB COST SHEET Date Initiated March 2 Date Completed Units Completed For Stock Direct Materials Req. No. Amount 14873 $660 Direct Labor Ticket Hours Amount 843 5 $45 Cost Summary Direct Materials Manufacturing Overhead Hours Rate Amount Units Shipped $ Direct Labor $ Manufacturing Overhead $ Total Cost $ Unit Product Cost $ Date Number Balance gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 93 12/11/08 1:27:49 AM user-s180 /broker/MH-BURR/MHBR094/MHBR094-03/upload 93 Systems Design: Job-Order Costing materials shown earlier on the materials requisition form has been charged to Job 2B47 on its job cost sheet. The requisition number 14873 from the materials requisition form is also recorded on the job cost sheet to make it easier to identify the source document for the direct materials charge. Measuring Direct Labor Cost Direct labor cost is handled similarly to direct materials cost. Direct labor consists of labor charges that are easily traced to a particular job. Labor charges that cannot be easily traced directly to any job are treated as part of manufacturing overhead. As discussed in the previous chapter, this latter category of labor costs is called indirect labor and includes tasks such as maintenance, supervision, and cleanup. Workers use time tickets to record the time they spend on each job and task. A completed time ticket is an hour-by-hour summary of the employees activities throughout the day. An example of an employee time ticket is shown in Exhibit 33. When working on a specic job, the employee enters the job number on the time ticket and notes the amount of time spent on that job. When not assigned to a particular job, the employee records the nature of the indirect labor task (such as cleanup and maintenance) and the amount of time spent on the task. At the end of the day, the time tickets are gathered and the Accounting Department calculates the wage cost for each entry on the time ticket and then enters the direct laborhours and costs on individual job cost sheets. (See Exhibit 32 for an example of how direct labor costs are entered on the job cost sheet.) The system we have just described is a manual method for recording and posting labor costs. Today many companies rely on computerized systems and no longer record labor time by hand on sheets of paper. One computerized approach uses bar codes to capture data. Each employee and each job has a unique bar code. When beginning work on a job, the employee scans three bar codes using a handheld device much like the bar code readers at grocery store checkout stands. The rst bar code indicates that a job is being started; the second is the unique bar code on the employees identity badge; and the third is the unique bar code of the job itself. This information is fed automatically via an electronic network to a computer that notes the time and records all of the data. When the task is completed, the employee scans a bar code indicating the task is complete, the bar code on his or her identity badge, and the bar code attached to the job. This information is relayed to the computer that again notes the time, and a time ticket is automatically prepared. Because all of the source data is already in computer les, the labor costs can be automatically posted to job cost sheets (or their electronic equivalents). Computers, coupled with technology such as bar codes, can eliminate much of the drudgery involved in routine bookkeeping activities while at the same time increasing timeliness and accuracy. Time Ticket No. 843 Employee Mary Holden Started 7:00 12:30 2:30 Totals Supervisor Ended 12:00 2:30 3:30 E X H I B I T 33 Employee Time Ticket Date March 3 Station 4 Time Completed 5.0 2.0 1.0 8.0 Rate $9 9 9 Amount $45 18 9 $72 Job Number 2B47 2B50 Maintenance gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 94 12/11/08 1:27:49 AM user-s180 94 /broker/MH-BURR/MHBR094/MHBR094-03/upload Chapter 3 IN BUSINESS BUCKING THE TREND: USING PEOPLE INSTEAD OF MACHINES For decades overhead costs have been going up and labor costs have been going down as companies have replaced people with machines. However, at the French automaker Renault, the exact opposite has been happening with its new, no-frills vehicle called the Logan. The Logan was intentionally stripped of costly elements and unnecessary technology so that the car could be sold for $6,000 in emerging Eastern European markets. The cars simplied design enables Renaults manufacturing plant in Romania to assemble the car almost entirely with people instead of robots. The monthly pay for a line worker at Renaults Romanian plant is $324 versus an average of more than $4,700 per worker in Western European countries. Thanks in part to low-cost labor, Logans production costs are estimated to be just $1,089 per unit. The Logan is nding buyers not only in emerging markets but also in more advanced Western European nations where customers have been clamoring for the car. Renault expects sales for the Logan to climb to one million vehicles by 2010adding $341 million to its prots. Source: Gail Edmondson and Constance Faivre dArcier, Got 5,000 Euros? Need a New Car? BusinessWeek, July 4, 2005, p. 49. L EARNING OBJECTIVE 3 Compute predetermined overhead rates and explain why estimated overhead costs (rather than actual overhead costs) are used in the costing process. Applying Manufacturing Overhead Recall that product costs include manufacturing overhead as well as direct materials and direct labor. Therefore, manufacturing overhead also needs to be recorded on the job cost sheet. However, assigning manufacturing overhead to a specic job involves some difculties. There are three reasons for this: 1. Manufacturing overhead is an indirect cost. This means that it is either impossible or difcult to trace these costs to a particular product or job. 2. Manufacturing overhead consists of many different items ranging from the grease used in machines to the annual salary of the production manager. 3. Because of the xed costs in manufacturing overhead, total manufacturing overhead costs tend to remain relatively constant from one period to the next even though the number of units produced can uctuate widely. Consequently, the average cost per unit will vary from one period to the next. Given these problems, allocation is used to assign overhead costs to products. Allocation is accomplished by selecting an allocation base that is common to all of the companys products and services. An allocation base is a measure such as direct laborhours (DLH) or machine-hours (MH) that is used to assign overhead costs to products and services. The most widely used allocation bases in manufacturing are direct laborhours, direct labor cost, machine-hours and (where a company has only a single product) units of product. Manufacturing overhead is commonly applied to products using a predetermined overhead rate. The predetermined overhead rate is computed by dividing the total estimated manufacturing overhead cost for the period by the estimated total amount of the allocation base as follows: Predetermined overhead rate Estimated total manufacturing overhead cost Estimated total amount of the allocation base The predetermined overhead rate is computed before the period begins. The rst step is to estimate the amount of the allocation base that will be required to support operations in the upcoming period. The second step is to estimate the total manufacturing cost at that level of activity. The third step is to compute the predetermined overhead rate. We will have more to say about the rst and second steps in subsequent chapters. In this chapter we will assume that the total amount of the allocation base and the total manufacturing overhead costs have already been estimated. gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 95 12/11/08 1:27:50 AM user-s180 /broker/MH-BURR/MHBR094/MHBR094-03/upload Systems Design: Job-Order Costing To repeat, the predetermined overhead rate is computed before the period begins. The predetermined overhead rate is then used to apply overhead cost to jobs throughout the period. The process of assigning overhead cost to jobs is called overhead application. The formula for determining the amount of overhead cost to apply to a particular job is: Overhead applied to a particular job Predetermined overhead rate Amount of the allocation base incurred by the job For example, if the predetermined overhead rate is $8 per direct labor-hour, then $8 of overhead cost is applied to a job for each direct labor-hour incurred on the job. When the allocation base is direct labor-hours, the formula becomes: Overhead applied to a particular job Predetermined overhead rate Actual direct labor-hours charged to the job Using the Predetermined Overhead Rate To illustrate the steps involved in computing and using a predetermined overhead rate, lets return to Yost Precision Machining. The company has estimated that 40,000 direct labor-hours would be required to support the production planned for the year and that the total manufacturing overhead costs would be $320,000 at that level of activity. Consequently, its predetermined overhead rate for the year would be $8 per direct labor-hour, as shown below: Predetermined overhead rate Estimated total manufacturing overhead cost Estimated total amount of the allocation base $320,000 40,000 direct labor-hours $8 per direct labor-hour The job cost sheet in Exhibit 34 indicates that 27 direct labor-hours (i.e., DLHs) were charged to Job 2B47. Therefore, a total of $216 of manufacturing overhead cost would be applied to the job: Overhead applied to Job 2B47 Predetermined overhead rate $8 per DLH Actual direct labor-hours charged to Job 2B47 27 DLHs $216 of overhead applied to Job 2B47 This amount of overhead has been entered on the job cost sheet in Exhibit 34. Note that this is not the actual amount of overhead caused by the job. Actual overhead costs are not assigned to jobsif that could be done, the costs would be direct costs, not overhead. The overhead assigned to the job is simply a share of the total overhead that was estimated at the beginning of the year. A normal cost system, which we have been describing, applies overhead to jobs by multiplying a predetermined overhead rate by the actual amount of the allocation base incurred by the jobs. Overhead may be applied as direct labor-hours are charged to jobs, or all of the overhead can be applied when the job is completed. The choice is up to the company. However, if a job is not completed at the end of the accounting period, overhead should be applied to that job so that the cost of work in process inventory can be determined. The Need for a Predetermined Rate Instead of using a predetermined rate based on estimates, why not base the overhead rate on the actual total manufacturing overhead cost and the actual total amount of the allocation base incurred on a monthly, quarterly, or annual basis? If an actual rate is computed monthly or quarterly, seasonal factors in overhead costs or in the allocation base can produce uctuations in the overhead rate. For example, the costs of heating and cooling a factory in Illinois will be highest in the winter and summer months and lowest in the 95 gar79611_ch03_088-147.indd Page 96 12/11/08 1:27:50 AM user-s180 96 /broker/MH-BURR/MHBR094/MHBR094-03/upload Chapter 3 E X H I B I T 34 A Completed Job Cost Sheet JOB COST SHEET Date Initiated March 2 Date Completed March 8 Job Number 2B47 Department Milling Item Special order coupling For Stock Direct Materials Req. No. Amount 14873 14875 14912 $ 660 506 238 $1,404 Ticket Units Completed Direct Labor Hours Amount 843 846 850 851 5 8 4 10 27 $ 45 60 21 54 $180 Cost Summary 2 Manufacturing Overhead Hours Rate Amount 27 $8/DLH $216 Units Shipped Direct Materials $1,404 Date Number Balance Direct Labor $ 180 March 8 2 Manufacturing Overhead $ 216 Total Product Cost $1,800 Unit Product Cost $ 900* *$1,800 2 units = $900 per unit. spring and fall. If the overhead rate is recomputed at the end of each month or each quarter based on actual costs and activity, the overhead rate would go up in the winter and summer and down in the spring and fall. As a result, two identical jobs, one completed in the winter and one completed in the spring, would be assigned different manufacturing overhead costs. Many managers believe that such uctuations in product costs serve no useful purpose. To avoid such uctuations, actual overhead rates could be computed on an annual or less-frequent basis. However, if the overhead rate is computed annually based on the actual costs and activity for the year, the manufacturing overhead assigned to any particular job would not be known until the end of the year. For example, the cost of Job 2B47 at Yost Precision Machining would not be known until the end of the year, even though the job will be completed and shipped to the customer in March. For these reasons, most companies use predetermined overhead rates rather than actual overhead rates in their cost accounting systems. Choice of an Allocation Base for Overhead Cost Ideally, the allocation base in the predetermined overhead rate should drive the overhead cost. A cost driver is a factor, such as machine-hours, beds occupied, computer time, or ight-hours, that causes overhead costs. If the base in the predetermined overhead rate does not drive overhead costs, product costs will be distorted. For example, if direct labor-hours is used to allocate overhead, but in reality overhead has little to do with direct labor-hours, then products with high direct labor-hour requirements will be overcosted. gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 97 12/11/08 1:27:50 AM user-s180 /broker/MH-BURR/MHBR094/MHBR094-03/upload 97 Systems Design: Job-Order Costing Most companies use direct labor-hours or direct labor cost as the allocation base for manufacturing overhead. However, as discussed in earlier chapters, major shifts are taking place in the structure of costs. In the past, direct labor accounted for up to 60% of the cost of many products, with overhead cost making up only a portion of the remainder. This situation has been changing for two reasons. First, sophisticated automated equipment has taken over functions that used to be performed by direct labor workers. Because the costs of acquiring and maintaining such equipment are classied as overhead, this increases overhead while decreasing direct labor. Second, products are becoming more sophisticated and complex and are changed more frequently. This increases the need for highly skilled indirect workers such as engineers. As a result of these two trends, direct labor has decreased relative to overhead as a component of product costs. In companies where direct labor and overhead costs have been moving in opposite directions, it would be difcult to argue that direct labor drives overhead costs. Accordingly, managers in some companies use activity-based costing principles to redesign their cost accounting systems. Activity-based costing is designed to more accurately reect the demands that products, customers, and other cost objects make on overhead resources. The activity-based approach is discussed in more detail in Chapter 8. Although direct labor may not be an appropriate allocation base in some industries, in others it continues to be a signicant driver of manufacturing overhead. Indeed, most manufacturing companies in the United States continue to use direct labor as the primary or secondary allocation base for manufacturing overhead. The key point is that the allocation base used by the company should really drive, or cause, overhead costs, and direct labor is not always the most appropriate allocation base. WAIST MANAGEMENT IN BUSINESS Research from the University of Michigan suggests that a companys health-care costs are driven to a signicant extent by the weight of its employees. Workers who are overweight can cost as much as $1,500 more per year to insure than other workers. So what is a company to do? Park Place Entertainment, a casino operator with more than 7,000 employees, decided to attack the problem by holding a weight-loss contest. Over two years, the companys workforce dropped 20 tons of weight. After the contest, 12 diabetics were able to stop using medications that cost $13,300 per year per employee. Additionally, the company believes that its contest caused a decline in absenteeism and an increase in productivity. Source: Jill Hecht Maxwell, Worker Waist Management, Inc. magazine, August 2004, p. 32; Jessi Hempel, Dieting for Dollars, BusinessWeek, November 3, 2003, p. 10. THE COST OF COMPLEXITY AT CHRYSLER While direct labor is an important cost driver for many companies, other cost drivers can inuence protability. For example, Chryslers 2007 Dodge Nitro was available to buyers in 167,000 congurations. The costs of supporting seven exterior paint colors, two engine options, three trim levels, ve feature packages, and up to 17 additional options for each of the ve feature packages were exorbitant. By contrast, the Honda CR-V, which outsells the Nitro by a ratio of more than 2:1, comes in only 88 congurations. Chryslers CEO, Thomas LaSorda, plans to redesign the 2008 Nitro so that it can be ordered in only 650 congurations. Similarly, he plans to reduce the number of congurations available in the 2008 Pacica from 35,820 to 680. When asked if customers will complain about the cutbacks in available options, Chryslers Vice President of Marketing J. Bartoli said, If theres no one out there asking for it, have you really taken anything away? Source: Joann Muller, Multiplication Problems, Forbes, May 21, 2007, p. 48. IN BUSINESS gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 98 12/23/08 2:31:15 AM user-s176 98 /broker/MH-BURR/MHBR094/MHBR094-03/upload/MHBR094-03 Chapter 3 Computation of Unit Costs With the application of Yost Precision Machinings $216 of manufacturing overhead to the job cost sheet in Exhibit 34, the job cost sheet is complete except for two nal steps. First, the totals for direct materials, direct labor, and manufacturing overhead are transferred to the Cost Summary section of the job cost sheet and added together to obtain the total cost for the job. Then the total product cost ($1,800) is divided by the number of units (2) to obtain the unit product cost ($900). As indicated earlier, this unit product cost is an average cost and should not be interpreted as the cost that would actually be incurred if another unit were produced. The incremental cost of an additional unit is something less than the average unit cost of $900 because much of the actual overhead costs would not change if another unit were produced. The completed job cost sheet will serve as the basis for valuing unsold units in ending inventory and for determining cost of goods sold. Summary of Document Flows The sequence of events that we have discussed above, from receiving an order to completing a job, is summarized in Exhibit 35. M ANAGERIAL ACCOUNTING IN ACTION The Wrap-up In the 8:00 A.M. daily planning meeting on March 9, Jean Yost, the president of Yost Precision Machining, once again drew attention to Job 2B47, the experimental couplings: Jean: I see Job 2B47 is completed. Lets get those couplings shipped immediately to Loops Unlimited so they can get their testing program under way. Marc, how much are we going to bill Loops for those two units? Marc: Because we agreed to sell the experimental couplings at cost, we will be charging Loops Unlimited just $900 a unit. Jean: Fine. Lets hope the couplings work out and we make some money on the big order later. Job-Order CostingThe Flow of Costs L EARNING OBJECTIVE 4 Understand the ow of costs in a job-order costing system and prepare appropriate journal entries to record costs. We are now ready to take a more detailed look at the ow of costs through the companys general ledger. To illustrate, we will consider a single months activity at Ruger Corporation, a producer of gold and silver commemorative medallions. Ruger Corporation has two jobs in process during April, the rst month of its scal year. Job A, a special minting of 1,000 gold medallions commemorating the invention of motion pictures, was started during March. By the end of March, $30,000 in manufacturing costs had been recorded for the job. Job B, an order for 10,000 silver medallions commemorating the fall of the Berlin Wall, was started in April. The Purchase and Issue of Materials On April 1, Ruger Corporation had $7,000 in raw materials on hand. During the month, the company purchased on account an additional $60,000 in raw materials. The purchase is recorded in journal entry (1) below: (1) Raw Materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000 Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000 As explained in the previous chapter, Raw Materials is an asset account. Thus, when raw materials are purchased, they are initially recorded as an assetnot as an expense. Sales order A sales order is prepared as a basis for issuing a Production order A production order initiates work on a job. Costs are charged through E X H I B I T 35 The Flow of Documents in a Job-Order Costing System Predetermined overhead rates Direct labor time ticket Materials requisition form These production costs are accumulated on a form, prepared by the accounting department, known as a Job cost sheet The job cost sheet is used to compute unit product costs that in turn are used to value ending inventories and to determine cost of goods sold. gar79611_ch03_088-147.indd Page 99 12/11/08 1:27:54 AM user-s180 /broker/MH-BURR/MHBR094/MHBR094-03/upload 99 gar79611_ch03_088-147.indd Page 100 12/11/08 1:27:54 AM user-s180 100 /broker/MH-BURR/MHBR094/MHBR094-03/upload Chapter 3 Issue of Direct and Indirect Materials During April, $52,000 in raw materials were requisitioned from the storeroom for use in production. These raw materials included $50,000 of direct and $2,000 of indirect materials. Entry (2) records issuing the materials to the production departments. (2) Work in Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Raw Materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000 2,000 52,000 The materials charged to Work in Process represent direct materials for specic jobs. These costs are also recorded on the appropriate job cost sheets. This point is illustrated in Exhibit 36, where $28,000 of the $50,000 in direct materials is charged to Job As cost sheet and the remaining $22,000 is charged to Job Bs cost sheet. (In this example, all data are presented in summary form and the job cost sheet is abbreviated.) The $2,000 charged to Manufacturing Overhead in entry (2) represents indirect materials. Observe that the Manufacturing Overhead account is separate from the Work in Process account. The purpose of the Manufacturing Overhead account is to accumulate all manufacturing overhead costs as they are incurred during a period. Before leaving Exhibit 36 we need to point out one additional thing. Notice from the exhibit that the job cost sheet for Job A contains a beginning balance of $30,000. We stated earlier that this balance represents the cost of work done during March that has been carried forward to April. Also note that the Work in Process account contains the same $30,000 balance. Thus, the Work in Process account summarizes all of the costs appearing on the job cost sheets of the jobs that are in process. Job A was the only job in process at the beginning of April, so the beginning balance in the Work in Process account equals Job As beginning balance of $30,000. Labor Cost Employee time tickets are lled out by workers, collected, and forwarded to the Accounting Department. In the Accounting Department, wages are computed and the resulting E X H I B I T 36 Raw Materials Cost Flows Work in Process Raw Materials Bal. 7,000 (2) 52,000 (1) 60,000 Manufacturing Overhead Bal. 30,000 (2) 50,000 Job Cost Sheet Job A Balance. . . . . . . . . . $30,000 Direct materials. . . $28,000 (2) 2,000 Job Cost Sheet Job B Balance. . . . . . . . . . $0 Direct materials. . . $22,000 Indirect materials Materials Requisition Forms $52,000 Direct materials gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 101 12/11/08 1:27:55 AM user-s180 /broker/MH-BURR/MHBR094/MHBR094-03/upload 101 Systems Design: Job-Order Costing E X H I B I T 37 Labor Cost Flows Salaries and Wages Payable (3) 75,000 Work in Process Manufacturing Overhead (2) 2,000 (3) 15,000 Bal. 30,000 (2) 50,000 (3) 60,000 Job Cost Sheet Job A Balance. . . . . . . . . . $30,000 Direct materials. . . $28,000 Direct labor. . . . . . . $40,000 Job Cost Sheet Job B Balance. . . . . . . . . . $0 Direct materials. . . $22,000 Direct labor. . . . . . . $20,000 Indirect labor Direct labor Various Time Tickets $75,000 costs are classied as either direct or indirect labor. In April, $60,000 was recorded for direct labor and $15,000 for indirect labor. The following entry summarizes those events: (3) Work in Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Salaries and Wages Payable . . . . . . . . . . . . . . . . . . . . . . . . . 60,000 15,000 75,000 Only the direct labor cost of $60,000 is added to the Work in Process account. At the same time that direct labor costs are added to Work in Process, they are also added to the individual job cost sheets, as shown in Exhibit 37. During April, $40,000 of direct labor cost was charged to Job A and the remaining $20,000 was charged to Job B. The labor costs charged to Manufacturing Overhead represent the indirect labor costs of the period, such as supervision, janitorial work, and maintenance. Manufacturing Overhead Costs Recall that all manufacturing costs other than direct materials and direct labor are classied as manufacturing overhead costs. These costs are entered directly into the Manufacturing Overhead account as they are incurred. To illustrate, assume that Ruger Corporation incurred the following general factory costs during April: Utilities (heat, water, and power) . . . . . . . . . . . Rent on factory equipment . . . . . . . . . . . . . . . Miscellaneous factory overhead costs . . . . . . . $21,000 16,000 3,000 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $40,000 gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 102 12/11/08 1:27:55 AM user-s180 102 /broker/MH-BURR/MHBR094/MHBR094-03/upload Chapter 3 The following entry records the incurrence of these costs: (4) Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts Payable* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 40,000 *Accounts such as Cash may also be credited In addition, assume that during April, Ruger Corporation recognized $13,000 in accrued property taxes and that $7,000 in prepaid insurance expired on factory buildings and equipment. The following entry records these items: (5) Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Property Taxes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Prepaid Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 13,000 7,000 Finally, assume that the company recognized $18,000 in depreciation on factory equipment during April. The following entry records the accrual of this depreciation: (6) Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accumulated Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,000 18,000 In short, manufacturing overhead costs are recorded directly into the Manufacturing Overhead account as they are incurred. Applying Manufacturing Overhead L EARNING OBJECTIVE 5 Apply overhead cost to Work in Process using a predetermined overhead rate. Because actual manufacturing costs are charged to the Manufacturing Overhead control account rather than to Work in Process, how are manufacturing overhead costs assigned to Work in Process? The answer is, by means of the predetermined overhead rate. Recall from our discussion earlier in the chapter that a predetermined overhead rate is established at the beginning of each year. The rate is calculated by dividing the estimated total manufacturing overhead cost for the year by the estimated total amount of the allocation base (measured in machine-hours, direct labor-hours, or some other base). The predetermined overhead rate is then used to apply overhead costs to jobs. For example, if machine-hours is the allocation base, overhead cost is applied to each job by multiplying the predetermined overhead rate by the number of machine-hours charged to the job. To illustrate, assume that Ruger Corporations predetermined overhead rate is $6 per machine-hour. Also assume that during April, 10,000 machine-hours were worked on Job A and 5,000 machine-hours were worked on Job B (a total of 15,000 machine-hours). Thus, $90,000 in overhead cost ($6 per machine-hour 15,000 machine-hours $90,000) would be applied to Work in Process. The following entry records the application of Manufacturing Overhead to Work in Process: (7) Work in Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000 90,000 The ow of costs through the Manufacturing Overhead account is shown in Exhibit 38. The actual overhead costs on the debit side in the Manufacturing Overhead account in Exhibit 38 are the costs that were added to the account in entries (2)(6). Observe that recording these actual overhead costs [entries (2)(6)] and the application of overhead to Work in Process [entry (7)] represent two separate and entirely distinct processes. gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 103 12/11/08 1:58:19 AM user-s180 /broker/MH-BURR/MHBR094/MHBR094-03/upload 103 Systems Design: Job-Order Costing Manufacturing Overhead Work in Process Bal. 30,000 (2) 50,000 (3) 60,000 (7) 90,000 Actual overhead costs Balance Job Cost Sheet Job A Balance. . . . . . . . . . . . . . . . . . $30,000 Direct materials. . . . . . . . . . . $28,000 Direct labor. . . . . . . . . . . . . . . $40,000 Manufacturing overhead. . . $60,000 Total. . . . . . . . . . . . . . . . . . . . . $158,000 (2) (3) (4) (5) (6) 2,000 (7) 15,000 40,000 20,000 18,000 95,000 5,000 90,000 Applied overhead costs 90,000 Job Cost Sheet Job B Balance. . . . . . . . . . . . . . . . . . . Direct materials. . . . . . . . . . . . Direct labor. . . . . . . . . . . . . . . . Manufacturing overhead. . . Total. . . . . . . . . . . . . . . . . . . . . . $0 $22,000 $20,000 $30,000 $72,000 Overhead Applied to Work in Process $6 per machine-hour 15,000 machine-hours = $90,000 The Concept of a Clearing Account The Manufacturing Overhead account operates as a clearing account. As we have noted, actual factory overhead costs are debited to the account as they are incurred throughout the year. When a job is completed (or at the end of an accounting period), overhead cost is applied to the job using the predetermined overhead rate, and Work in Process is debited and Manufacturing Overhead is credited. This sequence of events is illustrated below: Manufacturing Overhead (a clearing account) Actual overhead costs are charged to this account as they are incurred throughout the period. Overhead is applied to Work in Process using the predetermined overhead rate. As we emphasized earlier, the predetermined overhead rate is based entirely on estimates of what the level of activity and overhead costs are expected to be, and it is established before the year begins. As a result, the overhead cost applied during a year will almost certainly turn out to be more or less than the actual overhead cost incurred. For example, notice from Exhibit 38 that Ruger Corporations actual overhead costs for the period are $5,000 greater than the overhead cost that has been applied to Work in Process, resulting in a $5,000 debit balance in the Manufacturing Overhead account. We will reserve discussion of what to do with this $5,000 balance until the next section, Problems of Overhead Application. For the moment, we can conclude from Exhibit 38 that the cost of a completed job consists of the actual direct materials cost of the job, the actual direct labor cost of the job, and the manufacturing overhead cost applied to the job. Pay particular attention to the following subtle but important point: Actual overhead costs are not charged to jobs; actual overhead costs do not appear on the job cost sheet nor do they appear E X H I B I T 38 The Flow of Costs in Overhead Application gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 104 12/11/08 1:27:55 AM user-s180 104 /broker/MH-BURR/MHBR094/MHBR094-03/upload Chapter 3 in the Work in Process account. Only the applied overhead cost, based on the predetermined overhead rate, appears on the job cost sheet and in the Work in Process account. Nonmanufacturing Costs In addition to manufacturing costs, companies also incur selling and administrative costs. As explained in the previous chapter, these costs should be treated as period expenses and charged directly to the income statement. Nonmanufacturing costs should not go into the Manufacturing Overhead account. To illustrate the correct treatment of nonmanufacturing costs, assume that Ruger Corporation incurred $30,000 in selling and administrative salary costs during April. The following entry summarizes the accrual of those salaries: (8) Salaries Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Salaries and Wages Payable . . . . . . . . . . . . . . . . . . . . . . . . 30,000 30,000 Assume that depreciation on ofce equipment during April was $7,000. The entry is as follows: (9) Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accumulated Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000 7,000 Pay particular attention to the difference between this entry and entry (6) where we recorded depreciation on factory equipment. In journal entry (6), depreciation on factory equipment was debited to Manufacturing Overhead and is therefore a product cost. In journal entry (9) above, depreciation on ofce equipment is debited to Depreciation Expense. Depreciation on ofce equipment is a period expense rather than a product cost. Finally, assume that advertising was $42,000 and that other selling and administrative expenses in April totaled $8,000. The following entry records these items: (10) Advertising Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other Selling and Administrative Expense . . . . . . . . . . . . . . . . Accounts Payable* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42,000 8,000 50,000 *Other accounts, such as Cash may be credited. The amounts in entries (8) through (10) all go directly into expense accountsthey have no effect on product costs. The same will be true of any other selling and administrative expenses incurred during April, including sales commissions, depreciation on sales equipment, rent on ofce facilities, insurance on ofce facilities, and related costs. L EARNING OBJECTIVE 6 Prepare schedules of cost of goods manufactured and cost of goods sold. Cost of Goods Manufactured When a job has been completed, the nished output is transferred from the production departments to the nished goods warehouse. By this time, the accounting department will have charged the job with direct materials and direct labor cost, and manufacturing overhead will have been applied using the predetermined overhead rate. A transfer of costs is made within the costing system that parallels the physical transfer of goods to the nished goods warehouse. The costs of the completed job are transferred out of the Work in Process account and into the Finished Goods account. The sum of all amounts gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 105 12/11/08 1:27:55 AM user-s180 /broker/MH-BURR/MHBR094/MHBR094-03/upload 105 Systems Design: Job-Order Costing transferred between these two accounts represents the cost of goods manufactured for the period. In the case of Ruger Corporation, assume that Job A was completed during April. The following entry transfers the cost of Job A from Work in Process to Finished Goods: (11) Finished Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Work in Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158,000 158,000 The $158,000 represents the completed cost of Job A, as shown on the job cost sheet in Exhibit 38. Because Job A was the only job completed during April, the $158,000 also represents the cost of goods manufactured for the month. Job B was not completed by the end of the month, so its cost will remain in the Work in Process account and carry over to the next month. If a balance sheet is prepared at the end of April, the cost accumulated thus far on Job B will appear as the asset Work in Process inventory. Cost of Goods Sold As nished goods are shipped to customers, their accumulated costs are transferred from the Finished Goods account to the Cost of Goods Sold account. If an entire job is shipped at one time, then the entire cost appearing on the job cost sheet is transferred to the Cost of Goods Sold account. In most cases, however, only a portion of the units involved in a particular job will be immediately sold. In these situations, the unit product cost must be used to determine how much product cost should be removed from Finished Goods and charged to Cost of Goods Sold. For Ruger Corporation, we will assume 750 of the 1,000 gold medallions in Job A were shipped to customers by the end of the month for total sales revenue of $225,000. Because 1,000 units were produced and the total cost of the job from the job cost sheet was $158,000, the unit product cost was $158. The following journal entries would record the sale (all sales were on account): (12) Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (13) Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Finished Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (750 units $158 per unit $118,500) . . . . . . . . . . . . . . . 225,000 225,000 118,500 118,500 Entry (13) completes the ow of costs through the job-order costing system. Summary of Cost Flows To pull the entire Ruger Corporation example together, journal entries (1) through (13) are summarized in Exhibit 39. The ow of costs through the accounts is presented in T-account form in Exhibit 310 (page 107). Exhibit 311 (page 108) presents a schedule of cost of goods manufactured and a schedule of cost of goods sold for Ruger Corporation. Note particularly from Exhibit 311 that the manufacturing overhead cost on the schedule of cost of goods manufactured is the overhead applied to jobs during the monthnot the actual manufacturing overhead costs incurred. The reason for this can be traced back to journal entry (7) and the T-account for Work in Process that appears in Exhibit 310. Under a normal costing system as illustrated in this chapter, appliednot actualoverhead costs are applied to jobs and thus to Work in Process inventory. L EARNING OBJECTIVE 7 Use T-accounts to show the ow of costs in a job-order costing system. gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 106 12/11/08 1:27:56 AM user-s180 106 E X H I B I T 39 Summary of Ruger Corporation Journal Entries /broker/MH-BURR/MHBR094/MHBR094-03/upload Chapter 3 (1) Raw Materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000 (2) Work in Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Raw Materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000 2,000 (3) Work in Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Salaries and Wages Payable . . . . . . . . . . . . . . . . . . . . . . . . . 60,000 15,000 (4) Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 (5) Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Property Taxes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Prepaid Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000 52,000 75,000 40,000 20,000 13,000 7,000 (6) Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accumulated Depreciation. . . . . . . . . . . . . . . . . . . . . . . . . . . 18,000 (7) Work in Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000 (8) Salaries Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Salaries and Wages Payable . . . . . . . . . . . . . . . . . . . . . . . . . 30,000 (9) Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accumulated Depreciation. . . . . . . . . . . . . . . . . . . . . . . . . . . (10) Advertising Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other Selling and Administrative Expense . . . . . . . . . . . . . . . . Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,000 90,000 30,000 7,000 7,000 42,000 8,000 50,000 (11) Finished Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Work in Process. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158,000 (12) Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225,000 (13) Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Finished Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118,500 158,000 225,000 118,500 gar79611_ch03_088-147.indd Page 107 12/11/08 1:27:56 AM user-s180 /broker/MH-BURR/MHBR094/MHBR094-03/upload 107 Systems Design: Job-Order Costing E X H I B I T 310 Summary of Cost FlowsRuger Corporation Accounts Receivable Bal. (12) Accounts Payable XX 225,000 Bal. (1) (4) (10) Prepaid Insurance Capital Stock XX 60,000 40,000 50,000 Bal. XX Retained Earnings Bal. Bal. (5) 7,000 Bal. (3) (8) Raw Materials Bal. (1) Bal. 7,000 60,000 15,000 (2) 30,000 50,000 60,000 90,000 72,000 Sales XX 75,000 30,000 (12) 52,000 Bal. (5) (11) 158,000 XX 13,000 (13) 10,000 158,000 49,500 118,500 Salaries Expense (8) 30,000 Depreciation Expense (9) Finished Goods Bal. (11) Bal. 225,000 Cost of Goods Sold Property Taxes Payable Work in Process Bal. (2) (3) (7) Bal. XX Salaries and Wages Payable XX (13) 7,000 Advertising Expense 118,500 (10) 42,000 Other Selling and Administrative Expense Accumulated Depreciation (10) Bal. (6) (9) 8,000 XX 18,000 7,000 Manufacturing Overhead (2) (3) (4) (5) (6) Bal. 2,000 15,000 40,000 20,000 18,000 95,000 5,000 (7) 90,000 90,000 Explanation of entries: (1) Raw materials purchased. (2) Direct and indirect materials issued into production. (3) Direct and indirect factory labor cost incurred. (4) Utilities and other factory costs incurred. (5) Property taxes and insurance incurred on the factory. (6) Depreciation recorded on factory assets. (7) Overhead cost applied to Work in Process. (8) Administrative salaries expense incurred. (9) Depreciation recorded on ofce equipment. (10) Advertising and other selling and administrative expense incurred. (11) Cost of goods manufactured transferred to nished goods. (12) Sale of Job A recorded. (13) Cost of goods sold recorded for Job A. gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 108 12/11/08 1:27:56 AM user-s180 108 E X H I B I T 311 Schedules of Cost of Goods Manufactured and Cost of Goods Sold /broker/MH-BURR/MHBR094/MHBR094-03/upload Chapter 3 Cost of Goods Manufactured Direct materials: Raw materials inventory, beginning . . . . . . . . . . . . . . . . Add: Purchases of raw materials . . . . . . . . . . . . . . . . . . $ 7,000 60,000 Total raw materials available . . . . . . . . . . . . . . . . . . . . . . Deduct: Raw materials inventory, ending . . . . . . . . . . . . 67,000 15,000 Raw materials used in production. . . . . . . . . . . . . . . . . . Deduct: Indirect materials included in manufacturing overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52,000 2,000 $ 50,000 Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Manufacturing overhead applied to work in process . . . . . 60,000 90,000 Total manufacturing costs. . . . . . . . . . . . . . . . . . . . . . . . . . Add: Beginning work in process inventory . . . . . . . . . . . . . 200,000 30,000 Deduct: Ending work in process inventory . . . . . . . . . . . . . 230,000 72,000 Cost of goods manufactured . . . . . . . . . . . . . . . . . . . . . . . $158,000 Cost of Goods Sold Finished goods inventory, beginning . . . . . . . . . . . . . . . . . Add: Cost of goods manufactured . . . . . . . . . . . . . . . . . . . $ 10,000 158,000 Goods available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . Deduct: Finished goods inventory, ending . . . . . . . . . . . . . 168,000 49,500 Unadjusted cost of goods sold . . . . . . . . . . . . . . . . . . . . . . Add: Underapplied overhead . . . . . . . . . . . . . . . . . . . . . . . 118,500 5,000 Adjusted cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . $123,500 *Note that the underapplied overhead is added to cost of goods sold. If overhead were overapplied, it would be deducted from cost of goods sold. Note also, as shown in Exhibit 311, that the cost of goods manufactured for the month ($158,000) agrees with the amount transferred from Work in Process to Finished Goods for the month as recorded earlier in entry (11). Also note that this $158,000 is used in computing the cost of goods sold for the month. If you carefully compare the Schedule of Cost of Goods Manufactured in Exhibit 311 to the Schedule of Cost of Goods Manufactured in Chapter 2, you will see two differences. First, when the direct materials cost is computed in Exhibit 311, the cost of the indirect materials included in manufacturing overhead is deducted from the raw materials used in production. This was not done in Chapter 2 because the examples we used did not involve any indirect materials. Second, you may have noticed that the term Manufacturing overhead applied to work in process is used in the schedule in this chapter whereas the simpler term Manufacturing overhead was used in Chapter 2. We did not want to get into the complications involved in applying overhead in the last chapter, so we used the simpler term without specifying where the manufacturing overhead cost comes from. In this chapter, we have learned that the manufacturing overhead cost is applied to jobs by multiplying the predetermined overhead rate by the amount of the allocation base recorded for the jobs. If you carefully compare the Schedule of Cost of Goods Sold in Exhibit 311 to the Income Statement for Graham Manufacturing in Chapter 2, you will also note that there is a difference in the way the cost of goods sold is computed. In Exhibit 311, something called Underapplied overhead is added to the unadjusted cost of goods sold to arrive at the adjusted cost of goods sold. In the next section we will discuss what this means. Finally, an income statement for April is presented in Exhibit 312. Observe that the cost of goods sold on this statement ($123,500) is carried over from Exhibit 311. gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 109 12/11/08 1:27:57 AM user-s180 /broker/MH-BURR/MHBR094/MHBR094-03/upload 109 Systems Design: Job-Order Costing E X H I B I T 312 Income Statement Ruger Corporation Income Statement For the Month Ending April 30 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost of goods sold ($118,500 $5,000) . . . . . . . . . . . . $225,000 123,500 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Selling and administrative expenses: Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . . Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . Other expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101,500 Net operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . $30,000 7,000 42,000 8,000 87,000 $ 14,500 Problems of Overhead Application We need to consider two complications relating to overhead application: (1) underapplied and overapplied overhead; and (2) the disposition of any balance remaining in the Manufacturing Overhead account at the end of a period. Underapplied and Overapplied Overhead Because the predetermined overhead rate is established before the period begins and is based entirely on estimated data, the overhead cost applied to Work in Process will generally differ from the amount of overhead cost actually incurred. In the case of Ruger Corporation, for example, the predetermined overhead rate of $6 per hour was used to apply $90,000 of overhead cost to Work in Process, whereas actual overhead costs for April proved to be $95,000 (see Exhibit 38). The difference between the overhead cost applied to Work in Process and the actual overhead costs of a period is called either underapplied or overapplied overhead. For Ruger Corporation, overhead was underapplied by $5,000 because the applied cost ($90,000) was $5,000 less than the actual cost ($95,000). If the situation had been reversed and the company had applied $95,000 in overhead cost to Work in Process while incurring actual overhead costs of only $90,000, then the overhead would have been overapplied. What is the cause of underapplied or overapplied overhead? The causes can be complex, and a full explanation will have to wait for later chapters. Nevertheless, the basic problem is that the method of applying overhead to jobs using a predetermined overhead rate assumes that actual overhead costs will be proportional to the actual amount of the allocation base incurred during the period. If, for example, the predetermined overhead rate is $6 per machine-hour, then it is assumed that actual overhead costs incurred will be $6 for every machine-hour that is actually worked. There are at least two reasons why this may not be true. First, much of the overhead often consists of xed costs that do not change as the number of machine-hours incurred goes up or down. Second, spending on overhead items may or may not be under control. If individuals who are responsible for overhead costs do a good job, those costs should be less than were expected at the beginning of the period. If they do a poor job, those costs will be more than expected. Nevertheless, as we indicated above a fuller explanation of the causes of underapplied and overapplied overhead will have to wait for later chapters. To illustrate what can happen, suppose that two companiesTurbo Crafters and Black & Howellhave prepared the following estimated data for the coming year: L EARNING OBJECTIVE 8 Compute underapplied or overapplied overhead cost and prepare the journal entry to close the balance in Manufacturing Overhead to the appropriate accounts. gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 110 12/23/08 5:01:33 PM user-s180 110 /Users/user-s180/Desktop/Dhiru-23-12-08/New/MHBR094-03 Chapter 3 Turbo Crafters Allocation base . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Estimated manufacturing overhead cost (a) . . . . . . . . . . Estimated total amount of the allocation base (b) . . . . . . Predetermined overhead rate (a) (b) . . . . . . . . . . . . . . Black & Howell Machine-hours $300,000 75,000 machine-hours $4 per machine-hour Direct materials cost $120,000 $80,000 direct materials cost 150% of direct materials cost Note that when the allocation base is dollars (such as direct materials cost in the case of Black & Howell) the predetermined overhead rate is expressed as a percentage of the allocation base. When dollars are divided by dollars, the result is a percentage. Now assume that because of unexpected changes in overhead spending and in demand for the companies products, the actual overhead cost and the actual activity recorded during the year in each company are as follows: Turbo Crafters Actual manufacturing overhead cost . . . . . . . . . . . . . . . . . . . . . . Actual total amount of the allocation base . . . . . . . . . . . . . . . . . . Black & Howell $290,000 68,000 machine-hours $130,000 $90,000 direct materials cost For each company, note that the actual data for both cost and the allocation base differ from the estimates used in computing the predetermined overhead rate. This results in underapplied and overapplied overhead as follows: Turbo Crafters Actual manufacturing overhead cost . . . . . . . . . . . . . . . . Manufacturing overhead cost applied to Work in Process during the year: Predetermined overhead rate (a) . . . . . . . . . . . . . . . . . Actual total amount of the allocation base (b) . . . . . . . Manufacturing overhead applied (a) $290,000 $4 per machine-hour 68,000 machine-hours Black & Howell $130,000 150% of direct materials cost $ 90,000 direct materials cost (b) . . . . . . . . . . $272,000 $135,000 Underapplied (overapplied) manufacturing overhead . . . $ 18,000 $ (5,000) For Turbo Crafters, the amount of overhead cost applied to Work in Process ($272,000) is less than the actual overhead cost for the year ($290,000). Therefore, overhead is underapplied. For Black & Howell, the amount of overhead cost applied to Work in Process ($135,000) is greater than the actual overhead cost for the year ($130,000), so overhead is overapplied. A summary of these concepts is presented in Exhibit 313. Disposition of Underapplied or Overapplied Overhead Balances If you look at the Manufacturing Overhead T-account in Exhibit 310, you will see that there is a debit balance of $5,000. Remember that debit entries to the account represent actual overhead costs incurred, whereas credit entries represent overhead costs applied to jobs. In this case, the actual overhead costs incurred exceeded the overhead costs applied to jobs by $5,000hence the debit balance of $5,000. This may sound familiar. We just discussed in the previous section the fact that the overhead costs incurred gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 111 12/11/08 1:27:58 AM user-s180 /broker/MH-BURR/MHBR094/MHBR094-03/upload Systems Design: Job-Order Costing E X H I B I T 313 Summary of Overhead Concepts At the beginning of the period: Estimated total manufacturing overhead cost Estimated total amount of the allocation base Predetermined overhead rate Actual total amount of the allocation base incurred during the period Total manufacturing overhead applied Total manufacturing overhead applied Underapplied (overapplied) overhead During the period: Predetermined overhead rate At the end of the period: Actual total manufacturing overhead cost 111 ($95,000) exceeded the overhead costs applied ($90,000), and that the difference is called underapplied overhead. These are just two ways of looking at the same thing. If there is a debit balance in the Manufacturing Overhead account of X dollars, then the overhead is underapplied by X dollars. On the other hand, if there is a credit balance in the Manufacturing Overhead account of Y dollars, then the overhead is overapplied by Y dollars. What do we do with the balance in the Manufacturing Overhead account at the end of the accounting period? The underapplied or overapplied balance remaining in the Manufacturing Overhead account at the end of a period is treated in one of two ways: 1. Closed out to Cost of Goods Sold. 2. Allocated among the Work in Process, Finished Goods, and Cost of Goods Sold accounts in proportion to the overhead applied during the current period in ending balances. Closed Out to Cost of Goods Sold Closing out the balance in Manufacturing Overhead to Cost of Goods Sold is simpler than the allocation method. Returning to the example of Ruger Corporation, the entry to close the $5,000 of underapplied overhead to Cost of Goods Sold is: (14) Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 5,000 Note that because the Manufacturing Overhead account has a debit balance, Manufacturing Overhead must be credited to close out the account. This has the effect of increasing Cost of Goods Sold for April to $123,500: Unadjusted cost of goods sold [from entry (13)] . . . . . . . . . Add underapplied overhead [entry (14) above] . . . . . . . . . . $118,500 5,000 Adjusted cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . $123,500 After this adjustment has been made, Ruger Corporations income statement for April will appear as shown earlier in Exhibit 312. gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 112 12/11/08 1:27:58 AM user-s180 112 /broker/MH-BURR/MHBR094/MHBR094-03/upload Chapter 3 Note that this adjustment makes sense. The unadjusted cost of goods sold is based on the amount of manufacturing overhead applied to jobs, not the manufacturing overhead costs actually incurred. Because overhead was underapplied, not enough cost was applied to jobs. Hence, the cost of goods sold was understated. Adding the underapplied overhead to the cost of goods sold corrects this understatement. Allocated between Accounts Allocation of underapplied or overapplied overhead between Work in Process, Finished Goods, and Cost of Goods Sold is more accurate than closing the entire balance into Cost of Goods Sold. This allocation assigns overhead costs to where they would have gone in the rst place had it not been for the errors in estimating the predetermined overhead rate. Had Ruger Corporation chosen to allocate the underapplied overhead among the inventory accounts and Cost of Goods Sold, it would rst be necessary to determine the amount of overhead that had been applied during April to each of the accounts. The computations would have been as follows: Overhead applied in work in process inventory, April 30 (Job B) . . Overhead applied in nished goods inventory, April 30 Job A: ($60,000/1,000 units $60 per unit) 250 units . . . . . Overhead applied in cost of goods sold, April Job A: ($60,000/1,000 units $60 per unit) 750 units . . . . . $30,000 33.33% 15,000 16.67% 45,000 50.00% Total overhead applied . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $90,000 100.00% Based on the above percentages, the underapplied overhead (i.e., the debit balance in Manufacturing Overhead) would be allocated as shown in the following journal entry: Work in Process (33.33% $5,000) . . . . . . . . . . . . . . . . . . Finished Goods (16.67% $5,000) . . . . . . . . . . . . . . . . . . . Cost of Goods Sold (50.00% $5,000) . . . . . . . . . . . . . . . Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . . 1,666.50 833.50 2,500.00 5,000.00 Note that the rst step in the allocation process was to determine the amount of overhead applied in each of the accounts. For Finished Goods, for example, the total amount of overhead applied to Job A, $60,000, was divided by the total number of units in Job A, 1,000 units, to arrive at the average overhead applied of $60 per unit. Because 250 units from Job A were still in ending nished goods inventory, the amount of overhead applied in the Finished Goods Inventory account was $60 per unit multiplied by 250 units or $15,000 in total. If overhead had been overapplied, the entry above would have been just the reverse, because a credit balance would have existed in the Manufacturing Overhead account. Which Method Should Be Used for Disposing of Underapplied or Overapplied Overhead? The allocation method is generally considered more accurate than simply closing out the underapplied or overapplied overhead to Cost of Goods Sold. However, the allocation method is more complex. We will always specify which method you are to use in problem assignments. A General Model of Product Cost Flows Exhibit 314 presents a T-account model of the ow of costs in a product costing system. This model can be very helpful in understanding how production costs ow through a costing system and nally end up as Cost of Goods Sold on the income statement. gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 113 12/11/08 1:27:58 AM user-s180 /broker/MH-BURR/MHBR094/MHBR094-03/upload 113 Systems Design: Job-Order Costing E X H I B I T 314 A General Model of Cost Flows Raw Materials Debited for the cost of materials purchased Credited for direct materials added to Work in Process Credited for indirect materials added to Manufacturing Overhead Work in Process Debited for the cost of direct materials, direct labor, and manufacturing overhead applied Salaries and Wages Payable Credited for direct labor added to Work in Process Credited for the cost of goods manufactured Finished Goods Credited for indirect labor added to Manufacturing Overhead Debited for the cost of goods manufactured Manufacturing Overhead Cost of Goods Sold Debited for actual Credited for overoverhead costs head cost applied incurred to Work in Process Underapplied overhead cost Credited for the cost of goods sold Debited for the cost of goods sold Overapplied overhead cost Multiple Predetermined Overhead Rates Our discussion in this chapter has assumed that there is a single predetermined overhead rate for an entire factory called a plantwide overhead rate. This is a fairly common practiceparticularly in smaller companies. But in larger companies, multiple predetermined overhead rates are often used. In a multiple predetermined overhead rate system each production department may have its own predetermined overhead rate. Such a system, while more complex, is more accurate because it can reect differences across departments in how overhead costs are incurred. For example, in departments that are relatively labor intensive overhead might be allocated based on direct labor-hours and in departments that are relatively machine intensive overhead might be allocated based on machine-hours. When multiple predetermined overhead rates are used, overhead is applied in each department according to its own overhead rate as jobs proceed through the department. Job-Order Costing in Service Companies Job-order costing is used in service organizations such as law rms, movie studios, hospitals, and repair shops, as well as in manufacturing companies. In a law rm, for example, each client is a job, and the costs of that job are accumulated day by day on a gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 114 12/11/08 1:27:59 AM user-s180 114 /broker/MH-BURR/MHBR094/MHBR094-03/upload Chapter 3 job cost sheet as the clients case is handled by the rm. Legal forms and similar inputs represent the direct materials for the job; the time expended by attorneys is like direct labor; and the costs of secretaries and legal aids, rent, depreciation, and so forth, represent the overhead. In a movie studio such as Columbia Pictures, each lm produced by the studio is a job, and costs of direct materials (costumes, props, lm, etc.) and direct labor (actors, directors, and extras) are charged to each lms job cost sheet. A share of the studios overhead costs, such as utilities, depreciation of equipment, wages of maintenance workers, and so forth, is also charged to each lm. In sum, job-order costing is a versatile and widely used costing method that may be encountered in virtually any organization that provides diverse products or services. IN BUSINESS MANAGING JOB COSTS IN A SERVICE BUSINESS IBM has created a software program called Professional Marketplace to match IBM employees with client needs. Using Marketplace, IBM consultants working for customers can search through 100 job classications and 10,000 skills, guring out who inside IBM is available, where they are located and roughly how much it costs the company to use them. Thus far, the results have been encouraging. IBM has reduced its reliance on outside contractors by 5% to 7% and its consultants spend more of their time in billable work. Furthermore, IBMs senior consultants can search across the globe for available employees with particular niche skills with the click of a mouse instead of having to rely on numerous time-consuming phone calls and emails. Source: Charles Forelle, IBM Tool Deploys Employees Efciently, The Wall Street Journal, July 14, 2005, p. B3. Use of Information Technology Earlier in the chapter we discussed how bar code technology can be used to record labor timereducing the drudgery in that task and increasing accuracy. Bar codes have many other uses. In a company with a well-developed bar code system, the manufacturing cycle begins with the receipt of a customers order in electronic form. Until very recently, the order would have been received via electronic data interchange (EDI), which involves a network of computers linking organizations. An EDI network allows companies to electronically exchange business documents and other information that extend into all areas of business activity from ordering raw materials to shipping completed goods. Recently, EDI has been challenged by a far cheaper web-based alternative XML (Extensible Markup Language), an extension of HTML (Hypertext Markup Language). HTML uses codes to tell your web browser how to display information on your screen, but the computer doesnt know what the information isit just displays it. XML provides additional tags that identify the kind of information that is being exchanged. For example, price data might be coded as <price> 14.95 <price>. When your computer reads this data and sees the tags <price> surrounding 14.95, it will immediately know that this is a price. XML tags can designate many different kinds of informationcustomer orders, medical records, bank statements, and so onand the tags will indicate to your computer how to display, store, and retrieve the information. Ofce Depot is an early adopter of XML, which it is using to facilitate e-commerce with its large customers. gar79611_ch03_088-147.indd Page 115 12/11/08 1:28:00 AM user-s180 /broker/MH-BURR/MHBR094/MHBR094-03/upload Systems Design: Job-Order Costing 115 Once an order has been received via EDI or in the form of an XML le, the computer draws up a list of required raw materials and sends out electronic purchase orders to suppliers. When materials arrive at the companys plant, bar codes applied by the suppliers are scanned to update inventory records and to trigger payment for the materials. The bar codes are scanned again when the materials are requisitioned for use in production. At that point, the computer credits the Raw Materials inventory account for the amount and type of goods requisitioned and debits the Work in Process inventory account. A unique bar code is assigned to each job. This bar code is scanned to update Work in Process records for labor and other costs incurred in the manufacturing process. When goods are completed, another scan is performed to transfer the cost and quantity of goods from the Work in Process inventory account to the Finished Goods inventory account, or to charge Cost of Goods Sold for goods ready to be shipped. Goods ready to be shipped are packed into containers that are bar coded with information that includes the customer number, the type and quantity of goods being shipped, and the order number. This bar code is then used for preparing billing information and for tracking the packed goods until placed on a carrier for shipment to the customer. Some customers require that the packed goods be bar coded with point-of-sale labels that can be scanned at retail check-out counters. These scans allow the retailer to update inventory records, verify price, and generate a customer receipt. RFID: THE NEXT GENERATION BEYOND BAR CODES Bar code technology has revolutionized how organizations gather data. However, bar code readers cannot read a bar code more than a few feet away nor can they read a bar code that is not visible. This creates inefciencies when companies attempt to track large amounts of raw materials, nished goods, or merchandise inventory. Radio Frequency Identication Systems (RFID) overcome these inherent limitations of bar codes. For example, a tractor trailer full of merchandise with RFID tags can be read without even opening the trailer doors. According to Kurt Salmon Associates, RFID technology can lower warehousing and distribution costs by 3% to 5% largely because employees no longer need to scan the bar code on each item. Companies such as Home Depot, Marks & Spencer, Metro AG, Procter & Gamble, and Wal-Mart are moving quickly to adopt RFID technology. In fact, Wal-Mart is requiring its top 100 suppliers to put RFID tags on all of their pallets, cases, cartons, and high margin items. A survey conducted by PC Magazine indicates that more than half of the companies in the automotive, consumer goods, and transportation and logistics industries plan to adopt RFID. Some experts believe that, once technological advances drop the cost of an RFID tag from 2530 cents down to 5 cents, this technology will be very widely adopted. Sources: Meredith Levinson, The RFID Imperative, CIO magazine, December 2003 (www.cio.com/archive/ 120103/retail.html) and Here Comes RFID Chips, PC Magazine, October 18, 2005, pp. 3133. In short, bar code technology is being integrated into many areas of business activity. When combined with EDI or XML, it eliminates a lot of clerical drudgery and allows companies to capture and exchange more data and to analyze and report information much more quickly and completely and with less error than with manual systems. IN BUSINESS gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 116 12/11/08 1:28:01 AM user-s180 116 /broker/MH-BURR/MHBR094/MHBR094-03/upload Chapter 3 Summary Job-order costing and process costing are widely used to track costs. Job-order costing is used in situations where the organization offers many different products or services, such as in furniture manufacturing, hospitals, and legal rms. Process costing is used where units of product are homogeneous, such as in our milling or cement production. Materials requisition forms and labor time tickets are used to assign direct materials and direct labor costs to jobs in a job-order costing system. Manufacturing overhead costs are assigned to jobs using a predetermined overhead rate. All of the costs are recorded on a job cost sheet. The predetermined overhead rate is determined before the period begins by dividing the estimated total manufacturing cost for the period by the estimated total amount of the allocation base for the period. The most frequently used allocation bases are direct labor-hours and machine-hours. Overhead is applied to jobs by multiplying the predetermined overhead rate by the actual amount of the allocation base recorded for the job. Because the predetermined overhead rate is based on estimates, the actual overhead cost incurred during a period may be more or less than the amount of overhead cost applied to production. Such a difference is referred to as underapplied or overapplied overhead. The underapplied or overapplied overhead for a period can be either closed out to Cost of Goods Sold or allocated between Work in Process, Finished Goods, and Cost of Goods Sold. When overhead is underapplied, manufacturing overhead costs have been understated and therefore inventories and/or expenses must be adjusted upwards. When overhead is overapplied, manufacturing overhead costs have been overstated and therefore inventories and/or expenses must be adjusted downwards. Review Problem: Job-Order Costing Hogle Corporation is a manufacturer that uses job-order costing. On January 1, the beginning of its scal year, the companys inventory balances were as follows: Raw materials . . . . . . . . . . . . Work in process . . . . . . . . . . Finished goods . . . . . . . . . . . $20,000 $15,000 $30,000 The company applies overhead cost to jobs on the basis of machine-hours worked. For the current year, the company estimated that it would work 75,000 machine-hours and incur $450,000 in manufacturing overhead cost. The following transactions were recorded for the year: a. Raw materials were purchased on account, $410,000. b. Raw materials were requisitioned for use in production, $380,000 ($360,000 direct materials and $20,000 indirect materials). c. The following costs were accrued for employee services: direct labor, $75,000; indirect labor, $110,000; sales commissions, $90,000; and administrative salaries, $200,000. d. Sales travel costs were $17,000. e. Utility costs in the factory were $43,000. f. Advertising costs were $180,000. g. Depreciation was recorded for the year, $350,000 (80% relates to factory operations, and 20% relates to selling and administrative activities). h. Insurance expired during the year, $10,000 (70% relates to factory operations, and the remaining 30% relates to selling and administrative activities). i. Manufacturing overhead was applied to production. Due to greater than expected demand for its products, the company worked 80,000 machine-hours during the year. j. Goods costing $900,000 to manufacture according to their job cost sheets were completed during the year. gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 117 12/11/08 1:28:01 AM user-s180 /broker/MH-BURR/MHBR094/MHBR094-03/upload Systems Design: Job-Order Costing k. Goods were sold on account to customers during the year for a total of $1,500,000. The goods cost $870,000 to manufacture according to their job cost sheets. Required: 1. 2. 3. 4. Prepare journal entries to record the preceding transactions. Post the entries in (1) above to T-accounts (dont forget to enter the beginning balances in the inventory accounts). Is Manufacturing Overhead underapplied or overapplied for the year? Prepare a journal entry to close any balance in the Manufacturing Overhead account to Cost of Goods Sold. Do not allocate the balance between ending inventories and Cost of Goods Sold. Prepare an income statement for the year. Solution to Review Problem 1. a. b. c. d. e. f. g. h. i. Raw Materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 410,000 Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Work in Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 360,000 Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 Raw Materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Work in Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75,000 Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110,000 Sales Commissions Expense. . . . . . . . . . . . . . . . . . . . . . . . . . 90,000 Administrative Salaries Expense . . . . . . . . . . . . . . . . . . . . . . 200,000 Salaries and Wages Payable . . . . . . . . . . . . . . . . . . . . . . . . Sales Travel Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,000 Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43,000 Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Advertising Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180,000 Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280,000 Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,000 Accumulated Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000 Insurance Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 Prepaid Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The predetermined overhead rate for the year is computed as follows: Predetermined overhead rate 410,000 380,000 475,000 17,000 43,000 180,000 350,000 10,000 Estimated total manufacturing overhead cost Estimated total amount of the allocation base $450,000 75,000 machine-hours $6 per machine-hour Based on the 80,000 machine-hours actually worked during the year, the company applied $480,000 in overhead cost to production: $6 per machine-hour 80,000 machinehours $480,000. The following entry records this application of overhead cost: j. k. Work in Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . . Finished Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Work in Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Finished Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 480,000 480,000 900,000 900,000 1,500,000 1,500,000 870,000 870,000 117 gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 118 12/11/08 1:28:01 AM user-s180 118 2. Chapter 3 Accounts Receivable (k) /broker/MH-BURR/MHBR094/MHBR094-03/upload Manufacturing Overhead 1,500,000 (b) (c) (e) (g) (h) Prepaid Insurance (h) 10,000 20,000 110,000 43,000 280,000 7,000 (i) Sales 480,000 (k) Cost of Goods Sold 460,000 480,000 Bal. (k) 20,000 410,000 Bal. (b) Sales Commissions Expense 50,000 380,000 15,000 360,000 75,000 480,000 Bal. Accumulated Depreciation (g) (c) 90,000 350,000 Administrative Salaries Expense Accounts Payable Work in Process Bal. (b) (c) (i) 870,000 20,000 Raw Materials Bal. (a) 1,500,000 ( j) 900,000 (a) (d) (e) (f) (c) 410,000 17,000 43,000 180,000 200,000 30,000 Sales Travel Expense (d) Salaries and Wages Payable Finished Goods Bal. ( j) 30,000 900,000 Bal. (k) (c) 475,000 17,000 Advertising Expense (f) 180,000 870,000 60,000 Depreciation Expense (g) 70,000 Insurance Expense (h) 3. 3,000 Manufacturing overhead is overapplied for the year. The entry to close it out to Cost of Goods Sold is as follows: Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost of Goods Sold. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4. 20,000 20,000 Hogle Corporation Income Statement For the Year Ended December 31 Sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost of goods sold ($870,000 $20,000) . . . . $1,500,000 850,000 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . Selling and administrative expenses: Sales commissions expense . . . . . . . . . . . . . Administrative salaries expense . . . . . . . . . . Sales travel expense . . . . . . . . . . . . . . . . . . . Advertising expense . . . . . . . . . . . . . . . . . . . Depreciation expense . . . . . . . . . . . . . . . . . . Insurance expense . . . . . . . . . . . . . . . . . . . . 