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Chapter 2

Cost Terms, Concepts, and Classifications Learning Objectives LO1. Identify and give examples of each of the three basic manufacturing cost categories. LO2. Distinguish between product costs and period costs and give examples of each. LO3. Prepare an income statement including calculation of the cost of goods sold. LO4. Prepare a schedule of cost of goods manufactured. LO5. Understand the differences between variable costs and fixed costs. LO6. Understand the differences between direct and indirect costs. LO7. Define and give examples of cost classifications used in making decisions: differential

costs, opportunity costs, and sunk costs. LO8. (Appendix 2A) Properly account for labor costs associated with idle time, overtime, and

fringe benefits. LO9. (Appendix 2B) Identify the four types of quality costs and explain how they interact. LO10. (Appendix 2B) Prepare and interpret a quality cost report. New in this Edition • Many new In Business boxes have been added. • New shorter exercises that cover a single learning objective have been created. Chapter Overview

A. General Theme. Costs can be classified in a number of ways—depending on the purpose of the classification. For example, classification of costs for purposes of determining inventory valuations and cost of goods sold for external reports differs from the classification of costs that would be carried out to aid decision-making. It is important to note that the classifications of costs are not mutually exclusive. That is, a particular cost may be classified in many different ways—depending on the purpose of the classification. B. Cost Classifications for Preparing External Financial Statements. (Exercises 2-1, 2-2, 2-3, 2-4, 2-10, 2-11, and 2-12.) This section of the chapter focuses on the problem of valuing inventories and determining cost of goods sold for external financial reports. Before beginning this discussion, you may want to explain the difference between a manufacturing and a merchandising company. Manufacturing companies convert raw materials into a product. The company then sells that product either to other companies or, less commonly, directly to individuals. “Manufacturing” includes restaurants, movie studios, and other service-type companies as well as the more obvious examples of manufacturing such as automobile and clothing production. Merchandising companies, by contrast, buy finished products and resell the products to customers. Valuing inventories and determining cost of goods sold is simple in a merchandising company, but is difficult in a manufacturing company. For that reason, we concentrate on manufacturing in this section of the chapter.

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1. Manufacturing costs. These costs are incurred to make a product. Manufacturing costs are

usually grouped into three main categories: direct materials, direct labor, and manufacturing overhead.

a. Direct materials. Direct materials consist of those raw material inputs that become an

integral part of a finished product and can be easily traced into it. Examples include the aircraft engines on a Boeing 777, the Intel processing chip in a personal computer, and the blank video cassette in a pre-recorded video.

b. Direct Labor. Direct labor consists of that portion of labor cost that can be easily traced

to a product. Direct labor is sometimes referred to as “touch labor” since it consists of the costs of workers who “touch” the product as it is being made.

c. Manufacturing Overhead. Manufacturing overhead consists of all manufacturing costs

other than direct materials and direct labor. These costs cannot be easily and conveniently traced to products. Examples include miscellaneous supplies such as rivets in a Boeing 777, supervisors, janitors, factory facility charges, etc.

d. Prime versus Conversion Costs. Prime cost consists of direct materials plus direct

labor. Conversion cost consists of direct labor plus manufacturing overhead.

2. Non-manufacturing costs. A manufacturing company incurs many other costs in addition to manufacturing costs. For financial reporting purposes most of these other costs are typically classified as selling (marketing) costs and administrative costs. Marketing and administrative costs are incurred in both manufacturing and merchandising firms. a. Marketing Costs. These costs include the costs of making sales, taking customer orders,

and delivering the product to customers. These costs are also referred to as order-getting and order-filling costs.

b. Administrative Costs. These costs include all executive, organizational, and clerical

costs that are not classified as production or marketing costs.

3. Period vs. product costs. Costs can also be classified as period or product costs. a. Period Costs. Period costs are expensed in the time period in which they are incurred.

All selling and administrative costs are typically considered to be period costs. You should be careful to point out that the usual rules of accrual accounting apply. For example, administrative salary costs are “incurred” when they are earned and not necessarily when they are paid to employees.

b. Product Costs. Product costs are added to units of product (i.e., “inventoried”) as they

are incurred and are not treated as expenses until the units are sold. This can result in a delay of one or more periods between the time in which the cost is incurred and when it appears as an expense on the income statement. Product costs are also known as inventoriable costs. The discussion in the chapter follows the usual interpretation of GAAP in which all manufacturing costs are treated as product costs.

4. Inventory valuations and Cost of Goods Sold. In a manufacturing company, raw

materials purchases are recorded in a raw materials inventory account. These costs are

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transferred to a work in process inventory account when the materials are released to the production departments. Other manufacturing costs—direct labor and manufacturing overhead—are charged to the work in process inventory account as incurred. As work in process is completed, its costs are transferred to the finished goods inventory account. These costs become expenses only when the finished goods are sold. Period expenses are taken directly to the income statement as expenses of the period.

5. Schedule of Cost of Goods Manufactured. Because of inventories, the cost of goods sold

for a period is not simply the manufacturing costs incurred during the period. Some of the cost of goods sold may be for units completed in a previous period. And some of the units completed in the current period may not have been sold and will still be on the balance sheet as assets. The cost of goods sold is computed with the aid of a schedule of costs of goods manufactured, which takes into account changes in inventories. The schedule of cost of goods manufactured is not ordinarily included in external financial reports, but must be compiled by accountants within the company in order to arrive at the cost of goods sold. You should take some time to explain the cost of goods manufactured schedule since it is often difficult for students to understand.

C. Cost Classifications to Describe Cost Behavior. (Exercises 2-5 and 2-11.) Managers often need to be able to predict how costs will change in response to changes in activity. The activity might be the output of goods or services or it might be some measure of activity internal to the company such as the number of purchase orders processed during a period. In this chapter, nearly all of the illustrations assume that the activity is the output of goods or services. In later chapters, other measures of activity will be introduced. While there are other ways to classify costs according to how they react to changes in activity, in this chapter we introduce the simple variable and fixed classifications. A variable cost is constant per unit of activity but changes in total as the activity level rises and falls. A fixed cost is constant in total for changes in activity within the relevant range. (Just about any cost will change if there is a big enough change in activity. Fixed costs do not change for changes in activity that fall within the “relevant range.”) When expressed on a per unit basis, a fixed cost is inversely related to activity—the per unit cost decreases when activity rises and increases when activity falls. There is some controversy concerning the proper definition of the “relevant range.” Some refer to the relevant range as the range of activity within which the company usually operates. We refer to the relevant range as the range of activity within which the assumptions about variable and fixed costs are valid. Either definition could be used—our choice was dictated by our desire to highlight the notion that fixed costs can change if the level of activity changes enough. D. Cost Classifications for Assigning Costs. (Exercise 2-6.) Managers often want costs to be assigned to “cost objects” such as products, customers, departments, etc. for pricing or other purposes. A direct cost is a cost that can be conveniently and easily traced to a particular cost object. Indirect costs are everything else. A cost would be considered indirect for one of two reasons: either it is impractical or it is impossible to trace the cost to the cost object. 1. Common costs. For example, it is impossible to trace the factory managers’ salary in a

multi-product plant to any particular product made in the plant. Even if a product were dropped entirely, we would ordinarily expect the factory manager’s salary to remain the same. This is an example of a “common cost” and later in the text we emphasize that such costs should not be allocated for decision-making or performance evaluation purposes.

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2. Variable indirect costs. On the other hand, other costs are treated as indirect costs because it would not be practical to treat them otherwise. For example, it would be possible to measure the precise amount of solder used on each circuit board produced at a HP plant, but it wouldn’t be worth the effort. Instead, solder would typically be considered an indirect material and would be included in overhead.

E. Cost Classifications for Decision-Making. (Exercise 2-7.) Every decision involves choosing from among at least two alternatives. Only those costs and benefits that differ between alternatives are relevant in making the selection. This concept is explored in greater detail in the chapter on relevant costs. However, decision-making contexts crop up from time to time in the text before that chapter, so it is a good idea to familiarize students with relevant cost concepts. 1. Differential Costs. A differential cost is a cost that differs between alternatives. The cost

may exist in only one of the alternatives or the total amount of the cost may differ between the alternatives. In the latter case, the differential cost would be the difference between the cost under one alternative and the cost under the other. Differential costs are also called incremental costs. Differential costs and opportunity costs should be the focus of decision-making. They are the only relevant costs and all others should be ignored.

2. Opportunity Costs. An opportunity cost is the potential benefit that is given up by

selecting one alternative over another. The concept of an opportunity cost is rather difficult for students to understand because it is not an actual expenditure and it is rarely (if ever) shown on the accounting books of an organization. It is, however, a cost that must be considered in decisions.

3. 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. Since sunk costs cannot be changed and therefore cannot be differential costs, they should be ignored in decision making. While students usually accept the idea that sunk costs should be ignored on an abstract level, like most people they often have difficulty putting this idea into practice.

F. Classification of Labor Costs (Appendix 2A). (Exercises 2-8 and 2-13.) Factory labor costs are classified as direct or indirect labor. Direct labor is basically “touch labor.” Indirect labor is the rest of the manufacturing labor cost and it is classified as part of manufacturing overhead. Examples of indirect labor include the wages and salaries of janitors, supervisors, material handlers, and maintenance workers. 1. Idle Time. Some labor costs, such as idle time, are not easily identified as either direct or

indirect labor. Idle time represents the wages of direct labor workers who are idle due to machine breakdowns, material shortages, and so forth. Typically, these costs are classified as overhead costs and are allocated across all products.

2. Overtime Premium. The overtime premium paid to factory workers is usually considered

to be part of manufacturing overhead. It is argued that it would be unfair to charge an overtime premium against a product that happened to be scheduled for the overtime period. Therefore, the overtime premium is usually added to overhead and spread among all jobs of the period. It should be noted that if a company works overtime specifically because of a special request or a rush order job, the overtime premium may appropriately be charged against that particular job.

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3. Fringe Benefits. These costs include payments made to insurance and retirement plans as well as various employee taxes such as social security. Typically, companies treat these costs as manufacturing overhead. However, it would be more accurate to split fringe benefits between the portion that relates to direct labor and the portion that relates to indirect labor. Only those fringe benefits that relate to indirect labor should be included in manufacturing overhead; the rest should be considered as part of direct labor cost.

G. Quality Costs (Appendix 2B) (Exercise 2-9.) The term quality has many meanings. Quality can mean that a product has many features not found in other products; it can mean that it is well-designed; or it can mean that it is defect-free. In this appendix, the focus is on the presence or absence of defects. Quality of conformance is the degree to which the actual product or service meets its design specifications. Anything that does not meet design specifications is a defect and is indicative of low quality of conformance. 1. Costs of Internal and External Failure. The costs of not meeting design specifications

are classified as internal failure costs and external failure costs. Defects that are detected internally result in costs such as scrap or rework. Defective units that are released to customers create external failure costs. Examples of external failure costs include customer returns and exchanges, repairs under warranties, product recalls, and lost sales due to a reputation for selling defective products.

2. Costs of Reducing Defects. There are basically only two ways to reduce defects and the

resulting costs of internal and external failures. Either the defects can be prevented or they can be detected and corrected.

a. Defects can be prevented by designing products that are “robust;” that is, that are not

sensitive to variations and errors in the production process. Defects can also be prevented by improving production processes. Statistical process control has been especially useful in driving variation out of production processes and thereby reducing defect rates. Most experts believe that until the late 1980s too little attention was paid in the United States to prevention. Instead, reliance was placed on detecting defects once they had occurred.

b. Defective units can be detected before they are delivered to customers by inspecting

and testing units throughout the production process. This approach to reducing defects is expensive since it involves inspection labor and testing equipment. Moreover, when there is no idle capacity every defective unit that must be reworked or that is scrapped uses precious capacity. The resulting opportunity costs can be quite large.

H. The Trade-Off Between Prevention and Appraisal Costs and Internal and External Failure Costs. Generally speaking, companies should focus more effort on prevention and appraisal. And prevention is usually better than appraisal. Most authorities agree that the costs of internal and external failures have been largely hidden and as a consequence managers are unaware of the magnitude of the problem. Very simple steps can often be taken to prevent defects. These simple steps pay enormous dividends in terms of reducing the need for appraisal and in reducing the incidence of internal and external failures. I. Quality Cost Report Quality consultants claim that top managers often do not pay enough attention to quality since the costs of low quality (i.e., high defect rates) are hidden by the typical cost accounting system. While accounting systems often report statistics concerning

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scrap and there may be a quality assurance department with its own budget, many of the other costs associated with defects are buried in general overhead or in other accounts. A quality cost report makes these costs visible and organizes the data so as to help managers make trade-offs. Since the reports are really just attention-directing devices, the numbers in the reports do not have to be precise. 1. Data for the Quality Cost Report. The costs of nonconformance (i.e., defects) often cut

across departmental lines and are therefore somewhat difficult to collect. Moreover, some of the costs of nonconformance are entirely external to the company and are not captured by the accounting system at all. The most prominent example of this is the cost of lost sales. Nevertheless, as we indicated above, precision is not terribly important so these measurement and identification problems should not be overemphasized. All of the examples and problems in the text assume that the data collection work has already been done.

2. Format and use of the Quality Cost Report. It is very helpful to sort the various quality

costs into the four categories of prevention, appraisal, internal failure, and external failure costs. By comparing the amounts in the various categories, managers can get some feel for what should be done. For example, if the prevention and appraisal costs are very small relative to the internal and external failure costs, it is likely that not enough is being spent to prevent and detect defects. If prevention costs are low relative to appraisal costs, it is likely that not enough is being spent on prevention relative to inspection. Moreover, by comparing results across years, managers can track the effects of their decisions and gauge the success of quality improvement programs.

3. The future of the Quality Cost Report. A company’s first quality cost report probably has

the greatest effect. Managers are often surprised by the magnitude of the costs associated with defects. This is often enough by itself to propel the company into ambitious quality improvement programs. However, unless the company’s chart of accounts is modified, compiling periodic quality cost reports is a time-consuming task. Moreover, some of the most important data—the data external to the company—will almost always be missing. And, while the quality cost report can help steer managers in the appropriate direction (e.g., increase prevention costs), it cannot tell managers how to go about preventing defects. For these reasons, many companies stop producing quality cost reports once their quality improvement program is well-established.

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Assignment Materials

Assignment Topic Level of

Difficulty Suggested

Time Exercise 2-1 Classifying manufacturing costs ....................................................... Basic 15 min. Exercise 2-2 Classification of costs as period or product cost ............................... Basic 15 min. Exercise 2-3 Constructing an income statement .................................................... Basic 15 min. Exercise 2-4 Prepare a schedule of cost of goods manufactured ........................... Basic 15 min. Exercise 2-5 Classification of costs as fixed or variable........................................ Basic 15 min. Exercise 2-6 Identifying direct and indirect costs .................................................. Basic 15 min. Exercise 2-7 Differential, opportunity, and sunk costs .......................................... Basic 15 min. Exercise 2-8 (Appendix 2A) Classification of overtime cost................................. Basic 15 min. Exercise 2-9 (Appendix 2B) Classification of quality costs .................................. Basic 15 min. Exercise 2-10 Preparation of a schedule of COGM and COGS............................... Basic 30 min. Exercise 2-11 Classification of costs as fixed or variable and as selling and

administrative or product ............................................................. Basic 15 min. Exercise 2-12 Product cost flows; product versus period costs ............................... Basic 30 min. Exercise 2-13 (Appendix 2A) Classification of labor costs .................................... Basic 15 min. Problem 2-14 Cost identification ............................................................................. Basic 30 min. Problem 2-15 Cost classification ............................................................................. Basic 30 min. Problem 2-16 Cost classification ............................................................................. Basic 30 min. Problem 2-17 (Appendix 2A) Allocating labor costs ............................................. Basic 30 min. Problem 2-18 (Appendix 2B) Quality cost report ................................................... Medium 60 min. Problem 2-19 Classification of various costs........................................................... Medium 30 min. Problem 2-20 Classification of salary cost as a period or product cost ................... Medium 15 min. Problem 2-21 Variable and fixed costs; subtleties of direct and indirect costs........ Medium 15 min. Problem 2-22 (Appendix 2B) Analyzing a quality cost report ................................ Medium 45 min. Problem 2-23 Ethics and the manager ..................................................................... Medium 30 min. Problem 2-24 Schedule of cost of goods manufactured; cost behavior ................... Medium 60 min. Problem 2-25 Cost classification and cost behavior ................................................ Medium 45 min. Problem 2-26 Schedule of cost of goods manufactured; income statement ............ Medium 60 min. Problem 2-27 Schedule of cost of goods manufactured; income statement; cost

behavior........................................................................................ Medium 60 min. Problem 2-28 Income statement; schedule of cost of goods manufactured............. Difficult 60 min. Problem 2-29 Working with incomplete data from the income statement and

schedule of cost of goods manufactured ...................................... Difficult 45 min. Case 2-30 Inventory computations from incomplete data ................................. Difficult 60 min. Case 2-31 Missing data; income statement; schedule of cost of goods

manufactured................................................................................ Difficult 60 min. Essential Problems:* Problem 2-14 or 2-19, Problem 2-15 or 2-16, Problem 2-24 or 2-27,

Problem 2-25 Supplementary Problems:* Problem 2-20, Problem 2-21, Problem 2-23, Problem 2-26, Problem

2-28, Problem 2-29, Case 2-30, Case 2-31 Appendix 2A Essential Problems: Problem 2-17 Appendix 2B Essential Problems: Problem 2-18 Appendix 2B Supplementary Problems: Problem 2-22 *See the front of the Solutions Manual for an explanation of “Essential” and “Supplementary”

problems.

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Chapter 2 Lecture Notes

Helpful Hint: Before beginning the lecture, show students the second segment from the first tape of the McGraw-Hill/Irwin Managerial/Cost Accounting video library. This segment introduces students to many of the concepts discussed in chapter 2. The lecture notes reinforce the concepts introduced in the video.

Chapter theme: Managers need to rely upon different classifications of costs for different purposes. The four main purposes emphasized in this chapter include preparing external financial reports, predicting cost behavior, assigning costs to cost objects, and making business decisions.

I. General cost classifications: Our initial focus is on

manufacturing companies since their basic activities include most of the activities found in other types of business organizations. Nonetheless, many of the concepts developed in this chapter apply to diverse organizations.

A. Classifications of manufacturing costs (e.g., direct

materials, direct labor, and manufacturing overhead):

i. Direct materials − Raw materials that become an integral part of the finished product and that can be physically and conveniently traced to it.

ii. Direct labor − Labor costs that can be easily

traced to individual units of product (also called touch labor).

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iii. Manufacturing overhead − Includes all manufacturing costs except direct materials and direct labor. These costs cannot be easily traced to specific units produced (also called indirect manufacturing cost, factory overhead, and factory burden).

1. Includes indirect materials that are part of

the finished product, but that cannot be easily traced to it.

2. Includes indirect labor costs that cannot be physically or conveniently traced to the creation of products.

3. Other examples of manufacturing overhead include: maintenance and repairs on production equipment, heat and light, property taxes, depreciation and insurance on manufacturing facilities, etc.

Helpful Hint: Use something in the classroom such as a chair to illustrate manufacturing cost concepts. Center discussion on the raw materials classified as direct materials and as manufacturing overhead; labor costs classified as direct labor and as manufacturing overhead; and other costs incurred to produce the chair that are classified as manufacturing overhead.

iv. Prime cost − Direct materials plus direct labor.

v. Conversion cost – Direct labor plus

manufacturing overhead.

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“In Business Insights” The amount of manufacturing costs for a manufacturing company is often quite high when stated as a percentage of sales. For example: “Dissecting the Value Chain” (page 39)

• The apparel company United Colors of Benetton reports that cost of sales is 56.4% of sales.

• Even though the company spends large sums on advertising, the cost of sales is still quite high in relation to net sales.

B. Classifications of nonmanufacturing costs (also

called selling, general and administrative, or S, G & A costs).

i. Marketing or selling costs – Includes all

costs necessary to secure customer orders and get the finished product into the hands of the customer.

ii. Administrative costs – Includes all

executive, organizational, and clerical costs associated with the general management of an organization.

“In Business Insights” The amount of selling, general, and administrative expenses are significant for most organizations. For example: “Bloated Sales and Administrative Expenses” (page 40)

• The Boston Consulting Group found that S, G & A expenses at America’s 1,000 largest companies

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grew at an average rate of 1.7% per year between 1985 and 1996 and then exploded to an average of 10% growth per year between 1997 and 2000.

• If companies had maintained their historical balance between sales revenue and S, G & A expenses from 1997-2000, the S, G & A expenses would have been $500 million lower in the year 2000 for the average company on the list.

• These findings suggest that S, G & A expenses tend to creep up at a faster rate during economic booms, thus creating problems when the economy falls into recession.

“Why Is Tuition So High?” (page 38)

• Forbes magazine reports that administrative costs are very high for colleges and universities.

• More specifically, an average of 2.5 administrators are employed for each faculty member in public colleges and 1.9 in private colleges.

C. Product costs versus period costs

i. Product costs (also called inventoriable

costs) – Includes all the costs that are involved in acquiring or making a product. More specifically, it includes direct materials, direct labor, and manufacturing overhead.

1. Consistent with the matching principle,

product costs are recognized as expenses when the products are sold.

ii. Period costs – Includes all marketing or

selling costs and administrative costs.

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1. These costs are expensed on the income statement in the period incurred.

Quick Check − product versus period costs

II. Cost classifications on financial statements

A. Merchandising vs. manufacturing companies

i. Merchandising companies − Purchase finished goods from suppliers for resale to customers.

ii. Manufacturing companies − Purchase raw

materials from suppliers and produce and sell finished goods to customers.

B. The balance sheet: merchandising vs.

manufacturing companies

i. Merchandising companies do not have to distinguish between raw materials, work in process, and finished goods. They report one inventory number on their balance sheet labeled merchandise inventory.

ii. Manufacturing companies report three types

of inventory on their balance sheets.

1. Raw materials – The materials used to make the product.

2. Work in process – Consists of units of product that are partially complete, but will

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require further work to be saleable to customers.

3. Finished goods – Consists of units of product that have been completed but not yet sold to customers.

C. The income statement: merchandising vs.

manufacturing companies

i. Merchandising companies calculate cost of goods sold as:

COGS = BMI + Purchases – EMI

ii. Manufacturing companies calculate cost of

goods sold as:

COGS = BFGI + COGM – EFGI

Helpful Hint: Before proceeding, enhance students’ understanding by explaining that the raw materials, work in process, and finished goods inventories all follow the same logic. They start out with some beginning inventory. Additions are made during the period. At the end of the period, everything that started in the inventory or that was added must either be in the ending inventory or have been transferred out to another inventory account or to cost of goods sold. Quick Check − inventory flows

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D. The schedule of cost of goods manufactured

i. This schedule contains the three elements of costs mentioned previously, namely direct materials, direct labor, and manufacturing overhead.

ii. It calculates the cost of raw material, direct

labor and manufacturing overhead used in production.

iii. It calculates the manufacturing costs

associated with goods that were finished during the period.

E. Product cost flows

i. To create a schedule of cost of goods

manufactured as well as a balance sheet and income statement, it is important to understand the flow of product costs:

1. Raw material purchases made during the

period are added to beginning raw materials inventory. The ending raw materials inventory is deducted to arrive at the raw materials used in production.

a. As items are removed from raw materials inventory and placed into the production process, they are called direct materials.

2. Direct labor and manufacturing overhead (also called conversion costs) used in production are added to direct materials to arrive at total manufacturing costs.

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3. Total manufacturing costs are added to the beginning work in process to arrive at total work in process.

4. The ending work in process inventory is deducted from the total work in process for the period to arrive at the cost of goods manufactured.

5. The cost of goods manufactured is added to the beginning finished goods inventory to arrive at cost of goods available for sale. The ending finished goods inventory is deducted from this figure to arrive at cost of goods sold.

6. All raw materials, work in process, and unsold finished goods at the end of the period are shown as inventoriable costs in the asset section of the balance sheet.

7. As finished goods are sold, their costs are transferred to cost of goods sold on the income statement.

8. Selling and administrative expenses are not involved in making the product; therefore, they are treated as period costs and reported in the income statement for the period the cost is incurred.

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Quick Check − product cost flows

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III. Cost classifications for predicting cost behavior

A. Cost behavior refers to how a cost will react to changes in the level of activity within the relevant range. The most commonly used classifications of cost behavior are variable and fixed costs:

i. Variable cost − A cost that varies, in total, in

direct proportion to changes in the level of activity. However, variable cost per unit is constant.

ii. Fixed cost − A cost that remains constant, in

total, regardless of changes in the level of the activity. However, if expressed on a per unit basis, the average fixed cost per unit varies inversely with changes in activity.

iii. It is helpful to think about variable and fixed

cost behavior in a 2x2 matrix.

Helpful Hint: To illustrate fixed costs, ask students for the cost of a large pizza. Then ask: What would be the cost per student if two students buy a pizza? What if four students buy a pizza? This makes it clear why average fixed costs change on a per unit basis. To illustrate variable costs, add that a beverage costs $1 and each student eating the pizza has one beverage. So, if two people were eating the pizza, the total beverage bill would come to $2; if four people, $4. The cost per beverage remains the same, but the total cost depends on the number of people ordering a beverage. Quick Check – variable vs. fixed costs.

