In this example setting the denominator to equal the

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In this example, setting the denominator to equal the master budget (the lowest of the four capacity levels here), minimizes the loss to the manager from being unable to sell the entire production quantity of 220,000 bulbs. 9-41
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3. In this scenario, the manager of ELF produces 220,000 bulbs and sells 200,000 of them, and the production volume variance is prorated. Given the absence of ending work in process inventory or beginning inventory of any kind, the fraction of the production volume variance that is absorbed into the cost of goods sold is given by 200,000/220,000 or 10/11. The operating income under various denominator levels is then given by the following modification of the solution to requirement 3 of 9-37: Theoretical Practical Normal Master Budget Revenue $1,800,000 $1,800,000 $1,800,000 $1,800,000 Less: Cost of goods sold 750,000 900,000 1,300,000 1,500,000 Prorated production- volume variance a 659,091 U 509,091 U 109,091 U (90,909 ) F Gross margin 390,909 390,909 390,909 390,909 Variable selling b 50,000 50,000 50,000 50,000 Fixed selling 250,000 250,000 250,000 250,000 Operating income $ 90,909 $ 90,909 $ 90,909 $ 90,909 a (10/11) × 725,000, × 560,000, × 120,000, × 100,000 b 200,000 × 0.25 Under the proration approach, operating income is $90,909 regardless of the denominator initially used. Thus, in contrast to the case where the production volume variance is written off to cost of goods sold, there is no temptation under the proration approach for the manager to play games with the choice of denominator level. 9-42
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9-39 (30 min.) Cost allocation, downward demand spiral. SOLUTION EXHIBIT 9-39 2009 Master Budget (1) Practical Capacity (2) 2010 Master Budget (3) Budgeted fixed costs $1,533,00 0 $1,533,00 0 $1,533,00 0 Denominator level 1,022,000 1,460,000 876,000 Budgeted fixed cost per meal Budgeted fixed costs ÷ Denominator level ($1,533,000 ÷ 1,022,000; $1,533,000 ÷ 1,460,000; $1,533,000 ÷ 876,000) $ 1.50 $ 1.05 $ 1.75 Budgeted variable cost per meal 4.5 0 4.5 0 4.5 0 Total budgeted cost per meal $ 6.0 0 $ 5.5 5 $ 6.2 5 1. The 2009 budgeted fixed costs are $1,533,000. Deliman budgets for 1,022,000 meals in 2009, and this is used as the denominator level to calculate the fixed cost per meal. $1,533,000 ÷ 1,022,000 = $1.50 fixed cost per meal. (see column (1) in Solution Exhibit 9-39). 2. In 2010, 3 hospitals have dropped out of the purchasing group and the master budget is 876,000 meals. If this is used as the denominator level, fixed cost per meal = $1,533,000 ÷ 876,000 = $1.75 per meal, and the total budgeted cost per meal would be $6.25 (see column (3) in Solution Exhibit 9-39). If the hospitals have already been complaining about quality and cost and are allowed to purchase from outside, they will not accept this higher price. More hospitals may begin to purchase meals from outside the system, leading to a downward demand spiral, possibly putting Deliman out of business. 3. The basic problem is that Deliman has excess capacity and the associated excess fixed costs. If Smith uses the practical capacity of 1,460,000 meals as the denominator level, the fixed cost per meal will be $1.05 (see column (2) in Solution Exhibit 9-39), and the total budgeted cost per meal would be $5.55, probably a more acceptable price to the customers (it may even draw back the three hospitals that have chosen to buy outside). This denominator level will also isolate the cost of unused capacity and not allocate it to the meals produced. To make the $5.55 price
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