650,000 Net operating income . . . . . . . . . . . . . . . . . . . . $ 90,000 200,000 17,000 180,000 70,000 3,000 560,000 $ 90,000 gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 119 12/11/08 1:28:02 AM user-s180 /broker/MH-BURR/MHBR094/MHBR094-03/upload 119 Systems Design: Job-Order Costing Glossary Absorption costing A costing method that includes all manufacturing costsdirect materials, direct labor, and both variable and xed manufacturing overheadin the cost of a product. (p. 89) Allocation base A measure of activity such as direct labor-hours or machine-hours that is used to assign costs to cost objects. (p. 94) Bill of materials A document that shows the quantity of each type of direct material required to make a product. (p. 91) Cost driver A factor, such as machine-hours, beds occupied, computer time, or ight-hours, that causes overhead costs. (p. 96) Job cost sheet A form prepared for a job that records the materials, labor, and manufacturing overhead costs charged to that job. (p. 92) Job-order costing A costing system used in situations where many different products, jobs, or services are produced each period. (p. 89) Materials requisition form A document that species the type and quantity of materials to be drawn from the storeroom and that identies the job that will be charged for the cost of those materials. (p. 91) Multiple predetermined overhead rates A costing system with multiple overhead cost pools and a different predetermined overhead rate for each cost pool, rather than a single predetermined overhead rate for the entire company. Each production department may be treated as a separate overhead cost pool. (p. 113) Normal cost system A costing system in which overhead costs are applied to a job by multiplying a predetermined overhead rate by the actual amount of the allocation base incurred by the job. (p. 95) Overapplied overhead A credit balance in the Manufacturing Overhead account that occurs when the amount of overhead cost applied to Work in Process exceeds the amount of overhead cost actually incurred during a period. (p. 109) Overhead application The process of charging manufacturing overhead cost to job cost sheets and to the Work in Process account. (p. 95) Plantwide overhead rate A single predetermined overhead rate that is used throughout a plant. (p. 113) Predetermined overhead rate A rate used to charge manufacturing overhead cost to jobs that is established in advance for each period. It is computed by dividing the estimated total manufacturing overhead cost for the period by the estimated total amount of the allocation base for the period. (p. 94) Process costing A costing system used in situations where a single, homogeneous product (such as cement or our) is produced for long periods of time. (p. 89) Time ticket A document that is used to record the amount of time an employee spends on various activities. (p. 93) Underapplied overhead A debit balance in the Manufacturing Overhead account that occurs when the amount of overhead cost actually incurred exceeds the amount of overhead cost applied to Work in Process during a period. (p. 109) Questions 31 32 33 34 35 36 37 Why arent actual manufacturing overhead costs traced to jobs just as direct materials and direct labor costs are traced to jobs? When would job-order costing be used instead of process costing? What is the purpose of the job cost sheet in a job-order costing system? What is a predetermined overhead rate, and how is it computed? Explain how a sales order, a production order, a materials requisition form, and a labor time ticket are involved in producing and costing products. Explain why some production costs must be assigned to products through an allocation process. Why do companies use predetermined overhead rates rather than actual manufacturing overhead costs to apply overhead to jobs? gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 120 12/11/08 1:28:02 AM user-s180 120 /broker/MH-BURR/MHBR094/MHBR094-03/upload Chapter 3 38 39 310 311 312 313 314 315 What factors should be considered in selecting a base to be used in computing the predetermined overhead rate? If a company fully allocates all of its overhead costs to jobs, does this guarantee that a prot will be earned for the period? What account is credited when overhead cost is applied to Work in Process? Would you expect the amount applied for a period to equal the actual overhead costs of the period? Why or why not? What is underapplied overhead? Overapplied overhead? What disposition is made of these amounts at the end of the period? Provide two reasons why overhead might be underapplied in a given year. What adjustment is made for underapplied overhead on the schedule of cost of goods sold? What adjustment is made for overapplied overhead? What is a plantwide overhead rate? Why are multiple overhead rates, rather than a plantwide overhead rate, used in some companies? What happens to overhead rates based on direct labor when automated equipment replaces direct labor? Multiple-choice questions are provided on the text website at www.mhhe.com/garrison13e. Exercises EXERCISE 31 Process Costing and Job-Order Costing [LO1] Which method of determining product costs, job-order costing or process costing, would be more appropriate in each of the following situations? a. An Elmers glue factory. b. A textbook publisher such as McGraw-Hill. c. An Exxon oil renery. d. A facility that makes Minute Maid frozen orange juice. e. A Scott paper mill. f. A custom home builder. g. A shop that customizes vans. h. A manufacturer of specialty chemicals. i. An auto repair shop. j. A Firestone tire manufacturing plant. k. An advertising agency. l. A law ofce. EXERCISE 32 Job-Order Costing Documents [LO2] Cycle Gear Corporation has incurred the following costs on job number W456, an order for 20 special sprockets to be delivered at the end of next month. Direct materials: On April 10, requisition number 15673 was issued for 20 titanium blanks to be used in the special order. The blanks cost $15.00 each. On April 11, requisition number 15678 was issued for 480 hardened nibs also to be used in the special order. The nibs cost $1.25 each. Direct labor: On April 12, Jamie Unser worked from 11:00 AM until 2:45 PM on Job W456. He is paid $9.60 per hour. On April 18, Melissa Chan worked from 8:15 AM until 11:30 AM on Job W456. She is paid $12.20 per hour. Required: 1. 2. On what documents would these costs be recorded? How much cost should have been recorded on each of the documents for Job W456? gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 121 12/11/08 1:28:02 AM user-s180 /broker/MH-BURR/MHBR094/MHBR094-03/upload Systems Design: Job-Order Costing EXERCISE 33 Compute the Predetermined Overhead Rate [LO3] Harris Fabrics computes its predetermined overhead rate annually on the basis of direct labor hours. At the beginning of the year it estimated that its total manufacturing overhead would be $134,000 and the total direct labor would be 20,000 hours. Its actual total manufacturing overhead for the year was $123,900 and its actual total direct labor was 21,000 hours. Required: Compute the companys predetermined overhead rate for the year. EXERCISE 34 Prepare Journal Entries [LO4] Larned Corporation recorded the following transactions for the just completed month. a. $80,000 in raw materials were purchased on account. b. $71,000 in raw materials were requisitioned for use in production. Of this amount, $62,000 was for direct materials and the remainder was for indirect materials. c. Total labor wages of $112,000 were incurred. Of this amount, $101,000 was for direct labor and the remainder was for indirect labor. d. Additional manufacturing overhead costs of $175,000 were incurred. Required: Record the above transactions in journal entries. EXERCISE 35 Apply Overhead [LO5] Luthan Company uses a predetermined overhead rate of $23.40 per direct labor-hour. This predetermined rate was based on 11,000 estimated direct labor-hours and $257,400 of estimated total manufacturing overhead. The company incurred actual total manufacturing overhead costs of $249,000 and 10,800 total direct labor-hours during the period. Required: Determine the amount of manufacturing overhead that would have been applied to units of product during the period. EXERCISE 36 Schedules of Cost of Goods Manufactured and Cost of Goods Sold [LO6] Primare Corporation has provided the following data concerning last months manufacturing operations. Purchases of raw materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Indirect materials included in manufacturing overhead . . . . . . . . . . . . . . . . . . . . . . . . . Direct labor. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Manufacturing overhead applied to work in process . . . . . . . . . . . . . . . . . . . . . . . . . . . Underapplied overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Inventories Raw materials . . . . . . . . . . . . . . . . . . . . . . . . . . Work in process . . . . . . . . . . . . . . . . . . . . . . . . . Finished goods. . . . . . . . . . . . . . . . . . . . . . . . . . Beginning Ending $12,000 $56,000 $35,000 $30,000 $5,000 $58,000 $87,000 $4,000 $18,000 $65,000 $42,000 Required: 1. 2. Prepare a schedule of cost of goods manufactured for the month. Prepare a schedule of cost of goods sold for the month. EXERCISE 37 Prepare T-Accounts [LO7, LO8] Jurvin Enterprises recorded the following transactions for the just completed month. The company had no beginning inventories. a. $94,000 in raw materials were purchased for cash. b. $89,000 in raw materials were requisitioned for use in production. Of this amount, $78,000 was for direct materials and the remainder was for indirect materials. c. Total labor wages of $132,000 were incurred and paid. Of this amount, $112,000 was for direct labor and the remainder was for indirect labor. d. Additional manufacturing overhead costs of $143,000 were incurred and paid. 121 gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 122 12/11/08 1:28:03 AM user-s180 122 /broker/MH-BURR/MHBR094/MHBR094-03/upload Chapter 3 e. f. g. Manufacturing overhead costs of $152,000 were applied to jobs using the companys predetermined overhead rate. All of the jobs in progress at the end of the month were completed and shipped to customers. Any underapplied or overapplied overhead for the period was closed out to Cost of Goods Sold. Required: 1. 2. Post the above transactions to T-accounts. Determine the cost of goods sold for the period. EXERCISE 38 Underapplied and Overapplied Overhead [LO8] Osborn Manufacturing uses a predetermined overhead rate of $18.20 per direct labor-hour. This predetermined rate was based on 12,000 estimated direct labor-hours and $218,400 of estimated total manufacturing overhead. The company incurred actual total manufacturing overhead costs of $215,000 and 11,500 total direct labor-hours during the period. Required: 1. 2. Determine the amount of underapplied or overapplied manufacturing overhead for the period. Assuming that the entire amount of the underapplied or overapplied overhead is closed out to Cost of Goods Sold, what would be the effect of the underapplied or overapplied overhead on the companys gross margin for the period? EXERCISE 39 Applying Overhead to a Job [LO5] Sigma Corporation applies overhead cost to jobs on the basis of direct labor cost. Job V, which was started and completed during the current period, shows charges of $5,000 for direct materials, $8,000 for direct labor, and $6,000 for overhead on its job cost sheet. Job W, which is still in process at year-end, shows charges of $2,500 for direct materials and $4,000 for direct labor. Required: Should any overhead cost be added to Job W at year-end? If so, how much? Explain. EXERCISE 310 Predetermined Overhead Rate; Applying Overhead; Underapplied or Overapplied Overhead [LO3, LO5, LO8] Estimated cost and operating data for three companies for the upcoming year follow: Company X Direct labor-hours . . . . . . . . . . . . . . . . . . . . Machine-hours . . . . . . . . . . . . . . . . . . . . . . Direct materials cost . . . . . . . . . . . . . . . . . . Manufacturing overhead cost . . . . . . . . . . . Company Y Company Z 80,000 30,000 $400,000 $536,000 45,000 70,000 $290,000 $315,000 60,000 21,000 $300,000 $480,000 Predetermined overhead rates are computed using the following allocation bases in the three companies: Allocation Base Company X . . . . . . . . . Company Y. . . . . . . . . . Company Z . . . . . . . . . Direct labor-hours Machine-hours Direct materials cost Required: 1. 2. Compute each companys predetermined overhead rate. Assume that Company X works on three jobs during the upcoming year. Direct labor-hours recorded by job are: Job 418, 12,000 hours; Job 419, 36,000 hours; and Job 420, 30,000 hours. How much overhead will the company apply to Work in Process for the year? If actual overhead costs total $530,000 for the year, will overhead be underapplied or overapplied? By how much? gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 123 12/11/08 1:28:03 AM user-s180 /broker/MH-BURR/MHBR094/MHBR094-03/upload Systems Design: Job-Order Costing EXERCISE 311 Applying Overhead; Journal Entries; Disposition of Underapplied or Overapplied Overhead [LO4, LO7, LO8] The following information is taken from the accounts of Latta Company. The entries in the T-accounts are summaries of the transactions that affected those accounts during the year. Manufacturing Overhead (a) Bal. 460,000 (b) Work in Process 390,000 Bal. 70,000 (b) Bal. Finished Goods Bal. (c) 50,000 710,000 Bal. (d) 15,000 260,000 85,000 390,000 (c) 710,000 40,000 Cost of Goods Sold 640,000 (d) 640,000 120,000 The overhead that had been applied to production during the year is distributed among the ending balances in the accounts as follows: Work in Process, ending . . . . . . . Finished Goods, ending . . . . . . . . Cost of Goods Sold . . . . . . . . . . . $ 19,500 58,500 312,000 Overhead applied . . . . . . . . . . . . . $390,000 For example, of the $40,000 ending balance in Work in Process, $19,500 was overhead that had been applied during the year. Required: 1. 2. 3. Identify reasons for entries (a) through (d). Assume that the company closes any balance in the Manufacturing Overhead account directly to Cost of Goods Sold. Prepare the necessary journal entry. Assume instead that the company allocates any balance in the Manufacturing Overhead account to the other accounts in proportion to the overhead applied in their ending balances. Prepare the necessary journal entry, with supporting computations. EXERCISE 312 Applying Overhead; T-accounts; Journal Entries [LO3, LO4, LO5, LO7, LO8] Harwood Company uses a job-order costing system. Overhead costs are applied to jobs on the basis of machine-hours. At the beginning of the year, management estimated that the company would incur $192,000 in manufacturing overhead costs and work 80,000 machine-hours. Required: 1. 2. Compute the companys predetermined overhead rate. Assume that during the year the company works only 75,000 machine-hours and incurs the following costs in the Manufacturing Overhead and Work in Process accounts: Manufacturing Overhead (Maintenance) (Indirect materials) (Indirect labor) (Utilities) (Insurance) (Depreciation) 21,000 8,000 60,000 32,000 7,000 56,000 Work in Process ? (Direct materials) (Direct labor) (Overhead) 710,000 90,000 ? 123 gar79611_ch03_088-147.indd Page 124 12/11/08 1:28:04 AM user-s180 124 /broker/MH-BURR/MHBR094/MHBR094-03/upload Chapter 3 3. 4. Copy the data in the T-accounts above onto your answer sheet. Compute the amount of overhead cost that would be applied to Work in Process for the year and make the entry in your T-accounts. Compute the amount of underapplied or overapplied overhead for the year and show the balance in your Manufacturing Overhead T-account. Prepare a journal entry to close out the balance in this account to Cost of Goods Sold. Explain why the manufacturing overhead was underapplied or overapplied for the year. EXERCISE 313 Applying Overhead; Computing Unit Product Cost [LO5] A company assigns overhead cost to completed jobs on the basis of 125% of direct labor cost. The job cost sheet for Job 313 shows that $10,000 in direct materials has been used on the job and that $12,000 in direct labor cost has been incurred. A total of 1,000 units were produced in Job 313. Required: What is the unit product cost for Job 313? EXERCISE 314 Journal Entries and T-accounts [LO4, LO5, LO7] The Polaris Company uses a job-order costing system. The following data relate to October, the rst month of the companys scal year. a. Raw materials purchased on account, $210,000. b. Raw materials issued to production, $190,000 ($178,000 direct materials and $12,000 indirect materials). c. Direct labor cost incurred, $90,000; indirect labor cost incurred, $110,000. d. Depreciation recorded on factory equipment, $40,000. e. Other manufacturing overhead costs incurred during October, $70,000 (credit Accounts Payable). f. The company applies manufacturing overhead cost to production on the basis of $8 per machine-hour. A total of 30,000 machine-hours were recorded for October. g. Production orders costing $520,000 according to their job cost sheets were completed during October and transferred to Finished Goods. h. Production orders that had cost $480,000 to complete according to their job cost sheets were shipped to customers during the month. These goods were sold on account at 25% above cost. Required: 1. 2. Prepare journal entries to record the information given above. Prepare T-accounts for Manufacturing Overhead and Work in Process. Post the relevant information above to each account. Compute the ending balance in each account, assuming that Work in Process has a beginning balance of $42,000. EXERCISE 315 Applying Overhead in a Service Company [LO2, LO3, LO5] Leeds Architectural Consultants began operations on January 2. The following activity was recorded in the companys Work in Process account for the rst month of operations: Work in Process Costs of subcontracted work Direct staff costs Studio overhead 230,000 75,000 120,000 To completed projects 390,000 Leeds Architectural Consultants is a service rm, so the names of the accounts it uses are different from the names used in manufacturing companies. Costs of Subcontracted Work is comparable to Direct Materials; Direct Staff Costs is the same as Direct Labor; Studio Overhead is the same as Manufacturing Overhead; and Completed Projects is the same as Finished Goods. Apart from the difference in terms, the accounting methods used by the company are identical to the methods used by manufacturing companies. Leeds Architectural Consultants uses a job-order costing system and applies studio overhead to Work in Process on the basis of direct staff costs. At the end of January, only one job was still in process. This job (Lexington Gardens Project) had been charged with $6,500 in direct staff costs. Required: 1. 2. Compute the predetermined overhead rate that was in use during January. Complete the following job cost sheet for the partially completed Lexington Gardens Project. gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 125 12/11/08 1:28:05 AM user-s180 /broker/MH-BURR/MHBR094/MHBR094-03/upload Systems Design: Job-Order Costing Job Cost SheetLexington Gardens Project As of January 31 Costs of subcontracted work . . . . . . . . . . . . . . Direct staff costs . . . . . . . . . . . . . . . . . . . . . . . Studio overhead . . . . . . . . . . . . . . . . . . . . . . . . $? ? ? Total cost to January 31 . . . . . . . . . . . . . . . . . . $? EXERCISE 316 Applying Overhead; Journal Entries; T-accounts [LO3, LO4, LO5, LO7] Dillon Products manufactures various machined parts to customer specications. The company uses a job-order costing system and applies overhead cost to jobs on the basis of machine-hours. At the beginning of the year, it was estimated that the company would work 240,000 machine-hours and incur $4,800,000 in manufacturing overhead costs. The company spent the entire month of January working on a large order for 16,000 custommade machined parts. The company had no work in process at the beginning of January. Cost data relating to January follow: a. Raw materials purchased on account, $325,000. b. Raw materials requisitioned for production, $290,000 (80% direct materials and 20% indirect materials). c. Labor cost incurred in the factory, $180,000 (one-third direct labor and two-thirds indirect labor). d. Depreciation recorded on factory equipment, $75,000. e. Other manufacturing overhead costs incurred, $62,000 (credit Accounts Payable). f. Manufacturing overhead cost was applied to production on the basis of 15,000 machine-hours actually worked during the month. g. The completed job was moved into the nished goods warehouse on January 31 to await delivery to the customer. (In computing the dollar amount for this entry, remember that the cost of a completed job consists of direct materials, direct labor, and applied overhead.) Required: 1. 2. 3. 4. Prepare journal entries to record items (a) through (f) above [ignore item (g) for the moment]. Prepare T-accounts for Manufacturing Overhead and Work in Process. Post the relevant items from your journal entries to these T-accounts. Prepare a journal entry for item (g) above. Compute the unit product cost that will appear on the job cost sheet. EXERCISE 317 Applying Overhead; Cost of Goods Manufactured [LO5, LO6, LO8] The following cost data relate to the manufacturing activities of Chang Company during the just completed year: Manufacturing overhead costs incurred: Indirect materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Indirect labor. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Property taxes, factory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Utilities, factory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation, factory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Insurance, factory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 15,000 130,000 8,000 70,000 240,000 10,000 Total actual manufacturing overhead costs incurred . . . . . . . . . . . . . . . . $473,000 Other costs incurred: Purchases of raw materials (both direct and indirect) . . . . . . . . . . . . . . . Direct labor cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $400,000 $60,000 Inventories: Raw materials, beginning . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Raw materials, ending . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Work in process, beginning . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Work in process, ending . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $20,000 $30,000 $40,000 $70,000 125 gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 126 12/11/08 1:28:05 AM user-s180 126 /broker/MH-BURR/MHBR094/MHBR094-03/upload Chapter 3 The company uses a predetermined overhead rate to apply overhead cost to production. The rate for the year was $25 per machine-hour. A total of 19,400 machine-hours was recorded for the year. Required: 1. 2. Compute the amount of underapplied or overapplied overhead cost for the year. Prepare a schedule of cost of goods manufactured for the year. EXERCISE 318 Varying Predetermined Overhead Rates [LO3, LO5] Kingsport Containers, Ltd, of the Bahamas experiences wide variation in demand for the 200-liter steel drums it fabricates. The leakproof, rustproof steel drums have a variety of uses from storing liquids and bulk materials to serving as makeshift musical instruments. The drums are made to order and are painted according to the customers specicationsoften in bright patterns and designs. The company is well known for the artwork that appears on its drums. Unit product costs are computed on a quarterly basis by dividing each quarters manufacturing costs (materials, labor, and overhead) by the quarters production in units. The companys estimated costs, by quarter, for the coming year follow: Quarter First Second Third Fourth Direct materials . . . . . . . . . . . . . . . . . . . Direct labor. . . . . . . . . . . . . . . . . . . . . . . Manufacturing overhead . . . . . . . . . . . . $240,000 128,000 300,000 $120,000 64,000 220,000 $60,000 32,000 180,000 $180,000 96,000 260,000 Total manufacturing costs . . . . . . . . . . . $668,000 $404,000 $272,000 $536,000 Number of units to be produced. . . . . . . Estimated unit product cost . . . . . . . . . . 80,000 $8.35 40,000 $10.10 20,000 $13.60 60,000 $8.93 Management nds the variation in unit costs confusing and difcult to work with. It has been suggested that the problem lies with manufacturing overhead because it is the largest element of cost. Accordingly, you have been asked to nd a more appropriate way of assigning manufacturing overhead cost to units of product. After some analysis, you have determined that the companys overhead costs are mostly xed and therefore show little sensitivity to changes in the level of production. Required: 1. 2. The company uses a job-order costing system. How would you recommend that manufacturing overhead cost be assigned to production? Be specic, and show computations. Recompute the companys unit product costs in accordance with your recommendations in (1) above. EXERCISE 319 Applying Overhead in a Service Company; Journal Entries [LO4, LO5, LO8] Vista Landscaping uses a job-order costing system to track the costs of its landscaping projects. The company provides garden design and installation services for its clients. The table below provides data concerning the three landscaping projects that were in progress during April. There was no work in process at the beginning of April. Project Harris Designer-hours . . . . . . . . . . . . . . . . . Direct materials cost . . . . . . . . . . . . . Direct labor cost . . . . . . . . . . . . . . . . . Chan James 120 $4,500 $9,600 100 $3,700 $8,000 90 $1,400 $7,200 Actual overhead costs were $30,000 for April. Overhead costs are applied to projects on the basis of designer-hours because most of the overhead is related to the costs of the garden design studio. gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 127 12/11/08 1:28:06 AM user-s180 /broker/MH-BURR/MHBR094/MHBR094-03/upload 127 Systems Design: Job-Order Costing The predetermined overhead rate is $90 per designer-hour. The Harris and Chan projects were completed in April; the James project was not completed by the end of the month. Required: 1. 2. 3. 4. Compute the amount of overhead cost that would have been charged to each project during April. Prepare a journal entry showing the completion of the Harris and Chan projects and the transfer of costs to the Completed Projects (i.e., Finished Goods) account. What is the balance in the Work in Process account at the end of the month? What is the balance in the Overhead account at the end of the month? What is this balance called? EXERCISE 320 Departmental Overhead Rates [LO2, LO3, LO5] White Company has two departments, Cutting and Finishing. The company uses a job-order costing system and computes a predetermined overhead rate in each department. The Cutting Department bases its rate on machine-hours, and the Finishing Department bases its rate on direct labor cost. At the beginning of the year, the company made the following estimates: Department Cutting Direct labor-hours . . . . . . . . . . . . . . . . . . . . . . . . . . Machine-hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Manufacturing overhead cost . . . . . . . . . . . . . . . . . . Direct labor cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . Finishing 6,000 48,000 $360,000 $50,000 30,000 5,000 $486,000 $270,000 Required: 1. 2. Compute the predetermined overhead rate to be used in each department. Assume that the overhead rates that you computed in (1) above are in effect. The job cost sheet for Job 203, which was started and completed during the year, showed the following: Department Cutting Direct labor-hours . . . . . . . . . . . . . . . . . . . . . . . . . . . Machine-hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Materials requisitioned . . . . . . . . . . . . . . . . . . . . . . . . Direct labor cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3. Finishing 6 80 $500 $70 20 4 $310 $150 Compute the total overhead cost applied to Job 203. Would you expect substantially different amounts of overhead cost to be assigned to some jobs if the company used a plantwide overhead rate based on direct labor cost, rather than using departmental rates? Explain. No computations are necessary. Problems PROBLEM 321 Cost Flows; T-Accounts; Income Statement [LO3, LO5, LO7, LO8] Supreme Videos, Inc., produces short musical videos for sale to retail outlets. The companys balance sheet accounts as of January 1, the beginning of its scal year, are given on the following page. gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 128 12/11/08 1:28:07 AM user-s180 128 /broker/MH-BURR/MHBR094/MHBR094-03/upload Chapter 3 Supreme Videos, Inc. Balance Sheet January 1 Assets Current assets: Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . Inventories: Raw materials (lm, costumes) . . . . . . . . . . . . . . . . Videos in process . . . . . . . . . . . . . . . . . . . . . . . . . . Finished videos awaiting sale . . . . . . . . . . . . . . . . . $ 63,000 102,000 $ 30,000 45,000 81,000 Prepaid insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . Studio and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . Less accumulated depreciation . . . . . . . . . . . . . . . . . . . 156,000 9,000 330,000 730,000 210,000 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Liabilities and Stockholders Equity Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Capital stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $420,000 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 270,000 Total liabilities and stockholders equity . . . . . . . . . . . . . 520,000 $850,000 $160,000 690,000 $850,000 Because the videos differ in length and in complexity of production, the company uses a joborder costing system to determine the cost of each video produced. Studio (manufacturing) overhead is charged to videos on the basis of camera-hours of activity. At the beginning of the year, the company estimated that it would work 7,000 camera-hours and incur $280,000 in studio overhead cost. The following transactions were recorded for the year: a. Film, costumes, and similar raw materials purchased on account, $185,000. b. Film, costumes, and other raw materials issued to production, $200,000 (85% of this material was considered direct to the videos in production, and the other 15% was considered indirect). c. Utility costs incurred in the production studio, $72,000. d. Depreciation recorded on the studio, cameras, and other equipment, $84,000. Three-fourths of this depreciation related to actual production of the videos, and the remainder related to equipment used in marketing and administration. e. Advertising expense incurred, $130,000. f. Costs for salaries and wages were incurred as follows: Direct labor (actors and directors) . . . . . . . . . . . . . . $82,000 Indirect labor (carpenters to build sets, costume designers, and so forth) . . . . . . . . . . . . . $110,000 Administrative salaries . . . . . . . . . . . . . . . . . . . . . . . $95,000 g. Prepaid insurance expired during the year, $7,000 (80% related to production of videos, and 20% related to marketing and administrative activities). h. Miscellaneous marketing and administrative expenses incurred, $8,600. i. Studio (manufacturing) overhead was applied to videos in production. The company recorded 7,250 camera-hours of activity during the year. j. Videos that cost $550,000 to produce according to their job cost sheets were transferred to the nished videos warehouse to await sale and shipment. k. Sales for the year totaled $925,000 and were all on account. The total cost to produce these videos according to their job cost sheets was $600,000. l. Collections from customers during the year totaled $850,000. m. Payments to suppliers on account during the year, $500,000; payments to employees for salaries and wages, $285,000. gar79611_ch03_088-147.indd Page 129 12/11/08 1:28:07 AM user-s180 /broker/MH-BURR/MHBR094/MHBR094-03/upload Systems Design: Job-Order Costing Required: 1. 2. 3. 4. Prepare a T-account for each account on the companys balance sheet and enter the beginning balances. Record the transactions directly into the T-accounts. Prepare new T-accounts as needed. Key your entries to the letters (a) through (m) above. Compute the ending balance in each account. Is the Studio (manufacturing) Overhead account underapplied or overapplied for the year? Make an entry in the T-accounts to close any balance in the Studio Overhead account to Cost of Goods Sold. Prepare an income statement for the year. (Do not prepare a schedule of cost of goods manufactured; all of the information needed for the income statement is available in the T-accounts.) PROBLEM 322 Comprehensive Problem [LO3, LO4, LO5, LO7, LO8] Gold Nest Company of Guandong, China, is a family-owned enterprise that makes birdcages for the South China market. A popular pastime among older Chinese men is to take their pet birds on daily excursions to teahouses and public parks where they meet with other bird owners to talk and play mahjong. A great deal of attention is lavished on these birds, and the birdcages are often elaborately constructed from exotic woods and contain porcelain feeding bowls and silver roosts. Gold Nest Company makes a broad range of birdcages that it sells through an extensive network of street vendors who receive commissions on their sales. The Chinese currency is the renminbi, which is denoted by Rmb. All of the companys transactions with customers, employees, and suppliers are conducted in cash; there is no credit. The company uses a job-order costing system in which overhead is applied to jobs on the basis of direct labor cost. At the beginning of the year, it was estimated that the total direct labor cost for the year would be Rmb200,000 and the total manufacturing overhead cost would be Rmb330,000. At the beginning of the year, the inventory balances were as follows: Raw materials . . . . . . . . . . . . . . . . . . Work in process . . . . . . . . . . . . . . . . . Finished goods. . . . . . . . . . . . . . . . . . a. b. c. Rmb25,000 Rmb10,000 Rmb40,000 During the year, the following transactions were completed: Raw materials purchased for cash, Rmb275,000. Raw materials requisitioned for use in production, Rmb280,000 (materials costing Rmb220,000 were charged directly to jobs; the remaining materials were indirect). Costs for employee services were incurred as follows: Direct labor. . . . . . . . . . . . . . . . . . . . . Rmb180,000 Indirect labor . . . . . . . . . . . . . . . . . . . Rmb72,000 Sales commissions . . . . . . . . . . . . . . Rmb63,000 Administrative salaries . . . . . . . . . . . . Rmb90,000 d. e. f. g. h. i. j. Rent for the year was Rmb18,000 (Rmb13,000 of this amount related to factory operations, and the remainder related to selling and administrative activities). Utility costs incurred in the factory, Rmb57,000. Advertising costs incurred, Rmb140,000. Depreciation recorded on equipment, Rmb100,000. (Rmb88,000 of this amount was on equipment used in factory operations; the remaining Rmb12,000 was on equipment used in selling and administrative activities.) ? Manufacturing overhead cost was applied to jobs, Rmb . Goods that had cost Rmb675,000 to manufacture according to their job cost sheets were completed. Sales for the year totaled Rmb1,250,000. The total cost to manufacture these goods according to their job cost sheets was Rmb700,000. Required: 1. 2. Prepare journal entries to record the transactions for the year. Prepare T-accounts for inventories, Manufacturing Overhead, and Cost of Goods Sold. Post relevant data from your journal entries to these T-accounts (dont forget to enter the beginning balances in your inventory accounts). Compute an ending balance in each account. 129 gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 130 12/11/08 1:28:07 AM user-s180 130 /broker/MH-BURR/MHBR094/MHBR094-03/upload Chapter 3 3. 4. Is Manufacturing Overhead underapplied or overapplied for the year? Prepare a journal entry to close any balance in the Manufacturing Overhead account to Cost of Goods Sold. Prepare an income statement for the year. (Do not prepare a schedule of cost of goods manufactured; all of the information needed for the income statement is available in the journal entries and T-accounts you have prepared.) PROBLEM 323 Journal Entries; T-Accounts; Cost Flows [LO4, LO5, LO7] Almeda Products, Inc., uses a job-order costing system. The companys inventory balances on April 1, the start of its scal year, were as follows: Raw materials . . . . . . . . . . . . . . . . . . . . . Work in process . . . . . . . . . . . . . . . . . . . . Finished goods . . . . . . . . . . . . . . . . . . . . $32,000 $20,000 $48,000 During the year, the following transactions were completed: a. Raw materials were purchased on account, $170,000. b. Raw materials were issued from the storeroom for use in production, $180,000 (80% direct and 20% indirect). c. Employee salaries and wages were accrued as follows: direct labor, $200,000; indirect labor, $82,000; and selling and administrative salaries, $90,000. d. Utility costs were incurred in the factory, $65,000. e. Advertising costs were incurred, $100,000. f. Prepaid insurance expired during the year, $20,000 (90% related to factory operations, and 10% related to selling and administrative activities). g. Depreciation was recorded, $180,000 (85% related to factory assets, and 15% related to selling and administrative assets). h. Manufacturing overhead was applied to jobs at the rate of 175% of direct labor cost. i. Goods that cost $700,000 to manufacture according to their job cost sheets were transferred to the nished goods warehouse. j. Sales for the year totaled $1,000,000 and were all on account. The total cost to manufacture these goods according to their job cost sheets was $720,000. Required: 1. 2. 3. 4. Prepare journal entries to record the transactions for the year. Prepare T-accounts for Raw Materials, Work in Process, Finished Goods, Manufacturing Overhead, and Cost of Goods Sold. Post the appropriate parts of your journal entries to these T-accounts. Compute the ending balance in each account. (Dont forget to enter the beginning balances in the inventory accounts.) Is Manufacturing Overhead underapplied or overapplied for the year? Prepare a journal entry to close this balance to Cost of Goods Sold. Prepare an income statement for the year. (Do not prepare a schedule of cost of goods manufactured; all of the information needed for the income statement is available in the journal entries and T-accounts you have prepared.) PROBLEM 324 T-accounts; Applying Overhead [LO5, LO7, LO8] Hudson Companys trial balance as of January 1, the beginning of its scal year, is given below: Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . Raw Materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Work in Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Finished Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Prepaid Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Plant and Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . Accumulated Depreciation . . . . . . . . . . . . . . . . . . . . . . . Accounts Payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Capital Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,000 18,000 9,000 20,000 32,000 4,000 210,000 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $300,000 $ 53,000 38,000 160,000 49,000 $300,000 gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 131 12/11/08 1:58:41 AM user-s180 /broker/MH-BURR/MHBR094/MHBR094-03/upload Systems Design: Job-Order Costing Hudson Company uses a job-order costing system. During the year, the following transactions took place: a. Raw materials purchased on account, $40,000. b. Raw materials were requisitioned for use in production, $38,000 (85% direct and 15% indirect). c. Factory utility costs incurred, $19,100. d. Depreciation was recorded on plant and equipment, $36,000. Three-fourths of the depreciation related to factory equipment, and the remainder related to selling and administrative equipment. e. Advertising expense incurred, $48,000. f. Costs for salaries and wages were incurred as follows: Direct labor. . . . . . . . . . . . . . . . . . . . . . . . Indirect labor . . . . . . . . . . . . . . . . . . . . . . Administrative salaries . . . . . . . . . . . . . . . $45,000 $10,000 $30,000 g. Prepaid insurance expired during the year, $3,000 (80% related to factory operations, and 20% related to selling and administrative activities). h. Miscellaneous selling and administrative expenses incurred, $9,500. i. Manufacturing overhead was applied to production. The company applies overhead on the basis of $8 per machine-hour; 7,500 machine-hours were recorded for the year. j. Goods that cost $140,000 to manufacture according to their job cost sheets were transferred to the nished goods warehouse. k. Sales for the year totaled $250,000 and were all on account. The total cost to manufacture these goods according to their job cost sheets was $130,000. l. Collections from customers during the year totaled $245,000. m. Payments to suppliers on account during the year, $150,000; payments to employees for salaries and wages, $84,000. Required: 1. 2. 3. 4. Prepare a T-account for each account in the companys trial balance and enter the opening balances shown on the prior page. Record the transactions above directly into the T-accounts. Prepare new T-accounts as needed. Key your entries to the letters (a) through (m) above. Find the ending balance in each account. Is manufacturing overhead underapplied or overapplied for the year? Make an entry in the T-accounts to close any balance in the Manufacturing Overhead account to Cost of Goods Sold. Prepare an income statement for the year. (Do not prepare a schedule of cost of goods manufactured; all of the information needed for the income statement is available in the T-accounts.) PROBLEM 325 Multiple Departments; Overhead Rates; Underapplied or Overapplied Overhead [LO3, LO5, LO8] Hobart, Evans, and Nix is a small law rm that employs 10 partners and 12 support persons. The rm uses a job-order costing system to accumulate costs chargeable to each client, and it is organized into two departmentsthe Research and Documents Department and the Litigation Department. The rm uses predetermined overhead rates to charge the costs of these departments to its clients. At the beginning of the year, the rms management made the following estimates for the year: Department Research and Documents Research-hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . Direct attorney-hours . . . . . . . . . . . . . . . . . . . . . . . . Legal forms and supplies . . . . . . . . . . . . . . . . . . . . . Direct attorney cost . . . . . . . . . . . . . . . . . . . . . . . . . Departmental overhead cost . . . . . . . . . . . . . . . . . . Litigation 24,000 9,000 $16,000 $450,000 $840,000 18,000 $5,000 $900,000 $360,000 The predetermined overhead rate in the Research and Documents Department is based on research-hours, and the rate in the Litigation Department is based on direct attorney cost. 131 gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 132 12/11/08 1:28:08 AM user-s180 132 /broker/MH-BURR/MHBR094/MHBR094-03/upload Chapter 3 The costs charged to each client are made up of three elements: legal forms and supplies used, direct attorney costs incurred, and an applied amount of overhead from each department in which work is performed on the case. Case 418-3 was initiated on February 23 and completed on May 16. During this period, the following costs and time were recorded on the case: Department Research and Documents Research-hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . Direct attorney-hours . . . . . . . . . . . . . . . . . . . . . . . . Legal forms and supplies . . . . . . . . . . . . . . . . . . . . . Direct attorney cost . . . . . . . . . . . . . . . . . . . . . . . . . Litigation 26 7 $80 $350 114 $40 $5,700 Required: 1. 2. 3. 4. Compute the predetermined overhead rate used during the year in the Research and Documents Department. Compute the rate used in the Litigation Department. Using the rates you computed in (1) above, compute the total overhead cost applied to Case 418-3. What would be the total cost charged to Case 418-3? Show computations by department and in total for the case. At the end of the year, the rms records revealed the following actual cost and operating data for all cases handled during the year: Department Research and Documents Research-hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . Direct attorney-hours . . . . . . . . . . . . . . . . . . . . . . . . Legal forms and supplies . . . . . . . . . . . . . . . . . . . . . Direct attorney cost . . . . . . . . . . . . . . . . . . . . . . . . . Departmental overhead cost . . . . . . . . . . . . . . . . . . Litigation 26,000 8,000 $19,000 $400,000 $870,000 15,000 $6,000 $750,000 $315,000 Determine the amount of underapplied or overapplied overhead cost in each department for the year. PROBLEM 326 T-accounts; Overhead Rates; Journal Entries [LO2, LO3, LO4, LO5, LO7] AOZT Volzhskije Motory of St. Petersburg, Russia, makes marine motors for vessels ranging in size from harbor tugs to open-water icebreakers. (The Russian currency is the ruble, which is denoted by RUR. All currency amounts below are in thousands of RUR.) The company uses a job-order costing system. Only three jobsJob 208, Job 209, and Job 210were worked on during May and June. Job 208 was completed on June 20; the other two jobs were uncompleted on June 30. Job cost sheets on the three jobs are given below: Job Cost Sheet Job 208 May costs incurred:* Direct materials . . . . . . . . . . . . . . . Direct labor . . . . . . . . . . . . . . . . . . . Manufacturing overhead . . . . . . . . . June costs incurred: Direct materials . . . . . . . . . . . . . . . Direct labor . . . . . . . . . . . . . . . . . . . Manufacturing overhead . . . . . . . . . Job 209 RUR9,500 RUR8,000 RUR11,200 RUR5,100 RUR3,000 RUR4,200 RUR RUR RUR RUR RUR4,000 RUR ? RUR6,000 RUR7,500 RUR ? RUR7,200 RUR8,500 RUR ? *Jobs 208 and 209 were started during May. Job 210 gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 133 12/23/08 5:22:52 PM user-s180 /Users/user-s180/Desktop/Dhiru-23-12-08/New/MHBR094-03 Systems Design: Job-Order Costing The following additional information is available: a. Manufacturing overhead is applied to jobs on the basis of direct labor cost. b. Balances in the inventory accounts at May 31 were: Raw Materials . . . . . . . . . . . . . . . . . . Work in Process . . . . . . . . . . . . . . . . . Finished Goods . . . . . . . . . . . . . . . . . RUR30,000 RUR? RUR50,000 Required: 1. 2. 3. 4. 5. Prepare T-accounts for Raw Materials, Work in Process, Finished Goods, and Manufacturing Overhead. Enter the May 31 balances given above; in the case of Work in Process, compute the May 31 balance and enter it into the Work in Process T-account. Prepare journal entries for June as follows: a. Prepare an entry to record the issue of materials into production and post the entry to appropriate T-accounts. (In the case of direct materials, it is not necessary to make a separate entry for each job.) Indirect materials used during June totaled RUR3,600. b. Prepare an entry to record the incurrence of labor cost and post the entry to appropriate T-accounts. (In the case of direct labor cost, it is not necessary to make a separate entry for each job.) Indirect labor cost totaled RUR7,000 for June. c. Prepare an entry to record the incurrence of RUR19,400 in various actual manufacturing overhead costs for June. (Credit Accounts Payable.) Post this entry to the appropriate T-accounts. What apparent predetermined overhead rate does the company use to assign overhead cost to jobs? Using this rate, prepare a journal entry to record the application of overhead cost to jobs for June (it is not necessary to make a separate entry for each job). Post this entry to appropriate T-accounts. As stated earlier, Job 208 was completed during June. Prepare a journal entry to show the transfer of this job off of the production line and into the nished goods warehouse. Post the entry to appropriate T-accounts. Determine the balance at June 30 in the Work in Process inventory account. How much of this balance consists of costs charged to Job 209? To Job 210? PROBLEM 327 Schedule of Cost of Goods Manufactured; Overhead Analysis [LO3, LO5, LO6, LO7] Gitano Products operates a job-order costing system and applies overhead cost to jobs on the basis of direct materials used in production (not on the basis of raw materials purchased). All materials are classied as direct materials. In computing a predetermined overhead rate at the beginning of the year, the companys estimates were: manufacturing overhead cost, $800,000; and direct materials to be used in production, $500,000. The company has provided the following data in the form of an Excel worksheet: 133 gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 134 12/11/08 1:28:09 AM user-s180 134 /broker/MH-BURR/MHBR094/MHBR094-03/upload Chapter 3 Required: 1. 2. 3. 4. 5. a. Compute the predetermined overhead rate for the year. b. Compute the amount of underapplied or overapplied overhead for the year. Prepare a schedule of cost of goods manufactured for the year. Compute the Cost of Goods Sold for the year. (Do not include any underapplied or overapplied overhead in your Cost of Goods Sold gure.) What options are available for disposing of underapplied or overapplied overhead? Job 215 was started and completed during the year. What price would have been charged to the customer if the job required $8,500 in direct materials and $2,700 in direct labor cost and the company priced its jobs at 25% above the jobs cost according to the accounting system? Direct materials made up $24,000 of the $70,000 ending Work in Process inventory balance. Supply the information missing below: Direct materials . . . . . . . . . . . . . . . . . . . Direct labor. . . . . . . . . . . . . . . . . . . . . . . Manufacturing overhead . . . . . . . . . . . . $24,000 ? ? Work in process inventory . . . . . . . . . . . $70,000 PROBLEM 328 Multiple Departments; Applying Overhead [LO3, LO5, LO8] High Desert Potteryworks makes a variety of pottery products that it sells to retailers such as Home Depot. The company uses a job-order costing system in which predetermined overhead rates are used to apply manufacturing overhead cost to jobs. The predetermined overhead rate in the Molding Department is based on machine-hours, and the rate in the Painting Department is based on direct labor cost. At the beginning of the year, the companys management made the following estimates: Department Molding Direct labor-hours . . . . . . . . . . . . . . . . . . . . . . . . . . . Machine-hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Direct materials cost . . . . . . . . . . . . . . . . . . . . . . . . . Direct labor cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Manufacturing overhead cost . . . . . . . . . . . . . . . . . . . Painting 12,000 70,000 $510,000 $130,000 $602,000 60,000 8,000 $650,000 $420,000 $735,000 Job 205 was started on August 1 and completed on August 10. The companys cost records show the following information concerning the job: Department Molding Direct labor-hours . . . . . . . . . . . . . . . . . . . . . . . . . . . Machine-hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Materials placed into production . . . . . . . . . . . . . . . . Direct labor cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Painting 30 110 $470 $290 85 20 $332 $680 Required: 1. 2. 3. 4. Compute the predetermined overhead rate used during the year in the Molding Department. Compute the rate used in the Painting Department. Compute the total overhead cost applied to Job 205. What would be the total cost recorded for Job 205? If the job contained 50 units, what would be the unit product cost? At the end of the year, the records of High Desert Potteryworks revealed the following actual cost and operating data for all jobs worked on during the year: gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 135 12/11/08 1:28:09 AM user-s180 /broker/MH-BURR/MHBR094/MHBR094-03/upload Systems Design: Job-Order Costing Department Molding Direct labor-hours . . . . . . . . . . . . . . . . . . . . . . . . . . . Machine-hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Direct materials cost . . . . . . . . . . . . . . . . . . . . . . . . . Direct labor cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Manufacturing overhead cost . . . . . . . . . . . . . . . . . . . Painting 10,000 65,000 $430,000 $108,000 $570,000 62,000 9,000 $680,000 $436,000 $750,000 What was the amount of underapplied or overapplied overhead in each department at the end of the year? PROBLEM 329 Plantwide versus Departmental Overhead Rates; Underapplied or Overapplied Overhead [LO3, LO5, LO8] Blast it! said David Wilson, president of Teledex Company. Weve just lost the bid on the Koopers job by $2,000. It seems were either too high to get the job or too low to make any money on half the jobs we bid. Teledex Company manufactures products to customers specications and operates a job-order costing system. Manufacturing overhead cost is applied to jobs on the basis of direct labor cost. The following estimates were made at the beginning of the year: Department Fabricating Direct labor. . . . . . . . . . . . . . . . . . . . . . Manufacturing overhead . . . . . . . . . . . Machining Assembly Total Plant $200,000 $350,000 $100,000 $400,000 $300,000 $90,000 $600,000 $840,000 Jobs require varying amounts of work in the three departments. The Koopers job, for example, would have required manufacturing costs in the three departments as follows: Department Fabricating Direct materials . . . . . . . . . . . . . . . . . . Direct labor. . . . . . . . . . . . . . . . . . . . . . Manufacturing overhead . . . . . . . . . . . Machining Assembly Total Plant $3,000 $2,800 ? $200 $500 ? $1,400 $6,200 ? $4,600 $9,500 ? The company uses a plantwide overhead rate to apply manufacturing overhead cost to jobs. Required: 1. 2. 3. 4. Assuming use of a plantwide overhead rate: a. Compute the rate for the current year. b. Determine the amount of manufacturing overhead cost that would have been applied to the Koopers job. Suppose that instead of using a plantwide overhead rate, the company had used a separate predetermined overhead rate in each department. Under these conditions: a. Compute the rate for each department for the current year. b. Determine the amount of manufacturing overhead cost that would have been applied to the Koopers job. Explain the difference between the manufacturing overhead that would have been applied to the Koopers job using the plantwide rate in question 1 (b) above and using the departmental rates in question 2 (b). Assume that it is customary in the industry to bid jobs at 150% of total manufacturing cost (direct materials, direct labor, and applied overhead). What was the companys bid price on the Koopers job? What would the bid price have been if departmental overhead rates had been used to apply overhead cost? 135 gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 136 12/11/08 1:28:09 AM user-s180 136 /broker/MH-BURR/MHBR094/MHBR094-03/upload Chapter 3 5. At the end of the year, the company assembled the following actual cost data relating to all jobs worked on during the year. Department Fabricating Direct materials . . . . . . . . . . . . . . . . . . . Direct labor. . . . . . . . . . . . . . . . . . . . . . . Manufacturing overhead . . . . . . . . . . . . Machining Assembly Total Plant $190,000 $210,000 $360,000 $16,000 $108,000 $420,000 $114,000 $262,000 $84,000 $320,000 $580,000 $864,000 Compute the underapplied or overapplied overhead for the year (a) assuming that a plantwide overhead rate is used, and (b) assuming that departmental overhead rates are used. PROBLEM 330 T-Account Analysis of Cost Flows [LO3, LO6, LO8] Selected T-accounts of Moore Company are given below for the just completed year: Raw Materials Bal. 1/1 Debits Bal. 12/31 15,000 120,000 Manufacturing Overhead Credits ? Debits Bal. 12/31 Credits ? 25,000 Work in Process Bal. 1/1 Direct materials Direct labor Overhead 230,000 20,000 90,000 150,000 240,000 Factory Wages Payable Credits 470,000 Debits 185,000 Bal. 1/1 Credits Bal. 12/31 9,000 180,000 4,000 ? Finished Goods Bal. 1/1 Debits 40,000 ? Bal. 12/31 Cost of Goods Sold Credits ? Debits ? 60,000 Required: 1. 2. 3. 4. 5. 6. 7. 8. What was the cost of raw materials put into production during the year? How much of the materials in (1) above consisted of indirect materials? How much of the factory labor cost for the year consisted of indirect labor? What was the cost of goods manufactured for the year? What was the cost of goods sold for the year (before considering underapplied or overapplied overhead)? If overhead is applied to production on the basis of direct labor cost, what rate was in effect during the year? Was manufacturing overhead underapplied or overapplied? By how much? Compute the ending balance in the Work in Process inventory account. Assume that this balance consists entirely of goods started during the year. If $8,000 of this balance is direct labor cost, how much of it is direct materials cost? Manufacturing overhead cost? PROBLEM 331 Journal Entries; T-Accounts; Comprehensive Problem; Financial Statements; [LO3, LO4, LO5, LO6, LO7, LO8] Froya Fabrikker A/S of Bergen, Norway, is a small company that manufactures specialty heavy equipment for use in North Sea oil elds. (The Norwegian currency is the krone, which is denoted gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 137 12/11/08 1:28:10 AM user-s180 /broker/MH-BURR/MHBR094/MHBR094-03/upload Systems Design: Job-Order Costing by Nkr.) The company uses a job-order costing system and applies manufacturing overhead cost to jobs on the basis of direct labor-hours. At the beginning of the year, the following estimates were made for the purpose of computing the predetermined overhead rate: manufacturing overhead cost, Nkr360,000; and direct labor-hours, 900. The following transactions took place during the year (all purchases and services were acquired on account): a. Raw materials were purchased for use in production, Nkr200,000. b. Raw materials were requisitioned for use in production (all direct materials), Nkr185,000. c. Utility bills were incurred, Nkr70,000 (90% related to factory operations, and the remainder related to selling and administrative activities). d. Salary and wage costs were incurred: Direct labor (975 hours) . . . . . . . . . . . . . . . . . Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . Selling and administrative salaries . . . . . . . . . Nkr230,000 Nkr90,000 Nkr110,000 e. f. g. Maintenance costs were incurred in the factory, Nkr54,000. Advertising costs were incurred, Nkr136,000. Depreciation was recorded for the year, Nkr95,000 (80% related to factory equipment, and the remainder related to selling and administrative equipment). h. Rental cost incurred on buildings, Nkr120,000 (85% related to factory operations, and the remainder related to selling and administrative facilities). i. Manufacturing overhead cost was applied to jobs, Nkr ? . j. Cost of goods manufactured for the year, Nkr770,000. k. Sales for the year (all on account) totaled Nkr1,200,000. These goods cost Nkr800,000 according to their job cost sheets. The balances in the inventory accounts at the beginning of the year were: Raw Materials . . . . . . . . . . . . . . . . . . . Work in Process . . . . . . . . . . . . . . . . . . Finished Goods . . . . . . . . . . . . . . . . . . Nkr30,000 Nkr21,000 Nkr60,000 Required: 1. 2. 3. 4. 5. 6. Prepare journal entries to record the preceding data. Post your entries to T-accounts. (Dont forget to enter the beginning inventory balances above.) Determine the ending balances in the inventory accounts and in the Manufacturing Overhead account. Prepare a schedule of cost of goods manufactured. Prepare a journal entry to close any balance in the Manufacturing Overhead account to Cost of Goods Sold. Prepare a schedule of cost of goods sold. Prepare an income statement for the year. Job 412 was one of the many jobs started and completed during the year. The job required Nkr8,000 in direct materials and 39 hours of direct labor time at a total direct labor cost of Nkr9,200. The job contained only four units. If the company bills at a price 60% above the unit product cost on the job cost sheet, what price per unit would have been charged to the customer? PROBLEM 332 Predetermined Overhead Rate; Disposition of Underapplied or Overapplied Overhead [LO3, LO8] Bieler & Cie of Altdorf, Switzerland, makes furniture using the latest automated technology. The company uses a job-order costing system and applies manufacturing overhead cost to products on the basis of machine-hours. The currency in Switzerland is the Swiss franc, which is denoted by Sfr. The following estimates were used in preparing the predetermined overhead rate at the beginning of the year: Machine-hours . . . . . . . . . . . . . . . . . . Manufacturing overhead cost. . . . . . . 75,000 Sfr900,000 137 gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 138 12/11/08 1:28:10 AM user-s180 138 /broker/MH-BURR/MHBR094/MHBR094-03/upload Chapter 3 During the year, a glut of furniture on the market resulted in cutting back production and a buildup of furniture in the companys warehouse. The companys cost records revealed the following actual cost and operating data for the year: Machine-hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000 Manufacturing overhead cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Sfr850,000 Inventories at year-end: Raw materials. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Work in process (includes overhead applied of 36,000) . . . . . . . . . . Finished goods (includes overhead applied of 180,000) . . . . . . . . . . Cost of goods sold (includes overhead applied of 504,000) . . . . . . . . . Sfr30,000 Sfr100,000 Sfr500,000 Sfr1,400,000 Required: 1. 2. 3. 4. 5. Compute the companys predetermined overhead rate. Compute the underapplied or overapplied overhead. Assume that the company closes any underapplied or overapplied overhead directly to Cost of Goods Sold. Prepare the appropriate journal entry. Assume that the company allocates any underapplied or overapplied overhead to Work in Process, Finished Goods, and Cost of Goods Sold on the basis of the amount of overhead applied that remains in each account at the end of the year. Prepare the journal entry to show the allocation for the year. How much higher or lower will net operating income be if the underapplied or overapplied overhead is allocated rather than closed directly to Cost of Goods Sold? Cases CASE 333 Ethics and the Manager [LO3, LO5, LO8] Terri Ronsin had recently been transferred to the Home Security Systems Division of National Home Products. Shortly after taking over her new position as divisional controller, she was asked to develop the divisions predetermined overhead rate for the upcoming year. The accuracy of the rate is important because it is used throughout the year and any overapplied or underapplied overhead is closed out to Cost of Goods Sold at the end of the year. National Home Products uses direct labor-hours in all of its divisions as the allocation base for manufacturing overhead. To compute the predetermined overhead rate, Terri divided her estimate of the total manufacturing overhead for the coming year by the production managers estimate of the total direct labor-hours for the coming year. She took her computations to the divisions general manager for approval but was quite surprised when he suggested a modication in the base. Her conversation with the general manager of the Home Security Systems Division, Harry Irving, went like this: Ronsin: Here are my calculations for next years predetermined overhead rate. If you approve, we can enter the rate into the computer on January 1 and be up and running in the job-order costing system right away this year. Irving: Thanks for coming up with the calculations so quickly, and they look just ne. There is, however, one slight modication I would like to see. Your estimate of the total direct laborhours for the year is 440,000 hours. How about cutting that to about 420,000 hours? Ronsin: I dont know if I can do that. The production manager says she will need about 440,000 direct labor-hours to meet the sales projections for the year. Besides, there are going to be over 430,000 direct labor-hours during the current year and sales are projected to be higher next year. Irving: Teri, I know all of that. I would still like to reduce the direct labor-hours in the base to something like 420,000 hours. You probably dont know that I had an agreement with your predecessor as divisional controller to shave 5% or so off the estimated direct labor-hours every year. That way, we kept a reserve that usually resulted in a big boost to net operating income at gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 139 12/11/08 1:28:13 AM user-s180 /broker/MH-BURR/MHBR094/MHBR094-03/upload Systems Design: Job-Order Costing the end of the scal year in December. We called it our Christmas bonus. Corporate headquarters always seemed as pleased as punch that we could pull off such a miracle at the end of the year. This system has worked well for many years, and I dont want to change it now. Required: 1. 2. Explain how shaving 5% off the estimated direct labor-hours in the base for the predetermined overhead rate usually results in a big boost in net operating income at the end of the scal year. Should Terri Ronsin go along with the general managers request to reduce the direct laborhours in the predetermined overhead rate computation to 420,000 direct labor-hours? CASE 334 Critical Thinking; Interpretation of Manufacturing Overhead Rates [LO3, LO5] Kelvin Aerospace, Inc., manufactures parts such as rudder hinges for the aerospace industry. The company uses a job-order costing system with a predetermined plantwide overhead rate based on direct labor-hours. On December 16, 2008, the companys controller made a preliminary estimate of the predetermined overhead rate for the year 2009. The new rate was based on the estimated total manufacturing overhead cost of $3,402,000 and the estimated 63,000 total direct labor-hours for 2009: Predetermined overhead rate $3,402,000 63,000 hours $54 per direct labor-hour This new predetermined overhead rate was communicated to top managers in a meeting on December 19. The rate did not cause any comment because it was within a few pennies of the overhead rate that had been used during 2008. One of the subjects discussed at the meeting was a proposal by the production manager to purchase an automated milling machine built by Sunghi Industries. The president of Kelvin Aerospace, Harry Arcany, agreed to meet with the sales representative from Sunghi Industries to discuss the proposal. On the day following the meeting, Mr. Arcany met with Jasmine Chang, Sunghi Industries sales representative. The following discussion took place: Arcany: Wally, our production manager, asked me to meet with you because he is interested in installing an automated milling machine. Frankly, Im skeptical. Youre going to have to show me this isnt just another expensive toy for Wallys people to play with. Chang: This is a great machine with direct bottom-line benets. The automated milling machine has three major advantages. First, it is much faster than the manual methods you are using. It can process about twice as many parts per hour as your present milling machines. Second, it is much more exible. There are some up-front programming costs, but once those have been incurred, almost no setup is required to run a standard operation. You just punch in the code for the standard operation, load the machines hopper with raw material, and the machine does the rest. Arcany: What about cost? Having twice the capacity in the milling machine area wont do us much good. That center is idle much of the time anyway. Chang: I was getting there. The third advantage of the automated milling machine is lower cost. Wally and I looked over your present operations, and we estimated that the automated equipment would eliminate the need for about 6,000 direct labor-hours a year. What is your direct labor cost per hour? Arcany: The wage rate in the milling area averages about $32 per hour. Fringe benets raise that gure to about $41 per hour. Chang: Dont forget your overhead. Arcany: Next year the overhead rate will be $54 per hour. Chang: So including fringe benets and overhead, the cost per direct labor-hour is about $95. Arcany: Thats right. Chang: Since you can save 6,000 direct labor-hours per year, the cost savings would amount to about $570,000 a year. And our 60-month lease plan would require payments of only $348,000 per year. Arcany: That sounds like a no-brainer. When can you install the equipment? Shortly after this meeting, Mr. Arcany informed the companys controller of the decision to lease the new equipment, which would be installed over the Christmas vacation period. The controller realized that this decision would require a recomputation of the predetermined overhead rate for the year 2009 because the decision would affect both the manufacturing overhead and the 139 gar79611_ch03_088-147.indd Page 140 12/23/08 2:33:04 AM user-s176 140 /broker/MH-BURR/MHBR094/MHBR094-03/upload/MHBR094-03 Chapter 3 direct labor-hours for the year. After talking with both the production manager and the sales representative from Sunghi Industries, the controller discovered that in addition to the annual lease cost of $348,000, the new machine would also require a skilled technician/programmer who would have to be hired at a cost of $50,000 per year to maintain and program the equipment. Both of these costs would be included in factory overhead. There would be no other changes in total manufacturing overhead cost, which is almost entirely xed. The controller assumed that the new machine would result in a reduction of 6,000 direct labor-hours for the year from the levels that had initially been planned. When the revised predetermined overhead rate for the year 2009 was circulated among the companys top managers, there was considerable dismay. Required: 1. 2. 3. 4. Recompute the predetermined rate assuming that the new machine will be installed. Explain why the new predetermined overhead rate is higher (or lower) than the rate that was originally estimated for the year 2009. What effect (if any) would this new rate have on the cost of jobs that do not use the new automated milling machine? Why would managers be concerned about the new overhead rate? After seeing the new predetermined overhead rate, the production manager admitted that he probably wouldnt be able to eliminate all of the 6,000 direct labor-hours. He had been hoping to accomplish the reduction by not replacing workers who retire or quit, but that had not been possible. As a result, the real labor savings would be only about 2,000 hoursone worker. Given this additional information, evaluate the original decision to acquire the automated milling machine from Sunghi Industries. RESEARCH AND APPLICATION 335 [LO1, LO2, LO3] The questions in this exercise are based on Toll Brothers, Inc., one of the largest home builders in the United States. To answer the questions, you will need to download Toll Brothers 2004 annual report (www.tollbrothers.com/homesearch/servlet/HomeSearch?app IRannual) and its Form 10-K for the Fiscal year ended October 31, 2004. To access the 10-K report, go to www.sec.gov/edgar/searchedgar/companysearch.html. Input CIK code 794170 and hit enter. In the gray box on the right-hand side of your computer screen dene the scope of your search by inputting 10-K and then pressing enter. Select the 10-K with a ling date of January 13, 2005. You do not need to print these documents to answer the questions. Required: 1. 2. 3. 4. 5. 6. 7. 8. What is Toll Brothers strategy for success in the marketplace? Does the company rely primarily on a customer intimacy, operational excellence, or product leadership customer value proposition? What evidence supports your conclusion? What business risks does Toll Brothers face that may threaten the companys ability to satisfy stockholder expectations? What are some examples of control activities that the company could use to reduce these risks? (Hint: Focus on pages 1011 of the 10-K.) Would Toll Brothers be more likely to use process costing or job-order costing? Why? What are some examples of Toll Brothers direct material costs? Would you expect the bill of materials for each of Toll Brothers homes to be the same or different? Why? Describe the types of direct labor costs incurred by Toll Brothers. Would Toll Brothers use employee time tickets at their home sites under construction? Why or why not? What are some examples of overhead costs that are incurred by Toll Brothers? Some companies establish prices for their products by marking up their full manufacturing cost (i.e., the sum of direct materials, direct labor, and manufacturing overhead costs). For example, a company may set prices at 150% of each products full manufacturing cost. Does Toll Brothers price its houses using this approach? How does Toll Brothers assign manufacturing overhead costs to cost objects? From a nancial reporting standpoint, why does the company need to assign manufacturing overhead costs to cost objects? gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 141 12/11/08 1:28:14 AM user-s180 /broker/MH-BURR/MHBR094/MHBR094-03/upload 141 Systems Design: Job-Order Costing Appendix 3A: The Predetermined Overhead Rate and Capacity Companies typically base their predetermined overhead rates on the estimated, or budgeted, amount of the allocation base for the upcoming period. This is the method that is used in the chapter, but it is a practice that has come under severe criticism.1 The criticism centers on how xed manufacturing overhead costs are handled under this traditional approach. As we shall see, the critics argue that, in general, too much xed manufacturing overhead cost is applied to products. To focus on this issue, we will make two simplifying assumptions in this appendix: (1) we will consider only xed manufacturing overhead; and (2) we will assume that the actual xed manufacturing overhead at the end of the period is the same as the estimated, or budgeted, xed manufacturing overhead at the beginning of the period. Neither of these assumptions is entirely realistic. Ordinarily, some manufacturing overhead is variable and even xed costs can differ from what was expected at the beginning of the period, but making those assumptions enables us to focus on the primary issues the critics raise. An example will help us to understand the controversy. Prahad Corporation manufactures music CDs for local recording studios. The companys CD duplicating machine is capable of producing a new CD every 10 seconds from a master CD. The company leases the CD duplicating machine for $180,000 per year, and this is the companys only manufacturing overhead cost. With allowances for setups and maintenance, the machine is theoretically capable of producing up to 900,000 CDs per year. However, due to weak retail sales of CDs, the companys commercial customers are unlikely to order more than 600,000 CDs next year. The company uses machine time as the allocation base for applying manufacturing overhead to CDs. These data are summarized below: Prahad Corporation Data Total manufacturing overhead cost. . . . . . . . . . . . Allocation basemachine time per CD . . . . . . . . Capacity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Budgeted output for next year . . . . . . . . . . . . . . . $180,000 per year 10 seconds per CD 900,000 CDs per year 600,000 CDs If Prahad follows common practice and computes its predetermined overhead rate using estimated or budgeted gures, then its predetermined overhead rate for next year would be $0.03 per second of machine time computed as follows: Predetermined overhead rate Estimated total manufacturing overhead cost Estimated total amount of the allocation base $180,000 600,000 CDs 10 seconds per CD $0.03 per second Because each CD requires 10 seconds of machine time, each CD will be charged for $0.30 of overhead cost. 1 Institute of Management Accountants, Measuring the Cost of Capacity: Statements on Management Accounting, Number 4Y, Montvale, NJ; Thomas Klammer, ed., Capacity Measurement and Improvement: A Managers Guide to Evaluating and Optimizing Capacity Productivity (Chicago: CAM-I, Irwin Professional Publishing); and C. J. McNair, The Hidden Costs of Capacity, The Journal of Cost Management (Spring 1994), pp. 1224. LEARNING OBJECTIVE 9 Understand the implications of basing the predetermined overhead rate on activity at capacity rather than on estimated activity for the period. gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 142 12/11/08 1:28:15 AM user-s180 142 /broker/MH-BURR/MHBR094/MHBR094-03/upload Chapter 3 Critics charge that there are two problems with this procedure. First, if predetermined overhead rates are based on budgeted activity and overhead includes signicant xed costs, then the unit product costs will uctuate depending on the budgeted level of activity for the period. For example, if the budgeted output for the year was only 300,000 CDs, the predetermined overhead rate would be $0.06 per second of machine time or $0.60 per CD rather than $0.30 per CD. In general, if budgeted output falls, the overhead cost per unit will increase; it will appear that the CDs cost more to make. Managers may then be tempted to increase prices at the worst possible timejust as demand is falling. Second, critics charge that under the traditional approach, products are charged for resources that they dont use. When the xed costs of capacity are spread over estimated activity, the units that are produced must shoulder the costs of unused capacity. That is why the applied overhead cost per unit increases as the level of activity falls. The critics argue that products should be charged only for the capacity that they use; they should not be charged for the capacity they dont use. This can be accomplished by basing the predetermined overhead rate on capacity as follows: Predetermined overhead rate based on capacity Estimated total manufacturing overhead cost at capacity Estimated total amount of the allocation base at capacity $180,000 900,000 CDs 10 seconds per CD $0.02 per second It is important to realize that the numerator in this predetermined overhead rate is the estimated total manufacturing overhead cost at capacity. In general, the numerator in a predetermined overhead rate is the estimated total manufacturing overhead cost for the level of activity in the denominator. Ordinarily, the estimated total manufacturing overhead cost at capacity will be larger than the estimated total manufacturing overhead cost at the estimated level of activity. The estimated level of activity in this case was 600,000 CDs (or 6 million seconds of machine time), whereas capacity is 900,000 CDs (or 9 million seconds of machine time). The estimated total manufacturing overhead cost at 600,000 CDs was $180,000. This also happens to be the estimated total manufacturing overhead cost at 900,000 CDs, but that only happens because we have assumed that the manufacturing overhead is entirely xed. If manufacturing overhead contained any variable element, the total manufacturing overhead would be larger at 900,000 CDs than at 600,000 CDs and, in that case, the predetermined overhead rate should reect that fact. At any rate, returning to the computation of the predetermined overhead rate based on capacity, the predetermined overhead rate is $0.02 per second and so the overhead cost applied to each CD would be $0.20. This charge is constant and would not be affected by the level of activity during a period. If output falls, the charge would still be $0.20 per CD. This method will almost certainly result in underapplied overhead. If actual output at Prahad Corporation is 600,000 CDs, then only $120,000 of overhead cost would be applied to products ($0.20 per CD 600,000 CDs). Because the actual overhead cost is $180,000, overhead would be underapplied by $60,000. Because we assume here that manufacturing overhead is entirely xed and that actual manufacturing overhead equals the manufacturing overhead that was estimated at the beginning of the year, all of this underapplied overhead represents the cost of unused capacity. In other words, if there had been no unused capacity, there would have been no underapplied overhead. The critics suggest that the underapplied overhead that results from unused capacity should be separately disclosed on the income statement as the Cost of Unused Capacitya period expense. Disclosing this cost as a lump sum on the income statement, rather than burying it in Cost of Goods Sold or ending inventories, makes it much more visible to managers. An example of such an income statement appears on the following page: gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 143 12/11/08 1:28:15 AM user-s180 /broker/MH-BURR/MHBR094/MHBR094-03/upload Systems Design: Job-Order Costing 143 Prahad Corporation Income Statement For the Year Ended December 31 Sales1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost of goods sold2 . . . . . . . . . . . . . . . . . . . . . $1,200,000 1,080,000 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . Other expenses: Cost of unused capacity3 . . . . . . . . . . . . . . . Selling and administrative expenses4 . . . . . . 