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“In Business Insights” Variable costs in some industries can be very low relative to fixed costs. For example: “The Cost of a Call” (page 50)

• Costs in the telecommunications industry are almost all fixed.

• The cost of physically transporting a call is only about 7% of what customers pay for the call.

• It costs a telephone company more to bill a customer for a phone call than it costs the phone company to actually make the call.

IV. Cost classifications for assigning costs to cost objects

A. Cost object − Anything for which cost data are desired

including products, customers, jobs, organizational subunits, etc. For purposes of assigning costs to cost objects costs are classified two ways:

i. Direct costs − Costs that can be easily and

conveniently traced to a unit of product or other cost object.

ii. Indirect costs − Costs that cannot be easily

and conveniently traced to a unit of product or other cost object.

1. Common costs − Indirect costs incurred to

support a number of cost objects. These costs cannot be traced to any individual cost object.

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V. Cost classifications for decision making

A. It is important to realize that every decision involves a choice between at least two alternatives. The goal of making decisions is to identify those costs that are either relevant or irrelevant to the decision. To make decisions, it is essential to have a grasp on three concepts:

i. Differential costs (or incremental costs) − A

difference in cost between any two alternatives (a difference in revenue between two alternatives is called differential revenue).

1. Differential costs can be either fixed or

variable.

“In Business Insights” Incremental costs can be negligible for some companies in certain situations. For example:

“Using Those Empty Seats” (page 52) • The Corporate Angel Network arranges free

flights on some 1,500 corporate jets from over 500 companies for cancer patients who need specialized treatment outside their home areas.

• Corporate jets typically fly with only one or two executives on board. The incremental cost of occupying an empty seat is negligible.

• Since its founding, the Corporate Angel Network has leveraged the incremental cost concept by arranging over 14,000 free flights for cancer patients.

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ii. Opportunity cost − The potential benefit that is given up when one alternative is selected over another.

1. These costs are not usually entered into the

accounting records of an organization, but must be explicitly considered in all decisions.

Helpful Hint: Ask students what opportunity costs they incur by attending class. Their opportunity cost is the value to them of the activity they would be doing otherwise (e.g., working, sleeping, partying, studying, etc.)

iii. Sunk cost − A cost that has already been incurred and that cannot be changed now or in the future.

Helpful Hint: Ask students: “Suppose you had purchased gold for $400 an ounce, but now it is selling for $250 an ounce. Should you wait for the gold to reach $400 an ounce before selling it?” Many students will say “yes” even though the $400 purchase is a sunk cost. Quick Check − relevant costs

VI. Summary of the types of cost classifications

A. We have looked at the cost classifications used for financial reporting, predicting cost behavior, assigning costs to cost objects, and making business decisions.

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VII. Appendix 2A: further classification of labor costs

A. Accounting for idle time, overtime, and fringe benefits

i. Idle time − Machine breakdowns, material shortages, power failures and the like result in idle time. The labor costs incurred during idle time are ordinarily treated as manufacturing overhead. This enables the costs to be spread across all the production rather than the units in process when the disruptions occur.

ii. Overtime − The overtime premiums for all

factory workers are usually considered to be part of manufacturing overhead. This is done to avoid penalizing particular products or customer orders simply because they happen to fall on the tail end of the daily production schedule.

iii. Labor fringe benefits − These costs relate to

employment-related costs paid by an employer such as insurance programs, retirement plans, and supplemental unemployment programs. They also include the employer’s share of Social Security, Medicare, workers’ compensation, federal employment tax, and state unemployment insurance.

1. These costs often add up to 30% to 40% of

an employee’s base pay. 2. Some companies include all of these costs in

manufacturing overhead. Other companies

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opt for the conceptually superior method of treating fringe benefit expenses of direct laborers as additional direct labor costs.

VIII. Appendix 2B: cost of quality

A. Quality costs − Costs incurred to prevent defects or

that result from defects in products. Many companies are working hard to reduce their quality costs. Those companies that are succeeding have a high quality of conformance in the sense that the overwhelming majority of the products that they produce conform to design specifications and are free from defects.

“In Business Insights” Quality management is critically important to many organizations. In fact, many companies are investing significant resources training quality improvement experts known as “Black Belts.” For example: “The Quality Black Belt” (Page 59)

• General Electric (GE) makes it clear to young managers that they do not have much of a future with GE unless they become trained Black Belts.

• GE hopes to save $7 to $10 billion over the next decade as a result of its Black Belt program.

B. There are four broad categories of quality costs:

i. Prevention costs − Are incurred to support

activities whose purpose is to reduce the number of defects.

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Helpful Hint: Suppose an ice cream company has been having problems with unpleasant gritty ice crystals in its ice cream. Ask students how they would prevent the ice crystal defect. One approach would be to investigate the manufacturing process. Perhaps the gritty ice crystals are caused by temperature variations in the freezer. Controlled experiments could be run varying the temperature and inspecting for ice crystals. If this is the cause, the variation in temperature could be decreased or the ingredients changed so they would be less sensitive to temperature changes.

ii. Appraisal costs − Are incurred to identify defective products before the products are shipped to customers.

Helpful Hint: Continuing the ice cream example, ask students how they would “inspect out” the ice crystal problem. This may be more difficult and expensive than it first appears. For example, the problem could occur only in half-gallon containers or at random in a small (but important) number of containers. Or, the ice crystals could only be detected by tasting ice cream near the bottom of the container. “Inspecting out” the problem would make a lot of ice cream unsaleable.

iii. Internal failure costs − Are incurred as a result of identifying defects before they are shipped to customers.

iv. External failure costs − Are incurred as a

result of defective products being delivered to customers.

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Helpful Hint: Continuing with the ice cream example, ask students to identify examples of internal and external failure costs. Internal failure costs could result from throwing away defective ice cream. External failure costs could result from customers returning defective ice cream or failing to purchase the ice cream company’s product at a later date.

v. Examples of each type of quality cost include:

1. Prevention − Quality training, quality

circles, statistical process control activities, etc.

2. Appraisal − Testing and inspection of incoming materials, final product testing, depreciation of testing equipment, etc.

3. Internal failure − Scrap, spoilage, rework, etc.

4. External failure − Cost of field servicing and handling customer complaints, warranty repairs, lost sales arising from reputation of poor quality, etc.

vi. Distribution of quality costs − Graphs are

often used to depict the relationship between the four types of quality costs. The graph illustrates four key concepts.

1. When the quality of conformance is low,

total quality cost is high and most of this cost consists of internal and external failure costs.

2. Total quality costs drop rapidly as the quality of conformance increases.

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3. Companies reduce their total quality costs by focusing their efforts on prevention and appraisal because the cost savings from reduced defects usually overwhelm the costs of additional prevention and appraisal.

Helpful Hint: Continuing with the ice cream example, the prevention activities mentioned earlier may reveal that, if fluctuating temperatures is the problem, a simple thermostat may solve the problem. The cost to identify the problem and install a thermostat is much less that the costs of scrapped ice cream, customer returns and complaints, and lost future business.

4. Total quality costs are minimized when the quality of conformance is less than 100%. This is a debatable point in the sense that some experts believe that total quality costs are not minimized until the quality of conformance is 100%.

C. Quality cost report − This report details the

prevention, appraisal, internal failure, and external failure costs that arise from a company’s current quality control efforts.

i. When interpreting a cost of quality report

managers should look for two trends. First, increases in prevention and appraisal costs should be more than offset by decreases in internal and external failure costs. Second, the total quality costs as a percent of sales should decrease.

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“In Business Insights” The Cost of Quality can be very expensive for organizations. For example, companies that sell products that rely on software are well aware of the cost of “bugs” in their software: “Fighting Bugs” (page 64)

• Raytheon Electronics Systems (RES) once estimated that its cost of quality (i.e., the costs of preventing, detecting, and fixing bugs) was almost 60% of the total cost of producing software for its products.

• RES reduced its cost of quality to 15% of total software production costs by using software management tools that are designed to prevent bugs from being written into the computer code in the first place.

ii. Quality cost reports can also be prepared in

graphic form. Managers should still look for the same two trends whether the data is presented in a graphic or table format.

iii. Uses of quality cost information:

1. It helps managers see the financial significance of defects.

2. It helps managers identify the relative importance of the quality problems faced by the company.

3. It helps managers see whether their quality costs are poorly distributed. In general, costs should be distributed more toward prevention and to a lesser extent appraisal than toward failures.

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iv. Limitations of quality cost information

1. Simply measuring and reporting quality cost problems does not solve quality problems.

2. Results usually lag behind quality improvement programs. Initially, prevention and appraisal cost increases may not be offset by decreases in failure costs.

3. The most important quality cost, lost sales arising from customer ill-will, is often omitted from quality cost reports because it is difficult to estimate.

“In Business Insights” External failure costs are often grossly understated by companies. For example: “External Failure; It’s Worse Than You Think” (Page 65)

• Venky Nagar and Madhav Rajan studied quality costs at 11 manufacturing plants of a large U.S. company.

• Statistical analysis from these 11 plants revealed that a $1 increase in external failure costs was associated with a $26 decrease in cumulative future sales and a $10.40 cumulative decrease in future profits.

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IX. International aspects of quality

A. The International Organization for Standardization, based in Geneva Switzerland, has established quality control guidelines know as the ISO 9000 standards. For a company to become ISO 9000 certified by a certifying agency it must demonstrate that:

i. A quality control system is in use, and the system clearly defines an expected level of quality.

ii. The system is fully operational and is backed

up with detailed documentation of quality control procedures.

iii. The intended level of quality is being

achieved on a sustained basis.

B. Although the ISO 9000 standards were developed in Europe they have become widely accepted elsewhere throughout the world including the United States.

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Chapter 2 Transparency Masters

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© The McGraw-Hill Companies, Inc., 2006. All rights reserved.

AN OVERVIEW OF COST TERMS IN CHAPTER 2

Purpose of classification Cost classifications

Preparing an income statement and balance sheet

• Product costs • Direct materials • Direct labor • Manufacturing overhead

• Period costs (nonmanufacturing costs) • Marketing and selling costs • Administrative costs

Predicting changes in cost due to changes in activity

• Variable costs • Fixed costs

Assigning costs • Direct costs • Indirect costs

Making decisions • Differential costs • Sunk costs • Opportunity costs

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COST CLASSIFICATIONS IN MANUFACTURING COMPANIES (Exhibit 2-1)

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COST FLOWS IN A MANUFACTURING COMPANY (Exhibit 2-6)

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COST FLOWS EXAMPLE

EXAMPLE: Ryarder Company incurred the following costs last month:

Purchases of raw materials .......... $200,000Direct labor ................................ $270,000

Manufacturing overhead: Indirect materials ..................... $ 5,000Indirect labor ........................... 100,000Utilities, factory........................ 80,000Property taxes, factory ............. 36,000Insurance, factory .................... 9,000Equipment rental...................... 70,000Depreciation, factory ................ 120,000

Total manufacturing overhead ..... $420,000

But:

• Some of the goods sold this month were produced in previous months.

• Some of the costs listed above were incurred to make goods that were not sold this month.

Therefore:

• Cost of goods sold does not equal the sum of the above costs.

• We need to determine the values of the various inventories.

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COST FLOWS EXAMPLE (cont’d)

Additional data for Ryarder Company:

Raw materials inventory: Beginning raw materials inventory ............. $10,000 Purchases of raw materials........................ $200,000 Ending raw materials inventory.................. $30,000 Raw materials used in production .............. ?

Work in process inventory:

Beginning work in process inventory .......... $40,000 Total manufacturing costs ......................... ? Ending work in process inventory............... $60,000 Cost of goods manufactured (i.e., finished) ?

Finished goods inventory:

Beginning finished goods inventory ............ $130,000 Cost of goods manufactured (i.e., finished) ? Ending finished goods inventory ................ $80,000 Cost of goods sold .................................... ?

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INVENTORY FLOWS (Exhibit 2-3)

Basic Equation for Inventory Accounts:

Beginning Additions Ending Withdrawals + = + balance to inventory balance from inventory

or

Withdrawals Beginning Additions Ending = + -from inventory balance to inventory balance

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COST FLOWS EXAMPLE (cont’d)

Computation of raw materials used in production

Beginning raw materials inventory ................ $ 10,000 + Purchases of raw materials........................... 200,000 – Ending raw materials inventory..................... 30,000 = Raw materials used in production ................. $180,000

Computation of total manufacturing cost Raw materials used in production ................. $180,000 + Direct labor ................................................. 270,000 + Manufacturing overhead .............................. 420,000 = Total manufacturing costs ............................ $870,000

Computation of cost of goods manufactured

Beginning work in process inventory ............. $ 40,000 + Total manufacturing costs ............................ 870,000 – Ending work in process inventory.................. 60,000 = Cost of goods manufactured (i.e., finished) ... $850,000

Computation of cost of goods sold Beginning finished goods inventory .............. $130,000 + Cost of goods manufactured (i.e., finished) .. 850,000 – Ending finished goods inventory .................. 80,000 = Cost of goods sold ...................................... $900,000

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SCHEDULE OF COST OF GOODS MANUFACTURED

Ryarder Company Schedule of Cost of Goods Manufactured

Direct materials: Beginning raw materials inventory.......... $ 10,000 Add: Purchases of raw materials ............ 200,000 Raw materials available for use .............. 210,000 Deduct: Ending raw materials inventory.. 30,000 Raw materials used in production........... $180,000 Direct labor............................................. 270,000 Manufacturing overhead: Indirect materials.................................. 5,000 Indirect labor........................................ 100,000 Utilities, factory..................................... 80,000 Property taxes, factory .......................... 36,000 Insurance, factory................................. 9,000 Equipment rental .................................. 70,000 Depreciation, factory ............................. 120,000 Total overhead costs................................ 420,000 Total manufacturing costs ........................ 870,000 Add: Beginning work in process inventory . 40,000 910,000 Deduct: Ending work in process inventory . 60,000 Cost of goods manufactured..................... $850,000

Cost of Goods Sold Beginning finished goods inventory........... $130,000 Add: Cost of goods manufactured............. 850,000 Goods available for sale ........................... 980,000 Deduct: Ending finished goods inventory... 80,000 Cost of goods sold................................... $900,000

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COST CLASSIFICATIONS TO DESCRIBE COST BEHAVIOR

To describe how costs react to changes in activity, costs are often classified as variable or fixed.

VARIABLE COSTS

Variable cost behavior can be summarized as follows:

Variable Cost Behavior In Total Per Unit

Total variable cost increases and decreases in proportion

to changes in activity.

Variable cost per unit is constant.

EXAMPLE: A company manufactures microwave ovens. Each oven requires a timing device that costs $30. The per unit and total cost of the timing device at various levels of activity (i.e., number of ovens produced) would be:

Cost per Number of Total Variable Timing Ovens Cost—Timing Device Produced Devices $30 1 $30 $30 10 $300 $30 100 $3,000 $30 200 $6,000

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FIXED COSTS

Fixed cost behavior can be summarized as follows:

Fixed Cost Behavior In Total Per Unit

Total fixed cost is not affected by changes in activity (i.e., total fixed cost remains constant even

if activity changes).

Fixed cost per unit decreases as the activity level rises and increases as the activity level

falls.

EXAMPLE: Assume again that a company manufactures microwave ovens. The company pays $9,000 per month to rent its factory building. The total and per unit cost of rent at various levels of activity would be:

Number of Rent Cost Ovens Rent Cost per Month Produced per Oven $9,000 1 $9,000 $9,000 10 $900 $9,000 100 $90 $9,000 200 $45

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A GRAPHIC VIEW OF COST BEHAVIOR

100 200 0

$3,000

$6,000

Microwaves produced

Total Variable Cost

100 2000

$9,000

Microwaves produced

Total Fixed Cost

RELEVANT RANGE

If activity changes enough, fixed costs may change. For example, if microwave production were doubled, another factory building might have to be rented.

The relevant range is the range of activity within which the assumptions that have been made about variable and fixed costs are valid. For example, the relevant range within which total fixed factory rent is $9,000 per month might be 1 to 200 microwaves produced per month.

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COST CLASSIFICATIONS FOR ASSIGNING COSTS

COST OBJECT

A cost object is anything for which cost data are desired.

Examples:

• Products

• Customers

• Departments

• Jobs

DIRECT COSTS

A direct cost is a cost that can be easily and conveniently traced to a particular cost object.

Examples:

• The direct costs of a Ford SUV would include the cost of the steering wheel purchased by Ford from a supplier, the costs of direct labor workers, the costs of the tires, and so on.

• The direct costs of a hospital’s radiology department would include X-ray film used in the department, the salaries of radiologists, and the costs of radiology lab equipment.

INDIRECT COSTS

An indirect cost is a cost that cannot be easily and conveniently traced to a particular cost object.

Examples:

• Manufacturing overhead, such as the factory managers’ salary at a multi-product plant, is an indirect cost of any one product.

• General hospital administration costs are indirect costs of the radiology lab.

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COST CLASSIFICATIONS FOR DECISION-MAKING

DIFFERENTIAL COST

Every decision involves choosing from among at least two alternatives. Any cost that differs between alternatives is a differential cost. Only the differential costs are relevant in making a decision.

EXAMPLE: Bill is currently employed as a lifeguard, but he has been offered a job in an auto service center in the same town. The differential revenues and costs between the two jobs are listed below:

Auto Differential Life- service costs and guard center revenues Monthly salary.................... $1,200 $1,500 $300 Monthly expenses:

Commuting...................... 30 90 60 Meals .............................. 150 150 0 Apartment rent ................ 450 450 0 Uniform rental ................. 0 50 50 Union dues ...................... 10 0 (10)

Total monthly expenses ...... 640 740 100 Net monthly income............ $ 560 $ 760 $200

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OPPORTUNITY COST

An opportunity cost is the potential benefit given up when selecting one course of action over another.

EXAMPLE: Linda is employed in the campus bookstore and is paid $65 per day. One of her friends is getting married and Linda would like to attend the wedding, but she would have to miss a day of work. If she attends the wedding, the $65 in lost wages will be an opportunity cost of attending the wedding.

EXAMPLE: The reception for the wedding mentioned above will be held in the ballroom at the Lexington Club. The manager of the Lexington Club had to decide between accepting the booking for the wedding reception or accepting a booking for a corporate seminar. The hall could have been rented to the corporation for $600. The lost rental revenue of $600 is an opportunity cost of accepting the reservation for the wedding.

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. Sunk costs are irrelevant and should be ignored in decisions.

EXAMPLE: Linda has already purchased a ticket to a rock concert for $35. Unfortunately, if she goes to the wedding, she will be unable to attend the concert. The $35 is a sunk cost that she should ignore when deciding whether or not to attend the wedding. [However, any amount she can get by reselling the ticket is NOT a sunk cost.]

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ACCOUNTING FOR LABOR COSTS (Appendix 2A)

Labor costs can be categorized as follows:

Direct labor

Indirect labor (part of manufacturing

overhead) Other labor costs (Discussed earlier) Janitors Idle time Supervisors Overtime premium Materials handlers Labor fringe benefits Engineers Night security guards Maintenance workers

IDLE TIME

Idle time represents the wages of direct labor workers who are idle due to machine breakdowns, material shortages, power failures, and the like. The cost of idle time is often added to manufacturing overhead.

EXAMPLE: An assembly line worker is idle for 2 hours during the week due to a power failure. If the worker is paid $15 per hour and works a normal 40 hour week, labor cost would be allocated as follows between direct labor and manufacturing overhead:

Direct labor cost ($15 per hour × 38 hours)................. $570Manufacturing overhead cost ($15 per hour × 2 hours) 30Total cost for the week .............................................. $600

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OVERTIME PREMIUM

Any overtime premium paid to factory workers (direct as well as indirect labor) is usually considered to be part of manufacturing overhead.

EXAMPLE: Assume again that an assembly line worker is paid $15 per hour. The worker is paid time and a half for overtime (time in excess of 40 hours per week). During a given week this employee works 46 hours and has no idle time. Labor cost would be allocated as follows:

Direct labor cost ($15 per hour × 46 hours)...................... $690Manufacturing overhead cost ($7.50 per hour × 6 hours) .. 45Total cost for the week ................................................... $735

LABOR FRINGE BENEFITS

Labor fringe benefits are made up of employment related costs paid by the employer. These costs are handled in two different ways by companies:

1. Many companies treat all such costs as indirect labor and add them to manufacturing overhead.

2. Other companies treat that portion of fringe benefits that relates to direct labor as additional direct labor cost.

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QUALITY COSTS (Appendix 2B)

• The costs of correcting defective units before they reach customers are called internal failure costs. Examples:

• Scrapped units.

• Rework of defective units.

• Costs that are incurred by releasing defective units to customers are called external failure costs. Examples:

• Costs of fixing products under warranty.

• Loss of sales due to a tarnished reputation.

• The costs of internal and external failures can be avoided by:

• Preventing defects.

• Finding defective units before they are released.

The costs associated with these activities are called prevention costs and appraisal costs, respectively.

• Generally, prevention is the best policy. It is usually far easier and less expensive to prevent defects than to fix them.

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EXAMPLES OF QUALITY COSTS (Exhibit 2B-1)

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TRADING-OFF QUALITY COSTS (Exhibit 2B-2)

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QUALITY COST REPORTS

• Quality cost reports summarize prevention costs, appraisal costs, internal failure costs, and external failure costs that would otherwise be hidden in general overhead.

• Managers are often surprised by how much defects cost.

• The report helps identify where the biggest quality problems lie.

• The report helps managers assess how resources should be distributed. If internal and external failure costs are high relative to prevention and appraisal costs, more should probably be spent on prevention and appraisal.

• Since quality cost reports are largely an attention-directing device, the costs do not have to be precise.

• Unfortunately, the cost of lost sales due to external failures is usually excluded from the reports due to measurement difficulties.

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SAMPLE QUALITY COST REPORT (Exhibit 2B-3)

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Chapter 3

Systems Design—Job-Order Costing Learning Objectives LO1. 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. Prepare journal entries to record costs in a job-order costing system. LO5. Apply overhead cost to Work In Process using a predetermined overhead rate. LO6. Use T-accounts to show the flow of costs in a job-order costing system, and prepare

schedules of cost of goods manufactured and cost of goods sold. LO7. Compute under- or overapplied overhead cost and prepare the journal entry to close the

balance in Manufacturing Overhead to the appropriate accounts. LO8. (Appendix 3A) Understand the implications of basing the predetermined overhead rate on

activity at capacity rather than on estimated activity for the period. New in this Edition • New In Business boxes have been added. • New shorter exercises that cover a single learning objective have been created. Chapter Overview A. Costing Systems. (Exercise 3-1.) Two major types of costing systems are used in manufacturing and many service companies: process costing and job-order costing. 1. Process Costing. A process costing system is used where a single, homogeneous product

or service is produced. In a process costing system, total manufacturing costs are divided by total number of units produced during a given period. The unit cost that results is a broad, average figure. Process costing is used in industries such as cement, flour, brick, and oil refining.

2. Job-Order Costing. Job-order costing is used when different types of products, jobs, or

batches are produced within a period. In a job-order costing system, direct materials costs and direct labor costs are usually traced directly to jobs. Overhead is applied to jobs using a predetermined rate. Actual overhead costs are not traced to jobs. Examples of industries in which job-order costing is used include special order printing, shipbuilding, construction, hospitals, professional services such as law firms, and movie studios.

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Note that in some situations either job-order costing or process costing could be used, depending on the level of detail needed and the desires of management.

B. Job-Order Costing—An Overview. (Exercises 3-2, 3-3, 3-9, 3-11, 3-12, 3-13, 3-15, and 3-16.) The discussion in the text and below assumes that a paper-based manual system is used for recording costs. Cost and other data are recorded on materials requisition forms, time tickets, and job cost sheets. Of course, many companies now enter cost and other data directly into computer databases and have dispensed with these paper documents. Nevertheless, the data residing in the computer typically consists of a “virtual” version of the manual system. Since a manual system is easy for students to understand, we continue to rely on it when describing a job-order costing system. 1. Job Cost Sheet. Each job has its own job cost sheet on which costs are charged to the job.

The job cost sheet will have some code or descriptive data to identify the particular job and will contain spaces to record costs of materials, labor, and overhead. Exhibit 3-4 provides an illustration of a job cost sheet.

2. Materials Costs. When a job is started, materials that will be required to complete the job

are withdrawn from the storeroom. The document that authorizes these withdrawals and that specifies the types and amounts of materials withdrawn is called the materials requisition form. The materials requisition form identifies the job to which the materials are to be charged. Care must be taken when charging materials to distinguish between direct and indirect materials. An example of a materials requisition form is shown in Exhibit 3-1 in the text.

3. Labor. Labor costs are recorded on a document called a time ticket or a time sheet. Each

employee records the amount of time he or she spends on each job and each task on a time ticket. The time spent on a particular job is considered direct labor and its cost is traced to that job. The cost of time spent on other tasks, not traceable to any particular job, is usually considered part of manufacturing overhead. An example of an employee time ticket is shown in Exhibit 3-3 in the text.