120,000 Net operating income . . . . . . . . . . . . . . . . . . . . $ 60,000 90,000 150,000 ($ 30,000) 1 Assume sales of 600,000 CDs at $2 per CD. Assume the unit product cost of the CDs is $1.80, including $0.20 for manufacturing overhead. 3 See the calculations in the text on the prior page. Underapplied overhead is $60,000. 4 Assume selling and administrative expenses total $90,000. 2 N ote that the cost of unused capacity is prominently displayed on this income statement. Ofcial pronouncements do not prohibit basing predetermined overhead rates on capacity for external reports.2 Nevertheless, basing the predetermined overhead rate on estimated or budgeted activity is a long-established practice in industry, and some managers and accountants may object to the large amounts of underapplied overhead that would often result from using capacity to determine predetermined overhead rates. And some may insist that the underapplied overhead be allocated among Cost of Goods Sold and ending inventorieswhich would defeat the purpose of basing the predetermined overhead rate on capacity. RESOURCE CONSUMPTION ACCOUNTING Clopay Plastic Products Company, headquartered in Cincinnati, Ohio, recently implemented a pilot application of a German cost accounting system known in the United States as Resource Consumption Accounting (RCA). One of the benets of RCA is that it uses the estimated total amount of the allocation base at capacity to calculate overhead rates and to assign costs to cost objects. This makes idle capacity visible to managers who can react to this information by either growing sales or taking steps to reduce the amount and cost of available capacity. It also ensures that products are only charged for the resources used to produce them. Clopays old cost system spread all of the companys manufacturing overhead costs over the units produced. So, if Clopays senior managers decided to discontinue what appeared to be an unprotable product, the unit costs of the remaining products would increase as the xed overhead costs of the newly idled capacity were spread over the remaining products. Source: B. Douglas Clinton and Sally A. Webber, Heres Innovation in Management Accounting with Resource Consumption Accounting, Strategic Finance, October 2004, pp. 2126. 2 Institute of Management Accountants, Measuring the Cost of Capacity, pp. 4647. IN BUSINESS gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 144 12/11/08 1:28:16 AM user-s180 144 /broker/MH-BURR/MHBR094/MHBR094-03/upload Chapter 3 Appendix 3A Exercises and Problems EXERCISE 3A1 Overhead Rates and Capacity Issues [LO3, LO5, LO8, LO9] Security Pension Services helps clients to set up and administer pension plans that are in compliance with tax laws and regulatory requirements. The rm uses a job-order costing system in which overhead is applied to clients accounts on the basis of professional staff hours charged to the accounts. Data concerning two recent years appear below: 2008 Estimated professional staff hours to be charged to clients accounts . . . . . . . . . . . . . . . Estimated overhead cost . . . . . . . . . . . . . . . . . . . . . . . . Professional staff hours available. . . . . . . . . . . . . . . . . . 2009 4,600 $310,500 6,000 4,500 $310,500 6,000 Professional staff hours available is a measure of the capacity of the rm. Any hours available that are not charged to clients accounts represent unused capacity. All of the rms overhead is xed. Required: 1. 2. 3. 4. Marta Brinksi is an established client whose pension plan was set up many years ago. In both 2008 and 2009, only 2.5 hours of professional staff time were charged to Ms. Brinksis account. If the company bases its predetermined overhead rate on the estimated overhead cost and the estimated professional staff hours to be charged to clients, how much overhead cost would have been applied to Ms. Brinksis account in 2008? In 2009? Suppose that the company bases its predetermined overhead rate on the estimated overhead cost and the estimated professional staff hours to be charged to clients as in (1) above. Also suppose that the actual professional staff hours charged to clients accounts and the actual overhead costs turn out to be exactly as estimated in both years. By how much would the overhead be underapplied or overapplied in 2008? In 2009? Refer back to the data concerning Ms. Brinksi in (1) above. If the company bases its predetermined overhead rate on the professional staff hours available, how much overhead cost would have been applied to Ms. Brinksis account in 2008? In 2009? Suppose that the company bases its predetermined overhead rate on the professional staff hours available as in (3) above. Also suppose that the actual professional staff hours charged to clients accounts and the actual overhead costs turn out to be exactly as estimated in both years. By how much would the overhead be underapplied or overapplied in 2008? In 2009? PROBLEM 3A2 Predetermined Overhead Rate and Capacity [LO3, LO5, LO8, LO9] Platinum Tracks, Inc., is a small audio recording studio located in Los Angeles. The company handles work for advertising agenciesprimarily for radio adsand has a few singers and bands as clients. Platinum Tracks handles all aspects of recording from editing to making a digital master from which CDs can be copied. The competition in the audio recording industry in Los Angeles has always been tough, but it has been getting even tougher over the last several years. The studio has been losing customers to newer studios that are equipped with more up-to-date equipment and that are able to offer very attractive prices and excellent service. Summary data concerning the last two years of operations follow: 2008 Estimated hours of studio service . . . . . . . . . . . . . . . . . Estimated studio overhead cost . . . . . . . . . . . . . . . . . . . Actual hours of studio service provided . . . . . . . . . . . . . Actual studio overhead cost incurred . . . . . . . . . . . . . . . Hours of studio service at capacity . . . . . . . . . . . . . . . . 2009 1,000 $160,000 750 $160,000 1,600 800 $160,000 500 $160,000 1,600 gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 145 12/11/08 1:28:17 AM user-s180 /broker/MH-BURR/MHBR094/MHBR094-03/upload Systems Design: Job-Order Costing The company applies studio overhead to recording jobs on the basis of the hours of studio service provided. For example, 40 hours of studio time were required to record, edit, and master the Verde Baja music CD for a local Latino band. All of the studio overhead is xed, and the actual overhead cost incurred was exactly as estimated at the beginning of the year in both 2008 and 2009. Required: 1. 2. 3. 4. Platinum Tracks computes its predetermined overhead rate at the beginning of each year based on the estimated studio overhead and the estimated hours of studio service for the year. How much overhead would have been applied to the Verde Baja job if it had been done in 2008? In 2009? By how much would overhead have been underapplied or overapplied in 2008? In 2009? The president of Platinum Tracks has heard that some companies in the industry have changed to a system of computing the predetermined overhead rate at the beginning of each year based on the hours of studio service that could be provided at capacity. He would like to know what effect this method would have on job costs. How much overhead would have been applied using this method to the Verde Baja job if it had been done in 2008? In 2009? By how much would overhead have been underapplied or overapplied in 2008 using this method? In 2009? How would you interpret the underapplied or overapplied overhead that results from using studio hours at capacity to compute the predetermined overhead rate? What fundamental business problem is Platinum Tracks facing? Which method of computing the predetermined overhead rate is likely to be more helpful in facing this problem? Explain. CASE 3A3 Ethics; Predetermined Overhead Rate and Capacity [LO5, LO8, LO9] Pat Miranda, the new controller of Vault Hard Drives, Inc., has just returned from a seminar on the choice of the activity level in the predetermined overhead rate. Even though the subject did not sound exciting at rst, she found that there were some important ideas presented that should get a hearing at her company. After returning from the seminar, she arranged a meeting with the production manager, J. Stevens, and the assistant production manager, Marvin Washington. Pat: I ran across an idea that I wanted to check out with both of you. Its about the way we compute predetermined overhead rates. J.: Were all ears. Pat: We compute the predetermined overhead rate by dividing the estimated total factory overhead for the coming year by the estimated total units produced for the coming year. Marvin: Weve been doing that as long as Ive been with the company. J.: And it has been done that way at every other company Ive worked at, except at most places they divide by direct labor-hours. Pat: We use units because it is simpler and we basically make one product with minor variations. But, theres another way to do it. Instead of basing the overhead rate on the estimated total units produced for the coming year, we could base it on the total units produced at capacity. Marvin: Oh, the Marketing Department will love that. It will drop the costs on all of our products. Theyll go wild over there cutting prices. Pat: That is a worry, but I wanted to talk to both of you rst before going over to Marketing. J.: Arent you always going to have a lot of underapplied overhead? Pat: Thats correct, but let me show you how we would handle it. Heres an example based on our budget for next year. Budgeted (estimated) production . . . . . . . . . . . . . . . . . . . . . . . . . . . Budgeted sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Capacity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Selling price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Variable manufacturing cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total manufacturing overhead cost (all xed). . . . . . . . . . . . . . . . . . Administrative and selling expenses (all xed). . . . . . . . . . . . . . . . . Beginning inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160,000 units 160,000 units 200,000 units $60 per unit $15 per unit $4,000,000 $2,700,000 $0 145 gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 146 12/11/08 1:28:20 AM user-s180 146 /broker/MH-BURR/MHBR094/MHBR094-03/upload Chapter 3 Traditional Approach to Computation of the Predetermined Overhead Rate Estimated total manufacturing overhead cost, $4,000,000 Estimated total units produced, 160,000 $25 per unit Budgeted Income Statement Revenue (160,000 units $60 per unit) . . . . . . . . . . . . . . . . . . . . . . Cost of goods sold: Variable manufacturing (160,000 units $15 per unit) . . . . . . . . . Manufacturing overhead applied (160,000 units $25 per unit) . . . . . . . . . . . . . . . . . . . . . . . . . . $9,600,000 $2,400,000 4,000,000 6,400,000 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . 3,200,000 2,700,000 Net operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 500,000 New Approach to Computation of the Predetermined Overhead Rate Using Capacity in the Denominator Estimated total manufacturing overhead cost at capacity, $4,000,000 Total units at capacity, 200,000 $20 per unit Budgeted Income Statement Revenue (160,000 units $60 per unit) . . . . . . . . . . . . . . . . . . . . . . Cost of goods sold: Variable manufacturing (160,000 units $15 per unit) . . . . . . . . . Manufacturing overhead applied (160,000 units $20 per unit) . . . . . . . . . . . . . . . . . . . . . . . . . . $9,600,000 $2,400,000 3,200,000 5,600,000 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost of unused capacity [(200,000 units 160,000 units) $20 per unit] . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . 4,000,000 Net operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 500,000 800,000 2,700,000 J.: Whoa!! I dont think I like the looks of that Cost of unused capacity. If that thing shows up on the income statement, someone from headquarters is likely to come down here looking for some people to lay off. Marvin: Im worried about something else too. What happens when sales are not up to expectations? Can we pull the hat trick? Pat: Im sorry, I dont understand. J.: Marvins talking about something that happens fairly regularly. When sales are down and profits look like they are going to be lower than the president told the owners they were going to be, the president comes down here and asks us to deliver some more prots. Marvin: And we pull them out of our hat. J.: Yeah, we just increase production until we get the prots we want. Pat: I still dont understand. You mean you increase sales? J.: Nope, we increase production. Were the production managers, not the sales managers. Pat: I get it. Since you have produced more, the sales force has more units it can sell. J.: Nope, the marketing people dont do a thing. We just build inventories and that does the trick. gar79611_ch03_088-147.indd gar79611_ch03_088-147.indd Page 147 12/11/08 1:28:20 AM user-s180 /broker/MH-BURR/MHBR094/MHBR094-03/upload Systems Design: Job-Order Costing Required: In all of the questions below, assume that the predetermined overhead rate under the traditional method is $25 per unit, and under the new method it is $20 per unit. Also assume that under the traditional method any underapplied or overapplied overhead is taken directly to the income statement as an adjustment to Cost of Goods Sold. 1. Suppose actual production is 160,000 units. Compute the net operating incomes that would be realized under the traditional and new methods if actual sales are 150,000 units and everything else turns out as expected. 2. How many units would have to be produced under each of the methods in order to realize the budgeted net operating income of $500,000 if actual sales are 150,000 units and everything else turns out as expected? 3. What effect does the new method based on capacity have on the volatility of net operating income? 4. Will the hat trick be easier or harder to perform if the new method based on capacity is used? 5. Do you think the hat trick is ethical? 147 Chapter gar79611_ch04_148-187.indd Page 148 12/12/08 9:38:02 PM user-s180 4 /Users/user-s180/Desktop/TempWork/DEC/12-12-08/Dhiru 12-12-08/New/MHBR094-04 Systems Design: Process Costing Costing the Quicker-Picker-Upper LEARNING OBJECTIVES After studying Chapter 4, you should be able to: Record the flow of materials, labor, and overhead through a process costing system. LO2 Compute the equivalent units of production using the weightedaverage method. LO3 Compute the cost per equivalent unit using the weighted-average method. LO4 Assign costs to units using the weighted-average method. LO5 LO6 Prepare a cost reconciliation report. LO7 (Appendix 4A) Compute the cost per equivalent unit using the FIFO method. LO8 (Appendix 4A) Assign costs to units using the FIFO method. LO9 (Appendix 4A) Prepare a cost reconciliation report using the FIFO method. LO10 (Appendix 4B) Allocate service department costs to operating departments using the direct method. LO11 (Appendix 4B) Allocate service department costs to operating departments using the step-down method. (Appendix 4A) Compute the equivalent units of production using the FIFO method. 148 Source: Conversation with Brad Bays, formerly a Procter & Gamble financial executive. BU SI N ES S FOC U S LO1 If you have ever spilled milk, there is a good chance that you used Bounty paper towels to clean up the mess. Procter & Gamble (P&G) manufactures Bounty in two main processing departmentsPaper Making and Paper Converting. In the Paper Making Department, wood pulp is converted into paper and then spooled into 2,000 pound rolls. In the Paper Converting Department, two of the 2,000 pound rolls of paper are simultaneously unwound into a machine that creates a two-ply paper towel that is decorated, perforated, and embossed to create texture. The large sheets of paper towels that emerge from this process are wrapped around a cylindrical cardboard core measuring eight feet in length. Once enough sheets wrap around the core, the eight foot roll is cut into individual rolls of Bounty that are sent down a conveyor to be wrapped, packed, and shipped. In this type of manufacturing environment, costs cannot be readily traced to individual rolls of Bounty; however, given the homogeneous nature of the product, the total costs incurred in the Paper Making Department can be spread uniformly across its output of 2,000 pound rolls of paper. Similarly, the total costs incurred in the Paper Converting Department (including the cost of the 2,000 pound rolls that are transferred in from the Paper Making Department) can be spread uniformly across the number of cases of Bounty produced. P&G uses a similar costing approach for many of its products such as Tide, Crest toothpaste, and Pringles. gar79611_ch04_148-187.indd Page 149 12/12/08 9:38:14 PM user-s180 /Users/user-s180/Desktop/TempWork/DEC/12-12-08/Dhiru 12-12-08/New/MHBR094-04 Systems Design: Process Costing A s explained in the previous chapter, job-order costing and process costing are two common methods for determining unit product costs. A joborder costing system is used when many different jobs or products are worked on each period. Examples of industries that use job-order costing include furniture manufacturing, special-order printing, shipbuilding, and many types of service organizations. By contrast, process costing is used most commonly in industries that convert raw materials into homogeneous (i.e., uniform) products, such as bricks, soda, or paper, on a continuous basis. Examples of companies that would use process costing include Reynolds Aluminum (aluminum ingots), Scott Paper (toilet paper), General Mills (our), Exxon (gasoline and lubricating oils), Coppertone (sunscreens), and Kellogg (breakfast cereals). In addition, process costing is sometimes used in companies with assembly operations. A form of process costing may also be used in utilities that produce gas, water, and electricity. Our purpose in this chapter is to explain how product costing works in a process costing system. Comparison of Job-Order and Process Costing In some ways process costing is very similar to job-order costing, and in some ways it is very different. In this section, we focus on these similarities and differences to provide a foundation for the detailed discussion of process costing that follows. Similarities between Job-Order and Process Costing Much of what you learned in the previous chapter about costing and cost ows applies equally well to process costing in this chapter. We are not throwing out all that we have learned about costing and starting from scratch with a whole new system. The similarities between job-order and process costing can be summarized as follows: 1. Both systems have the same basic purposesto assign material, labor, and manufacturing overhead costs to products and to provide a mechanism for computing unit product costs. 2. Both systems use the same basic manufacturing accounts, including Manufacturing Overhead, Raw Materials, Work in Process, and Finished Goods. 3. The ow of costs through the manufacturing accounts is basically the same in both systems. As can be seen from this comparison, much of the knowledge that you have already acquired about costing is applicable to a process costing system. Our task now is to rene and extend your knowledge to process costing. Differences between Job-Order and Process Costing There are three differences between job-order and process costing. First, process costing is used when a company produces a continuous ow of units that are indistinguishable from one another. Job-order costing is used when a company produces many different jobs that have unique production requirements. Second, under process costing, it makes no sense to try to identify materials, labor, and overhead costs with a particular customer order (as we did with job-order costing) because each order is just one of many that are lled from a continuous ow of virtually identical units from the production line. Accordingly, process costing accumulates costs by department (rather than by order) and assigns these costs uniformly to all units that pass through the department during a period. Job cost sheets (which we used for job-order costing) are not used to accumulate costs. Third, process costing systems compute unit costs by department. This differs from job-order 149 gar79611_ch04_148-187.indd gar79611_ch04_148-187.indd Page 150 12/12/08 9:38:14 PM user-s180 150 /Users/user-s180/Desktop/TempWork/DEC/12-12-08/Dhiru 12-12-08/New/MHBR094-04 Chapter 4 E X H I B I T 41 Differences between Job-Order and Process Costing Job-Order Costing Process Costing 1. Many different jobs are worked on during each period, with each job having different production requirements. 2. Costs are accumulated by individual job. 3. Unit costs are computed by job on the job cost sheet. 1. A single product is produced either on a continuous basis or for long periods of time. All units of product are identical. 2. Costs are accumulated by department. 3. Unit costs are computed by department. costing where unit costs are computed by job on the job cost sheet. Exhibit 41 summarizes the differences just described. Cost Flows in Process Costing Before going through a detailed example of process costing, it will be helpful to see how, in a general way, manufacturing costs ow through a process costing system. Processing Departments A processing department is an organizational unit where work is performed on a product and where materials, labor, or overhead costs are added to the product. For example, a Nalleys potato chip factory might have three processing departmentsone for preparing potatoes, one for cooking, and one for inspecting and packaging. A brick factory might have two processing departmentsone for mixing and molding clay into brick form and one for ring the molded brick. Some products and services may go through a number of processing departments, while others may go through only one or two. Regardless of the number of processing departments, they all have two essential features. First, the activity in the processing department is performed uniformly on all of the units passing through it. Second, the output of the processing department is homogeneous; in other words, all of the units produced are identical. Products in a process costing environment, such as bricks or potato chips, typically ow in sequence from one department to another as in Exhibit 42. E X H I B I T 42 Sequential Processing Departments Processing costs Basic raw material inputs (potatoes) Processing Department (potato preparation) Processing costs Partially completed goods (prepared potatoes) Processing Department (cooking) Processing costs Partially completed goods (cooked potato chips) Processing Department (inspecting and packing) Finished goods (packaged potato chips) gar79611_ch04_148-187.indd Page 151 12/12/08 9:38:15 PM user-s180 /Users/user-s180/Desktop/TempWork/DEC/12-12-08/Dhiru 12-12-08/New/MHBR094-04 151 Systems Design: Process Costing IN BUSINESS COCA-COLAS PROCESSING DEPARTMENTS In 2004, the Coca-Cola Company sold more than $21 billion of products in over 200 countries. Some of the companys key processing steps include washing and rinsing bottles, mixing and blending ingredients, lling and capping bottles, and labeling and packaging bottles. Raw material costs are added at various stages during this process. For example, sugar, ltered water, carbon dioxide, and syrup are added during the mixing and blending stage of the process. Bottle caps are added during the lling and capping step, and paper labels are added during the labeling and packaging stage. Coca-Colas manufacturing process is well suited for process costing because it produces a continuous stream of identical bottles of soda. The material costs and conversion costs that are incurred at the various stages of the production process can be assigned to products by spreading them evenly over the total volume of production. Source: The Coca-Cola Company 2004 annual report. The Flow of Materials, Labor, and Overhead Costs Cost accumulation is simpler in a process costing system than in a job-order costing system. In a process costing system, instead of having to trace costs to hundreds of different jobs, costs are traced to only a few processing departments. A T-account model of materials, labor, and overhead cost ows in a process costing system is shown in Exhibit 43. Several key points should be noted from this exhibit. First, note that a separate Work in Process account is maintained for each processing department. In contrast, in a job-order costing system the entire company may have only one E X H I B I T 43 T-Account Model of Process Costing Flows Raw Materials Wages Payable Manufacturing Overhead Work in Process Department A XXX Work in Process Department B XXX XXX Finished Goods XXX Cost of Goods Sold XXX gar79611_ch04_148-187.indd Page 152 12/12/08 9:38:17 PM user-s180 152 /Users/user-s180/Desktop/TempWork/DEC/12-12-08/Dhiru 12-12-08/New/MHBR094-04 Chapter 4 Work in Process account. Second, note that the completed production of the rst processing department (Department A in the exhibit) is transferred to the Work in Process account of the second processing department (Department B). After further work in Department B, the completed units are then transferred to Finished Goods. (In Exhibit 43, we show only two processing departments, but a company can have many processing departments.) Finally, note that materials, labor, and overhead costs can be added in any processing departmentnot just the rst. Costs in Department Bs Work in Process account consist of the materials, labor, and overhead costs incurred in Department B plus the costs attached to partially completed units transferred in from Department A (called transferred-in costs). Materials, Labor, and Overhead Cost Entries L EARNING OBJECTIVE 1 Record the ow of materials, labor, and overhead through a process costing system. To complete our discussion of cost ows in a process costing system, in this section we show journal entries relating to materials, labor, and overhead costs at Megans Classic Cream Soda, a company that has two processing departmentsFormulating and Bottling. In the Formulating Department, ingredients are checked for quality and then mixed and injected with carbon dioxide to create bulk cream soda. In the Bottling Department, bottles are checked for defects, lled with cream soda, capped, visually inspected again for defects, and then packed for shipping. Materials Costs As in job-order costing, materials are drawn from the storeroom using a materials requisition form. Materials can be added in any processing department, although it is not unusual for materials to be added only in the rst processing department, with subsequent departments adding only labor and overhead costs. At Megans Classic Cream Soda, some materials (i.e., water, avors, sugar, and carbon dioxide) are added in the Formulating Department and some materials (i.e., bottles, caps, and packing materials) are added in the Bottling Department. The journal entry to record the materials used in the rst processing department, the Formulating Department, is as follows: Work in ProcessFormulating . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Raw Materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . XXX XXX The journal entry to record the materials used in the second processing department, the Bottling Department, is as follows: Work in ProcessBottling. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Raw Materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . XXX XXX Labor Costs In process costing, labor costs are traced to departmentsnot to individual jobs. The following journal entry records the labor costs in the Formulating Department at Megans Classic Cream Soda: Work in ProcessFormulating . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Salaries and Wages Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . XXX XXX A similar entry would be made to record labor costs in the Bottling Department. Overhead Costs In process costing, as in job-order costing, predetermined overhead rates are usually used. Manufacturing overhead cost is applied according to the amount of the allocation base that is incurred in the department. The following journal entry records the overhead cost applied in the Formulating Department: Work in ProcessFormulating . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . XXX XXX A similar entry would be made to apply manufacturing overhead costs in the Bottling Department. gar79611_ch04_148-187.indd gar79611_ch04_148-187.indd Page 153 12/12/08 9:38:18 PM user-s180 /Users/user-s180/Desktop/TempWork/DEC/12-12-08/Dhiru 12-12-08/New/MHBR094-04 153 Systems Design: Process Costing Completing the Cost Flows Once processing has been completed in a department, the units are transferred to the next department for further processing, as illustrated in the T-accounts in Exhibit 43. The following journal entry transfers the cost of partially completed units from the Formulating Department to the Bottling Department: Work in ProcessBottling. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Work in ProcessFormulating . . . . . . . . . . . . . . . . . . . . . . . . . . . XXX XXX After processing has been completed in the Bottling Department, the costs of the completed units are transferred to the Finished Goods inventory account: Finished Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Work in ProcessBottling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . XXX XXX Finally, when a customers order is lled and units are sold, the cost of the units is transferred to Cost of Goods Sold: Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Finished Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . XXX XXX To summarize, the cost ows between accounts are basically the same in a process costing system as they are in a job-order costing system. The only difference at this point is that in a process costing system each department has a separate Work in Process account. THE DIFFERENCE BETWEEN LABOR RATES AND LABOR COST IN BUSINESS The emergence of China as a global competitor has increased the need for managers to understand the difference between labor rates and labor cost. Labor rates reect the amount paid to employees per hour or month. Labor costs measure the employee compensation paid per unit of output. For example, Tenneco has plants in Shanghai, China, and Litcheld, Michigan, that both manufacture exhaust systems for automobiles. The monthly labor rate per employee at the Shanghai plant ranges from $210$250, whereas the same gure for the Litcheld plant ranges from $1,880$4,064. A nave interpretation of these labor rates would be to automatically assume that the Shanghai plant is the lower labor cost facility. A wiser comparison of the two plants labor costs would account for the fact that the Litcheld plant produced 1.4 million exhaust systems in 2005 compared to 400,000 units at the Shanghai plant, while having only 20% more employees than the Shanghai plant. Source: Alex Taylor III, A Tale of Two Factories, Fortune, September 18, 2006, pp. 118126. We now turn our attention to Double Diamond Skis, a company that manufactures a high-performance deep-powder ski, and that uses process costing to determine its unit product costs. The companys production process is illustrated in Exhibit 44. Skis go through a sequence of ve processing departments, starting with the Shaping and Milling Department and ending with the Finishing and Pairing Department. The basic idea in process costing is to add together all of the costs incurred in a department during a period and then to spread those costs uniformly across the units processed in that department during that period. As we shall see, applying this simple idea involves a few complications. Equivalent Units of Production After materials, labor, and overhead costs have been accumulated in a department, the departments output must be determined so that unit product costs can be computed. The difculty is that a department usually has some partially completed units in its ending A skilled technician selects skis to form a pair and adjusts the skis camber. X-FACTOR Finished Goods The wooden core and various layers are stacked in a mold, polyurethane foam is injected into the mold, and then the mold is placed in a press that fuses the parts together. X-FACTOR Molding Department *Adapted from Bill Gout, Jesse James Doquilo, and Studio M D, Capped Crusaders, Skiing, October 1993, pp. 138144. The semi-finished skis are tuned by stone grinding and belt sanding. The ski edges are beveled and polished. X-FACTOR Finishing and Pairing Department Grinding and Sanding Department X-FACTOR Graphics are applied to the back of clear plastic top sheets using a heattransfer process. X-FACTOR X-FACTOR X-FACTOR X-FACTOR X-FACTOR X-FACTOR Computer-assisted milling machines shape the wood core and aluminum sheets that serve as the backbone of the ski. X-FACTOR Graphics Application Department X-FACTOR X-FACTOR Shaping and Milling Department X-FACTOR X-FACTOR E X H I B I T 44 The Production Process at Double Diamond Skis* X-FACTOR X-FACTOR 154 X-FACTOR X-FACTOR gar79611_ch04_148-187.indd Page 154 12/12/08 9:38:22 PM user-s180 /Users/user-s180/Desktop/TempWork/DEC/12-12-08/Dhiru 12-12-08/New/MHBR094-04 gar79611_ch04_148-187.indd gar79611_ch04_148-187.indd Page 155 12/12/08 9:38:24 PM user-s180 /Users/user-s180/Desktop/TempWork/DEC/12-12-08/Dhiru 12-12-08/New/MHBR094-04 155 Systems Design: Process Costing inventory. It does not seem reasonable to count these partially completed units as equivalent to fully completed units when counting the departments output. Therefore, these partially completed units are translated into an equivalent number of fully completed units. In process costing, this translation is done using the following formula: Equivalent units Number of partially completed units Percentage completion As the formula states, equivalent units is the product of the number of partially completed units and the percentage completion of those units with respect to the processing in the department. Roughly speaking, the equivalent units is the number of complete units that could have been obtained from the materials and effort that went into the partially complete units. For example, suppose the Molding Department at Double Diamond has 500 units in its ending work in process inventory that are 60% complete with respect to processing in the department. These 500 partially complete units are equivalent to 300 fully complete units (500 60% 300). Therefore, the ending work in process inventory contains 300 equivalent units. These equivalent units are added to any units completed during the period to determine the departments output for the periodcalled the equivalent units of production. Equivalent units of production for a period can be computed in different ways. In this chapter, we discuss the weighted-average method. In Appendix 4A, we discuss the FIFO method. The FIFO method of process costing is a method in which equivalent units and unit costs relate only to work done during the current period. In contrast, the weightedaverage method blends together units and costs from the current period with units and costs from the prior period. In the weighted-average method, the equivalent units of production for a department are the number of units transferred to the next department (or to nished goods) plus the equivalent units in the departments ending work in process inventory. Weighted-Average Method Under the weighted-average method, a departments equivalent units are computed as follows: Weighted-Average Method (a separate calculation is made for each cost category in each processing department) Equivalent units of production Units transferred to the next department or to nished goods Equivalent units in ending work in process inventory Note that the computation of the equivalent units of production involves adding the number of units transferred out of the department to the equivalent units in the departments ending inventory. There is no need to compute the equivalent units for the units transferred out of the departmentthey are 100% complete with respect to the work done in that department or they would not be transferred out. In other words, each unit transferred out of the department is counted as one equivalent unit. Consider the Shaping and Milling Department at Double Diamond. This department uses computerized milling machines to precisely shape the wooden core and metal sheets that will be used to form the backbone of the ski. (See Exhibit 44 for an overview of the production process at Double Diamond.) The activity shown at the top of the next page took place in the department in May. Note the use of the term conversion in the table on the next page. Conversion cost, as dened in an earlier chapter, is direct labor cost plus manufacturing overhead cost. In process costing, conversion cost is often treated as a single element of product cost. Note that the beginning work in process inventory was 55% complete with respect to materials costs and 30% complete with respect to conversion costs. This means that 55% of the materials costs required to complete the units in the department had already been incurred. Likewise, 30% of the conversion costs required to complete the units had already been incurred. L EARNING OBJECTIVE 2 Compute the equivalent units of production using the weightedaverage method. gar79611_ch04_148-187.indd gar79611_ch04_148-187.indd Page 156 12/12/08 9:38:24 PM user-s180 156 /Users/user-s180/Desktop/TempWork/DEC/12-12-08/Dhiru 12-12-08/New/MHBR094-04 Chapter 4 Percent Complete Shaping and Milling Department Beginning work in process . . . . . . . . . . . . . . . Units started into production during May . . . . . . . . . . . . . . . . . . . . . . . . . Units completed during May and transferred to the next department . . . . . . . Ending work in process . . . . . . . . . . . . . . . . . Units Materials Conversion 55% 30% 100%* 40% 100%* 25% 200 5,000 4,800 400 *We always assume that units transferred out of a department are 100% complete with respect to the processing done in that department. Two equivalent unit gures must be computedone for materials and one for conversion. These computations are shown in Exhibit 45. Note that the computations in Exhibit 45 ignore the fact that the units in the beginning work in process inventory were partially complete. For example, the 200 units in beginning inventory were already 30% complete with respect to conversion costs. Nevertheless, the weighted-average method is concerned only with the 4,900 equivalent units that are in ending inventories and in units transferred to the next department; it is not concerned with the fact that the beginning inventory was already partially complete. In other words, the 4,900 equivalent units computed using the weighted-average method include work that was accomplished in prior periods. This is a key point concerning the weighted-average method and it is easy to overlook. Exhibit 46 provides an alternative way of looking at the computation of equivalent units of production. This exhibit depicts the equivalent units computation for conversion costs. Study it carefully before going on. IN BUSINESS CUTTING CONVERSION COSTS Cemex SA, the worlds third largest cement maker, owns 54 plants. Each of these plants consumes 800 tons of fuel a day heating kilns to 2,700 degrees Fahrenheit. Consequently, energy costs account for 40% of the companys overall conversion costs. Historically, Cemex relied exclusively on coal to heat its kilns; however, faced with soaring coal prices and shrinking prots, the company desperately needed a cheaper fuel. Cemex turned its attention to an oil industry waste product called petroleum coke that burns hotter than coal and costs half as much. The company spent about $150 million to convert its kilns to burn petroleum coke. Overall, Cemex has cut its energy bills by 17%, helping it earn higher prot margins than its biggest rivals. Source: John Lyons, Expensive Energy? Burn Other Stuff, One Firm Decides, The Wall Street Journal, September 1, 2004, pp. A1 and A8. E X H I B I T 45 Equivalent Units of Production: Weighted-Average Method Shaping and Milling Department Materials Conversion Units transferred to the next department . . . . . . . . . . . . . . . . Ending work in process: Materials: 400 units 40% complete . . . . . . . . . . . . . . . . . Conversion: 400 units 25% complete . . . . . . . . . . . . . . . 4,800 4,800 Equivalent units of production . . . . . . . . . . . . . . . . . . . . . . . . 4,960 160 100 4,900 gar79611_ch04_148-187.indd Page 157 12/23/08 4:30:12 PM user-s180 /Users/user-s180/Desktop/Dhiru-23-12-08/New/MHBR094-04 157 Systems Design: Process Costing Beginning work in process E X H I B I T 46 Visual Perspective of Equivalent Units of Production Double Diamond Skis Shaping and Milling Department Conversion Costs (weighted-average method) 5,000 units started 200 units 30% complete 4,600 units started and completed 400 units 25% complete Ending work in process 4,800 units completed Units completed and transferred 4,800 to next department Ending work in process: 100 400 units 25% Equivalent units of production 4,900 Compute and Apply Costs In the last section we computed the equivalent units of production for materials and for conversion at Double Diamond Skis. In this section we will compute the cost per equivalent unit for materials and for conversion. We will then use these costs to value ending work in process and nished goods inventories. Exhibit 47 displays all of the data concerning Mays operations in the Shaping and Milling Department that we will need to complete these tasks. LEARNING OBJECTIVE 3 Compute the cost per equivalent unit using the weighted-average method. Cost per Equivalent UnitWeighted-Average Method In the weighted-average method, the cost per equivalent unit is computed as follows: Weighted-Average Method (a separate calculation is made for each cost category in each processing department) Cost per equivalent unit Cost of beginning Cost added work in process inventory during the period Equivalent units of production Work in process, beginning: Units in process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Completion with respect to materials . . . . . . . . . . . . . . . . . . . . . . . . . Completion with respect to conversion . . . . . . . . . . . . . . . . . . . . . . . . Costs in the beginning inventory: Materials cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conversion cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 9,600 5,575 Total cost in the beginning inventory . . . . . . . . . . . . . . . . . . . . . . . . . . $ 15,175 Units started into production during the period . . . . . . . . . . . . . . . . . . . Units completed and transferred out . . . . . . . . . . . . . . . . . . . . . . . . . . . Costs added to production during the period: Materials cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conversion cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 4,800 $368,600 350,900 Total cost added in the department . . . . . . . . . . . . . . . . . . . . . . . . . . . . $719,500 Work in process, ending: Units in process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stage of completion with respect to materials . . . . . . . . . . . . . . . . . . Stage of completion with respect to conversion . . . . . . . . . . . . . . . . . 200 55% 30% 400 40% 25% E X H I B I T 47 Shaping and Milling Department Data for May Operations gar79611_ch04_148-187.indd gar79611_ch04_148-187.indd Page 158 12/12/08 9:38:26 PM user-s180 158 /Users/user-s180/Desktop/TempWork/DEC/12-12-08/Dhiru 12-12-08/New/MHBR094-04 Chapter 4 Note that the numerator is the sum of the cost of beginning work in process inventory and of the cost added during the period. Thus, the weighted-average method blends together costs from the prior and current periods. That is why it is called the weighted-average method; it averages together units and costs from both the prior and current periods. The costs per equivalent unit for materials and for conversion are computed below for the Shaping and Milling Department for May: Shaping and Milling Department Costs per Equivalent Unit Cost of beginning work in process inventory . . . . . . . . . . . . . Costs added during the period . . . . . . . . . . . . . . . . . . . . . . . . $378,200 $356,475 Equivalent units of production (see the computations in the previous section) (b) . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost per equivalent unit (a) (b) . . . . . . . . . . . . . . . . . . . . . . Assign costs to units using the weighted-average method. Conversion $ 5,575 350,900 Total cost (a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . L EARNING OBJECTIVE 4 Materials $ 9,600 368,600 4,960 $76.25 4,900 $72.75 Applying CostsWeighted-Average Method The costs per equivalent unit are used to value units in ending inventory and units that are transferred to the next department. For example, each unit transferred out of Double Diamonds Shaping and Milling Department to the Graphics Application Department, as depicted in Exhibit 44, will carry with it a cost of $149.00 ($76.25 for materials cost and $72.75 for conversion cost). Because 4,800 units were transferred out in May to the next department, the total cost assigned to those units would be $715,200 (4,800 units $149.00 per unit). A complete accounting of the costs of both ending work in process inventory and the units transferred out appears below: Shaping and Milling Department Costs of Ending Work in Process Inventory and the Units Transferred Out Materials Conversion Ending work in process inventory: Equivalent units of production (materials: 400 units 40% complete; conversion: 400 units 25% complete) (a) . . . . . . . . . . . . Cost per equivalent unit (see above) (b) . . . . . . . Cost of ending work in process inventory (a) (b) Units completed and transferred out: Units transferred to the next department (a) . . . . Cost per equivalent unit (see above) (b) . . . . . . . Cost of units transferred out (a) (b). . . . . . . . . 160 $76.25 $12,200 100 $72.75 $7,275 Total $19,475 4,800 4,800 $76.25 $72.75 $366,000 $349,200 $715,200 In each case, the equivalent units are multiplied by the cost per equivalent unit to determine the cost assigned to the units. This is done for each cost categoryin this case, materials and conversion. The equivalent units for the units completed and transferred out are simply the number of units transferred to the next department because they would not have been transferred unless they were complete. gar79611_ch04_148-187.indd Page 159 12/12/08 9:38:27 PM user-s180 /Users/user-s180/Desktop/TempWork/DEC/12-12-08/Dhiru 12-12-08/New/MHBR094-04 159 Systems Design: Process Costing Cost Reconciliation Report L EARNING OBJECTIVE 5 The costs assigned to ending work in process inventory and to the units transferred out reconcile with the costs we started with in Exhibit 47 as shown below: Prepare a cost reconciliation report. Shaping and Milling Department Cost Reconciliation Costs to be accounted for: Cost of beginning work in process inventory (Exhibit 47) . . . . . . . . . . . Costs added to production during the period (Exhibit 47) . . . . . . . . . . $ 15,175 719,500 Total cost to be accounted for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $734,675 Costs accounted for as follows: Cost of ending work in process inventory (see page 158) . . . . . . . . . . . Cost of units transferred out (see page 158) . . . . . . . . . . . . . . . . . . . . . $ 19,475 715,200 Total cost accounted for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $734,675 The $715,200 cost of the units transferred to the next department, Graphics Application, will be accounted for in that department as costs transferred in. It will be treated in the process costing system as just another category of costs like materials or conversion costs. The only difference is that the costs transferred in will always be 100% complete with respect to the work done in the Graphics Applications Department. Costs are passed on from one department to the next in this fashion, until they reach the last processing department, Finishing and Pairing. When the products are completed in this last department, their costs are transferred to nished goods. Operation Costing The costing systems discussed in Chapters 3 and 4 represent the two ends of a continuum. On one end is job-order costing, which is used by companies that produce many different products in one facility. On the other end is process costing, which is used by companies that produce homogeneous products in large quantities. Between these two extremes there are many hybrid systems that include characteristics of both job-order and process costing. One of these hybrids is called operation costing. Operation costing is used in situations where products have some common characteristics and some individual characteristics. Shoes, for example, have common characteristics in that all styles involve cutting and sewing that can be done on a repetitive basis, using the same equipment and following the same basic procedures. Shoes also have individual characteristicssome are made of expensive leathers and others may be made using inexpensive synthetic materials. In a situation such as this, where products have some common characteristics but also must be processed individually, operation costing may be used to determine product costs. As mentioned above, operation costing is a hybrid system that employs aspects of both job-order and process costing. Products are typically processed in batches when operation costing is used, with each batch charged for its own specic materials. In this sense, operation costing is similar to job-order costing. However, labor and overhead costs are accumulated by operation or by department, and these costs are assigned to units as in process costing. If shoes are being produced, each shoe is charged the same per unit conversion cost, regardless of the style involved, but it is charged with its specic materials cost. Thus, the company is able to distinguish between styles in terms of materials, but it is able to employ the simplicity of a process costing system for labor and overhead costs. gar79611_ch04_148-187.indd gar79611_ch04_148-187.indd Page 160 12/12/08 9:38:27 PM user-s180 160 /Users/user-s180/Desktop/TempWork/DEC/12-12-08/Dhiru 12-12-08/New/MHBR094-04 Chapter 4 Examples of other products for which operation costing may be used include electronic equipment (such as semiconductors), textiles, clothing, and jewelry (such as rings, bracelets, and medallions). Products of this type are typically produced in batches, but they can vary considerably from model to model or from style to style in terms of the cost of materials. Summary Process costing is used in situations where homogeneous products or services are produced on a continuous basis. Costs ow through the manufacturing accounts in basically the same way in a process costing system as in a job-order costing system. However, costs are accumulated by department rather than by job in process costing. In process costing, the equivalent units of production must be determined for each cost category in each department. Under the weighted-average method, the equivalent units of production equals the number of units transferred out to the next department or to nished goods plus the equivalent units in ending work in process inventory. The equivalent units in ending inventory equals the product of the number of partially completed units in ending work in process inventory and their percentage of completion with respect to the specic cost category. Under the weighted-average method, the cost per equivalent unit for a specic cost category is computed by adding the cost of beginning work in process inventory and the cost added during the period and then dividing the result by the equivalent units of production. The cost per equivalent unit is then used to value the ending work in process inventory and the units transferred out to the next department or to nished goods. The cost reconciliation report reconciles the cost of beginning inventory and the costs added to production during the period to the cost of ending inventory and the cost of units transferred out. Costs are transferred from one department to the next until the last processing department. At that point, the cost of completed units is transferred to nished goods. Review Problem: Process Cost Flows and Costing Units Luxguard Home Paint Company produces exterior latex paint, which it sells in one-gallon containers. The company has two processing departmentsBase Fab and Finishing. White paint, which is used as a base for all the companys paints, is mixed from raw ingredients in the Base Fab Department. Pigments are then added to the basic white paint, the pigmented paint is squirted under pressure into one-gallon containers, and the containers are labeled and packed for shipping in the Finishing Department. Information relating to the companys operations for April follows: a. Issued raw materials for use in production: Base Fab Department, $851,000; and Finishing Department, $629,000. b. Incurred direct labor costs: Base Fab Department, $330,000; and Finishing Department, $270,000. c. Applied manufacturing overhead cost: Base Fab Department, $665,000; and Finishing Department, $405,000. d. Transferred basic white paint from the Base Fab Department to the Finishing Department, $1,850,000. e. Transferred paint that had been prepared for shipping from the Finishing Department to Finished Goods, $3,200,000. Required: 1. 2. 3. Prepare journal entries to record items (a) through (e) above. Post the journal entries from (1) above to T-accounts. The balance in the Base Fab Departments Work in Process account on April 1 was $150,000; the balance in the Finishing Departments Work in Process account was $70,000. After posting entries to the T-accounts, nd the ending balance in each departments Work in Process account. Determine the cost of ending work in process inventories and of units transferred out of the Base Fab Department in April. The following additional information is available regarding production in the Base Fab Department during April: gar79611_ch04_148-187.indd gar79611_ch04_148-187.indd Page 161 12/12/08 9:38:27 PM user-s180 /Users/user-s180/Desktop/TempWork/DEC/12-12-08/Dhiru 12-12-08/New/MHBR094-04 Systems Design: Process Costing Production data: Units (gallons) in process, April 1: materials 100% complete, labor and overhead 60% complete . . . . . . . . . . . . . . . . . . . . . . . . . . . . Units (gallons) started into production during April . . . . . . . . . . . . . . . . . Units (gallons) completed and transferred to the Finishing Department . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Units (gallons) in process, April 30: materials 50% complete, labor and overhead 25% complete . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost data: Work in process inventory, April 1: Materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Labor. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000 420,000 370,000 80,000 $ 92,000 21,000 37,000 Total cost of work in process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost added during April: Materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 851,000 330,000 665,000 Total cost added during April . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4. $ 150,000 $1,846,000 Prepare a cost reconciliation report for April. Solution to Review Problem 1. a. b. c. d. e. Work in ProcessBase Fab Department . . . . . . . . . . . . . . . . . 851,000 Work in ProcessFinishing Department . . . . . . . . . . . . . . . . . 629,000 Raw Materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Work in ProcessBase Fab Department . . . . . . . . . . . . . . . . . 330,000 Work in ProcessFinishing Department . . . . . . . . . . . . . . . . . 270,000 Salaries and Wages Payable . . . . . . . . . . . . . . . . . . . . . . . . . Work in ProcessBase Fab Department . . . . . . . . . . . . . . . . . 665,000 Work in ProcessFinishing Department . . . . . . . . . . . . . . . . . 405,000 Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . Work in ProcessFinishing Department . . . . . . . . . . . . . . . . . 1,850,000 Work in ProcessBase Fab Department . . . . . . . . . . . . . . . Finished Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,200,000 Work in ProcessFinishing Department . . . . . . . . . . . . . . . 1,480,000 600,000 1,070,000 1,850,000 3,200,000 2. Raw Materials Bal. XXX (a) Salaries and Wages Payable 1,480,000 (b) Work in Process Base Fab Department Bal. (a) (b) (c) 150,000 851,000 330,000 665,000 Bal. (d) 1,850,000 Manufacturing Overhead 146,000 (Various actual costs) Work in ProcessFinishing Department Bal. (a) (b) (c) (d) 70,000 629,000 270,000 405,000 1,850,000 Bal. 24,000 (e) 3,200,000 600,000 (c) Finished Goods Bal. (e) XXX 3,200,000 1,070,000 161 gar79611_ch04_148-187.indd gar79611_ch04_148-187.indd Page 162 12/12/08 9:38:27 PM user-s180 162 /Users/user-s180/Desktop/TempWork/DEC/12-12-08/Dhiru 12-12-08/New/MHBR094-04 Chapter 4 3. First, we must compute the equivalent units of production for each cost category: Base Fab Department Equivalent Units of Production Materials Labor Overhead Units transferred to the next department . . . . . . . . . . . . . . . . . Ending work in process inventory (materials: 80,000 units 50% complete; labor: 80,000 units 25% complete; overhead: 80,000 units 25% complete) . . . . . . . . . . . . . . 370,000 370,000 370,000 40,000 20,000 20,000 Equivalent units of production . . . . . . . . . . . . . . . . . . . . . . . . . 410,000 390,000 390,000 Labor Overhead Then we must compute the cost per equivalent unit for each cost category: Base Fab Department Costs per Equivalent Unit Materials Costs: Cost of beginning work in process inventory . . . . . . . . . . . Costs added during the period . . . . . . . . . . . . . . . . . . . . . . $ 92,000 $ 21,000 $ 37,000 851,000 330,000 665,000 Total cost (a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $943,000 $351,000 $702,000 Equivalent units of production (b). . . . . . . . . . . . . . . . . . . . . . Cost per equivalent unit (a) (b) . . . . . . . . . . . . . . . . . . . . . . 410,000 $2.30 390,000 $0.90 390,000 $1.80 The costs per equivalent unit can then be applied to the units in ending work in process inventory and the units transferred out as follows: Base Fab Department Costs of Ending Work in Process Inventory and the Units Transferred Out Materials Labor Overhead Ending work in process inventory: Equivalent units of production . . . . . . . . . . . . Cost per equivalent unit . . . . . . . . . . . . . . . . . Cost of ending work in process inventory . . . . Units completed and transferred out: Units transferred to the next department . . . . Cost per equivalent unit . . . . . . . . . . . . . . . . . Cost of units completed and transferred out. . 40,000 $2.30 $92,000 20,000 $0.90 $18,000 20,000 $1.80 $36,000 Total $146,000 370,000 370,000 370,000 $2.30 $0.90 $1.80 $851,000 $333,000 $666,000 $1,850,000 4. Base Fab Department Cost Reconciliation Costs to be accounted for: Cost of beginning work in process inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . Costs added to production during the period . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 150,000 1,846,000 Total cost to be accounted for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,996,000 Costs accounted for as follows: Cost of ending work in process inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost of units transferred out . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 146,000 1,850,000 Total cost accounted for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,996,000 gar79611_ch04_148-187.indd Page 163 12/23/08 1:51:10 AM user-s176 /broker/MH-BURR/MHBR094/MHBR094-04/upload/MHBR094-04 163 Systems Design: Process Costing Glossary Conversion cost Direct labor cost plus manufacturing overhead cost. (p. 155) Equivalent units The product of the number of partially completed units and their percentage of completion with respect to a particular cost. Equivalent units are the number of complete whole units that could be obtained from the materials and effort contained in partially completed units. (p. 155) Equivalent units of production (weighted-average method) The units transferred to the next department (or to nished goods) during the period plus the equivalent units in the departments ending work in process inventory. (p. 155) FIFO method A process costing method in which equivalent units and unit costs relate only to work done during the current period. (p. 155) Operation costing A hybrid costing system used when products have some common characteristics and some individual characteristics. (p. 159) Process costing A costing method used when essentially homogeneous products are produced on a continuous basis. (p. 149) Processing department An organizational unit where work is performed on a product and where materials, labor, or overhead costs are added to the product. (p. 150) Weighted-average method A process costing method that blends together units and costs from both the current and prior periods. (p. 155) Questions 41 42 43 44 45 46 47 48 Under what conditions would it be appropriate to use a process costing system? In what ways are job-order and process costing similar? Why is cost accumulation simpler in a process costing system than it is in a job-order costing system? How many Work in Process accounts are maintained in a company that uses process costing? Assume that a company has two processing departmentsMixing and Firing. Prepare a journal entry to show a transfer of work in process from the Mixing Department to the Firing Department. Assume that a company has two processing departmentsMixing followed by Firing. Explain what costs might be added to the Firing Departments Work in Process account during a period. What is meant by the term equivalent units of production when the weighted-average method is used? Watkins Trophies, Inc., produces thousands of medallions made of bronze, silver, and gold. The medallions are identical except for the materials used in their manufacture. What costing system would you advise the company to use? Multiple-choice questions are provided on the text website at www.mhhe.com/garrison13e. Exercises EXERCISE 41 Process Costing Journal Entries [LO1] Quality Brick Company produces bricks in two processing departmentsMolding and Firing. Information relating to the companys operations in March follows: a. Raw materials were issued for use in production: Molding Department, $23,000; and Firing Department, $8,000. b. Direct labor costs were incurred: Molding Department, $12,000; and Firing Department, $7,000. c. Manufacturing overhead was applied: Molding Department, $25,000; and Firing Department, $37,000. gar79611_ch04_148-187.indd gar79611_ch04_148-187.indd Page 164 12/12/08 9:38:28 PM user-s180 164 /Users/user-s180/Desktop/TempWork/DEC/12-12-08/Dhiru 12-12-08/New/MHBR094-04 Chapter 4 d. e. f. Unred, molded bricks were transferred from the Molding Department to the Firing Department. According to the companys process costing system, the cost of the unred, molded bricks was $57,000. Finished bricks were transferred from the Firing Department to the nished goods warehouse. According to the companys process costing system, the cost of the nished bricks was $103,000. Finished bricks were sold to customers. According to the companys process costing system, the cost of the nished bricks sold was $101,000. Required: Prepare journal entries to record items (a) through (f) above. EXERCISE 42 Computation of Equivalent UnitsWeighted-Average Method [LO2] Clonex Labs, Inc., uses a process costing system. The following data are available for one department for October: Percent Completed Units Work in process, October 1 . . . . . . . . . . . Work in process, October 31 . . . . . . . . . . Materials Conversion 30,000 15,000 65% 80% 30% 40% The department started 175,000 units into production during the month and transferred 190,000 completed units to the next department. Required: Compute the equivalent units of production for October assuming that the company uses the weighted-average method of accounting for units and costs. EXERCISE 43 Cost per Equivalent UnitWeighted-Average Method [LO3] Superior Micro Products uses the weighted-average method in its process costing system. Data for the Assembly Department for May appear below: Materials Work in process, May 1 . . . . . . . . . . . . . . Cost added during May . . . . . . . . . . . . . . Equivalent units of production . . . . . . . . . Labor Overhead $18,000 $238,900 35,000 $5,500 $80,300 33,000 $27,500 $401,500 33,000 Required: 1. 2. Compute the cost per equivalent unit for materials, for labor, and for overhead. Compute the total cost per equivalent whole unit. EXERCISE 44 Applying Costs to UnitsWeighted-Average Method [LO4] Data concerning a recent periods activity in the Prep Department, the rst processing department in a company that uses process costing, appear below: Materials Equivalent units of production in ending work in process . . . . . . . . Cost per equivalent unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conversion 2,000 $13.86 800 $4.43 A total of 20,100 units were completed and transferred to the next processing department during the period. gar79611_ch04_148-187.indd gar79611_ch04_148-187.indd Page 165 12/12/08 9:38:29 PM user-s180 /Users/user-s180/Desktop/TempWork/DEC/12-12-08/Dhiru 12-12-08/New/MHBR094-04 Systems Design: Process Costing Required: Compute the cost of the units transferred to the next department during the period and the cost of ending work in process inventory. EXERCISE 45 Cost Reconciliation ReportWeighted-Average Method [LO5] Maria Am Corporation uses a process costing system. The Baking Department is one of the processing departments in its strudel manufacturing facility. In June in the Baking Department, the cost of beginning work in process inventory was $3,570, the cost of ending work in process inventory was $2,860, and the cost added to production was $43,120. Required: Prepare a cost reconciliation report for the Baking Department for June. EXERCISE 46 Process Costing Journal Entries [LO1] Chocolaterie de Geneve, SA, is located in a French-speaking canton in Switzerland. The company makes chocolate trufes that are sold in popular embossed tins. The company has two processing departmentsCooking and Molding. In the Cooking Department, the raw ingredients for the trufes are mixed and then cooked in special candy-making vats. In the Molding Department, the melted chocolate and other ingredients from the Cooking Department are carefully poured into molds and decorative ourishes are applied by hand. After cooling, the trufes are packed for sale. The company uses a process costing system. The T-accounts below show the ow of costs through the two departments in April (all amounts are in Swiss francs): Work in ProcessCooking Balance 4/1 Direct materials Direct labor Overhead 8,000 42,000 50,000 75,000 Transferred out 160,000 Work in ProcessMolding Balance 4/1 Transferred in Direct labor Overhead 4,000 160,000 36,000 45,000 Transferred out 240,000 Required: Prepare journal entries showing the ow of costs through the two processing departments during April. EXERCISE 47 Equivalent UnitsWeighted-Average Method [LO2] Hielta Oy, a Finnish company, processes wood pulp for various manufacturers of paper products. Data relating to tons of pulp processed during June are provided below: Percent Completed Tons of Pulp Work in process, June 1 . . . . . . . . . . . . . . . . . . Work in process, June 30 . . . . . . . . . . . . . . . . . Started into production during June . . . . . . . . . 20,000 30,000 190,000 Materials Labor and Overhead 90% 60% 80% 40% Required: 1. 2. Compute the number of tons of pulp completed and transferred out during June. Compute the equivalent units of production for materials and for labor and overhead for June. 165 gar79611_ch04_148-187.indd gar79611_ch04_148-187.indd Page 166 12/12/08 9:38:29 PM user-s180 166 /Users/user-s180/Desktop/TempWork/DEC/12-12-08/Dhiru 12-12-08/New/MHBR094-04 Chapter 4 EXERCISE 48 Equivalent Units and Cost per Equivalent UnitWeighted-Average Method [LO2, LO3] Pureform, Inc., manufactures a product that passes through two departments. Data for a recent month for the rst department follow: Units Work in process, beginning . . . . . . . . . Units started in process . . . . . . . . . . . . Units transferred out . . . . . . . . . . . . . . . Work in process, ending . . . . . . . . . . . . Cost added during the month . . . . . . . . Materials Labor Overhead 5,000 45,000 42,000 8,000 $4,320 $1,040 $1,790 $52,800 $21,500 $32,250 The beginning work in process inventory was 80% complete with respect to materials and 60% complete with respect to labor and overhead. The ending work in process inventory was 75% complete with respect to materials and 50% complete with respect to labor and overhead. Required: Assume that the company uses the weighted-average method of accounting for units and costs. 1. Compute the equivalent units for the month for the rst department. 2. Determine the costs per equivalent unit for the month. EXERCISE 49 Equivalent Units and Cost per Equivalent UnitWeighted-Average Method [LO2, LO3, LO4] Helix Corporation produces prefabricated ooring in a series of steps carried out in production departments. All of the material that is used in the rst production department is added at the beginning of processing in that department. Data for May for the rst production department follow: Percent Complete Units Work in process inventory, May 1 . . . . . . . . . . . . . . . Work in process inventory, May 31 . . . . . . . . . . . . . . Materials Conversion 5,000 10,000 100% 100% 40% 30% Materials cost in work in process inventory, May 1. . . . . . . . . . . . . . . Conversion cost in work in process inventory, May 1 . . . . . . . . . . . . . Units started into production. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Units transferred to the next production department . . . . . . . . . . . . . Materials cost added during May . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conversion cost added during May . . . . . . . . . . . . . . . . . . . . . . . . . . $1,500 $4,000 180,000 175,000 $54,000 $352,000 Required: 1. 2. 3. Assume that the company uses the weighted-average method of accounting for units and costs. Determine the equivalent units for May for the rst process. Compute the costs per equivalent unit for May for the rst process. Determine the total cost of ending work in process inventory and the total cost of units transferred to the next process in May. EXERCISE 410 Comprehensive Exercise; Second Production DepartmentWeighted-Average Method [LO2, LO3, LO4, LO5] Scribners Corporation produces ne papers in three production departmentsPulping, Drying, and Finishing. In the Pulping Department, raw materials such as wood ber and rag cotton are mechanically and chemically treated to separate their bers. The result is a thick slurry of bers. In the Drying Department, the wet bers transferred from the Pulping Department are laid down on porous webs, pressed to remove excess liquid, and dried in ovens. In the Finishing Department, the dried paper is coated, cut, and spooled onto reels. The company uses the weighted-average method in its process costing system. Data for March for the Drying Department follow: gar79611_ch04_148-187.indd Page 167 12/12/08 9:38:29 PM user-s180 /Users/user-s180/Desktop/TempWork/DEC/12-12-08/Dhiru 12-12-08/New/MHBR094-04 Systems Design: Process Costing Percent Completed Units Work in process inventory, March 1 . . . . . . . . . . . . . . . Work in process inventory, March 31 . . . . . . . . . . . . . . Pulping Conversion 5,000 8,000 100% 100% 20% 25% Pulping cost in ork in process inventory, March 1. . . . . . . . . . . . . . . . . Units transferred to the next production department . . . . . . . . . . . . . . Pulping cost added during March . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conversion cost added during March . . . . . . . . . . . . . . . . . . . . . . . . . . $500 157,000 $102,450 $31,300 No materials are added in the Drying Department. Pulping cost represents the costs of the wet bers transferred in from the Pulping Department. Wet ber is processed in the Drying Department in batches; each unit in the above table is a batch and one batch of wet bers produces a set amount of dried paper that is passed on to the Finishing Department. Required: 1. 2. 3. 4. Determine the equivalent units for March for pulping and conversion. Compute the costs per equivalent unit for March for pulping and conversion. Determine the total cost of ending work in process inventory and the total cost of units transferred to the Finishing Department in March. Prepare a cost reconciliation report for the Drying Department for March. EXERCISE 411 Cost Assignment; Cost ReconciliationWeighted-Average Method [LO2, LO4, LO5] Superior Micro Products uses the weighted-average method in its process costing system. During January, the Delta Assembly Department completed its processing of 25,000 units and transferred them to the next department. The cost of beginning inventory and the costs added during January amounted to $599,780 in total. The ending inventory in January consisted of 3,000 units, which were 80% complete with respect to materials and 60% complete with respect to labor and overhead. The costs per equivalent unit for the month were as follows: Materials Cost per equivalent unit . . . . . . . . . . . . . . . . . . . . . . Labor Overhead $12.50 $3.20 $6.40 Required: 1. 2. 3. Compute the equivalent units of materials, labor, and overhead in the ending inventory for the month. Compute the cost of ending inventory and of the units transferred to the next department for January. Prepare a cost reconciliation for January. (Note: You will not be able to break the cost to be accounted for into the cost of beginning inventory and costs added during the month.) EXERCISE 412 Equivalent UnitsWeighted-Average Method [LO2] Alaskan Fisheries, Inc., processes salmon for various distributors. Two departments are involved Cleaning and Packing. Data relating to pounds of salmon processed in the Cleaning Department during July are presented below: Percent Completed Pounds of Salmon Work in process, July 1 . . . . . . . . . . . . . . . . . . . . Work in process, July 31 . . . . . . . . . . . . . . . . . . . Materials Labor and Overhead 20,000 25,000 100% 100% 30% 60% A total of 380,000 pounds of salmon were started into processing during July. All materials are added at the beginning of processing in the Cleaning Department. Required: Compute the equivalent units for July for both materials and labor and overhead assuming that the company uses the weighted-average method of accounting for units. 167 gar79611_ch04_148-187.indd gar79611_ch04_148-187.indd Page 168 12/12/08 9:38:29 PM user-s180 168 /Users/user-s180/Desktop/TempWork/DEC/12-12-08/Dhiru 12-12-08/New/MHBR094-04 Chapter 4 Problems PROBLEM 413 Comprehensive ProblemWeighted-Average Method [LO2, LO3, LO4, LO5] Sunspot Beverages, Ltd., of Fiji makes blended tropical fruit drinks in two stages. Fruit juices are extracted from fresh fruits and then blended in the Blending Department. The blended juices are then bottled and packed for shipping in the Bottling Department. The following information pertains to the operations of the Blending Department for June. (The currency in Fiji is the Fijian dollar.) Required: Assume that the company uses the weighted-average method. 1. Determine the equivalent units for June for the Blending Department. 2. Compute the costs per equivalent unit for the Blending Department. 3. Determine the total cost of ending work in process inventory and the total cost of units transferred to the Bottling Department. 4. Prepare a cost reconciliation report for the Blending Department for June. PROBLEM 414 Comprehensive ProblemWeighted-Average Method [LO2, LO3, LO4, LO5] Builder Products, Inc., manufactures a caulking compound that goes through three processing stages prior to completion. Information on work in the rst department, Cooking, is given below for May: Production data: Pounds in process, May 1; materials 100% complete; conversion 80% complete . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Pounds started into production during May . . . . . . . . . . . . . . . . . . . . Pounds completed and transferred out. . . . . . . . . . . . . . . . . . . . . . . . Pounds in process, May 31; materials 60% complete; conversion 20% complete . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost data: Work in process inventory, May 1: . . . . . . . . . . . . . . . . . . . . . . . . . . . Materials cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conversion cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost added during May: Materials cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conversion cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 100,000 ? 15,000 $1,500 $7,200 $154,500 $90,800 The company uses the weighted-average method. Required: 1. 2. 3. 4. Compute the equivalent units of production. Compute the costs per equivalent unit for the month. Determine the cost of ending work in process inventory and of the units transferred out to the next department. Prepare a cost reconciliation report for the month. PROBLEM 415 Comprehensive Problem; Second Production DepartmentWeighted-Average Method [LO2, LO3, LO4, LO5] Old Country Links Inc. produces sausages in three production departmentsMixing, Casing and Curing, and Packaging. In the Mixing Department, meats are prepared and ground and then mixed gar79611_ch04_148-187.indd gar79611_ch04_148-187.indd Page 169 12/12/08 9:38:30 PM user-s180 /Users/user-s180/Desktop/TempWork/DEC/12-12-08/Dhiru 12-12-08/New/MHBR094-04 Systems Design: Process Costing with spices. The spiced meat mixture is then transferred to the Casing and Curing Department, where the mixture is force-fed into casings and then hung and cured in climate-controlled smoking chambers. In the Packaging Department, the cured sausages are sorted, packed, and labeled. The company uses the weighted-average method in its process costing system. Data for September for the Casing and Curing Department follow: Percent Completed Units Materials Conversion 1 1 100% 100% 90% 80% 80% 70% Mixing Work in process inventory, September 1 . . . . . . . Work in process inventory, September 30 . . . . . . Mixing Materials Conversion $1,670 $81,460 $90 $6,006 $605 $42,490 Work in process inventory, September 1 . . . . . . . . . . . . . . Cost added during September . . . . . . . . . . . . . . . . . . . . . . Mixing cost represents the costs of the spiced meat mixture transferred in from the Mixing Department. The spiced meat mixture is processed in the Casing and Curing Department in batches; each unit in the above table is a batch and one batch of spiced meat mixture produces a set amount of sausages that are passed on to the Packaging Department. During September, 50 batches (i.e., units) were completed and transferred to the Packaging Department. Required: 1. 2. 3. 4. Determine the equivalent units for September for mixing, materials, and conversion. Do not round off your computations. Compute the costs per equivalent unit for September for mixing, materials, and conversion. Determine the total cost of ending work in process inventory and the total cost of units transferred to the Packaging Department in September. Prepare a cost reconciliation report for the Casing and Curing Department for September. PROBLEM 416 Interpreting a ReportWeighted-Average Method [LO2, LO3, LO4] Cooperative San Jos of southern Sonora state in Mexico makes a unique syrup using cane sugar and local herbs. The syrup is sold in small bottles and is prized as a avoring for drinks and for use in desserts. The bottles are sold for $12 each. (The Mexican currency is the peso and is denoted by $.) The rst stage in the production process is carried out in the Mixing Department, which removes foreign matter from the raw materials and mixes them in the proper proportions in large vats. The company uses the weighted-average method in its process costing system. A hastily prepared report for the Mixing Department for April appears below: Units to be accounted for: Work in process, April 1 (materials 90% complete; conversion 80% complete) . . . . . . . . . . . . . . . . . . . . . . Started into production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000 200,000 Total units to be accounted for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230,000 Units accounted for as follows: Transferred to next department. . . . . . . . . . . . . . . . . . . . . . . . . . . . . Work in process, April 30 (materials 75% complete; conversion 60% complete) . . . . . . . . . . . . . . . . . . 190,000 40,000 Total units accounted for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230,000 Cost Reconciliation Cost to be accounted for: Work in process, April 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost added during the month . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 98,000 827,000 Total cost to be accounted for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $925,000 Cost accounted for as follows: Work in process, April 30 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Transferred to next department. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119,400 $805,600 Total cost accounted for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $925,000 169 gar79611_ch04_148-187.indd gar79611_ch04_148-187.indd Page 170 12/12/08 9:38:30 PM user-s180 170 /Users/user-s180/Desktop/TempWork/DEC/12-12-08/Dhiru 12-12-08/New/MHBR094-04 Chapter 4 Management would like some additional information about Cooperative San Joss operations. Required: 1. 2. 3. 4. What were the equivalent units for the month? What were the costs per equivalent unit for the month? The beginning inventory consisted of the following costs: materials, $67,800; and conversion cost, $30,200. The costs added during the month consisted of: materials, $579,000; and conversion cost, $248,000. How many of the units transferred to the next department were started and completed during the month? The manager of the Mixing Department stated, Materials prices jumped from about $2.50 per unit in March to $3 per unit in April, but due to good cost control I was able to hold our materials cost to less than $3 per unit for the month. Should this manager be rewarded for good cost control? Explain. PROBLEM 417 Analysis of Work in Process T-accountWeighted-Average Method [LO1, LO2, LO3, LO4] Weston Products manufactures an industrial cleaning compound that goes through three processing departmentsGrinding, Mixing, and Cooking. All raw materials are introduced at the start of work in the Grinding Department. The Work in Process T-account for the Grinding Department for May is given below: Work in ProcessGrinding Department Inventory, May 1 Materials Conversion 21,800 Completed and transferred to the Mixing Department ? 133,400 225,500 Inventory, May 31 ? The May 1 work in process inventory consisted of 18,000 pounds with $14,600 in materials cost and $7,200 in conversion cost. The May 1 work in process inventory was 100% complete with respect to materials and 30% complete with respect to conversion. During May, 167,000 pounds were started into production. The May 31 inventory consisted of 15,000 pounds that were 100% complete with respect to materials and 60% complete with respect to conversion. The company uses the weighted-average method to account for units and costs. Required: 1. 2. 3. Determine the equivalent units of production for May. Determine the costs per equivalent unit for May. Determine the cost of the units completed and transferred to the Mixing Department during May. PROBLEM 418 Cost Flows [LO1] Lubricants, Inc., produces a special kind of grease that is widely used by race car drivers. The grease is produced in two processing departments: Rening and Blending. Raw materials are introduced at various points in the Rening Department. The following incomplete Work in Process account is available for the Rening Department for March: Work in ProcessRening Department March 1 balance Materials Direct labor Overhead March 31 balance 38,000 Completed and transferred to Blending ? 495,000 72,000 181,000 ? The March 1 work in process inventory in the Rening Department consists of the following elements: materials, $25,000; direct labor, $4,000; and overhead, $9,000. gar79611_ch04_148-187.indd gar79611_ch04_148-187.indd Page 171 12/12/08 9:38:31 PM user-s180 /Users/user-s180/Desktop/TempWork/DEC/12-12-08/Dhiru 12-12-08/New/MHBR094-04 171 Systems Design: Process Costing Costs incurred during March in the Blending Department were: materials used, $115,000; direct labor, $18,000; and overhead cost applied to production, $42,000. Required: 1. 2. Prepare journal entries to record the costs incurred in both the Rening Department and Blending Department during March. Key your entries to the items (a) through (g) below. a. Raw materials were issued for use in production. b. Direct labor costs were incurred. c. Manufacturing overhead costs for the entire factory were incurred, $225,000. (Credit Accounts Payable.) d. Manufacturing overhead cost was applied to production using a predetermined overhead rate. e. Units that were complete with respect to processing in the Rening Department were transferred to the Blending Department, $740,000. f. Units that were complete with respect to processing in the Blending Department were transferred to Finished Goods, $950,000. g. Completed units were sold on account, $1,500,000. The Cost of Goods Sold was $900,000. Post the journal entries from (1) above to T-accounts. The following account balances existed at the beginning of March. (The beginning balance in the Rening Departments Work in Process account is given on the prior page.) Raw Materials . . . . . . . . . . . . . . . . . . . . . . . . . . . Work in ProcessBlending Department . . . . . . . Finished Goods . . . . . . . . . . . . . . . . . . . . . . . . . . $618,000 $65,000 $20,000 After posting the entries to the T-accounts, nd the ending balance in the inventory accounts and the manufacturing overhead account. Cases CASE 419 Second DepartmentWeighted-Average Method [LO2, LO3, LO4] I think we goofed when we hired that new assistant controller, said Ruth Scarpino, president of Provost Industries. Just look at this report that he prepared for last month for the Finishing Department. I cant make heads or tails out of it. Finishing Department costs: Work in process inventory, April 1, 450 units; materials 100% complete; conversion 60% complete . . . . . . . . . . . . . . . . . . . Costs transferred in during the month from the preceding department, 1,950 units . . . . . . . . . . . . . . . . . . . . . . . . . . Materials cost added during the month . . . . . . . . . . . . . . . . . . . . . . . . Conversion costs incurred during the month . . . . . . . . . . . . . . . . . . . . $ 8,208* 17,940 6,210 13,920 Total departmental costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $46,278 Finishing Department costs assigned to: Units completed and transferred to nished goods, 1,800 units at $25.71 per unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Work in process inventory, April 30, 600 units; materials 0% complete; conversion 35% complete . . . . . . . . . . . . . . . . . . . . . $46,278 Total departmental costs assigned . . . . . . . . . . . . . . . . . . . . . . . . . . . . $46,278 0 *Consists of cost transferred in, $4,068; materials cost, $1,980; and conversion cost, $2,160. Hes struggling to learn our system, replied Frank Harrop, the operations manager. The problem is that hes been away from process costing for a long time, and its coming back slowly. Its not just the format of his report that Im concerned about. Look at that $25.71 unit cost that hes come up with for April. Doesnt that seem high to you? said Ms. Scarpino. gar79611_ch04_148-187.indd Page 172 12/12/08 9:38:31 PM user-s180 172 /Users/user-s180/Desktop/TempWork/DEC/12-12-08/Dhiru 12-12-08/New/MHBR094-04 Chapter 4 Yes, it does seem high; but on the other hand, I know we had an increase in materials prices during April, and that may be the explanation, replied Mr. Harrop. Ill get someone else to redo this report and then we may be able to see whats going on. Provost Industries manufactures a ceramic product that goes through two processing departmentsMolding and Finishing. The company uses the weighted-average method in its process costing. Required: 1. 2. Prepare a report for the Finishing Department showing how much cost should have been assigned to the units completed and transferred to nished goods, and how much cost should have been assigned to ending work in process inventory in the Finishing Department. Explain to the president why the unit cost on the new assistant controllers report is so high. CASE 420 Ethics and the Manager, Understanding the Impact of Percentage Completion on ProtWeighted-Average Method [LO2, LO3, LO4] Gary Stevens and Mary James are production managers in the Consumer Electronics Division of General Electronics Company, which has several dozen plants scattered in locations throughout the world. Mary manages the plant located in Des Moines, Iowa, while Gary manages the plant in El Segundo, California. Production managers are paid a salary and get an additional bonus equal to 5% of their base salary if the entire division meets or exceeds its target prots for the year. The bonus is determined in March after the companys annual report has been prepared and issued to stockholders. Shortly after the beginning of the new year, Mary received a phone call from Gary that went like this: Gary: Hows it going, Mary? Mary: Fine, Gary. Hows it going with you? Gary: Great! I just got the preliminary prot gures for the division for last year and we are within $200,000 of making the years target prots. All we have to do is pull a few strings, and well be over the top! Mary: What do you mean? Gary: Well, one thing that would be easy to change is your estimate of the percentage completion of your ending work in process inventories. Mary: I dont know if I can do that, Gary. Those percentage completion gures are supplied by Tom Winthrop, my lead supervisor, who I have always trusted to provide us with good estimates. Besides, I have already sent the percentage completion gures to corporate headquarters. Gary: You can always tell them there was a mistake. Think about it, Mary. All of us managers are doing as much as we can to pull this bonus out of the hat. You may not want the bonus check, but the rest of us sure could use it. The nal processing department in Marys production facility began the year with no work in process inventories. During the year, 210,000 units were transferred in from the prior processing department and 200,000 units were completed and sold. Costs transferred in from the prior department totaled $39,375,000. No materials are added in the nal processing department. A total of $20,807,500 of conversion cost was incurred in the nal processing department during the year. Required: 1. 2. 3. 4. Tom Winthrop estimated that the units in ending inventory in the nal processing department were 30% complete with respect to the conversion costs of the nal processing department. If this estimate of the percentage completion is used, what would be the Cost of Goods Sold for the year? Does Gary Stevens want the estimated percentage completion to be increased or decreased? Explain why. What percentage completion would result in increasing reported net operating income by $200,000 over the net operating income that would be reported if the 30% gure were used? Do you think Mary James should go along with the request to alter estimates of the percentage completion? Why or why not? Appendix 4A: FIFO Method The FIFO method of process costing differs from the weighted-average method in two ways: (1) the computation of equivalent units, and (2) the way in which costs of beginning inventory are treated. The FIFO method is generally considered more accurate than gar79611_ch04_148-187.indd gar79611_ch04_148-187.indd Page 173 12/12/08 9:38:35 PM user-s180 /Users/user-s180/Desktop/TempWork/DEC/12-12-08/Dhiru 12-12-08/New/MHBR094-04 173 Systems Design: Process Costing the weighted-average method, but it is more complex. The complexity is not a problem for computers, but the FIFO method is a little more difcult to understand and to learn than the weighted-average method. Equivalent UnitsFIFO Method The computation of equivalent units under the FIFO method differs from the computation under the weighted-average method in two ways. First, the units transferred out is divided into two parts. One part consists of the units from the beginning inventory that were completed and transferred out, and the other part consists of the units that were both started and completed during the current period. Second, full consideration is given to the amount of work expended during the current period on units in the beginning work in process inventory as well as on units in the ending inventory. Thus, under the FIFO method, both beginning and ending inventories are converted to an equivalent units basis. For the beginning inventory, the equivalent units represent the work done to complete the units; for the ending inventory, the equivalent units represent the work done to bring the units to a stage of partial completion at the end of the period (the same as with the weighted-average method). The formula for computing the equivalent units of production under the FIFO method is more complex than under the weighted-average method: FIFO Method (a separate calculation is made for each cost category in each processing department) Equivalent units of production Equivalent units to complete beginning work in process inventory* Units started and completed during the period Equivalent units in ending work in process inventory *Equivalent units to complete beginning work in process inventory Units in beginning work in process inventory ( 100% Percentage completion of beginning work in process inventory ) Or, the equivalent units of production can also be determined as follows: Equivalent units of production Units transferred out Equivalent units in ending work in process inventory Equivalent units in beginning work in process inventory To illustrate the FIFO method, refer again to the data for the Shaping and Milling Department at Double Diamond Skis. The department completed and transferred 4,800 units to the Graphics Application Department during May. Because 200 of these units came from the beginning inventory, the Shaping and Milling Department must have started and completed 4,600 units during May. The 200 units in the beginning inventory were 55% complete with respect to materials and only 30% complete with respect to conversion costs when the month started. Thus, to complete these units the department must have added another 45% of materials costs (100% 55% 45%) and another 70% of conversion costs (100% 30% 70%). Following this line of reasoning, the equivalent units for the department for May would be computed as shown in Exhibit 4A1. L EARNING OBJECTIVE 6 Compute the equivalent units of production using the FIFO method. gar79611_ch04_148-187.indd gar79611_ch04_148-187.indd Page 174 12/12/08 9:38:35 PM user-s180 174 /Users/user-s180/Desktop/TempWork/DEC/12-12-08/Dhiru 12-12-08/New/MHBR094-04 Chapter 4 E X H I B I T 4A1 Equivalent Units of Production: FIFO Method Materials To complete beginning work in process: Materials: 200 units (100% 55%)* . . . . . . . . . . . . Conversion: 200 units (100% 30%)* . . . . . . . . . . . Units started and completed during the period . . . . . . . . Ending work in process: Materials: 400 units 40% complete . . . . . . . . . . . . . . Conversion: 400 units 25% complete . . . . . . . . . . . . 4,600 Equivalent units of production . . . . . . . . . . . . . . . . . . . . . 4,850 Conversion 90 140 4,600 160 100 4,840 *This is the work needed to complete the units in beginning inventory. 5,000 units started 400 units in ending work in process 4,600 units started and completed. This can also be computed as 4,800 units completed and transferred to the next department 200 units in beginning work in process inventory. The FIFO method assumes that the units in beginning inventory are nished rst. Comparison of Equivalent Units of Production under the Weighted-Average and FIFO Methods Stop at this point and compare the data in Exhibit 4A1 with the data in Exhibit 45 in the chapter, which shows the computation of equivalent units under the weighted-average method. Also refer to Exhibit 4A2, which compares the two methods. The essential difference between the two methods is that the weighted-average method blends work and costs from the prior period with work and costs in the current period, whereas the FIFO method separates the two periods. To see this more clearly, consider the following reconciliation of the two calculations of equivalent units: Shaping and Milling Department Materials Conversion Equivalent unitsweighted-average method . . . . . . . . . . . . Less equivalent units in beginning inventory: 200 units 55%. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 units 30%. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,960 4,900 Equivalent units of productionFIFO method. . . . . . . . . . . . 4,850 110 60 4,840 From the above, it is evident that the FIFO method removes the equivalent units that were already in beginning inventory from the equivalent units as dened using the weightedaverage method. Thus, the FIFO method isolates the equivalent units that are due to work performed during the current period. The weighted-average method blends together the equivalent units already in beginning inventory with the equivalent units that are due to work performed in the current period. Cost per Equivalent UnitFIFO Method L EARNING OBJECTIVE 7 Compute the cost per equivalent unit using the FIFO method. In the FIFO method, the cost per equivalent unit is computed as follows: FIFO Method (a separate calculation is made for each cost category in each processing department) Cost per equivalent unit Cost added during the period Equivalent units of production gar79611_ch04_148-187.indd Page 175 12/12/08 9:38:36 PM user-s180 /Users/user-s180/Desktop/TempWork/DEC/12-12-08/Dhiru 12-12-08/New/MHBR094-04 175 Systems Design: Process Costing E X H I B I T 4A2 Visual Perspective of Equivalent Units of Production Double Diamond Skis Shaping and Milling Department Conversion Costs Weighted-Average Method Beginning work in process 200 units 30% complete 5,000 units started 4,600 units started and completed Units completed and transferred to next department Ending work in process: 400 units 25% Equivalent units of production 400 units 25% complete Ending work in process 400 units 25% complete Ending work in process 4,800 100 4,900 FIFO Method Beginning work in process 200 units 30% complete 5,000 units started 4,600 units started and completed Beginning work in process: 200 units 70%* Units started and completed Ending work in process: 400 units 25% Equivalent units of production 140 4,600 100 4,840 * 100% 30% = 70%. This 70% represents the work needed to complete the units in the beginning inventory. Unlike the weighted-average method, in the FIFO method the cost per equivalent unit is based only on the costs incurred in the department in the current period. The costs per equivalent unit for materials and for conversion are computed below for the Shaping and Milling Department for May: Shaping and Milling Department Costs per Equivalent UnitFIFO method Cost added during the period (a) . . . . . . . . . Equivalent units of production (b) . . . . . . . . . Cost per equivalent unit (a) (b) . . . . . . . . . Materials $368,600 4,850 $76.00 Conversion $350,900 4,840 $72.50 gar79611_ch04_148-187.indd gar79611_ch04_148-187.indd Page 176 12/12/08 9:38:36 PM user-s180 176 /Users/user-s180/Desktop/TempWork/DEC/12-12-08/Dhiru 12-12-08/New/MHBR094-04 Chapter 4 Applying CostsFIFO Method L EARNING OBJECTIVE 8 Assign costs to units using the FIFO method. The costs per equivalent unit are used to value units in ending inventory and units that are transferred to the next department. For example, each unit transferred out of the Shaping and Milling Department to the Graphics Application Department will carry with it a cost of $148.50$76.00 for materials cost and $72.50 for conversion cost. Because 4,800 units were transferred out in May to the next department, the total cost assigned to those units would be $712,800 (4,800 units $148.50 per unit). A complete accounting of the costs of both ending work in process inventory and the units transferred out appears below. It is more complicated than the weighted average method. This is because the cost of the units transferred out consists of three separate components: (1) the cost of beginning work in process inventory; (2) the cost to complete the units in beginning work in process inventory; and (3) the cost of units started and completed during the period. Shaping and Milling Department Costs of Ending Work in Process Inventory and Units Transferred OutFIFO Method Materials Conversion Ending work in process inventory: Equivalent units of production (see Exhibit 4A1) (a) . . . . . . . . . . . . . . . . . . . . 160 100 Cost per equivalent unit (see above) (b) . . . . . . . $76.00 $72.50 Cost of ending work in process inventory (a) (b) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $12,160 $7,250 Units transferred out: Cost in beginning work in process inventory . . $9,600 Cost to complete the units in beginning work in process inventory: Equivalent units of production required to complete the units in beginning inventory (see Exhibit 4A1) (a) . . . . . . . . . . . . . . . . . . 90 Cost per equivalent unit (see above) (b). . . . . . $76.00 Cost to complete the units in beginning inventory (a) (b) . . . . . . . . . . . . . . . . . . . . $6,840 Cost of units started and completed this period: Units started and completed this period (see Exhibit 4A1) (a) . . . . . . . . . . . . . . . . . . . . 4,600 Cost per equivalent unit (see above) (b) . . . . . . . $76.00 Cost of units started and completed this period (a) (b) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $349,600 Total cost of units transferred out . . . . . . . . . . . . . . $5,575 Total $19,410 $15,175 140 $72.50 $10,150 $16,990 4,600 $72.50 $333,500 $ 683,100 $715,265 Again, note that the cost of the units transferred out consists of three distinct componentsthe cost of beginning work in process inventory, the cost to complete the units in beginning inventory, and the cost of units started and completed during the period. This is a major difference between the weighted-average and FIFO methods. L EARNING OBJECTIVE 9 Prepare a cost reconciliation report using the FIFO method. Cost Reconciliation ReportFIFO Method The costs assigned to ending work in process inventory and to the units transferred out reconcile with the costs we started with in Exhibit 47 as shown on the following page: gar79611_ch04_148-187.indd gar79611_ch04_148-187.indd Page 177 12/12/08 9:38:37 PM user-s180 /Users/user-s180/Desktop/TempWork/DEC/12-12-08/Dhiru 12-12-08/New/MHBR094-04 Systems Design: Process Costing Shaping and Milling Department Cost Reconciliation Costs to be accounted for: Cost of beginning work in process inventory (Exhibit 47) . . . . . . . . . Costs added to production during the period (Exhibit 47) . . . . . . . . . $ 15,175 719,500 Total cost to be accounted for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $734,675 Costs accounted for as follows: Cost of ending work in process inventory (see page 176) . . . . . . . . . Cost of units transferred out (see page 176). . . . . . . . . . . . . . . . . . . . $ 19,410 715,265 Total cost accounted for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $734,675 The $715,265 cost of the units transferred to the next department, Graphics Application, will be accounted for in that department as costs transferred in. As in the weightedaverage method, this cost will be treated in the process costing system as just another category of costs like materials or conversion costs. The only difference is that the costs transferred in will always be 100% complete with respect to the work done in the Graphics Applications Department. Costs are passed on from one department to the next in this fashion, until they reach the last processing department, Finishing and Pairing. When the products are completed in this last department, their costs are transferred to nished goods. A Comparison of Costing Methods In most situations, the weighted-average and FIFO methods will produce very similar unit costs. If there never are any ending inventories, the two methods will produce identical results. The reason for this is that without any ending inventories, no costs can be carried forward into the next period and the weighted-average method will base unit costs on just the current periods costsjust as in the FIFO method. If there are ending inventories, either erratic input prices or erratic production levels would also be required to generate much of a difference in unit costs under the two methods. This is because the weighted-average method will blend the unit costs from the prior period with the unit costs of the current period. Unless these unit costs differ greatly, the blending will not make much difference. Nevertheless, from the standpoint of cost control, the FIFO method is superior to the weighted-average method. Current performance should be evaluated based on costs of the current period only but the weighted-average method mixes costs of the current period with costs of the prior period. Thus, under the weighted-average method, the managers apparent performance in the current period is inuenced by what happened in the prior period. This problem does not arise under the FIFO method because the FIFO method makes a clear distinction between costs of prior periods and costs incurred during the current period. For the same reason, the FIFO method also provides more up-to-date cost data for decision-making purposes. On the other hand, the weighted-average method is simpler to apply than the FIFO method, but computers can handle the additional calculations with ease once they have been appropriately programmed. Appendix 4A Exercises and Problems EXERCISE 4A1 Computation of Equivalent UnitsFIFO Method [LO6] Refer to the data for Clonex Labs, Inc., in Exercise 42. Required: Compute the equivalent units of production for October assuming that the company uses the FIFO method of accounting for units and costs. 177 gar79611_ch04_148-187.indd gar79611_ch04_148-187.indd Page 178 12/12/08 9:38:37 PM user-s180 178 /Users/user-s180/Desktop/TempWork/DEC/12-12-08/Dhiru 12-12-08/New/MHBR094-04 Chapter 4 EXERCISE 4A2 Cost per Equivalent UnitFIFO Method [LO7] Superior Micro Products uses the FIFO method in its process costing system. Data for the Assembly Department for May appear below: Materials Cost added during May . . . . . . . . . . . . . . . $193,320 Equivalent units of production . . . . . . . . . . 27,000 Labor Overhead $62,000 25,000 $310,000 25,000 Required: Compute the cost per equivalent unit for materials, labor, overhead, and in total. EXERCISE 4A3 Applying Costs to UnitsFIFO Method [LO8] Data concerning a recent periods activity in the Assembly Department, the rst processing department in a company that uses process costing, appear below: Materials Conversion Cost of work in process inventory at the beginning of the period . . . . . . . Equivalent units of production in the ending work in process inventory . . Equivalent units of production required to complete the beginning work in process inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost per equivalent unit for the period . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,200 400 $650 200 600 $2.32 1,200 $0.75 A total of 26,000 units were completed and transferred to the next processing department during the period. Beginning work in process inventory consisted of 2,000 units and ending work in process inventory consisted of 1,000 units. Required: Using the FIFO method, compute the cost of the units transferred to the next department during the period and the cost of ending work in process inventory. EXERCISE 4A4 Cost Reconciliation ReportFIFO Method [LO9] Schroeder Baking Corporation uses a process costing system in its large-scale baking operations. The Mixing Department is one of the companys processing departments. In the Mixing Department in July, the cost of beginning work in process inventory was $1,460, the cost of ending work in process inventory was $3,120, and the cost added to production was $36,540. Required: Prepare a cost reconciliation report for the Mixing Department for July. EXERCISE 4A5 Computation of Equivalent UnitsFIFO Method [LO6] MediSecure, Inc., produces clear plastic containers for pharmacies in a process that starts in the Molding Department. Data concerning that departments operations in the most recent period appear below: Beginning work in process: Units in process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stage of completion with respect to materials . . . . . . . . . . . . . . . . . Stage of completion with respect to conversion . . . . . . . . . . . . . . . . Units started into production during the month. . . . . . . . . . . . . . . . . . . Units completed and transferred out. . . . . . . . . . . . . . . . . . . . . . . . . . . Ending work in process: Units in process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stage of completion with respect to materials . . . . . . . . . . . . . . . . . Stage of completion with respect to conversion . . . . . . . . . . . . . . . . 500 80% 40% 153,600 153,700 400 75% 20% gar79611_ch04_148-187.indd gar79611_ch04_148-187.indd Page 179 12/12/08 9:38:37 PM user-s180 /Users/user-s180/Desktop/TempWork/DEC/12-12-08/Dhiru 12-12-08/New/MHBR094-04 Systems Design: Process Costing Required: MediSecure uses the FIFO method in its process costing system. Compute the equivalent units of production for the period for the Molding Department. EXERCISE 4A6 Equivalent Units and Cost per Equivalent UnitFIFO Method [LO6, LO7, LO8] Refer to the data for Pureform, Inc., in Exercise 48. Required: Assume that the company uses the FIFO method of accounting for units and costs. 1. Compute the equivalent units for the month for the rst processing department. 2. Determine the costs per equivalent unit for the month. EXERCISE 4A7 Equivalent UnitsFIFO Method [LO6] Refer to the data for Hielta Oy in Exercise 47. Assume that the company uses the FIFO method in its process costing system. Required: 1. 2. Compute the number of tons of pulp completed and transferred out during June. Compute the equivalent units of production for materials and for labor and overhead for June. EXERCISE 4A8 Equivalent Units; Applying CostsFIFO Method [LO6, LO7, LO8] Jarvene Corporation uses the FIFO method in its process costing system. The following data are for the most recent month of operations in one of the companys processing departments: Units in beginning inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . Units started into production . . . . . . . . . . . . . . . . . . . . . . . . . . Units in ending inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Units transferred to the next department . . . . . . . . . . . . . . . . . 400 3,000 300 3,100 Materials Percentage completion of beginning inventory . . . . . . . Percentage completion of ending inventory . . . . . . . . . Conversion 80% 70% 40% 60% The cost of beginning inventory according to the companys costing system was $11,040 of which $8,120 was for materials and the remainder was for conversion cost. The costs added during the month amounted to $132,730. The costs per equivalent unit for the month were: Materials Cost per equivalent unit . . . . . . . . . . . . . . . . . . . . . . Conversion $25.40 $18.20 Required: 1. 2. 3. 4. 5. Compute the total cost per equivalent unit for the month. Compute the equivalent units of material and of conversion costs in the ending inventory. Compute the equivalent units of material and of conversion costs that were required to complete the beginning inventory. Determine the number of units started and completed during the month. Determine the costs of ending inventory and units transferred out. EXERCISE 4A9 Equivalent UnitsFIFO Method [LO6] Refer to the data for Alaskan Fisheries, Inc., in Exercise 412. Required: Compute the equivalent units for July for the Cleaning Department assuming that the company uses the FIFO method of accounting for units. PROBLEM 4A10 Equivalent Units; Cost per Equivalent Unit; Applying CostsFIFO Method [LO6, LO7, LO8, LO9] Refer to the data for the Blending Department of Sunspots Beverages, Ltd., in Problem 413. Assume that the company uses the FIFO method rather than the weighted-average method in its process costing system. 179 gar79611_ch04_148-187.indd Page 180 12/12/08 9:38:38 PM user-s180 180 /Users/user-s180/Desktop/TempWork/DEC/12-12-08/Dhiru 12-12-08/New/MHBR094-04 Chapter 4 Required: 1. 2. 3. 4. Determine the equivalent units for June for the Blending Department. Compute the costs per equivalent unit for June for the Blending Department. Determine the total cost of ending work in process inventory and the total cost of units transferred to the next process for the Blending Department in June. Prepare a cost reconciliation report for the Blending Department for June. PROBLEM 4A11 Equivalent Units; Applying Costs; Cost Reconciliation ReportFIFO Method [LO6, LO7, LO8, LO9] Selzik Company makes super-premium cake mixes that go through two processing departments, Blending and Packaging. The following activity was recorded in the Blending Department during July: Production data: Units in process, July 1 (materials 100% complete; conversion 30% complete) . . . 10,000 Units started into production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 170,000 Units in process, July 31 (materials 100% complete; conversion 40% complete) . . 20,000 Cost data: Work in process inventory, July 1: Materials cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $8,500 Conversion cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,900 Cost added during the month: Materials cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $139,400 Conversion cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $244,200 All materials are added at the beginning of work in the Blending Department. The company uses the FIFO method in its process costing system. Required: 1. 2. 3. 4. Determine the equivalent units for July for the Blending Department. Compute the costs per equivalent unit for July for the Blending Department. Determine the total cost of ending work in process inventory and the total cost of units transferred to the next process for the Blending Department in July. Prepare a cost reconciliation report for the Blending Department for July. CASE 4A12 Second DepartmentFIFO Method [LO6, LO7, LO8] Refer to the data for Provost Industries in Case 419. Assume that the company uses the FIFO method in its process costing system. Required: 1. 2. Prepare a report for the Finishing Department for April showing how much cost should have been assigned to the units completed and transferred to nished goods and how much cost should have been assigned to the ending work in process inventory. As stated in the case, the company experienced an increase in materials prices during April. Would the effects of this price increase tend to show up more under the weighted-average method or under the FIFO method? Why? Appendix 4B: Service Department Allocations Most large organizations have both operating departments and service departments. The central purposes of the organization are carried out in the operating departments. In contrast, service departments do not directly engage in operating activities. Instead, they provide services or assistance to the operating departments. Examples of operating departments include the Surgery Department at Mt. Sinai Hospital, the Geography Department at the University of Washington, the Marketing Department at Allstate Insurance Company, and production departments at manufacturers such as Mitsubishi, HewlettPackard, and Michelin. In process costing, the processing departments are all operating departments. Examples of service departments include Cafeteria, Internal Auditing, Human Resources, Cost Accounting, and Purchasing. gar79611_ch04_148-187.indd gar79611_ch04_148-187.indd Page 181 12/12/08 9:38:38 PM user-s180 /Users/user-s180/Desktop/TempWork/DEC/12-12-08/Dhiru 12-12-08/New/MHBR094-04 181 Systems Design: Process Costing The overhead costs of operating departments commonly include allocations of costs from the service departments. To the extent that service department costs are classied as production costs, they should be included in unit product costs and thus must be allocated to operating departments in a process costing system. Three approaches are used to allocate the costs of service departments to other departments: the direct method, the step-down method, and the reciprocal method. These three methods are discussed in the following sections. However, before getting into the details of these methods, a few words are in order concerning interdepartmental services. Interdepartmental Services Many service departments provide services to each other, as well as to operating departments. For example, the Cafeteria Department provides meals for all employees, including those assigned to other service departments, as well as to employees of the operating departments. In turn, the Cafeteria Department may receive services from other service departments, such as from Custodial Services or from Personnel. Services provided between service departments are known as interdepartmental or reciprocal services. Direct Method L EARNING OBJECTIVE 10 The direct method is the simplest of the three cost allocation methods. It ignores the services provided by a service department to other service departments (e.g., reciprocal services) and allocates all service department costs directly to operating departments. Even if a service department (such as Personnel) provides a large amount of service to another service department (such as the cafeteria), no allocations are made between the two departments. Rather, all costs are allocated directly to the operating departments, bypassing the other service departments. Hence the term direct method. For an example of the direct method, consider Mountain View Hospital, which has two service departments and two operating departments as shown below. The hospital allocates its Hospital Administration costs on the basis of employee-hours and its Custodial Services costs on the basis of square feet occupied. Service Departments Operating Departments Hospital Custodial Administration Services Laboratory Departmental costs before allocation . . . . Employee hours . Space occupied square feet . . . $360,000 12,000 $90,000 6,000 $261,000 18,000 10,000 200 5,000 Patient Care Total $689,000 $1,400,000 30,000 66,000 45,000 60,200 The direct method of allocating the hospitals service department costs to the operating departments is shown in Exhibit 4B1. Several things should be noted in this exhibit. First, the employee-hours of the Hospital Administration Department and the Custodial Services Department are ignored when allocating the costs of Hospital Administration using the direct method. Under the direct method, any of the allocation base attributable to the service departments themselves is ignored; only the amount of the allocation base attributable to the operating departments is used in the allocation. Note that the same rule is used when allocating the costs of the Custodial Services Department. Even though the Hospital Administration and Custodial Services departments occupy some space, this is ignored when the Custodial Services costs are allocated. Finally, note that after all Allocate service department costs to operating departments using the direct method. gar79611_ch04_148-187.indd Page 182 12/12/08 9:38:39 PM user-s180 182 /Users/user-s180/Desktop/TempWork/DEC/12-12-08/Dhiru 12-12-08/New/MHBR094-04 Chapter 4 E X H I B I T 4B1 Direct Method of Allocation Service Departments Operating Departments Hospital Administration Custodial Services Laboratory Patient Care Total Departmental costs before allocation . . . . . . . . . . . . $360,000 $90,000 $261,000 $689,000 $1,400,000 Allocation: Hospital Administration costs (18 48, 30 48)* . . . . . . . . Custodial Services costs (5 50, 45 50) . . . . . . . . . . . . (360,000) (90,000) 135,000 9,000 225,000 81,000 Total cost after allocation . . . . . . . . . . . . . . . . . . . . . . $ $405,000 $995,000 0 $ 0 $1,400,000 *Based on the employee-hours in the two operating departments, which are 18,000 hours 30,000 hours 48,000 hours. Based on the square feet occupied by the two operating departments, which is 5,000 square feet 45,000 square feet 50,000 square feet. allocations have been completed, all of the service department costs are contained in the two operating departments. Although the direct method is simple, it is less accurate than the other methods because it ignores interdepartmental services. Step-Down Method LEARNING OBJECTIVE 11 Allocate service department costs to operating departments using the step-down method. E X H I B I T 4B2 Graphic IllustrationStepDown Method Unlike the direct method, the step-down method provides for allocation of a service departments costs to other service departments, as well as to operating departments. The step-down method is sequential. The sequence typically begins with the department that provides the greatest amount of service to other service departments. After its costs have been allocated, the process continues, step by step, ending with the department that provides the least amount of services to other service departments. This step procedure is illustrated in Exhibit 4B2. Hospital Administration Costs are allocated to other departments on the basis of employee-hours. Custodial Services Costs are allocated to operating departments on the basis of square feet occupied. Laboratory Patient Care gar79611_ch04_148-187.indd Page 183 12/12/08 9:38:42 PM user-s180 /Users/user-s180/Desktop/TempWork/DEC/12-12-08/Dhiru 12-12-08/New/MHBR094-04 183 Systems Design: Process Costing E X H I B I T 4B3 Step-Down Method of Allocation Service Departments Operating Departments Hospital Administration Custodial Services Laboratory Departmental costs before allocation . . . . . . . . . . . . $360,000 $ 90,000 $261,000 Allocation: Hospital Administration costs (6 54, 18 54, 30 54)* . . . . Custodial Services costs (5 50, 45 50) . . . . . . . . . . . . (360,000) 40,000 (130,000) 120,000 13,000 Total cost after allocation . . . . . . . . . . . . . . . . . . . . . . $ $ 0 0 $394,000 Patient Care $ 689,000 $1,400,000 200,000 117,000 $1,006,000 $1,400,000 *Based on the employee-hours in Custodial Services and the two operating departments, which are 6,000 hours 18,000 hours 30,000 hours 54,000 hours. As in Exhibit 4B1, this allocation is based on the square feet occupied by the two operating departments. Exhibit 4B3 shows the details of the step-down method. Note the following three key points about these allocations. First, under Allocation in Exhibit 4B3, you see two allocations, or steps. In the rst step, the costs of Hospital Administration are allocated to another service department (Custodial Services) as well as to the operating departments. In contrast to the direct method, the allocation base for Hospital Administration costs now includes the employee-hours for Custodial Services as well as for the operating departments. However, the allocation base still excludes the employeehours for Hospital Administration itself. In both the direct and step-down methods, any amount of the allocation base attributable to the service department whose cost is being allocated is always ignored. Second, looking again at Exhibit 4B3, note that in the second step under the Allocation heading, the cost of Custodial Services is allocated to the two operating departments, and none of the cost is allocated to Hospital Administration even though Hospital Administration occupies space in the building. In the step-down method, any amount of the allocation base that is attributable to a service department whose cost has already been allocated is ignored. After a service departments costs have been allocated, costs of other service departments are not reallocated back to it. Third, note that the cost of Custodial Services allocated to other departments in the second step ($130,000) in Exhibit 4B3 includes the costs of Hospital Administration that were allocated to Custodial Services in the first step in Exhibit 4B3. Reciprocal Method The reciprocal method gives full recognition to interdepartmental services. Under the step-down method discussed above only partial recognition of interdepartmental services is possible. The step-down method always allocates costs forwardnever backward. The reciprocal method, by contrast, allocates service department costs in both directions. Thus, because Custodial Services in the prior example provides services for Hospital Administration, part of Custodial Services costs will be allocated back to Hospital Administration if the reciprocal method is used. At the same time, part of Hospital Administrations costs will be allocated forward to Custodial Services. Reciprocal allocation requires the use of simultaneous linear equations and is beyond the scope of this book. Examples of the reciprocal method can be found in more advanced cost accounting texts. Total gar79611_ch04_148-187.indd Page 184 12/12/08 9:38:43 PM user-s180 184 /Users/user-s180/Desktop/TempWork/DEC/12-12-08/Dhiru 12-12-08/New/MHBR094-04 Chapter 4 Appendix 4B Exercises and Problems EXERCISE 4B1 Direct Method [LO10] Seattle Western University has provided the following data to be used in its service department cost allocations: Service Departments Operating Departments Administration Facility Services Undergraduate Programs Graduate Programs $2,400,000 $1,600,000 25,000 10,000 $26,800,000 20,000 70,000 $5,700,000 5,000 30,000 Departmental costs before allocations . . . . . . . . . . . . . Student credit-hours. . . . . . . . Space occupiedsquare feet Required: Using the direct method, allocate the costs of the service departments to the two operating departments. Allocate the costs of Administration on the basis of student credit-hours and Facility Services costs on the basis of space occupied. EXERCISE 4B2 Step-Down Method [LO11] Madison Park Co-op, a whole foods grocery and gift shop, has provided the following data to be used in its service department cost allocations: Service Departments Operating Departments Administration Departmental costs before allocations. . Employee-hours . . . . . . . . . . . . . . . . . . . Space occupiedsquare feet . . . . . . . . Janitorial Groceries Gifts $150,000 320 250 $40,000 160 100 $2,320,000 3,100 4,000 $950,000 740 1,000 Required: Using the step-down method, allocate the costs of the service departments to the two operating departments. Allocate Administration rst on the basis of employee-hours and then Janitorial on the basis of space occupied. EXERCISE 4B3 Step-Down Method [LO11] The Ferre Publishing Company has three service departments and two operating departments. Selected data from a recent period on the ve departments follow: Service Departments Operating Departments Administration Costs . . . . . . . . . . . . . . . . . . . . . . . . Number of employees . . . . . . . . . . . Square feet of space occupied. . . . . Hours of press time . . . . . . . . . . . . . Janitorial Maintenance Binding Printing Total $140,000 60 15,000 $105,000 35 10,000 $48,000 140 20,000 $275,000 315 40,000 30,000 $430,000 210 100,000 60,000 $998,000 760 185,000 90,000 The company allocates service department costs by the step-down method in the following order: Administration (number of employees), Janitorial (space occupied), and Maintenance (hours of press time). Required: Using the step-down method, allocate the service department costs to the operating departments. gar79611_ch04_148-187.indd Page 185 12/12/08 9:38:44 PM user-s180 /Users/user-s180/Desktop/TempWork/DEC/12-12-08/Dhiru 12-12-08/New/MHBR094-04 Systems Design: Process Costing EXERCISE 4B4 Direct Method [LO10] Refer to the data for the Ferre Publishing Company in Exercise 4B3. Required: Assuming that the company uses the direct method rather than the step-down method to allocate service department costs, how much cost would be assigned to each operating department? PROBLEM 4B5 Step-Down Method versus Direct Method; Predetermined Overhead Rates [LO10, LO11] The Sendai Co., Ltd., of Japan has budgeted costs in its various departments as follows for the coming year: Factory Administration . . . . . . . . . . Custodial Services . . . . . . . . . . . . . Personnel . . . . . . . . . . . . . . . . . . . . Maintenance . . . . . . . . . . . . . . . . . Machiningoverhead . . . . . . . . . . Assemblyoverhead . . . . . . . . . . . 270,000,000 68,760,000 28,840,000 45,200,000 376,300,000 175,900,000 Total cost . . . . . . . . . . . . . . . . . . . . 965,000,000 The Japanese currency is the yen, denoted by . The company allocates service department costs to other departments in the order listed below. Number of Employees Factory Administration . . . . Custodial Services . . . . . . . Personnel . . . . . . . . . . . . . . Maintenance . . . . . . . . . . . Machining. . . . . . . . . . . . . . Assembly . . . . . . . . . . . . . . Square Feet of Space Occupied Direct LaborHours MachineHours 12 4 5 25 40 60 3,000 5,000 22,000 30,000 90,000 5,000 2,000 3,000 10,000 70,000 20,000 20,000 80,000 70,000 10,000 146 Department Total LaborHours 150,000 110,000 100,000 80,000 Machining and Assembly are operating departments; the other departments are service departments. Factory Administration is allocated on the basis of labor-hours; Custodial Services on the basis of square feet occupied; Personnel on the basis of number of employees; and Maintenance on the basis of machine-hours. Required: 1. 2. 3. 4. Allocate service department costs to consuming departments by the step-down method. Then compute predetermined overhead rates in the operating departments using a machine-hours basis in Machining and a direct labor-hours basis in Assembly. Repeat (1) above, this time using the direct method. Again compute predetermined overhead rates in Machining and Assembly. Assume that the company doesnt bother with allocating service department costs but simply computes a single plantwide overhead rate based on total overhead costs (both service department and operating department costs) divided by total direct labor-hours. Compute the plantwide overhead rate. Suppose a job requires machine and labor time as follows: MachineHours Direct Labor-Hours Machining Department . . . . . . . . . Assembly Department . . . . . . . . . 190 10 25 75 Total hours . . . . . . . . . . . . . . . . . . 200 100 185 gar79611_ch04_148-187.indd Page 186 12/12/08 9:38:44 PM user-s180 186 /Users/user-s180/Desktop/TempWork/DEC/12-12-08/Dhiru 12-12-08/New/MHBR094-04 Chapter 4 Using the overhead rates computed in (1), (2), and (3) above, compute the amount of overhead cost that would be assigned to the job if the overhead rates were developed using the stepdown method, the direct method, and the plantwide method. PROBLEM 4B6 Step-Down Method [LO11] Woodbury Hospital has three service departments and three operating departments. Estimated cost and operating data for all departments in the hospital for the forthcoming quarter are presented in the table below: Service Departments Housekeeping Services Operating Departments Food Services Admin. Services Laboratory Radiology General Hospital Total Variable costs. . . . . . . . . . . . . . . . Fixed costs . . . . . . . . . . . . . . . . . . $ 0 87,000 $193,860 107,200 $158,840 90,180 $243,600 162,300 $304,800 215,700 $ 74,500 401,300 $ 975,600 1,063,680 Total cost . . . . . . . . . . . . . . . . . . . $87,000 $301,060 $249,020 $405,900 $520,500 $475,800 $2,039,280 800 2,000 1,000 68,000 71,800 0.8% 6,500 2.4% 10,000 14,000 1.6% 7,500 7,000 95.2% 108,000 25,000 100% 150,000 46,000 30% 20% 50% 100% Meals served . . . . . . . . . . . . . . . . Percentage of peak-period needsFood Services . . . . . . . Square feet of space . . . . . . . . . . Files processed . . . . . . . . . . . . . . Percentage of peak-period needsAdmin. Services . . . . . 5,000 13,000 The costs of the service departments are allocated by the step-down method using the allocation bases and in the order shown in the following table: Service Department Housekeeping Services . . . . . . . . . . . Food Services . . . . . . . . . . . . . . . . . . Administrative Services . . . . . . . . . . . Costs Incurred Allocation Bases Fixed Variable Fixed Variable Fixed Square feet of space Meals served Peak-period needsFood Services Files processed Peak-period needsAdmin. Services All billing in the hospital is done through Laboratory, Radiology, or General Hospital. The hospitals administrator wants the costs of the three service departments allocated to these three billing centers. Required: Prepare the cost allocation desired by the hospital administrator. (Use the step-down method.) Include under each billing center the direct costs of the center, as well as the costs allocated from the service departments. CASE 4B7 Step-Down Method versus Direct Method [LO10, LO11] This is really an odd situation, said Jim Carter, general manager of Highland Publishing Company. We get most of the jobs we bid on that require a lot of press time in the Printing Department, yet prots on those jobs are never as high as they ought to be. On the other hand, we lose most of the jobs we bid on that require a lot of time in the Binding Department. I would be inclined to think that the problem is with our overhead rates, but were already computing separate overhead rates for each department. So what else could be wrong? Highland Publishing Company is a large organization that offers a variety of printing and binding work. The Printing and Binding departments are supported by three service departments. The costs of these service departments are allocated to other departments in the order listed on the following page. (For each service department, use the allocation base that provides the best measure of service provided, as discussed in the chapter.) gar79611_ch04_148-187.indd Page 187 12/12/08 9:38:45 PM user-s180 /Users/user-s180/Desktop/TempWork/DEC/12-12-08/Dhiru 12-12-08/New/MHBR094-04 Systems Design: Process Costing Department Total LaborHours Square Feet of Space Occupied Number of Employees MachineHours Direct LaborHours Personnel . . . . . . . . . . Custodial Services . . . Maintenance . . . . . . . Printing. . . . . . . . . . . . Binding . . . . . . . . . . . . 20,000 30,000 50,000 90,000 260,000 4,000 6,000 20,000 80,000 40,000 10 15 25 40 120 150,000 30,000 60,000 175,000 450,000 150,000 210 180,000 235,000 Budgeted overhead costs in each department for the current year are shown below: Personnel . . . . . . . . . . . . . . . . . Custodial Services . . . . . . . . . . Maintenance . . . . . . . . . . . . . . Printing . . . . . . . . . . . . . . . . . . . Binding . . . . . . . . . . . . . . . . . . . $ 360,000 141,000 201,000 525,000 373,500 Total budgeted cost . . . . . . . . . $1,600,500 Because of its simplicity, the company has always used the direct method to allocate service department costs to the two operating departments. Required: 1. 2. 3. Using the step-down method, allocate the service department costs to the consuming departments. Then compute predetermined overhead rates for the current year using machine-hours as the allocation base in the Printing Department and direct labor-hours as the allocation base in the Binding Department. Repeat (1) above, this time using the direct method. Again compute predetermined overhead rates in the Printing and Binding departments. Assume that during the current year the company bids on a job that requires machine and labor time as follows: MachineHours Printing Department . . . . . . . . . . Binding Department . . . . . . . . . . b. 15,400 800 900 2,000 Total hours . . . . . . . . . . . . . . . . . a. Direct Labor-Hours 16,200 2,900 Determine the amount of overhead cost that would be assigned to the job if the company used the overhead rates developed in (1) above. Then determine the amount of overhead cost that would be assigned to the job if the company used the overhead rates developed in (2) above. Explain to Mr. Carter, the general manager, why the step-down method provides a better basis for computing predetermined overhead rates than the direct method. 187 gar79611_ch05_188-232.indd Page 188 12/13/08 7:29:38 PM user-s180 Chapter 5 /broker/MH-BURR/MHBR094/MHBR094-05/upload Cost Behavior: Analysis and Use The Business of Art Sculpture LEARNING OBJECTIVES After studying Chapter 5, you should be able to: Understand how fixed and variable costs behave and how to use them to predict costs. LO2 Use a scattergraph plot to diagnose cost behavior. LO3 Analyze a mixed cost using the high-low method. LO4 Prepare an income statement using the contribution format. LO5 (Appendix 5A) Analyze a mixed cost using the least-squares regression method. Source: Conversations with Shidoni personnel, including Bill Rogers and Harry Gold, and Shidoni literature. See www.shidoni.com for more information concerning the company. 188 B U S IN E SS FO CU S LO1 Shidoni Foundry, located in Tesuque, New Mexico, is a fine art casting and fabrication facility. The process of creating a bronze or other metal sculpture is complex. The artist creates the sculpture using modeling clay and then hires a foundry such as Shidoni to produce the actual metal sculpture. Shidoni craftspeople make a rubber mold from the clay model then use that mold to make a wax version of the original. The wax is in turn used to make a ceramic casting mold, and finally the bronze version is cast. Both the wax and the ceramic casting mold are destroyed in the process of making the metal casting, but the rubber mold is not and can be reused to make additional castings. The surface of the metal sculpture can be treated with various patinas. One of the accompanying photos shows Harry Gold, the shops patina artist, applying a patina to a metal sculpture with brush and blowtorch. The other photo shows a finished sculpture with patinas applied. The artist is faced with a difficult business decision. The rubber mold for a small figure such as the seated Indian in the accompanying photo costs roughly $500; the mold for a life-size figure such as the cowboy costs $3,800 to $5,000. This is just for the mold! Fortunately, as discussed above, a number of metal castings can be made from each mold. However, each life-size casting costs $8,500 to $11,000. In contrast, a casting of the much smaller Indian sculpture would cost about $750. Given the fixed costs of the mold and variable costs of the casting, finish treatments, and bases, the artist must decide how many castings to produce and how to price them. The fewer the castings, the greater the rarity factor, and hence the higher the price that can be charged to art lovers. However, in that case, the fixed costs of making the mold must be spread across fewer items. The artist must make sure not to price the sculptures so high that the investment in molds and in the castings cannot be recovered. gar79611_ch05_188-232.indd Page 189 12/13/08 7:29:42 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-05/upload 189 Cost Behavior: Analysis and Use I n Chapter 2, we stated that costs can be classied by behavior. Cost behavior refers to how a cost will change as the level of activity changes. Managers who understand how costs behave can predict how costs will change under various alternatives. Conversely, attempting to make decisions without a thorough understanding of cost behavior patterns can lead to disaster. For example, cutting back production of a product line might result in far less cost savings than managers assume if they confuse xed costs with variable costs. To avoid such problems, managers must be able to accurately predict what costs will be at various activity levels. This chapter briey reviews the denitions of variable and xed costs and then discusses the behavior of these costs in greater depth than in Chapter 2. The chapter also introduces the concept of a mixed cost, which is a cost that has both variable and xed cost elements. The chapter concludes by introducing a new income statement format called the contribution formatin which costs are organized by their behavior rather than by the traditional functions of production, sales, and administration. Types of Cost Behavior Patterns In Chapter 2 we mentioned only variable and xed costs. In this chapter we will examine a third cost behavior pattern, known as a mixed or semivariable cost. All three cost behavior patternsvariable, xed, and mixedare found in most organizations. The relative proportion of each type of cost in an organization is known as its cost structure. For example, an organization might have many xed costs but few variable or mixed costs. Alternatively, it might have many variable costs but few xed or mixed costs. In this chapter, we will concentrate on gaining a fuller understanding of the behavior of each type of cost. In the next chapter, we explore how cost structure impacts decisions. COST STRUCTURE: A MANAGEMENT CHOICE IN BUSINESS Some managers are thriftier than others. Kenneth Iverson built Nucor Steel into the most successful U.S. steel company of recent years by developing a whole new approach to steel-making using costefcient minimills. Iverson ran his company with few layers of management and a commitment to employees that everyone would be treated alike. Workers were dissuaded from joining a union by high wages and a series of Nosno management dining rooms, no company yachts, no company planes, no rst-class travel for executives, and no support staff to pamper the upper echelons. Iverson ran the largest steel company in the U.S. with only 20 people in his headquarters. By responding to market signals, focusing on a single major product line, and treating his employees with respect and compassion, Mr. Iverson contributed immensely to the industrial rebirth in this country. Source: Donald F. Barnett and Robert W. Crandall, Remembering a Man of Steel, The Wall Street Journal, April 23, 2002, p. B4. Variable Costs L EARNING OBJECTIVE 1 We explained in Chapter 2 that a variable cost is a cost whose total dollar amount varies in direct proportion to changes in the activity level. If the activity level doubles, the total variable cost also doubles. If the activity level increases by only 10%, then the total variable cost increases by 10% as well. Understand how xed and variable costs behave and how to use them to predict costs. gar79611_ch05_188-232.indd gar79611_ch05_188-232.indd Page 190 12/13/08 7:29:43 PM user-s180 190 /broker/MH-BURR/MHBR094/MHBR094-05/upload Chapter 5 IN BUSINESS ADVERTISING ON THE WEB Many companies spend a growing portion of their advertising budgets on web-based contextual advertising. Here is an example of how it works. A tour company specializing in trips to Belize partners with National Geographic and Quigo Technologies, a software company, to ensure that every time a visitor reads a National Geographic article mentioning the word Belize, a pop-up advertisement contains a link to the tour companys website. The tour company pays 50 cents each time a visitor clicks on that link. The 50 cents is split between iExplore.com, National Geographics on-line business, and Quigo Technologies. For the tour company, this form of advertising is a clear example of a variable cost. The cost per click is constant at 50 cents per unit, but the total advertising cost rises as the number of clicks increases. The challenge for software developers at companies such as Quigo Technologies, Google, and Yahoo is to write programs that intelligently select ads that are relevant to the context of a given web page. Providing superior contextual relevance increases the likelihood that web surfers will click on an advertisement, which in turn increases the revenue generated. Quigo Technologies Michael Yavonditte claims that his companys ads are clicked on 0.7% of the time versus 0.2% for competitors. Source: Chana R. Schoenberger, Out of Context Forbes, November 29, 2004, pp. 6468. We also found in Chapter 2 that a variable cost remains constant if expressed on a per unit basis. To provide an example, consider Nooksack Expeditions, a small company that provides daylong whitewater rafting excursions on rivers in the North Cascade Mountains. The company provides all of the necessary equipment and experienced guides, and it serves gourmet meals to its guests. The meals are purchased from a caterer for $30 a person for a daylong excursion. If we look at the cost of the meals on a per person basis, it remains constant at $30. This $30 cost per person will not change, regardless of how many people participate in a daylong excursion. The behavior of this variable cost, on both a per unit and a total basis, is tabulated as follows: Number of Guests 250 . . . . . . . . . 500 . . . . . . . . . 750 . . . . . . . . . 1,000 . . . . . . . . . Cost of Meals per Guest Total Cost of Meals $30 $30 $30 $30 $7,500 $15,000 $22,500 $30,000 The idea that a variable cost is constant per unit but varies in total with the activity level is crucial to understanding cost behavior patterns. We shall rely on this concept repeatedly in this chapter and in chapters ahead. Exhibit 51 illustrates variable cost behavior. Note that the graph of the total cost of the meals slants upward to the right. This is because the total cost of the meals is directly proportional to the number of guests. In contrast, the graph of the per unit cost of meals is at because the cost of the meals per guest is constant at $30. The Activity Base For a cost to be variable, it must be variable with respect to something. That something is its activity base. An activity base is a measure of whatever causes the incurrence of variable cost. An activity base is sometimes referred to as a cost driver. Some of the most common activity bases are direct labor-hours, machinehours, units produced, and units sold. Other examples of activity bases (cost drivers) include the number of miles driven by salespersons, the number of pounds of laundry gar79611_ch05_188-232.indd Page 191 12/13/08 7:29:44 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-05/upload 191 Cost Behavior: Analysis and Use E X H I B I T 51 Variable Cost Behavior Total Cost of Meals Per Unit Cost of Meals $30,000 $60 A variable cost increases, in total, in proportion to activity A variable cost is constant per unit of activity $50 Cost of meals per guest Total cost of meals $25,000 $20,000 $15,000 $10,000 $5,000 $40 $30 $20 $10 $0 $0 0 250 500 750 Number of guests 1,000 0 250 500 750 Number of guests cleaned by a hotel, the number of calls handled by technical support staff at a software company, and the number of beds occupied in a hospital. People sometimes get the notion that if a cost doesnt vary with production or with sales, then it is not a variable cost. This is not correct. As suggested by the range of bases listed above, costs are caused by many different activities within an organization. Whether a cost is variable or xed depends on whether it is caused by the activity under consideration. For example, when analyzing the cost of service calls under a product warranty, the relevant activity measure is the number of service calls made. Those costs that vary in total with the number of service calls made are the variable costs of making service calls. Nevertheless, unless stated otherwise, you can assume that the activity base under consideration is the total volume of goods and services provided by the organization. So, for example, if we ask whether direct materials at Ford is a variable cost, the answer is yes because the cost of direct materials is variable with respect to Fords total volume of output. We will specify the activity base only when it is something other than total output. Extent of Variable Costs The number and type of variable costs in an organization will depend in large part on the organizations structure and purpose. A public utility like Florida Power and Light, with large investments in equipment, will tend to have few variable costs. Most of the costs are associated with its plant, and these costs tend to be insensitive to changes in levels of service provided. A manufacturing company like Black and Decker, by contrast, will often have many variable costs; these costs will be associated with both manufacturing and distributing its products to customers. A merchandising company like Wal-Mart or J. K. Gill will usually have a high proportion of variable costs in its cost structure. In most merchandising companies, the cost of merchandise purchased for resale, a variable cost, constitutes a very large component of total cost. Service companies, by contrast, have diverse cost structures. Some service companies, such as the Skippers restaurant chain, have fairly large variable costs because of the costs of their raw materials. On the other hand, service companies involved in consulting, auditing, engineering, dental, medical, and architectural activities have very large xed costs in the form of expensive facilities and highly trained salaried employees. 