4. Manufacturing Overhead. Manufacturing overhead includes all manufacturing costs that

are not traced to a particular job. In practice, manufacturing overhead usually consists of all manufacturing costs other than direct materials and direct labor. Since manufacturing overhead costs are not traced to jobs, they must be allocated to jobs if absorption costing is used. a. We do not dwell on the reasons for allocating all manufacturing overhead to jobs in this

chapter. What costs should or should not be allocated to jobs and to products remains a controversial issue. In the chapter we confine discussion to absorption costing since that is the approach that is used in the vast majority of organizations for both external and internal reporting.

b. In order to allocate overhead costs, management must choose an allocation base. The

most widely used allocation bases are direct labor-hours, direct labor costs, and machine-hours. (These bases have been severely criticized in recent years. Critics charge that overhead is largely unrelated to, or even negatively correlated with, machine-hours or direct labor-hours.) In the costing system illustrated in the chapter, a predetermined overhead rate is computed by dividing the estimated total overhead for the upcoming period by the estimated total amount of the allocation base.

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c. Ideally overhead cost should be strictly proportional to the allocation base; in other

words, an x% change in the allocation base should cause an x% change in the overhead cost. Only then will the allocated overhead costs be useful in decision-making and in performance evaluation. However, much of the overhead typically consists of costs that are not proportional to any conceivable allocation base and hence any scheme for allocating such costs will inevitably lead to costs that are biased and unreliable for decision-making and performance evaluation. In practice, the overriding concern is to select some basis or bases for allocating all overhead costs and scant attention is paid to questions of causality. These issues are not raised in the text at this point since students will not be ready to understand them until after having studied cost behavior in more depth in later chapters.

d. At any rate, the actual amount of the allocation base incurred by a job is recorded on

the job cost sheet. The actual amount of the allocation base is then multiplied by the predetermined overhead rate to determine the amount of overhead that is applied to the job.

C. Job Order Costing—The Flow of Costs. (Exercises 3-4, 3-10, 3-13, 3-14, 3-15, and 3-17.) Exhibit 3-14 in the text provides a model for the cost flows in a job-order costing system. 1. Overview of Cost Flows. The basic flow of costs in a job-order system begins by

recording the costs of material, labor, and manufacturing overhead. a. Direct material and direct labor costs are debited to the Work In Process account. Any

indirect material or indirect labor costs are debited to the Manufacturing Overhead control account, along with any other actual manufacturing overhead costs incurred during the period. Manufacturing overhead is applied to Work In Process using the predetermined rate. The offsetting credit entry is to the Manufacturing Overhead control account.

b. The cost of finished units is credited to Work In Process and debited to the Finished

Goods inventory account. c. When units are sold, their costs are credited to Finished Goods and debited to Cost of

Good Sold.

2. The Manufacturing Overhead Control Account. Manufacturing Overhead is a temporary control account.

a. As stated above, actual overhead costs are recorded on the debit side of the

Manufacturing Overhead control account. Overhead costs applied to Work in Process using predetermined rates are recorded on the credit side of the account.

b. Any discrepancy between overhead costs incurred and overhead costs applied shows up

as a balance in the Manufacturing Overhead control account at the end of the period. A debit balance is called underapplied overhead and a credit balance is called overapplied overhead.

D. Under- and Overapplied Overhead. (Exercises 3-6, 3-7, 3-8, 3-13, 3-14, 3-16 and 3-17.) Since the predetermined overhead rate is based entirely on estimated data, the actual amount

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of overhead cost incurred will almost always differ from the amount of overhead cost that is applied to the Work In Process account. The difference is termed underapplied or overapplied overhead, and as discussed above, can be determined by the ending balance in the Manufacturing Overhead control account. An underapplied balance occurs when more overhead cost is actually incurred than is applied to the Work In Process account. An overapplied balance results from applying more overhead to Work In Process than is actually incurred. 1. Cause of Under- and Overapplied Overhead. When a predetermined overhead rate is

used, it is implicitly assumed that the overhead cost is variable with (i.e., proportional to) the allocation base. For example, if the predetermined overhead rate is $20 per direct labor-hour, it is implicitly assumed that the actual overhead costs will increase by $20 for each additional direct labor-hour that is incurred. If, however, some of the overhead is fixed with respect to the allocation base, this will not happen and there will be a discrepancy between the actual total amount of the overhead and the overhead that is applied using the $20 rate. In addition, the actual total overhead can differ from the estimated total overhead because of poor controls over overhead spending or because of inability to accurately forecast overhead costs.

2. Disposition of Under- and Overapplied Overhead. Two approaches to dealing with an

under- or overapplied overhead balance in the accounts are illustrated in the text. a. The simplest approach is to close out the under- or overapplied overhead to Cost of

Goods Sold. This is the method that is used in most of the exercises and problems because it is easiest for students to understand and master.

b. The second approach is to allocate the under- or overapplied balance to Cost of Goods

Sold and to the Work In Process and Finished Goods inventory accounts. The basis of allocation is the amount of overhead applied during the period in the ending balance of each of these accounts. This method is equivalent to waiting until the end of the period to allocate the actual overhead costs based on the actual amount of the allocation base incurred.

3. The Effect of Under- and Overapplied Overhead on Net Operating Income.

a. If overhead is underapplied, less overhead has been applied to inventory than has actually been incurred. Enough overhead must be added to Cost of Goods Sold (and perhaps ending inventories) to eliminate this discrepancy. Since Cost of Goods Sold is increased, underapplied overhead reduces net income.

b. If overhead is overapplied, more overhead has been applied to inventory than has

actually been incurred. Enough overhead must be removed from Cost of Goods Sold (and perhaps ending inventories) to eliminate this discrepancy. Since Cost of Goods Sold is decreased, overapplied overhead increases net operating income.

E. The Predetermined Overhead Rate and the Level of Activity (Appendix 3A). (Exercise 3-16.) Interest has been recently rekindled in the issue of how to select the denominator level of activity in the predetermined overhead rate. In the main body of the chapter, it is assumed that the denominator is the estimated total amount of the allocation base for the period. While this is the most common method used in practice, it has some serious drawbacks.

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1. Drawbacks of basing the predetermined overhead rate on the estimated level of activity.

a. If overhead contains substantial fixed costs, then as the estimated level of activity

decreases, the predetermined overhead rate will increase. Thus if the company starts losing sales due to a recession or other reason, the company’s unit costs will increase. This could result in some managers increasing prices or dropping products, which is likely to be exactly the wrong thing to do in this situation.

b. Products are charged with resources they don’t use. If a product uses 10% of the

capacity of a fixed resource, it is argued that it should be charged with only 10% of the cost of that resource. If all of the products a company makes use only 50% of the capacity of the fixed resource, the cost of that idle capacity should be separately recognized as a period expense rather than spread over the products that use the resource during the period. Under the conventional approach, products are charged for both their share of the capacity they use and for a share of the idle capacity they do not use. So if a product uses 10% of the capacity of a resource, but 50% of the capacity is idle, then under the conventional approach the product would be charged with 20% of the total cost of the resource.

2. Suggested solution. It has been suggested that predetermined overhead rates should be

based on the amount of the allocation base at capacity rather than on the estimated amount of the allocation base for the upcoming period. This proposal would result in stable unit costs that do not rise and fall with decreases and increases in the expected level of activity. The underapplied overhead that results from the discrepancy between the actual level of activity and the level of activity at capacity can be treated as a period expense and taken directly to the income statement. In the text we suggest the title “Cost of Unused Capacity” for this income statement item, but other names would work as well. By showing this amount separately, the cost of idle capacity is highlighted for management attention. For a good discussion of these issues, we recommend the IMA’s Statement on Management Accounting 4Y, Measuring the Cost of Capacity, March 31, 1996. Even though we have a great deal of sympathy with this proposal, we continue to use the conventional approach in the main body of the text since it still predominates in practice.

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Time Exercise 3-1 Process costing and job-order costing ................................... Basic 10 min. Exercise 3-2 Job-order costing documents................................................. Basic 15 min. Exercise 3-3 Compute the predetermined overhead rate............................ Basic 10 min. Exercise 3-4 Prepare journal entries........................................................... Basic 15 min. Exercise 3-5 Apply overhead ..................................................................... Basic 10 min. Exercise 3-6 Applying overhead; cost of goods manufactured .................. Basic 15 min. Exercise 3-7 Prepare T-accounts ................................................................ Basic 20 min. Exercise 3-8 Under- and overapplied overhead ......................................... Basic 10 min. Exercise 3-9 Departmental overhead rates ................................................. Basic 15 min. Exercise 3-10 Journal entries and T-accounts .............................................. Basic 30 min. Exercise 3-11 Applying overhead in a service company.............................. Basic 30 min. Exercise 3-12 Varying predetermined overhead rates.................................. Basic 30 min. Exercise 3-13 Applying overhead; T-accounts; journal entries ................... Basic 30 min. Exercise 3-14 Applying overhead; journal entries; disposition of under-

or overapplied overhead ................................................... Basic 15 min. Exercise 3-15 Applying overhead; journal entries; T-accounts ................... Basic 30 min. Exercise 3-16 (Appendix 3A) Overhead rates and capacity issues .............. Basic 30 min. Exercise 3-17 Applying overhead in a service company; journal entries..... Basic 30 min. Problem 3-18 Comprehensive problem........................................................ Basic 45 min. Problem 3-19 Cost flows; T-accounts; income statements .......................... Basic 60 min. Problem 3-20 Journal entries, T-accounts; cost flows.................................. Basic 60 min. Problem 3-21 T-accounts; applying overhead.............................................. Basic 60 min. Problem 3-22 T-accounts; overhead rates; journal entries ........................... Medium 60 min. Problem 3-23 Multiple departments; applying overhead ............................. Medium 30 min. Problem 3-24 T-account analysis of cost flows ........................................... Medium 45 min. Problem 3-25 Journal entries; T-accounts; disposition of under- or

overapplied overhead; income statement.......................... Medium 90 min. Problem 3-26 Predetermined overhead rate; disposition of under- or

overapplied overhead........................................................ Medium 30 min. Problem 3-27 Schedule of cost of goods manufactured; overhead

analysis ............................................................................. Medium 60 min. Problem 3-28 (Appendix 3A) Predetermined overhead rate and capacity... Medium 60 min. Problem 3-29 Multiple departments; overhead rates; under- or

overapplied overhead........................................................ Medium 30 min. Problem 3-30 Plantwide versus departmental overhead rates; under- or

overapplied overhead........................................................ Difficult 60 min. Problem 3-31 Comprehensive problem; journal entries; T-accounts;

financial statements .......................................................... Difficult 120 min. Problem 3-32 Comprehensive problem; T-accounts; job-order cost

flows; financial statements ............................................... Difficult 120 min. Case 3-33 Critical thinking; interpretation of manufacturing

overhead rates ................................................................... Difficult 45 min. Case 3-34 (Appendix 3A) Ethics; predetermined overhead rate and

capacity............................................................................. Difficult 120 min. Case 3-35 Ethics and the manager.......................................................... Difficult 45 min.

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Essential Problems: Problem 3-18 or 3-20, Problem 3-19 or 3-21, Problem 3-22, Problem 3-23 or 3-29

Supplementary Problems: Problem 3-24, Problem 3-25, Problem 3-26, Problem 3-27, Problem 3-30, Problem 3-31 or 3-32, Case 3-33, Case 3-35

Appendix 3A Essential Problems: Problem 3-28 Appendix 3A Supplementary Problems: Case 30-34

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Helpful Hint: Before beginning the lecture, show students the third segment from the first tape of the McGraw-Hill/Irwin Managerial/Cost Accounting video library. This segment introduces students to many of the concepts discussed in chapter 3. The lecture notes reinforce the concepts introduced in the video.

Chapter theme: Managers need to assign costs to products to facilitate external financial reporting and internal decision making. This chapter illustrates an absorption costing approach (also called a full cost approach) to calculating product costs known as job-order costing.

Helpful Hint: Briefly review the concepts of fixed and variable manufacturing costs to help students grasp the meaning of absorption costing. Mention that total fixed costs are constant and therefore change on a per unit basis. Variable costs are proportional to the number of units produced and are constant on a per unit basis.

I. Process and job-order costing: Two costing systems are

commonly used in manufacturing and many service companies; these two systems are known as process costing and job-order costing.

A. Process costing systems

i. This type of cost system is used when:

1. A company produces many units of a single product.

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2. One unit of product is indistinguishable from other units of product.

3. The identical nature of each unit of product enables assigning the same average cost per unit.

ii. Examples of companies that would use process

costing include:

1. Weyerhaeuser (paper manufacturing) 2. Reynolds Aluminum (refining aluminum

ingots) 3. Coca-Cola (mixing and bottling beverages)

B. Job-order costing systems

i. This type of cost system is used when:

1. Many different products are produced each period.

2. Products are manufactured to order. 3. The unique nature of each order requires

tracing or allocating costs to each job, and maintaining cost records for each job.

ii. Examples of companies that would use job-order

costing include:

1. Boeing (aircraft manufacturing) 2. Bechtel International (large scale

construction) 3. Walt Disney Studios (movie production)

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C. Comparing process costing and job-order costing

i. With job-order costing, many jobs are worked on during the period; with process costing, a single product is produced for a long period of time.

ii. With job-order costing, costs are accumulated by

individual jobs; with process costing, costs are accumulated by departments.

iii. With job-order costing, average unit costs are

computed by job; with process costing, average unit costs are computed for a particular operation or by department.

Helpful Hint: To clarify the difference between process and job-order costing, contrast a company manufacturing standard metal desks with a company manufacturing custom-made hardwood desks. Ask the class, which company would probably use process costing and which company would probably use job-order costing, and why.

Quick Check − job-order vs. process costing

II. Job-order costing−an overview

A. Types of manufacturing costs that are assigned to products using a job-order costing system:

i. Direct costs

1. Direct materials − Traced directly to each

job as the work is performed.

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2. Direct labor − Traced directly to each job as the work is performed.

ii. Indirect costs

1. Manufacturing overhead (including

indirect materials and indirect labor) − These costs are allocated to jobs rather than directly traced to each job.

B. The job cost sheet − The accounting department relies

upon a job cost sheet for tracking the direct and indirect costs associated with a given job.

i. An overview of a job cost sheet for a hypothetical

company called PearCo:

1. A job number uniquely identifies each job. 2. Direct material, direct labor and

manufacturing overhead costs are accumulated for each job.

3. The job cost sheet is a subsidiary ledger to the Work in Process account.

ii. Measuring direct materials cost

1. Once a sales order has been received and a

production order issued, the Production Department prepares a materials requisition form to specify the type, quantity, and total cost of materials (e.g., $116) to be drawn from the storeroom, and the job number (e.g., A-143) to which the cost of the materials is to be charged.

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a. For an existing product, the production department can refer to a bill of materials to determine the type and quantity of each item of materials needed to complete a unit of product.

2. The Accounting Department records the total direct material cost (e.g., $116) on the appropriate job cost sheet. Notice, the material requisition number (e.g., X7-6890) is included on the job cost sheet to provide easy access to the source document.

iii. Measuring direct labor costs

1. Workers use time tickets to record the

amount of time that they spent on each job and the total cost assigned to each job.

2. The Accounting Department records the labor costs from the time tickets (e.g., $88) on to the job cost sheet.

“In Business Insights” The direct labor cost as a percent of a product’s total cost is often very small. For example: “Relation of Direct Labor to Product Cost” (Page 92)

• The National Labor Committee based in New York estimates that the labor cost to assemble a $90 pair of Nike sneakers is only $1.20.

Consequently, many companies have stopped tracking direct labor costs separately. For example: “A More Productive Use of Time” (Page 92)

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• United Electric Controls, Inc., located in Waterton, Massachusetts, converted all direct laborers to salaried workers and stopped producing labor reports.

• The manufacturing vice president decided that he wanted employees spending their time making products rather than filling out labor time tickets.

“In Business Insights” While many companies have stopped tracking direct labor costs separately, others now rely upon computer systems to assign direct labor costs to jobs. For example: “Cleaning Up with Bar Codes” (page 93)

• Bradford Soap Works is a manufacturer of private label bar soap.

• Employees wear identification badges with a bar code that reveals their relevant personal data.

• The bar codes are used to charge workers’ time directly to specific orders.

• The bar codes have decreased clerical errors from 500 errors per 10,000 transactions to just one error per 10,000 transactions.

iv. Manufacturing overhead application:

1. An allocation base, such as direct labor

hours, direct labor dollars, or machine hours, is used to assign manufacturing overhead to products. Allocation bases are used because: i. It is impossible or difficult to trace these

costs to particular jobs (i.e.,

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manufacturing overhead is an indirect cost).

a. Manufacturing overhead consists of many different items ranging from the grease used in machines to the production manager’s salary.

b. Many types of manufacturing overhead costs are fixed even though output may fluctuate during the year.

2. The predetermined overhead rate is calculated by dividing the estimated amount of manufacturing overhead for the coming period by the estimated quantity of the allocation base for the coming period. Ideally, the allocation base chosen should be the cost driver of overhead cost.

a. Predetermined overhead rates that rely upon estimated data are often used because:

i. Actual overhead costs for the period are not known until the end of the period, thus inhibiting the ability to estimate job costs during the period.

ii. Actual overhead costs can fluctuate seasonally, thus misleading decision makers.

iii. It simplifies record keeping. 3. Manufacturing overhead is applied to jobs

using the predetermined overhead rate multiplied by the actual amount of the allocation base used completing the job (this is called a normal costing system). For example, assume PearCo:

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a. Applies overhead to jobs based on direct labor hours.

b. Estimated its total overhead for the year to be $640,000.

c. Estimated its total direct labor hours for the year to be 160,000.

d. Calculated its predetermined overhead rate to be $4 per direct labor hour.

i. The amount of overhead that would be applied to the job cost sheet that we have been working with related to Job A-143 is $32, calculated as follows:

1. Eight direct labor hours were worked on Job A-143.

2. The predetermined overhead rate is $4 per direct labor hour.

3. 8 direct labor hours × $4 per hour = $32

v. Completing the job cost sheet

1. The total direct material, direct labor, and

manufacturing overhead costs assigned to Job A-143 is $236. Since this particular job included two units of production, the average cost per unit is $118.

a. The average unit cost should not be interpreted as the costs that would actually be incurred if another unit were produced.

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b. The fixed overhead would not change if another unit were produced,

so the incremental cost of another unit is something less than $118.

Quick Check − job cost accounting

C. Job-order costing: document flow summary

i. A sales order is prepared as a basis for issuing a production order.

ii. A production order initiates work on a job.

iii. A materials requisition is used to draw direct and indirect materials from the storeroom.

1. Direct material costs are charged to specific

jobs. 2. Indirect material costs are included in

manufacturing overhead.

iv. Employee time tickets are used to quantify direct and indirect labor costs.

1. Direct labor costs are charged to specific jobs.

2. Indirect labor costs are included in manufacturing overhead.

v. The predetermined overhead rate is used to apply

manufacturing overhead costs to jobs.

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III. Job-order costing−the flow of costs

Helpful Hint: Sometimes students need a brief review of journal entries and the use of T-accounts before beginning this section of the chapter.

A. The transactions (in T-account and journal entry form) that capture the flow of costs in a job-order costing system are as follows:

i. The purchase and issue of raw materials.

1. In T-account form:

a. The cost of raw material purchases is debited, and although not shown, the credit side of the transaction would be to Accounts Payable.

b. The cost of direct material requisitions is debited to Work in Process and added to the job cost sheets which serve as a subsidiary ledger.

c. The cost of indirect material requisitions is debited to Manufacturing Overhead.

2. In journal entry form: a. Debit Raw Materials and credit

Accounts Payable. b. Debit Work in Process and

Manufacturing Overhead and credit Raw Materials.

ii. The recording of labor costs.

1. In T-account form:

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a. Direct labor costs are debited to Work in Process and added to the job cost sheets which serve as a subsidiary ledger.

b. Indirect labor costs are debited to Manufacturing Overhead.

2. In journal entry form: a. Debit Work in Process and

Manufacturing Overhead and credit Salaries and Wages Payable.

iii. Recording actual manufacturing overhead costs

(other than indirect materials and indirect labor).

1. In T-account form: a. The manufacturing overhead costs

are debited to Manufacturing Overhead.

b. The credit side of the entry is the various liability accounts (e.g., Accounts Payable and Property Taxes Payable), prepaid asset accounts (e.g., Prepaid Insurance) and contra-asset accounts (e.g., Accumulated Depreciation).

2. In journal entry form: a. Debit Manufacturing Overhead and

credit various accounts as shown

iv. Applying manufacturing overhead costs to work in process

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1. In T-account form: a. Work in process is debited and

Manufacturing Overhead is credited by the amount of the actual quantity of the allocation base multiplied by the predetermined rate.

b. Actual manufacturing overhead costs are not debited to Work in Process, nor are they charged to jobs via the job cost sheets.

c. The Manufacturing Overhead account is a clearing account. The actual amount of overhead incurred during the period on the debit side of the account will almost certainly not equal the amount applied to Work in Process as shown on the credit side of the account. This requires a year-end adjusting entry that will be discussed shortly.

2. In journal entry form: a. Debit Work in Process and Credit

Manufacturing Overhead.

Helpful Hint: Students sometimes have difficulty understanding the use of Manufacturing Overhead as a clearing account. Explain that the purpose of the clearing account is to find any discrepancy that exists between the amount of overhead applied to inventory and the amount of overhead actually incurred. Actual overhead incurred is debited to the account. Overhead applied to inventory using the predetermined rate is credited to the account.

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v. Accounting for nonmanufacturing costs

Helpful Hint: Review the concepts of product and period costs at this point. Since period costs are not directly related to the actual manufacture of the products, they are expensed as incurred.

1. Companies that use job-order cost systems to assign manufacturing costs to products also incur nonmanufacturing costs.

2. Nonmanufacturing costs should not go into the Manufacturing Overhead account.

3. Nonmanufacturing costs are not assigned to individual jobs, rather they are expensed in the period incurred. For example:

a. The salary expenses of employees that work in a marketing, selling or administrative capacity are expensed in the period incurred.

b. Advertising expenses are expensed in the period incurred.

vi. Transferring completed units from work in

process to finished goods

1. In T-account form: a. The sum of all amounts transferred

from work in process to finished goods represents the cost of goods manufactured for the period.

b. The Work in Process account is credited and the Finished Goods account is debited.

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2. In journal entry form: a. Debit Finished Goods and credit

Work in Process.

vii. Transferring finished goods to cost of goods sold

1. In T-account form: a. Debit Cost of Goods Sold and credit

Finished Goods. b. If only a portion of the units

associated with a particular job are shipped, then the unit cost figure from the job cost sheet is used to determine the amount of the journal entry.

c. This journal entry is also accompanied by a journal entry that recognizes the sales revenue.

2. In journal entry form: a. Debit Accounts Receivable and credit

Sales. b. Debit Cost of Goods Sold and credit

Finished Goods.

Helpful Hint: As a concluding thought, remind students that all inventory accounts are governed by the same logic: Beginning inventory + Additions = Ending Inventory + Transfers out. In the case of raw materials, transfers out consist of both direct and indirect materials requisitions. Direct materials requisitions are added to Work in Process inventory. Indirect materials requisitions are debited to Manufacturing Overhead. Additions to Work in Process consist of direct materials requisitions, direct labor, and overhead applied. Transfers out of Work in

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Process consist of costs transferred to Finished Goods. Transfers out of Finished Goods consist of Cost of Goods Sold.

IV. Problems of overhead application

A. There are two complications relating to overhead application.

i. Defining and computing underapplied and

overapplied overhead

1. The difference between the overhead cost applied to Work in Process and the actual overhead costs of a period is termed either underapplied or overapplied overhead.

a. Underapplied overhead exists when the amount of overhead applied to jobs during the period using the predetermined overhead rate is less than the total amount of overhead actually incurred during the period.

b. Overapplied overhead exists when the amount of overhead applied to jobs during the period using the predetermined overhead rate is greater than the total amount of overhead actually incurred during the period.

Helpful Hint: Students need to understand that factory overhead must be estimated at the beginning of the production period. Therefore, there will most likely be a difference between actual and applied overhead. A debit balance in the Manufacturing Overhead account

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indicates more overhead has been incurred than has been applied to inventory and overhead is underapplied. A credit balance indicates more overhead has been applied than has been incurred and overhead is overapplied.

2. Computing underapplied or overapplied overhead, an example:

a. Assume that PearCo’s actual overhead and direct labor hours for the year are $650,000 and 170,000, respectively.

b. Recall that PearCo’s total estimated overhead and direct labor hours for the year were $640,000 and 160,000, respectively. Therefore, the predetermined overhead rate would be $4 per direct labor hour.

c. The amount of overhead applied to jobs during the year would be 170,000 direct labor hours × $4 per hour = $680,000.

d. In this example, overhead is overapplied by $680,000 − $650,000 = $30,000.

Quick Check − underapplied and overapplied overhead ii. Disposition of under- or overapplied overhead

balances

1. Any remaining balance in the Manufacturing Overhead account, such as PearCo.’s $30,000 of overapplied overhead, is disposed of in one of two ways:

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a. It can be closed out to Cost of Goods Sold.

b. It can be allocated between Work in Process, Finished Goods, and Cost of Goods Sold in proportion to the overhead applied during the current period in the ending balances of these accounts.

2. The journal entry, in T-account form, to close out PearCo.’s $30,000 of overapplied overhead into Cost of Goods Sold would be as follows:

a. Debit Manufacturing Overhead and credit Cost of Goods Sold.

3. Calculating the allocation of under- or overapplied overhead between Work in Process, Finished Goods, and Cost of Goods Sold.

a. Assume the overhead applied in Ending Work in Process Inventory, Ending Finished Goods Inventory, and Cost of Goods Sold is $68,000, $204,000, and $408,000, respectively.

b. In this case, the allocation percentages for Work in Process, Finished Goods, and Cost of Goods Sold would be 10%, 30%, and 60%, respectively.

c. The allocation of the $30,000 of overapplied overhead would be: Work in Process, $3,000; Finished Goods, $9,000; and Cost of Goods Sold, $18,000.

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4. The journal entry to close out the $30,000 of overapplied overhead to each of the three accounts would be:

a. Debit Manufacturing Overhead and credit Work in Process, Finished Goods, and Cost of Goods Sold.

5. In summary, there are two methods for disposing of under- and overapplied overhead.

a. Close out to Cost of Goods Sold b. Allocate between Work in Process,

Finished Goods, and Cost of Goods Sold.

Quick Check − under- and overapplied overhead

V. Selected topics

A. Multiple predetermined overhead rates

i. The chapter discussion assumes that there is a

single predetermined overhead rate for an entire factory called a plantwide overhead rate.

ii. In larger companies, multiple predetermined

overhead rates are often used. For example, each production department may have its own predetermined overhead rate.

iii. While using multiple predetermined overhead rates

is more complex, it is also more accurate because it reflects differences across departments in how overhead costs are incurred.

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B. Job-order costing in services companies

i. Although our attention has focused upon manufacturing applications, it bears re-emphasizing that job-order costing is also used in services industries.

1. For example, in a law firm, each client

represents a “job.” Legal forms and similar inputs represent direct materials. The time expended by attorneys represents direct labor. The costs of secretaries, clerks, rent, depreciation, and so forth, represent the overhead.

C. The use of information technology

i. Previously, the chapter discussed the use of bar

code technology to track direct labor costs; however, bar code technology is being integrated into all areas of business activity.

“In Business Insights” Many companies are integrating bar code technology throughout their organizations. For example: “Managing Diversity with Technology” (Page 113)

• Andersen Windows of Bayport, Minnesota has used technology to customize window configurations to individual customer orders.

• Andersen has installed hundreds of Macintosh-based systems at distributors and retailers around the country.

• Customers can use these systems to customize a standard window design to their individual

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needs. The computer automatically checks to ensure the structural soundness of the newly designed window.

• Once the sale is made, the sales order and all the necessary specifications are electronically transmitted to Andersen.

• Andersen assigns a unique number to the order and tracks it in real time from the assembly line to the warehouse using bar code technology.

• In one year, Andersen offered 188,000 different products, yet fewer than one in 200 van loads contained an order discrepancy.

ii. When combined with Electronic Data

Interchange (EDI) or a web-based programming language called Extensible Markup Language (XML), bar coding eliminates the inefficiencies and inaccuracies associated with manual clerical processes.

“In Business Insights” Many companies are using XML to enhance their ability to compete using the internet. “Using XML to Enhance Web Commerce” (Page 113)

• W.W. Grainger Inc. maintains a web-based catalog of all the maintenance and repair supplies that it sells to customers.

• For an effective web-based catalog, the company needs up-to-date, detailed product descriptions from its own suppliers.

• Grainger uses software from OnDisplay Inc. to add XML tags to product descriptions collected from its vendors’ databases.

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• When Grainger’s customers use the web to request product information, the XML tags ensure that all the information from a diverse number of suppliers is displayed to customers in a standardized format.

• This process cuts in half the amount of time required to post new product information to Grainger’s web catalog.

VI. Appendix 3A: the predetermined overhead rate and

capacity (Slide # 63 is a title slide)

A. Calculating predetermined overhead rates using an estimated, or budgeted amount of the allocation base

i. This method was used throughout the chapter;

however, recently it has been criticized in two ways:

1. Basing the predetermined overhead rate on budgeted activity results in product costs that fluctuate depending upon the activity level.

2. Calculating predetermined rates based upon budgeted activity charges products for costs that they do not use.

B. Capacity-based overhead rates

i. The aforementioned criticisms can be overcome by using “estimated total units in the allocation base at capacity” in the denominator of the predetermined overhead rate calculation (rather than the

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“estimated total units in the allocation base” in the denominator).

i. The following example will help distinguish

between these two approaches.

1. Assume that a company leases a piece of equipment for $100,000 per year. If run at full capacity, the machine can produce 50,000 units per year.

2. The company estimates that 40,000 units will be produced and sold next year.

3. The predetermined overhead rate, if based on the estimated number of units that will be produced and sold, is $2.50 per unit.

4. The predetermined overhead rate, if based on the number of units produced at capacity, is $2.00.

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C. Income statement preparation

i. Critics suggest that the underapplied overhead that results from idle capacity should be disclosed on the income statement as the cost of unused capacity − a period expense.

1. Using a measure of capacity in the

denominator of the predetermined overhead rate enables this type of disclosure.

2. Using the estimated or budgeted amount of the allocation base in the denominator of the predetermined overhead rate calculation does not enable this type of disclosure.

a. Underapplied overhead is not treated as a period expense rather it is closed out to work in process, finished goods, and/or cost of goods sold.

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AGENDA: JOB-ORDER COSTING

1. The documents used and the flow of costs in job-order costing.

a. Materials requisition form.

b. Direct labor time ticket.

c. Job cost sheet.

2. Applying overhead using a predetermined overhead rate.

a. Computing the predetermined overhead rate.

b. Applying the predetermined overhead rate to jobs.

3. Underapplied and overapplied overhead. How is it determined? What is it? What is done with it?

4. Journal entries and T-accounts in a job-order costing system.

5. (Appendix) The predetermined overhead rate and capacity.

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THE FLOW OF DOCUMENTS IN A

JOB-ORDER COSTING SYSTEM

PredeterminedOvhd. Rates

Direct LaborTime Ticket

MaterialsRequisition

Job CostSheet

A sales order is preparedas a basis for issuing a ...

A production order initiateswork on a job, whereby costs

are charged through ...

The various costs of production areaccumulated on a form, prepared by theaccounting department, known as a ...

The job cost sheet forms the basis for valuingending inventories and Cost of Goods Sold.

ProductionOrder

SalesOrder

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MATERIALS REQUISITION FORM

(Exhibit 3-1)

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EMPLOYEE TIME TICKET

(Exhibit 3-3)

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JOB COST SHEET

(Exhibit 3-4)

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APPLICATION OF OVERHEAD

• In a job-order costing system, the cost of a job consists of:

1. Actual direct material costs traced to the job.

2. Actual direct labor costs traced to the job.

3. Manufacturing overhead applied to the job using a predetermined overhead rate. Actual overhead costs are not assigned to jobs.

• A predetermined overhead rate is used to assign overhead cost to products and services. It is:

• Based on estimated data.

• Established before the period begins.

• Why use estimated data?

• Waiting until the year is over to determine actual overhead costs would be too late. Managers want cost data immediately.

• Overhead rates, if based on actual costs and activity, would vary substantially from month to month. Much of this variation would be due to random changes in activity.

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PREDETERMINED OVERHEAD RATE FORMULA

The formula for computing a predetermined overhead rate is:

Estimated total manufacturing overhead costPredetermined =overhead rate Estimated total amount of the allocation base

The company in the preceding example applies overhead costs to jobs on the basis of direct labor-hours. In other words, direct labor-hours is the allocation base.

At the beginning of the year the company estimated that it would incur $320,000 in manufacturing overhead costs and would work 40,000 direct labor-hours. The company’s predetermined overhead rate is:

$320,000= $8 per DLH

40,000 DLHs

APPLICATION OF OVERHEAD TO JOBS

The process of assigning overhead to jobs is known as applying overhead.

In the preceding example, Job 2B47 required 27 direct labor-hours. Therefore, $216 of overhead cost was applied to the job as follows:

Predetermined overhead rate .................... $8 per DLH Direct labor-hours required for Job 2B47 .... × 27 DLHs Overhead applied to Job 2B47 ................... $216

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JOB-ORDER COSTING EXAMPLE

In the example appearing on the next few pages, we will trace how costs flow through Reeder Company’s job-order costing system.

1. Summary journal entries for the year for Reeder Company appear below:

a. Raw materials were purchased on account for $150,000.

Raw Materials .................................................... 150,000 Accounts Payable ..................................... 150,000

b. Raw materials that cost $160,000 were issued from the storeroom for use in production. Of this total, $136,000 was for direct materials and $24,000 for indirect materials.

Work in Process ................................................. 136,000 Manufacturing Overhead .................................... 24,000 Raw Materials........................................... 160,000

Note: Actual manufacturing overhead costs incurred are debited to a control account called Manufacturing Overhead.

c. The following costs were incurred for employee services: direct labor, $200,000; indirect labor, $85,000; selling and administrative wages and salaries, $90,000.

Work in Process ................................................. 200,000 Manufacturing Overhead .................................... 85,000 Wage and Salary Expense................................... 90,000 Salaries and Wages Payable ...................... 375,000

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JOB-ORDER COSTING EXAMPLE (cont’d)

d. Utility costs of $40,000 were incurred in the factory.

Manufacturing Overhead .................................... 40,000 Accounts Payable (or Cash) ....................... 40,000

e. Prepaid insurance of $20,000 expired during the year. (80% related to factory operations and 20% to selling and administration.)

Manufacturing Overhead .................................... 16,000 Insurance Expense............................................. 4,000 Prepaid Insurance..................................... 20,000

f. Advertising costs of $100,000 were incurred during the year.

Advertising Expense ........................................... 100,000 Accounts Payable (or Cash) ....................... 100,000

g. Depreciation of $145,000 was accrued for the year on factory assets and $15,000 on selling and administrative assets.

Manufacturing Overhead .................................... 145,000 Depreciation Expense ......................................... 15,000 Accumulated Depreciation ......................... 160,000

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h. Manufacturing overhead was applied to jobs. The company’s predetermined overhead rate was based on the following estimates: manufacturing overhead, $315,000; direct labor cost, $210,000.

$315,000= 1.5 or 150%

$210,000

Since the total direct labor cost incurred was $200,000, the total manufacturing overhead applied to work in process was 150% of this amount or $300,000. The journal entry to record this is:

Work in Process ................................................. 300,000 Manufacturing Overhead ........................... 300,000

i. Goods that cost $650,000 to manufacture according to their job cost sheets were completed and transferred to the finished goods warehouse.

Finished Goods .................................................. 650,000 Work in Process........................................ 650,000

j. Sales for the year (all on credit) were $900,000.

Accounts Receivable........................................... 900,000 Sales ....................................................... 900,000

k. The goods that were sold had cost $600,000 to manufacture according to their job cost sheets.

Cost of Goods Sold............................................. 600,000 Finished Goods......................................... 600,000

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2. T-accounts are provided below for the manufacturing accounts (beginning balances are assumed).

Raw Materials Work in Process Bal. 20,000 Bal. 74,000 (a) 150,000 160,000 (b) (b) 136,000 650,000 (i) Bal. 10,000 (c) 200,000 (h) 300,000 Bal. 60,000

Finished Goods Manufacturing Overhead

Bal. 40,000 (b) 24,000 300,000 (h) (f) 650,000 600,000 (k) (c) 85,000 Bal. 90,000 (d) 40,000 (e) 16,000 (g) 145,000 Bal. 10,000

Cost of Goods Sold (k) 600,000

a) Purchase of raw materials. g) Depreciation of factory assets. b) Issue of materials. h) Apply manufacturing overhead. c) Labor costs. i) WIP completed. d) Factory utility costs. k) Finished Goods sold. e) Factory insurance costs.

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UNDER- AND OVERAPPLIED OVERHEAD

Since predetermined overhead rates are based on estimated data, at the end of an accounting period overhead costs are usually either underapplied or overapplied. In the example, overhead is underapplied by $10,000, which can be determined by examining the balance in the Manufacturing Overhead account:

Manufacturing Overhead (b) 24,000 300,000 (h) Actual (c) 85,000 Applied Overhead (d) 40,000 Overhead Costs (e) 16,000 Costs (g) 145,000 310,000 300,000 Under-applied Bal. 10,000

The difference of $10,000 between the actual overhead costs and the applied overhead costs in this case is called underapplied overhead because actual overhead costs exceeded the overhead costs that were applied to inventory.

Alternatively, the amount of the under- or overapplied overhead can be determined as follows:

Actual overhead costs incurred ...................... $310,000 Applied overhead costs (150% × $200,000) ... 300,000 Underapplied overhead ................................. $ 10,000

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3. Disposition of under- or overapplied overhead.

a. Close the balance in Manufacturing Overhead to Cost of Goods Sold:

Cost of Goods Sold............................................. 10,000 Manufacturing Overhead ........................... 10,000

or

b. Allocate the balance in Manufacturing Overhead among Work in Process, Finished Goods, and Cost of Goods Sold in proportion to the amount of overhead applied during the period in each account at the end of the period. (The figures below are given.)

Overhead applied during the current period in the ending balance of:

Work in Process ................................. $ 24,000 8% Finished Goods .................................. 36,000 12 Cost of Goods Sold............................. 240,000 80 Total ................................................. $300,000 100%

The journal entry to record the allocation of the underapplied overhead of $10,000 would be:

Work in Process (8% of $10,000)........................ 800 Finished Goods (12% of $10,000) ....................... 1,200 Cost of Goods Sold (80% of $10,000).................. 8,000 Manufacturing Overhead ........................... 10,000

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Reeder Company Schedule of Cost of Goods Manufactured

Direct materials: Beginning raw materials inventory.......... $ 20,000 Add: Purchases of raw materials ............ 150,000 Total raw materials available.................. 170,000 Deduct: Ending raw materials inventory.. 10,000 Raw materials used in production........... 160,000 Less: Indirect materials ......................... 24,000 $136,000

Direct labor............................................. 200,000 Manufacturing overhead applied* ............. 300,000 Total manufacturing costs ........................ 636,000 Add: Beginning work in process inventory . 74,000 710,000 Deduct: Ending work in process inventory . 60,000 Cost of goods manufactured..................... $650,000

* Note that manufacturing overhead applied during the period is used to compute the total manufacturing costs on the schedule of cost of goods manufactured, not the actual manufacturing costs.

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4. Reeder Company’s income statement for the year (assuming that the underapplied overhead is closed directly to Cost of Goods Sold) would be:

Reeder Company Income Statement

Sales ..................................................... $900,000Cost of goods sold ($600,000 + $10,000) . 610,000Gross margin.......................................... 290,000Less selling and administrative expenses:

Wage and salary expense ..................... $ 90,000 Insurance expense ............................... 4,000 Advertising expense ............................. 100,000 Depreciation expense ........................... 15,000 209,000

Net operating income.............................. $ 81,000

Reeder Company Schedule of Cost of Goods Sold

Beginning finished goods inventory .......... $ 40,000Add: Cost of goods manufactured ............ 650,000Goods available for sale........................... 690,000Ending finished goods inventory............... 90,000Unadjusted cost of goods sold ................. 600,000Add: Underapplied overhead.................... 10,000Adjusted cost of goods sold ..................... $610,000

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COST FLOWS IN A JOB-ORDER COSTING SYSTEM (Exhibit 3-14)

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THE PREDETERMINED OVERHEAD RATE AND CAPACITY (APPENDIX 3A)

• Difficulties with the traditional approach:

Estimated total manufacturing overhead costPredetermined =overhead rate Estimated total amount of the allocation base

• Manufacturing overhead typically includes large amounts of fixed costs. As activity (and the amount of the allocation base) falls, the predetermined overhead rate increases.

• Products appear to cost more when activity has declined.

• May lead to pressure to increase selling prices.

• Products are charged for resources they don’t use (unused or idle capacity). As activity falls, the increased costs of idle capacity are spread across fewer units.

• Alternative approach:

Estimated total manufacturing overhead costPredetermined =overhead rate Total amount of the allocation base at capacity

• Underapplied overhead resulting from unused capacity is treated as a period expense and is called Cost of Unused Capacity on the income statement.

• Since the denominator is more stable than in the traditional approach, this method results in a more stable predetermined overhead rate. The costs of products will not appear to increase as the activity level falls.

• Products are only charged for the resources they use. They are not charged for the idle capacity they don’t use. If a product uses 10% of the capacity of a machine, it will be charged for only 10% of the costs of the machine regardless of how much capacity is unused.

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Chapter 4

System Design—Process Costing Learning Objectives LO1. Record the flow of materials, labor, and overhead through a process costing system. LO2. Compute the equivalent units of production using the weighted-average method. LO3. Prepare a quantity schedule using the weighted-average method. LO4. Compute the costs per equivalent unit using the weighted-average method. LO5. Prepare a cost reconciliation using the weighted-average method. LO6. (Appendix 4A) Compute the equivalent units of production using the FIFO method. LO7. (Appendix 4A) Prepare a quantity schedule using the FIFO method. LO8. (Appendix 4A) Compute the costs per equivalent unit using the FIFO method. LO9. (Appendix 4A) Prepare a cost reconciliation using the FIFO method. New in this Edition • Additional simple exercises have been created. Chapter Overview A. Job-Order Costing vs. Process Costing. Process costing is used in industries that produce homogenous products such as bricks, flour, and cement on a continuous basis. 1. Similarities between job-order and process costing. Job-order and process costing

systems share some characteristics: a. Both systems have the same basic purpose—to assign material, labor, and overhead

cost to products. b. Both systems use the same basic manufacturing accounts: Manufacturing Overhead,

Raw Materials, Work In Process, and Finished Goods. c. The flow of costs through the manufacturing accounts is basically the same.

2. Differences between job-order and process costing. The differences between job-order

and process costing occur because the flow of units in a process costing system is more or less continuous and the units are essentially indistinguishable from one another. Under process costing: a. A single homogenous product is produced on a continuous basis over a long period of

time. This differs from job-order costing in which many different products may be produced in a single period.

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b. Costs in process costing are accumulated by department, rather than by individual job. c. The department production report is the key document in process costing, showing the

accumulation and disposition of cost. In job-order costing, the job-cost sheet is the key document.

B. Overview of Process Costing. (Exercises 4-1 and 4-10.) Manufacturing costs are accumulated in processing departments in a process costing system. A processing department is any location in the organization where work is performed on a product and where materials, labor, and overhead costs are added to the product. Processing departments should also have two other features. First, the activity performed in the processing department should be essentially the same for all units that pass through the department. Second, the output of the department should be homogeneous. In process costing, the average cost of processing units for a period is assigned to each unit passing through the department. Two process costing methods are illustrated in the text—the weighted-average method and the FIFO method. While the FIFO method provides more current cost data for decision-making and performance evaluation purposes, it is more difficult for students to grasp. For that reason, the FIFO method is covered in an appendix. C. Equivalent Units of Product. (Exercises 4-2, 4-11, 4-13, and 4-17.) In order to calculate the average cost per unit, the total number of units must be determined. Partially completed units pose a difficulty that is overcome using the concept of equivalent units. Equivalent units are the equivalent, in terms of completed units, of partially completed units. The formula for computing equivalent units is:

Number ofEquivalent Percentagepartially completedunits completionunits= ×

Equivalent units are the number of complete, whole units one could obtain from the materials and effort contained in partially completed units. Under the weighted-average method, the equivalent units for a particular cost category (e.g., materials or conversion cost) is computed by adding together the number of units completed and transferred out to the next department during the period and the equivalent units in the ending work in process inventory in the department.

Units transferred toEquivalent Equivalent unitsunits of the next department in ending work in

or to finished goods process inventoryproduction= +

D. Production Report. The purpose of a production report is to summarize all of the activity that takes place in a department's work in process account for a period. A production report consists of three parts:

• A quantity schedule and a computation of equivalent units. • A computation of costs per equivalent unit. • A reconciliation of all cost flows into and out of the department during the period.

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E. Production Report: Weighted-Average Method. (Exercise 4-13 followed by Exercise 4-14.) Emphasize that the weighted-average method does not attempt to separate units in the beginning inventory from units started during the current period. Costs and units from beginning inventory are blended together with costs and units from the current period. 1. Quantity Schedule and Equivalent Units. (Exercises 4-2, 4-4, and 4-11.) The first step in

preparing a production report is to prepare a quantity schedule, which shows the physical flow of units through the department. This schedule allows managers to see at glance how many units moved through the department during the period. Using the quantity schedule, the equivalent units can be easily computed.

2. Costs per Equivalent Unit. (Exercises 4-6 and 4-13.) The second step in preparing a

production report is to calculate the costs per equivalent unit. The cost per equivalent unit is computed for a particular cost category (i.e., materials, labor, overhead, or conversion) by dividing its total cost by its total equivalent units. Note that under the weighted-average method the costs include both the costs already in beginning inventory as well as the costs added by the department during the current period.

3. Cost Reconciliation. (Exercise 4-7.) The third step in preparing a production report is to

prepare a cost reconciliation. The purpose of a cost reconciliation is to show how the costs from beginning work in process inventory and costs that have been added during the period are accounted for. a. Costs come into the department from units in beginning inventory, from material,

labor, and overhead costs that are added during the period, and from any units that might have been transferred in from a prior department.

b. A department's costs are accounted for by showing the costs that are transferred out to

the next department (or to finished goods) and by specifying the costs that remain in the ending work in process inventory.

F. 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 and on the other is process costing. Between the two extremes, there are many “hybrid” systems. Operation costing is an example of such a hybrid system. It is used in situations where products have some common as well as individual characteristics. TVs, for example, have some common characteristics in that all models must be assembled and tested following the same basic steps. However, each model has different components with different costs. The costs of the components (materials) would be charged to a batch of a particular model individually, as in job-order costing, but the conversion costs may be assigned using process costing. G. FIFO Method (Appendix 4A). (Exercise 4-15 followed by Exercise 4-16.) The FIFO method segregates the units and costs in the beginning inventory from the units and costs of the current period. 1. Quantity Schedule. (Exercises 4-5 and 4-12.) The quantity schedule prepared under the

FIFO method is identical to that prepared under the weighted-average method, except that the “units transferred out” are separated into those units that came from beginning inventory and those units that were started and completed this period.

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2. Equivalent Units. (Exercises 4-3 and 4-12.) The FIFO method differs from the weighted-average method for computation of equivalent units in two ways. a. First, under the FIFO method the “units transferred out” figure is split between units

completed from the beginning inventory and units started and completed during the current period.

b. Second, the equivalent units refers to just the equivalent units for the work performed

during the current period. The equivalent units under the FIFO method consist of three amounts: the work needed to complete the units in the beginning inventory; the work expended on the units started and completed during the current period; and the work expended on partially completed units in the ending inventory.

c. This method is called the FIFO method because it assumes that the units in beginning

inventory are completed and transferred out before any new units are started. The costs of beginning inventory are segregated from costs added during the period.

d. The only difference in the equivalent unit calculations between the two methods is that

the equivalent units in beginning inventory are included in the weighted-average method. Under the weighted-average method the costs already in beginning inventory will be added to the costs incurred during the period to arrive at unit costs. To be consistent we must add the equivalent units already in beginning inventory to the equivalent units for the work performed during the current period.

3. Costs per Equivalent Unit. (Exercise 4-8.) In computing costs per equivalent unit, costs

associated with the beginning work in process inventory are ignored. It is assumed that the units in beginning inventory are completed and transferred to the next department before any new units are worked on. Providing that more units are transferred out than were in beginning inventory, all of the costs associated with beginning inventory will be transferred to the next department.

4. Cost Reconciliation. (Exercises 4-9 and 4-16.) As with the weighted-average method, the

purpose of a cost reconciliation is to show how the costs have been charged to a department during a period and to show how these costs are accounted for. a. The “Costs to be accounted for” section of the report is the same as for the weighted-

average method. b. The “Cost accounted for” section differs from the weighted-average method in that

four layers of cost are involved. These layers are (1) the cost in the beginning inventory, (2) the cost required to complete the units in the beginning inventory, (3) the cost of units started and completed during the current period, and (4) the cost of the ending work in process inventory.

H. Evaluation of Weighted-Average and FIFO (Appendix 4A). The weighted-average method is simpler to learn and apply than the FIFO method, but the FIFO method is generally considered to be superior for cost control. The reason is that the FIFO method helps to isolate current performance by segregating current costs from prior period costs. The weighted-average method mixes the costs of the current period with the costs of prior periods.