1,000 gar79611_ch05_188-232.indd Page 192 12/13/08 7:29:44 PM user-s180 192 E X H I B I T 52 Examples of Variable Costs /broker/MH-BURR/MHBR094/MHBR094-05/upload Chapter 5 Type of Organization Costs that Are Normally Variable with Respect to Volume of Output Merchandising company Cost of goods (merchandise) sold Manufacturing company Direct materials Direct labor* Variable elements of manufacturing overhead: Indirect materials Lubricants Supplies Power Both merchandising and manufacturing companies Variable elements of selling and administrative costs: Commissions Shipping costs Service organizations Supplies *Direct labor may or may not be variable in practice. See the discussion later in this chapter. Some of the more frequently encountered variable costs are listed in Exhibit 52 above. This exhibit is not a complete listing of all costs that can be considered variable. Moreover, some of the costs listed in the exhibit may behave more like xed than variable costs in some organizations and in some circumstances. We will see examples of this later in the chapter. Nevertheless, Exhibit 52 provides a useful listing of many of the costs that normally would be considered variable with respect to the volume of output. True Variable versus Step-Variable Costs Not all variable costs have exactly the same behavior pattern. Some variable costs behave in a true variable or proportionately variable pattern. Other variable costs behave in a step-variable pattern. True Variable Costs Direct materials is a true or proportionately variable cost because the amount used during a period will vary in direct proportion to the level of production activity. Moreover, any amounts purchased but not used can be stored and carried forward to the next period as inventory. Step-Variable Costs The cost of a resource that is obtained in large chunks and that increases or decreases only in response to fairly wide changes in activity is known as a step-variable cost. For example, the wages of skilled repair technicians are often considered to be a step-variable cost. Such a technicians time can only be obtained in large chunksit is difcult to hire a skilled technician on anything other than a full-time basis. Moreover, any technicians time not currently used cannot be stored as inventory and carried forward to the next period. If the time is not used effectively, it is gone forever. Furthermore, a repair technician can work at a leisurely pace if pressures are light but intensify his or her efforts if pressures build up. For this reason, small changes in the level of production may have no effect on the number of technicians employed by the company. Exhibit 53 contrasts the behavior of a step-variable cost with the behavior of a true variable cost. Notice that the cost of repair technicians changes only with fairly wide changes in volume and that additional technicians come in large, indivisible chunks. Great care must be taken in working with these kinds of costs to prevent fat from building up in an organization. There may be a tendency to employ additional help more quickly than needed, and there is a natural reluctance to lay people off when volume declines. gar79611_ch05_188-232.indd Page 193 12/24/08 4:19:30 PM user-s180 /Users/user-s180/Desktop/Dhiru 24-12-08/New/MHBR094-05 193 Cost Behavior: Analysis and Use Repair Technician Wages (step variable) E X H I B I T 53 True Variable versus Step-Variable Costs Cost Cost Direct Materials (true variable) Volume Volume HOW MANY GUIDES? IN BUSINESS Majestic Ocean Kayaking, of Ucluelet, British Columbia, is owned and operated by Tracy MorbenEeftink. The company offers a number of guided kayaking excursions ranging from three-hour tours of the Ucluelet harbor to six-day kayaking and camping trips in Clayoquot Sound. One of the companys excursions is a four-day kayaking and camping trip to The Broken Group Islands in the Pacic Rim National Park. Special regulations apply to trips in the parkincluding a requirement that one certied guide must be assigned for every ve guests or fraction thereof. For example, a trip with 12 guests must have at least three certied guides. Guides are not salaried and are paid on a perday basis. Therefore, the cost to the company of the guides for a trip is a step-variable cost rather than a xed cost or a strictly variable cost. One guide is needed for 1 to 5 guests, two guides for 6 to 10 guests, three guides for 11 to 15 guests, and so on. Sources: Tracy Morben-Eeftink, owner, Majestic Ocean Kayaking. For more information about the company, see www.oceankayaking.com. WHAT GOES UP DOESNT NECESSARILY COME DOWN The traditional view of variable costs is that they behave similarly in response to either increases or decreases in activity. However, the results of a research study using data from 7,629 companies spanning a 20-year period suggests otherwise. In this study, a 1% increase in sales corresponded with a 0.55% increase in selling and administrative costs, while a 1% decrease in sales corresponded with a 0.35% decrease in selling and administrative costs. These results suggest that many costs do not mechanistically increase or decrease in response to changes in the activity base; rather they change in response to managers decisions about how to react to changes in the level of the activity base. When volume falls, managers must decide whether to maintain committed resources and bear the costs of operating with unutilized capacity or reduce committed resources and incur the adjustment costs of retrenching and, if volume is restored, replacing committed resources at a later date. Managers faced with these choices are less likely to reduce expenses when they perceive that a decrease in activity level is temporary or when the cost of adjusting committed resources is high. Source: Mark C. Anderson, Rajiv D. Banker, and Surya N. Janakiraman, Are Selling, General, and Administrative Costs Sticky? Journal of Accounting Research, March 2003, pp. 4763. IN BUSINESS gar79611_ch05_188-232.indd Page 194 12/13/08 7:29:47 PM user-s180 194 /broker/MH-BURR/MHBR094/MHBR094-05/upload Chapter 5 E X H I B I T 54 Curvilinear Costs and the Relevant Range Cost Relevant range Economists curvilinear cost function Accountants straight-line approximation Volume The Linearity Assumption and the Relevant Range Except in the case of step-variable costs, we ordinarily assume a strictly linear relationship between cost and volume. Economists correctly point out that many costs that the accountant classies as variable actually behave in a curvilinear fashion; that is, the relation between cost and activity is a curve. A curvilinear cost is illustrated in Exhibit 54. Although many costs are not strictly linear, a curvilinear cost can be satisfactorily approximated with a straight line within a narrow band of activity known as the relevant range. The relevant range is that range of activity within which the assumptions made about cost behavior are reasonably valid. For example, note that the dashed line in Exhibit 54 approximates the curvilinear cost with very little loss of accuracy within the shaded relevant range. However, outside of the relevant range this particular straight line is a poor approximation to the curvilinear cost relationship. Managers should always keep in mind that assumptions made about cost behavior may be invalid if activity falls outside of the relevant range. Fixed Costs In our discussion of cost behavior patterns in Chapter 2, we stated that total xed costs remain constant within the relevant range of activity. To continue the Nooksack Expeditions example, assume the company rents a building for $500 per month to store its equipment. Within the relevant range, the total amount of rent paid is the same regardless of the number of guests the company takes on its expeditions during any given month. Exhibit 55 depicts this cost behavior pattern. Because xed costs remain constant in total, the average xed cost per unit becomes progressively smaller as the level of activity increases. If Nooksack Expeditions has only 250 guests in a month, the $500 xed rental cost would amount to an average of $2 per guest. If there are 1,000 guests, the xed rental cost would average only 50 cents per guest. Exhibit 55 illustrates this aspect of the behavior of xed costs. Note that as the number of guests increases, the average xed cost per unit drops, but it drops at a decreasing rate. The rst guests have the biggest impact on the average xed cost per unit. It is necessary in some contexts to express xed costs on an average per unit basis. For example, in Chapter 2 we showed how unit product costs computed for use in external nancial statements contain both variable and xed costs. As a general rule, however, we caution against expressing xed costs on an average per unit basis in internal reports because it creates the false impression that xed costs are like variable costs and that total xed costs actually change as the level of activity changes. To avoid confusion in internal reporting and decisionmaking situations, xed costs should be expressed in total rather than on a per unit basis. gar79611_ch05_188-232.indd Page 195 12/24/08 5:24:44 AM user-s176 /broker/MH-BURR/MHBR094/MHBR094-05/upload/MHBR094-05 195 Cost Behavior: Analysis and Use E X H I B I T 55 Fixed Cost Behavior Total Fixed Cost of Renting the Building Per Unit Fixed Cost of Renting the Building $5.00 $4.50 Fixed costs remain constant in total dollar amount through wide ranges of activity. Cost of building rental $4.00 $3.50 $3.00 $500 Fixed costs decrease on a per unit basis as the activity level increases. $2.50 $2.00 $1.50 $1.00 $0.50 $0 $0 0 250 500 750 1,000 Number of guests 1,250 0 250 500 750 1,000 Number of guests IN BUSINESS COSTING THE TREK Jackson Hole Llamas is owned and operated by Jill Aanonsen/Hodges and David Hodges. The company provides guided tours to remote areas of Yellowstone National Park and the Jedediah Smith Wilderness, with the llamas carrying the baggage for the multiday treks. Jill and David operate out of their ranch in Jackson Hole, Wyoming, leading about 10 trips each summer season. All food is provided as well as tents and sleeping pads. Based on the number of guests on a trip, Jill and David will decide how many llamas will go on the trip and how many will remain on the ranch. Llamas are transported to the trailhead in a special trailer. The company has a number of costs, some of which are listed below: Cost Cost Behavior Food and beverage costs Truck and trailer operating costs Guide wages Variable with respect to the number of guests and the length of the trip in days. Variable with respect to the number of miles to the trailhead. Step variable; Jill and David serve as the guides on most trips and hire guides only for larger groups. Variable with respect to the number of guests and length of the trip in days. Jackson Hole Llamas owns its tents, but they wear out through use and must be repaired or eventually replaced. Variable with respect to the number of guests, and hence the number of llamas, on a trip. [Actually, the cost of feeding llamas may decrease with the number of guests on a trip. When a llama is on a trek, it lives off the land eating grasses and other vegetation found in meadows and along the trail. When a llama is left on the ranch, it may have to be fed purchased feed.] Fixed. Costs of providing tents Cost of feeding llamas Property taxes 1,250 Source: Jill Aanonsen/Hodges and David Hodges, owners and operators of Jackson Hole Llamas, www.jhllamas.com. gar79611_ch05_188-232.indd Page 196 12/13/08 7:29:48 PM user-s180 196 /broker/MH-BURR/MHBR094/MHBR094-05/upload Chapter 5 Types of Fixed Costs Fixed costs are sometimes referred to as capacity costs because they result from outlays made for buildings, equipment, skilled professional employees, and other items needed to provide the basic capacity for sustained operations. For planning purposes, xed costs can be viewed as either committed or discretionary. Committed Fixed Costs Investments in facilities, equipment, and the basic organization often cant be signicantly reduced even for short periods of time without making fundamental changes. Such costs are referred to as committed xed costs. Examples include depreciation of buildings and equipment, real estate taxes, insurance expenses, and salaries of top management and operating personnel. Even if operations are interrupted or cut back, committed xed costs remain largely unchanged in the short term. During a recession, for example, a company wont usually eliminate key executive positions or sell off key facilitiesthe basic organizational structure and facilities ordinarily are kept intact. The costs of restoring them later are likely to be far greater than any shortrun savings that might be realized. Once a decision is made to acquire committed xed resources, the company may be locked into that decision for many years to come. Consequently, such commitments should be made only after careful analysis of the available alternatives. Investment decisions involving committed xed costs will be examined in a later chapter. Discretionary Fixed Costs Discretionary xed costs (often referred to as managed xed costs) usually arise from annual decisions by management to spend on certain xed cost items. Examples of discretionary xed costs include advertising, research, public relations, management development programs, and internships for students. Two key differences exist between discretionary xed costs and committed xed costs. First, the planning horizon for a discretionary xed cost is short termusually a single year. By contrast, committed xed costs have a planning horizon that encompasses many years. Second, discretionary xed costs can be cut for short periods of time with minimal damage to the long-run goals of the organization. For example, spending on management development programs can be reduced because of poor economic conditions. Although some unfavorable consequences may result from the cutback, it is doubtful that these consequences would be as great as those that would result if the company decided to economize by laying off key personnel. Whether a particular cost is regarded as committed or discretionary may depend on managements strategy. For example, during recessions when the level of home building is down, many construction companies lay off most of their workers and virtually disband operations. Other construction companies retain large numbers of employees on the payroll, even though the workers have little or no work to do. While these latter companies may be faced with short-term cash ow problems, it will be easier for them to respond quickly when economic conditions improve. And the higher morale and loyalty of their employees may give these companies a signicant competitive advantage. The most important characteristic of discretionary xed costs is that management is not locked into its decisions regarding such costs. Discretionary costs can be adjusted from year to year or even perhaps during the course of a year if necessary. IN BUSINESS A TWIST ON FIXED AND VARIABLE COSTS Mission Controls designs and installs automation systems for food and beverage manufacturers. At most companies, when sales drop and cost cutting is necessary, top managers lay off workers. The founders of Mission Controls decided to do something different when sales dropthey slash their own salaries before they even consider letting any of their employees go. This makes their own salaries somewhat variable, while the wages and salaries of workers act more like xed costs. The payoff is a loyal and committed workforce. Source: Christopher Caggiano, Employment, Guaranteed for Life, Inc. magazine, October 15, 2002, p. 74. gar79611_ch05_188-232.indd Page 197 12/13/08 7:29:49 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-05/upload Cost Behavior: Analysis and Use 197 The Trend toward Fixed Costs The trend in many industries is toward greater xed costs relative to variable costs. Chores that used to be performed by hand have been taken over by machines. For example, grocery clerks at stores like Safeway and Kroger used to key in prices by hand on cash registers. Now stores are equipped with barcode readers that enter price and other product information automatically. In general, competition has created pressure to give customers more value for their moneya demand that often can only be satised by automating business processes. For example, an H & R Block employee used to ll out tax returns for customers by hand and the advice given to a customer largely depended on the knowledge of that particular employee. Now, sophisticated computer software based on the accumulated knowledge of many experts is used to complete tax returns, and the software provides tax planning and other advice tailored to the customers needs. As automation intensies, the demand for knowledge workersthose who work primarily with their minds rather than their muscleshas grown tremendously. Because knowledge workers tend to be salaried, highly trained, and difcult to replace, the costs of compensating these workers are often relatively xed and are committed rather than discretionary. A NEW TWIST ON SENDING JOBS OFFSHORE SeaCode (www.sea-code.com) is a San Diego based company that offers a new twist on the popular practice of outsourcing jobs from the United States to foreign countries with lower labor costs. The company houses 600 computer programmers from around the world on a cruise ship three miles off the coast of Los Angeles. This oating tech factory is subject to the labor laws of whatever ag the boat chooses to y rather than to U.S. labor laws. SeaCode pays its knowledge workers $1,500 to $1,800 per month, which is below prevailing salaries on the U.S. mainland but exceeds the salaries in many countries. The company claims that it has been inundated with resumes of college graduates from across the globe. SeaCodes clients get access to highly skilled labor at a lower cost than would have to be paid for similar jobs housed on U.S. soil. In addition, rather than having to y halfway around the world to places such as India or China to oversee projects, U.S. managers can y to Los Angeles and in a brief time be three miles off the California coast checking on the status of offshore operations. Source: Reed Tucker, Will a Floating Tech Factory Fly? Fortune, September 5, 2005, p. 28. Is Labor a Variable or a Fixed Cost? As the preceding discussion suggests, wages and salaries may be xed or variable. The behavior of wage and salary costs will differ from one country to another, depending on labor regulations, labor contracts, and custom. In some countries, such as France, Germany, and Japan, management has little exibility in adjusting the labor force to changes in business activity. In countries such as the United States and the United Kingdom, management typically has much greater latitude. However, even in these less restrictive environments, managers may choose to treat employee compensation as a xed cost for several reasons. First, many managers are reluctant to decrease their workforce in response to shortterm declines in sales. These managers realize that the success of their businesses hinges on retaining highly skilled and trained employees. If these valuable workers are laid off, it is unlikely that they would ever return or be easily replaced. Furthermore, laying off workers undermines the morale of those employees who remain. Second, managers do not want to be caught with a bloated payroll in an economic downturn. Therefore, managers are reluctant to add employees in response to short-term increases in sales. Instead, more and more companies rely on temporary and part-time workers to take up the slack when their permanent, full-time employees are unable to handle all of the demand for their products and services. In such companies, labor costs are a complex mixture of xed and variable costs. IN BUSINESS gar79611_ch05_188-232.indd Page 198 12/13/08 7:29:50 PM user-s180 198 /broker/MH-BURR/MHBR094/MHBR094-05/upload Chapter 5 IN BUSINESS HEDGING THEIR BETS WITH CONTINGENT EMPLOYEES Companies in white-collar industries such as media, public relations, and technology frequently hire contingent employees from stafng agencies to reduce the risk of being saddled with a bloated payroll during a business downturn. Contingent employees earn an hourly wage from their stafng agency, but they do not receive any fringe benets. Companies employing contingent workers like the exibility of being able to lay off these people with one telephone call to the stafng agency. Brad Karsh, president of a Chicago employment-coaching service called JobBound recommends a similar lack of commitment to his clients who accept contingent employment positions. Its exactly like dating, he says. You dont want to be loyal if theyre not going to be loyal to you. Source: Daniel Nasaw, Companies Are Hedging Their Bets by Hiring Contingent Employees, The Wall Street Journal, September 14, 2004, p. B10. Many major companies have undergone waves of downsizing in recent years in which large numbers of employeesparticularly managershave lost their jobs. This downsizing may seem to suggest that even management salaries should be regarded as variable costs, but this would not be a valid conclusion. Downsizing has largely been the result of attempts to reengineer business processes and cut costs rather than a response to a decline in sales activity. This underscores an important, but subtle, point. Fixed costs can changethey just dont change in response to small changes in activity. In sum, there is no clear-cut answer to the question Is labor a variable or xed cost? It depends on how much exibility management has to adjust the workforce and managements strategy. Nevertheless, unless otherwise stated, we will assume in this text that direct labor is a variable cost. This assumption is more likely to be valid for companies in the United States than in countries where employment laws permit much less exibility. Fixed Costs and the Relevant Range The concept of the relevant range, which was introduced in the discussion of variable costs, is also important in understanding xed costsparticularly discretionary xed costs. The levels of discretionary xed costs are typically decided at the beginning of the year and depend on the needs of planned programs such as advertising and training. The scope of these programs will depend, in turn, on the overall anticipated level of activity for the year. At very high levels of activity, programs are often broadened or expanded. For example, if the company hopes to increase sales by 25%, it would probably plan for much larger advertising costs than if no sales increase were planned. So the planned level of activity might affect total discretionary xed costs. However, once the total discretionary xed costs have been budgeted, they are unaffected by the actual level of activity. For example, once the advertising budget has been established and spent, it will not be affected by how many units are actually sold. Therefore, the cost is xed with respect to the actual number of units sold. Discretionary xed costs are easier to adjust than committed xed costs. They also tend to be less lumpy. Committed xed costs consist of costs such as buildings, equipment, and the salaries of key personnel. It is difcult to buy half a piece of equipment or to hire a quarter of a product-line manager, so the step pattern depicted in Exhibit 56 is typical for such costs. The relevant range of activity for a xed cost is the range of activity over which the graph of the cost is at as in Exhibit 56. As a company expands its level of activity, it may outgrow its present facilities, or the key management team may need to be expanded. The result, of course, will be increased committed xed costs as larger facilities are built and as new management positions are created. gar79611_ch05_188-232.indd Page 199 12/13/08 7:29:51 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-05/upload 199 Cost Behavior: Analysis and Use Cost Relevant range Volume One reaction to the step pattern depicted in Exhibit 56 is to conclude that discretionary and committed xed costs are really just step-variable costs. To some extent this is true, because almost all costs can be adjusted in the long run. There are two major differences, however, between the step-variable costs depicted earlier in Exhibit 53 and the xed costs depicted in Exhibit 56. The rst difference is that the step-variable costs can often be adjusted quickly as conditions change, whereas once xed costs have been set, they usually cant be changed easily. A step-variable cost such as the wages of repair technicians, for example, can be adjusted upward or downward by hiring and laying off technicians. By contrast, once a company has signed a lease for a building, it is locked into that level of lease cost for the life of the contract. The second difference is that the width of the steps depicted for step-variable costs is much narrower than the width of the steps depicted for the xed costs in Exhibit 56. The width of the steps relates to volume or level of activity. For step-variable costs, the width of a step might be 40 hours of activity per week in the case of repair technicians. For xed costs, however, the width of a step might be thousands or even tens of thousands of hours of activity. In essence, the width of the steps for step-variable costs is generally so narrow that these costs can be treated essentially as variable costs for most purposes. The width of the steps for xed costs, on the other hand, is so wide that these costs should be treated as entirely xed within the relevant range. Mixed Costs A mixed cost contains both variable and xed cost elements. Mixed costs are also known as semivariable costs. To continue the Nooksack Expeditions example, the company must pay a license fee of $25,000 per year plus $3 per rafting party to the states Department of Natural Resources. If the company runs 1,000 rafting parties this year, then the total fees paid to the state would be $28,000, made up of $25,000 in xed cost plus $3,000 in variable cost. Exhibit 57 depicts the behavior of this mixed cost. Even if Nooksack fails to attract any customers, the company will still have to pay the license fee of $25,000. This is why the cost line in Exhibit 57 intersects the vertical cost axis at the $25,000 point. For each rafting party the company organizes, the total cost of the state fees will increase by $3. Therefore, the total cost line slopes upward as the variable cost of $3 per party is added to the xed cost of $25,000 per year. E X H I B I T 56 Fixed Costs and the Relevant Range gar79611_ch05_188-232.indd gar79611_ch05_188-232.indd Page 200 12/13/08 7:29:51 PM user-s180 200 /broker/MH-BURR/MHBR094/MHBR094-05/upload Chapter 5 E X H I B I T 57 Mixed Cost Behavior Cost of state license fees $30,000 $29,000 Slope = Variable cost per unit of activity $28,000 $27,000 Variable cost element $26,000 $25,000 Fixed cost element Intercept = Total fixed cost $0 0 500 1,000 Number of rafting parties Because the mixed cost in Exhibit 57 is represented by a straight line, the following equation for a straight line can be used to express the relationship between a mixed cost and the level of activity: Y a bX In this equation, Y The total mixed cost a The total xed cost (the vertical intercept of the line) b The variable cost per unit of activity (the slope of the line) X The level of activity Because the variable cost per unit equals the slope of the straight line, the steeper the slope, the higher the variable cost per unit. In the case of the state fees paid by Nooksack Expeditions, the equation is written as follows: Y $25,000 $3.00X Total mixed cost Total xed cost Variable cost per unit of activity Activity level This equation makes it easy to calculate the total mixed cost for any level of activity within the relevant range. For example, suppose that the company expects to organize 800 rafting parties in the next year. The total state fees would be calculated as follows: Y $25,000 ($3.00 per rafting party 800 rafting parties) $27,400 The Analysis of Mixed Costs Mixed costs are very common. For example, the overall cost of providing X-ray services to patients at the Harvard Medical School Hospital is a mixed cost. The costs of equipment depreciation and radiologists and technicians salaries are xed, but the costs of X-ray lm, power, and supplies are variable. At Southwest Airlines, maintenance costs gar79611_ch05_188-232.indd Page 201 12/24/08 5:25:07 AM user-s176 /broker/MH-BURR/MHBR094/MHBR094-05/upload/MHBR094-05 Cost Behavior: Analysis and Use 201 are a mixed cost. The company incurs xed costs for renting maintenance facilities and for keeping skilled mechanics on the payroll, but the costs of replacement parts, lubricating oils, tires, and so forth, are variable with respect to how often and how far the companys aircraft are own. The xed portion of a mixed cost represents the minimum cost of having a service ready and available for use. The variable portion represents the cost incurred for actual consumption of the service, thus it varies in proportion to the amount of service actually consumed. How does management go about actually estimating the xed and variable components of a mixed cost? The most common methods used in practice are account analysis and the engineering approach. In account analysis, an account is classied as either variable or xed based on the analysts prior knowledge of how the cost in the account behaves. For example, direct materials would be classied as variable and a building lease cost would be classied as xed because of the nature of those costs. The total xed cost of an organization is the sum of the costs for the accounts that have been classied as xed. The variable cost per unit is estimated by dividing the sum of the costs for the accounts that have been classied as variable by the total activity. The engineering approach to cost analysis involves a detailed analysis of what cost behavior should be, based on an industrial engineers evaluation of the production methods to be used, the materials specications, labor requirements, equipment usage, production efciency, power consumption, and so on. For example, Pizza Hut might use the engineering approach to estimate the cost of preparing and serving a particular take-out pizza. The cost of the pizza would be estimated by carefully costing the specic ingredients used to make the pizza, the power consumed to cook the pizza, and the cost of the container the pizza is delivered in. The engineering approach must be used in those situations IN BUSINESS OPERATIONS DRIVE COSTS White Grizzly Adventures is a snowcat skiing and snowboarding company in Meadow Creek, British Columbia, that is owned and operated by Brad and Carole Karal. The company shuttles 12 guests to the top of the companys steep and tree-covered terrain in a modied snowcat. Guests stay as a group at the companys lodge for a xed number of days and are provided healthy gourmet meals. Brad and Carole must decide each year when snowcat operations will begin in December and when they will end in early spring, and how many nonoperating days to schedule between groups of guests for maintenance and rest. These decisions affect a variety of costs. Examples of costs that are xed and variable with respect to the number of days of operation at White Grizzly include: Cost Property taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Summer road maintenance and tree clearing . . . . . . . Lodge depreciation. . . . . . . . . . . . . . . . . . . . . . . . . . . . Snowcat operator and guides. . . . . . . . . . . . . . . . . . . . Cooks and lodge help . . . . . . . . . . . . . . . . . . . . . . . . . Snowcat depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . Snowcat fuel. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Food* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost BehaviorFixed or Variable with Respect to Days of Operation Fixed Fixed Fixed Variable Variable Variable Variable Variable *The costs of food served to guests theoretically depend on the number of guests in residence. However, the lodge is almost always lled to its capacity of 12 persons when the snowcat operation is running, so food costs can be considered to be driven by the days of operation. Source: Brad & Carole Karal, owners and operators of White Grizzly Adventures, www.whitegrizzly.com. gar79611_ch05_188-232.indd Page 202 12/24/08 5:25:17 AM user-s176 202 /broker/MH-BURR/MHBR094/MHBR094-05/upload/MHBR094-05 Chapter 5 where no past experience is available concerning activity and costs. In addition, it is sometimes used together with other methods to improve the accuracy of cost analysis. Account analysis works best when analyzing costs at a fairly aggregated level, such as the cost of serving patients in the emergency room (ER) of Cook County General Hospital. The costs of drugs, supplies, forms, wages, equipment, and so on, can be roughly classied as variable or xed and a mixed cost formula for the overall cost of the emergency room can be estimated fairly quickly. However, this method does not recognize that some of the accounts may have both xed and variable cost elements. For example, the cost of electricity for the ER is a mixed cost. Most of the electricity is a xed cost because it is used for heating and lighting. However, the consumption of electricity increases with activity in the ER because diagnostic equipment, operating theater lights, debrillators, and so on, all consume electricity. The most effective way to estimate the xed and variable elements of such a mixed cost may be to analyze past records of cost and activity data. These records should reveal whether electrical costs vary signicantly with the number of patients and if so, by how much. The remainder of this section explains how to conduct such an analysis of past cost and activity data. M ANAGERIAL ACCOUNTING IN ACTION The Issue Dr. Derek Chalmers, the chief executive ofcer of Brentline Hospital, motioned Kinh Nguyen, the chief nancial ofcer of the hospital, into his ofce. Derek: I wanted to talk to you about our maintenance expenses. They seem to be bouncing around a lot. Over the last half year or so they have been as low as $7,400 and as high as $9,800 per month. Kinh: That type of variation is normal for maintenance expenses. Derek: But we budgeted a constant $8,400 a month. Cant we do a better job of predicting what these costs are going to be? And how do we know when weve spent too much in a month? Shouldnt there be some explanation for these variations? Kinh: Now that you mention it, we are in the process of tightening up our budgeting process. Our rst step is to break all of our costs down into xed and variable components. Derek: How will that help? Kinh: Well, it will permit us to predict what the level of costs will be. Some costs are xed and shouldnt change much. Other costs go up and down as our activity goes up and down. The trick is to gure out what is driving the variable component of the costs. Derek: What about the maintenance costs? Kinh: My guess is that the variations in maintenance costs are being driven by our overall level of activity. When we treat more patients, our equipment is used more intensively, which leads to more maintenance expense. Derek: How would you measure the level of overall activity? Would you use patientdays? Kinh: I think so. Each day a patient is in the hospital counts as one patient-day. The greater the number of patient-days in a month, the busier we are. Besides, our budgeting is all based on projected patient-days. Derek: Okay, so suppose you are able to break the maintenance costs down into xed and variable components. What will that do for us? Kinh: Basically, I will be able to predict what maintenance costs should be as a function of the number of patient-days. Derek: I can see where that would be useful. We could use it to predict costs for budgeting purposes. Kinh: We could also use it as a benchmark. Based on the actual number of patient-days for a period, I can predict what the maintenance costs should have been. We can compare this to the actual spending on maintenance. Derek: Sounds good to me. Let me know when you get the results. gar79611_ch05_188-232.indd Page 203 12/13/08 7:29:54 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-05/upload 203 Cost Behavior: Analysis and Use Diagnosing Cost Behavior with a Scattergraph Plot L EARNING OBJECTIVE 2 Kinh Nguyen began his analysis of maintenance costs by collecting cost and activity data for a number of recent months. Those data are displayed below: Month January . . . . . . . . February. . . . . . . . March . . . . . . . . . . April . . . . . . . . . . . May. . . . . . . . . . . . June . . . . . . . . . . . July . . . . . . . . . . . . Activity Level: Maintenance Patient-Days Cost Incurred 5,600 7,100 5,000 6,500 7,300 8,000 6,200 $7,900 $8,500 $7,400 $8,200 $9,100 $9,800 $7,800 The rst step in analyzing the cost and activity data is to plot the data on a scattergraph. This plot immediately reveals any nonlinearities or other problems with the data. The scattergraph of maintenance costs versus patient-days at Brentline Hospital is shown in the top half of Exhibit 58. Two things should be noted about this scattergraph: 1. The total maintenance cost, Y, is plotted on the vertical axis. Cost is known as the dependent variable because the amount of cost incurred during a period depends on the level of activity for the period. (That is, as the level of activity increases, total cost will also ordinarily increase.) 2. The activity, X (patient-days in this case), is plotted on the horizontal axis. Activity is known as the independent variable because it causes variations in the cost. From the scattergraph, it is evident that maintenance costs do increase with the number of patient-days. In addition, the scattergraph reveals that the relation between maintenance costs and patient-days is approximately linear. In other words, the points lie more or less along a straight line. Such a straight line has been drawn using a ruler in the bottom half of Exhibit 58. Cost behavior is considered linear whenever a straight line is a reasonable approximation for the relation between cost and activity. Note that the data points do not fall exactly on the straight line. This will almost always happen in practice; the relation is seldom perfectly linear. Note that the straight line in Exhibit 58 has been drawn through the point representing 7,300 patient-days and a total maintenance cost of $9,100. Drawing the straight line through one of the data points helps make a quick-and-dirty estimate of variable and xed costs. The vertical intercept where the straight line crosses the Y axisin this case, about $3,300is the rough estimate of the xed cost. The variable cost can be quickly estimated by subtracting the estimated xed cost from the total cost at the point lying on the straight line. Total maintenance cost for 7,300 patient-days (a point falling on the straight line) . . . . . . . . . . . . . . . . . . Less estimated xed cost (the vertical intercept) . . . . . . . . . $9,100 3,300 Estimated total variable cost for 7,300 patient-days. . . . . . . $5,800 The average variable cost per unit at 7,300 patient-days is computed as follows: Variable cost per unit $5,800 7,300 patient-days $0.79 per patient-day (rounded) Use a scattergraph plot to diagnose cost behavior. gar79611_ch05_188-232.indd Page 204 12/13/08 7:29:54 PM user-s180 204 /broker/MH-BURR/MHBR094/MHBR094-05/upload Chapter 5 E X H I B I T 58 Scattergraph Method of Cost Analysis $12,000 Plotting the Data Y Maintenance cost $10,000 $8,000 $6,000 $4,000 $2,000 $0 0 $12,000 Y 2,000 8,000 4,000 6,000 Patient-days X 10,000 Drawing a Straight-line Approximation Relevant range $10,000 Maintenance cost $9,100 $8,000 Slope Variable cost: $0.79 per patient-day $6,000 $4,000 Intercept Fixed cost: $3,300 $2,000 $0 0 2,000 4,000 6,000 7,300 8,000 X 10,000 Patient-days Combining the estimate of the xed cost and the estimate of the variable cost per patientday, we can express the relation between cost and activity as follows: Y $3,300 $0.79X where X is the number of patient-days. We hasten to add that this is a quick-and-dirty method of estimating the xed and variable cost elements of a mixed cost; it is seldom used in practice when the nancial implications of a decision based on the data are signicant. However, setting aside the estimates of the xed and variable cost elements, plotting the data on a scattergraph is an essential diagnostic step that is too often overlooked. Suppose, for example, we had been interested in the relation between total nursing wages and the number of patient-days at gar79611_ch05_188-232.indd Page 205 12/13/08 7:29:54 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-05/upload Cost Behavior: Analysis and Use $180,000 E X H I B I T 59 More than One Relevant Range Y $160,000 Total nursing wages $140,000 $120,000 $100,000 $80,000 $60,000 $40,000 $20,000 $0 0 $180,000 2,000 4,000 6,000 Patient-days Relevant range Y 8,000 X 10,000 Relevant range $160,000 Total nursing wages $140,000 $120,000 $100,000 $80,000 $60,000 $40,000 $20,000 $0 0 205 2,000 4,000 6,000 Patient-days 8,000 X 10,000 the hospital. The permanent, full-time nursing staff can handle up to 7,000 patient-days in a month. Beyond that level of activity, part-time nurses must be called in to help out. The cost and activity data for nurses are plotted on the scattergraph in Exhibit 59. Looking at that scattergraph, it is evident that two straight lines would do a much better job of tting the data than a single straight line. Up to 7,000 patient-days, total nursing wages are essentially a xed cost. Above 7,000 patient-days, total nursing wages are a mixed cost. This happens because, as stated above, the permanent, full-time nursing staff can handle up to 7,000 patient-days in a month. Above that level, part-time nurses are called in to help, which adds to the cost. Consequently, two straight lines (and two equations) would be used to represent total nursing wagesone for the relevant range of 5,600 to 7,000 patient-days and one for the relevant range of 7,000 to 8,000 patient-days. gar79611_ch05_188-232.indd Page 206 12/13/08 7:29:54 PM user-s180 206 /broker/MH-BURR/MHBR094/MHBR094-05/upload Chapter 5 E X H I B I T 510 A Diagnostic Scattergraph Plot $16,000 Y Telephone costs $14,000 $12,000 $10,000 $8,000 $6,000 $4,000 $2,000 $0 0 2,000 4,000 6,000 Patient-days 8,000 X 10,000 As another example, suppose that Brentline Hospitals management is interested in the relation between the hospitals telephone costs and patient-days. Patients are billed directly for their use of telephones, so those costs do not appear on the hospitals cost records. Rather, management is concerned about the charges for the staffs use of telephones. The data for this cost are plotted in Exhibit 510. It is evident from the plot that while the telephone costs do vary from month to month, they are not related to patientdays. Something other than patient-days is driving the telephone bills. Therefore, it would not make sense to analyze this cost any further by attempting to estimate a variable cost per patient-day for telephone costs. Plotting the data helps diagnose such situations. The High-Low Method LEARNING OBJECTIVE 3 Analyze a mixed cost using the high-low method. In addition to the quick-and-dirty method described in the preceding section, more precise methods are available for estimating xed and variable costs. However, it must be emphasized that xed and variable costs should be computed only if a scattergraph plot conrms that the relation is approximately linear. In the case of maintenance costs at Brentline Hospital, the relation does appear to be linear. In the case of telephone costs, there isnt any clear relation between telephone costs and patient-days, so there is no point in estimating how much of the cost varies with patient-days. Assuming that the scattergraph plot indicates a linear relation between cost and activity, the xed and variable cost elements of a mixed cost can be estimated using the highlow method or the least-squares regression method. The high-low method is based on the rise-over-run formula for the slope of a straight line. As discussed above, if the relation between cost and activity can be represented by a straight line, then the slope of the straight line is equal to the variable cost per unit of activity. Consequently, the following formula can be used to estimate the variable cost. Variable cost Slope of the line Rise Run Y2 X2 Y1 X1 To analyze mixed costs with the high-low method, begin by identifying the period with the lowest level of activity and the period with the highest level of activity. The period with the lowest activity is selected as the rst point in the above formula and the period gar79611_ch05_188-232.indd gar79611_ch05_188-232.indd Page 207 12/13/08 7:29:55 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-05/upload Cost Behavior: Analysis and Use with the highest activity is selected as the second point. Consequently, the formula becomes: Variable cost Y2 X2 Y1 X1 Cost at the high activity level High activity level Cost at the low activity level Low activity level or Variable cost Change in cost Change in activity Therefore, when the high-low method is used, the variable cost is estimated by dividing the difference in cost between the high and low levels of activity by the change in activity between those two points. To return to the Brentline Hospital example, using the high-low method, we rst identify the periods with the highest and lowest activityin this case, June and March. We then use the activity and cost data from these two periods to estimate the variable cost component as follows: Patient-Days Maintenance Cost Incurred High activity level (June). . . . . . . . Low activity level (March) . . . . . . . 8,000 5,000 $9,800 7,400 Change. . . . . . . . . . . . . . . . . . . . . 3,000 $2,400 Variable cost Change in cost Change in activity $2,400 3,000 patient-days $0.80 per patient-day Having determined that the variable maintenance cost is 80 cents per patient-day, we can now determine the amount of xed cost. This is done by taking the total cost at either the high or the low activity level and deducting the variable cost element. In the computation below, total cost at the high activity level is used in computing the xed cost element: Fixed cost element Total cost $9,800 Variable cost element ($0.80 per patient-day 8,000 patient-days) $3,400 Both the variable and xed cost elements have now been isolated. The cost of maintenance can be expressed as $3,400 per month plus 80 cents per patient-day or as: Y $3,400 Total maintenance cost $0.80X Total patient-days The data used in this illustration are shown graphically in Exhibit 511. Notice that a straight line has been drawn through the points corresponding to the low and high levels of activity. In essence, that is what the high-low method doesit draws a straight line through those two points. Sometimes the high and low levels of activity dont coincide with the high and low amounts of cost. For example, the period that has the highest level of activity may not have the highest amount of cost. Nevertheless, the costs at the highest and lowest levels 207 gar79611_ch05_188-232.indd Page 208 12/13/08 7:29:55 PM user-s180 208 /broker/MH-BURR/MHBR094/MHBR094-05/upload Chapter 5 E X H I B I T 511 High-Low Method of Cost Analysis Activity Patient- Maintenance Level Days Cost $12,000 High Low Y Maintenance cost $10,000 8,000 5,000 $9,800 $7,400 Slope Variable cost: $0.80 per patient-day Point relating to the low activity level $8,000 Point relating to the high activity level $6,000 $4,000 Intercept Fixed cost: $3,400 $2,000 $0 0 2,000 4,000 6,000 Patient-days 8,000 X 10,000 of activity are always used to analyze a mixed cost under the high-low method. The reason is that the analyst would like to use data that reect the greatest possible variation in activity. The high-low method is very simple to apply, but it suffers from a major (and sometimes critical) defectit utilizes only two data points. Generally, two data points are not enough to produce accurate results. Additionally, the periods with the highest and lowest activity tend to be unusual. A cost formula that is estimated solely using data from these unusual periods may misrepresent the true cost behavior during normal periods. Such a distortion is evident in Exhibit 511. The straight line should probably be shifted down somewhat so that it is closer to more of the data points. For these reasons, other methods of cost analysis that use all of the data will generally be more accurate than the high-low method. A manager who chooses to use the high-low method should do so with a full awareness of its limitations. Fortunately, computer software makes it very easy to use sophisticated statistical methods, such as least-squares regression, that use all of the data and that are capable of providing much more information than just the estimates of variable and xed costs. The details of these statistical methods are beyond the scope of this text, but the basic approach is discussed below. Nevertheless, even if the least-squares regression approach is used, it is always a good idea to plot the data in a scattergraph. By simply looking at the scattergraph, you can quickly verify whether it makes sense to t a straight line to the data using least-squares regression or some other method. The Least-Squares Regression Method The least-squares regression method, unlike the high-low method, uses all of the data to separate a mixed cost into its xed and variable components. A regression line of the form Y a bX is tted to the data, where a represents the total xed cost and b represents the variable cost per unit of activity. The basic idea underlying the least-squares regression method is illustrated in Exhibit 512 using hypothetical data points. Notice gar79611_ch05_188-232.indd Page 209 12/13/08 7:29:55 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-05/upload 209 Cost Behavior: Analysis and Use E X H I B I T 512 The Concept of Least-Squares Regression Cost Y Actual Y Estimated Y Error Regression line Y = a + bX X Level of activity from the exhibit that the deviations from the plotted points to the regression line are measured vertically on the graph. These vertical deviations are called the regression errors. There is nothing mysterious about the least-squares regression method. It simply computes the regression line that minimizes the sum of these squared errors. The formulas that accomplish this are fairly complex and involve numerous calculations, but the principle is simple. Fortunately, computers are adept at carrying out the computations required by the least-squares regression formulas. The datathe observed values of X and Yare entered into the computer, and software does the rest. In the case of the Brentline Hospital maintenance cost data, a statistical software package on a personal computer can calculate the following least-squares regression estimates of the total xed cost (a) and the variable cost per unit of activity (b): a $3,431 b $0.759 Therefore, using the least-squares regression method, the xed element of the maintenance cost is $3,431 per month and the variable portion is 75.9 cents per patient-day. In terms of the linear equation Y a bX, the cost formula can be written as Y $3,431 $0.759X where activity (X) is expressed in patient-days. While a statistical software application was used in this example to calculate the values of a and b, the estimates can also be computed using a spreadsheet application such as Microsoft Excel. In Appendix 5A to this chapter, we show how this can be done. In addition to estimates of the intercept (xed cost) and slope (variable cost per unit), least-squares regression software ordinarily provides a number of other very useful statistics. One of these statistics is the R2, which is a measure of goodness of t. The R2 tells us the percentage of the variation in the dependent variable (cost) that is explained by variation in the independent variable (activity). The R2 varies from 0% to 100%, and the higher the percentage, the better. In the case of the Brentline Hospital maintenance cost data, the R2 is 0.90, which indicates that 90% of the variation in maintenance costs is explained by the variation in patient-days. This is reasonably high and is an indication of a good t. On the other hand, a low R2 would be an indication of a poor t. You should gar79611_ch05_188-232.indd Page 210 12/24/08 5:25:45 AM user-s176 210 /broker/MH-BURR/MHBR094/MHBR094-05/upload/MHBR094-05 Chapter 5 always plot the data in a scattergraph, but it is particularly important to check the data visually when the R2 is low. A quick look at the scattergraph can reveal that there is little relation between the cost and the activity or that the relation is something other than a simple straight line. In such cases, additional analysis would be required. M ANAGERIAL ACCOUNTING IN ACTION The Wrap-up After completing the analysis of maintenance costs, Kinh Nguyen met with Dr. Derek Chalmers to discuss the results. Kinh: We used least-squares regression analysis to estimate the xed and variable components of maintenance costs. According to the results, the xed cost per month is $3,431 and the variable cost per patient-day is 75.9 cents. Derek: Okay, so if we plan for 7,800 patient-days next month, what is your estimate of the maintenance costs? Kinh: That will take just a few seconds to gure out. [Kinh wrote the following calculations on a pad of paper.] Fixed costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Variable costs: 7,800 patient-days $0.759 per patient-day . . . . . . $3,431 Total expected maintenance costs . . . . . . . . . . . . . . . . $9,351 5,920 Derek: Nine thousand three hundred and fty one dollars; isnt that a bit too precise? Kinh: Sure. I dont really believe the maintenance costs will be exactly this gure. However, based on the information we have, this is the best estimate we can come up with. Derek: This type of estimate will be a lot better than just guessing like we have done in the past. Thanks. I hope to see more of this kind of analysis. Multiple Regression Analysis In the discussion thus far, we have assumed that a single factor such as patient-days drives the variable cost component of a mixed cost. This assumption is acceptable for many mixed costs, but in some situations the variable cost element may be driven by a number of factors. For example, shipping costs may depend on both the number of units shipped and the weight of the units. In a situation such as this, multiple regression is necessary. Multiple regression is an analytical method that is used when the dependent variable (i.e., cost) is caused by more than one factor. Although adding more factors, or variables, makes the computations more complex, the principles involved are the same as in the simple least-squares regressions discussed above. The Contribution Format Income Statement L EARNING OBJECTIVE 4 Prepare an income statement using the contribution format. Separating costs into xed and variable elements helps to predict costs and provide benchmarks. As we will see in later chapters, separating costs into xed and variable elements is also often crucial in making decisions. This crucial distinction between xed and variable costs is at the heart of the contribution approach to constructing income statements. The unique thing about the contribution approach is that it provides managers with an income statement that clearly distinguishes between xed and variable costs and therefore facilitates planning, control, and decision making. gar79611_ch05_188-232.indd Page 211 12/13/08 7:29:56 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-05/upload 211 Cost Behavior: Analysis and Use Why a New Income Statement Format? An income statement prepared using the traditional approach, as illustrated in Chapter 2, is organized in a functional formatemphasizing the functions of production, administration, and sales. No attempt is made to distinguish between xed and variable costs. Under the heading Administrative expense, for example, both variable and xed costs are lumped together. Although an income statement prepared in the functional format may be useful for external reporting purposes, it has serious limitations when used for internal purposes. Internally, managers need cost data organized in a format that will facilitate planning, control, and decision making. As we shall see in the chapters ahead, these tasks are much easier when costs are identied as xed or variable. The contribution format income statement has been developed in response to these needs. The Contribution Approach Exhibit 513 uses a simple example to compare a contribution approach income statement to the traditional approach discussed in Chapter 2. Notice that the contribution approach separates costs into xed and variable categories, rst deducting variable expenses from sales to obtain the contribution margin. The contribution margin is the amount remaining from sales revenues after variable expenses have been deducted. This amount contributes toward covering xed expenses and then toward prots for the period. The contribution format income statement is used as an internal planning and decision-making tool. Its emphasis on cost behavior facilitates cost-volume-prot analysis (such as we shall be doing in the next chapter), management performance appraisals, and budgeting. Moreover, the contribution approach helps managers organize data pertinent to numerous decisions such as product-line analysis, pricing, use of scarce resources, and make or buy analysis. All of these topics are covered in later chapters. E X H I B I T 513 Comparison of the Contribution Income Statement with the Traditional Income Statement (the data are given) Traditional Approach (costs organized by function) Sales . . . . . . . . . . . . . . . . . . . . . . . . . Cost of goods sold . . . . . . . . . . . . . . . Gross margin . . . . . . . . . . . . . . . . . . . Selling and administrative expenses: Selling. . . . . . . . . . . . . . . . . . . . . . . $3,100* Administrative . . . . . . . . . . . . . . . . . 1,900* Net operating income . . . . . . . . . . . . . Contribution Approach (costs organized by behavior) $12,000 6,000* 6,000 5,000 $ 1,000 Sales . . . . . . . . . . . . . . . . . . . . . . . . . Variable expenses: Variable production . . . . . . . . . . . . . Variable selling . . . . . . . . . . . . . . . . Variable administrative . . . . . . . . . . Contribution margin . . . . . . . . . . . . . . Fixed expenses: Fixed production . . . . . . . . . . . . . . . Fixed selling . . . . . . . . . . . . . . . . . . Fixed administrative . . . . . . . . . . . . Net operating income . . . . . . . . . . . . . $12,000 $2,000 600 400 3,000 9,000 4,000 2,500 1,500 8,000 $ 1,000 *Contains both variable and xed expenses. This is the income statement for a manufacturing company; thus, when the income statement is placed in the contribution format, the cost of goods sold is divided between variable production costs and xed production costs. If this were the income statement for a merchandising company (which simply purchases completed goods from a supplier), then the cost of goods sold would be all variable. gar79611_ch05_188-232.indd gar79611_ch05_188-232.indd Page 212 12/13/08 7:29:57 PM user-s180 212 /broker/MH-BURR/MHBR094/MHBR094-05/upload Chapter 5 Summary As we shall see in later chapters, the ability to predict how costs respond to changes in activity is critical for making decisions, controlling operations, and evaluating performance. Three major classications of costs were discussed in this chaptervariable, xed, and mixed. Mixed costs consist of variable and xed elements and can be expressed in equation form as Y a bX, where X is the activity, Y is the cost, a is the xed cost element, and b is the variable cost per unit of activity. Several methods can be used to estimate the xed and variable cost components of a mixed cost using past records of cost and activity. If the relation between cost and activity appears to be linear based on a scattergraph plot, then the variable and xed components of the mixed cost can be estimated using the quick-and-dirty method, the high-low method, or the least-squares regression method. The quick-and-dirty method is based on drawing a straight line and then using the slope and the intercept of the straight line to estimate the variable and xed cost components of the mixed cost. The high-low method implicitly draws a straight line through the points of lowest activity and highest activity. In most situations, the least-squares regression method is preferred to both the quick-and-dirty and high-low methods. Computer software is widely available for using the least-squares regression method. These software applications provide a variety of useful statistics along with estimates of the intercept (xed cost) and slope (variable cost per unit). Nevertheless, even when least-squares regression is used, the data should be plotted to conrm that the relationship is really a straight line. Managers use costs organized by behavior to help make many decisions. The contribution format income statement can aid decision making because it classies costs by cost behavior (i.e., variable versus xed) rather than by the functions of production, administration, and sales. Review Problem 1: Cost Behavior Neptune Rentals operates a boat rental service. Consider the following costs of the company over the relevant range of 5,000 to 8,000 hours of operating time for its boats: Hours of Operating Time 5,000 6,000 7,000 8,000 Total costs: Variable costs . . . . . . . . . Fixed costs . . . . . . . . . . . $ 20,000 168,000 $ ? ? $ ? ? $ ? ? Total costs . . . . . . . . . . . . . $188,000 $ ? $ ? $ ? Cost per hour: Variable cost . . . . . . . . . . Fixed cost . . . . . . . . . . . . $ ? ? $ ? ? $ ? ? $ ? ? Total cost per hour . . . . . . . $ ? $ ? $ ? $ ? Required: Compute the missing amounts, assuming that cost behavior patterns remain unchanged within the relevant range of 5,000 to 8,000 hours. Solution to Review Problem 1 The variable cost per hour can be computed as follows: $20,000 5,000 hours $4 per hour gar79611_ch05_188-232.indd Page 213 12/13/08 7:29:57 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-05/upload Cost Behavior: Analysis and Use Therefore, the missing amounts are as follows: Hours of Operating Time 5,000 6,000 7,000 8,000 Total costs: Variable costs (@ $4 per hour) . . . . . Fixed costs . . . . . . . . . . $ 20,000 168,000 $ 24,000 168,000 $ 28,000 168,000 $ 32,000 168,000 Total costs . . . . . . . . . . . . $188,000 $192,000 $196,000 $200,000 Cost per hour: Variable cost . . . . . . . . . Fixed cost . . . . . . . . . . . $ 4.00 33.60 $ 4.00 28.00 $ 4.00 24.00 $ 4.00 21.00 Total cost per hour . . . . . . $ 37.60 $ 32.00 $ 28.00 $ 25.00 Observe that the total variable costs increase in proportion to the number of hours of operating time, but that these costs remain constant at $4 if expressed on a per hour basis. In contrast, the total xed costs do not change with changes in the level of activity. They remain constant at $168,000 within the relevant range. With increases in activity, however, the xed cost per hour decreases, dropping from $33.60 per hour when the boats are operated 5,000 hours a period to only $21.00 per hour when the boats are operated 8,000 hours a period. Because of this troublesome aspect of xed costs, they are most easily (and most safely) dealt with on a total basis, rather than on a unit basis, in cost analysis work. Review Problem 2: High-Low Method The administrator of Azalea Hills Hospital would like a cost formula linking the administrative costs involved in admitting patients to the number of patients admitted during a month. The Admitting Departments costs and the number of patients admitted during the immediately preceding eight months are given in the following table: Month Number of Patients Admitted Admitting Department Costs 1,800 1,900 1,700 1,600 1,500 1,300 1,100 1,500 $14,700 $15,200 $13,700 $14,000 $14,300 $13,100 $12,800 $14,600 May . . . . . . . . . . . . . . June . . . . . . . . . . . . . . July . . . . . . . . . . . . . . August . . . . . . . . . . . . September . . . . . . . . . October . . . . . . . . . . . November . . . . . . . . . December . . . . . . . . . Required: 1. 2. Use the high-low method to estimate the xed and variable components of admitting costs. Express the xed and variable components of admitting costs as a cost formula in the form Y a bX. Solution to Review Problem 2 1. The rst step in the high-low method is to identify the periods of the lowest and highest activity. Those periods are November (1,100 patients admitted) and June (1,900 patients admitted). 213 gar79611_ch05_188-232.indd gar79611_ch05_188-232.indd Page 214 12/13/08 7:29:58 PM user-s180 214 /broker/MH-BURR/MHBR094/MHBR094-05/upload Chapter 5 The second step is to compute the variable cost per unit using those two data points: Number of Patients Admitted Admitting Department Costs High activity level (June) . . . . . . . . . . . Low activity level (November) . . . . . . . 1,900 1,100 $15,200 12,800 Change . . . . . . . . . . . . . . . . . . . . . . . . 800 $ 2,400 Month Variable cost Change in cost Change in activity $2,400 800 patients admitted $3 per patient admitted The third step is to compute the xed cost element by deducting the variable cost element from the total cost at either the high or low activity. In the computation below, the high point of activity is used: Fixed cost element Total cost $15,200 Variable cost element ($3 per patient admitted 1,900 patients admitted) $9,500 2. The cost formula is Y $9,500 $3X. Glossary Account analysis A method for analyzing cost behavior in which an account is classied as either variable or xed based on the analysts prior knowledge of how the cost in the account behaves. (p. 201) Activity base A measure of whatever causes the incurrence of a variable cost. For example, the total cost of X-ray lm in a hospital will increase as the number of X-rays taken increases. Therefore, the number of X-rays is the activity base that explains the total cost of X-ray lm. (p. 190) Committed xed costs Investments in facilities, equipment, and basic organizational structure that cant be signicantly reduced even for short periods of time without making fundamental changes. (p. 196) Contribution approach An income statement format that organizes costs by their behavior. Costs are separated into variable and xed categories rather than being separated according to organizational functions. (p. 210) Contribution margin The amount remaining from sales revenues after all variable expenses have been deducted. (p. 211) Cost structure The relative proportion of xed, variable, and mixed costs in an organization. (p. 189) Dependent variable A variable that responds to some causal factor; total cost is the dependent variable, as represented by the letter Y, in the equation Y a bX. (p. 203) Discretionary xed costs Those xed costs that arise from annual decisions by management to spend on certain xed cost items, such as advertising and research. (p. 196) Engineering approach A detailed analysis of cost behavior based on an industrial engineers evaluation of the inputs that are required to carry out a particular activity and of the prices of those inputs. (p. 201) High-low method A method of separating a mixed cost into its xed and variable elements by analyzing the change in cost between the high and low activity levels. (p. 206) Independent variable A variable that acts as a causal factor; activity is the independent variable, as represented by the letter X, in the equation Y a bX. (p. 203) Least-squares regression method A method of separating a mixed cost into its xed and variable elements by tting a regression line that minimizes the sum of the squared errors. (p. 208) Linear cost behavior Cost behavior is said to be linear whenever a straight line is a reasonable approximation for the relation between cost and activity. (p. 203) gar79611_ch05_188-232.indd gar79611_ch05_188-232.indd Page 215 12/13/08 7:29:58 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-05/upload 215 Cost Behavior: Analysis and Use Mixed cost A cost that contains both variable and xed cost elements. (p. 199) Multiple regression An analytical method required when variations in a dependent variable are caused by more than one factor. (p. 210) R2 A measure of goodness of t in least-squares regression analysis. It is the percentage of the variation in the dependent variable that is explained by variation in the independent variable. (p. 209) Relevant range The range of activity within which assumptions about variable and xed cost behavior are reasonably valid. (p. 194) Step-variable cost The cost of a resource that is obtained in large chunks and that increases and decreases only in response to fairly wide changes in activity. (p. 192) Questions 51 52 53 54 55 56 57 58 59 510 511 512 513 514 515 Distinguish between (a) a variable cost, (b) a xed cost, and (c) a mixed cost. What effect does an increase in volume have on a. Unit xed costs? b. Unit variable costs? c. Total xed costs? d. Total variable costs? Dene the following terms: (a) cost behavior and (b) relevant range. What is meant by an activity base when dealing with variable costs? Give several examples of activity bases. Distinguish between (a) a variable cost, (b) a mixed cost, and (c) a step-variable cost. Plot the three costs on a graph, with activity plotted horizontally and cost plotted vertically. Managers often assume a strictly linear relationship between cost and volume. How can this practice be defended in light of the fact that many costs are curvilinear? Distinguish between discretionary xed costs and committed xed costs. Classify the following xed costs as normally being either committed or discretionary: a. Depreciation on buildings. b. Advertising. c. Research. d. Long-term equipment leases. e. Pension payments to the companys retirees. f. Management development and training. Does the concept of the relevant range apply to xed costs? Explain. What is the major disadvantage of the high-low method? Give the general formula for a mixed cost. Which term represents the variable cost? The xed cost? What is meant by the term least-squares regression? What is the difference between ordinary least-squares regression analysis and multiple regression analysis? What is the difference between a contribution approach income statement and a traditional approach income statement? What is the contribution margin? Multiple-choice questions are provided on the text website at www.mhhe.com/garrison13e. Exercises EXERCISE 51 Fixed and Variable Cost Behavior [LO1] Espresso Express operates a number of espresso coffee stands in busy suburban malls. The xed weekly expense of a coffee stand is $1,200 and the variable cost per cup of coffee served is $0.22. Required: 1. Fill in the following table with your estimates of total costs and cost per cup of coffee at the indicated levels of activity for a coffee stand. Round off the cost of a cup of coffee to the nearest tenth of a cent. gar79611_ch05_188-232.indd Page 216 12/13/08 7:30:00 PM user-s180 216 /broker/MH-BURR/MHBR094/MHBR094-05/upload Chapter 5 Cups of Coffee Served in a Week 2,000 2,100 2,200 ? ? ? ? ? ? ? ? ? ? ? ? Fixed cost . . . . . . . . . . . . . . . . . . . . . . . . . . Variable cost . . . . . . . . . . . . . . . . . . . . . . . . Total cost . . . . . . . . . . . . . . . . . . . . . . . . . . . Average cost per cup of coffee served . . . . 2. Does the average cost per cup of coffee served increase, decrease, or remain the same as the number of cups of coffee served in a week increases? Explain. EXERCISE 52 Scattergraph Analysis [LO2] Oki Products, Ltd., has observed the following processing costs at various levels of activity over the last 15 months: Month Units Produced Processing Cost 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 4,500 11,000 12,000 5,500 9,000 10,500 7,500 5,000 11,500 6,000 8,500 10,000 6,500 9,500 8,000 $38,000 $52,000 $56,000 $40,000 $47,000 $52,000 $44,000 $41,000 $52,000 $43,000 $48,000 $50,000 $44,000 $48,000 $46,000 ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ Required: 1. 2. Prepare a scattergraph using the above data. Plot cost on the vertical axis and activity on the horizontal axis. Fit a line to your plotted points using a ruler. Using the quick-and-dirty method, what is the approximate monthly xed cost? The approximate variable cost per unit processed? Show your computations. EXERCISE 53 High-Low Method [LO3] The Cheyenne Hotel in Big Sky, Montana, has accumulated records of the total electrical costs of the hotel and the number of occupancy-days over the last year. An occupancy-day represents a room rented out for one day. The hotels business is highly seasonal, with peaks occurring during the ski season and in the summer. Month Occupancy-Days January. . . . . . . . . . . . February . . . . . . . . . . . March . . . . . . . . . . . . . April . . . . . . . . . . . . . . May . . . . . . . . . . . . . . . June . . . . . . . . . . . . . . July . . . . . . . . . . . . . . . August. . . . . . . . . . . . . September . . . . . . . . . October. . . . . . . . . . . . November . . . . . . . . . . December . . . . . . . . . . 1,736 1,904 2,356 960 360 744 2,108 2,406 840 124 720 1,364 Electrical Costs $4,127 $4,207 $5,083 $2,857 $1,871 $2,696 $4,670 $5,148 $2,691 $1,588 $2,454 $3,529 gar79611_ch05_188-232.indd gar79611_ch05_188-232.indd Page 217 12/13/08 7:30:01 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-05/upload Cost Behavior: Analysis and Use Required: 1. 2. Using the high-low method, estimate the xed cost of electricity per month and the variable cost of electricity per occupancy-day. Round off the xed cost to the nearest whole dollar and the variable cost to the nearest whole cent. What other factors other than occupancy-days are likely to affect the variation in electrical costs from month to month? EXERCISE 54 Contribution Format Income Statement [LO4] The Alpine House, Inc., is a large retailer of winter sports equipment. An income statement for the companys Ski Department for a recent quarter is presented below: The Alpine House, Inc. Income StatementSki Department For the Quarter Ended March 31 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost of goods sold. . . . . . . . . . . . . . . . . . $150,000 90,000 Gross margin . . . . . . . . . . . . . . . . . . . . . . Selling and administrative expenses: Selling expenses . . . . . . . . . . . . . . . . . Administrative expenses . . . . . . . . . . . 60,000 $30,000 10,000 Net operating income. . . . . . . . . . . . . . . . 40,000 $ 20,000 Skis sell, on the average, for $750 per pair. Variable selling expenses are $50 per pair of skis sold. The remaining selling expenses are xed. The administrative expenses are 20% variable and 80% xed. The company does not manufacture its own skis; it purchases them from a supplier for $450 per pair. Required: 1. 2. Prepare a contribution format income statement for the quarter. For every pair of skis sold during the quarter, what was the contribution toward covering xed expenses and toward earning prots? EXERCISE 55 Cost Behavior; Contribution Format Income Statement [LO1, LO4] Harris Company manufactures and sells a single product. A partially completed schedule of the companys total and per unit costs over the relevant range of 30,000 to 50,000 units produced and sold annually is given below: Units Produced and Sold 30,000 40,000 50,000 Total costs: Variable costs . . . . . . . . . Fixed costs . . . . . . . . . . . $180,000 300,000 ? ? ? ? Total costs . . . . . . . . . . . . . $480,000 ? ? Cost per unit: Variable cost . . . . . . . . . . Fixed cost . . . . . . . . . . . . ? ? ? ? ? ? Total cost per unit. . . . . . . . ? ? ? Required: 1. 2. Complete the schedule of the companys total and unit costs above. Assume that the company produces and sells 45,000 units during the year at a selling price of $16 per unit. Prepare a contribution format income statement for the year. 217 gar79611_ch05_188-232.indd gar79611_ch05_188-232.indd Page 218 12/13/08 7:30:02 PM user-s180 218 /broker/MH-BURR/MHBR094/MHBR094-05/upload Chapter 5 EXERCISE 56 High-Low Method; Scattergraph Analysis [LO2, LO3] The following data relating to units shipped and total shipping expense have been assembled by Archer Company, a wholesaler of large, custom-built air-conditioning units for commercial buildings: Units Shipped Month Total Shipping Expense 3 6 4 5 7 8 2 $1,800 $2,300 $1,700 $2,000 $2,300 $2,700 $1,200 January . . . . . . . . February. . . . . . . . March . . . . . . . . . . April . . . . . . . . . . . May . . . . . . . . . . . June . . . . . . . . . . . July. . . . . . . . . . . . Required: 1. 2. 3. Using the high-low method, estimate a cost formula for shipping expense. The president of the company has no condence in the high-low method and would like you to check your results using a scattergraph. a. Prepare a scattergraph, using the data given above. Plot cost on the vertical axis and activity on the horizontal axis. Use a ruler to t a straight line to your plotted points. b. Using your scattergraph, estimate the approximate variable cost per unit shipped and the approximate xed cost per month with the quick-and-dirty method. What factors, other than the number of units shipped, are likely to affect the companys total shipping expense? Explain. EXERCISE 57 Cost Behavior; High-Low Method [LO1, LO3] Hoi Chong Transport, Ltd., operates a eet of delivery trucks in Singapore. The company has determined that if a truck is driven 105,000 kilometers during a year, the average operating cost is 11.4 cents per kilometer. If a truck is driven only 70,000 kilometers during a year, the average operating cost increases to 13.4 cents per kilometer. (The Singapore dollar is the currency used in Singapore.) Required: 1. 2. 3. Using the high-low method, estimate the variable and xed cost elements of the annual cost of the truck operation. Express the variable and xed costs in the form Y a bX. If a truck were driven 80,000 kilometers during a year, what total cost would you expect to be incurred? EXERCISE 58 High-Low Method; Predicting Cost [LO1, LO3] The Lakeshore Hotels guest-days of occupancy and custodial supplies expense over the last seven months were: Month March . . . . . . . . . . . April . . . . . . . . . . . . May . . . . . . . . . . . . . June . . . . . . . . . . . . July . . . . . . . . . . . . . August. . . . . . . . . . . September . . . . . . . Guest-Days of Occupancy Custodial Supplies Expense 4,000 6,500 8,000 10,500 12,000 9,000 7,500 $7,500 $8,250 $10,500 $12,000 $13,500 $10,750 $9,750 Guest-days is a measure of the overall activity at the hotel. For example, a guest who stays at the hotel for three days is counted as three guest-days. Required: 1. 2. Using the high-low method, estimate a cost formula for custodial supplies expense. Using the cost formula you derived above, what amount of custodial supplies expense would you expect to be incurred at an occupancy level of 11,000 guest-days? gar79611_ch05_188-232.indd gar79611_ch05_188-232.indd Page 219 12/13/08 7:30:03 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-05/upload 219 Cost Behavior: Analysis and Use EXERCISE 59 Scattergraph Analysis; High-Low Method [LO2, LO3] Refer to the data for Lakeshore Hotel in Exercise 58. Required: 1. 2. 3. Prepare a scattergraph using the data from Exercise 58. Plot cost on the vertical axis and activity on the horizontal axis. Using a ruler, t a straight line to your plotted points. Using the quick-and-dirty method, what is the approximate monthly xed cost? The approximate variable cost per guest-day? Scrutinize the points on your graph and explain why the high-low method would or would not yield an accurate cost formula in this situation. EXERCISE 510 High-Low Method; Predicting Cost [LO1, LO3] St. Marks Hospital contains 450 beds. The average occupancy rate is 80% per month. In other words, on average, 80% of the hospitals beds are occupied by patients. At this level of occupancy, the hospitals operating costs are $32 per occupied bed per day, assuming a 30-day month. This $32 gure contains both variable and xed cost elements. During June, the hospitals occupancy rate was only 60%. A total of $326,700 in operating cost was incurred during the month. Required: 1. 2. Using the high-low method, estimate: a. The variable cost per occupied bed on a daily basis. b. The total xed operating costs per month. Assume an occupancy rate of 70% per month. What amount of total operating cost would you expect the hospital to incur? Problems PROBLEM 511 Contribution Format versus Traditional Income Statement [LO4] Marwicks Pianos, Inc., purchases pianos from a large manufacturer and sells them at the retail level. The pianos cost, on the average, $2,450 each from the manufacturer. Marwicks Pianos, Inc., sells the pianos to its customers at an average price of $3,125 each. The selling and administrative costs that the company incurs in a typical month are presented below: Costs Selling: Advertising . . . . . . . . . . . . . . . . . . . . . . . Sales salaries and commissions . . . . . . . Delivery of pianos to customers . . . . . . . Utilities. . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation of sales facilities . . . . . . . . . Administrative: Executive salaries . . . . . . . . . . . . . . . . . . Insurance. . . . . . . . . . . . . . . . . . . . . . . . . Clerical . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation of office equipment. . . . . . . Cost Formula $700 per month $950 per month, plus 8% of sales $30 per piano sold $350 per month $800 per month $2,500 per month $400 per month $1,000 per month, plus $20 per piano sold $300 per month During August, Marwicks Pianos, Inc., sold and delivered 40 pianos. Required: 1. 2. 3. Prepare an income statement for Marwicks Pianos, Inc., for August. Use the traditional format, with costs organized by function. Redo (1) above, this time using the contribution format, with costs organized by behavior. Show costs and revenues on both a total and a per unit basis down through contribution margin. Refer to the income statement you prepared in (2) above. Why might it be misleading to show the xed costs on a per unit basis? gar79611_ch05_188-232.indd gar79611_ch05_188-232.indd Page 220 12/13/08 7:30:06 PM user-s180 220 /broker/MH-BURR/MHBR094/MHBR094-05/upload Chapter 5 PROBLEM 512 Cost Behavior; High-Low Method; Contribution Format Income Statement [LO1, LO3, LO4] Morrisey & Brown, Ltd., of Sydney is a merchandising company that is the sole distributor of a product that is increasing in popularity among Australian consumers. The companys income statements for the three most recent months follow: Morrisey & Brown, Ltd. Income Statements For the Three Months Ended September 30 July August September Sales in units . . . . . . . . . . . . . . . . . . . . . 4,000 4,500 5,000 Sales revenue . . . . . . . . . . . . . . . . . . . . Cost of goods sold . . . . . . . . . . . . . . . . . A$400,000 240,000 A$450,000 270,000 A$500,000 300,000 Gross margin . . . . . . . . . . . . . . . . . . . . . 160,000 180,000 200,000 Selling and administrative expenses: Advertising expense . . . . . . . . . . . . . . Shipping expense . . . . . . . . . . . . . . . . Salaries and commissions . . . . . . . . . Insurance expense . . . . . . . . . . . . . . . Depreciation expense. . . . . . . . . . . . . 