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Time Exercise 4-1 Process costing journal entries........................................................ Basic 20 min. Exercise 4-2 Computation of equivalent units—WAC........................................ Basic 10 min. Exercise 4-3 (Appendix 4A) Computation of equivalent units—FIFO ............... Basic 10 min. Exercise 4-4 Preparation of quantity schedule—WAC ....................................... Basic 15 min. Exercise 4-5 (Appendix 4A) Preparation of quantity schedule—FIFO............... Basic 15 min. Exercise 4-6 Cost per equivalent unit—WAC..................................................... Basic 15 min. Exercise 4-7 Cost reconciliation—WAC............................................................. Basic 20 min. Exercise 4-8 (Appendix 4A) Cost per equivalent unit—FIFO ............................ Basic 10 min. Exercise 4-9 (Appendix 4A) Cost reconciliation—FIFO .................................... Basic 45 min. Exercise 4-10 Process costing journal entries........................................................ Basic 10 min. Exercise 4-11 Quantity schedule and equivalent units—WAC ............................. Basic 15 min. Exercise 4-12 (Appendix 4A) Quantity schedule and equivalent units—FIFO..... Basic 15 min. Exercise 4-13 Equivalent units and cost per equivalent unit—WAC .................... Basic 20 min. Exercise 4-14 Cost reconciliation—WAC [assign after Exercise 4-13] ................ Basic 15 min. Exercise 4-15 (Appendix 4A) Quantity schedule; equivalent units; cost per

equivalent unit—FIFO ............................................................... Basic 20 min. Exercise 4-16 (Appendix 4A) Cost reconciliation—FIFO [assign after

Exercise 4-15] ............................................................................ Basic 20 min. Exercise 4-17 Quantity schedule; equivalent units, and cost per equivalent

unit—WAC ................................................................................ Basic 20 min. Exercise 4-18 (Appendix 4A) Quantity schedule; equivalent units, and cost

per equivalent unit—FIFO......................................................... Basic 20 min. Problem 4-19 Step-by-step production report—WAC .......................................... Basic 45 min. Problem 4-20 (Appendix 4A) Step-by-step production report—FIFO.................. Basic 45 min. Problem 4-21 Production report—WAC ............................................................... Basic 45 min. Problem 4-22 (Appendix 4A) Production report—FIFO....................................... Basic 45 min. Problem 4-23 Analysis of Work in Process T-account—WAC ............................ Medium 45 min. Problem 4-24 (Appendix 4A) Analysis of Work in Process T-account—FIFO.... Medium 45 min. Problem 4-25 Interpreting a production report—WAC......................................... Medium 30 min. Problem 4-26 Comprehensive process costing problem—WAC .......................... Difficult 90 min. Problem 4-27 Equivalent units; costing of inventories; journal entries—WAC ... Difficult 60 min. Problem 4-28 Comprehensive process costing problem—WAC .......................... Difficult 90 min. Case 4-29 Ethics and the manager; understanding the impact of

percentage completion on profit—WAC ................................... Difficult 90 min. Case 4-30 Production report of second department—WAC............................ Difficult 45 min. Case 4-31 (Appendix 4A) Production report of second department—FIFO ... Difficult 60 min. Essential Problems: Problem 4-19, Problem 4-21 Supplementary Problems: Problem 4-23, Problem 4-25, Problem 4-26, Problem 4-27, Problem

4-28, Case 4-29, Case 4-30 Appendix 4A Essential Problems: Problem 4-20, Problem 4-22 Appendix 4A Supplementary Problems: Problem 4-24, Case 4-31 Linked problems and exercises: Exercise 4-14 should be assigned in conjunction with Exercise 4-13

Exercise 4-16 should be assigned in conjunction with Exercise 4-15

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Helpful Hint: Before beginning the lecture, show students the fourth segment from the first tape of the McGraw-Hill/Irwin Managerial/Cost Accounting video library. This segment introduces students to many of the concepts discussed in chapter 4. The lecture notes reinforce the concepts introduced in the video.

Chapter theme: Managers need to assign costs to products to facilitate external financial reporting and internal decision making. This chapter illustrates an absorption costing approach to calculating product costs known as process costing.

I. Comparison of job-order and process costing

A. Similarities between job-order and process costing

i. Both systems assign material, labor and overhead costs to products and they provide a mechanism for computing unit product costs.

ii. Both systems use the same manufacturing accounts,

including Manufacturing Overhead, Raw Materials, Work in Process, and Finished Goods.

iii. The flow of costs through the manufacturing

accounts is basically the same in both systems.

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B. Differences between job-order and process costing

i. Process costing is used when a single product is produced on a continuing basis or for a long period of time. Job-order costing is used when many different jobs are worked each period.

ii. Process costing systems accumulate costs by

department. Job-order costing systems accumulate costs by individual jobs.

iii. Process costing systems use department

production reports to accumulate costs. Job-order costing systems use job cost sheets to accumulate costs.

iv. Process costing systems compute unit costs by

department. Job-order costing systems compute unit costs by job.

Quick Check − process vs. job-order costing “In Business Insights” Some companies use a hybrid approach to calculating product costs that combines elements of process and job-order costing. For example: “A Hybrid Approach” (page 147)

• Some hospital pharmacies may use process costing to develop the cost of formulating the base solution for parenterals (that is, drugs delivered by injection or through the blood stream).

• Job-order costing can be used to accumulate the additional costs incurred to create specific parenteral solutions.

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• The additional costs include the ingredients added to the base solution and the time spent by the pharmacist to prepare a specific prescribed solution.

II. A perspective of process cost flows

A. Processing departments − Any location in an organization where materials, labor or overhead are added to the product.

i. The activities performed in a processing

department are performed uniformly on all units of production. Furthermore, the output of a processing department must be homogeneous.

ii. Processing departments can be organized

sequentially or in parallel.

1. Sequential processing means that units flow in a sequence from one department to another.

2. Parallel processing is used, where after a point, some units go through different processing departments than others.

a. For example, a petroleum refinery separates crude oil into intermediate products that go through separate processes to become end products such as gasoline, jet fuel, and heating oil.

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B. The flow of materials, labor, and overhead costs

i. The flow of costs through the manufacturing

accounts is basically the same for process and job-order costing.

1. Direct material, direct labor and

manufacturing overhead are added to Work in Process. When work in process is completed the costs are transferred to Finished Goods. When finished goods are sold, the costs are transferred to Cost of Goods Sold.

ii. Nonetheless, there is a key fundamental

difference between process and job-order costing systems.

1. Job-order costing systems trace and apply

manufacturing costs to jobs. a. One Work in Process account is often

used to accumulate costs for all jobs. The individual job cost sheets serve as a subsidiary ledger.

2. Process costing systems trace and apply manufacturing costs to departments.

a. A separate Work in Process account is maintained for each processing department.

iii. T-account and journal entry views of process

cost flows (For purposes of this example, assume there are two processing departments − A and B).

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Helpful Hint: Explain that the journal entries for job-order and process costing are similar, with the exception of the specific Work in Process account for each department under process costing.

1. The flow of raw material costs.

a. In T-account form: i. Direct material costs are debited

to the appropriate departmental Work in Process account depending upon where the materials were added to the production process. The Raw Materials account is credited for the corresponding amounts.

b. In journal entry form: i. Debit the respective departmental

Work in Process accounts. Credit Raw Materials.

2. The flow of labor costs. a. In T-account form:

i. Direct labor costs are debited to the appropriate departmental Work in Process account depending upon where the labor was added to the production process. Salaries and Wages Payable is credited for the corresponding amounts.

b. In journal entry form: i. Debit the respective departmental

Work in Processes accounts. Credit Salaries and Wages Payable.

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3. The flow of manufacturing overhead costs.

a. In T-account form: i. Manufacturing overhead costs

are debited to the respective departmental Work in Process accounts. Manufacturing Overhead is credited by the corresponding amounts.

1. Predetermined overhead rates are usually used to apply overhead to the departments.

b. In journal entry form: i. Debit the appropriate

departmental Work in Process accounts. Credit Manufacturing Overhead.

4. The flow of manufacturing costs for partially completed units transferred from Department A to Department B:

a. In T-account form: i. The cost of direct materials,

direct labor and manufacturing overhead assigned to partially completed units from Department A is debited to Department B and credited to Department A.

ii. The transferred-in costs from Department A are added to the manufacturing costs incurred in Department B.

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b. In journal entry form: i. Debit Work in Process −

Department B and credit Work in Process − Department A.

5. The flow of manufacturing costs from the final processing department to finished goods.

a. In T-account form: i. Debit Finished Goods and credit

Work in Process − Department B for the amount of the cost of goods manufactured.

b. In journal entry form: i. Debit Finished Goods and credit

Work in Process − Department B.

6. The flow of manufacturing costs from Finished Goods to Cost of Goods Sold.

a. In T-account form: i. Debit Cost of Goods Sold and

credit Finished Goods. b. In journal entry form:

i. Debit Cost of Goods Sold and credit Finished Goods.

III. Equivalent units of production

A. Equivalent units − are defined as the product of the number of partially completed units and the percentage completion of those units.

i. Equivalent units need to be calculated because a

department usually has some partially completed units in its beginning and ending inventory. These

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partially completed units complicate the determination of a department’s output for a given period and the unit cost that should be assigned to that output.

Helpful Hint: Explain that equivalent units simply restate the ending work in process inventory as if it were comprised of a smaller number of fully completed units.

ii. Equivalent units − the basic idea.

1. Two half completed products are equivalent

to one complete product. 2. 10,000 units 70% complete are equivalent to

7,000 equivalent units.

Quick Check − calculating equivalent units iii. Equivalent units can be calculated two ways.

1. The FIFO method is covered in the

appendix. 2. The weighted-average method is included

within the main portion of the chapter and it is covered next.

B. The weighted-average method of calculating

equivalent units and the cost per equivalent unit

i. Characteristics of the weighted-average method:

1. This method makes no distinction between work done in the prior and current periods.

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2. This method blends together units and costs from the prior and current periods.

ii. Treatment of direct labor

1. Direct labor costs are often small in

comparison to the other product costs in process cost systems.

2. Therefore, direct labor and manufacturing overhead are often combined into one classification of product cost called conversion costs. The forthcoming example combines these costs.

iii. An example of the weighted-average method

1. Assume that Smith Company reported activity for June as shown on this slide.

2. The first step in calculating the equivalent units is to identify the units completed and transferred out of Department A in June (5,400 units).

3. The second step is to identify the equivalent units of production in ending work in process with respect to materials for the month (540 units) and adding this to the 5,400 units from step one.

4. The third step is to identify the equivalent units of production in ending work in process with respect to conversion for the month (270 units) and adding this to the 5,400 units from step one.

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Helpful Hint: Explain that there will most likely be differences in the equivalent unit calculations between material and conversion costs, as materials are usually added at the beginning of production, while conversion costs are added during the period.

5. The equivalent units of production equals

the units completed and transferred out (5,400 units) plus the equivalent units remaining in work in process (540 units for materials and 270 units for conversion).

6. A different visual depiction of the equivalent units calculation for materials is shown on this slide.

7. A different visual depiction of the equivalent units calculation for conversion is shown on this slide.

Helpful Hint: The treatment of beginning inventory under the weighted-average method often puzzles students, since work done in the prior periods is included in the equivalent units. Explain that this is called the weighted-average method precisely because it averages together beginning inventory and work performed in the current period. Costs and units are treated consistently. Both the equivalent units and the costs that go into the unit cost calculations under the weighted-average method include amounts already in beginning inventory.

IV. Production report − weighted-average method

A. There are three sections in a production report:

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i. The quantity schedule shows the flow of units through the department and a computation of equivalent units.

ii. The costs per equivalent unit section shows the

computation of costs per equivalent unit.

iii. The cost reconciliation section shows the reconciliation of all cost flows into and out of the department during the period.

Helpful Hint: Explain that a production report indicates where units and costs came from (beginning work in process and additional units and costs) and where these units and costs end up (finished goods and ending work in process).

B. An example of a production report

i. Assume that Double Diamond Skis uses the weighted-average method of process costing to determine unit costs in its Shaping and Milling Department.

ii. Assume the following facts as shown on this slide.

iii. The first step is to prepare the quantity schedule

and compute the equivalent units.

1. Calculate the units to be accounted for (5,200 units) and the allocation of those units between “completed and transferred”

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(4,800 units) and ending work in process (400 units).

2. Calculate the equivalent units in ending work in process with respect to materials (160 units) and add these units to the units completed and transferred (4800 units) to obtain total equivalent units with respect to materials for the period (4,960 units).

3. Calculate the equivalent units in ending work in process with respect to conversion (100 units) and add these units to the units completed and transferred (4800 units) to obtain the total equivalent units with respect to conversion for the period (4,900 units).

iv. The second step is to calculate the cost per

equivalent unit.

1. Generally speaking, the cost per equivalent unit is calculated by dividing the costs for the period by the equivalent units of production for the period.

2. Calculate the total material and conversion costs to be accounted for during the period by summing the costs added during the period ($368,600 for materials and $350,900 for conversion) and the costs in beginning work in process ($9,600 for materials and $5,575 for conversion).

3. Calculate the cost per equivalent unit for materials ($76.25).

4. Calculate the cost per equivalent unit for conversion ($72.75), and the total cost per equivalent unit ($149.00).

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v. The third step is to prepare a cost reconciliation. 1. Enter the number of units completed and

transferred out during the period (4,800 units) as well as the equivalent units of materials and conversion in the ending work in process (160 units for materials and 100 units for conversion).

2. Multiply the number of units completed and transferred out (4,800 units) by the total cost per equivalent unit ($149) to obtain the cost of units transferred out during the period ($715,200).

3. Multiply the number of equivalent units in ending work in process with respect to materials (160 units) by the material cost per equivalent unit ($76.25) to obtain the total material cost in ending work in process ($12,200).

4. Multiply the number of equivalent units in ending work in process with respect to conversion (100 units) by the conversion cost per equivalent unit ($72.75) to obtain the total conversion cost in ending work in process ($7,275).

5. Sum all costs included in the reconciliation to obtain total cost accounted for ($734,675).

V. Operation costing

A. Operation costing is a hybrid of job-order and process

costing because it possesses attributes of both approaches.

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i. Operation costing is commonly used when batches of many different products pass through the same processing departments.

1. For example, similar to job-order costing, a

shoe manufacturer may charge each batch of shoes for its own specific material costs (e.g., shoes made with expensive leather would be charged accordingly, as would shoes made with inexpensive synthetic materials).

2. Similar to process costing, the shoe manufacturer may accumulate the labor and overhead costs by department and assign the same conversion cost per unit to each shoe regardless of the shoe style.

VI. Appendix 4A: FIFO method (slide 54: title slide)

A. FIFO vs. weighted-average method

i. The FIFO method (generally considered more

accurate than the weighted-average method) differs from the weighted-average method in two ways:

1. The computation of equivalent units 2. The way in which the costs of beginning

inventory are treated in the cost reconciliation report.

B. Equivalent units − FIFO method

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i. Let’s revisit the Smith Company example that was used to illustrate the weighted-average method.

1. Assume the following activity, as shown on

the slide, is reported in Department A for the month of June.

2. The first step is to determine the number of units completed and transferred out of Department A in June (5,400 units).

3. The second step is to add the equivalent units of production in ending work in process inventory (540 units for materials and 270 units for conversion) to the units completed and transferred out.

4. The third step is to subtract the equivalent units in beginning work in process inventory (120 units for materials and 60 units for conversion) from the sum of the units completed and transferred out and the equivalent units in ending work in process inventory.

a. This calculation results in 5,820 and 5,610 equivalent units of materials and conversion, respectively.

5. A different visual depiction of the calculation of equivalent units with respect to materials is as follows.

6. A different visual depiction of the calculation of equivalent units with respect to conversion is as follows.

C. Comparing equivalent units of production under the

weighted-average and FIFO methods

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i. The equivalent units in beginning inventory are subtracted from the equivalent units of production per the weighted-average method to obtain the equivalent units of production under the FIFO method. This can be illustrated using the Smith Company example as follows:

1. The equivalent units of material produced

per the weighted-average method (5,940 units) minus the equivalent units of material in beginning inventory (120 units) equals the equivalent units of production per the FIFO method (5,820 units).

2. The equivalent units of conversion per the weighted-average method (5,670 units) minus the equivalent units of conversion in beginning inventory (60 units) equals the equivalent units of production per the FIFO method (5,610 units).

Helpful Hint: The only difference in the equivalent unit calculations between the weighted-average and FIFO methods is that the equivalent units in beginning inventory are included in the weighted-average method. Emphasize again that under the weighted-average method the costs already in beginning inventory will be added to the costs incurred during the period to arrive at unit costs. To be consistent, equivalent units already in beginning inventory must be added to the equivalent units for work performed during the period.

D. The production report − FIFO method

i. Let’s revisit the Double Diamond Skis example that

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Assume the following activity, as shown on the slide, is reported in the Shaping and Milling Department for the month of May.

1. The first step is to prepare a quantity

schedule and to compute the equivalent units.

a. First, calculate the total units to be accounted for (5,200 units). This is the sum of the units in beginning work in process (200 units) and the units started into production during the period (5,000 units).

b. Second, calculate the equivalent units of material and conversion that were transferred from beginning work in process to the next department (90 units for materials and 140 units for conversion).

c. Third, calculate the number of units started and completed during the month (4,600 units).

d. Fourth, calculate the equivalent units of material and conversion that are in ending work in process inventory (160 units for materials and 100 units for conversion).

e. Fifth, calculate the total equivalent units for materials (4,850 units) and conversion (4,840 units).

2. The second step is to compute the cost per equivalent unit.

a. First, calculate the costs to be accounted for during the period ($734,675). Notice, the costs of

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beginning work in process ($15,175) are not broken down by material and conversion components.

b. Second, divide the costs added to the department for materials ($368,600) by the equivalent units of production (4,850 units) to obtain the cost per equivalent unit for materials ($76.00).

c. Third, divide the conversion costs added to the department ($350,900) by the equivalent units of production (4,840 units) to obtain the conversion cost per equivalent unit ($72.50).

d. Fourth, add the material and conversion costs per equivalent unit to obtain the total cost per equivalent unit ($148.50).

3. The third step is to prepare a cost reconciliation.

a. First, calculate the total cost from beginning inventory transferred to the next department ($32,165).

i. This includes the costs in beginning inventory ($15,175) plus the costs incurred to complete the unfinished equivalent units in beginning inventory ($6,840 for materials and $10,150 for conversion).

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b. Second, calculate the cost of units started and completed during the period ($683,100).

c. Third, calculate the costs in ending work in process inventory ($12,160 for materials and $7,250 for conversion).

d. The sum of these three numbers ($734,675) should agree with the total costs to be accounted for in the “Costs per Equivalent Unit” portion of the production report ($734,675).

Helpful Hint: Remind students that the only difference between the FIFO and weighted-average approaches is the treatment of units in beginning inventory and the costs of beginning inventory. In essence, the weighted-average approach simply combines the units in beginning inventory and the costs of beginning inventory with all other units and all costs incurred during the period. The FIFO method segregates the beginning inventory. Providing that the number of units transferred out is at least as large as the number of units in beginning inventory, the costs already in beginning inventory are simply transferred out under the FIFO method.

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TM 4-1


AGENDA: PROCESS COSTING

1. Differences between job-order and process costing.

2. Overview of cost flows in process costing.

3. The concept of equivalent (whole) units for partially completed units.

4. Overview of the weighted-average method for determining costs.

5. Departmental production report using the weighted-average method.

a. Quantity schedule and computation of equivalent units.

b. Computation of costs per equivalent unit.

c. Cost reconciliation: assigning costs to units transferred out and to ending work in process inventory.

6. (Appendix) FIFO method production report.

7. (Appendix) Comparison of weighted-average and FIFO methods.

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TM 4-2


DIFFERENCES BETWEEN JOB-ORDER AND PROCESS COSTING

(Exhibit 4-1)

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TM 4-3


SEQUENTIAL PROCESSING DEPARTMENTS (Exhibit 4-2)

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TM 4-4


T-ACCOUNT MODEL OF PROCESS COSTING FLOWS (Exhibit 4-3)

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TM 4-5


OVERVIEW OF PROCESS COSTING

A. In process costing, costs are accumulated in processing departments.

B. A separate departmental production report is compiled for each processing department. This report provides the details of how costs are assigned to units that pass through the department.

C. Costs to be accounted for in each processing department consist of:

1) Costs of the beginning work in process inventory in the department.

2) Costs added during the period.

a. Costs of units transferred in from a preceding department.

b. Costs added in the department itself.

Materials + Labor + Overhead

Conversion Costs

D. Costs are accounted for by assigning them to:

1) Ending work in process inventory in the department.

2) Units transferred out to the next department (or to finished goods).

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OVERVIEW OF PROCESS COSTING (continued)

E. In process costing, each unit is assigned the average cost of units processed through the department.

F. Two things must be known to compute the average cost per unit in a department:

1) The total cost.

2) The total number of units processed.

G. Partially completed units are converted to equivalent (whole) units.

For example, 200 units in ending inventory are 25% complete with respect to conversion costs.

Equivalent Number of partially Percentage = × units completed units completion

= 200 × 50% = 50 EUs

H. The two common methods of computing average costs per unit are the weighted-average method and the FIFO method. The FIFO method is discussed in Appendix 4A.

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TM 4-7


WEIGHTED-AVERAGE METHOD

• The weighted-average method averages together the beginning work in process inventories with the units started during the current period.

• For each category of cost in each processing department the following calculations are made:

Costs to be Costs of Costs addedaccounted = beginning WIP + during the

for inventory current period

Equivalent Units Equivalent unitsunits of = transferred + of ending WIP

production out inventory

Units transferred out of the department are 100% complete with respect to the work done in the department.

Costs to be accounted forCost per = EU Equivalent units of production

Costs of units Units Cost = ×transferred out transferred out per EU

Costs of units in Equivalent units of Cost = × ending WIP inventory ending WIP inventory per EU

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TM 4-8


WEIGHTED-AVERAGE METHOD (cont’d)

EXAMPLE: Halsey Company makes small sailboats. During the most recent month, the following activity was recorded in the Hull Fabrication Department for conversion costs.

Work in process, beginning (80% complete) ... 15,000 units Units started into production ......................... 180,000 units Units transferred out..................................... 175,000 units Work in process, ending (30% complete) ....... 20,000 units Conversion Costs: Work in process, beginning............................ $24,000 Conversion costs incurred during the month ... $338,000

Costs to be Costs of Costs addedaccounted = beginning WIP + during the

for inventory current period

= $24,0000 + $338,000 = $362,000

Equivalent Units Equivalent unitsunits of = transferred + of ending WIP

production out inventory

=175,000 + (20,000 × 30%) = 181,000

Costs to be accounted forCost per EU =

Equivalent units of production

$362,000= = $2 per EU

181,000 EU

Costs of units Units Cost = ×transferred out transferred out per EU

= 175,000 × $2 = $350,000

Costs of units in Equivalent units of Cost = ×ending WIP inventory ending WIP inventory per EU

= (20,000 × 30%) × $2 = $12,000

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TM 4-9


PRODUCTION REPORT

The production report summarizes all of the activity and cost flows in a department.

The production report has three separate, but highly interrelated, parts:

1. A quantity schedule with equivalent units.

2. Computation of costs per equivalent unit.

3. A reconciliation of all cost flows into and out of the department during the period.

EXAMPLE: The following data are for the first processing department at Midwest Refining, a company that reclaims petroleum products from used motor oil.

Units Materials Conversion Work in process, beginning:

Units in process .......................... 10,000 Percentage completion................ 60% 50% Cost of beginning inventory ......... $4,300 $7,600

Units started into production .......... 190,000 Costs added in the department

during the current period ............ $74,100 $140,400 Units completed and transferred..... 180,000 Work in process, ending:

Units in process .......................... 20,000 Percentage completion................ 80% 25%

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TM 4-10


QUANTITY SCHEDULE AND EQUIVALENT UNITS: WEIGHTED-AVERAGE METHOD

• The quantity schedule accounts for the physical flow of units through a department for a period.

• The equivalent units are also shown for the units transferred out of the department and for ending work in process inventory.

Quantity Schedule

Units to be accounted for: Work in process, beginning .... 10,000 Started into production .......... 190,000

Total units to be accounted for . 200,000 Equivalent Units (EU) Materials ConversionUnits accounted for as follows:

Units transferred out ............. 180,000 180,000 180,000Work in process, ending*....... 20,000 16,000 5,000

Total units accounted for.......... 200,000 196,000 185,000

* Materials: 20,000 units × 80% complete = 16,000 EUs; Conversion: 20,000 units × 25% complete = 5,000 EUs

Note: The quantity schedule is based on the following equation:

Units in beginning work in process + Units started into production = Units transferred out + Units in ending work in process

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TM 4-11


COMPUTATION OF COSTS PER EQUIVALENT UNIT: WEIGHTED-AVERAGE METHOD

Total Whole Cost Materials Conversion Unit Cost to be accounted for:

Work in process, beginning $ 11,900 $ 4,300 $ 7,600Costs added ...................... 214,500 74,100 140,400

Total cost to be accounted for (a)............................... $226,400 $78,400 $148,000

Equivalent units (b) .............. 196,000 185,000Cost per EU (a) ÷ (b) .......... $0.40 + $0.80 = $1.20

COST RECONCILIATION: WEIGHTED-AVERAGE METHOD

Total Equivalent Units (EU) Cost Materials ConversionCost accounted for as follows:

Transferred out: 180,000 units @ $1.20 each...... $216,000 180,000 180,000

Work in process, ending: Materials @ $0.40 per EU......... 6,400 16,000 Conversion @ $0.80 per EU...... 4,000 5,000

Total work in process, ending ...... 10,400 Total cost accounted for ................ $226,400

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TM 4-12


FIFO METHOD (Appendix)

• The FIFO method separates the costs of beginning inventory from the costs incurred during the current period. (The weighted-average method combines them.)

• FIFO assumes the beginning inventory is completed before any new units are started.

QUANTITY SCHEDULE AND EQUIVALENT UNITS: FIFO METHOD

Quantity Schedule Units to be accounted for:

Work in process, beginning .......... 10,000 Started into production ................ 190,000

Total units to be accounted for........ 200,000 Equivalent Units (EU) Materials ConversionUnits accounted for as follows:

Transferred out: From beginning inventory*........ 10,000 4,000 5,000 Started and completed†............. 170,000 170,000 170,000

Work in process, ending............... 20,000 16,000 5,000 Total units accounted for ................ 200,000 190,000 180,000

* Materials: 10,000 × (100% – 60%) = 4,000 EUs Conversion: 10,000 × (100% – 50%) = 5,000 EUs † 19,000 units started – 20,000 units in ending WIP = 170,000 units

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TM 4-13


COMPARISON OF EQUIVALENT UNITS

Beginning Workin Process: 10,000 Units 60% Complete

Started andCompleted: 170,000 Units

Ending Workin Process: 20,000 Units 80% Complete

Weighted-Average Method

190,000 Units Started

Units transferred to next department:Work in process, ending: 20,000 units x 80%Equivalent units of production

180,000

16,000196,000

FIFO Method

Work in process, beginning: 10,000 units x (100% - 60%)Units started and completed:Work in process, ending: 20,000 units x 80%Equivalent units of production

4,000170,000

16,000190,000

Beginning Workin Process: 10,000 Units 60% Complete

Started andCompleted: 170,000 Units

Ending Workin Process: 20,000 Units 80% Complete

190,000 Units Started

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TM 4-14


COMPUTATION OF COSTS PER EQUIVALENT UNIT: FIFO METHOD

Total Whole Cost Materials Conversion Unit Cost to be accounted for:

Work in process, beginning .. $ 11,900Cost added in the

department (a) ................. 214,500 $ 74,100 $140,400Total cost to be accounted for. $226,400Equivalent units (b) ................ 190,000 180,000Cost per EU (a) ÷ (b) $0.39 + $0.78 = $1.17

Note: Unlike the weighted-average method, under the FIFO method only the costs added by the department during the current month are included when computing the costs per EU. The costs of beginning inventory are not included in the cost per EU under the FIFO method.

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TM 4-15


COST RECONCILIATION: FIFO METHOD

Total Equivalent Units Cost Materials Conversion Cost accounted for as follows:

Transferred out: From beginning inventory:

Cost in beginning inventory..... $ 11,900 Cost to complete these units:

Materials @ $0.39 per EU ... 1,560 4,000 Conversion @ $0.78 per EU 3,900 5,000

Total cost from beginning inventory................................. 17,360

Units started and completed 170,000 units @ $1.17 each ..... 198,900 170,000 170,000

Total cost transferred..................... 216,260

Work in process, ending: Materials @ $0.39 per EU............ 6,240 16,000 Conversion @ $0.78 per EU......... 3,900 5,000

Total work in process, ending ......... 10,140

Total cost accounted for ................... $226,400

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TM 4-16


A COMPARISON OF PRODUCTION REPORT CONTENT (Exhibit 4A-4)

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Chapter 5

Cost Behavior: Analysis and Use Learning Objectives LO1. 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. New in this Edition • Many new In Business boxes have been added. • The end-of-chapter materials have been expanded by adding several new shorter exercises. Chapter Overview A. Types of Cost Behavior Patterns. (Exercises 5-1, 5-6, 5-7, 5-8, 5-11, and 5-12.) At least three cost behavior patterns—variable, fixed, and mixed—are found in most organizations. Of course, many other types of cost behavior patterns exist, but these three patterns are fairly common and the mixed cost model can be used to provide approximations to more complex cost behavior patterns within a relevant range. It is important for managers to understand the behavior of each type of cost. 1. Variable Costs. The total amount of a variable cost varies in direct proportion to changes

in the activity level. When expressed on a per unit basis, variable costs are constant. Examples of costs that are normally variable with respect to output volume are listed in Exhibit 5-2. Be careful to point out to students that some of these costs may be fixed in some organizations. This is particularly true of direct labor and other employee wages and salaries that may be effectively fixed due to labor laws in a country, custom, labor contracts, or the organization’s personnel policies. Exhibit 5-8 in the text points out that in practice there is a wide variation in how some of these costs are classified by individual companies. a. Activity base (cost driver). For a cost to be variable, it must be variable with respect to

some activity base. An activity base is a measure of whatever causes the incurrence of a variable cost. Some of the most common activity bases are machine-hours, units produced, and units sold. A measure of activity should be used to allocate a cost for decision-making purposes only if it actually causes the cost.

b. True variable and step-variable costs. Some variable costs, such as direct materials,

vary in direct proportion to the level of activity. These costs are called true variable

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costs. A cost that is obtainable only in large chunks and that increases or decreases in response to fairly wide changes in the activity level is known as a step-variable cost. For example, direct labor may be a step-variable cost when workers are only hired on a full-time basis. The difference between a true variable and a step-variable cost is illustrated in Exhibit 5-3 in the text.

c. In reality, many costs are curvilinear. Most frequently, costs increase less than

proportionately with activity. Nevertheless, within any given narrow band of activity even a curvilinear cost function is approximately linear. This narrow band of activity within which a particular straight line is a reasonable approximation to the true underlying cost function is called its relevant range.

• Thus, within the relevant range, variable cost per unit can be assumed to be constant.

Exhibit 5-4 in the text illustrates a curvilinear cost and the notion of the relevant range.

• The notion of the relevant range often causes confusion. Some individuals refer to

the relevant range as the range of activity within which the company expects to operate or has operated in the recent past. That is not what we mean by the relevant range. The relevant range, as we use the term, is the range of activity within which a particular straight line provides a reasonable approximation to the real underlying cost function.

2. Fixed Costs. A fixed cost remains constant in total dollar amount within the relevant range.

Since fixed costs remain constant in total, the amount of cost computed on a per unit basis becomes smaller as the number of units produced increases. Care must be exercised in interpreting fixed costs that have been expressed on a per unit basis; they should not be misinterpreted as variable costs. a. For planning purposes, fixed costs can be viewed as either committed or discretionary.

• Committed fixed costs. Committed fixed costs relate to investment in buildings,

equipment, and the basic organizational structure of a company. Committed fixed costs are long-term and can’t be significantly reduced even for a short period of time without seriously impairing long-run goals.

• Discretionary fixed costs. Discretionary fixed costs are those that management

adjusts periodically. Examples of discretionary fixed costs include advertising, research, and management development programs. The planning horizon for discretionary fixed costs is fairly short—usually a single year. Management may be able to adjust these fixed costs as circumstances change.

b. The relevant range for a fixed cost is that range of activity over which total fixed cost

does not change. Exhibit 5-6 in the text illustrates this idea. 3. Mixed Costs. A mixed cost contains both variable and fixed cost elements. Many costs are

mixed and can be expressed in terms of the cost formula Y = a + bX, where Y is the total estimated cost, a is the estimated total fixed cost, b is the estimated variable cost per unit of activity, and X is the amount of activity. Even when the underlying cost is not linear, this formula can provide a reasonable approximation to the underlying cost function within the relevant range.

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4. Classification of costs. A cost that is considered variable in one organization may be

considered fixed in another due, for example, to differing employment policies. Exhibit 5-8 in the text shows that there is a lot of variation in how companies classify costs in terms of behavior.

B. Analysis of Mixed Costs. For planning and control purposes, mixed costs should be broken down into variable and fixed components. A number of methods can be used to analyze mixed costs. Account analysis and the engineering approach are mentioned briefly in this chapter and are covered in more detail in later chapters. This chapter discusses in more depth three techniques for analyzing past records of cost and activity—the scattergraph method, the high-low method, and least-squares regression. 1. The Scattergraph Method. (Exercises 5-2, 5-9, and 5-10.)

a. The data should be plotted no matter what method is ultimately used to estimate fixed and variable costs. A graph is constructed with cost on the vertical axis and activity on the horizontal axis. Costs at various levels of activity are then plotted on the graph. This plot will often provide important insights concerning the underlying relationship and can help in identifying nonlinearities and outliers (unusual points) that should be ignored.

b. While this is not ordinarily done in practice, a line can be fitted to the plotted points by

eye with a straightedge. The line should be placed so that approximately equal numbers of points fall above and below it. While not strictly necessary, in the text and in problems we always draw the line through one of the points to simplify calculations. This line can then be used to derive what we call “quick-and-dirty” estimates of the fixed and variable costs. The fixed cost can be estimated by the vertical intercept. The variable cost per unit can be estimated by computing the slope of the line.

2. The High-Low Method. (Exercises 5-2, 5-4, 5-7, 5-8, 5-9, and 5-11.) The high-low

method of analyzing mixed costs focuses exclusively on the high and low levels of activity. The difference in cost observed at these two extremes is divided by the change in activity to estimate the variable cost per unit of activity.

A major defect of the high-low method is that it utilizes only two points and ignores all of the other data. Generally, two points are not enough to produce accurate results. Moreover, the periods in which the high and low activity levels occur are often not typical of most periods.

3. The Least-Squares Regression Method. (Exercises 5-3 and 5-12.) Using mathematical

formulas, the least-squares regression method fits a regression line that minimizes the sum of the squared errors. Exhibit 5-13 can be used as a basis for discussing the theory of least-squares regression.

a. We don’t go into the details of the computation of the least-squares regression

estimates since computer software is widely used for performing this chore. The appendix to the chapter shows how to use Excel to do the necessary calculations.

b. In addition to estimates of the slope (variable cost per unit) and the intercept (total

fixed cost), least-squares regression software can produce a variety of informative

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statistics. One of the most informative is the R2, which is a measure of the goodness of fit of the regression line. It tells us the percentage of the variation in the dependent variable (cost) that is explained by variation in the independent variable (activity). We do not show in the text how the R2 is computed, but you may want to discuss its interpretation with students.

c. Multiple regression analysis should be used when the cost is caused by more than one

factor.

C. The Contribution Format. (Exercises 5-5 and 5-6.) Two major approaches can be used to prepare an income statement. The difference between these two approaches centers on the way in which costs are organized. 1. The Traditional Approach. The traditional approach to the income statement organizes

data in a functional format, based on the functions of production, administration, and sales. The emphasis is on the purposes for which the costs were incurred. No attempt is made to identify the behavior of costs included under each functional heading. This approach is used to prepare income statements for external reporting purposes.

2. The Contribution Approach. The contribution approach to the income statement

organizes costs by behavior, rather than by function.

a. The contribution approach separates costs into fixed and variable categories. Variable expenses are deducted to obtain the contribution margin. Fixed expenses are then deducted from the contribution margin to obtain net operating income.

b. The contribution approach to the income statement makes it much easier for managers

to understand the relations between volume and expenses, and volume and profits. Variable and fixed costs are not lumped together. Since planning and decision-making often involve changes in the level of activity, contribution income statements can be very useful. Unfortunately, the contribution approach is seldom used in practice.

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Time Exercise 5-1 Fixed and variable cost behavior Basic 15 min. Exercise 5-2 High-low method; scattergraph analysis.................................. Basic 45 min. Exercise 5-3 (Appendix 5A) Least-squares regression................................. Basic 30 min. Exercise 5-4 High-low method ..................................................................... Basic 20 min. Exercise 5-5 Contribution format income statement .................................... Basic 20 min. Exercise 5-6 Cost behavior; contribution format income statement............. Basic 20 min. Exercise 5-7 High-low method; predicting cost ........................................... Basic 30 min. Exercise 5-8 High-low method; predicting cost .......................................... Basic 20 min. Exercise 5-9 Scattergraph analysis; high-low method.................................. Basic 30 min. Exercise 5-10 Scattergraph analysis ............................................................... Basic 30 min. Exercise 5-11 Cost behavior; high-low method.............................................. Basic 20 min. Exercise 5-12 (Appendix 5A) Least-squares regression................................. Basic 30 min. Problem 5-13 Cost behavior; high-low method; contribution income

statement ............................................................................. Basic 45 min. Problem 5-14 Contribution format versus traditional income statement........ Basic 45 min. Problem 5-15 (Appendix 5A) Least-squares regression; scattergraph; cost

behavior ............................................................................. Basic 45 min. Problem 5-16 Identifying cost behavior patterns............................................ Medium 30 min. Problem 5-17 High-low and scattergraph analysis......................................... Medium 45 min. Problem 5-18 (Appendix 5A) Least-squares regression method.................... Medium 30 min. Problem 5-19 Scattergraph analysis ............................................................... Medium 30 min. Problem 5-20 (Appendix 5A) Least-squares regression method.................... Medium 30 min. Problem 5-21 (Appendix 5A) Least-squares regression analysis;

contribution income statement ........................................... Medium 45 min. Problem 5-22 High-low method; cost of goods manufactured....................... Difficult 45 min. Problem 5-23 High-low method; predicting cost ........................................... Difficult 45 min. Problem 5-24 High-low method; predicting cost ........................................... Difficult 45 min. Case 5-25 (Appendix 5A) Analysis of mixed costs, job-cost system,

and activity-based costing................................................... Difficult 90 min. Case 5-26 Scattergraph analysis; selection of an activity base................. Medium 45 min. Case 5-27 Analysis of mixed costs in a pricing decision.......................... Difficult 90 min. Case 5-28 (Appendix 5A) Mixed cost analysis by three methods............ Difficult 90 min. Essential Problems: Problem 5-13, Problem 5-17 or Problem 5-19, Problem 5-23 or Problem 5-

24 Supplementary Problems: Problem 5-14, Problem 5-16, Problem 5-22, Case 5-25, Case 5-26,

Case 5-27, Case 5-28 Appendix 5A Essential Problems: Problem 5-15 Appendix 5A Supplementary Problems: Problem 5-18, Problem 5-20, Problem 5-21 Linked problems and exercises: Exercise 5-3 should be assigned in conjunction with Exercise 5-2 Exercise 5-9 should be assigned in conjunction with Exercise 5-8 Problem 5-18 should be assigned in conjunction with Problem 5-17

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Helpful Hint: The McGraw-Hill/Irwin Managerial/Cost Accounting video library does not contain a segment that relates to Chapter 5.

Chapter theme: Managers who understand how costs behave are better able to predict costs and make decisions under various circumstances. This chapter explores the meaning of fixed, variable and mixed costs (the relative proportions of which define an organization’s cost structure). It also introduces a new income statement called the contribution approach.

I. Types of cost behavior patterns

A. Variable costs

i. A variable cost is a cost whose total dollar amount varies in direct proportion to changes in the activity level.

1. An activity base (also called a cost driver)

is a measure of what causes the incurrence of variable costs. As the level of the activity base increases, the variable cost increases proportionally.

a. Units produced (or sold) is not the only activity base within companies. A cost can be considered variable if it varies with activity bases such as

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miles driven, machine hours, or labor hours.

2. As an example of an activity base, consider your total long distance telephone bill. The activity base is the number of minutes that you talk.

ii. Variable costs remain constant if expressed on a

per unit basis.

1. Referring to the telephone example, the cost per minute talked is constant (e.g., 10 cents per minute)

iii. Extent of variable costs

1. The proportion of variable costs differs

across organizations. For example: a. A public utility like Florida Power

and Light, with large investments in equipment, will tend to have fewer variable costs.

b. A manufacturing company like Black and Decker will often have many variable costs associated with the manufacture and distribution of its products to customers.

c. A merchandising company like Wal-Mart will usually have a high proportion of variable costs such as the cost of merchandise purchased for resale.

d. Some service companies, such as restaurants, have a high proportion of variable costs due to their raw

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material costs. Other service companies, such as an architectural firm, have a high proportion of fixed costs in the form of highly trained salaried employees.

iv. Common examples of variable costs

1. Merchandising companies − cost of goods

sold 2. Manufacturing companies − direct materials,

direct labor, and variable overhead. 3. Merchandising and manufacturing

companies − commissions, shipping costs, and clerical costs such as invoicing.

4. Service companies − supplies, travel, and clerical.

Helpful Hint: Students tend to assume that a certain type of cost is always variable or fixed. They should examine the facts of each situation before deciding whether a cost is fixed or variable. For example, a company’s employment policy may determine whether direct labor costs are fixed or variable with respect to volume of output.

B. True variable versus step-variable costs

i. True variable costs − the amount used during the

period varies in direct proportion to the activity level.

1. The long distance phone bill was one

example of a true variable cost.

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2. Direct material is another example of a cost that behaves in a true variable pattern.

a. Direct materials purchased but not used can be stored and carried forward to the next period as inventory.

ii. Step-variable costs − A resource that is obtainable

only in large chunks and whose costs change only in response to fairly wide changes in activity.

1. For example, maintenance workers are often

considered to be a variable cost, but this labor cost does not behave as a true variable cost.

a. Small changes in the level of production are not likely to have any effect on the number of maintenance workers employed.

b. Only fairly wide changes in the activity level will cause a change in the number of maintenance workers employed.

i. Maintenance workers are obtainable only in large chunks of a whole person who is capable of working approximately 2,000 hours a year.

“In Business Insights” Step-variable costs can change for reasons that have nothing to do with changes in the activity level. For example:

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“Coping with the Fallout from September 11” (page 186)

• Filterfresh is a company that services coffee machines located in commercial offices.

• Post September 11, heightened security clearance measures at customer locations have added about one hour per day to each deliveryman’s route.

• This has required Filterfresh to hire 24 more delivery people to do the same work it did prior to September 11.

C. The linearity assumption and the relevant range

i. Economists correctly point out that many costs that

accountants classify as variable costs actually behave in a curvilinear fashion.

ii. Nonetheless, within a narrow band of activity

known as the relevant range, a curvilinear cost can be satisfactorily approximated by a straight line.

1. The relevant range is that range of activity

within which the assumptions made about cost behavior are valid.

Helpful Hint: Slide 13 can be tied in with economics courses students have taken. Ask what happens to average costs when the cost curve bends downward and what economists call this part of the curve. Average costs are falling and this is roughly equivalent to what economists call “increasing returns to scale.” You can repeat the same question for the part of the curve that bends upward.

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D. Fixed costs

i. A fixed cost is a cost whose total dollar amount remains constant as the activity level changes.

1. For example, your monthly basic telephone

bill is probably fixed and does not change when you make more local calls.

ii. Average fixed costs per unit decrease as the

activity level increases.

1. For example, the fixed cost per local call decreases as more local calls are made.

E. Types of fixed costs

i. Committed fixed costs

1. These costs are long-term in nature (i.e.,

greater than one year). 2. These costs cannot be significantly

reduced even for short periods of time without seriously impairing the profitability or long-run goals of the organization.

a. Examples of committed-fixed costs include depreciation on buildings and equipment, and real estate taxes.

“In Business Insights” Committed fixed costs may be more flexible than they would appear at first glance. For example: “Sharing Office Space to Reduce Committed Fixed Costs” (page 191)

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• Doctors in private practice have been under enormous pressure in recent years to cut costs.

• Dr. Edward Betz of California reduced the committed fixed costs of maintaining his office by letting a urologist use the office on Wednesday afternoons and Friday mornings for $1,500 per month.

• Dr. Betz uses these times to work on paperwork at home. He also makes up for lost time by treating patients on Saturdays.

ii. Discretionary fixed costs

1. These costs usually arise from annual

decisions by management to spend in certain fixed cost areas.

2. These costs can be cut for short periods of time with minimal damage to the long-run goals of the organization.

a. Examples of discretionary fixed costs include advertising and research and development.

3. A cost may be discretionary or committed depending upon management’s strategy.

a. For example, some construction companies may layoff workers during months with minimal customer demand. However, other construction companies may opt to retain their workers all year.

“In Business Insights” The extent of a company’s discretionary fixed costs is a function of management choices. For example:

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“Cost Structure: A Management Choice” (page 184) • Nucor Steel is the most successful U.S. steel

company of recent years due in large part to its cost-efficiency.

• Nucor treats all employees alike. There are no management dining rooms, company yachts or airplanes, no first-class travel for executives, and no support staff to pamper the upper echelons.

• All of these management actions serve to lower discretionary fixed costs for Nucor.

• In addition, Nucor relies upon fewer layers of management. In fact, although Nucor is the largest steel company in the U.S., its headquarters employs only 20 people.

iii. The trend toward fixed costs

1. The trend in many industries is toward

greater fixed costs relative to variable costs. For example:

a. H&R Block employees used to fill out tax returns for customers by hand. Now, computer software is used to complete tax returns.

b. Safeway and Kroger employees used to key-in prices by hand on cash registers. Now, barcode readers enter price and other product information automatically.

c. As machines take over many mundane tasks previously performed by humans, “knowledge workers” are demanded for their minds rather than their muscles.

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i. Knowledge workers tend to be salaried, highly-trained and difficult to replace; consequently, the cost of compensating these valued employees in relatively fixed rather than variable.

“In Business Insights” By making investments in technology many internet companies have created radically different cost structures from their “bricks and mortar” counterparts. For example:

“Selling Online” (page 185)

• Onsale, an internet auctioneer of discontinued computers and House of Fabrics, a traditional retailer, each has roughly the same revenue of about $250 million per year.

• However, House of Fabrics, with 5,500 employees, has revenue per employee of about $90,000. At Onsale, with only 200 employees, the figure is $1.18 million per employee.

• Onsale relies upon investments in technology to reduce its labor cost.

iv. Is labor a variable or a fixed cost?

1. The behavior of wage and salary costs can

differ across countries, depending on labor regulations, labor contracts, and custom. For example:

a. In France, Germany, China, and Japan management has little flexibility in adjusting the size of the

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labor force; hence, labor costs are more fixed in nature.

“In Business Insights” Survey research supports the assertion that labor costs are viewed as more fixed in nature in certain countries. For example: “Cost Behavior in the U.S. and Japan” (page 195)

• A total of 257 American and 40 Japanese manufacturing companies responded to a questionnaire concerning their management practices.

• The findings indicate that approximately 40% of the Japanese companies surveyed viewed production labor as a fixed cost, while approximately 10% of U.S. companies surveyed viewed production labor as a fixed cost.

b. In the United States and the United

Kingdom, management typically has much greater latitude; hence, labor costs are more variable in nature.

“In Business Insights” Regulatory requirements can influence the fixed versus variable nature of labor costs in American companies. For example: “The Regulatory Burden” (page 193)

• Peter Drucker claims that “the driving force behind the steady growth of temps…is the growing burden of rules and regulations for employers.”

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• According to the Small Business Administration, the owner of a small business spends up to a quarter of his or her time on employment-related paperwork. Furthermore, the cost of complying with government regulations is over $5,000 per employee per year.

• This motivates small businesses to rely upon temporary workers, thus converting labor from a fixed cost to a variable cost.

2. Within countries managers can view labor

costs differently depending upon their strategy. Nonetheless, most companies in the United States continue to view direct labor as a variable cost.

“In Business Insights” Managers can view labor costs differently depending upon their strategy. For example: “A Twist on Fixed and Variable Costs” (page 191)

• Mission Controls designs and installs automation systems for food and beverage manufacturers.

• When sales drop, the founders of this company slash their own salaries rather than laying off workers.

• This makes their own salaries somewhat variable, while the wages and salaries of workers act more like fixed costs. The payoff is a loyal and committed work force.

“Labor at Southwest Airlines” (page 192)

• Southwest Airlines is the most profitable airline in the United States.

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• Prior to stepping down as President and CEO of the airline in 2001, Herb Kelleher wrote “The thing that would disturb me the most to see after I’m no longer CEO is layoffs at Southwest. Nothing kills your company’s culture like layoffs.”

• Because of Southwest Airline’s commitment to its employees, all wages and salaries are basically committed fixed costs.

F. Fixed costs and the relevant range

i. The relevant range of activity for a fixed cost is the

range of activity over which the graph of the cost is flat.

1. For example, assume office space is available at a rental rate of $30,000 per year in increments of 1,000 square feet.

2. Fixed costs would increase in a step fashion at a rate of $30,000 for each additional 1,000 square feet.

ii. While this step-function pattern appears similar to

the idea of step-variable costs, there are two important differences between step-variable costs and fixed costs.

1. Step-variable costs can often be adjusted quickly as conditions change, whereas fixed costs cannot be changed easily.

2. The width of the steps for fixed costs is wider than the width of the steps for step-variable costs.

a. For example, a step-variable cost such as maintenance workers may have steps with a width of 40 hours a week.

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b. However, fixed costs may have steps that have a width of thousands or tens of thousands of hours of activity.

Helpful Hint: Discuss with students that over a given level of production, certain costs, such as custodial salaries, would remain fixed. However, if activity increases to the point where a second shift is needed, custodial salaries would need to increase since activity is outside the relevant range.

Quick Check − cost behavior patterns

G. Mixed costs (also called semivariable costs)

i. A mixed cost contains both variable and fixed cost

elements.

1. For example, utility bills often contain fixed and variable cost components.

a. The fixed portion of the utility bill is constant regardless of kilowatt hours consumed. This cost represents the minimum cost that is incurred to have the service ready and available for use.

b. The variable portion of the bill varies in direct proportion to the consumption of kilowatt hours.

ii. An equation can be used to express the relationship

between mixed costs and the level of the activity. This equation can be used to calculate what the total mixed cost would be for any level of activity.

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1. The equation is Y = a + bX a. Y = The total mixed cost. b. a = The total fixed cost (the vertical

intercept of the line). c. b = The variable cost per unit of

activity (the slope of the line). d. X = The level of activity.

iii. For example, if your fixed monthly utility charge is $40, your variable cost is .03 per kilowatt hour, and your monthly activity level was 2,000 kilowatt hours, this equation can be used to calculate your total utility cost of $100.