21,000 34,000 78,000 6,000 15,000 21,000 36,000 84,000 6,000 15,000 21,000 38,000 90,000 6,000 15,000 Total selling and administrative expenses 154,000 162,000 170,000 A$ 18,000 A$ 30,000 Net operating income. . . . . . . . . . . . . . . A$ 6,000 (Note: Morrisey & Brown, Ltd.s Australian-formatted income statement has been recast in the format common in the United States. The Australian dollar is denoted here by A$.) Required: 1. 2. 3. Identify each of the companys expenses (including cost of goods sold) as either variable, xed, or mixed. Using the high-low method, separate each mixed expense into variable and xed elements. State the cost formula for each mixed expense. Redo the companys income statement at the 5,000-unit level of activity using the contribution format. PROBLEM 513 Identifying Cost Behavior Patterns [LO1] A number of graphs displaying cost behavior patterns are shown below. The vertical axis on each graph represents total cost, and the horizontal axis represents level of activity (volume). Required: 1. For each of the following situations, identify the graph below that illustrates the cost behavior pattern involved. Any graph may be used more than once. a. Cost of raw materials used. b. Electricity billa at xed charge, plus a variable cost after a certain number of kilowatt-hours are used. c. City water bill, which is computed as follows: First 1,000,000 gallons or less . . . . . . . . Next 10,000 gallons . . . . . . . . . . . . . . . . Next 10,000 gallons . . . . . . . . . . . . . . . . Next 10,000 gallons . . . . . . . . . . . . . . . . Etc.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . d. $1,000 at fee $0.003 per gallon used $0.006 per gallon used $0.009 per gallon used Etc. Depreciation of equipment, where the amount is computed by the straight-line method. When the depreciation rate was established, it was anticipated that the obsolescence factor would be greater than the wear and tear factor. gar79611_ch05_188-232.indd Page 221 12/15/08 5:54:59 PM user-s180 /Users/user-s180/Desktop/Dhiru 15-012-08/New/MHBR094-05 Cost Behavior: Analysis and Use e. f. g. h. i. Rent on a factory building donated by the city, where the agreement calls for a xed fee payment unless 200,000 labor-hours or more are worked, in which case no rent need be paid. Salaries of maintenance workers, where one maintenance worker is needed for every 1,000 hours of machine-hours or less (that is, 0 to 1,000 hours requires one maintenance worker, 1,001 to 2,000 hours requires two maintenance workers, etc.). Cost of raw materials, where the cost starts at $7.50 per unit and then decreases by 5 cents per unit for each of the rst 100 units purchased, after which it remains constant at $2.50 per unit. Rent on a factory building donated by the county, where the agreement calls for rent of $100,000 less $1 for each direct labor-hour worked in excess of 200,000 hours, but a minimum rental payment of $20,000 must be paid. Use of a machine under a lease, where a minimum charge of $1,000 is paid for up to 400 hours of machine time. After 400 hours of machine time, an additional charge of $2 per hour is paid up to a maximum charge of $2,000 per period. 1 3 4 5 6 7 8 9 2. 2 10 11 12 How would a knowledge of cost behavior patterns such as those above be of help to a manager in analyzing the cost structure of his or her company? (CPA, adapted) PROBLEM 514 High-Low and Scattergraph Analysis [LO2, LO3] Pleasant View Hospital of British Columbia has just hired a new chief administrator who is anxious to employ sound management and planning techniques in the business affairs of the hospital. Accordingly, she has directed her assistant to summarize the cost structure of the various departments so that data will be available for planning purposes. The assistant is unsure how to classify the utilities costs in the Radiology Department because these costs do not exhibit either strictly variable or xed cost behavior. Utilities costs are very high in the department due to a CAT scanner that draws a large amount of power and is kept running at all times. The scanner cant be turned off due to the long warm-up period required for its use. When the scanner is used to scan a patient, it consumes an additional burst of power. The assistant has accumulated the following data on utilities costs and use of the scanner since the rst of the year. 221 gar79611_ch05_188-232.indd Page 222 12/13/08 7:30:07 PM user-s180 222 /broker/MH-BURR/MHBR094/MHBR094-05/upload Chapter 5 The chief administrator has informed her assistant that the utilities cost is probably a mixed cost that will have to be broken down into its variable and xed cost elements by use of a scattergraph. The assistant feels, however, that if an analysis of this type is necessary, then the high-low method should be used, since it is easier and quicker. The controller has suggested that there may be a better approach. Required: 1. 2. Using the high-low method, estimate a cost formula for utilities. Express the formula in the form Y a bX. (The variable rate should be stated in terms of cost per scan.) Prepare a scattergraph using the data above. (The number of scans should be placed on the horizontal axis, and utilities cost should be placed on the vertical axis.) Fit a straight line to the plotted points using a ruler and estimate a cost formula for utilities using the quick-and-dirty method. PROBLEM 515 High-Low Method; Predicting Cost [LO1, LO3] Sawaya Co., Ltd., of Japan is a manufacturing company whose total factory overhead costs uctuate considerably from year to year according to increases and decreases in the number of direct labor-hours worked in the factory. Total factory overhead costs (in Japanese yen, denoted ) at high and low levels of activity for recent years are given below: Level of Activity Low Direct labor-hours. . . . . . . . . . . . . . . . Total factory overhead costs. . . . . . . . High 50,000 14,250,000 75,000 17,625,000 The factory overhead costs above consist of indirect materials, rent, and maintenance. The company has analyzed these costs at the 50,000-hour level of activity as follows: Indirect materials (variable) . . . . . . . . . Rent (xed) . . . . . . . . . . . . . . . . . . . . . . Maintenance (mixed) . . . . . . . . . . . . . . 5,000,000 6,000,000 3,250,000 Total factory overhead costs . . . . . . . . 14,250,000 To have data available for planning, the company wants to break down the maintenance cost into its variable and xed cost elements. gar79611_ch05_188-232.indd Page 223 12/13/08 7:30:08 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-05/upload Cost Behavior: Analysis and Use Required: 1. 2. 3. Estimate how much of the 17,625,000 factory overhead cost at the high level of activity consists of maintenance cost. (Hint: To do this, it may be helpful to rst determine how much of the 17,625,000 consists of indirect materials and rent. Think about the behavior of variable and xed costs!) Using the high-low method, estimate a cost formula for maintenance. What total factory overhead costs would you expect the company to incur at an operating level of 70,000 direct labor-hours? PROBLEM 516 High-Low Method; Cost of Goods Manufactured [LO1, LO3] Amfac Company manufactures a single product. The company keeps careful records of manufacturing activities from which the following information has been extracted: Level of Activity MarchLow Number of units produced . . . . . . . . . . . . . . . . Cost of goods manufactured . . . . . . . . . . . . . . Work in process inventory, beginning . . . . . . . Work in process inventory, ending . . . . . . . . . . Direct materials cost per unit . . . . . . . . . . . . . . Direct labor cost per unit . . . . . . . . . . . . . . . . . Manufacturing overhead cost, total . . . . . . . . . JuneHigh 6,000 $168,000 $9,000 $15,000 $6 $10 ? 9,000 $257,000 $32,000 $21,000 $6 $10 ? The companys manufacturing overhead cost consists of both variable and xed cost elements. To have data available for planning, management wants to determine how much of the overhead cost is variable with units produced and how much of it is xed per month. Required: 1. 2. 3. For both March and June, estimate the amount of manufacturing overhead cost added to production. The company had no underapplied or overapplied overhead in either month. (Hint: A useful way to proceed might be to construct a schedule of cost of goods manufactured.) Using the high-low method, estimate a cost formula for manufacturing overhead. Express the variable portion of the formula in terms of a variable rate per unit of product. If 7,000 units are produced during a month, what would be the cost of goods manufactured? (Assume that work in process inventories do not change and that there is no underapplied or overapplied overhead cost for the month.) PROBLEM 517 High-Low Method; Predicting Cost [LO1, LO3] Nova Companys total overhead cost at various levels of activity are presented below: Month April . . . . . . . . . May. . . . . . . . . . June . . . . . . . . . July . . . . . . . . . . MachineHours Total Overhead Cost 70,000 60,000 80,000 90,000 $198,000 $174,000 $222,000 $246,000 Assume that the total overhead cost above consists of utilities, supervisory salaries, and maintenance. The breakdown of these costs at the 60,000 machine-hour level of activity is: Utilities (variable) . . . . . . . . . . . . Supervisory salaries (xed). . . . Maintenance (mixed) . . . . . . . . . $ 48,000 21,000 105,000 Total overhead cost . . . . . . . . . . $174,000 223 gar79611_ch05_188-232.indd gar79611_ch05_188-232.indd Page 224 12/13/08 7:30:08 PM user-s180 224 /broker/MH-BURR/MHBR094/MHBR094-05/upload Chapter 5 Nova Companys management wants to break down the maintenance cost into its variable and xed cost elements. Required: 1. 2. 3. 4. Estimate how much of the $246,000 of overhead cost in July was maintenance cost. (Hint: to do this, it may be helpful to rst determine how much of the $246,000 consisted of utilities and supervisory salaries. Think about the behavior of variable and xed costs!) Using the high-low method, estimate a cost formula for maintenance. Express the companys total overhead cost in the linear equation form Y a bX. What total overhead cost would you expect to be incurred at an operating activity level of 75,000 machine-hours? Cases CASE 518 Analysis of Mixed Costs in a Pricing Decision [LO1, LO2 or LO3 or LO5] Maria Chavez owns a catering company that serves food and beverages at parties and business functions. Chavezs business is seasonal, with a heavy schedule during the summer months and holidays and a lighter schedule at other times. One of the major events Chavezs customers request is a cocktail party. She offers a standard cocktail party and has estimated the cost per guest as follows: Food and beverages. . . . . . . . . . . . . . . . Labor (0.5 hrs. @ $10.00/hr.) . . . . . . . . . Overhead (0.5 hrs. @ $13.98/hr.) . . . . . . $15.00 5.00 6.99 Total cost per guest . . . . . . . . . . . . . . . . $26.99 The standard cocktail party lasts three hours and Chavez hires one worker for every six guests, so that works out to one-half hour of labor per guest. These workers are hired only as needed and are paid only for the hours they actually work. When bidding on cocktail parties, Chavez adds a 15% markup to yield a price of about $31 per guest. She is condent about her estimates of the costs of food and beverages and labor but is not as comfortable with the estimate of overhead cost. The $13.98 overhead cost per labor-hour was determined by dividing total overhead expenses for the last 12 months by total labor-hours for the same period. Monthly data concerning overhead costs and labor-hours follow: LaborHours Overhead Expenses January . . . . . . . . . . February . . . . . . . . . March. . . . . . . . . . . . April . . . . . . . . . . . . . May . . . . . . . . . . . . . June. . . . . . . . . . . . . July . . . . . . . . . . . . . August . . . . . . . . . . . September . . . . . . . . October . . . . . . . . . . November . . . . . . . . December . . . . . . . . 2,500 2,800 3,000 4,200 4,500 5,500 6,500 7,500 7,000 4,500 3,100 6,500 $ 55,000 59,000 60,000 64,000 67,000 71,000 74,000 77,000 75,000 68,000 62,000 73,000 Total . . . . . . . . . . . . . 57,600 $805,000 Month Chavez has received a request to bid on a 180-guest fund-raising cocktail party to be given next month by an important local charity. (The party would last the usual three hours.) She would like to win this contract because the guest list for this charity event includes many prominent individuals that she would like to land as future clients. Maria is condent that these potential customers would be favorably impressed by her companys services at the charity event. gar79611_ch05_188-232.indd Page 225 12/13/08 7:30:09 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-05/upload Cost Behavior: Analysis and Use Required: 1. 2. 3. Estimate the contribution to prot of a standard 180-guest cocktail party if Chavez charges her usual price of $31 per guest. (In other words, by how much would her overall prot increase?) How low could Chavez bid for the charity event in terms of a price per guest and still not lose money on the event itself? The individual who is organizing the charitys fund-raising event has indicated that he has already received a bid under $30 from another catering company. Do you think Chavez should bid below her normal $31 per guest price for the charity event? Why or why not? (CMA, adapted) CASE 519 Scattergraph Analysis; Selection of an Activity Base [LO2] Angora Wraps of Pendleton, Oregon, makes ne sweaters out of pure angora wool. The business is seasonal, with the largest demand during the fall, the winter, and Christmas holidays. The company must increase production each summer to meet estimated demand. The company has been analyzing its costs to determine which costs are xed and variable for planning purposes. Below are data for the companys activity and direct labor costs over the last year. Month Thousands of Units Produced January . . . . . . . . . . . . February . . . . . . . . . . . March. . . . . . . . . . . . . . April . . . . . . . . . . . . . . . May . . . . . . . . . . . . . . . June . . . . . . . . . . . . . . . July. . . . . . . . . . . . . . . . August . . . . . . . . . . . . . September . . . . . . . . . . October . . . . . . . . . . . . November . . . . . . . . . . December . . . . . . . . . . 98 76 75 80 85 102 52 136 138 132 86 56 Number of Paid Days Direct Labor Cost 20 20 21 22 22 21 19 21 22 23 18 21 $14,162 $12,994 $15,184 $15,038 $15,768 $15,330 $13,724 $14,162 $15,476 $15,476 $12,972 $14,074 The number of workdays varies from month to month due to the number of weekdays, holidays, and days of vacation in the month. The paid days include paid vacations (in July) and paid holidays (in November and December). The number of units produced in a month varies depending on demand and the number of workdays in the month. The company has eight workers who are classied as direct labor. Required: 1. 2. 3. Plot the direct labor cost and units produced on a scattergraph. (Place cost on the vertical axis and units produced on the horizontal axis.) Plot the direct labor cost and number of paid days on a scattergraph. (Place cost on the vertical axis and the number of paid days on the horizontal axis.) Which measure of activitynumber of units produced or paid daysshould be used as the activity base for explaining direct labor cost? Explain RESEARCH AND APPLICATION 520 [LO1, LO2, LO3, LO4] The questions in this problem are based on Blue Nile, Inc. To answer the questions, you will need to download Blue Niles 2004 Form 10-K at www.sec.gov/edgar/searchedgar/company search.html. Once at this website, input CIK code 1091171 and hit enter. In the gray box on the right-hand side of your computer screen dene the scope of your search by inputting 10-K and 225 gar79611_ch05_188-232.indd Page 226 12/13/08 7:30:10 PM user-s180 226 /broker/MH-BURR/MHBR094/MHBR094-05/upload Chapter 5 then pressing enter. Select the 10-K/A with a ling date of March 25, 2005. You do not need to print this document to answer the questions. You will need the information below to answer the questions. 2004 2005 Quarter 1 Net sales . . . . . . . . . Cost of sales . . . . . . Gross prot . . . . . . . Selling, general, and administrative expense . . . . . . . . Operating income . . Quarter 2 Quarter 3 Quarter 4 Quarter 1 Quarter 2 ? ? ? ? ? ? ? ? ? ? ? ? $44,116 $34,429 $9,687 $43,826 $33,836 $9,990 $5,308 ? $5,111 ? $5,033 ? $7,343 ? $6,123 $3,564 $6,184 $3,806 Required: 1. 2. 3. 4. 5. 6. 7. What is Blue Niles strategy for success in the marketplace? Does the company rely primarily on a customer intimacy, operational excellence, or product leadership customer value proposition? What evidence from the 10-K supports your conclusion? What business risks does Blue Nile face that may threaten its ability to satisfy stockholder expectations? What are some examples of control activities that the company could use to reduce these risks? (Hint: Focus on pages 819 of the 10-K.) Are some of the risks faced by Blue Nile difcult to reduce through control activities? Explain. Is Blue Nile a merchandiser or a manufacturer? What information contained in the 10-K supports your answer? Using account analysis, would you label cost of sales and selling, general, and administrative expense as variable, xed, or mixed costs? Why? (Hint: focus on pages 2426 and 38 of the 10-K.) Cite one example of a variable cost, step-variable cost, discretionary xed cost, and committed xed cost for Blue Nile. Fill in the blanks in the table above based on information contained in the 10-K. Using the high-low method, estimate the variable and xed cost elements of the quarterly selling, general, and administrative expense. Express Blue Niles variable and xed selling, general, and administrative expenses in the form Y a bX, where X is net sales. Prepare a contribution format income statement for the third quarter of 2005 assuming that Blue Niles net sales were $45,500 and its cost of sales as a percentage of net sales remained unchanged from the prior quarter. How would you describe Blue Niles cost structure? Is Blue Niles cost of sales as a percentage of sales higher or lower than competitors with bricks and mortar jewelry stores? Appendix 5A: Least-Squares Regression Computations LEARNING OBJECTIVE 5 Analyze a mixed cost using the least-squares regression method. The least-squares regression method for estimating a linear relationship is based on the equation for a straight line: Y a bX As explained in the chapter, least-squares regression selects the values for the intercept a and the slope b that minimize the sum of the squared errors. The following formulas, which are derived in statistics and calculus texts, accomplish that objective: gar79611_ch05_188-232.indd Page 227 12/13/08 7:30:11 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-05/upload 227 Cost Behavior: Analysis and Use b a n( XY) ( X )( Y ) n( X 2) ( X )2 ( Y) b( X) n where: X The level of activity (independent variable) Y The total mixed cost (dependent variable) a The total xed cost (the vertical intercept of the line) b The variable cost per unit of activity (the slope of the line) n Number of observations Sum across all n observations Manually performing the calculations required by the formulas is tedious at best. Fortunately, statistical software packages are widely available that perform the calculations automatically. Spreadsheet software, such as Microsoft Excel, can also be used to do least-squares regressionalthough it requires a little more work than using a specialized statistical application. To illustrate how Excel can be used to calculate the intercept a, the slope b, and the R2, we will use the Brentline Hospital data for maintenance costs on page 203. The worksheet in Exhibit 5A1 contains the data and the calculations. As you can see, the X values (the independent variable) have been entered in cells B4 through B10. The Y values (the dependent variable) have been entered in cells C4 through C10. The slope, intercept, and R2 are computed using the Excel functions INTERCEPT, SLOPE, and RSQ. You must specify the range of cells for the Y values and for the X values. E X H I B I T 5A1 The Least-Squares Regression Worksheet for Brentline Hospital gar79611_ch05_188-232.indd gar79611_ch05_188-232.indd Page 228 12/13/08 7:30:11 PM user-s180 228 /broker/MH-BURR/MHBR094/MHBR094-05/upload Chapter 5 E X H I B I T 5A2 A Scattergraph Plot of the Brentline Hospital Data $12,000 Y Maintenance cost $10,000 $8,000 $6,000 $4,000 $2,000 $0 0 2,000 4,000 6,000 Patient-days 8,000 X 10,000 In Exhibit 5A1, cell B12 contains the formula INTERCEPT(C4:C10,B4:B10); cell B13 contains the formula SLOPE(C4:C10,B4:B10); and cell B14 contains the formula RSQ(C4:C10,B4:B10). According to the calculations carried out by Excel, the xed maintenance cost (the intercept) is $3,431 per month and the variable cost (the slope) is $0.759 per patient-day. Therefore, the cost formula for maintenance cost is: Y a bX Y $3,431 $0.759X 2 Note that the R (i.e., RSQ) is 0.90, whichas previously discussedis quite good and indicates that 90% of the variation in maintenance costs is explained by the variation in patient-days. Plotting the data is easy in Excel. Select the range of values that you would like to plotin this case, cells B4:C10. Then select the Chart Wizard tool on the toolbar and make the appropriate choices in the various dialogue boxes that appear. When you are nished, you should have a scattergraph that looks like the plot in Exhibit 5A2. Note that the relation between cost and activity is approximately linear, so it is reasonable to t a straight line to the data as we have implicitly done with the least-squares regression. Appendix 5A Exercises and Problems EXERCISE 5A1 (Appendix 5A) Least-Squares Regression [LO5] Bargain Rental Car offers rental cars in an off-airport location near a major tourist destination in California. Management would like to better understand the behavior of the companys costs. One of those costs is the cost of washing cars. The company operates its own car wash facility in which each rental car that is returned is thoroughly cleaned before being released for rental to another customer. Management believes that the costs of operating the car wash should be related to the number of rental returns. Accordingly, the following data have been compiled: gar79611_ch05_188-232.indd gar79611_ch05_188-232.indd Page 229 12/13/08 7:30:11 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-05/upload Cost Behavior: Analysis and Use Rental Returns Month January . . . . . . . . . . . . February . . . . . . . . . . . March . . . . . . . . . . . . . April . . . . . . . . . . . . . . May . . . . . . . . . . . . . . . June . . . . . . . . . . . . . . July . . . . . . . . . . . . . . . August. . . . . . . . . . . . . September . . . . . . . . . October . . . . . . . . . . . . November . . . . . . . . . . December . . . . . . . . . . Car Wash Costs 2,380 2,421 2,586 2,725 2,968 3,281 3,353 3,489 3,057 2,876 2,735 2,983 $10,825 $11,865 $11,332 $12,422 $13,850 $14,419 $14,935 $15,738 $13,563 $11,889 $12,683 $13,796 Required: Using least-squares regression, estimate the xed cost and variable cost elements of monthly car wash costs. The xed cost element should be estimated to the nearest dollar and the variable cost element to the nearest cent. EXERCISE 5A2 (Appendix 5A) Least-Squares Regression [LO1, LO5] George Caloz & Frres, located in Grenchen, Switzerland, makes prestige high-end custom watches in small lots. One of the companys products, a platinum diving watch, goes through an etching process. The company has observed etching costs (expressed in Swiss Francs, SFr) as follows over the last six weeks: Week 1........ 2........ 3........ 4........ 5........ 6........ Units Total Etching Cost 4 3 8 6 7 2 SFr18 17 25 20 24 16 30 SFr120 For planning purposes, management would like to know the amount of variable etching cost per unit and the total xed etching cost per week. Required: 1. 2. 3. Using the least-squares regression method, estimate the variable and xed elements of etching cost. Express the cost data in (1) above in the form Y a bX. If the company processes ve units next week, what would be the expected total etching cost? EXERCISE 5A3 (Appendix 5A) Least-Squares Regression [LO5] Refer to the data for Archer Company in Exercise 56. Required: 1. 2. Using the least-squares regression method, estimate a cost formula for shipping expense. If you also completed Exercise 56, prepare a simple table comparing the variable and xed cost elements of shipping expense as computed under the quick-and-dirty method, the highlow method, and the least-squares regression method. PROBLEM 5A4 (Appendix 5A) Least-Squares Regression Method; Scattergraph; Cost Behavior [LO1, LO2, LO5] Professor John Morton has just been appointed chairperson of the Finance Department at Westland University. In reviewing the departments cost records, Professor Morton has found the following total cost associated with Finance 101 over the last several terms: 229 gar79611_ch05_188-232.indd Page 230 12/13/08 7:30:13 PM user-s180 230 /broker/MH-BURR/MHBR094/MHBR094-05/upload Chapter 5 Professor Morton knows that there are some variable costs, such as amounts paid to graduate assistants, associated with the course. He would like to have the variable and xed costs separated for planning purposes. Required: 1. 2. 3. 4. Using the least-squares regression method, estimate the variable cost per section and the total xed cost per term for Finance 101. Express the cost data derived in (1) above in the linear equation form Y a bX. Assume that because of the small number of sections offered during the Winter Term this year, Professor Morton will have to offer eight sections of Finance 101 during the Fall Term. Compute the expected total cost for Finance 101. Can you see any problem with using the cost formula from (2) above to derive this total cost gure? Explain. Prepare a scattergraph and t a straight line to the plotted points using the cost formula expressed in (2) above. PROBLEM 5A5 (Appendix 5A) Least-Squares Regression Analysis; Contribution Format Income Statement [LO4, LO5] Milden Company has an exclusive franchise to purchase a product from the manufacturer and distribute it on the retail level. As an aid in planning, the company has decided to start using a contribution format income statement. To have data to prepare such a statement, the company has analyzed its expenses and has developed the following cost formulas: Cost Cost Formula Cost of good sold. . . . . . . . . . . . Advertising expense . . . . . . . . . Sales commissions . . . . . . . . . . Shipping expense . . . . . . . . . . . Administrative salaries. . . . . . . . Insurance expense . . . . . . . . . . Depreciation expense . . . . . . . . $35 per unit sold $210,000 per quarter 6% of sales ? $145,000 per quarter $9,000 per quarter $76,000 per quarter Management has concluded that shipping expense is a mixed cost, containing both variable and xed cost elements. Units sold and the related shipping expense over the last eight quarters follow: Quarter Year 1: First . . . . . . . . . . . . . Second. . . . . . . . . . . Third . . . . . . . . . . . . . Fourth. . . . . . . . . . . . Units Sold (000) Shipping Expense 10 16 18 15 $119,000 $175,000 $190,000 $164,000 continued gar79611_ch05_188-232.indd gar79611_ch05_188-232.indd Page 231 12/13/08 7:30:14 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-05/upload Cost Behavior: Analysis and Use Units Sold (000) Quarter Shipping Expense 11 17 20 13 $130,000 $185,000 $210,000 $147,000 Year 2: First . . . . . . . . . . . . . Second. . . . . . . . . . . Third . . . . . . . . . . . . . Fourth. . . . . . . . . . . . Milden Companys president would like a cost formula derived for shipping expense so that a budgeted contribution format income statement can be prepared for the next quarter. Required: 1. 2. Using the least-squares regression method, estimate a cost formula for shipping expense. (Since the Units Sold above are in thousands of units, the variable cost you compute will also be in thousands of units. It can be left in this form, or you can convert your variable cost to a per unit basis by dividing it by 1,000.) In the rst quarter of Year 3, the company plans to sell 12,000 units at a selling price of $100 per unit. Prepare a contribution format income statement for the quarter. PROBLEM 5A6 (Appendix 5A) Least-Squares Regression Method [LO5] Refer to the data for Pleasant View Hospital in Problem 514. Required: 1. 2. Using the least-squares regression method, estimate a cost formula for utilities. (Round the variable cost to the nearest cent.) Refer to the graph prepared in part (2) of Problem 514. Explain why in this case the high-low method would be the least accurate of the three methods in deriving a cost formula. CASE 5A7 (Appendix 5A) Analysis of Mixed Costs, Job-Order Costing, and Activity-Based Costing [LO1, LO2, LO5] Hokuriku-Seika Co., Ltd., of Yokohama, Japan, is a subcontractor to local manufacturing companies. The company specializes in precision metal cutting using focused high-pressure water jets and high-energy lasers. The company has a traditional job-order costing system in which direct labor and direct materials costs are assigned directly to jobs, but factory overhead is applied to jobs using a predetermined overhead rate based on direct labor-hours. Management uses this job cost data for valuing cost of goods sold and inventories for external reports. For internal decision making, management has largely ignored this cost data because direct labor costs are basically xed and management believes overhead costs actually have little to do with direct labor-hours. Recently, management has become interested in activity-based costing (ABC) as a way of estimating job costs and other costs for decision-making purposes. Management assembled a cross-functional team to design a prototype ABC system. Electrical costs were among the rst factory overhead costs investigated by the team. Electricity is used to provide light, to power equipment, and to heat the building in the winter and cool it in the summer. The ABC team proposed allocating electrical costs to jobs based on machine-hours because running the machines consumes signicant amounts of electricity. Data assembled by the team concerning actual direct labor-hours, machine-hours, and electrical costs over a recent eight-week period appear below. (The Japanese currency is the yen, which is denoted by .) Direct LaborHours MachineHours Electrical Costs Week 1. . . . . . . . . . . . Week 2. . . . . . . . . . . . Week 3. . . . . . . . . . . . Week 4. . . . . . . . . . . . Week 5. . . . . . . . . . . . Week 6. . . . . . . . . . . . Week 7. . . . . . . . . . . . Week 8. . . . . . . . . . . . 8,920 8,810 8,950 8,990 8,840 8,890 8,950 8,990 7,200 8,200 8,700 7,200 7,400 8,800 6,400 7,700 77,100 84,400 80,400 75,500 81,100 83,300 79,200 85,500 Total . . . . . . . . . . . . . . 71,340 61,600 646,500 231 gar79611_ch05_188-232.indd gar79611_ch05_188-232.indd Page 232 12/13/08 7:30:15 PM user-s180 232 /broker/MH-BURR/MHBR094/MHBR094-05/upload Chapter 5 To help assess the effect of the proposed change to machine-hours as the allocation base, the eight-week totals were converted to annual gures by multiplying them by six. Direct LaborHours Estimated annual total (eightweek total above 6) . . . . . . . . . MachineHours Electrical Costs 428,040 369,600 3,879,000 Required: 1. 2. 3. 4. 5. 6. Assume that the estimated annual totals from the above table are used to compute the companys predetermined overhead rate. What would be the predetermined overhead rate for electrical costs if the allocation base is direct labor-hours? Machine-hours? Hokuriku-Seika Co. intends to bid on a job for a shipyard that would require 350 direct labor-hours and 270 machine-hours. How much electrical cost would be charged to this job using the predetermined overhead rate computed in (1) above if the allocation base is direct labor-hours? Machine-hours? Prepare a scattergraph in which you plot direct labor-hours on the horizontal axis and electrical costs on the vertical axis. Prepare another scattergraph in which you plot machine-hours on the horizontal axis and electrical costs on the vertical axis. Do you agree with the ABC team that machine-hours is a better allocation base for electrical costs than direct labor-hours? Why? Using machine-hours as the measure of activity, estimate the xed and variable components of electrical costs using least-squares regression. How much electrical cost do you think would actually be caused by the shipyard job in (2) above? Explain. What factors, apart from direct labor-hours and machine-hours, are likely to affect consumption of electrical power in the company? RESEARCH AND APPLICATION 5A8 [LO5] This question should be answered only after Research and Application 520 is completed. Required: 1. 2. Referring to the data for Blue Nile in Research and Application 520 and the data on net sales available on the companys website, estimate the variable and xed components of the companys quarterly selling, general, and administrative expense. Express Blue Niles variable and xed selling, general, and administrative expenses in the form Y a bX, where X is net sales. Using the formula from part (1) above, prepare a contribution format income statement for the third quarter of 2005 assuming that Blue Niles net sales were $45,500 and its cost of sales as a percentage of net sales remained unchanged from the prior quarter. gar79611_ch06_233-278.indd Page 233 12/15/08 11:33:14 PM user-s176 6 Chapter Cost-Volume-Prot Relationships /broker/MH-BURR/MHBR094/MHBR094-06/MHBR094-06 B U SIN ESS FOCU S What Happened to the Prot? Chip Conley is CEO of Joie de Vivre Hospitality, a company that owns and operates 28 hospitality businesses in northern California. Conley summed up the companys experience after the dot.com crash and 9/11 as follows: In the history of American hotel markets, no hotel market has ever seen a drop in revenues as precipitous as the one in San Francisco and Silicon Valley in the last two years. On average, hotel revenues . . . dropped 40% to 45%. . . . Weve been fortunate that our breakeven point is lower than our competitions. . . . But the problem is that the hotel business is a xed-cost business. So in an environment where you have those precipitous drops and our costs are moderately xed, our net incomeswell, theyre not incomes anymore, theyre losses. LEARNING OBJECTIVES After studying Chapter 6, you should be able to: LO1 Explain how changes in activity affect contribution margin and net operating income. LO2 Prepare and interpret a cost-volume-profit (CVP) graph and a profit graph. LO3 Use the contribution margin ratio (CM ratio) to compute changes in contribution margin and net operating income resulting from changes in sales volume. LO4 Show the effects on contribution margin of changes in variable costs, fixed costs, selling price, and volume. LO5 Determine the level of sales needed to achieve a desired target profit. LO6 Determine the break-even point. LO7 Compute the margin of safety and explain its significance. LO8 Compute the degree of operating leverage at a particular level of sales and explain how it can be used to predict changes in net operating income. LO9 Compute the break-even point for a multiproduct company and explain the effects of shifts in the sales mix on contribution margin and the break-even point. Source: Karen Dillon, Shop Talk, Inc. magazine, December 2002, pp. 111114. 233 gar79611_ch06_233-278.indd gar79611_ch06_233-278.indd Page 234 12/31/08 4:27:09 PM user-s180 234 /broker/MH-BURR/MHBR094/MHBR094-06/upload Chapter 6 C ost-volume-prot (CVP) analysis is a powerful tool that helps managers understand the relationships among cost, volume, and prot. CVP analysis focuses on how prots are affected by the following ve factors: 1. 2. 3. 4. 5. Selling prices. Sales volume. Unit variable costs. Total xed costs. Mix of products sold. Because CVP analysis helps managers understand how prots are affected by these key factors, it is a vital tool in many business decisions. These decisions include what products and services to offer, what prices to charge, what marketing strategy to use, and what cost structure to implement. To help understand the role of CVP analysis in business decisions, consider the case of Acoustic Concepts, Inc., a company founded by Prem Narayan. M ANAGERIAL ACCOUNTING IN ACTION The Issue Prem, who was a graduate student in engineering at the time, started Acoustic Concepts to market a radical new speaker he had designed for automobile sound systems. The speaker, called the Sonic Blaster, uses an advanced microprocessor and proprietary software to boost amplication to awesome levels. Prem contracted with a Taiwanese electronics manufacturer to produce the speaker. With seed money provided by his family, Prem placed an order with the manufacturer and ran advertisements in auto magazines. The Sonic Blaster was an almost immediate success, and sales grew to the point that Prem moved the companys headquarters out of his apartment and into rented quarters in a nearby industrial park. He also hired a receptionist, an accountant, a sales manager, and a small sales staff to sell the speakers to retail stores. The accountant, Bob Luchinni, had worked for several small companies where he had acted as a business advisor as well as accountant and bookkeeper. The following discussion occurred soon after Bob was hired: Prem: Bob, Ive got a lot of questions about the companys nances that I hope you can help answer. Bob: Were in great shape. The loan from your family will be paid off within a few months. Prem: I know, but I am worried about the risks Ive taken on by expanding operations. What would happen if a competitor entered the market and our sales slipped? How far could sales drop without putting us into the red? Another question Ive been trying to resolve is how much our sales would have to increase to justify the big marketing campaign the sales staff is pushing for. Bob: Marketing always wants more money for advertising. Prem: And they are always pushing me to drop the selling price on the speaker. I agree with them that a lower price will boost our volume, but Im not sure the increased volume will offset the loss in revenue from the lower price. Bob: It sounds like these questions are all related in some way to the relationships among our selling prices, our costs, and our volume. I shouldnt have a problem coming up with some answers. Prem: Can we meet again in a couple of days to see what you have come up with? Bob: Sounds good. By then Ill have some preliminary answers for you as well as a model you can use for answering similar questions in the future. The Basics of Cost-Volume-Prot (CVP) Analysis Bob Luchinnis preparation for his forthcoming meeting with Prem begins where our study of cost behavior in the preceding chapter left offwith the contribution income statement. The contribution income statement emphasizes the behavior of costs and therefore is extremely helpful to managers in judging the impact on prots of changes in selling price, gar79611_ch06_233-278.indd gar79611_ch06_233-278.indd Page 235 12/15/08 11:33:19 PM user-s176 /broker/MH-BURR/MHBR094/MHBR094-06/MHBR094-06 235 Cost-Volume-Prot Relationships cost, or volume. Bob will base his analysis on the following contribution income statement he prepared last month: Acoustic Concepts, Inc. Contribution Income Statement For the Month of June Sales (400 speakers) . . . . . . . . . Variable expenses . . . . . . . . . . . . Total $100,000 60,000 Contribution margin . . . . . . . . . . Fixed expenses . . . . . . . . . . . . . . 40,000 35,000 Net operating income . . . . . . . . . $ Per Unit $250 150 $100 5,000 Notice that sales, variable expenses, and contribution margin are expressed on a per unit basis as well as in total on this contribution income statement. The per unit gures will be very helpful to Bob in some of his calculations. Note that this contribution income statement has been prepared for managements use inside the company and would not ordinarily be made available to those outside the company. Contribution Margin As explained in the previous chapter, contribution margin is the amount remaining from sales revenue after variable expenses have been deducted. Thus, it is the amount available to cover xed expenses and then to provide prots for the period. Notice the sequence herecontribution margin is used rst to cover the xed expenses, and then whatever remains goes toward prots. If the contribution margin is not sufcient to cover the xed expenses, then a loss occurs for the period. To illustrate with an extreme example, assume that Acoustic Concepts sells only one speaker during a particular month. The companys income statement would appear as follows: Contribution Income Statement Sales of 1 Speaker Total 250 150 Per Unit $250 150 Contribution margin . . . . . . . . . Fixed expenses . . . . . . . . . . . . 100 35,000 $100 Net operating loss . . . . . . . . . . $(34,900) Sales (1 speaker) . . . . . . . . . . . Variable expenses . . . . . . . . . . $ For each additional speaker the company sells during the month, $100 more in contribution margin becomes available to help cover the xed expenses. If a second speaker is sold, for example, then the total contribution margin will increase by $100 (to a total of $200) and the companys loss will decrease by $100, to $34,800: Contribution Income Statement Sales of 2 Speakers Total 500 300 Per Unit $250 150 Contribution margin . . . . . . . . . Fixed expenses . . . . . . . . . . . . 200 35,000 $100 Net operating loss . . . . . . . . . . $(34,800) Sales (2 speakers) . . . . . . . . . . Variable expenses . . . . . . . . . . $ L EARNING OBJECTIVE 1 Explain how changes in activity affect contribution margin and net operating income. gar79611_ch06_233-278.indd gar79611_ch06_233-278.indd Page 236 12/15/08 11:33:19 PM user-s176 236 /broker/MH-BURR/MHBR094/MHBR094-06/MHBR094-06 Chapter 6 If enough speakers can be sold to generate $35,000 in contribution margin, then all of the xed expenses will be covered and the company will break even for the monththat is, it will show neither prot nor loss but just cover all of its costs. To reach the breakeven point, the company will have to sell 350 speakers in a month because each speaker sold yields $100 in contribution margin: Contribution Income Statement Sales of 350 Speakers Sales (350 speakers) . . . . . . . . . Variable expenses . . . . . . . . . . . Total $87,500 52,500 Per Unit $250 150 Contribution margin . . . . . . . . . . Fixed expenses . . . . . . . . . . . . . 35,000 35,000 $100 Net operating income . . . . . . . . . $ 0 Computation of the break-even point is discussed in detail later in the chapter; for the moment, note that the break-even point is the level of sales at which prot is zero. Once the break-even point has been reached, net operating income will increase by the amount of the unit contribution margin for each additional unit sold. For example, if 351 speakers are sold in a month, then the net operating income for the month will be $100 because the company will have sold 1 speaker more than the number needed to break even: Contribution Income Statement Sales of 351 Speakers Sales (351 speakers) . . . . . . . . . Variable expenses . . . . . . . . . . . Total $87,750 52,650 Per Unit $250 150 Contribution margin . . . . . . . . . . Fixed expenses . . . . . . . . . . . . . 35,100 35,000 $100 Net operating income . . . . . . . . . $ 100 If 352 speakers are sold (2 speakers above the break-even point), the net operating income for the month will be $200. If 353 speakers are sold (3 speakers above the breakeven point), the net operating income for the month will be $300, and so forth. To estimate the prot at any sales volume above the break-even point, simply multiply the number of units sold in excess of the break-even point by the unit contribution margin. The result represents the anticipated prots for the period. Or, to estimate the effect of a planned increase in sales on prots, simply multiply the increase in units sold by the unit contribution margin. The result will be the expected increase in prots. To illustrate, if Acoustic Concepts is currently selling 400 speakers per month and plans to increase sales to 425 speakers per month, the anticipated impact on prots can be computed as follows: Increased number of speakers to be sold . . . . . . . . . Contribution margin per speaker . . . . . . . . . . . . . . . . 25 $100 Increase in net operating income . . . . . . . . . . . . . . . . $2,500 gar79611_ch06_233-278.indd gar79611_ch06_233-278.indd Page 237 12/15/08 11:33:20 PM user-s176 /broker/MH-BURR/MHBR094/MHBR094-06/MHBR094-06 Cost-Volume-Prot Relationships These calculations can be veried as follows: Sales Volume 400 Speakers 425 Speakers Difference (25 Speakers) Per Unit Sales (@ $250 per speaker) . . . . . $100,000 Variable expenses (@ $150 per speaker) . . . . . . . . 60,000 $106,250 $6,250 $250 63,750 3,750 150 42,500 35,000 2,500 0 $100 7,500 $2,500 Contribution margin . . . . . . . . . . . Fixed expenses . . . . . . . . . . . . . . Net operating income . . . . . . . . . . 40,000 35,000 $ 5,000 $ To summarize, if sales are zero, the companys loss would equal its xed expenses. Each unit that is sold reduces the loss by the amount of the unit contribution margin. Once the break-even point has been reached, each additional unit sold increases the companys prot by the amount of the unit contribution margin. CVP Relationships in Equation Form The contribution format income statement can be expressed in equation form as follows: Prot (Sales Variable expenses) Fixed expenses For brevity, we use the term prot to stand for net operating income in equations. When a company has only a single product, as at Acoustic Concepts, we can further rene the equation as follows: Sales Selling price per unit Variable expenses Prot (P Q Quantity sold Variable expenses per unit V Q) P Q Quantity sold V Q Fixed expenses We can do all of the calculations of the previous section using this simple equation. For example, on page 236 we computed that the net operating income (prot) at sales of 351 speakers would be $100. We can arrive at the same conclusion using the above equation as follows: Prot (P Q Prot ($250 351 ($250 $150) ($100) 351 $35,100 V Q) Fixed expenses $150 351) 351 $35,000 $35,000 $35,000 $35,000 $100 It is often useful to express the simple prot equation in terms of the unit contribution margin (Unit CM) as follows: Unit CM Selling price per unit Prot (P Q V Prot (P V) Q Prot Unit CM Q Q) Variable expenses per unit Fixed expenses Fixed expenses Fixed expenses P V 237 gar79611_ch06_233-278.indd gar79611_ch06_233-278.indd Page 238 12/15/08 11:33:20 PM user-s176 238 /broker/MH-BURR/MHBR094/MHBR094-06/MHBR094-06 Chapter 6 We could also have used this equation to determine the prot at sales of 351 speakers as follows: Prot Unit CM $100 Q 351 $35,100 Fixed expenses $35,000 $35,000 $100 For those who are comfortable with algebra, the quickest and easiest approach to solving the problems in this chapter may be to use the simple prot equation in one of its forms. CVP Relationships in Graphic Form L EARNING OBJECTIVE 2 Prepare and interpret a costvolume-prot (CVP) graph and a prot graph. The relationships among revenue, cost, prot, and volume are illustrated on a costvolume-prot (CVP) graph. A CVP graph highlights CVP relationships over wide ranges of activity. To help explain his analysis to Prem Narayan, Bob Luchinni prepared a CVP graph for Acoustic Concepts. Preparing the CVP Graph In a CVP graph (sometimes called a break-even chart), unit volume is represented on the horizontal (X) axis and dollars on the vertical (Y ) axis. Preparing a CVP graph involves three steps as depicted in Exhibit 61: 1. Draw a line parallel to the volume axis to represent total xed expense. For Acoustic Concepts, total xed expenses are $35,000. 2. Choose some volume of unit sales and plot the point representing total expense (xed and variable) at the sales volume you have selected. In Exhibit 61, Bob Luchinni chose a volume of 600 speakers. Total expense at that sales volume is: Fixed expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Variable expense (600 speakers $150 per speaker) . . . . . . . . . Total expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . E X H I B I T 61 Preparing the CVP Graph $ 35,000 90,000 $125,000 $175,000 Step 3 (total sales revenue) $150,000 $125,000 Step 2 (total expense) $100,000 $75,000 Step 1 (fixed expense) $50,000 $25,000 $0 0 100 200 300 400 500 600 Volume in speakers sold 700 800 gar79611_ch06_233-278.indd gar79611_ch06_233-278.indd Page 239 12/15/08 11:33:20 PM user-s176 /broker/MH-BURR/MHBR094/MHBR094-06/MHBR094-06 239 Cost-Volume-Prot Relationships E X H I B I T 62 The Completed CVP Graph $175,000 Total revenue $150,000 $125,000 Break-even point: 350 speakers or $87,500 in sales Total expense $100,000 $75,000 $50,000 Variable expense at $150 per speaker Profit area Total fixed expense, $35,000 Loss area $25,000 $0 0 100 200 300 400 500 Volume in speakers sold 600 700 After the point has been plotted, draw a line through it back to the point where the xed expense line intersects the dollars axis. 3. Again choose some sales volume and plot the point representing total sales dollars at the activity level you have selected. In Exhibit 61, Bob Luchinni again chose a volume of 600 speakers. Sales at that sales volume total $150,000 (600 speakers $250 per speaker). Draw a line through this point back to the origin. The interpretation of the completed CVP graph is given in Exhibit 62. The anticipated prot or loss at any given level of sales is measured by the vertical distance between the total revenue line (sales) and the total expense line (variable expense plus xed expense). The break-even point is where the total revenue and total expense lines cross. The break-even point of 350 speakers in Exhibit 62 agrees with the break-even point computed earlier. As discussed earlier, when sales are below the break-even pointin this case, 350 units the company suffers a loss. Note that the loss (represented by the vertical distance between the total expense and total revenue lines) gets bigger as sales decline. When sales are above the break-even point, the company earns a prot and the size of the prot (represented by the vertical distance between the total revenue and total expense lines) increases as sales increase. An even simpler form of the CVP graph, which we call a prot graph, is presented in Exhibit 63. That graph is based on the following equation: Prot Unit CM Q Fixed expenses In the case of Acoustic Concepts, the equation can be expressed as: Prot $100 Q $35,000 gar79611_ch06_233-278.indd gar79611_ch06_233-278.indd Page 240 12/16/08 12:18:29 AM user-s176 240 /broker/MH-BURR/MHBR094/MHBR094-06/MHBR094-06 Chapter 6 E X H I B I T 63 The Prot Graph $40,000 $35,000 $30,000 $25,000 $20,000 $15,000 $10,000 Break-even point: 350 speakers Profit $5,000 $0 -$5,000 -$10,000 -$15,000 -$20,000 -$25,000 -$30,000 -$35,000 -$40,000 0 100 200 300 400 500 600 700 800 Volume in speakers sold Because this is a linear equation, it plots as a single straight line. To plot the line, compute the prot at two different sales volumes, plot the points, and then connect them with a straight line. For example, when the sales volume is zero (i.e., Q 0), the prot is $35,000 ( $100 0 $35,000). When Q is 600, the prot is $25,000 ( $100 600 $35,000). These two points are plotted in Exhibit 63 and a straight line has been drawn through them. The break-even point on the prot graph is the volume of sales at which prot is zero and is indicated by the dashed line on the graph. Note that the prot steadily increases to the right of the break-even point as the sales volume increases and that the loss becomes steadily worse to the left of the break-even point as the sales volume decreases. Contribution Margin Ratio (CM Ratio) L EARNING OBJECTIVE 3 Use the contribution margin ratio (CM ratio) to compute changes in contribution margin and net operating income resulting from changes in sales volume. In the previous section, we explored how cost-volume-prot relationships can be visualized. In this section, we show how the contribution margin ratio can be used in costvolume-prot calculations. As the rst step, we have added a column to Acoustic Concepts contribution format income statement in which sales revenues, variable expenses, and contribution margin are expressed as a percentage of sales: Total Sales (400 speakers) . . . . . . . . . Variable expenses . . . . . . . . . . . Contribution margin . . . . . . . . . . Fixed expenses . . . . . . . . . . . . . Net operating income . . . . . . . . . Per Unit Percent of Sales $100,000 60,000 40,000 35,000 $ 5,000 $250 150 $100 100% 60% 40% gar79611_ch06_233-278.indd Page 241 12/15/08 11:33:21 PM user-s176 /broker/MH-BURR/MHBR094/MHBR094-06/MHBR094-06 Cost-Volume-Prot Relationships The contribution margin as a percentage of sales is referred to as the contribution margin ratio (CM ratio). This ratio is computed as follows: Contribution margin Sales CM ratio For Acoustic Concepts, the computations are: CM ratio Total contribution margin Total sales $40,000 $100,000 40% In a company such as Acoustic Concepts that has only one product, the CM ratio can also be computed on a per unit basis as follows: CM ratio Unit contribution margin Unit selling price $100 $250 40% The CM ratio shows how the contribution margin will be affected by a change in total sales. Acoustic Concepts CM ratio of 40% means that for each dollar increase in sales, total contribution margin will increase by 40 cents ($1 sales CM ratio of 40%). Net operating income will also increase by 40 cents, assuming that xed costs are not affected by the increase in sales. As this illustration suggests, the impact on net operating income of any given dollar change in total sales can be computed by simply applying the CM ratio to the dollar change. For example, if Acoustic Concepts plans a $30,000 increase in sales during the coming month, the contribution margin should increase by $12,000 ($30,000 increase in sales CM ratio of 40%). As we noted above, net operating income will also increase by $12,000 if xed costs do not change. This is veried by the following table: Sales Volume Present Expected Increase Percent of Sales Sales . . . . . . . . . . . . . . . . . . Variable expenses . . . . . . . . $100,000 60,000 $130,000 78,000* $30,000 18,000 100% 60% Contribution margin . . . . . . . Fixed expenses . . . . . . . . . . 40,000 35,000 52,000 35,000 12,000 0 40% 5,000 $ 17,000 $12,000 Net operating income . . . . . . *$130,000 expected sales $78,000. $ $250 per unit 520 units. 520 units $150 per unit The relation between prot and the CM ratio can also be expressed using the following equation: Prot CM ratio Sales Fixed expenses1 For example, at sales of $130,000, the prot is expected to be $17,000 as shown below: Prot 1 CM ratio Sales Fixed expenses 0.40 $130,000 $35,000 $52,000 $35,000 $17,000 This equation can be derived using the basic prot equation and the denition of the CM ratio as follows: Prot (Sales Variable expenses) Fixed expenses Prot Contribution margin Fixed expenses Contribution margin Prot Sales Fixed expense Sales Prot CM ratio Sales Fixed expenses 241 gar79611_ch06_233-278.indd Page 242 12/15/08 11:33:21 PM user-s176 242 /broker/MH-BURR/MHBR094/MHBR094-06/MHBR094-06 Chapter 6 Again, if you are comfortable with algebra, this approach will often be quicker and easier than constructing contribution format income statements. The CM ratio is particularly valuable in situations where the dollar sales of one product must be traded off against the dollar sales of another product. In this situation, products that yield the greatest amount of contribution margin per dollar of sales should be emphasized. Some Applications of CVP Concepts L EARNING OBJECTIVE 4 Show the effects on contribution margin of changes in variable costs, xed costs, selling price, and volume. Bob Luchinni, the accountant at Acoustic Concepts, wanted to demonstrate to the companys president Prem Narayan how the concepts developed on the preceding pages can be used in planning and decision making. Bob gathered the following basic data: Per Unit Percent of Sales Selling price . . . . . . . . . . . . . . . Variable expenses . . . . . . . . . . $250 150 100% 60% Contribution margin . . . . . . . . . $100 40% Recall that xed expenses are $35,000 per month. Bob Luchinni will use these data to show the effects of changes in variable costs, xed costs, sales price, and sales volume on the companys protability in a variety of situations. Before proceeding further, however, we need to introduce another conceptthe variable expense ratio. The variable expense ratio is the ratio of variable expenses to sales. It can be computed by dividing the total variable expenses by the total sales, or in a single product analysis, it can be computed by dividing the variable expenses per unit by the unit selling price. In the case of Acoustic Concepts, the variable expense ratio is 0.60; that is, variable expense is 60% of sales. Change in Fixed Cost and Sales Volume Acoustic Concepts is currently selling 400 speakers per month at $250 per speaker for total monthly sales of $100,000. The sales manager feels that a $10,000 increase in the monthly advertising budget would increase monthly sales by $30,000 to a total of 520 units. Should the advertising budget be increased? The following table shows the nancial impact of the proposed change in the monthly advertising budget: Current Sales Sales with Additional Advertising Budget Difference Percent of Sales Sales . . . . . . . . . . . . . . . . . . Variable expenses . . . . . . . . $100,000 60,000 $130,000 78,000* $30,000 18,000 100% 60% Contribution margin . . . . . . . Fixed expenses . . . . . . . . . . 40,000 35,000 52,000 45,000 12,000 10,000 40% 7,000 $ 2,000 Net operating income . . . . . . $ 5,000 $ *520 units $150 per unit $78,000. $35,000 additional $10,000 monthly advertising budget $45,000. gar79611_ch06_233-278.indd gar79611_ch06_233-278.indd Page 243 12/15/08 11:33:22 PM user-s176 /broker/MH-BURR/MHBR094/MHBR094-06/MHBR094-06 Cost-Volume-Prot Relationships Assuming no other factors need to be considered, the increase in the advertising budget should be approved because it would increase net operating income by $2,000. There are two shorter ways to arrive at this solution. The rst alternative solution follows: Alternative Solution 1 Expected total contribution margin: $130,000 40% CM ratio . . . . . . . . . . . . . . . . . . Present total contribution margin: $100,000 40% CM ratio . . . . . . . . . . . . . . . . . . $52,000 40,000 Incremental contribution margin . . . . . . . . . . . . . . . . Change in xed expenses: Less incremental advertising expense . . . . . . . . . 12,000 Increased net operating income . . . . . . . . . . . . . . . . $ 2,000 10,000 Because in this case only the xed costs and the sales volume change, the solution can be presented in an even shorter format, as follows: Alternative Solution 2 Incremental contribution margin: $30,000 40% CM ratio . . . . . . . . . . . . . . . . . Less incremental advertising expense . . . . . . . . . $12,000 10,000 Increased net operating income . . . . . . . . . . . . . . $ 2,000 Notice that this approach does not depend on knowledge of previous sales. Also note that it is unnecessary under either shorter approach to prepare an income statement. Both of the alternative solutions involve an incremental analysisthey consider only those items of revenue, cost, and volume that will change if the new program is implemented. Although in each case a new income statement could have been prepared, the incremental approach is simpler and more direct and focuses attention on the specic changes that would occur as a result of the decision. Change in Variable Costs and Sales Volume Refer to the original data. Recall that Acoustic Concepts is currently selling 400 speakers per month. Prem is considering the use of higher-quality components, which would increase variable costs (and thereby reduce the contribution margin) by $10 per speaker. However, the sales manager predicts that using higher-quality components would increase sales to 480 speakers per month. Should the higher-quality components be used? The $10 increase in variable costs would decrease the unit contribution margin by $10from $100 down to $90. Solution Expected total contribution margin with higher-quality components: 480 speakers $90 per speaker . . . . . . . . . . . . . . . . . . $43,200 Present total contribution margin: 400 speakers $100 per speaker . . . . . . . . . . . . . . . . . 40,000 Increase in total contribution margin . . . . . . . . . . . . . . . . . . $ 3,200 According to this analysis, the higher-quality components should be used. Because xed costs would not change, the $3,200 increase in contribution margin shown above should result in a $3,200 increase in net operating income. 243 gar79611_ch06_233-278.indd Page 244 12/15/08 11:33:22 PM user-s176 244 /broker/MH-BURR/MHBR094/MHBR094-06/MHBR094-06 Chapter 6 IN BUSINESS GROWING SALES AT AMAZON.COM Amazon.com was deciding between two tactics for growing sales and prots. The rst approach was to invest in television advertising. The second approach was to offer free shipping on larger orders. To evaluate the rst option, Amazon.com invested in television ads in two markets Minneapolis, Minnesota, and Portland, Oregon. The company quantied the prot impact of this choice by subtracting the increase in xed advertising costs from the increase in contribution margin. The prot impact of television advertising paled in comparison to the free super saver shipping program, which the company introduced on orders over $99. In fact, the free shipping option proved to be so popular and protable that within two years Amazon.com dropped its qualifying threshold to $49 and then again to a mere $25. At each stage of this progression, Amazon.com used cost-volume-prot analysis to determine whether the extra volume from liberalizing the free shipping offer more than offset the associated increase in shipping costs. Source: Rob Walker, Because Optimism is Essential, Inc. magazine, April 2004 pp. 149150. Change in Fixed Cost, Sales Price, and Sales Volume Refer to the original data and recall again that Acoustic Concepts is currently selling 400 speakers per month. To increase sales, the sales manager would like to cut the selling price by $20 per speaker and increase the advertising budget by $15,000 per month. The sales manager believes that if these two steps are taken, unit sales will increase by 50% to 600 speakers per month. Should the changes be made? A decrease in the selling price of $20 per speaker would decrease the unit contribution margin by $20 down to $80. Solution Expected total contribution margin with lower selling price: 600 speakers $80 per speaker . . . . . . . . . . . . . . . . . Present total contribution margin: 400 speakers $100 per speaker . . . . . . . . . . . . . . . . $48,000 40,000 Incremental contribution margin . . . . . . . . . . . . . . . . . . . . Change in xed expenses: Less incremental advertising expense . . . . . . . . . . . . . . 8,000 15,000 Reduction in net operating income . . . . . . . . . . . . . . . . . . $ (7,000) According to this analysis, the changes should not be made. The $7,000 reduction in net operating income that is shown above can be veried by preparing comparative income statements as follows: Present 400 Speakers per Month Expected 600 Speakers per Month Total Per Unit Total Per Unit Difference Sales . . . . . . . . . . . . . . . Variable expenses . . . . . $100,000 60,000 $250 150 $138,000 90,000 $230 150 $38,000 30,000 Contribution margin . . . . Fixed expenses . . . . . . . 40,000 35,000 $100 $ 80 8,000 15,000 Net operating income (loss) $ *35,000 5,000 48,000 50,000* $ (2,000) Additional monthly advertising budget of $15,000 $ (7,000) $50,000. gar79611_ch06_233-278.indd Page 245 12/15/08 11:33:23 PM user-s176 /broker/MH-BURR/MHBR094/MHBR094-06/MHBR094-06 Cost-Volume-Prot Relationships IN BUSINESS DELTA ATTEMPTS TO BOOST TICKET SALES The United States Transportation Department ranked the Cincinnati/Northern Kentucky International Airport (CNK) as the second most expensive airport in the country. Because of its high ticket prices, CNK airport ofcials estimated that they were losing 28% of Cincinnati-area travelersabout 2,500 people per dayto ve surrounding airports that offered lower fares. Delta Airlines, which has 90% of the trafc at CNK, attempted to improve the situation by introducing SimpliFares. The program, which Delta touted with a $2 million media campaign, not only lowered fares but also reduced the ticket change fee from $100 to $50. From a cost-volume-prot standpoint, Delta was hoping that the increase in discretionary xed advertising costs and the decrease in sales revenue realized from lower ticket prices would be more than offset by an increase in sales volume. Source: James Pilcher, New Delta Fares Boost Ticket Sales, The Cincinnati Enquirer, September 3, 2004, pp. A1 and A12. Change in Variable Cost, Fixed Cost, and Sales Volume Refer to Acoustic Concepts original data. As before, the company is currently selling 400 speakers per month. The sales manager would like to pay salespersons a sales commission of $15 per speaker sold, rather than the at salaries that now total $6,000 per month. The sales manager is condent that the change would increase monthly sales by 15% to 460 speakers per month. Should the change be made? Solution Changing the sales staffs compensation from salaries to commissions would affect both xed and variable expenses. Fixed expenses would decrease by $6,000, from $35,000 to $29,000. Variable expenses per unit would increase by $15, from $150 to $165, and the unit contribution margin would decrease from $100 to $85. Expected total contribution margin with sales staff on commissions: 460 speakers $85 per speaker . . . . . . . . . . . . . . . . . . $39,100 Present total contribution margin: 400 speakers $100 per speaker . . . . . . . . . . . . . . . . . 40,000 Decrease in total contribution margin . . . . . . . . . . . . . . . . . Change in xed expenses: Add salaries avoided if a commission is paid . . . . . . . . . 6,000 Increase in net operating income . . . . . . . . . . . . . . . . . . . . $ 5,100 (900) According to this analysis, the changes should be made. Again, the same answer can be obtained by preparing comparative income statements: Present 400 Speakers per Month Expected 460 Speakers per Month Total Per Unit Total Per Unit Sales. . . . . . . . . . . . . . . . Variable expenses . . . . . . $100,000 60,000 $250 150 $115,000 75,900 $250 165 Contribution margin. . . . . Fixed expenses . . . . . . . . 40,000 35,000 $100 39,100 29,000 $ 85 Net operating income . . . $ 5,000 245 $ 10,100 Difference $15,000 15,900 900 (6,000)* $ 5,100 *Note: A reduction in xed expenses has the effect of increasing net operating income. gar79611_ch06_233-278.indd gar79611_ch06_233-278.indd Page 246 12/15/08 11:33:24 PM user-s176 246 /broker/MH-BURR/MHBR094/MHBR094-06/MHBR094-06 Chapter 6 Change in Selling Price Refer to the original data where Acoustic Concepts is currently selling 400 speakers per month. The company has an opportunity to make a bulk sale of 150 speakers to a wholesaler if an acceptable price can be negotiated. This sale would not disturb the companys regular sales and would not affect the companys total xed expenses. What price per speaker should be quoted to the wholesaler if Acoustic Concepts wants to increase its total monthly prots by $3,000? Solution Variable cost per speaker . . . . . . . Desired prot per speaker: $3,000 150 speakers . . . . . . . $150 Quoted price per speaker. . . . . . . . $170 20 Notice that xed expenses are not included in the computation. This is because xed expenses are not affected by the bulk sale, so all of the additional contribution margin increases the companys prots. Target Prot and Break-Even Analysis Target prot analysis and break-even analysis are used to answer questions such as how much would we have to sell to make a prot of $10,000 per month or how much would we have to sell to avoid incurring a loss? Target Prot Analysis L EARNING OBJECTIVE 5 Determine the level of sales needed to achieve a desired target prot. One of the key uses of CVP analysis is called target prot analysis. In target prot analysis, we estimate what sales volume is needed to achieve a specic target prot. For example, suppose that Prem Narayan of Acoustic Concepts would like to know what sales would have to be to attain a target prot of $40,000 per month. To answer this question, we can proceed using the equation method or the formula method. The Equation Method We can use a basic prot equation to nd the sales volume required to attain a target prot. In the case of Acoustic Concepts, the company has only one product so we can use the contribution margin form of the equation. Remembering that the target prot is $40,000, the unit contribution margin is $100, and the xed expense is $35,000, we can solve as follows: Prot $40,000 $100 Unit CM $100 Q Q $40,000 Q ($40,000 Q Q Fixed expense $35,000 $35,000 750 $35,000) $100 Thus, the target prot can be achieved by selling 750 speakers per month. The Formula Method The formula method is a short-cut version of the equation method. Note that in the next to the last line of the above solution, the sum of the target profit of $40,000 and the fixed expense of $35,000 is divided by the unit contribution margin of $100. In general, in a single-product situation, we can compute gar79611_ch06_233-278.indd gar79611_ch06_233-278.indd Page 247 12/16/08 12:18:46 AM user-s176 /broker/MH-BURR/MHBR094/MHBR094-06/MHBR094-06 Cost-Volume-Prot Relationships the sales volume required to attain a specific target profit using the following formula: Target prot Fixed expenses2 Unit CM Unit sales to attain the target prot In the case of Acoustic Concepts, the formula yields the following answer: Unit sales to attain the target prot Target prot Fixed expenses Unit CM $40,000 $35,000 $100 750 Note that this is the same answer we got when we used the equation methodand it always will be. The formula method simply skips a few steps in the equation method. Target Prot Analysis in Terms of Sales Dollars Instead of unit sales, we may want to know what dollar sales are needed to attain the target prot. We can get this answer using several methods. First, we could solve for the unit sales to attain the target prot using the equation method or the formula method and then multiply the result by the selling price. In the case of Acoustic Concepts, the required sales volume using this approach would be computed as 750 speakers $250 per speaker or $187,500 in total sales. We can also solve for the required sales volume to attain the target prot of $40,000 at Acoustic Concepts using the basic equation stated in terms of the contribution margin ratio: Prot $40,000 0.40 CM ratio 0.40 Sales Sales Sales $40,000 Sales ($40,000 Sales Fixed expenses $35,000 $35,000 $187,500 $35,000) 0.40 Note that in the next to the last line of the above solution, the sum of the target prot of $40,000 and the xed expense of $35,000 is divided by the contribution margin ratio of 0.40. In general, we can compute dollar sales to attain a target prot as follows: Dollar sales to attain a target prot 2 3 Target prot Fixed expenses3 CM ratio This equation can be derived as follows: Prot Unit CM Q Fixed expenses Target prot Unit CM Q Fixed expenses Unit CM Q Target prot Fixed expenses Q (Target prot Fixed expenses) Unit CM This equation can be derived as follows: Prot CM ratio Sales Fixed expenses Target prot CM ratio Sales Fixed expenses CM ratio Sales Target prot Fixed expenses Sales (Target prot Fixed expenses) CM ratio 247 gar79611_ch06_233-278.indd gar79611_ch06_233-278.indd Page 248 12/15/08 11:33:25 PM user-s176 248 /broker/MH-BURR/MHBR094/MHBR094-06/MHBR094-06 Chapter 6 At Acoustic Concepts, the formula yields the following answer: Dollar sales to attain a target prot Target prot Fixed expenses CM ratio $40,000 $35,000 $0.40 $187,500 Again, you get exactly the same answer whether you use the equation method or just use the formula. In companies with multiple products, sales volume is more conveniently expressed in terms of total sales dollars than in terms of unit sales. The contribution margin ratio approach to target prot analysis is particularly useful for such companies. Break-Even Analysis L EARNING OBJECTIVE 6 Determine the break-even point. Earlier in the chapter we dened the break-even point as the level of sales at which the companys prot is zero. What we call break-even analysis is really just a special case of target prot analysis in which the target prot is zero. We can use either the equation method or the formula method to solve for the break-even point, but for brevity we will illustrate just the formula method. The equation method works exactly like it did in target prot analysis. The only difference is that the target prot is zero in break-even analysis. Break-Even in Unit Sales In a single product situation, recall that the formula for the unit sales to attain a specic target prot is: Unit sales to attain the target prot Target prot Fixed expenses Unit CM To compute the unit sales to break even, all we have to do is to set the target prot to zero in the above equation as follows: Unit sales to break even Unit sales to break even $0 Fixed expenses Unit CM Fixed expenses Unit CM In the case of Acoustic Concepts, the break-even point can be computed as follows: Unit sales to break even Fixed expenses Unit CM $35,000 $100 350 Thus, as we determined earlier in the chapter, Acoustic Concepts breaks even at sales of 350 speakers per month. IN BUSINESS COSTS ON THE INTERNET The company eToys, which sells toys over the Internet, lost $190 million in 1999 on sales of $151 million. One big cost was advertising. eToys spent about $37 on advertising for each $100 of sales. (Other e-tailers were spending even morein some cases, up to $460 on advertising for each $100 in sales!) gar79611_ch06_233-278.indd gar79611_ch06_233-278.indd Page 249 12/15/08 11:33:26 PM user-s176 /broker/MH-BURR/MHBR094/MHBR094-06/MHBR094-06 Cost-Volume-Prot Relationships 249 eToys did have some advantages relative to bricks-and-mortar stores such as Toys R Us. eToys had much lower inventory costs because it only needed to keep on hand one or two of a slowmoving item, whereas a traditional store has to fully stock its shelves. And bricks-and-mortar retail spaces in malls and elsewhere do cost moneyon average, about 7% of sales. However, e-tailers such as eToys have their own set of disadvantages. Customers pick and pack their own items at a bricks-and-mortar outlet, but e-tailers have to pay employees to carry out this task. This costs eToys about $33 for every $100 in sales. And the technology to sell over the Internet is not free. eToys spent about $29 on its website and related technology for every $100 in sales. However, many of these costs of selling over the Internet are xed. Toby Lenk, the CEO of eToys, estimated that the company would pass its break-even point somewhere between $750 and $900 million in salesrepresenting less than 1% of the market for toys. eToys did not make this goal and laid off 70% of its employees in January 2001. Subsequently, eToys was acquired by KBToys.com. Sources: Erin Kelly, The Last e-Store on the Block, Fortune, September 18, 2000, pp. 214220; Jennifer Couzin, The Industry Standard, January 4, 2001. Break-Even in Sales Dollars We can nd the break-even point in sales dollars using several methods. First, we could solve for the break-even point in unit sales using the equation method or the formula method and then multiply the result by the selling price. In the case of Acoustic Concepts, the break-even point in sales dollars using this approach would be computed as 350 speakers $250 per speaker or $87,500 in total sales. We can also solve for the break-even point in sales dollars at Acoustic Concepts using the basic prot equation stated in terms of the contribution margin ratio or we can use the formula for the target prot. Again, for brevity, we will use the formula. Dollar sales to attain a target prot Dollar sales to break even Dollar sales to break even Target prot Fixed expenses CM ratio $0 Fixed expenses CM ratio Fixed expenses CM ratio The break-even point at Acoustic Concepts would be computed as follows: Dollar sales to break even Fixed expenses CM ratio $35,000 0.40 $87,500 COST OVERRUNS INCREASE THE BREAK-EVEN POINT When Airbus launched the A380 555-seat jetliner in 2000 the company said it would need to sell 250 units to break even on the project. By 2006, Airbus was admitting that more than $3 billion of cost overruns had raised the projects break-even point to 420 airplanes. Although Airbus has less than 170 orders for the A380, the company remains optimistic that it will sell 751 units over the next 20 years. Given that Airbus rival Boeing predicts the total market size for all airplanes with more than 400 seats will not exceed 990 units, it remains unclear if Airbus will ever break even on its investment in the A380 aircraft. Source: Daniel Michaels, Embattled Airbus Lifts Sales Target for A380 to Prot, The Wall Street Journal, October 20, 2006, p. A6. IN BUSINESS gar79611_ch06_233-278.indd Page 250 1/6/09 2:49:04 PM user-s176 250 /broker/MH-BURR/MHBR094/MHBR094-06/upload/MHBR094-06 Chapter 6 The Margin of Safety L EARNING OBJECTIVE 7 Compute the margin of safety and explain its signicance. The margin of safety is the excess of budgeted (or actual) sales dollars over the breakeven volume of sales dollars. It is the amount by which sales can drop before losses are incurred. The higher the margin of safety, the lower the risk of not breaking even and incurring a loss. The formula for the margin of safety is: Margin of safety in dollars Total budgeted (or actual) sales Break-even sales The margin of safety can also be expressed in percentage form by dividing the margin of safety in dollars by total dollar sales: Margin of safety percentage Margin of safety in dollars Total budgeted (or actual) sales in dollars The calculation of the margin of safety for Acoustic Concepts is: Sales (at the current volume of 400 speakers) (a) . . . . . . . . . Break-even sales (at 350 speakers). . . . . . . . . . . . . . . . . . . . $100,000 87,500 Margin of safety in dollars (b) . . . . . . . . . . . . . . . . . . . . . . . . . $ 12,500 Margin of safety percentage, (b) (a) . . . . . . . . . . . . . . . . . . 