II. The analysis of mixed costs

A. Account analysis and the engineering approach

i. In account analysis, each account under

consideration is classified as variable or fixed based on the analyst’s prior knowledge about how costs behave.

1. This approach is limited in value in the

sense that it glosses over the fact that some accounts may have both fixed and variable components.

ii. The engineering approach classifies costs based

upon an industrial engineer’s evaluation of production methods, material specifications, labor requirements, equipment usage, power consumption, as so on.

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1. This approach is particularly useful when no past experience is available concerning activity and costs.

B. The scattergraph plot (also called the quick-and-dirty

method)

i. The first step when using this method to analyze a mixed cost is to plot the data on a scattergraph.

1. The cost, which is known as the dependent

variable, is plotted on the Y axis. 2. The activity, which is known as the

independent variable, is plotted on the X axis.

ii. The second step is to examine the dots on the

scattergraph to see if they are linear, such that a straight line can be drawn that approximates the relation between cost and activity.

1. If the dots are not linear, do not analyze the

data any further. Instead, search for another independent variable that bears a stronger linear relationship with the dependent variable.

iii. The third step is to draw a straight line where,

roughly speaking, an equal number of points reside above and below the line. Make sure that the straight line goes through at least one data point on the scattergraph.

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iv. The fourth step is to identify the Y intercept.

1. This intercept represents the estimated fixed cost portion of the mixed cost ($10,000 in this example).

v. The fifth step is to estimate the variable cost per

unit of the activity.

1. Select one point on the scattergraph that intersects the straight line.

2. Determine the total cost and the total activity level at the chosen point.

3. Subtract the fixed costs from the total costs to arrive at the total variable costs for the chosen activity level.

4. Divide the total variable costs by the activity level at the chosen point. This is the variable cost per unit of activity.

5. Construct an equation that can be used to estimate total costs at any activity level.

C. The high-low method

i. This method can be used to analyze mixed costs if

a scattergraph plot reveals a linear relationship between the X and Y variables. For illustrative purposes, assume the following information.

ii. The first step is to choose the data points

pertaining to the highest and lowest activity levels (high = 800 units; low = 500 units).

1. Notice, this method relies upon two data

points to estimate the fixed and variable

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portions of a mixed cost, as opposed to one data point with the scattergraph method.

iii. The second step is to determine the total costs

associated with the two chosen points (high = $9,800; low = $7,400).

Helpful Hint: Emphasize that the high and low points are identified by the level of activity and not by the level of the cost.

iv. The third step is to calculate the change in cost

between the two data points ($2,400) and divide it by the change in activity level between the two data points (300 units).

1. The quotient represents an estimate of

variable cost per unit of activity ($8.00 per unit).

v. The fourth step is to take the total cost at either

activity level (in this case, $9,800) and deduct the variable cost component ($6,400). The residual represents the estimate of total fixed costs ($3,400).

1. The variable cost component ($6,400) is

determined by multiplying the level of activity (800 units) by the estimated variable cost per unit of the activity ($8.00 per unit).

vi. The fifth step is to construct an equation that can

be used to estimate the total cost at any activity level (Y = $3,400 + $8.00X).

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Quick Check − the high-low method

D. The least-squares regression method

i. This method can be used to analyze mixed costs if a scattergraph plot reveals an approximately linear relationship between the X and Y variables.

ii. This method uses all of the data points to estimate

the fixed and variable cost components of a mixed cost. This method is superior to the scattergraph plot method that relies upon only one data point and the high-low method that uses only two data points to estimate the fixed and variable cost components of a mixed cost.

iii. The basic goal of this method is to fit a straight line

to the data that minimizes the sum of the squared errors. The regression errors are the vertical deviations from the data points to the regression line.

iv. The formulas that are used for least-squares

regression are complex. Fortunately, computers can perform the calculations quickly. The observed values of the X and Y variables are entered into the computer and the software does the rest.

1. The output from the regression analysis can

be used to create an equation that enables you to estimate total costs at any activity level.

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v. The key statistic to look at when evaluating regression results is called R2, which is a measure of “goodness of fit.”

1. The R2 quantifies the percentage of the

variation in the dependent variable that is explained by variation in the independent variable. The R2 varies from 0% to 100%, and the higher the percentage the better.

vi. This example assumes that a single factor drives

the variable cost component of a mixed cost. If more than one factor drives the variable cost component, multiple regression can be used to perform the mixed cost analysis.

“In Business Insights” Least-squares regression can be used by companies to estimate the fixed and variable components of mixed costs. For example: “Managing Power Consumption” (page 205)

• The Tata Iron Steel Company is one of the largest companies in India.

• Management used simple least-squares regression to estimate the fixed and variable components of its power consumption.

• Total power consumption was the dependent variable and tons of steel processed was the independent variable.

• The regression model estimated the fixed power consumption per month and the variable power cost per ton of steel processed.

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E. Comparing results from the three methods

i. The three methods just discussed provide slightly different estimates of the fixed and variable cost components of the mixed cost. This is to be expected because each method uses differing amounts of the data points to provide estimates. Least-squares regression provides the most accurate estimates because it uses all of the data points.

III. The contribution approach income statement

A. The contribution approach provides an income

statement format geared directly to cost behavior, which has been the focus of discussion in this chapter.

i. This approach separates costs into fixed and

variable categories. Sales − variable costs = contribution margin. The contribution margin − fixed costs = net operating income.

ii. This approach is used as an internal planning and

decision making tool. For example, this approach is useful for:

1. Cost-volume-profit analysis (chapter 6). 2. Budgeting (chapter 9). 3. Segmented reporting of profit data (chapter

12). 4. Special decisions such as pricing and make

or buy analysis (chapter 13).

iii. The contribution approach differs from the traditional approach illustrated in chapter 2.

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1. The traditional approach organizes costs in a functional format. Costs relating to production, administration, and sales are grouped together without regard to their cost behavior.

2. The traditional approach is used primarily for external reporting purposes.

Helpful Hint: The income statement from the annual report of a well-known local manufacturing firm can be used to illustrate the functional income statement. Ask if the various expense categories on the income statement contain both fixed and variable costs. Also ask how to estimate the increase in profit that would result from a 4% increase in sales using the functional statement. There is no way to do this with reasonable accuracy, since there is no way to tell on a functional income statement what costs would increase.

IV. Appendix 5A: least-squares regression using Microsoft

Excel (Slide #50 is a title slide)

A. The data set

i. Assume that you have the following data set and that you wish to use Microsoft Excel to estimate the variable and fixed cost components of your total meals cost.

ii. You will need to calculate three key pieces of

information: the estimated variable cost per unit (called the slope of the line), the estimated fixed cost (called the intercept), and the R2.

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1. To get these three pieces of information you will need three Excel functions, namely LINEST, INTERCEPT, and RSQ.

iii. The first step within Excel is to place your cursor in

cell F4 and press the = key. Click on the pull down menu and scroll down to “More Functions.”

iv. When the function box opens, click on

“Statistical” and then on “LINEST.”

v. Enter the cell range for the cost amounts in the “Known_y’s” box. Enter the cell range for the quantity amounts in the “Known_x’s” box.

1. The slope, or estimated variable cost per

unit, is identified on the screen as shown. Click “OK” to put this value on your spreadsheet.

vi. Return to the function box and click on

“Statistical” and then on “INTERCEPT.”

1. The estimated fixed cost is identified on the screen as shown.

vii. Return to the function box and click on

“Statistical” and then on “RSQ.”

1. The estimated R2 for your estimated cost function is identified on the screen as shown.

53

54

55

56

57

58

59

60

52

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AGENDA: COST BEHAVIOR

1. Variable cost behavior.

2. Types of fixed costs: committed and discretionary.

3. Behavior of fixed costs in total and on a unit basis.

4. Mixed costs (combination of fixed and variable).

5. Scattergraph plot of a mixed cost.

6. High-low method of mixed cost analysis.

7. Least-squares regression method of mixed cost analysis.

8. Contribution income statement.

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VARIABLE COST BEHAVIOR

Many costs can be described as variable, fixed, or mixed.

A variable cost changes in total in proportion to changes in activity; a variable cost is constant on a per-unit basis.

EXAMPLE: Each bicycle requires one bicycle chain costing $8.

To

tal C

ost

of

Bic

ycle

Ch

ain

s

Number of Bicycles Produced100

$800 • $8 perbicyclechain

00

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EXAMPLES OF COSTS THAT ARE NORMALLY VARIABLE WITH RESPECT TO OUTPUT VOLUME

Merchandising company

Costs of goods (merchandise) sold

Manufacturing company

Manufacturing costs:

Prime costs:

Direct materials

Direct labor*

Variable portion of manufacturing overhead:

Indirect materials

Lubricants

Supplies

Power

Both merchandising and manufacturing companies

Selling, general, and administrative costs:

Commissions

Clerical costs, such as invoicing

Shipping costs

Service organizations

Supplies, travel, clerical

*Whether direct labor is fixed or variable will depend on the labor laws of the country, custom, and the company’s employment contracts and policies.

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FIXED COST BEHAVIOR

A fixed cost remains constant in total amount throughout wide ranges of activity.

EXAMPLE: Fashion photographer Lori Yang rents studio spaces in a prestige location for $50,000 a year. She measures her company’s activity in terms of the number of photo sessions.

Cost

Number of Photo Sessions

Cost ofStudioRental

$50,000

500 1,000

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FIXED COST BEHAVIOR (cont’d)

A fixed cost varies inversely with activity if expressed on a per unit basis.

$0

$40

$80

$120

$160

$200

0 500 1,000Number of Photo Sessions

Ave

rag

e C

ost

Per

Ph

oto

Ses

sio

n f

or

Stu

dio

Ren

tal

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TYPES OF FIXED COSTS

• Committed fixed costs relate to investment in plant, equipment, and basic administrative structure. It is difficult to reduce these fixed costs in the short-term. Examples include:

• Depreciation on plant facilities.

• Taxes on real estate.

• Salaries of key operating personnel.

• Discretionary fixed costs arise from annual decisions by management to spend in certain areas. These costs can often be reduced in the short-term. Examples include:

• Advertising.

• Research.

• Public relations.

• Management development programs.

TREND TOWARD FIXED COSTS

The trend is toward greater fixed costs relative to variable costs. The reasons for this trend are:

• Increased automation of business processes.

• Shift from laborers paid by the hour to salaried knowledge workers.

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MIXED COSTS

A mixed (or semi-variable) cost contains elements of both variable and fixed costs.

Example: Lori Yang leases an automated photo developer for $2,500 per year plus 2¢ per photo developed.

Photos Developed10,0000

$0

$2,800Variable

CostElement

FixedCost

Element

$2,500

15,0005,000

Lea

se C

ost

Intercept = a

Slope = b

X

Y

Equation of a straight line: Y = a + bX

Y = $2,500 + $0.02X

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MIXED COSTS (cont’d)

A cost that is considered fixed in one company might be considered variable or mixed in another company.

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SCATTERGRAPH METHOD

As the first step in the analysis of a mixed cost, the cost and its activity base should be plotted on a scattergraph. This helps to quickly diagnose the nature of the relation between the cost and the activity base.

Example: Piedmont Wholesale Florists has maintained records of the number of orders and billing costs in each quarter over the past several years.

Quarter Number

of OrdersBilling Costs

Year 1—1st 1,500 $42,0002nd 1,900 $46,0003rd 1,000 $37,0004th 1,300 $43,000

Year 2—1st 2,800 $54,0002nd 1,700 $47,0003rd 2,100 $51,0004th 1,100 $42,000

Year 3—1st 2,000 $48,0002nd 2,400 $53,0003rd 2,300 $49,000

These data are plotted on the next page, with the activity (number of orders) on the horizontal X axis and the cost (billing costs) on the vertical Y axis.

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A COMPLETED SCATTERGRAPH

$0

$10,000

$20,000

$30,000

$40,000

$50,000

$60,000

0 500 1,000 1,500 2,000 2,500 3,000

$48,000

Number of Orders

Bill

ing

Co

sts

X

Y

Regression Line

The relation between the number of orders and the billing cost is approximately linear. (A straight line that seems to reflect this basic relation was drawn with a ruler on the scattergraph.)

Since a straight line seems to be a reasonable fit to the data, we can proceed to estimate the variable and fixed elements of the cost using one of the following three methods.

1) Quick-and-dirty method based on the line in the scattergraph.

2) High-low method.

3) Least-squares regression method.

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THE QUICK-AND-DIRTY METHOD

The straight line drawn on the scattergraph can be used to make a quick-and-dirty estimate of the fixed and variable elements of billing costs.

Recall that we are trying to estimate the fixed cost, a, and the variable cost per unit, b, in the linear equation Y= a + bX.

• The vertical intercept, approximately $30,000 in this case, is a rough estimate of the fixed cost.

• The slope of the straight line is an estimate of the variable cost per unit

Select a point falling on the line (in this case 2,000 orders):

Total billing cost for 2,000 orders........ $48,000 Less fixed cost element (intercept)...... 30,000 Variable cost element for 2,000 orders $18,000

Variable cost per unit = $18,000 ÷ 2,000 orders = $9 per order.

Therefore, the cost formula for billing costs is $30,000 per quarter plus $9 per order or:

Y = $30,000 + $9X,

where X is the number of orders.

Because of the imprecision of this method of estimating the variable and fixed cost components of a mixed cost, it is seldom used in practice.

Nevertheless, it is always a good idea to plot the data on a scattergraph before using the more precise high-low or least-squares regression methods.

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ANALYSIS OF MIXED COSTS: HIGH-LOW METHOD

EXAMPLE: Kohlson Company has incurred the following shipping costs over the past eight months:

Units Sold

Shipping Cost

January .... 6,000 $66,000February... 5,000 $65,000March....... 7,000 $70,000April ......... 9,000 $80,000May.......... 8,000 $76,000June......... 10,000 $85,000July .......... 12,000 $100,000August...... 11,000 $87,000

With the high-low method, only the periods in which the lowest activity and the highest activity occurred are used to estimate the variable and fixed components of the mixed cost.

Units

Sold Shipping

Cost High activity level, July....... 12,000 $100,000 Low activity level, February 5,000 65,000 Change............................. 7,000 $ 35,000

Change in cost $35,000Variable cost= = =$5 per unit

Change in activity 7,000 units

Fixed cost = Total cost - Variable cost element

= $100,000 - (12,000 units × $5 per unit)

= $40,000

The cost formula for shipping cost is:

Y = $40,000 + $5X

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EVALUATION OF THE HIGH-LOW METHOD

$0

$20,000

$40,000

$60,000

$80,000

$100,000

0 2,000 4,000 6,000 8,000 10,000 12,000

Units Sold

Sh

ipp

ing

Co

sts

Y

X

VariableCost

$5/unit

FixedCost

$40,000

low levelof

activity

highlevel ofactivity

The high-low method suffers from two major defects:

1. It throws away all but two data points.

2. The high and low volume periods are often unusual.

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LEAST-SQUARES REGRESSION METHOD

The least-squares regression method for analyzing mixed costs uses mathematical formulas to determine the regression line that minimizes the sum of the squared “errors.”

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LEAST-SQUARES REGRESSION (cont’d)

Example: Montrose Hospital operates a cafeteria for employees. Management would like to know how cafeteria costs are affected by the number of meals served.

Meals Served

X

Total Cost

Y April ........... 4,000 $9,500May............ 1,000 $4,000June........... 3,000 $8,000July............ 5,000 $10,000August ....... 10,000 $19,500September.. 7,000 $14,000

Statistical software or a spreadsheet program can do the computations required by the least-squares method. The results in this case are:

Intercept (fixed cost) ........... $2,433Slope (variable cost)............. $1.68R2.......................................... 0.99

The fixed cost is therefore $2,433 per month and the variable cost is $1.68 per meal served, or:

Y = $2,433 + $1.68X, where X is meals served. R2 is a measure of the goodness of fit of the regression line. In this case, it indicates that 99% of the variation in cafeteria costs is due to the number of meals served. This suggests a very good fit.

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TRADITIONAL VERSUS CONTRIBUTION INCOME STATEMENT

Traditional Approach (costs organized by function)

Contribution Approach (costs organized by behavior)

Sales ............................. $60,000 Sales $60,000Less cost of goods sold* . 34,000 Less variable expenses: Gross margin ................. 26,000 Variable production ..... $12,000Less operating expenses: Variable selling............ 3,000

Selling*....................... $15,000 Variable administrative 1,000 16,000Administrative*............ 6,000 21,000 Contribution margin ....... 44,000

Net operating income ..... $ 5,000 Less fixed expenses: Fixed production ......... 22,000 Fixed selling................ 12,000 Fixed administrative .... 5,000 39,000 Net operating income..... $ 5,000

* Contains both variable and fixed elements since this is the income statement for a manufacturing company. If this were a merchandising company, then the cost of goods sold would be entirely variable.

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Chapter 6

Cost-Volume-Profit Relationships Learning Objectives LO1. Explain how changes in activity affect contribution margin and net operating income. LO2. Prepare and interpret a cost-volume-profit (CVP) 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. Compute the break-even point in unit sales and sales dollars. LO6. Determine the level of sales needed to achieve a desired target profit. 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 the

degree of operating leverage can be used to predict changes in net operating income. LO9. Compute the break-even point for a multiple product company and explain the effects of

shifts in the sales mix on contribution margin and the break-even point. New in this Edition • Several new In Business boxes have been added. • A number of new exercises have been added, each of which focuses on a single learning

objective. Chapter Overview A. The Basics of Cost-Volume-Profit (CVP) Analysis. (Exercises 6-1, 6-10, 6-14, and 6-15.) Cost-volume-profit (CVP) analysis is a key step in many decisions. CVP analysis involves specifying a model of the relations among the prices of products, the volume or level of activity, unit variable costs, total fixed costs, and the sales mix. This model is used to predict the impact on profits of changes in those parameters. 1. Contribution Margin. Contribution margin is the amount remaining from sales revenue

after variable expenses have been deducted. It contributes towards covering fixed costs and then towards profit.

2. Unit Contribution Margin. The unit contribution margin can be used to predict changes in

total contribution margin as a result of changes in the unit sales of a product. To do this, the unit contribution margin is simply multiplied by the change in unit sales. Assuming no change in fixed costs, the change in total contribution margin falls directly to the bottom line as a change in profits.

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3. Contribution Margin Ratio. The contribution margin (CM) ratio is the ratio of the contribution margin to total sales. It shows how the contribution margin is affected by a given dollar change in total sales. The contribution margin ratio is often easier to work with than the unit contribution margin, particularly when a company has many products. This is because the contribution margin ratio is denominated in sales dollars, which is a convenient way to express activity in multi-product firms.

B. Some Applications of CVP Concepts. (Exercises 6-4, 6-10, 6-11, 6-12, 6-13, and 6-16.) CVP analysis is typically used to estimate the impact on profits of changes in selling price, variable cost per unit, sales volume, and total fixed costs. CVP analysis can be used to estimate the effect on profit of a change in any one (or any combination) of these parameters. A variety of examples of applications of CVP are provided in the text. C. CVP Relationships in Graphic Form. (Exercises 6-2 and 6-11.) CVP graphs can be used to gain insight into the behavior of expenses and profits. The basic CVP graph is drawn with dollars on the vertical axis and unit sales on the horizontal axis. Total fixed expense is drawn first and then variable expense is added to the fixed expense to draw the total expense line. Finally, the total revenue line is drawn. The total profit (or loss) is the vertical difference between the total revenue and total expense lines. The break-even occurs at the point where the total revenue and total expenses lines cross.

D. Break-Even Analysis and Target Profit Analysis. (Exercises 6-5, 6-6, 6-11, 6-12, and 6-15.) Target profit analysis is concerned with estimating the level of sales required to attain a specified target profit. Break-even analysis is a special case of target profit analysis in which the target profit is zero. 1. Basic CVP equations. Both the equation and contribution (formula) methods of break-

even and target profit analysis are based on the contribution approach to the income statement. The format of this statement can be expressed in equation form as:

Profits = Sales − Variable expenses − Fixed expenses

In CVP analysis this equation is commonly rearranged and expressed as:

Sales = Variable expenses + Fixed expenses + Profits

a. The above equation can be expressed in terms of unit sales as follows:

Price × Unit sales = Unit variable cost × Unit sales + Fixed expenses + Profits ⇓

Unit contribution margin × Unit sales = Fixed expenses + Profits ⇓

Unit sales = Fixed expenses +ProfitsUnit contribution margin

b. The basic equation can also be expressed in terms of sales dollars using the variable

expense ratio: Sales = Variable expense ratio × Sales + Fixed expenses + Profits

⇓

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(1 − Variable expense ratio) × Sales = Fixed expenses + Profits ⇓

Contribution margin ratio* × Sales = Fixed expenses + Profits ⇓

Sales = Fixed expenses +ProfitsContribution margin ratio

* 1 − Variable expense ratio = 1− Variable expensesSales

= Sales-Variable expensesSales

= Contribution marginSales

= Contribution margin ratio 2. Break-even point using the equation method. The break-even point is the level of sales at

which profit is zero. It can also be defined as the point where total sales equals total expenses or as the point where total contribution margin equals total fixed expenses. Break-even analysis can be approached either by the equation method or by the contribution margin method. The two methods are logically equivalent.

a. The Equation Method—Solving for the Break-Even Unit Sales. This method

involves following the steps in section (1a) above. Substitute the selling price, unit variable cost and fixed expense in the first equation and set profits equal to zero. Then solve for the unit sales.

b. The Equation Method—Solving for the Break-Even Sales in Dollars. This method

involves following the steps in section (1b) above. Substitute the variable expense ratio and fixed expenses in the first equation and set profits equal to zero. Then solve for the sales.

3. Break-even point using the contribution method. This is a short-cut method that jumps

directly to the solution, bypassing the intermediate algebraic steps.

a. The Contribution Method—Solving for the Break-Even Unit Sales. This method involves using the final formula for unit sales in section (1a) above. Set profits equal to zero in the formula.

Break-even unit sales = Fixed expenses +$0Unit contribution margin

= Fixed expenses Unit contribution margin

b. The Contribution Method—Solving for the Break-Even Sales in Dollars. This

method involves using the final formula for sales in section (1b) above. Set profits equal to zero in the formula.

Break-even sales = Fixed expenses +$0Contribution margin ratio

= Fixed expensesContribution margin ratio

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4. Target profit analysis. Either the equation method or the contribution margin method can be used to find the number of units that must be sold to attain a target profit. In the case of the contribution margin method, the formulas are:

Unit sales to attain target profits = Fixed expenses +Target profitsUnit contribution margin

Dollar sales to attain target profits = Fixed expenses +Target profitsContribution margin ratio

Note that these formulas are the same as the break-even formulas if the target profit is zero. E. Margin of Safety. (Exercises 6-7 and 6-15.) The margin of safety is the excess of budgeted (or actual) sales over the break-even volume of sales. It is the amount by which sales can drop before losses begin to be incurred. The margin of safety can be computed in terms of dollars:

Margin of safety in dollars = Total sales – Break-even sales

or in percentage form:

Margin of safety percentage = Margin of safety in dollarsTotal sales

F. Cost Structure. Cost structure refers to the relative proportion of fixed and variable costs in an organization. Understanding a company’s cost structure is important for decision-making as well as for analysis of performance. G. Operating Leverage. (Exercises 6-8 and 6-16.) Operating leverage is a measure of how sensitive net operating income is to a given percentage change in sales.

1. Degree of operating leverage. The degree of operating leverage at a given level of sales is

computed as follows: Contribution marginDegree of operating leverage = Net operating income

2. The math underlying the degree of operating leverage. The degree of operating leverage

can be used to estimate how a given percentage change in sales volume will affect net income at a given level of sales, assuming there is no change in fixed expenses. To verify this, consider the following:

Degree of operating Percentage changeleverage in sales× = Contribution margin New sales-Sales

Net operating income Sales⎛ ⎞ ⎛ ⎞×⎜ ⎟ ⎜ ⎟

⎝ ⎠⎝ ⎠

= Contribution margin New sales-Sales

Sales Net operating income⎛ ⎞⎛ ⎞ × ⎜ ⎟⎜ ⎟

⎝ ⎠ ⎝ ⎠

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= New sales-SalesCM ratioNet operating income

⎛ ⎞× ⎜ ⎟⎝ ⎠

= CM ratio New sales-CM ratio SalesNet operating income

⎛ ⎞× ×⎜ ⎟⎝ ⎠

=

New contribution margin-Contribution marginNet operating income

⎛ ⎞⎜ ⎟⎝ ⎠

= Change in net operating incomeNet operating income

⎛ ⎞⎜ ⎟⎝ ⎠

= Percentage change in net operating income

Thus, providing that fixed expenses are not affected and the other assumptions of CVP analysis are valid, the degree of operating leverage provides a quick way to predict the percentage effect on profits of a given percentage increase in sales. The higher the degree of operating leverage, the larger the increase in net operating income.

3. Degree of operating leverage is not constant. The degree of operating leverage is not constant as the level of sales changes. For example, at the break-even point the degree of operating leverage is infinite since the denominator of the ratio is zero. Therefore, the degree of operating leverage should be used with some caution and should be recomputed for each level of starting sales.