12.5% This margin of safety means that at the current level of sales and with the companys current prices and cost structure, a reduction in sales of $12,500, or 12.5%, would result in just breaking even. In a single-product company like Acoustic Concepts, the margin of safety can also be expressed in terms of the number of units sold by dividing the margin of safety in dollars by the selling price per unit. In this case, the margin of safety is 50 speakers ($12,500 $250 per speaker 50 speakers). IN BUSINESS COMPUTING MARGIN OF SAFETY FOR A SMALL BUSINESS Sam Calagione owns Dogsh Head Craft Brewery, a microbrewery in Rehobeth Beach, Delaware. He charges distributors as much as $100 per case for his premium beers such as World Wide Stout. The high-priced microbrews bring in $800,000 in operating income on revenue of $7 million. Calagione reports that his raw ingredients and labor costs for one case of World Wide Stout are $30 and $16, respectively. Bottling and packaging costs are $6 per case. Gas and electric costs are about $10 per case. If we assume that World Wide Stout is representative of all Dogsh microbrews, then we can compute the companys margin of safety in ve steps. First, variable cost as a percentage of sales is 62% [($30 $16 $6 $10)/$100]. Second, the contribution margin ratio is 38% (1 0.62). Third, Dogshs total xed cost is $1,860,000 [($7,000,000 0.38) $800,000]. Fourth, the break-even point in sales dollars is $4,894,737 ($1,860,000/0.38). Fifth, the margin of safety is $2,105,263 ($7,000,000 $4,894,737). Source: Patricia Huang, Chteau Dogsh, Forbes, February 28, 2005, pp. 5759. M ANAGERIAL ACCOUNTING IN ACTION The Wrap-up Prem Narayan and Bob Luchinni met to discuss the results of Bobs analysis. Prem: Bob, everything you have shown me is pretty clear. I can see what impact some of the sales managers suggestions would have on our prots. Some of those suggestions gar79611_ch06_233-278.indd gar79611_ch06_233-278.indd Page 251 12/31/08 4:27:16 PM user-s180 /broker/MH-BURR/MHBR094/MHBR094-06/upload Cost-Volume-Prot Relationships are quite good and others are not so good. I am concerned that our margin of safety is only 50 speakers. What can we do to increase this number? Bob: Well, we have to increase total sales or decrease the break-even point or both. Prem: And to decrease the break-even point, we have to either decrease our xed expenses or increase our unit contribution margin? Bob: Exactly. Prem: And to increase our unit contribution margin, we must either increase our selling price or decrease the variable cost per unit? Bob: Correct. Prem: So what do you suggest? Bob: Well, the analysis doesnt tell us which of these to do, but it does indicate we have a potential problem here. Prem: If you dont have any immediate suggestions, I would like to call a general meeting next week to discuss ways we can work on increasing the margin of safety. I think everyone will be concerned about how vulnerable we are to even small downturns in sales. CVP Considerations in Choosing a Cost Structure Cost structure refers to the relative proportion of xed and variable costs in an organization. Managers often have some latitude in trading off between these two types of costs. For example, xed investments in automated equipment can reduce variable labor costs. In this section, we discuss the choice of a cost structure. We also introduce the concept of operating leverage. Cost Structure and Prot Stability Which cost structure is betterhigh variable costs and low xed costs, or the opposite? No single answer to this question is possible; each approach has its advantages. To show what we mean, refer to the contribution format income statements given below for two blueberry farms. Bogside Farm depends on migrant workers to pick its berries by hand, whereas Sterling Farm has invested in expensive berry-picking machines. Consequently, Bogside Farm has higher variable costs, but Sterling Farm has higher xed costs: Bogside Farm Sterling Farm Amount Percent Amount Percent Sales . . . . . . . . . . . . . . . . . . . Variable expenses . . . . . . . . . $100,000 60,000 100% 60% $100,000 30,000 100% 30% Contribution margin . . . . . . . . Fixed expenses . . . . . . . . . . . 40,000 30,000 40% 70,000 60,000 70% Net operating income . . . . . . . $ 10,000 $ 10,000 Which farm has the better cost structure? The answer depends on many factors, including the long-run trend in sales, year-to-year uctuations in the level of sales, and the attitude of the owners toward risk. If sales are expected to exceed $100,000 in the future, then Sterling Farm probably has the better cost structure. The reason is that its CM ratio is higher, and its prots will therefore increase more rapidly as sales increase. 251 gar79611_ch06_233-278.indd gar79611_ch06_233-278.indd Page 252 12/15/08 11:33:28 PM user-s176 252 /broker/MH-BURR/MHBR094/MHBR094-06/MHBR094-06 Chapter 6 To illustrate, assume that each farm experiences a 10% increase in sales without any increase in xed costs. The new income statements would be as follows: Bogside Farm Sterling Farm Amount Percent Amount Percent Sales . . . . . . . . . . . . . . . . . . . Variable expenses . . . . . . . . . $110,000 66,000 100% 60% $110,000 33,000 100% 30% Contribution margin . . . . . . . . Fixed expenses . . . . . . . . . . . 44,000 30,000 40% 77,000 60,000 70% Net operating income . . . . . . . $ 14,000 $ 17,000 Sterling Farm has experienced a greater increase in net operating income due to its higher CM ratio even though the increase in sales was the same for both farms. What if sales drop below $100,000? What are the farms break-even points? What are their margins of safety? The computations needed to answer these questions are shown below using the contribution margin method: Bogside Farm Sterling Farm Fixed expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Contribution margin ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 30,000 0.40 $ 60,000 0.70 Dollar sales to break even . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 75,000 $ 85,714 Total current sales (a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Break-even sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100,000 75,000 $100,000 85,714 Margin of safety in sales dollars (b) . . . . . . . . . . . . . . . . . . . . $ 25,000 $ 14,286 25.0% 14.3% Margin of safety percentage (b) (a) . . . . . . . . . . . . . . . . . . Bogside Farms margin of safety is greater and its contribution margin ratio is lower than Sterling Farm. Therefore, Bogside Farm is less vulnerable to downturns than Sterling Farm. Due to its lower contribution margin ratio, Bogside Farm will not lose contribution margin as rapidly as Sterling Farm when sales decline. Thus, Bogside Farms prot will be less volatile. We saw earlier that this is a drawback when sales increase, but it provides more protection when sales drop. And because its break-even point is lower, Bogside Farm can suffer a larger sales decline before losses emerge. To summarize, without knowing the future, it is not obvious which cost structure is better. Both have advantages and disadvantages. Sterling Farm, with its higher xed costs and lower variable costs, will experience wider swings in net operating income as sales uctuate, with greater prots in good years and greater losses in bad years. Bogside Farm, with its lower xed costs and higher variable costs, will enjoy greater prot stability and will be more protected from losses during bad years, but at the cost of lower net operating income in good years. gar79611_ch06_233-278.indd gar79611_ch06_233-278.indd Page 253 12/15/08 11:33:28 PM user-s176 /broker/MH-BURR/MHBR094/MHBR094-06/MHBR094-06 253 Cost-Volume-Prot Relationships IN BUSINESS A LOSING COST STRUCTURE Both JetBlue and United Airlines use an Airbus 235 to y from Dulles International Airport near Washington, DC, to Oakland, California. Both planes have a pilot, copilot, and four ight attendants. That is where the similarity ends. Based on 2002 data, the pilot on the United ight earned $16,350 to $18,000 a month compared to $6,800 per month for the JetBlue pilot. Uniteds senior ight attendants on the plane earned more than $41,000 per year; whereas the JetBlue attendants were paid $16,800 to $27,000 per year. Largely because of the higher labor costs at United, its costs of operating the ight were more than 60% higher than JetBlues costs. Due to intense fare competition from JetBlue and other low-cost carriers, United was unable to cover its higher operating costs on this and many other ights. Consequently, United went into bankruptcy at the end of 2002. Source: Susan Carey, Costly Race in the Sky, The Wall Street Journal, September 9, 2002, pp. B1 and B3. Operating Leverage A lever is a tool for multiplying force. Using a lever, a massive object can be moved with only a modest amount of force. In business, operating leverage serves a similar purpose. Operating leverage is a measure of how sensitive net operating income is to a given percentage change in dollar sales. Operating leverage acts as a multiplier. If operating leverage is high, a small percentage increase in sales can produce a much larger percentage increase in net operating income. Operating leverage can be illustrated by returning to the data for the two blueberry farms. We previously showed that a 10% increase in sales (from $100,000 to $110,000 in each farm) results in a 70% increase in the net operating income of Sterling Farm (from $10,000 to $17,000) and only a 40% increase in the net operating income of Bogside Farm (from $10,000 to $14,000). Thus, for a 10% increase in sales, Sterling Farm experiences a much greater percentage increase in prots than does Bogside Farm. Therefore, Sterling Farm has greater operating leverage than Bogside Farm. The degree of operating leverage at a given level of sales is computed by the following formula: Degree of operating leverage Contribution margin Net operating income The degree of operating leverage is a measure, at a given level of sales, of how a percentage change in sales volume will affect prots. To illustrate, the degree of operating leverage for the two farms at $100,000 sales would be computed as follows: Bogside Farm: $40,000 $10,000 4 Sterling Farm: $70,000 $10,000 7 Because the degree of operating leverage for Bogside Farm is 4, the farms net operating income grows four times as fast as its sales. In contrast, Sterling Farms net operating income grows seven times as fast as its sales. Thus, if sales increase by 10%, then we can expect the net operating income of Bogside Farm to increase by four times this amount, or by 40%, and the net operating income of Sterling Farm to increase by seven times this amount, or by 70%. L EARNING OBJECTIVE 8 Compute the degree of operating leverage at a particular level of sales and explain how it can be used to predict changes in net operating income. gar79611_ch06_233-278.indd gar79611_ch06_233-278.indd Page 254 12/15/08 11:33:29 PM user-s176 254 /broker/MH-BURR/MHBR094/MHBR094-06/MHBR094-06 Chapter 6 Percent Increase in Sales (1) Bogside Farm . . . . . . . Sterling Farm . . . . . . . Degree of Operating Leverage (2) Percent Increase in Net Operating Income (1) (2) 10% 10% 4 7 40% 70% What is responsible for the higher operating leverage at Sterling Farm? The only difference between the two farms is their cost structure. If two companies have the same total revenue and same total expense but different cost structures, then the company with the higher proportion of xed costs in its cost structure will have higher operating leverage. Referring back to the original example on page 251, when both farms have sales of $100,000 and total expenses of $90,000, one-third of Bogside Farms costs are xed but two-thirds of Sterling Farms costs are xed. As a consequence, Sterlings degree of operating leverage is higher than Bogsides. The degree of operating leverage is not a constant; it is greatest at sales levels near the break-even point and decreases as sales and prots rise. The following table shows the degree of operating leverage for Bogside Farm at various sales levels. (Data used earlier for Bogside Farm are shown in color.) Sales . . . . . . . . . . . . . . . . . . . $75,000 Variable expenses . . . . . . . . . 45,000 Contribution margin (a). . . . . . Fixed expenses . . . . . . . . . . . Net operating income (b) . . . . $ Degree of operating leverage, (a) (b) . . . . . . . . . . . . . . . 30,000 30,000 0 $80,000 $100,000 $150,000 $225,000 48,000 60,000 90,000 135,000 32,000 30,000 40,000 30,000 60,000 30,000 90,000 30,000 $ 2,000 $ 10,000 $ 30,000 $ 60,000 16 4 2 1.5 Thus, a 10% increase in sales would increase prots by only 15% (10% 1.5) if sales were previously $225,000, as compared to the 40% increase we computed earlier at the $100,000 sales level. The degree of operating leverage will continue to decrease the farther the company moves from its break-even point. At the break-even point, the degree of operating lever). age is innitely large ($30,000 contribution margin $0 net operating income IN BUSINESS OPERATING LEVERAGE: A KEY TO PROFITABLE E-COMMERCE Did you ever wonder why Expedia and eBay were among the rst Internet companies to become protable? One big reason is because they sell information products rather than physical products. For example, when somebody buys a physical product, such as a book from Amazon.com, the company needs to purchase a copy of the book from the publisher, process it, and ship it; hence, Amazon.coms gross margins are around 26%. However, once Expedia covers its xed overhead costs, the extra expense incurred to provide service to one more customer is practically zero; therefore, the incremental revenue provided by that customer falls to the bottom line. In the rst quarter of 2002, Expedia doubled its sales to $116 million and reported net income of $5.7 million compared to a loss of $17.6 million in the rst quarter of 2001. This is the beauty of having a high degree of operating leverage. Sales growth can quickly translate to prot growth when variable costs are negligible. Of course, operating leverage has a dark sideif Expedias sales plummet, its prots will nosedive as well. Source: Timothy J. Mullaney and Robert D. Hof, Finally, the Pot of Gold, BusinessWeek, June 24, 2002, pp. 104106. gar79611_ch06_233-278.indd gar79611_ch06_233-278.indd Page 255 12/15/08 11:33:30 PM user-s176 /broker/MH-BURR/MHBR094/MHBR094-06/MHBR094-06 255 Cost-Volume-Prot Relationships The degree of operating leverage can be used to quickly estimate what impact various percentage changes in sales will have on prots, without the necessity of preparing detailed income statements. As shown by our examples, the effects of operating leverage can be dramatic. If a company is near its break-even point, then even small percentage increases in sales can yield large percentage increases in prots. This explains why management will often work very hard for only a small increase in sales volume. If the degree of operating leverage is 5, then a 6% increase in sales would translate into a 30% increase in prots. Structuring Sales Commissions Companies usually compensate salespeople by paying them a commission based on sales, a salary, or a combination of the two. Commissions based on sales dollars can lead to lower prots. To illustrate, consider Pipeline Unlimited, a producer of surng equipment. Salespersons sell the companys products to retail sporting goods stores throughout North America and the Pacic Basin. Data for two of the companys surfboards, the XR7 and Turbo models, appear below: Model XR7 Turbo Selling price . . . . . . . . . . . . . Variable expenses . . . . . . . . $695 344 $749 410 Contribution margin . . . . . . . $351 $339 Which model will salespeople push hardest if they are paid a commission of 10% of sales revenue? The answer is the Turbo because it has the higher selling price and hence the larger commission. On the other hand, from the standpoint of the company, prots will be greater if salespeople steer customers toward the XR7 model because it has the higher contribution margin. To eliminate such conicts, commissions can be based on contribution margin rather than on selling price. If this is done, the salespersons will want to sell the mix of products that maximizes contribution margin. Providing that xed costs are not affected by the sales mix, maximizing the contribution margin will also maximize the companys prot.4 In effect, by maximizing their own compensation, salespersons will also maximize the companys prot. AN ALTERNATIVE APPROACH TO SALES COMMISSIONS Thrive Networks, located in Concord, Massachusetts, used to pay its three salesmen based on individually earned commissions. This system seemed to be working ne as indicated by the companys sales growth from $2.7 million in 2002 to $3.6 million in 2003. However, the company felt there was a better way to motivate and compensate its salesmen. It pooled commissions across the three salesmen and compensated them collectively. The new approach was designed to build teamwork and leverage each salesmans individual strengths. Jim Lippie, the director of business development, was highly skilled at networking and generating sales leads. John Barrows, the sales director, excelled at meeting with prospective clients and producing compelling proposals. Nate Wolfson, the CEO and nal member of the sales team, was the master at closing the deal. The new approach has worked so well that Wolfson plans to use three-person sales teams in his ofces nationwide. Source: Cara Cannella, Kill the Commissions, Inc. magazine, August 2004, p. 38. 4 This also assumes the company has no production constraint. If it does, the sales commissions should be modied. See the Protability Appendix at the end of the book. IN BUSINESS gar79611_ch06_233-278.indd gar79611_ch06_233-278.indd Page 256 12/15/08 11:33:30 PM user-s176 256 /broker/MH-BURR/MHBR094/MHBR094-06/MHBR094-06 Chapter 6 Sales Mix L EARNING OBJECTIVE 9 Compute the break-even point for a multiproduct company and explain the effects of shifts in the sales mix on contribution margin and the break-even point. IN BUSINESS Before concluding our discussion of CVP concepts, we need to consider the impact of changes in sales mix on a companys prot. The Denition of Sales Mix The term sales mix refers to the relative proportions in which a companys products are sold. The idea is to achieve the combination, or mix, that will yield the greatest amount of prots. Most companies have many products, and often these products are not equally protable. Hence, prots will depend to some extent on the companys sales mix. Prots will be greater if high-margin rather than low-margin items make up a relatively large proportion of total sales. Changes in the sales mix can cause perplexing variations in a companys prots. A shift in the sales mix from high-margin items to low-margin items can cause total prots to decrease even though total sales may increase. Conversely, a shift in the sales mix from low-margin items to high-margin items can cause the reverse effecttotal prots may increase even though total sales decrease. It is one thing to achieve a particular sales volume; it is quite another to sell the most protable mix of products. WAL-MART ATTEMPTS TO SHIFT ITS SALES MIX Almost 130 million customers shop at Wal-Marts 3,200 U.S. stores each week. However, less than half of them shop the whole storechoosing to buy only low-margin basics while skipping highermargin departments such as apparel. In an effort to shift its sales mix toward higher-margin merchandise, Wal-Mart has reduced spending on advertising and plowed the money into remodeling the clothing departments within its stores. The company hopes this remodeling effort will entice its customers to add clothing to their shopping lists while bypassing the apparel offerings of competitors such as Kohls and Target. Source: Robert Berner, Fashion Emergency at Wal-Mart, BusinessWeek, July 31, 2006, p. 67. Sales Mix and Break-Even Analysis If a company sells more than one product, break-even analysis is more complex than discussed to this point. The reason is that different products will have different selling prices, different costs, and different contribution margins. Consequently, the break-even point depends on the mix in which the various products are sold. To illustrate, consider Virtual Journeys Unlimited, a small company that imports DVDs from France. At present, the company sells two DVDs: the Le Louvre DVD, a tour of the famous art museum in Paris; and the Le Vin DVD, which features the wines and wine-growing regions of France. The companys September sales, expenses, and break-even point are shown in Exhibit 64. As shown in the exhibit, the break-even point is $60,000 in sales, which was computed by dividing the companys xed expenses of $27,000 by its overall CM ratio of 45%. However, this is the break-even only if the companys sales mix does not change. Currently, the Le Louvre DVD is responsible for 20% and the Le Vin DVD for 80% of the companys dollar sales. Assuming this sales mix does not change, if total sales are $60,000, the sales of the Le Louvre DVD would be $12,000 (20% of $60,000) and the sales of the Le Vin DVD would be $48,000 (80% of $60,000). As shown in Exhibit 64, at these levels of sales, the company would indeed break even. But $60,000 in sales represents the break-even point for the company only if the sales mix does not change. If the sales mix changes, then the break-even point will also usually change. This is illustrated by the results for October in which the sales mix shifted away from the more protable Le Vin DVD (which has a 50% CM ratio) toward the less protable Le Louvre CD (which has a 25% CM ratio). These results appear in Exhibit 65. gar79611_ch06_233-278.indd gar79611_ch06_233-278.indd Page 257 12/15/08 11:33:31 PM user-s176 /broker/MH-BURR/MHBR094/MHBR094-06/MHBR094-06 257 Cost-Volume-Prot Relationships E X H I B I T 64 Multiproduct Break-Even Analysis Virtual Journeys Unlimited Contribution Income Statement For the Month of September Le Louvre DVD Sales . . . . . . . . . . . . . . . . . . . . . . . . Variable expenses . . . . . . . . . . . . . . Contribution margin . . . . . . . . . . . . . Fixed expenses . . . . . . . . . . . . . . . . Le Vin DVD Amount $20,000 15,000 Percent 100% 75% Amount $80,000 40,000 Percent 100% 50% $ 5,000 25% $40,000 Total 50% Net operating income . . . . . . . . . . . . Amount $100,000 55,000 45,000 27,000 Percent 100% 55% 45% $ 18,000 Computation of the break-even point: $27,000 0.45 Fixed expenses Overall CM ratio $60,000 Verication of the break-even point: Current dollar sales . . . . . . . . . . . . . Percentage of total dollar sales . . . . Le Louvre DVD $20,000 20% Sales at the break-even point . . . . . $12,000 Le Vin DVD $80,000 80% $48,000 Le Louvre DVD Sales . . . . . . . . . . . . . . . . . . . . . . . . Variable expenses . . . . . . . . . . . . . . Contribution margin . . . . . . . . . . . . . Fixed expenses . . . . . . . . . . . . . . . . Total $100,000 100% $60,000 Le Vin DVD Amount $12,000 9,000 Percent 100% 75% Amount $48,000 24,000 Percent 100% 50% $ 3,000 25% $24,000 Total 50% Net operating income . . . . . . . . . . . . Amount $ 60,000 33,000 27,000 27,000 $ Percent 100% 55% 45% 0 E X H I B I T 65 Multiproduct Break-Even Analysis: A Shift in Sales Mix (see Exhibit 64) Virtual Journeys Unlimited Contribution Income Statement For the Month of October Le Louvre DVD Sales . . . . . . . . . . . . . . . . . . . . . . . . Variable expenses . . . . . . . . . . . . . . Contribution margin . . . . . . . . . . . . . Fixed expenses . . . . . . . . . . . . . . . . Le Vin DVD Amount $80,000 60,000 Percent 100% 75% Amount $20,000 10,000 Percent 100% 50% $20,000 25% $10,000 Total 50% Net operating income . . . . . . . . . . . . Amount $100,000 70,000 30,000 27,000 $ Computation of the break-even point: Fixed expenses Overall CM ratio $27,000 0.30 $90,000 3,000 Percent 100% 70% 30% gar79611_ch06_233-278.indd gar79611_ch06_233-278.indd Page 258 12/15/08 11:33:32 PM user-s176 258 /broker/MH-BURR/MHBR094/MHBR094-06/MHBR094-06 Chapter 6 Although sales have remained unchanged at $100,000, the sales mix is exactly the reverse of what it was in Exhibit 64, with the bulk of the sales now coming from the less protable Le Louvre DVD. Notice that this shift in the sales mix has caused both the overall CM ratio and total prots to drop sharply from the prior month even though total sales are the same. The overall CM ratio has dropped from 45% in September to only 30% in October, and net operating income has dropped from $18,000 to only $3,000. In addition, with the drop in the overall CM ratio, the companys break-even point is no longer $60,000 in sales. Because the company is now realizing less average contribution margin per dollar of sales, it takes more sales to cover the same amount of xed costs. Thus, the break-even point has increased from $60,000 to $90,000 in sales per year. In preparing a break-even analysis, an assumption must be made concerning the sales mix. Usually the assumption is that it will not change. However, if the sales mix is expected to change, then this must be explicitly considered in any CVP computations. IN BUSINESS PLAYING THE CVP GAME In 2002, General Motors (GM) gave away almost $2,600 per vehicle in customer incentives such as price cuts and 0% nancing. The pricing sacrices have been more than offset by volume gains, most of which have come from trucks and SUVs, like the Chevy Suburban and the GMC Envoy, which generate far more prot for the company than cars. Lehman Brothers analysts estimate that GM will sell an additional 395,000 trucks and SUVs and an extra 75,000 cars in 2002. The trucks, however, are the companys golden goose, hauling in an average [contribution margin] . . . of about $7,000, compared with just $4,000 for the cars. All told, the volume gains could bring in an additional $3 billion [in prots]. Source: Janice Revell, GMs Slow Leak, Fortune, October 28, 2002, pp. 105110. Assumptions of CVP Analysis A number of assumptions commonly underlie CVP analysis: 1. Selling price is constant. The price of a product or service will not change as volume changes. 2. Costs are linear and can be accurately divided into variable and xed elements. The variable element is constant per unit, and the xed element is constant in total over the entire relevant range. 3. In multiproduct companies, the sales mix is constant. 4. In manufacturing companies, inventories do not change. The number of units produced equals the number of units sold. While these assumptions may be violated in practice, the results of CVP analysis are often good enough to be quite useful. Perhaps the greatest danger lies in relying on simple CVP analysis when a manager is contemplating a large change in volume that lies outside of the relevant range. For example, a manager might contemplate increasing the level of sales far beyond what the company has ever experienced before. However, even in these situations the model can be adjusted as we have done in this chapter to take into account anticipated changes in selling prices, xed costs, and the sales mix that would otherwise violate the assumptions mentioned above. For example, in a decision that would affect xed costs, the change in xed costs can be explicitly taken into account as illustrated earlier in the chapter in the Acoustic Concepts example on pages 242245. gar79611_ch06_233-278.indd gar79611_ch06_233-278.indd Page 259 12/15/08 11:33:33 PM user-s176 /broker/MH-BURR/MHBR094/MHBR094-06/MHBR094-06 259 Cost-Volume-Prot Relationships Summary CVP analysis is based on a simple model of how prots respond to prices, costs, and volume. This model can be used to answer a variety of critical questions such as what is the companys breakeven volume, what is its margin of safety, and what is likely to happen if specic changes are made in prices, costs, and volume. A CVP graph depicts the relationships between unit sales on the one hand and xed expenses, variable expenses, total expenses, total sales, and prots on the other hand. The prot graph is simpler than the CVP graph and shows how prots depend on sales. The CVP and prot graphs are useful for developing intuition about how costs and prots respond to changes in sales. The contribution margin ratio is the ratio of the total contribution margin to total sales. This ratio can be used to quickly estimate what impact a change in total sales would have on net operating income. The ratio is also useful in break-even analysis. Target prot analysis is used to estimate how much sales would have to be to attain a specied target prot. The unit sales required to attain the target prot can be estimated by dividing the sum of the target prot and xed expense by the unit contribution margin. Break-even analysis is a special case of target prot analysis that is used to estimate how much sales would have to be to just break even. The unit sales required to break even can be estimated by dividing the xed expense by the unit contribution margin. The margin of safety is the amount by which the companys current sales exceeds break-even sales. The degree of operating leverage allows quick estimation of what impact a given percentage change in sales would have on the companys net operating income. The higher the degree of operating leverage, the greater is the impact on the companys prots. The degree of operating leverage is not constantit depends on the companys current level of sales. The prots of a multiproduct company are affected by its sales mix. Changes in the sales mix can affect the break-even point, margin of safety, and other critical factors. Review Problem: CVP Relationships Voltar Company manufactures and sells a specialized cordless telephone for high electromagnetic radiation environments. The companys contribution format income statement for the most recent year is given below: Total Per Unit Percent of Sales Sales (20,000 units) . . . . . . . . . . . Variable expenses . . . . . . . . . . . . $1,200,000 900,000 $60 45 100% ?% Contribution margin . . . . . . . . . . . Fixed expenses . . . . . . . . . . . . . . 300,000 240,000 $15 ?% Net operating income . . . . . . . . . . $ 60,000 Management is anxious to increase the companys prot and has asked for an analysis of a number of items. Required: 1. 2. 3. 4. 5. Compute the companys CM ratio and variable expense ratio. Compute the companys break-even point in both units and sales dollars. Use the equation method. Assume that sales increase by $400,000 next year. If cost behavior patterns remain unchanged, by how much will the companys net operating income increase? Use the CM ratio to compute your answer. Refer to the original data. Assume that next year management wants the company to earn a prot of at least $90,000. How many units will have to be sold to meet this target prot? Refer to the original data. Compute the companys margin of safety in both dollar and percentage form. gar79611_ch06_233-278.indd gar79611_ch06_233-278.indd Page 260 12/15/08 11:33:33 PM user-s176 260 /broker/MH-BURR/MHBR094/MHBR094-06/MHBR094-06 Chapter 6 6. 7. a. b. Compute the companys degree of operating leverage at the present level of sales. Assume that through a more intense effort by the sales staff, the companys sales increase by 8% next year. By what percentage would you expect net operating income to increase? Use the degree of operating leverage to obtain your Register to View AnswerVerify your answer to (b) by preparing a new contribution format income statement showing an 8% increase in sales. In an effort to increase sales and prots, management is considering the use of a higherquality speaker. The higher-quality speaker would increase variable costs by $3 per unit, but management could eliminate one quality inspector who is paid a salary of $30,000 per year. The sales manager estimates that the higher-quality speaker would increase annual sales by at least 20%. a. Assuming that changes are made as described above, prepare a projected contribution format income statement for next year. Show data on a total, per unit, and percentage basis. b. Compute the companys new break-even point in both units and dollars of sales. Use the formula method. c. Would you recommend that the changes be made? Solution to Review Problem 1. Unit contribution margin Unit selling price CM ratio Variable expense Selling price Variable expense ratio 2. Prot $0 Unit CM ($60 Q $45) $45 $60 $15 $60 25% 75% Fixed expenses Q $240,000 $15Q $240,000 Q $240,000 Q 16,000 units; or at $60 per unit, $960,000 $15 3. Increase in sales . . . . . . . . . . . . . . . . . . . . . . . . . . . Multiply by the CM ratio . . . . . . . . . . . . . . . . . . . . . . $400,000 25% Expected increase in contribution margin . . . . . . . . $100,000 Because the xed expenses are not expected to change, net operating income will increase by the entire $100,000 increase in contribution margin computed above. 4. Equation method: Prot $90,000 $15Q Unit CM ($60 Q $45) $90,000 Fixed expenses Q $240,000 $240,000 Q $330,000 Q $15 22,000 units Formula method: Unit sales to attain the target prot Target prot Fixed expenses Contribution margin per unit $90,000 $240,000 $15 per unit 22,000 units gar79611_ch06_233-278.indd gar79611_ch06_233-278.indd Page 261 12/15/08 11:33:33 PM user-s176 /broker/MH-BURR/MHBR094/MHBR094-06/MHBR094-06 Cost-Volume-Prot Relationships 5. Margin of safety in dollars Total sales Break-even sales $1,200,000 Margin of safety percentage 6. a. Degree of operating leverage $960,000 $240,000 Margin of safety in dollars Total sales Contribution margin Net operating income $240,000 $1,200,000 $300,000 $60,000 20% 5 b. Expected increase in sales . . . . . . . . . . . . . . . . . . . . . . . Degree of operating leverage . . . . . . . . . . . . . . . . . . . . . Expected increase in net operating income . . . . . . . . . . c. 8% 5 40% If sales increase by 8%, then 21,600 units (20,000 1.08 21,600) will be sold next year. The new contribution format income statement would be as follows: Total Per Unit Percent of Sales Sales (21,600 units) . . . . . . . . . . . Variable expenses . . . . . . . . . . . . $1,296,000 972,000 $60 45 100% 75% Contribution margin . . . . . . . . . . . Fixed expenses . . . . . . . . . . . . . . 324,000 240,000 $15 25% Net operating income . . . . . . . . . . $ 84,000 Thus, the $84,000 expected net operating income for next year represents a 40% increase over the $60,000 net operating income earned during the current year: $84,000 $60,000 $60,000 $24,000 $60,000 40% increase Note from the income statement above that the increase in sales from 20,000 to 21,600 units has increased both total sales and total variable expenses. 7. a. A 20% increase in sales would result in 24,000 units being sold next year: 20,000 units 1.20 24,000 units. Total Sales (24,000 units) . . . . . . . . . . . Variable expenses . . . . . . . . . . . . Per Unit Percent of Sales $1,440,000 1,152,000 $60 48* 100% 80% $12 20% Contribution margin . . . . . . . . . . . Fixed expenses . . . . . . . . . . . . . . Net operating income . . . . . . . . . . *$45 $3 $240,000 $48; $48 $30,000 288,000 210,000 $ 78,000 $60 80%. $210,000. Note that the change in per unit variable expenses results in a change in both the per unit contribution margin and the CM ratio. b. Unit sales to break even Fixed expenses Unit contribution margin $210,000 $12 per unit Dollar sales to break even 17,500 units Fixed expenses CM ratio $210,000 0.20 $1,050,000 261 gar79611_ch06_233-278.indd gar79611_ch06_233-278.indd Page 262 1/6/09 2:49:39 PM user-s176 262 /broker/MH-BURR/MHBR094/MHBR094-06/upload/MHBR094-06 Chapter 6 c. Yes, based on these data the changes should be made. The changes increase the companys net operating income from the present $60,000 to $78,000 per year. Although the changes also result in a higher break-even point (17,500 units as compared to the present 16,000 units), the companys margin of safety actually becomes greater than before: Margin of safety in dollars Total sales Break-even sales $1,440,000 $1,050,000 $390,000 As shown in (5) on the prior page, the companys present margin of safety is only $240,000. Thus, several benets will result from the proposed changes. Glossary Break-even point The level of sales at which prot is zero. (p. 236) Contribution margin ratio (CM ratio) A ratio computed by dividing contribution margin by dollar sales. (p. 241) Cost-volume-prot (CVP) graph A graphical representation of the relationships between an organizations revenues, costs, and prots on the one hand and its sales volume on the other hand. (p. 238) Degree of operating leverage A measure, at a given level of sales, of how a percentage change in sales will affect prots. The degree of operating leverage is computed by dividing contribution margin by net operating income. (p. 253) Incremental analysis An analytical approach that focuses only on those costs and revenues that change as a result of a decision. (p. 243) Margin of safety The excess of budgeted (or actual) dollar sales over the break-even dollar sales. (p. 250) Operating leverage A measure of how sensitive net operating income is to a given percentage change in dollar sales. (p. 253) Sales mix The relative proportions in which a companys products are sold. Sales mix is computed by expressing the sales of each product as a percentage of total sales. (p. 256) Target prot analysis Estimating what sales volume is needed to achieve a specic target prot. (p. 246) Variable expense ratio A ratio computed by dividing variable expenses by dollar sales (p. 242) Questions 61 62 63 64 65 66 67 68 69 What is meant by a products contribution margin ratio? How is this ratio useful in planning business operations? Often the most direct route to a business decision is an incremental analysis. What is meant by an incremental analysis? In all respects, Company A and Company B are identical except that Company As costs are mostly variable, whereas Company Bs costs are mostly xed. When sales increase, which company will tend to realize the greatest increase in prots? Explain. What is meant by the term operating leverage? What is meant by the term break-even point? In response to a request from your immediate supervisor, you have prepared a CVP graph portraying the cost and revenue characteristics of your companys product and operations. Explain how the lines on the graph and the break-even point would change if (a) the selling price per unit decreased, (b) xed cost increased throughout the entire range of activity portrayed on the graph, and (c) variable cost per unit increased. What is meant by the margin of safety? What is meant by the term sales mix? What assumption is usually made concerning sales mix in CVP analysis? Explain how a shift in the sales mix could result in both a higher break-even point and a lower net income. Multiple-choice questions are provided on the text website at www.mhhe.com/garrison13e. gar79611_ch06_233-278.indd Page 263 12/15/08 11:33:34 PM user-s176 /broker/MH-BURR/MHBR094/MHBR094-06/MHBR094-06 Cost-Volume-Prot Relationships Exercises EXERCISE 61 Preparing a Contribution Format Income Statement [LO1] Whirly Corporations most recent income statement is shown below: Total Per Unit Sales (10,000 units) . . . . . . . . . . . . Variable expenses . . . . . . . . . . . . . $350,000 200,000 $35.00 20.00 Contribution margin . . . . . . . . . . . . Fixed expenses. . . . . . . . . . . . . . . . 150,000 135,000 $15.00 Net operating income . . . . . . . . . . . $ 15,000 Required: Prepare a new contribution format income statement under each of the following conditions (consider each case independently): 1. The sales volume increases by 100 units. 2. The sales volume decreases by 100 units. 3. The sales volume is 9,000 units. EXERCISE 62 Prepare a Cost-Volume-Prot (CVP) Graph [LO2] Karlik Enterprises distributes a single product whose selling price is $24 and whose variable expense is $18 per unit. The companys monthly xed expense is $24,000. Required: 1. 2. Prepare a cost-volume-prot graph for the company up to a sales level of 8,000 units. Estimate the companys break-even point in unit sales using your cost-volume-prot graph. EXERCISE 63 Prepare a Prot Graph [LO2] Jaffre Enterprises distributes a single product whose selling price is $16 and whose variable expense is $11 per unit. The companys xed expense is $16,000 per month. Required: 1. 2. Prepare a prot graph for the company up to a sales level of 4,000 units. Estimate the companys break-even point in unit sales using your prot graph. EXERCISE 64 Computing and Using the CM Ratio [LO3] Last month when Holiday Creations, Inc., sold 50,000 units, total sales were $200,000, total variable expenses were $120,000, and xed expenses were $65,000. Required: 1. 2. What is the companys contribution margin (CM) ratio? Estimate the change in the companys net operating income if it were to increase its total sales by $1,000. EXERCISE 65 Changes in Variable Costs, Fixed Costs, Selling Price, and Volume [LO4] Data for Hermann Corporation are shown below: Per Unit Percent of Sales Selling price . . . . . . . . . . . . . . . . Variable expenses . . . . . . . . . . . $90 63 100% 70 Contribution margin . . . . . . . . . . $27 30% Fixed expenses are $30,000 per month and the company is selling 2,000 units per month. Required: 1. 2. The marketing manager argues that a $5,000 increase in the monthly advertising budget would increase monthly sales by $9,000. Should the advertising budget be increased? Refer to the original data. Management is considering using higher-quality components that would increase the variable cost by $2 per unit. The marketing manager believes the higher-quality product would increase sales by 10% per month. Should the higher-quality components be used? 263 gar79611_ch06_233-278.indd Page 264 12/24/08 5:37:59 AM user-s176 264 /broker/MH-BURR/MHBR094/MHBR094-06/upload/MHBR094-06 Chapter 6 EXERCISE 66 Compute the Level of Sales Required to Attain a Target Prot [LO5] Lin Corporation has a single product whose selling price is $120 and whose variable expense is $80 per unit. The companys monthly xed expense is $50,000. Required: 1. 2. Using the equation method, solve for the unit sales that are required to earn a target prot of $10,000. Using the formula method, solve for the unit sales that are required to earn a target prot of $15,000. EXERCISE 67 Compute the Break-Even Point [LO6] Mauro Products distributes a single product, a woven basket whose selling price is $15 and whose variable expense is $12 per unit. The companys monthly xed expense is $4,200. Required: 1. 2. 3. 4. Solve for the companys break-even point in unit sales using the equation method. Solve for the companys break-even point in sales dollars using the equation method and the CM ratio. Solve for the companys break-even point in unit sales using the formula method. Solve for the companys break-even point in sales dollars using the formula method and the CM ratio. EXERCISE 68 Compute the Margin of Safety [LO7] Molander Corporation is a distributor of a sun umbrella used at resort hotels. Data concerning the next months budget appear below: Selling price . . . . . . . Variable expenses . . Fixed expenses . . . . Unit sales . . . . . . . . . $30 per unit $20 per unit $7,500 per month 1,000 units per month Required: 1. 2. Compute the companys margin of safety. Compute the companys margin of safety as a percentage of its sales. EXERCISE 69 Compute and Use the Degree of Operating Leverage [LO8] Engberg Company installs lawn sod in home yards. The companys most recent monthly contribution format income statement follows: Amount Percent of Sales Sales. . . . . . . . . . . . . . . . . . . . Variable expenses . . . . . . . . . $80,000 32,000 100% 40% Contribution margin . . . . . . . . Fixed expenses. . . . . . . . . . . . 48,000 38,000 60% Net operating income . . . . . . . $10,000 Required: 1. 2. 3. Compute the companys degree of operating leverage. Using the degree of operating leverage, estimate the impact on net operating income of a 5% increase in sales. Verify your estimate from part (2) above by constructing a new contribution format income statement for the company assuming a 5% increase in sales. EXERCISE 610 Compute the Break-Even Point for a Multiproduct Company [LO9] Lucido Products markets two computer games: Claimjumper and Makeover. A contribution format income statement for a recent month for the two games appears on the folowing page: gar79611_ch06_233-278.indd Page 265 12/15/08 11:33:37 PM user-s176 /broker/MH-BURR/MHBR094/MHBR094-06/MHBR094-06 Cost-Volume-Prot Relationships Claimjumper Makeover Total Sales. . . . . . . . . . . . . . . . . . . . . . Variable expenses . . . . . . . . . . . $30,000 20,000 $70,000 50,000 $100,000 70,000 Contribution margin . . . . . . . . . . Fixed expenses . . . . . . . . . . . . . $10,000 $20,000 30,000 24,000 Net operating income . . . . . . . . . $ 6,000 Required: 1. 2. 3. Compute the overall contribution margin (CM) ratio for the company. Compute the overall break-even point for the company in sales dollars. Verify the overall break-even point for the company by constructing a contribution format income statement showing the appropriate levels of sales for the two products. EXERCISE 611 Using a Contribution Format Income Statement [LO1, LO4] Miller Companys most recent contribution format income statement is shown below: Total Per Unit Sales (20,000 units) . . . . . . . . . . . Variable expenses . . . . . . . . . . . . $300,000 180,000 $15.00 9.00 Contribution margin . . . . . . . . . . . Fixed expenses. . . . . . . . . . . . . . . 120,000 70,000 $ 6.00 Net operating income . . . . . . . . . . $ 50,000 Required: Prepare a new contribution format income statement under each of the following conditions (consider each case independently): 1. The number of units sold increases by 15%. 2. The selling price decreases by $1.50 per unit, and the number of units sold increases by 25%. 3. The selling price increases by $1.50 per unit, xed expenses increase by $20,000, and the number of units sold decreases by 5%. 4. The selling price increases by 12%, variable expenses increase by 60 cents per unit, and the number of units sold decreases by 10%. EXERCISE 612 Target Prot and Break-Even Analysis; Margin of Safety; CM Ratio [LO1, LO3, LO5, LO6, LO7] Menlo Company distributes a single product. The companys sales and expenses for last month follow: Total Per Unit Sales. . . . . . . . . . . . . . . . . . . . . . . . Variable expenses . . . . . . . . . . . . . $450,000 180,000 $30 12 Contribution margin . . . . . . . . . . . . Fixed expenses. . . . . . . . . . . . . . . . 270,000 216,000 $18 Net operating income . . . . . . . . . . . $ 54,000 Required: 1. 2. 3. What is the monthly break-even point in units sold and in sales dollars? Without resorting to computations, what is the total contribution margin at the break-even point? How many units would have to be sold each month to earn a target prot of $90,000? Use the formula method. Verify your answer by preparing a contribution format income statement at the target sales level. 265 gar79611_ch06_233-278.indd gar79611_ch06_233-278.indd Page 266 12/15/08 11:33:38 PM user-s176 266 /broker/MH-BURR/MHBR094/MHBR094-06/MHBR094-06 Chapter 6 4. Refer to the original data. Compute the companys margin of safety in both dollar and percentage terms. What is the companys CM ratio? If sales increase by $50,000 per month and there is no change in xed expenses, by how much would you expect monthly net operating income to increase? 5. EXERCISE 613 Target Prot and Break-Even Analysis [LO3, LO4, LO5, LO6] Lindon Company is the exclusive distributor for an automotive product that sells for $40 per unit and has a CM ratio of 30%. The companys xed expenses are $180,000 per year. The company plans to sell 16,000 units this year. Required: 1. 2. What are the variable expenses per unit? Using the equation method: a. What is the break-even point in units and sales dollars? b. What sales level in units and in sales dollars is required to earn an annual prot of $60,000? c. Assume that by using a more efcient shipper, the company is able to reduce its variable expenses by $4 per unit. What is the companys new break-even point in units and sales dollars? Repeat (2) above using the formula method. 3. EXERCISE 614 Missing Data; Basic CVP Concepts [LO1, LO9] Fill in the missing amounts in each of the eight case situations below. Each case is independent of the others. (Hint: One way to nd the missing amounts would be to prepare a contribution format income statement for each case, enter the known data, and then compute the missing items.) a. Assume that only one product is being sold in each of the four following case situations: Case Units Sold 1 2 3 4 15,000 ? 10,000 6,000 b. ..... ..... ..... ..... Sales Variable Expenses Contribution Margin per Unit Fixed Expenses Net Operating Income (Loss) $180,000 $100,000 ? $300,000 $120,000 ? $70,000 ? ? $10 $13 ? $50,000 $32,000 ? $100,000 ? $8,000 $12,000 $(10,000) Assume that more than one product is being sold in each of the four following case situations: Case Sales Variable Expenses 1 2 3 4 $500,000 $400,000 ? $600,000 ? $260,000 ? $420,000 ............. ............. ............. ............. Average Contribution Margin Ratio Fixed Expenses Net Operating Income (Loss) 20% ? 60% ? ? $100,000 $130,000 ? $7,000 ? $20,000 $(5,000) EXERCISE 615 Operating Leverage [LO4, LO8] Magic Realm, Inc., has developed a new fantasy board game. The company sold 15,000 games last year at a selling price of $20 per game. Fixed costs associated with the game total $182,000 per year, and variable costs are $6 per game. Production of the game is entrusted to a printing contractor. Variable costs consist mostly of payments to this contractor. Required: 1. Prepare a contribution format income statement for the game last year and compute the degree of operating leverage. gar79611_ch06_233-278.indd Page 267 12/15/08 11:33:39 PM user-s176 /broker/MH-BURR/MHBR094/MHBR094-06/MHBR094-06 Cost-Volume-Prot Relationships 2. Management is condent that the company can sell 18,000 games next year (an increase of 3,000 games, or 20%, over last year). Compute: a. The expected percentage increase in net operating income for next year. b. The expected total dollar net operating income for next year. (Do not prepare an income statement; use the degree of operating leverage to compute your answer.) EXERCISE 616 Target Prot and Break-Even Analysis [LO4, LO5, LO6] Outback Outtters sells recreational equipment. One of the companys products, a small camp stove, sells for $50 per unit. Variable expenses are $32 per stove, and xed expenses associated with the stove total $108,000 per month. Required: 1. 2. 3. 4. Compute the break-even point in number of stoves and in total sales dollars. If the variable expenses per stove increase as a percentage of the selling price, will it result in a higher or a lower break-even point? Why? (Assume that the xed expenses remain unchanged.) At present, the company is selling 8,000 stoves per month. The sales manager is convinced that a 10% reduction in the selling price would result in a 25% increase in monthly sales of stoves. Prepare two contribution format income statements, one under present operating conditions, and one as operations would appear after the proposed changes. Show both total and per unit data on your statements. Refer to the data in (3) above. How many stoves would have to be sold at the new selling price to yield a minimum net operating income of $35,000 per month? EXERCISE 617 Break-Even Analysis and CVP Graphing [LO2, LO4, LO6] The Hartford Symphony Guild is planning its annual dinner-dance. The dinner-dance committee has assembled the following expected costs for the event: Dinner (per person) . . . . . . . . . . . . . . . . . . . . . . . . . . Favors and program (per person) . . . . . . . . . . . . . . . . Band . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Rental of ballroom . . . . . . . . . . . . . . . . . . . . . . . . . . . Professional entertainment during intermission . . . . . Tickets and advertising . . . . . . . . . . . . . . . . . . . . . . . . $18 $2 $2,800 $900 $1,000 $1,300 The committee members would like to charge $35 per person for the evenings activities. Required: 1. 2. 3. Compute the break-even point for the dinner-dance (in terms of the number of persons who must attend). Assume that last year only 300 persons attended the dinner-dance. If the same number attend this year, what price per ticket must be charged in order to break even? Refer to the original data ($35 ticket price per person). Prepare a CVP graph for the dinnerdance from zero tickets up to 600 tickets sold. EXERCISE 618 Multiproduct Break-Even Analysis [LO9] Olongapo Sports Corporation is the distributor in the Philippines of two premium golf ballsthe Flight Dynamic and the Sure Shot. Monthly sales, expressed in pesos (P), and the contribution margin ratios for the two products follow: Product Flight Dynamic Sales . . . . . . . . . . . . CM ratio . . . . . . . . . . Sure Shot Total P150,000 80% P250,000 36% P400,000 ? Fixed expenses total P183,750 per month. Required: 1. 2. 3. Prepare a contribution format income statement for the company as a whole. Carry computations to one decimal place. Compute the break-even point for the company based on the current sales mix. If sales increase by P100,000 a month, by how much would you expect net operating income to increase? What are your assumptions? 267 gar79611_ch06_233-278.indd Page 268 12/15/08 11:33:41 PM user-s176 268 /broker/MH-BURR/MHBR094/MHBR094-06/MHBR094-06 Chapter 6 Problems PROBLEM 619 Basics of CVP Analysis [LO1, LO3, LO4, LO6, LO8] Feather Friends, Inc., distributes a high-quality wooden birdhouse that sells for $20 per unit. Variable costs are $8 per unit, and xed costs total $180,000 per year. Required: Answer the following independent questions: 1. What is the products CM ratio? 2. Use the CM ratio to determine the break-even point in sales dollars. 3. Due to an increase in demand, the company estimates that sales will increase by $75,000 during the next year. By how much should net operating income increase (or net loss decrease) assuming that xed costs do not change? 4. Assume that the operating results for last year were: Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Variable expenses . . . . . . . . . . . . . . . . . . . $400,000 160,000 Contribution margin . . . . . . . . . . . . . . . . . . Fixed expenses . . . . . . . . . . . . . . . . . . . . . 240,000 180,000 Net operating income . . . . . . . . . . . . . . . . $ 60,000 a. b. 5. 6. Compute the degree of operating leverage at the current level of sales. The president expects sales to increase by 20% next year. By what percentage should net operating income increase? Refer to the original data. Assume that the company sold 18,000 units last year. The sales manager is convinced that a 10% reduction in the selling price, combined with a $30,000 increase in advertising, would cause annual sales in units to increase by one-third. Prepare two contribution format income statements, one showing the results of last years operations and one showing the results of operations if these changes are made. Would you recommend that the company do as the sales manager suggests? Refer to the original data. Assume again that the company sold 18,000 units last year. The president does not want to change the selling price. Instead, he wants to increase the sales commission by $1 per unit. He thinks that this move, combined with some increase in advertising, would increase annual sales by 25%. By how much could advertising be increased with prots remaining unchanged? Do not prepare an income statement; use the incremental analysis approach. PROBLEM 620 Sales Mix; Multiproduct Break-Even Analysis [LO9] Gold Star Rice, Ltd., of Thailand exports Thai rice throughout Asia. The company grows three varieties of riceFragrant, White, and Loonzain. (The currency in Thailand is the baht, which is denoted by B.) Budgeted sales by product and in total for the coming month are shown below: Product White Fragrant Loonzain Total Percentage of total sales Sales . . . . . . . . . . . . . . . . . . . . . Variable expenses . . . . . . . . . . . 20% B150,000 108,000 100% 72% 52% B390,000 78,000 100% 20% 28% B210,000 84,000 100% 40% Contribution margin . . . . . . . . . . B 42,000 28% B312,000 80% B126,000 60% 100% B750,000 270,000 100% 36% 480,000 64% Fixed expenses . . . . . . . . . . . . . 449,280 Net operating income. . . . . . . . . B30,720 Dollar sales to break even Fixed expenses CM ratio B449,280 0.64 B702,000 As shown by these data, net operating income is budgeted at B30,720 for the month and break-even sales at B702,000. gar79611_ch06_233-278.indd gar79611_ch06_233-278.indd Page 269 12/15/08 11:33:42 PM user-s176 /broker/MH-BURR/MHBR094/MHBR094-06/MHBR094-06 Cost-Volume-Prot Relationships Assume that actual sales for the month total B750,000 as planned. Actual sales by product are: White, B300,000; Fragrant, B180,000; and Loonzain, B270,000. Required: 1. 2. 3. Prepare a contribution format income statement for the month based on actual sales data. Present the income statement in the format shown on the prior page. Compute the break-even point in sales dollars for the month based on your actual data. Considering the fact that the company met its B750,000 sales budget for the month, the president is shocked at the results shown on your income statement in (1) above. Prepare a brief memo for the president explaining why both the operating results and the break-even point in sales dollars are different from what was budgeted. PROBLEM 621 Basic CVP Analysis; Graphing [LO1, LO2, LO4, LO6] The Fashion Shoe Company operates a chain of womens shoe shops around the country. The shops carry many styles of shoes that are all sold at the same price. Sales personnel in the shops are paid a substantial commission on each pair of shoes sold (in addition to a small basic salary) in order to encourage them to be aggressive in their sales efforts. The following worksheet contains cost and revenue data for Shop 48 and is typical of the companys many outlets: Required: 1. 2. 3. 4. 5. 6. Calculate the annual break-even point in dollar sales and in unit sales for Shop 48. Prepare a CVP graph showing cost and revenue data for Shop 48 from zero shoes up to 17,000 pairs of shoes sold each year. Clearly indicate the break-even point on the graph. If 12,000 pairs of shoes are sold in a year, what would be Shop 48s net operating income or loss? The company is considering paying the store manager of Shop 48 an incentive commission of 75 cents per pair of shoes (in addition to the salespersons commission). If this change is made, what will be the new break-even point in dollar sales and in unit sales? Refer to the original data. As an alternative to (4) above, the company is considering paying the store manager 50 cents commission on each pair of shoes sold in excess of the break-even point. If this change is made, what will be the shops net operating income or loss if 15,000 pairs of shoes are sold? Refer to the original data. The company is considering eliminating sales commissions entirely in its shops and increasing xed salaries by $31,500 annually. If this change is made, what will be the new break-even point in dollar sales and in unit sales for Shop 48? Would you recommend that the change be made? Explain. 269 gar79611_ch06_233-278.indd Page 270 12/15/08 11:33:43 PM user-s176 270 /broker/MH-BURR/MHBR094/MHBR094-06/MHBR094-06 Chapter 6 PROBLEM 622 Basics of CVP Analysis; Cost Structure [LO1, LO3, LO4, LO5, LO6] Due to erratic sales of its sole producta high-capacity battery for laptop computersPEM, Inc., has been experiencing difculty for some time. The companys contribution format income statement for the most recent month is given below: Sales (19,500 units $30 per unit) . . . . . Variable expenses . . . . . . . . . . . . . . . . . . . $585,000 409,500 Contribution margin . . . . . . . . . . . . . . . . . . Fixed expenses . . . . . . . . . . . . . . . . . . . . . 175,500 180,000 Net operating loss . . . . . . . . . . . . . . . . . . . $ (4,500) Required: 1. 2. 3. 4. 5. Compute the companys CM ratio and its break-even point in both units and dollars. The president believes that a $16,000 increase in the monthly advertising budget, combined with an intensied effort by the sales staff, will result in an $80,000 increase in monthly sales. If the president is right, what will be the effect on the companys monthly net operating income or loss? (Use the incremental approach in preparing your answer.) Refer to the original data. The sales manager is convinced that a 10% reduction in the selling price, combined with an increase of $60,000 in the monthly advertising budget, will cause unit sales to double. What will the new contribution format income statement look like if these changes are adopted? Refer to the original data. The Marketing Department thinks that a fancy new package for the laptop computer battery would help sales. The new package would increase packaging costs by 75 cents per unit. Assuming no other changes, how many units would have to be sold each month to earn a prot of $9,750? Refer to the original data. By automating certain operations, the company could reduce variable costs by $3 per unit. However, xed costs would increase by $72,000 each month. a. Compute the new CM ratio and the new break-even point in both units and dollars. b. Assume that the company expects to sell 26,000 units next month. Prepare two contribution format income statements, one assuming that operations are not automated and one assuming that they are. (Show data on a per unit and percentage basis, as well as in total, for each alternative.) c. Would you recommend that the company automate its operations? Explain. PROBLEM 623 Sales Mix; Break-Even Analysis; Margin of Safety [LO7, LO9] Island Novelties, Inc., of Palau makes two products, Hawaiian Fantasy and Tahitian Joy. Present revenue, cost, and sales data for the two products follow: Hawaiian Fantasy Selling price per unit . . . . . . . . . . . . . . . . . Variable expenses per unit . . . . . . . . . . . . Number of units sold annually . . . . . . . . . . Tahitian Joy $15 $9 20,000 $100 $20 5,000 Fixed expenses total $475,800 per year. The Republic of Palau uses the U.S. dollar as its currency. Required: 1. Assuming the sales mix given above, do the following: a. Prepare a contribution format income statement showing both dollar and percent columns for each product and for the company as a whole. b. Compute the break-even point in dollars for the company as a whole and the margin of safety in both dollars and percent. gar79611_ch06_233-278.indd Page 271 12/15/08 11:33:45 PM user-s176 /broker/MH-BURR/MHBR094/MHBR094-06/MHBR094-06 Cost-Volume-Prot Relationships 2. 3. The company has developed a new product to be called Samoan Delight. Assume that the company could sell 10,000 units at $45 each. The variable expenses would be $36 each. The companys xed expenses would not change. a. Prepare another contribution format income statement, including sales of the Samoan Delight (sales of the other two products would not change). b. Compute the companys new break-even point in dollars and the new margin of safety in both dollars and percent. The president of the company examines your gures and says, Theres something strange here. Our xed expenses havent changed and you show greater total contribution margin if we add the new product, but you also show our break-even point going up. With greater contribution margin, the break-even point should go down, not up. Youve made a mistake somewhere. Explain to the president what has happened. PROBLEM 624 Interpretive Questions on the CVP Graph [LO2, LO6] A CVP graph such as the one shown below is a useful technique for showing relationships among an organizations costs, volume, and prots. 8 6 1 4 3 9 7 5 2 Required: 1. 2. Identify the numbered components in the CVP graph. State the effect of each of the following actions on line 3, line 9, and the break-even point. For line 3 and line 9, state whether the action will cause the line to: Remain unchanged. Shift upward. Shift downward. Have a steeper slope (i.e., rotate upward). Have a atter slope (i.e., rotate downward). Shift upward and have a steeper slope. Shift upward and have a atter slope. Shift downward and have a steeper slope. Shift downward and have a atter slope. In the case of the break-even point, state whether the action will cause the break-even point to: Remain unchanged. Increase. Decrease. Probably change, but the direction is uncertain. Treat each case independently. x. Example. Fixed costs are reduced by $5,000 per period. Answer (see choices above): Line 3: Shift downward. Line 9: Remain unchanged. Break-even point: Decrease. 271 gar79611_ch06_233-278.indd gar79611_ch06_233-278.indd Page 272 12/15/08 11:33:45 PM user-s176 272 /broker/MH-BURR/MHBR094/MHBR094-06/MHBR094-06 Chapter 6 a. b. c. d. e. The unit selling price is increased from $18 to $20. Unit variable costs are decreased from $12 to $10. Fixed costs are increased by $3,000 per period. Two thousand more units are sold during the period than were budgeted. Due to paying salespersons a commission rather than a flat salary, fixed costs are reduced by $8,000 per period and unit variable costs are increased by $3. Due to an increase in the cost of materials, both unit variable costs and the selling price are increased by $2. Advertising costs are increased by $10,000 per period, resulting in a 10% increase in the number of units sold. Due to automating an operation previously done by workers, fixed costs are increased by $12,000 per period and unit variable costs are reduced by $4. f. g. h. PROBLEM 625 Sales Mix; Commission Structure; Multiproduct Break-Even Analysis [LO9] Carbex, Inc., produces cutlery sets out of high-quality wood and steel. The company makes a standard cutlery set and a deluxe set and sells them to retail department stores throughout the country. The standard set sells for $60, and the deluxe set sells for $75. The variable expenses associated with each set are given below. Standard Deluxe $15.00 $9.00 $30.00 $11.25 Production costs . . . . . . . . . . . . . . . . . . . . . . . . Sales commissions (15% of sales price) . . . . . . The companys xed expenses each month are: Advertising . . . . . . . . . . . Depreciation . . . . . . . . . . Administrative. . . . . . . . . $105,000 $21,700 $63,000 Salespersons are paid on a commission basis to encourage them to be aggressive in their sales efforts. Mary Parsons, the nancial vice president, watches sales commissions carefully and has noted that they have risen steadily over the last year. For this reason, she was shocked to nd that even though sales have increased, prots for the current monthMayare down substantially from April. Sales, in sets, for the last two months are given below: Standard Deluxe Total 4,000 1,000 2,000 5,000 6,000 6,000 April . . . . . . . . . . . May . . . . . . . . . . . Required: 1. Prepare contribution format income statements for April and May. Use the following headings: Standard Amount Percent Deluxe Amount Percent Total Amount Percent Sales . . . . Etc . . . . . . 2. Place the xed expenses only in the Total column. Do not show percentages for the xed expenses. Explain the difference in net operating incomes between the two months, even though the same total number of sets was sold in each month. gar79611_ch06_233-278.indd Page 273 12/15/08 11:33:46 PM user-s176 /broker/MH-BURR/MHBR094/MHBR094-06/MHBR094-06 Cost-Volume-Prot Relationships 3. What can be done to the sales commissions to improve the sales mix? a. Using Aprils sales mix, what is the break-even point in sales dollars? b. Without doing any calculations, explain whether the break-even points would be higher or lower with Mays sales mix than Aprils sales mix. PROBLEM 626 Break-Even Analysis; Pricing [LO1, LO4, LO6] Minden Company introduced a new product last year for which it is trying to nd an optimal selling price. Marketing studies suggest that the company can increase sales by 5,000 units for each $2 reduction in the selling price. The companys present selling price is $70 per unit, and variable expenses are $40 per unit. Fixed expenses are $540,000 per year. The present annual sales volume (at the $70 selling price) is 15,000 units. Required: 1. 2. 3. 4. What is the present yearly net operating income or loss? What is the present break-even point in units and in dollar sales? Assuming that the marketing studies are correct, what is the maximum prot that the company can earn yearly? At how many units and at what selling price per unit would the company generate this prot? What would be the break-even point in units and in sales dollars using the selling price you determined in (3) above (e.g., the selling price at the level of maximum prots)? Why is this break-even point different from the break-even point you computed in (2) above? PROBLEM 627 Various CVP Questions: Break-Even Point; Cost Structure; Target Sales [LO1, LO3, LO4, LO5, LO6, LO8] Northwood Company manufactures basketballs. The company has a ball that sells for $25. At present, the ball is manufactured in a small plant that relies heavily on direct labor workers. Thus, variable costs are high, totaling $15 per ball, of which 60% is direct labor cost. Last year, the company sold 30,000 of these balls, with the following results: Sales (30,000 balls). . . . . . . . . . . . . . . . . . Variable expenses . . . . . . . . . . . . . . . . . . . $750,000 450,000 Contribution margin . . . . . . . . . . . . . . . . . . Fixed expenses . . . . . . . . . . . . . . . . . . . . . 300,000 210,000 Net operating income . . . . . . . . . . . . . . . . $ 90,000 Required: 1. 2. 3. 4. 5. 6. Compute (a) the CM ratio and the break-even point in balls, and (b) the degree of operating leverage at last years sales level. Due to an increase in labor rates, the company estimates that variable costs will increase by $3 per ball next year. If this change takes place and the selling price per ball remains constant at $25, what will be the new CM ratio and break-even point in balls? Refer to the data in (2) above. If the expected change in variable costs takes place, how many balls will have to be sold next year to earn the same net operating income ($90,000) as last year? Refer again to the data in (2) above. The president feels that the company must raise the selling price of its basketballs. If Northwood Company wants to maintain the same CM ratio as last year, what selling price per ball must it charge next year to cover the increased labor costs? Refer to the original data. The company is discussing the construction of a new, automated manufacturing plant. The new plant would slash variable costs per ball by 40%, but it would cause xed costs per year to double. If the new plant is built, what would be the companys new CM ratio and new break-even point in balls? Refer to the data in (5) above. a. If the new plant is built, how many balls will have to be sold next year to earn the same net operating income, $90,000, as last year? b. Assume the new plant is built and that next year the company manufactures and sells 30,000 balls (the same number as sold last year). Prepare a contribution format income statement and compute the degree of operating leverage. c. If you were a member of top management, would you have been in favor of constructing the new plant? Explain. 273 gar79611_ch06_233-278.indd Page 274 12/15/08 11:33:47 PM user-s176 274 /broker/MH-BURR/MHBR094/MHBR094-06/MHBR094-06 Chapter 6 PROBLEM 628 Graphing; Incremental Analysis; Operating Leverage [LO2, LO4, LO5, LO6, LO8] Angie Silva has recently opened The Sandal Shop in Brisbane, Australia, a store that specializes in fashionable sandals. Angie has just received a degree in business and she is anxious to apply the principles she has learned to her business. In time, she hopes to open a chain of sandal shops. As a rst step, she has prepared the following analysis for her new store: Sales price per pair of sandals . . . . . . . . . . . Variable expenses per pair of sandals. . . . . . $40 16 Contribution margin per pair of sandals. . . . . $24 Fixed expenses per year: Building rental . . . . . . . . . . . . . . . . . . . . . . Equipment depreciation . . . . . . . . . . . . . . . Selling . . . . . . . . . . . . . . . . . . . . . . . . . . . . Administrative . . . . . . . . . . . . . . . . . . . . . . $15,000 7,000 20,000 18,000 Total xed expenses . . . . . . . . . . . . . . . . . . . $60,000 Required: 1. 2. 3. 4. 5. How many pairs of sandals must be sold each year to break even? What does this represent in total sales dollars? Prepare a CVP graph or a prot graph for the store from zero pairs up to 4,000 pairs of sandals sold each year. Indicate the break-even point on your graph. Angie has decided that she must earn at least $18,000 the rst year to justify her time and effort. How many pairs of sandals must be sold to reach this target prot? Angie now has two salespersons working in the storeone full time and one part time. It will cost her an additional $8,000 per year to convert the part-time position to a full-time position. Angie believes that the change would bring in an additional $25,000 in sales each year. Should she convert the position? Use the incremental approach. (Do not prepare an income statement.) Refer to the original data. During the rst year, the store sold only 3,000 pairs of sandals and reported the following operating results: Sales (3,000 pairs) . . . . . . . . . . . . . . . . . . . . Variable expenses . . . . . . . . . . . . . . . . . . . . . Contribution margin . . . . . . . . . . . . . . . . . . . . Fixed expenses . . . . . . . . . . . . . . . . . . . . . . . 72,000 60,000 Net operating income . . . . . . . . . . . . . . . . . . a. b. $120,000 48,000 $ 12,000 What is the stores degree of operating leverage? Angie is confident that with a more intense sales effort and with a more creative advertising program she can increase sales by 50% next year. What would be the expected percentage increase in net operating income? Use the degree of operating leverage to compute your answer. PROBLEM 629 Changes in Cost Structure; Break-Even Analysis; Operating Leverage; Margin of Safety [LO4, LO6, LO7, LO8] Morton Companys contribution format income statement for last month is given below: Sales (15,000 units $30 per unit). . . . . . . . Variable expenses . . . . . . . . . . . . . . . . . . . . . $450,000 315,000 Contribution margin . . . . . . . . . . . . . . . . . . . . Fixed expenses . . . . . . . . . . . . . . . . . . . . . . . 135,000 90,000 Net operating income . . . . . . . . . . . . . . . . . . $ 45,000 gar79611_ch06_233-278.indd gar79611_ch06_233-278.indd Page 275 12/15/08 11:33:48 PM user-s176 /broker/MH-BURR/MHBR094/MHBR094-06/MHBR094-06 Cost-Volume-Prot Relationships The industry in which Morton Company operates is quite sensitive to cyclical movements in the economy. Thus, prots vary considerably from year to year according to general economic conditions. The company has a large amount of unused capacity and is studying ways of improving prots. Required: 1. 2. 3. 4. New equipment has come onto the market that would allow Morton Company to automate a portion of its operations. Variable costs would be reduced by $9 per unit. However, xed costs would increase to a total of $225,000 each month. Prepare two contribution format income statements, one showing present operations and one showing how operations would appear if the new equipment is purchased. Show an Amount column, a Per Unit column, and a Percent column on each statement. Do not show percentages for the xed costs. Refer to the income statements in (1) above. For both present operations and the proposed new operations, compute (a) the degree of operating leverage, (b) the break-even point in dollars, and (c) the margin of safety in both dollar and percentage terms. Refer again to the data in (1) above. As a manager, what factor would be paramount in your mind in deciding whether to purchase the new equipment? (Assume that enough funds are available to make the purchase.) Refer to the original data. Rather than purchase new equipment, the marketing manager argues that the companys marketing strategy should be changed. Rather than pay sales commissions, which are currently included in variable expenses, the company would pay salespersons xed salaries and would invest heavily in advertising. The marketing manager claims this new approach would increase unit sales by 30% without any change in selling price; the companys new monthly xed expenses would be $180,000; and its net operating income would increase by 20%. Compute the break-even point in dollar sales for the company under the new marketing strategy. Do you agree with the marketing managers proposal? PROBLEM 630 Target Prot and Break-Even Analysis [LO5, LO6] The Shirt Works sells a large variety of tee shirts and sweatshirts. Steve Hooper, the owner, is thinking of expanding his sales by hiring local high school students, on a commission basis, to sell sweatshirts bearing the name and mascot of the local high school. These sweatshirts would have to be ordered from the manufacturer six weeks in advance, and they could not be returned because of the unique printing required. The sweatshirts would cost Mr. Hooper $8 each with a minimum order of 75 sweatshirts. Any additional sweatshirts would have to be ordered in increments of 75. Since Mr. Hoopers plan would not require any additional facilities, the only costs associated with the project would be the costs of the sweatshirts and the costs of the sales commissions. The selling price of the sweatshirts would be $13.50 each. Mr. Hooper would pay the students a commission of $1.50 for each shirt sold. Required: 1. 2. To make the project worthwhile, Mr. Hooper would require a $1,200 prot for the rst three months of the venture. What level of sales in units and in dollars would be required to reach this target net operating income? Show all computations. Assume that the venture is undertaken and an order is placed for 75 sweatshirts. What would be Mr. Hoopers break-even point in units and in sales dollars? Show computations and explain the reasoning behind your answer. PROBLEM 631 Changes in Fixed and Variable Costs; Target Prot and Break-Even Analysis [LO4, LO5, LO6] Neptune Company produces toys and other items for use in beach and resort areas. A small, inatable toy has come onto the market that the company is anxious to produce and sell. The new toy will sell for $3 per unit. Enough capacity exists in the companys plant to produce 16,000 units of the toy each month. Variable costs to manufacture and sell one unit would be $1.25, and xed costs associated with the toy would total $35,000 per month. The companys Marketing Department predicts that demand for the new toy will exceed the 16,000 units that the company is able to produce. Additional manufacturing space can be rented from another company at a xed cost of $1,000 per month. Variable costs in the rented facility would total $1.40 per unit, due to somewhat less efcient operations than in the main plant. 275 gar79611_ch06_233-278.indd gar79611_ch06_233-278.indd Page 276 12/15/08 11:33:49 PM user-s176 276 /broker/MH-BURR/MHBR094/MHBR094-06/MHBR094-06 Chapter 6 Required: 1. 2. 3. Compute the monthly break-even point for the new toy in units and in total sales dollars. Show all computations. How many units must be sold each month to make a monthly prot of $12,000? If the sales manager receives a bonus of 10 cents for each unit sold in excess of the break-even point, how many units must be sold each month to earn a return of 25% on the monthly investment in xed costs? Cases CASE 632 Break-Evens for Individual Products in a Multiproduct Company [LO6, LO9] Cheryl Montoya picked up the phone and called her boss, Wes Chan, the vice president of marketing at Piedmont Fasteners Corporation: Wes, Im not sure how to go about answering the questions that came up at the meeting with the president yesterday. Whats the problem? The president wanted to know the break-even point for each of the companys products, but I am having trouble guring them out. Im sure you can handle it, Cheryl. And, by the way, I need your analysis on my desk tomorrow morning at 8:00 sharp in time for the follow-up meeting at 9:00. Piedmont Fasteners Corporation makes three different clothing fasteners in its manufacturing facility in North Carolina. Data concerning these products appear below: Velcro Normal annual sales volume . . . . . . . . . Unit selling price . . . . . . . . . . . . . . . . . . Variable cost per unit . . . . . . . . . . . . . . . Metal Nylon 100,000 $1.65 $1.25 200,000 $1.50 $0.70 400,000 $0.85 $0.25 Total xed expenses are $400,000 per year. All three products are sold in highly competitive markets, so the company is unable to raise its prices without losing unacceptable numbers of customers. The company has an extremely effective lean production system, so there are no beginning or ending work in process or nished goods inventories. Required: 1. 2. What is the companys over-all break-even point in total sales dollars? Of the total xed costs of $400,000, $20,000 could be avoided if the Velcro product were dropped, $80,000 if the Metal product were dropped, and $60,000 if the Nylon product were dropped. The remaining xed costs of $240,000 consist of common xed costs such as administrative salaries and rent on the factory building that could be avoided only by going out of business entirely. a. What is the break-even point in units for each product? b. If the company sells exactly the break-even quantity of each product, what will be the overall profit of the company? Explain this result. CASE 633 Cost Structure; Target Prot and Break-Even Analysis [LO4, LO5, LO6] Pittman Company is a small but growing manufacturer of telecommunications equipment. The company has no sales force of its own; rather, it relies completely on independent sales agents to market its products. These agents are paid a commission of 15% of selling price for all items sold. Barbara Cheney, Pittmans controller, has just prepared the companys budgeted income statement for next year. The statement follows: gar79611_ch06_233-278.indd Page 277 12/15/08 11:33:50 PM user-s176 /broker/MH-BURR/MHBR094/MHBR094-06/MHBR094-06 Cost-Volume-Prot Relationships Pittman Company Budgeted Income Statement For the Year Ended December 31 Sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . Manufacturing costs: Variable . . . . . . . . . . . . . . . . . . . . . . . . . Fixed overhead . . . . . . . . . . . . . . . . . . . $16,000,000 $7,200,000 2,340,000 Gross margin . . . . . . . . . . . . . . . . . . . . . . Selling and administrative costs: Commissions to agents. . . . . . . . . . . . . Fixed marketing costs . . . . . . . . . . . . . . Fixed administrative costs . . . . . . . . . . . 9,540,000 6,460,000 2,400,000 120,000* 1,800,000 4,320,000 Net operating income . . . . . . . . . . . . . . . . Fixed interest cost. . . . . . . . . . . . . . . . . . . 2,140,000 540,000 Income before income taxes. . . . . . . . . . . Income taxes (30%) . . . . . . . . . . . . . . . . . 1,600,000 480,000 Net income . . . . . . . . . . . . . . . . . . . . . . . . $ 1,120,000 *Primarily depreciation on storage facilities. As Barbara handed the statement to Karl Vecci, Pittmans president, she commented, I went ahead and used the agents 15% commission rate in completing these statements, but weve just learned that they refuse to handle our products next year unless we increase the commission rate to 20%. Thats the last straw, Karl replied angrily. Those agents have been demanding more and more, and this time theyve gone too far. How can they possibly defend a 20% commission rate? They claim that after paying for advertising, travel, and the other costs of promotion, theres nothing left over for prot, replied Barbara. I say its just plain robbery, retorted Karl. And I also say its time we dumped those guys and got our own sales force. Can you get your people to work up some cost gures for us to look at? Weve already worked them up, said Barbara. Several companies we know about pay a 7.5% commission to their own salespeople, along with a small salary. Of course, we would have to handle all promotion costs, too. We gure our xed costs would increase by $2,400,000 per year, but that would be more than offset by the $3,200,000 (20% $16,000,000) that we would avoid on agents commissions. The breakdown of the $2,400,000 cost follows: Salaries: Sales manager. . . . . . . . . . Salespersons . . . . . . . . . . . Travel and entertainment. . . . Advertising. . . . . . . . . . . . . . . $ 100,000 600,000 400,000 1,300,000 Total. . . . . . . . . . . . . . . . . . . . $2,400,000 Super, replied Karl. And I noticed that the $2,400,000 is just what were paying the agents under the old 15% commission rate. Its even better than that, explained Barbara. We can actually save $75,000 a year because thats what were having to pay the auditing rm now to check out the agents reports. So our overall administrative costs would be less. Pull all of these numbers together and well show them to the executive committee tomorrow, said Karl. With the approval of the committee, we can move on the matter immediately. Required: 1. Compute Pittman Companys break-even point in sales dollars for next year assuming: a. The agents commission rate remains unchanged at 15%. b. The agents commission rate is increased to 20%. c. The company employs its own sales force. 277 gar79611_ch06_233-278.indd gar79611_ch06_233-278.indd Page 278 12/15/08 11:33:51 PM user-s176 278 /broker/MH-BURR/MHBR094/MHBR094-06/MHBR094-06 Chapter 6 2. 3. 4. 5. Assume that Pittman Company decides to continue selling through agents and pays the 20% commission rate. Determine the volume of sales that would be required to generate the same net income as contained in the budgeted income statement for next year. Determine the volume of sales at which net income would be equal regardless of whether Pittman Company sells through agents (at a 20% commission rate) or employs its own sales force. Compute the degree of operating leverage that the company would expect to have on December 31 at the end of next year assuming: a. The agents commission rate remains unchanged at 15%. b. The agents commission rate is increased to 20%. c. The company employs its own sales force. Use income before income taxes in your operating leverage computation. Based on the data in (1) through (4) above, make a recommendation as to whether the company should continue to use sales agents (at a 20% commission rate) or employ its own sales force. Give reasons for your answer. (CMA, adapted) RESEARCH AND APPLICATION 634 [LO3, LO4, LO5, LO6, LO7, LO8, LO9] The questions in this exercise are based on the Benetton Group, a company headquartered in Italy and known in the United States primarily for one of its brands of fashion apparelUnited Colors of Benetton. To answer the questions, you will need to download the Benetton Groups 2004 Annual Report at www.benetton.com/investors. Once at this website, click on the link toward the top of the page called Site Map and then scroll down to the heading called Financial Reports and click on the year 2004. You do not need to print this document to answer the questions. Required: 1. 2. 3. 4. 5. 6. 7. 8. How do the formats of the income statements shown on pages 33 and 50 of Benettons annual report differ from one another (disregard everything beneath the line titled income from operations)? Which expenses shown on page 50 appear to have been reclassied as variable selling costs on page 33? Why do you think cost of sales is included in the computation of contribution margin on page 33? Perform two separate computations of Benettons break-even point in euros. For the rst computation, use data from 2003. For the second computation, use data from 2004. Why do the numbers that you computed differ from one another? What sales volume would have been necessary in 2004 for Benetton to attain a target income from operations of 300 million? Compute Benettons margin of safety using data from 2003 and 2004. Why do your answers for the two years differ from one another? What is Benettons degree of operating leverage in 2004? If Benettons sales in 2004 had been 6% higher than what is shown in the annual report, what income from operations would the company have earned? What percentage increase in income from operations does this represent? What income from operations would Benetton have earned in 2004 if it had invested an additional 10 million in advertising and promotions and realized a 3% increase in sales? As an alternative, what income from operations would Benetton have earned if it not only invested an additional 10 million in advertising and promotions but also raised its sales commission rate to 6% of sales, thereby generating a 5% increase in sales? Which of these two scenarios would have been preferable for Benetton? Assume that total sales in 2004 remained unchanged at 1,686 million (as shown on pages 33 and 50); however, the Casual sector sales were 1,554 million, the Sportswear and Equipment sector sales were 45 million, and the Manufacturing and Other sector sales were 87 million. What income from operations would Benetton have earned with this sales mix? (Hint: look at pages 36 and 37 of the annual report.) Why is the income from operations under this scenario different from what is shown in the annual report? gar79611_ch07_279-306.indd Page 279 12/17/08 10:40:57 PM user-s198 7 Chapter Variable Costing: A Tool for Management /broker/MH-BURR/MHBR094/MHBR094-07 B US IN ES S F O CU S IBMs $2.5 Billion Investment in Technology When it comes to state-of-the-art in automation, IBMs $2.5 billion semiconductor manufacturing facility in East Fishkill, New York, is tough to beat. The plant uses wireless networks, 600 miles of cable, and more than 420 servers to equip itself with what IBM claims is more computing power than NASA uses to launch a space shuttle. Each batch of 25 wafers (one wafer can be processed into 1,000 computer chips) travels through the East Fishkill plants manufacturing process without ever being touched by human hands. A computer system looks at orders and schedules production runs . . . adjusts schedules to allow for planned maintenance and . . . feeds vast reams of production data into enterprise-wide management and nancialreporting systems. The plant can literally run itself as was the case a few years ago when a snowstorm hit and everyone went home while the automated system continued to manufacture computer chips until it ran out of work. In a manufacturing environment such as this, labor costs are insignicant and xed overhead costs are huge. There is a strong temptation to build inventories and increase prots without increasing sales. How can this be done you ask? It would seem logical that producing more units would have no impact on prots unless the units were sold, right? Wrong! As we will discover in this chapter, absorption costingthe most widely used method of determining product costscan articially increase prots by increasing the quantity of units produced. LEARNING OBJECTIVES After studying Chapter 7, you should be able to: LO1 Explain how variable costing differs from absorption costing and compute unit product costs under each method. LO2 Prepare income statements using both variable and absorption costing. LO3 Reconcile variable costing and absorption costing net operating incomes and explain why the two amounts differ. LO4 Understand the advantages and disadvantages of both variable and absorption costing. Source: Ghostwriter, Big Blues $2.5 Billion Sales Tool, Fortune, September 19, 2005, pp. 316F316J. 279 gar79611_ch07_279-306.indd Page 280 12/17/08 10:41:13 PM user-s198 280 /broker/MH-BURR/MHBR094/MHBR094-07 Chapter 7 T wo general approaches are used in manufacturing companies for costing products for the purposes of valuing inventories and cost of goods sold. One approach, called absorption costing, was discussed in Chapter 3. Absorption costing is generally used for external nancial reports. The other approach, called variable costing, is preferred by some managers for internal decision making and must be used when an income statement is prepared in the contribution format. Ordinarily, absorption costing and variable costing produce different gures for net operating income, and the difference can be quite large. In addition to showing how these two methods differ, we will consider the arguments for and against each costing method and we will show how management decisions can be affected by the costing method chosen. Overview of Absorption and Variable Costing L EARNING OBJECTIVE 1 Explain how variable costing differs from absorption costing and compute unit product costs under each method. As discussed in the last two chapters, the contribution format income statement and costvolume-prot (CVP) analysis are valuable management tools. Both of these tools emphasize cost behavior and require that managers carefully distinguish between variable and xed costs. Absorption costing, which was discussed in Chapters 2 and 3, assigns both variable and xed manufacturing costs to productsmingling them in a way that makes it difcult for managers to distinguish between them. In contrast, variable costing focuses on cost behaviorclearly separating xed from variable costs. One of the strengths of variable costing is that it harmonizes with both the contribution approach and the CVP concepts discussed in the preceding chapter. Absorption Costing As discussed in Chapter 3, absorption costing treats all manufacturing costs as product costs, regardless of whether they are variable or xed. The cost of a unit of product under the absorption costing method consists of direct materials, direct labor, and both variable and xed manufacturing overhead. Thus, absorption costing allocates a portion of xed manufacturing overhead cost to each unit of product, along with the variable manufacturing costs. Because absorption costing includes all manufacturing costs in product costs, it is frequently referred to as the full cost method. Variable Costing Under variable costing, only those manufacturing costs that vary with output are treated as product costs. This would usually include direct materials, direct labor, and the variable portion of manufacturing overhead. Fixed manufacturing overhead is not treated as a product cost under this method. Rather, xed manufacturing overhead is treated as a period cost and, like selling and administrative expenses, it is expensed in its entirety each period. Consequently, the cost of a unit of product in inventory or in cost of goods sold under the variable costing method does not contain any xed manufacturing overhead cost. Variable costing is sometimes referred to as direct costing or marginal costing. Selling and Administrative Expense Selling and administrative expenses are never treated as product costs, regardless of the costing method. Thus, under absorption and variable costing, variable and xed selling and administrative expenses are always treated as period costs and are expensed as incurred. Summary of Differences The essential difference between variable costing and absorption costing, as illustrated in Exhibit 71, is how each method accounts for xed manufacturing overhead costsall other costs are treated the same under the two methods. In absorption costing, xed manufacturing overhead costs are included as part of the costs of work in process inventories. When units are completed, these costs are transferred gar79611_ch07_279-306.indd Page 281 12/17/08 10:41:13 PM user-s198 /broker/MH-BURR/MHBR094/MHBR094-07 281 Variable Costing: A Tool for Management Costs E X H I B I T 71 Variable Costing versus Absorption Costing Balance Sheet Raw Materials inventory a Direct materials used in production Direct labor Goods completed (cost of goods manufactured) so co rptio sti ng n Variable manufacturing overhead Work in Process inventory Ab Product costs Raw materials purchases Income Statement Cost of Goods Sold Finished Goods inventory Period costs Fixed manufacturing overhead oods sold Variab le costin g Selling and administrative Period Expenses to nished goods and only when the units are sold do these costs ow through to the income statement as part of cost of goods sold. In variable costing, xed manufacturing overhead costs are considered to be period costsjust like selling and administrative costsand are taken immediately to the income statement as period expenses. To illustrate the difference between variable costing and absorption costing, consider Weber Light Aircraft, a company that produces light recreational aircraft. Data concerning the companys operations appear below: Per Aircraft Selling price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Variable manufacturing overhead . . . . . . . . . . . . . . . . Fixed manufacturing overhead . . . . . . . . . . . . . . . . . . Variable selling and administrative expenses . . . . . . . Fixed selling and administrative expenses . . . . . . . . . Per Month $100,000 $19,000 $5,000 $1,000 $70,000 $10,000 $20,000 January Beginning inventory . . . . . . . . . . . . . . . . . . . . . . . . Production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Ending inventory. . . . . . . . . . . . . . . . . . . . . . . . . . . February March 0 1 1 0 0 2 1 1 1 2 3 0 We will rst construct the companys absorption costing income statements for January, February, and March. Then we will show how the companys net operating income would be determined for the same months using variable costing. gar79611_ch07_279-306.indd Page 282 12/17/08 10:41:16 PM user-s198 282 /broker/MH-BURR/MHBR094/MHBR094-07 Chapter 7 Absorption Costing Income Statement L EARNING OBJECTIVE 2 Prepare income statements using both variable and absorption costing. To prepare the companys absorption costing income statements for January, February, and March, we need to determine the companys unit product costs, cost of goods sold, and selling and administrative expenses for each month. The companys absorption costing unit product costs can be computed as follows1: Absorption Costing Unit Product Cost January Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Variable manufacturing overhead . . . . . . . . . . . . . . . Fixed manufacturing overhead ($70,000 1 unit produced in January; $70,000 2 units produced in February; $70,000 2 units produced in March) . . Absorption costing unit product cost . . . . . . . . . . . . February March $19,000 5,000 1,000 $19,000 5,000 1,000 $19,000 5,000 1,000 70,000 $95,000 35,000 $60,000 35,000 $60,000 Given these unit product costs, the cost of goods sold under absorption costing in each month would be determined as follows: Absorption Costing Cost of Goods Sold January February Absorption costing unit product cost (a) . . . . . . . Units sold (b) . . . . . . . . . . . . . . . . . . . . . . . . . . . . Absorption costing cost of goods sold (a) (b) . . $95,000 1 $95,000 $60,000 1 $60,000 March $60,000 3* $180,000 *One of the three units sold in March was produced in February. Since February and March both have unit product costs of $60,000, the March unit product cost of $60,000 can be multiplied by 3. And the companys selling and administrative expenses would be as follows: Selling and Administrative Expenses January February Variable selling and administrative expense (@ $10,000 per unit sold) . . . . . . . . . . . . . . Fixed selling and administrative expense . . . . Total selling and administrative expense . . . . . $10,000 20,000 $30,000 $10,000 20,000 $30,000 March $30,000 20,000 $50,000 Putting all of this together, the absorption costing income statements would appear as shown in Exhibit 72. 1 For simplicity, we assume in this section that an actual costing system is used in which actual costs are spread over the units produced during the period. If a predetermined overhead rate were used, the analysis would be similar, but more complex. gar79611_ch07_279-306.indd gar79611_ch07_279-306.indd Page 283 12/17/08 10:41:16 PM user-s198 /broker/MH-BURR/MHBR094/MHBR094-07 283 Variable Costing: A Tool for Management Absorption Costing Income Statements January February Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost of goods sold . . . . . . . . . . . . . . . . . . . . Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . Selling and administrative expenses . . . . . . . Net operating income (loss) . . . . . . . . . . . . . $100,000 95,000 5,000 30,000 $ (25,000) $100,000 60,000 40,000 30,000 $ 10,000 March $300,000 180,000 120,000 50,000 $ 70,000 Note that even though sales were exactly the same in January and February and the cost structure did not change, net operating income was $35,000 higher in February than in January under absorption costing. Variable Costing Contribution Format Income Statement As discussed earlier, the only reason that absorption costing income differs from variable costing income is that the methods account for xed manufacturing overhead differently. Under absorption costing, xed manufacturing overhead is included in product costs. In variable costing, xed manufacturing overhead is not included in product costs and instead is treated as a period expense, just like selling and administrative expenses. Under variable costing, product costs consist solely of variable production costs. At Weber Light Aircraft, the variable production cost per unit is $25,000, determined as follows: Variable Costing Unit Product Cost Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Variable manufacturing overhead . . . . . . . . . . . . . . . . . . . . . . . Variable costing unit product cost. . . . . . . . . . . . . . . . . . . . . . . $19,000 5,000 1,000 $25,000 Since the variable production cost is $25,000 per aircraft, the variable costing cost of goods sold can be easily computed as follows: Variable Costing Cost of Goods Sold January Variable production cost (a). . . . . . . . . . . . . . . . . Units sold (b) . . . . . . . . . . . . . . . . . . . . . . . . . . . . Variable cost of goods sold (a) (b). . . . . . . . . . $25,000 1 $25,000 February March $25,000 1 $25,000 $25,000 3 $75,000 The selling and administrative expenses will be the same as the amounts reported using absorption costing. The only difference will be how those costs appear on the income statement. The variable costing income statements for January, February, and March appear in Exhibit 73. The contribution format has been used in these income statements. E X H I B I T 72 Absorption Costing Income Statements gar79611_ch07_279-306.indd gar79611_ch07_279-306.indd Page 284 12/17/08 10:41:17 PM user-s198 284 /broker/MH-BURR/MHBR094/MHBR094-07 Chapter 7 E X H I B I T 73 Variable Costing Income Statements Variable Costing Contribution Format Income Statements January February Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Variable expenses: Variable cost of goods sold . . . . . . . . . . . . . Variable selling and administrative expense . . . . . . . . . . . . . . . . . . . . . . . . . . Total variable expenses . . . . . . . . . . . . . . . . . . Contribution margin . . . . . . . . . . . . . . . . . . . . . Fixed expenses: Fixed manufacturing overhead . . . . . . . . . . Fixed selling and administrative expense . . Total xed expenses . . . . . . . . . . . . . . . . . . . . Net operating income (loss) . . . . . . . . . . . . . . March $100,000 $100,000 $300,000 25,000 25,000 75,000 10,000 35,000 65,000 10,000 35,000 65,000 30,000 105,000 195,000 70,000 20,000 90,000 $ (25,000) 70,000 20,000 90,000 $ (25,000) 70,000 20,000 90,000 $105,000 Contrasting the absorption costing and variable costing income statements in Exhibits 72 and 73, note that net operating income is the same in January under absorption costing and variable costing, but differs in the other two months. We will discuss this in some depth shortly. Also note that the format of the variable costing income statement differs from the absorption costing income statement. An absorption costing income statement categorizes costs by functionmanufacturing versus selling and administrative. All of the manufacturing costs ow through the absorption costing cost of goods sold and all of the selling and administrative costs are listed separately as period expenses. In contrast, in the contribution approach above, costs are categorized according to how they behave. All of the variable expenses are listed together and all of the xed expenses are listed together. The variable expenses category includes manufacturing costs (i.e., variable cost of goods sold) as well as selling and administrative expenses. The xed expenses category also includes both manufacturing costs and selling and administrative expenses. Reconciliation of Variable Costing with Absorption Costing Income L EARNING OBJECTIVE 3 Reconcile variable costing and absorption costing net operating incomes and explain why the two amounts differ. As noted earlier, variable costing and absorption costing net operating incomes may not be the same. In the case of Weber Light Aircraft, the net operating incomes are the same in January, but differ in the other two months. These differences occur because under absorption costing some xed manufacturing overhead is capitalized in inventories (i.e., included in product costs) rather than currently expensed on the income statement. If inventories increase during a period, under absorption costing some of the xed manufacturing overhead of the current period will be deferred in ending inventories. For example, in February two aircraft were produced and each carried with it $35,000 ($70,000 2 aircraft produced) in xed manufacturing overhead. Since only one aircraft was sold, $35,000 of this xed manufacturing overhead was on the absorption costing income statement as part of cost of goods sold, but $35,000 would have been on the balance sheet as part of nished goods inventories. In contrast, under variable costing all of the $70,000 of xed manufacturing overhead appeared on the income statement as a period expense. Consequently, net operating income was higher under absorption costing than under variable costing by $35,000 in February. This was reversed in March when two units were produced, but three were sold. In March, under absorption costing $105,000 of xed manufacturing overhead was included in cost of goods sold ($35,000 for the unit produced in February and sold in March plus $35,000 for each of the two units produced and gar79611_ch07_279-306.indd Page 285 12/17/08 10:41:18 PM user-s198 /broker/MH-BURR/MHBR094/MHBR094-07 Variable Costing: A Tool for Management 285 sold in March), but only $70,000 was recognized as a period expense under variable costing. Hence, the net operating income in March was $35,000 lower under absorption costing than under variable costing. In general, when the units produced exceed unit sales and hence inventories increase, net operating income is higher under absorption costing than under variable costing. This occurs because some of the xed manufacturing overhead of the period is deferred in inventories under absorption costing. In contrast, when unit sales exceed the units produced and hence inventories decrease, net operating income is lower under absorption costing than under variable costing. This occurs because some of the xed manufacturing overhead of previous periods is released from inventories under absorption costing. When the units produced and unit sales are equal, no change in inventories occurs and absorption costing and variable costing net operating incomes are the same.2 Variable costing and absorption costing net operating incomes can be reconciled by determining how much xed manufacturing overhead was deferred in, or released from, inventories during the period. Fixed Manufacturing Overhead Deferred in, or Released from, Inventories under Absorption Costing January February Fixed manufacturing overhead in beginning inventories . . . . . . . . . . . . . . . . . . . . . . Fixed manufacturing overhead in ending inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fixed manufacturing overhead deferred in (released from) inventories . . . . . . . . . . . . . . . . . $0 $ March 0 $ 35,000 0 35,000 0 $0 $35,000 $(35,000) The reconciliation would then be reported in Exhibit 74: Reconciliation of Variable Costing and Absorption Costing Net Operating Incomes January February March Variable costing net operating income . . . . . Add (deduct) xed manufacturing overhead deferred in (released from) inventory under absorption costing . . . . . . . . . . . . . . $(25,000) Absorption costing net operating income . . . $(25,000) 0 $(25,000) 35,000 $ 10,000 $105,000 (35,000) $ 70,000 Again note that the difference between variable costing net operating income and absorption costing net operating income is entirely due to the amount of xed manufacturing overhead that is deferred in, or released from, inventories during the period under absorption costing. Changes in inventories affect absorption costing net operating incomethey do not affect variable costing net operating income, providing that the cost structure is stable. The reasons for differences between variable and absorption costing net operating incomes are summarized in Exhibit 75. When the units produced equal the units sold, as in January for Weber Light Aircraft, absorption costing net operating income will equal variable costing net operating income. This occurs because when production equals sales, 2 These general statements about the relation between variable costing and absorption costing net operating income assume LIFO is used to value inventories. Even when LIFO is not used, the general statements tend to be correct. E X H I B I T 74 Reconciliation of Variable Costing and Absorption Costing Net Operating Incomes gar79611_ch07_279-306.indd gar79611_ch07_279-306.indd Page 286 12/17/08 10:41:18 PM user-s198 286 /broker/MH-BURR/MHBR094/MHBR094-07 Chapter 7 E X H I B I T 75 Comparative Income Effects Absorption and Variable Costing Relation between Production and Sales for the Period Effect on Inventories Relation between Absorption and Variable Costing Net Operating Incomes Units produced Units sold No change in inventories Absorption costing net operating income Variable costing net operating income Units produced Units sold Inventories increase Absorption costing net operating income Variable costing net operating income* Units produced Units sold Inventories decrease Absorption costing net operating income Variable costing net operating income *Net operating income is higher under absorption costing because fixed manufacturing overhead cost is deferred in inventory under absorption costing as inventories increase. Net operating income is lower under absorption costing because fixed manufacturing overhead cost is released from inventory under absorption costing as inventories decrease. all of the xed manufacturing overhead incurred in the current period ows through to the income statement under both methods. When the units produced exceed the units sold, absorption costing net operating income will exceed variable costing net operating income. This occurs because inventories have increased; therefore, under absorption costing some of the xed manufacturing overhead incurred in the current period is deferred in ending inventories on the balance sheet, whereas under variable costing all of the xed manufacturing overhead incurred in the current period ows through to the income statement. In contrast, when the units produced are less than the units sold, absorption costing net operating income will be less than variable costing net operating income. This occurs because inventories have decreased; therefore, under absorption costing xed manufacturing overhead that had been deferred in inventories during a prior period ows through to the current periods income statement together with all of the xed manufacturing overhead incurred during the current period. Under variable costing, just the xed manufacturing overhead of the current period ows through to the income statement. IN BUSINESS THE BEHAVIORAL SIDE OF CALCULATING UNIT PRODUCT COSTS In 2004, Andreas STIHL, a manufacturer of chain saws and other landscaping products, asked its U.S. subsidiary, STIHL Inc., to replace its absorption costing income statements with the variable costing approach. From a computer systems standpoint, the change was not disruptive because STIHL used an enterprise system called SAP that accommodates both absorption and variable costing. However, from a behavioral standpoint, STIHL felt the change could be very disruptive. For example, STIHLs senior managers were keenly aware that the variable costing approach reported lower unit product costs than the absorption costing approach. Given this reality, the sales force might be inclined to erroneously conclude that each product had magically become more protable, thereby justifying ill-advised price reductions. Because of behavioral concerns such as this, STIHL worked hard to teach its employees how to interpret a variable costing income statement. Source: Carl S. Smith, Going for GPK: STIHL Moves Toward This Costing System in the United States, Strategic Finance, April 2005, pp. 3639. gar79611_ch07_279-306.indd gar79611_ch07_279-306.indd Page 287 12/26/08 5:05:23 PM user-s198 /Users/user-s198/Desktop/Garrison/MHBR094-07 287 Variable Costing: A Tool for Management IN BUSINESS SCRUTINIZING VARIABLE MANUFACTURING COSTS AT FORD Jim Padilla, the chief operating ofcer at the Ford Motor Company, believes in ranking vehicles by the amount of contribution margin earned. In other words, for internal decision-making purposes he views direct materials, direct labor, and variable manufacturing overhead as product costs and xed manufacturing overhead as a period cost. Historically, Ford has been willing to sell small cars that get good gas mileage at a loss to boost the companys average fuel economy and air-pollution emission ratings. Padilla is committed to scaling back this practice. He believes the company should give serious consideration to discontinuing any car that cannot generate enough sales to cover its variable production costs. Source: Alex Taylor III, Bills Brand-New Ford, Fortune, June 28, 2004, pp. 6876. Choosing a Costing Method The Impact on the Manager Absorption costing income statements can be confusing and are easily misinterpreted. Look again at the absorption costing income statements in Exhibit 72; a manager might wonder why net operating income went up from January to February even though sales were exactly the same. Was it a result of lower selling costs, more efcient operations, or was it some other factor? In fact, it was simply because the number of units produced exceeded the number of units sold in February and so some of the xed manufacturing overhead costs were deferred in inventories in that month. These costs have not gone awaythey will eventually ow through to the income statement in a later period when inventories go down. There is no way to tell this from the absorption costing income statements. In contrast, the variable costing income statements in Exhibit 73 are clear and easy to understand. All other things the same, when sales go up, net operating income goes up. When sales go down, net operating income goes down. When sales are constant, net operating income is constant. To avoid mistakes when absorption costing is used, readers of nancial statements should be alert to changes in inventory levels. Under absorption costing, if inventories increase, xed manufacturing overhead costs are deferred in inventories, which in turn increases net operating income. If inventories decrease, xed manufacturing overhead costs are released from inventories, which in turn decreases net operating income. Thus, when absorption costing is used, uctuations in net operating income can be due to changes in inventories rather than to changes in sales. BIG INVENTORIES AT THE BIG THREE DETROIT AUTOMAKERS The table below summarizes automobile inventory data for General Motors, Chrysler, Ford, Honda, and Toyota at the end of 2006. Company Name U.S. Market Share Vehicles in Inventory at 12/31/2006 Vehicles per 1% of Market Share General Motors DaimlerChrysler Ford Honda Toyota 24.6% 14.4% 17.5% 9.1% 15.4% 1,028,783 538,438 624,754 225,293 320,282 41,820 37,391 35,700 24,757 20,797 L EARNING OBJECTIVE 4 Understand the advantages and disadvantages of both variable and absorption costing. IN BUSINESS gar79611_ch07_279-306.indd gar79611_ch07_279-306.indd Page 288 12/17/08 10:41:35 PM user-s198 288 /broker/MH-BURR/MHBR094/MHBR094-07 Chapter 7 The Big Three Detroit automakers have exorbitant inventories because they still rely on mass production, whereas Honda and Toyota use lean production methods. The Detroit automakers try to lower their average xed overhead cost per unit by making as many vehicles as possible. This approach results in bloated inventories and the frequent use of incentives and rebates to generate sales. Toyota and Honda produce vehicles in response to customer orders, resulting in lower inventories and less reliance on costly marketing gimmicks. If the U.S. automakers tried to improve their competitiveness by substantially lowering their inventories it would reduce prots. Can you explain why this would be the case for companies that use absorption costing? How would you feel as a manager if your inventory reduction efforts resulted in lower prots and a smaller bonus? Source: Neal Boudette, Big Dealer to Detroit: Fix How You Make Cars, The Wall Street Journal, February 9, 2007, pp. A1 and A8 CVP Analysis and Absorption Costing CVP analysis requires that we break costs down into their xed and variable components. Because variable costing income statements categorize costs as xed and variable, it is much easier to use this income statement format to perform CVP analysis than attempting to use the absorption costing format, which mixes together xed and variable costs. Moreover, absorption costing net operating income may or may not agree with the results of CVP analysis. For example, lets suppose that you are interested in computing the sales that would be necessary to generate a target prot of $105,000 at Weber Light Aircraft. A CVP analysis based on the January variable costing income statement from Exhibit 73 would proceed as follows: Sales (a) . . . . . . . . . . . . . . . . . . . . . . . . . Contribution margin (b) . . . . . . . . . . . . . Contribution margin ratio (b) (a) . . . . . Total xed expenses . . . . . . . . . . . . . . . . Dollar sales to attain target prot $100,000 $65,000 65% $90,000 Target prot Fixed expenses CM ratio $105,000 $90,000 0.65 $300,000 Thus, a CVP analysis based on the January variable costing income statement predicts that the net operating income would be $105,000 when sales are $300,000. And indeed, the net operating income under variable costing is $105,000 when the sales are $300,000 in March. However, the net operating income under absorption costing is not $105,000 in March, even though the sales are $300,000. Why is this? The reason is that under absorption costing, net operating income can be distorted by changes in inventories. In March, inventories decreased, so some of the xed manufacturing overhead that had been deferred in Februarys ending inventories was released to the March income statement, resulting in a net operating income that is lower than the $105,000 predicted by CVP analysis. If inventories had increased in March, the opposite would have occurredthe absorption costing net operating income would have been higher than the $105,000 predicted by CVP analysis. Decision Making Under absorption costing, xed manufacturing overhead costs appear to be variable with respect to the number of units sold, but they are not. For example, in January, the gar79611_ch07_279-306.indd Page 289 12/26/08 5:05:53 PM user-s198 /Users/user-s198/Desktop/Garrison/MHBR094-07 289 Variable Costing: A Tool for Management absorption unit product cost at Weber Light Aircraft is $95,000, but the variable portion of this cost is only $25,000. Because the product costs are stated on a per unit basis, managers may mistakenly believe that if another unit is produced, it will cost the company $95,000. But of course it would not. The cost of producing another unit would be only $25,000. The misperception that absorption unit product costs are variable can lead to many problems, including inappropriate pricing decisions and decisions to drop products that are in fact protable. These problems with absorption costing product costs will be discussed more fully in later chapters. External Reporting and Income Taxes Practically speaking, absorption costing is required for external reports in the United States. A company that attempts to use variable costing on its external nancial reports runs the risk that its auditors may not accept the nancial statements as conforming to generally accepted accounting principles (GAAP).3 Tax law on this issue is clear-cut. Under the Tax Reform Act of 1986, a form of absorption costing must be used when lling out income tax forms. Even if a company must use absorption costing for its external reports, a manager can use variable costing income statements for internal reports. No particular accounting problems are created by using both costing methodsthe variable costing method for internal reports and the absorption costing method for external reports. As we demonstrated earlier in Exhibit 74, the adjustment from variable costing net operating income to absorption costing net operating income is a simple one that can be easily made at the end of the accounting period. Top executives are typically evaluated based on the earnings reported to shareholders on the companys external nancial reports. This creates a problem for top executives who might otherwise favor using variable costing for internal reports. They may feel that because they are evaluated based on absorption costing reports, decisions should also be based on absorption costing data. Advantages of Variable Costing and the Contribution Approach As stated earlier, even if the absorption approach is used for external reporting purposes, variable costing, together with the contribution format income statement, is an appealing alternative for internal reports. The advantages of variable costing can be summarized as follows: 1. Data required for CVP analysis can be taken directly from a contribution format income statement. These data are not available on a conventional absorption costing income statement. 2. Under variable costing, the prot for a period is not affected by changes in inventories. Other things remaining the same (i.e., selling prices, costs, sales mix, etc.), profits move in the same direction as sales when variable costing is used. 3. Managers often assume that unit product costs are variable costs. This is a problem under absorption costing because unit product costs are a combination of both xed and variable costs. Under variable costing, unit product costs do not contain xed costs. 3 The situation is actually slightly ambiguous concerning whether absorption costing is strictly required. Ofcial pronouncements do not actually prohibit variable costing. And some companies expense signicant elements of their xed manufacturing costs on their external reports. Nevertheless, the reality is that most accountants believe that absorption costing is required for external reporting and a manager who argues otherwise is likely to be unsuccessful. IFRS gar79611_ch07_279-306.indd gar79611_ch07_279-306.indd Page 290 12/17/08 10:41:36 PM user-s198 290 /broker/MH-BURR/MHBR094/MHBR094-07 Chapter 7 4. The impact of xed costs on prots is emphasized under the variable costing and contribution approach. The total amount of xed costs appears explicitly on the income statement, highlighting that the whole amount of xed costs must be covered for the company to be truly protable. In contrast, under absorption costing, the xed costs are mingled together with the variable costs and are buried in cost of goods sold and ending inventories. 5. Variable costing data make it easier to estimate the protability of products, customers, and other business segments. With absorption costing, protability is obscured by arbitrary xed cost allocations. These issues will be discussed in later chapters. 6. Variable costing ties in with cost control methods such as standard costs and exible budgets, which will be covered in later chapters. 7. Variable costing net operating income is closer to net cash ow than absorption costing net operating income. This is particularly important for companies with potential cash ow problems. With all of these advantages, one might wonder why absorption costing continues to be used almost exclusively for external reporting and why it is the predominant choice for internal reports as well. This is partly due to tradition, but absorption costing is also attractive to many accountants and managers because they believe it better matches costs with revenues. Advocates of absorption costing argue that all manufacturing costs must be assigned to products in order to properly match the costs of producing units of product with their revenues when they are sold. The xed costs of depreciation, taxes, insurance, supervisory salaries, and so on, are just as essential to manufacturing products as are the variable costs. Advocates of variable costing argue that xed manufacturing costs are not really the costs of any particular unit of product. These costs are incurred to have the capacity to make products during a particular period and will be incurred even if nothing is made during the period. Moreover, whether a unit is made or not, the xed manufacturing costs will be exactly the same. Therefore, variable costing advocates argue that xed manufacturing costs are not part of the costs of producing a particular unit of product and thus the matching principle dictates that xed manufacturing costs should be charged to the current period. At any rate, absorption costing is the generally accepted method for preparing mandatory external nancial reports and income tax returns. Probably because of the cost and possible confusion of maintaining two separate costing systemsone for external reporting and one for internal reportingmost companies use absorption costing for both external and internal reports. Variable Costing and the Theory of Constraints The Theory of Constraints (TOC), which was introduced in Chapter 1, suggests that the key to improving a companys prots is managing its constraints. For reasons that will be discussed in a later chapter, this requires careful identication of each products variable costs. Consequently, companies involved in TOC use a form of variable costing. One difference is that the TOC approach generally considers direct labor to be a xed cost. As discussed in earlier chapters, in many companies direct labor is not really a variable cost. Even though direct labor workers may be paid on an hourly basis, many companies have a commitmentsometimes enforced in labor contracts or by lawto guarantee workers a minimum number of paid hours. In TOC companies, there are two additional reasons to consider direct labor a xed cost. First, direct labor is not usually the constraint. In the simplest cases, the constraint is a machine. In more complex cases, the constraint is a policy (such as a poorly designed compensation scheme for salespersons) that prevents the company from using its resources more effectively. If direct labor is not the constraint, there is no reason to increase it. Hiring more direct labor would increase costs without increasing the output of salable products and services. gar79611_ch07_279-306.indd gar79611_ch07_279-306.indd Page 291 12/17/08 10:41:36 PM user-s198 /broker/MH-BURR/MHBR094/MHBR094-07 291 Variable Costing: A Tool for Management Second, TOC emphasizes continuous improvement to maintain competitiveness. Without committed and enthusiastic employees, sustained continuous improvement is virtually impossible. Because layoffs often have devastating effects on employee morale, managers involved in TOC are extremely reluctant to lay off employees. For these reasons, most managers in TOC companies regard direct labor as a committed xed cost rather than a variable cost. Hence, in the modied form of variable costing used in TOC companies, direct labor is not usually classied as a product cost. Impact of Lean Production As discussed in this chapter, variable and absorption costing will produce different net operating incomes whenever the number of units produced is different from the number of units soldin other words, whenever there is a change in the number of units in inventory. Absorption costing net operating income can be erratic, sometimes moving in a direction that is opposite from the movement in sales. When companies use Lean Production methods, these problems are reduced. The erratic movement of net operating income under absorption costing and the difference in net operating income between absorption and variable costing occur because of changes in the number of units in inventory. Under Lean Production, goods are produced to customers orders and the goal is to eliminate nished goods inventories entirely and reduce work in process inventory to almost nothing. If there is very little inventory, then changes in inventories will be very small and both variable and absorption costing will show basically the same net operating income. With very little inventory, absorption costing net operating income usually moves in the same direction as movements in sales. Of course, the cost of a unit of product will still be different between variable and absorption costing, as explained earlier in the chapter. But when Lean Production is used, the differences in net operating income will largely disappear. Summary Variable and absorption costing are alternative methods of determining unit product costs. Under variable costing, only those manufacturing costs that vary with output are treated as product costs. This includes direct materials, variable overhead, and ordinarily direct labor. Fixed manufacturing overhead is treated as a period cost and it is expensed on the income statement as incurred. By contrast, absorption costing treats xed manufacturing overhead as a product cost, along with direct materials, direct labor, and variable overhead. Under both costing methods, selling and administrative expenses are treated as period costs and they are expensed on the income statement as incurred. Because absorption costing treats xed manufacturing overhead as a product cost, a portion of xed manufacturing overhead is assigned to each unit as it is produced. If units of product are unsold at the end of a period, then the xed manufacturing overhead cost attached to those units is carried with them into the inventory account and deferred to a future period. When these units are later sold, the xed manufacturing overhead cost attached to them is released from the inventory account and charged against income as part of cost of goods sold. Thus, under absorption costing, it is possible to defer a portion of the xed manufacturing overhead cost from one period to a future period through the inventory account. Unfortunately, this shifting of xed manufacturing overhead cost between periods can cause erratic uctuations in net operating income and can result in confusion and unwise decisions. To guard against mistakes when they interpret income statement data, managers should be alert to changes in inventory levels or unit product costs during the period. gar79611_ch07_279-306.indd gar79611_ch07_279-306.indd Page 292 12/17/08 10:41:36 PM user-s198 292 /broker/MH-BURR/MHBR094/MHBR094-07 Chapter 7 Practically speaking, variable costing cant be used externally for either nancial or tax reporting. However, it may be used internally by managers for planning and control purposes. The variable costing approach works well with CVP analysis. Review Problem: Contrasting Variable and Absorption Costing Dexter Corporation produces and sells a single product, a wooden hand loom for weaving small items such as scarves. Selected cost and operating data relating to the product for two years are given below: Selling price per unit . . . . . . . . . . . . . . . . . . . Manufacturing costs: Variable per unit produced: Direct materials. . . . . . . . . . . . . . . . . . . . Direct labor . . . . . . . . . . . . . . . . . . . . . . . Variable overhead . . . . . . . . . . . . . . . . . . Fixed per year. . . . . . . . . . . . . . . . . . . . . . . Selling and administrative costs: Variable per unit sold . . . . . . . . . . . . . . . . . Fixed per year. . . . . . . . . . . . . . . . . . . . . . . $50 $11 $6 $3 $120,000 $4 $70,000 Year 1 Units in beginning inventory . . . . . . . . . . . . . Units produced during the year. . . . . . . . . . . Units sold during the year . . . . . . . . . . . . . . . Units in ending inventory. . . . . . . . . . . . . . . . Year 2 0 10,000 8,000 2,000 2,000 6,000 8,000 0 Required: 1. 2. 3. Assume the company uses absorption costing. a. Compute the unit product cost in each year. b. Prepare an income statement for each year. Assume the company uses variable costing. a. Compute the unit product cost in each year. b. Prepare an income statement for each year. Reconcile the variable costing and absorption costing net operating incomes. Solution to Review Problem 1. a. Under absorption costing, all manufacturing costs, variable and xed, are included in unit product costs: Year 1 Year 2 Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . Variable manufacturing overhead . . . . . . . . . . Fixed manufacturing overhead ($120,000 10,000 units) . . . . . . . . . . . . . . ($120,000 6,000 units) . . . . . . . . . . . . . . . $11 6 3 $11 6 3 Absorption costing unit product cost . . . . . . . . $32 12 20 $40 gar79611_ch07_279-306.indd Page 293 12/17/08 10:41:36 PM user-s198 /broker/MH-BURR/MHBR094/MHBR094-07 Variable Costing: A Tool for Management b. The absorption costing income statements follow: Year 1 Sales (8,000 units $50 per unit) . . . . . . . . . . . . . . . . . Cost of goods sold (8,000 units $32 per unit; (2,000 units $32 per unit) (6,000 units $40 per unit) . . . . . . . . . . . . . . . . . . . . $400,000 $400,000 256,000 304,000 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Selling and administrative expenses (8,000 units $4 per unit $70,000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144,000 96,000 102,000 102,000 Net operating income (loss) . . . . . . . . . . . . . . . . . . . . . 2. Year 2 $ 42,000 $ (6,000) a. Under variable costing, only the variable manufacturing costs are included in product costs: Year 1 Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . Variable manufacturing overhead . . . . . . . . . . $11 6 3 $11 6 3 Variable costing unit product cost . . . . . . . . . . b. Year 2 $20 $20 The variable costing income statements follow. Year 1 Sales (8,000 units $50 per unit) . . . . . . . . . Variable expenses: Variable cost of goods sold (8,000 units $20 per unit) . . . . . . . . . . Variable selling and administrative expenses (8,000 units $4 per unit) . . . . . . . . . . . . . . . . . . . . . . Contribution margin . . . . . . . . . . . . . . . . . . . Fixed expenses: Fixed manufacturing overhead . . . . . . . . . . Fixed selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . Net operating income . . . . . . . . . . . . . . . . . . 3. Year 2 $400,000 $160,000 32,000 $400,000 $160,000 192,000 32,000 208,000 120,000 70,000 192,000 208,000 120,000 190,000 70,000 $ 18,000 190,000 $ 18,000 The reconciliation of the variable and absorption costing net operating incomes follows: Year 1 Year 2 Variable costing net operating income . . . . . . . . . . . . . . . . . . Add xed manufacturing overhead costs deferred in inventory under absorption costing (2,000 units $12 per unit) . . . . . . . . . . . . . . . . . . . . . . . . Deduct xed manufacturing overhead costs released from inventory under absorption costing (2,000 units $12 per unit) . . . . . . . . . . . . . . . . . . . . . . . . $18,000 $18,000 Absorption costing net operating income (loss). . . . . . . . . . . . $42,000 24,000 (24,000) $ (6,000) 293 gar79611_ch07_279-306.indd Page 294 12/26/08 5:06:10 PM user-s198 294 /Users/user-s198/Desktop/Garrison/MHBR094-07 Chapter 7 Glossary Absorption costing A costing method that includes all manufacturing costsdirect materials, direct labor, and both variable and xed manufacturing overheadin unit product costs. (p. 280) Variable costing A costing method that includes only variable manufacturing costsdirect materials, direct labor, and variable manufacturing overheadin unit product costs. (p. 280) Questions 71 72 73 74 75 76 77 78 79 710 What is the basic difference between absorption costing and variable costing? Are selling and administrative expenses treated as product costs or as period costs under variable costing? Explain how xed manufacturing overhead costs are shifted from one period to another under absorption costing. What are the arguments in favor of treating xed manufacturing overhead costs as product costs? What are the arguments in favor of treating xed manufacturing overhead costs as period costs? If the units produced and unit sales are equal, which method would you expect to show the higher net operating income, variable costing or absorption costing? Why? If the units produced exceed unit sales, which method would you expect to show the higher net operating income, variable costing or absorption costing? Why? If xed manufacturing overhead costs are released from inventory under absorption costing, what does this tell you about the level of production in relation to the level of sales? Under absorption costing, how is it possible to increase net operating income without increasing sales? How does Lean Production reduce or eliminate the difference in reported net operating income between absorption and variable costing? Multiple-choice questions are provided on the text website at www.mhhe.com/garrison13e. Exercises EXERCISE 71 Variable and Absorption Costing Unit Product Costs [LO1] Ida Sidha Karya Company is a family-owned company located in the village of Gianyar on the island of Bali in Indonesia. The company produces a handcrafted Balinese musical instrument called a gamelan that is similar to a xylophone. The sounding bars are cast from brass and hand-led to attain just the right sound. The bars are then mounted on an intricately hand-carved wooden base. The gamelans are sold for 850 (thousand) rupiahs. (The currency in Indonesia is the rupiah, which is denoted by Rp.) Selected data for the companys operations last year follow (all currency values are in thousands of rupiahs): Units in beginning inventory. . . . . . . . . . . . . . . . . Units produced. . . . . . . . . . . . . . . . . . . . . . . . . . . Units sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Units in ending inventory . . . . . . . . . . . . . . . . . . . 0 250 225 25 Variable costs per unit: Direct materials . . . . . . . . . . . . . . . . . . . . . . . . Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . Variable manufacturing overhead . . . . . . . . . . . Variable selling and administrative . . . . . . . . . . Rp100 Rp320 Rp40 Rp20 Fixed costs: Fixed manufacturing overhead . . . . . . . . . . . . . Fixed selling and administrative . . . . . . . . . . . . Rp60,000 Rp20,000 gar79611_ch07_279-306.indd Page 295 12/17/08 10:41:37 PM user-s198 /broker/MH-BURR/MHBR094/MHBR094-07 Variable Costing: A Tool for Management Required: 1. 2. Assume that the company uses absorption costing. Compute the unit product cost for one gamelan. Assume that the company uses variable costing. Compute the unit product cost for one gamelan. EXERCISE 72 Variable Costing Income Statement; Explanation of Difference in Net Operating Income [LO2] Refer to the data in Exercise 71 for Ida Sidha Karya Company. The absorption costing income statement prepared by the companys accountant for last year appears below (all currency values are in thousands of rupiahs): Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost of goods sold . . . . . . . . . . . . . . . . . . . Rp191,250 157,500 Gross margin . . . . . . . . . . . . . . . . . . . . . . . Selling and administrative expense . . . . . . 33,750 24,500 Net operating income. . . . . . . . . . . . . . . . . Rp 9,250 Required: 1. 2. Determine how much of the ending inventory consists of xed manufacturing overhead cost deferred in inventory to the next period. Prepare an income statement for the year using variable costing. Explain the difference in net operating income between the two costing methods. EXERCISE 73 Reconciliation of Absorption and Variable Costing Net Operating Incomes [LO3] Jorgansen Lighting, Inc., manufactures heavy-duty street lighting systems for municipalities. The company uses variable costing for internal management reports and absorption costing for external reports to shareholders, creditors, and the government. The company has provided the following data: Year 1 Inventories: Beginning (units) . . . . . . . . . . . . . . . . . . . Ending (units) . . . . . . . . . . . . . . . . . . . . . . Variable costing net operating income . . . . . Year 2 Year 3 200 170 $1,080,400 170 180 $1,032,400 180 220 $996,400 The companys xed manufacturing overhead per unit was constant at $560 for all three years. Required: 1. 2. Determine each years absorption costing net operating income. Present your answer in the form of a reconciliation report as shown in Exhibit 74. In Year 4, the companys variable costing net operating income was $984,400 and its absorption costing net operating income was $1,012,400. Did inventories increase or decrease during Year 4? How much xed manufacturing overhead cost was deferred or released from inventory during Year 4? EXERCISE 74 Evaluating Absorption and Variable Costing as Alternative Costing Methods [LO4] The questions below pertain to two different scenarios involving a manufacturing company. In each scenario, the cost structure of the company is constant from year to year. Selling prices, unit variable costs, and total xed costs are the same in every year. However, unit sales and/or unit production levels may vary from year to year. Required: 1. Consider the following data for scenario A: Year 1 Variable costing net operating income . . . . . . $41,694 Absorption costing net operating income. . . . $41,694 Year 2 Year 3 $41,694 $66,755 $41,694 $20,036 295 gar79611_ch07_279-306.indd gar79611_ch07_279-306.indd Page 296 12/17/08 10:41:39 PM user-s198 296 /broker/MH-BURR/MHBR094/MHBR094-07 Chapter 7 a. b. 2. Were unit sales constant from year to year? Explain. What was the relation between unit sales and unit production levels in each year? For each year, indicate whether inventories grew or shrank. Consider the following data for scenario B: Year 1 Variable costing net operating income (loss) . . . . Absorption costing net operating income. . . . . . . Year 2 Year 3 $41,694 ($29,306) ($100,306) $41,694 $42,165 $42,637 a. b. 3. Were unit sales constant from year to year? Explain. What was the relation between unit sales and unit production levels in each year? For each year, indicate whether inventories grew or shrank. Given the patterns of net operating income in scenarios A and B above, which costing method, variable costing or absorption costing, do you believe provides a better reection of economic reality? Explain. EXERCISE 75 Variable and Absorption Costing Unit Product Costs and Income Statements [LO1, LO2] Lynch Company manufactures and sells a single product. The following costs were incurred during the companys rst year of operations: Variable costs per unit: Manufacturing: Direct materials . . . . . . . . . . . . . . . . . . . Direct labor . . . . . . . . . . . . . . . . . . . . . . . Variable manufacturing overhead . . . . . . Variable selling and administrative . . . . . . . . $6 $9 $3 $4 Fixed costs per year: Fixed manufacturing overhead. . . . . . . . . . Fixed selling and administrative . . . . . . . . . $300,000 $190,000 During the year, the company produced 25,000 units and sold 20,000 units. The selling price of the companys product is $50 per unit. Required: 1. 2. Assume that the company uses absorption costing: a. Compute the unit product cost. b. Prepare an income statement for the year. Assume that the company uses variable costing: a. Compute the unit product cost. b. Prepare an income statement for the year. EXERCISE 76 Inferring Costing Method; Unit Product Cost [LO1, LO4] Sierra Company incurs the following costs to produce and sell a single product. Variable costs per unit: Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Variable manufacturing overhead . . . . . . . . . . . . . Variable selling and administrative expenses . . . . $9 $10 $5 $3 Fixed costs per year: Fixed manufacturing overhead . . . . . . . . . . . . . . . Fixed selling and administrative expenses . . . . . . $150,000 $400,000 During the last year, 25,000 units were produced and 22,000 units were sold. The Finished Goods inventory account at the end of the year shows a balance of $72,000 for the 3,000 unsold units. gar79611_ch07_279-306.indd Page 297 12/17/08 10:41:40 PM user-s198 /broker/MH-BURR/MHBR094/MHBR094-07 Variable Costing: A Tool for Management Required: 1. 2. Is the company using absorption costing or variable costing to cost units in the Finished Goods inventory account? Show computations to support your answer. Assume that the company wishes to prepare nancial statements for the year to issue to its stockholders. a. Is the $72,000 figure for Finished Goods inventory the correct amount to use on these statements for external reporting purposes? Explain. b. At what dollar amount should the 3,000 units be carried in the inventory for external reporting purposes? EXERCISE 77 Variable Costing Income Statement; Reconciliation [LO2, LO3] Whitman Company has just completed its rst year of operations. The companys absorption costing income statement for the year appears below: Whitman Company Income Statement Sales (35,000 units $25 per unit) . . . . . . . . . . . . . . . . . . . . . . . . . Cost of goods sold (35,000 units $16 per unit) . . . . . . . . . . . . . . . $875,000 560,000 Gross margin. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . 315,000 280,000 Net operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 35,000 The companys selling and administrative expenses consist of $210,000 per year in xed expenses and $2 per unit sold in variable expenses. The $16 per unit product cost given above is computed as follows: Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Variable manufacturing overhead . . . . . . . . . . . . . . . . . . . . . . . . Fixed manufacturing overhead ($160,000 40,000 units) . . . . . $5 6 1 4 Absorption costing unit product cost . . . . . . . . . . . . . . . . . . . . . . $16 Required: 1. 2. Redo the companys income statement in the contribution format using variable costing. Reconcile any difference between the net operating income on your variable costing income statement and the net operating income on the absorption costing income statement above. EXERCISE 78 Variable Costing Unit Product Cost and Income Statement; Break-Even [LO1, LO2] Chuck Wagon Grills, Inc., makes a single producta handmade specialty barbecue grill that it sells for $210. Data for last years operations follow: Units in beginning inventory . . . . . . . . . . . . . Units produced . . . . . . . . . . . . . . . . . . . . . . . Units sold. . . . . . . . . . . . . . . . . . . . . . . . . . . . Units in ending inventory . . . . . . . . . . . . . . . . 0 20,000 19,000 1,000 Variable costs per unit: Direct materials . . . . . . . . . . . . . . . . . . . . . Direct labor. . . . . . . . . . . . . . . . . . . . . . . . . Variable manufacturing overhead. . . . . . . . Variable selling and administrative . . . . . . . $ 50 80 20 10 Total variable cost per unit . . . . . . . . . . . . . $160 Fixed costs: Fixed manufacturing overhead. . . . . . . . . . Fixed selling and administrative . . . . . . . . . $700,000 285,000 Total xed costs . . . . . . . . . . . . . . . . . . . . . $985,000 297 gar79611_ch07_279-306.indd gar79611_ch07_279-306.indd Page 298 12/17/08 10:41:40 PM user-s198 298 /broker/MH-BURR/MHBR094/MHBR094-07 Chapter 7 Required: 1. 2. 3. Assume that the company uses variable costing. Compute the unit product cost for one barbecue grill. Assume that the company uses variable costing. Prepare a contribution format income statement for the year. What is the companys break-even point in terms of the number of barbecue grills sold? EXERCISE 79 Absorption Costing Unit Product Cost and Income Statement [LO1, LO2] Refer to the data in Exercise 78 for Chuck Wagon Grills. Assume in this exercise that the company uses absorption costing. Required: 1. 2. Compute the unit product cost for one barbecue grill. Prepare an income statement. EXERCISE 710 Deducing Changes in Inventories [LO3] Parker Products Inc, a manufacturer, reported $123 million in sales and a loss of $18 million in its annual report to shareholders. According to a CVP analysis prepared for management, the companys break-even point is $115 million in sales. Required: Assuming that the CVP analysis is correct, is it likely that the companys inventory level increased, decreased, or remained unchanged during the year? Explain. Problems PROBLEM 711 Variable Costing Income Statement; Reconciliation [LO2, LO3] During Heaton Companys rst two years of operations, the company reported absorption costing net operating income as follows: Year 1 Year 2 Sales (@ $25 per unit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost of goods sold (@ $18 per unit) . . . . . . . . . . . . . . . . . . $1,000,000 720,000 $1,250,000 900,000 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Selling and administrative expenses* . . . . . . . . . . . . . . . . . 280,000 210,000 350,000 230,000 70,000 $ 120,000 Net operating income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ *$2 per unit variable; $130,000 fixed each year. The companys $18 unit product cost is computed as follows: Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Variable manufacturing overhead . . . . . . . . . . . . . . . . . . . . . . . Fixed manufacturing overhead ($270,000 45,000 units) . . . . $4 7 1 6 Absorption costing unit product cost . . . . . . . . . . . . . . . . . . . . . $18 Forty percent of xed manufacturing overhead consists of wages and salaries; the remainder consists of depreciation charges on production equipment and buildings. Production and cost data for the two years are: Year 1 Units produced . . . . . . . . . Units sold . . . . . . . . . . . . . Year 2 45,000 40,000 45,000 50,000 Required: 1. 2. Prepare a variable costing contribution format income statement for each year. Reconcile the absorption costing and the variable costing net operating income gures for each year. gar79611_ch07_279-306.indd Page 299 12/17/08 10:41:41 PM user-s198 /broker/MH-BURR/MHBR094/MHBR094-07 Variable Costing: A Tool for Management PROBLEM 712 Variable and Absorption Costing Unit Product Costs and Income Statements; Explanation of Difference in Net Operating Income [LO1, LO2, LO3] High Country, Inc., produces and sells many recreational products. The company has just opened a new plant to produce a folding camp cot that will be marketed throughout the United States. The following cost and revenue data relate to May, the rst month of the plants operation: Management is anxious to see how protable the new camp cot will be and has asked that an income statement be prepared for May. Required: 1. 2. 3. Assume that the company uses absorption costing. a. Determine the unit product cost. b. Prepare an income statement for May. Assume that the company uses variable costing. a. Determine the unit product cost. b. Prepare a contribution format income statement for May. Explain the reason for any difference in the ending inventory balances under the two costing methods and the impact of this difference on reported net operating income. PROBLEM 713 Absorption and Variable Costing; Production Constant, Sales Fluctuate [LO1, LO2, LO3, LO4] Tami Tyler opened Tamis Creations, Inc., a small manufacturing company, at the beginning of the year. Getting the company through its rst quarter of operations placed a considerable strain on Ms. Tylers personal nances. The following income statement for the rst quarter was prepared by a friend who has just completed a course in managerial accounting at State University. Tamis Creations, Inc. Income Statement For the Quarter Ended March 31 Sales (28,000 units). . . . . . . . . . . . . . . . . . . . . . . . Variable expenses: Variable cost of goods sold. . . . . . . . . . . . . . . . . Variable selling and administrative . . . . . . . . . . . Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . Fixed expenses: Fixed manufacturing overhead . . . . . . . . . . . . . . Fixed selling and administrative . . . . . . . . . . . . . Net operating loss . . . . . . . . . . . . . . . . . . . . . . . . . $1,120,000 $462,000 168,000 630,000 490,000 300,000 200,000 500,000 $ (10,000) 299 gar79611_ch07_279-306.indd Page 300 12/17/08 10:41:42 PM user-s198 300 /broker/MH-BURR/MHBR094/MHBR094-07 Chapter 7 Ms. Tyler is discouraged over the loss shown for the quarter, particularly because she had planned to use the statement as support for a bank loan. Another friend, a CPA, insists that the company should be using absorption costing rather than variable costing and argues that if absorption costing had been used the company would probably have reported at least some prot for the quarter. At this point, Ms. Tyler is manufacturing only one product, a swimsuit. Production and cost data relating to the swimsuit for the rst quarter follow: Units produced . . . . . . . . . . . . . . . . . . . . . . . . . Units sold. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000 28,000 Variable costs per unit: Direct materials . . . . . . . . . . . . . . . . . . . . . . . Direct labor. . . . . . . . . . . . . . . . . . . . . . . . . . . Variable manufacturing overhead. . . . . . . . . . Variable selling and administrative . . . . . . . . . $3.50 $12.00 $1.00 $6.00 Required: 1. 2. 3. Complete the following: a. Compute the unit product cost under absorption costing. b. Redo the companys income statement for the quarter using absorption costing. c. Reconcile the variable and absorption costing net operating income (loss) gures. Was the CPA correct in suggesting that the company really earned a prot for the quarter? Explain. During the second quarter of operations, the company again produced 30,000 units but sold 32,000 units. (Assume no change in total xed costs.) a. Prepare a contribution format income statement for the quarter using variable costing. b. Prepare an income statement for the quarter using absorption costing. c. Reconcile the variable costing and absorption costing net operating incomes. PROBLEM 714 Prepare and Reconcile Variable Costing Statements [LO1, LO2, LO3, LO4] Denton Company manufactures and sells a single product. Cost data for the product are given below: Variable costs per unit: Direct materials . . . . . . . . . . . . . . . . . . . . Direct labor. . . . . . . . . . . . . . . . . . . . . . . . Variable manufacturing overhead. . . . . . . Variable selling and administrative . . . . . . $7 10 5 3 Total variable cost per unit . . . . . . . . . . . . $25 Fixed costs per month: Fixed manufacturing overhead. . . . . . . . . Fixed selling and administrative . . . . . . . . $315,000 245,000 Total xed cost per month . . . . . . . . . . . . $560,000 The product sells for $60 per unit. Production and sales data for July and August, the rst two months of operations, follow: Units Produced July . . . . . . . . . . . August . . . . . . . . . Units Sold 17,500 17,500 15,000 20,000 gar79611_ch07_279-306.indd gar79611_ch07_279-306.indd Page 301 12/17/08 10:41:43 PM user-s198 /broker/MH-BURR/MHBR094/MHBR094-07 Variable Costing: A Tool for Management The companys Accounting Department has prepared absorption costing income statements for July and August as presented below: July August Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . $900,000 600,000 $1,200,000 800,000 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Selling and administrative expenses . . . . . . . . . . . . 300,000 290,000 400,000 305,000 Net operating income. . . . . . .