4. Operating leverage and cost structure. Richard Lord, “Interpreting and Measuring

Operating Leverage,” Issues in Accounting Education, Fall 1995, pp. 31xx-229, points out that the relation between operating leverage and the cost structure of the company is contingent. It is difficult, for example, to infer the relative proportions of fixed and variable costs in the cost structures of any two companies just by comparing their operating leverages. We can, however, say that if two single-product companies have the same profit, the same selling price, the same unit sales, and the same total expenses, then the company with the higher operating leverage will have a higher proportion of fixed costs in its cost structure. If they do not have the same profit, the same unit sales, the same selling price, and the same total expenses, we cannot safely make this inference about their cost structure. All of the statements in the text about operating leverage and cost structure assume that the companies being compared are identical except for the proportions of fixed and variable costs in their cost structures.

H. Structuring Sales Commissions. Students may have a tendency to overlook the importance of this section due to its brevity. You may want to discuss with your students how salespeople are ordinarily compensated (salary plus commissions based on sales) and how this can lead to dysfunctional behavior. For example, would a company make more money if its salespeople steered customers toward Model A or Model B as described below?

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Model A Model B Price $100 $150 Variable cost 75 130 Unit CM $ 25 $ 20 Which model will salespeople push hardest if they are paid a commission of 10% of sales revenue? I. Sales Mix. (Exercises 6-9, 6-14, and 6-17.) Sales mix is the relative proportions in which a company’s products are sold. Most companies have a number of products with differing contribution margins. Thus, changes in the sales mix can cause variations in a company’s profits. As a result, the break-even point in a multi-product company is dependent on the sales mix. 1. Constant sales mix assumption. In CVP analysis, it is usually assumed that the sales mix

will not change. Under this assumption, the break-even level of sales dollars can be computed using the overall contribution margin (CM) ratio. In essence, it is assumed that the company has only one product that consists of a basket of its various products in a specified proportion. The contribution margin ratio of this basket can be easily computed by dividing the total contribution margin of all products by total sales.

Overall CM ratio = Total contribution marginTotal sales

2. Use of the overall CM ratio. The overall contribution margin ratio can be used in CVP

analysis exactly like the contribution margin ratio for a single product company. For a multi-product company the formulas for break-even sales dollars and the sales required to attain a target profit are:

Break-even sales = Fixed expenses Overall CM ratio

Sales to achieve target profits = Fixed expenses +Target profitsOverall CM ratio

Note that these formulas are really the same as for the single product case. The constant

sales mix assumption allows us to use the same simple formulas.

3. Changes in sales mix. If the proportions in which products are sold change, then the overall contribution margin ratio will change. Since the sales mix is not in reality constant, the results of CVP analysis should be viewed with more caution in multi-product companies than in single product companies.

J. Assumptions in CVP Analysis. Simple CVP analysis relies on simplifying assumptions. However, if a manager knows that one of the assumptions is violated, the CVP analysis can often be easily modified to make it more realistic. 1. Selling price is constant. The assumption is that the selling price of a product will not

change as the unit volume changes. This is not wholly realistic since unit sales and the selling price are usually inversely related. In order to increase volume it is often necessary to drop the price. However, CVP analysis can easily accommodate more realistic

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assumptions. A number of examples and problems in the text show how to use CVP analysis to investigate situations in which prices are changed.

2. Costs are linear and can be accurately divided into variable and fixed elements. It is

assumed that the variable element is constant per unit and the fixed element is constant in total. This implies that operating conditions are stable. It also implies that the fixed costs are really fixed. When volume changes dramatically, this assumption becomes tenuous. Nevertheless, if the effects of a decision on fixed costs can be estimated, this can be explicitly taken into account in CVP analysis. A number of examples and problems in the text show how to use CVP analysis when fixed costs are affected.

3. The sales mix is constant in multi-product companies. This assumption is invoked so as

to use the simple break-even and target profit formulas in multi-product companies. If unit contribution margins are fairly uniform across products, violations of this assumption will not be important. However, if unit contribution margins differ a great deal, then changes in the sales mix can have a big impact on the overall contribution margin ratio and hence on the results of CVP analysis. If a manager can predict how the sales mix will change, then a more refined CVP analysis can be performed in which the individual contribution margins of products are computed.

4. In manufacturing companies, inventories do not change. It is assumed that everything

the company produces is sold in the same period. Violations of this assumption result in discrepancies between financial accounting net operating income and the profits calculated using the contribution approach. This topic is covered in detail in the chapter on variable costing.

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Time Exercise 6-1 Preparing a contribution margin format income statement ....... Basic 20 min. Exercise 6-2 Prepare a cost-volume-profit (CVP) graph ............................... Basic 30 min. Exercise 6-3 Computing and using the CM ratio........................................... Basic 10 min. Exercise 6-4 Changes in variable costs, fixed costs, selling price, and

volume.................................................................................. Basic 20 min. Exercise 6-5 Compute the break-even point .................................................. Basic 20 min. Exercise 6-6 Compute the level of sales required to attain a target profit ..... Basic 10 min. Exercise 6-7 Compute the margin of safety ................................................... Basic 10 min. Exercise 6-8 Compute and use the degree of operating leverage................... Basic 20 min. Exercise 6-9 Compute the break-even point for a multi-product company ... Basic 20 min. Exercise 6-10 Using a contribution format income statement ......................... Basic 20 min. Exercise 6-11 Break-even analysis and CVP graphing.................................... Basic 30 min. Exercise 6-12 Break-even and target profit analysis........................................ Basic 30 min. Exercise 6-13 Break-even and target profit analysis........................................ Basic 30 min. Exercise 6-14 Missing data; basic CVP concepts ............................................ Basic 20 min. Exercise 6-15 Break-even analysis; target profit; margin of safety; CM

ratio ...................................................................................... Basic 30 min. Exercise 6-16 Operating leverage .................................................................... Basic 15 min. Exercise 6-17 Multi-product break-even analysis............................................ Basic 30 min. Problem 6-18 Basic CVP analysis; graphing................................................... Basic 60 min. Problem 6-19 Basics of CVP analysis; cost structure...................................... Basic 60 min. Problem 6-20 Basics of CVP analysis ............................................................. Basic 60 min. Problem 6-21 Sales mix; multi-product break-even analysis .......................... Basic 30 min. Problem 6-22 Break-even analysis; pricing ..................................................... Medium 45 min. Problem 6-23 Interpretive questions on the CVP graph .................................. Medium 30 min. Problem 6-24 Various CVP questions; break-even point; cost structure;

target sales............................................................................ Medium 75 min. Problem 6-25 Graphing; incremental analysis; operating leverage ................. Medium 60 min. Problem 6-26 Changes in fixed and variable costs; break-even and target

profit analysis ....................................................................... Medium 30 min. Problem 6-27 Break-even and target profit analysis........................................ Medium 30 min. Problem 6-28 Changes in cost structure; break-even analysis; operating

leverage; margin of safety .................................................... Medium 60 min. Problem 6-29 Sales mix; break-even analysis; margin of safety ..................... Medium 45 min. Problem 6-30 Sales mix; multi-product break-even analysis .......................... Medium 60 min. Case 6-31 Detailed income statement; CVP analysis ................................ Difficult 60 min. Case 6-32 Missing data; break-even analysis; target profit; margin of

safety; operating leverage .................................................... Difficult 90 min. Case 6-33 Cost structure; break-even; target profits .................................. Difficult 75 min. Case 6-34 Break-even analysis with step fixed costs................................. Difficult 75 min. Case 6-35 Break-evens for individual products in a multi-product

company ............................................................................... Difficult 60 min.

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Essential Problems: Problem 6-18 or Problem 6-25, Problem 6-19 or Problem 6-20, Problem 6-21, Problem 6-24

Supplementary Problems: Problem 6-22, Problem 6-23, Problem 6-26, Problem 6-27, Problem 6-28, Problem 6-29, Problem 6-30, Case 6-31, Case 6-32, Case 6-33, Case 6-34, Case 6-35

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1 2

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Helpful Hint: Before beginning the lecture, show students the sixth segment from the first tape of the McGraw-Hill/Irwin Managerial/Cost Accounting video library. This segment introduces students to many of the concepts discussed in chapter 6. The lecture notes reinforce the concepts introduced in the video.

Chapter theme: Cost-volume-profit (CVP) analysis helps managers understand the interrelationships among cost, volume, and profit by focusing their attention on the interactions among the prices of products, volume of activity, per unit variable costs, total fixed costs, and mix of products sold. It is a vital tool used in many business decisions such as deciding what products to manufacture or sell, what pricing policy to follow, what marketing strategy to employ, and what type of productive facilities to acquire.

I. The basics of cost-volume-profit (CVP) analysis

A. The contribution income statement is helpful to

managers in judging the impact on profits of changes in selling price, cost, or volume. For example, let's look at a hypothetical contribution income statement for Racing Bicycle Company (RBC). Notice:

i. The emphasis on cost behavior. Variable

costs are separate from fixed costs. ii. The contribution margin defined as the

amount remaining from sales revenue after variable expenses have been deducted.

2

1

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3 4 5

6 7 8

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iii. Contribution margin is used first to cover

fixed expenses. Any remaining contribution margin contributes to net operating income.

iv. Sales, variable expenses, and contribution

margin can also be expressed on a per unit basis. Thus:

1. For each additional unit RBC sells, $200

more in contribution margin will help to cover fixed expenses and provide a profit.

2. Notice, each month RBC must generate at least $80,000 in total contribution margin to break-even (which is the level of sales at which profit is zero).

3. Therefore, if RBC sells 400 units a month, it will be operating at the break-even point.

4. If RBC sells one more bike (401 bikes), net operating income will increase by $200.

v. You do not need to prepare an income

statement to estimate profits at a particular sales volume. Simply multiply the number of units sold above break-even by the contribution margin per unit.

1. For example, if RBC sells 430 bikes, its net

operating income will be $6,000. Helpful Hint: Some students may prefer an algebraic approach to CVP analysis. The basic CVP model can be written as:

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Profit = (p – v)q – F or

Profit = cm × q – F

Where p is the unit selling price, v is the variable cost per unit, q is the unit sales, F is the fixed cost, and cm is the unit contribution margin.

B. CVP relationships in graphic form

i. The relations among revenue, cost, profit, and

volume can be expressed graphically by preparing a cost-volume-profit (CVP) graph. To illustrate, we will use contribution income statements for RBC Company at 300, 400, and 500 units sold.

Helpful Hint: Mention to students that the graphic form of CVP analysis may be preferable to them if they are uncomfortable with algebraic equations.

ii. In a CVP graph, unit volume is usually

represented on the horizontal (X) axis and dollars on the vertical (Y) axis. A CVP graph can be prepared in three steps.

1. Draw a line parallel to the volume axis to

represent total fixed expenses. 2. Choose some sales volume (e.g., 500 units)

and plot the point representing total expenses (e.g., fixed and variable) at that sales volume. Draw a line through the data point back to where the fixed expenses line intersects the dollar axis.

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3. Choose some sales volume (e.g., 500 units) and plot the point representing total sales dollars at the chosen activity level. Draw a line through the data point back to the origin.

iii. Interpreting the CVP graph.

1. The break-even point is where the total revenue and total expenses lines intersect.

2. The profit or loss at any given sales level is measured by the vertical distance between the total revenue and the total expenses lines.

Helpful Hint: As an interesting sidelight, ask students what the CVP graph would look like for a public agency like a county hospital receiving a fixed budget each year and collecting fees less than its variable costs. The graph would look like this:

This is the reverse of the usual situation. If such an organization has volume above the break-even point, it will experience financial difficulties.

Total expenses

Total revenue

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C. Contribution margin ratio (CM ratio)

i. The CM ratio is calculated by dividing the total contribution margin by total sales.

1. For RBC the CM ratio is 40%. Thus, each

$1.00 increase in sales results in a total contribution margin increase of 40¢.

ii. The CM ratio can also be calculated by

dividing the contribution margin per unit by the selling price per unit.

1. For RBC the CM ratio is 40%. 2. If RBC increases sales from 400 to 500

bikes, the increase in contribution margin ($20,000) can be calculated by multiplying the increase in sales ($50,000) by the CM ratio (40%).

Quick Check – contribution margin ratio

D. Applications of CVP concepts

Helpful Hint: The five examples that are forthcoming should indicate to students the range of uses of CVP analysis. In addition to assisting management in determining the level of sales that is needed to break-even or generate a certain dollar amount of profit, the examples illustrate how the results of alternative decisions can be quickly determined.

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i. Change in fixed cost and sales volume.

1. What is the profit impact if RBC can increase unit sales from 500 to 540 by increasing the monthly advertising budget by $10,000?

a. Preparing a contribution income statement reveals a $2,000 decrease in profits.

b. A shortcut solution using incremental analysis also reveals a $2,000 decrease in profits.

ii. Change in variable costs and sales volume.

1. What is the profit impact if RBC can use higher quality raw materials, thus increasing variable costs per unit by $10, to generate an increase in unit sales from 500 to 580?

a. A shortcut solution reveals a $10,200 increase in profits.

iii. Change in fixed cost, sales price, and sales

volume.

1. What is the profit impact if RBC: (1) cuts its selling price $20 per unit, (2) increases its advertising budget by $15,000 per month, and (3) increases unit sales from 500 to 650 units per month?


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iv. Change in variable cost, fixed cost, and sales volume.

1. What is the profit impact if RBC: (1) pays a

$15 sales commission per bike sold instead of paying salespersons flat salaries that currently total $6,000 per month, and (2) increases unit sales from 500 to 575 bikes?


v. Change in regular sales price.

1. If RBC has an opportunity to sell 150 bikes to a wholesaler without disturbing sales to other customers or fixed expenses, what price should it quote to the wholesaler if it wants to increase monthly profits by $3,000?

a. The price quote should be $320.

In Business Insights Real companies regularly manage the CVP levers in an effort to increase profits. For example: “Playing the CVP Game” (page 250)

• In 2002, General Motors (GM) gave away almost $2,600 per vehicle in customer incentives such as price cuts and 0% financing.

• GM reported that “The pricing sacrifices have been more than offset by volume gains.” Lehman Brothers analysts estimated that GM would sell an additional 395,000 trucks and SUVs and an extra 75,000 cars in 2002.

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• The trucks earn an average contribution margin of $7,000 per vehicle, while the cars earn about $4,000 per vehicle.

• All told, the volume gains were expected to bring in an additional $3 billion in profits for GM.

II. Break-even analysis

A. The breakeven point can be computed using either the

equation method or the contribution margin method.

i. The equation method is based on the

contribution approach income statement.

1. The equation can be stated in one of two ways:

Profits = (Sales – Variable expenses) – Fixed Expenses or Sales = Variable expenses + Fixed expenses + Profits

2. The equation method can be illustrated using

data from RBC.

a. The break-even point in units is determined by creating the equation as shown, where Q is the number of bikes sold, $500 is the unit selling price, $300 is the unit variable expense, and $80,000 is the total fixed expense.

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b. Solving this equation shows that the break-even point in units is 400 bikes.

3. The equation can be modified as shown to calculate the break-even point in sales dollars. In this equation, X is total sales dollars, 0.60 is the variable expense as a percentage of sales, and $80,000 is the total fixed expense.

a. Solving this equation shows that the break-even point is sales dollars is $200,000.

ii. The contribution margin method has two

key equations: Break-even point in units sold = Fixed expenses CM per unit Break-even point in sales dollars = Fixed expenses CM ratio

1. The contribution margin method can be

illustrated using data from RBC. a. The break-even point in unit sales (400

bikes) and sales dollars ($200,000) is the same as shown for the equation method.

Quick Check – break-even calculations

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In Business Insights The concept of a breakeven point is critically important to dot.com companies. For example: “Buying on the Go−A Dot.com Tale” (page 240)

• *CD is a company that allows customers to order music CDs on their cell phones. Suppose you hear a cut from a CD on your car radio that you would like to own. Pick up your cell phone, punch “*CD,” enter the radio station’s frequency, and the time you heard the song, and the CD will soon be on its way to you.

• *CD charges about $17 per CD, including shipping. The company pays its suppliers about $13 per CD.

• *CD expects to lose $1.5 million on sales of $1.5 million in its first year of operations. That assumes the company sells 88,000 CDs.

• Working backwards, it would appear the company’s fixed costs are about $1,850,000 per year. This means the company would need to sell over 460,000 CDs per year just to break-even!

B. Target profit analysis

i. The equation and contribution margin

methods can be used to determine the sales volume needed to achieve a target profit. For example:

1. Suppose RBC wants to know how many

bikes must be sold to earn a profit of $100,000.

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a. The equation method can be used to determine that 900 bikes must be sold to earn the desired target profit.

b. The contribution margin method can also be used to determine that 900 bikes must be sold to earn the target profit.

Quick Check – target profit calculations

C. The margin of safety

i. The margin of safety is the excess of

budgeted (or actual) sales over the break-even volume of sales. For example:

1. If we assume that RBC has actual sales of $250,000, given that we have already determined the break-even sales to be $200,000, the margin of safety is $50,000.

2. The margin of safety can be expressed as a percent of sales. For example:

a. RBC’s margin of safety is 20% of sales.

3. The margin of safety can be expressed in terms of the number of units sold. For example:

a. RBC’s margin of safety is 100 bikes.

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Quick Check – margin of safety calculations In Business Insights The margin of safety concept can be readily applied to real companies. For example: “Soup Nutsy” (page 243)

• Pak Melwani and Kumar Hathiramani opened a soup store in Manhattan after watching a Seinfeld episode featuring the “Soup Nazi.”

• The store, called Soup Nutsy, sells soup for $6 per serving while incurring variable costs of $2 per serving. Therefore, their CM ratio is 66.67%.

• The owners reported that they netted $210,000 of profit on sales of $700,000.

• Given this information it is possible to calculate Soup Nutsy’s total fixed costs ($256,690), break-even sales dollars ($385,000), and margin of safety (45%).

III. CVP considerations in choosing a cost structure

A. Cost structure and profit stability

i. Cost structure refers to the relative

proportion of fixed and variable costs in an organization. Managers often have some latitude in determining their organization's cost structure.

ii. There are advantages and disadvantages to

high fixed cost (or low variable cost) and low fixed cost (or high variable cost) structures.

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1. An advantage of a high fixed cost structure is that income will be higher in good years compared to companies with a lower proportion of fixed costs.

2. A disadvantage of a high fixed cost structure is that income will be lower in bad years compared to companies with a lower proportion of fixed costs.

3. Companies with low fixed cost structures enjoy greater stability in income across good and bad years.

In Business Insights Companies frequently compete with one another based on their cost structures. For example: “A Losing Cost Structure” (page 245)

• Both JetBlue and United Airlines use an Airbus 235 to fly from Dulles International airport near Washington D.C., to Oakland, California. Both planes have a pilot, copilot, and four flight attendants.

• Based on 2002 data, the pilot on the United Flight earned $16,350 to $18,000 per month compared to $6,800 per month for the JetBlue pilot.

• United’s senior flight attendants earned more than $41,000 per year; whereas the Jet Blue attendants were paid $16,800 to $27,000 per year.

• 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

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other flights. Consequently, United went into bankruptcy at the end of 2002.

B. Operating leverage

i. Operating leverage is a measure of how

sensitive net operating income is to percentage changes in sales.

ii. The degree of operating leverage is a

measure, at any given level of sales, of how a percentage change in sales volume will affect profits. It is computed as follows:

Degree of operating leverage = Contribution margin

Net operating income

iii. To illustrate, let’s revisit the contribution income statement for RBC:

1. RBC’s degree of operating leverage is 5

($100,000/$20,000). 2. With an operating leverage of 5, if RBC

increases its sales by 10%, net operating income would increase by 50%.

a. The 50% increase can be verified by preparing a contribution approach income statement.

Quick Check – operating leverage calculations

In Business Insights Operating leverage is an important concept that managers need to understand. Failure to understand this concept can cause serious problems. For example:

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“Fan Appreciation” (page 247) • Jerry Colangelo, the managing partner of the

Arizona Diamondbacks professional baseball team, spent over $100 million to sign six free agents.

• The doubling of the team’s payroll coupled with servicing the debt on the team’s new stadium, raised the D-backs annual operating expenses to about $100 million. Accordingly, the team needed to average 40,000 fans per game to break-even.

• In an effort to boost revenue, Colangelo decided, during Fan Appreciation Weekend, to raise ticket prices by 12%. Attendance for the season dropped by 15%, turning what should have been a $20 million profit into a loss of over $10 million.

• Note that a drop in attendance of 15% did not cut profits just by 15% – that’s the magic of operating leverage at work.

Helpful Hint: Emphasize that the degree of operating leverage is not a constant like unit variable cost or unit contribution margin that a manager can apply with confidence in a variety of situations. The degree of operating leverage depends on the level of sales and must be recomputed each time the sales level changes. Also, note that operating leverage is greatest at sales levels near the break-even point and it decreases as sales and profits rise.

IV. Structuring sales commissions

A. Companies generally compensate salespeople by

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on sales dollars can lead to lower profits in a company. Consider the following illustration:

i. Pipeline unlimited produces two types of

surfboards, the XR7 and the Turbo. The XR7 sells for $100 and generates a contribution margin per unit of $25. The Turbo sells for $150 and earns a contribution margin per unit of $18.

ii. Salespeople compensated based on sales

commission will push hard to sell the Turbo even-though the XR7 earns a higher contribution margin per unit.

iii. To eliminate this type of conflict,

commissions can be based on contribution margin rather than on selling price alone.

V. The concept of sales mix

A. The term sales mix refers to the relative proportions in which a company’s products are sold. Since different products have different selling prices, variable costs, and contribution margins, when a company sells more than one product, breakeven analysis become more complex as the following example illustrates:

Helpful Hint: Mention that these calculations typically assume a constant sales mix. The rationale for this assumption can be explained as follows. To use simple break-even and target profit formulas, we must assume the firm has a single product. So we do just that – even for multi-product companies. The trick is to assume the company is really selling baskets of products and each

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basket always contains the various products in the same proportions.

i. Assume the RBC sells bikes and carts. The

bikes comprise 45% of the company’s total sales revenue and the carts comprise the remaining 55%. The contribution margin ratio for both products combined is 48.2%.

ii. The break-even point in sales would be

$352,697. The bikes would account for 45% of this amount, or $158,714. The carts would account for 55% of the break-even sales, or $193,983.

1. Notice a slight rounding error of $176.

VI. Assumptions of CVP analysis

A. Four key assumptions underlie CVP analysis:

i. Selling price is constant.

ii. Costs are linear and can be accurately

divided into variable and fixed elements. The variable element is constant per unit, and the fixed element is constant in total over the entire relevant range.

iii. In multiproduct companies, the sales mix is

constant.

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iv. In manufacturing companies, inventories do not change. The number of units produced equals the number of units sold.

Helpful Hint: Point out that nothing is sacred about these assumptions. When violations of these assumptions are significant, managers can and do modify the basic CVP model. Spreadsheets allow practical models that incorporate more realistic assumptions. For example, nonlinear cost functions with step fixed costs can be modeled using “If…Then” functions.

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Muhammad Fahim Khan

TM 6-1


CVP ANALYSIS

Cost-volume-profit (CVP) analysis is concerned with the effects on net operating income of:

• Selling prices.

• Sales volume.

• Unit variable costs.

• Total fixed costs.

• The mix of products sold.

AGENDA

1. Review of contribution income statement.

2. Effects of changes in sales volume on net operating income.

3. CVP graph.

4. Contribution margin (CM) ratio.

5. Break-even analysis.

6. Target profit analysis.

7. Margin of safety.

8. Operating leverage.

9. Multi-product break-even analysis.

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TM 6-2


THE CONTRIBUTION APPROACH

A contribution format income statement is very useful in CVP analysis since it highlights cost behavior.

EXAMPLE: Last month’s contribution income statement for Nord Corporation, a manufacturer of exercise bicycles, follows:

Total Per Unit Percent Sales (500 bikes) ........... $250,000 $500 100% Less variable expenses... 150,000 300 60 Contribution margin ....... 100,000 $200 40% Less fixed expenses ....... 80,000 Net operating income..... $ 20,000

CONTRIBUTION MARGIN:

• The amount that sales (net of variable expenses) contributes toward covering fixed expenses and then toward profits.

• The unit contribution margin remains constant so long as the selling price and the unit variable cost do not change.

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VOLUME CHANGES AND NET OPERATING INCOME

Contribution income statements are given on this and the following page for monthly sales of 1, 2, 400, and 401 bikes.

Total Per Unit Percent Sales (1 bike) ...................... $ 500 $500 100% Less variable expenses ......... 300 300 60 Contribution margin ............. 200 $200 40% Less fixed expenses ............. 80,000 Net operating income (loss) .. $(79,800) Total Per Unit Percent Sales (2 bikes)..................... $ 1,000 $500 100% Less variable expenses ......... 600 300 60 Contribution margin ............. 400 $200 40% Less fixed expenses ............. 80,000 Net operating income (loss) .. $(79,600)

Note the following points:

1. The contribution margin must first cover the fixed expenses. If it doesn’t, there is a loss.

2. As additional units are sold, fixed expenses are whittled down until they have all been covered.

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VOLUME CHANGES AND NET OPERATING INCOME (cont’d)

Total Per Unit PercentSales (400 bikes) ................... $200,000 $500 100%Less variable expenses........... 120,000 300 60 Contribution margin ............... 80,000 $200 40%Less fixed expenses ............... 80,000 Net operating income (loss).... $ 0 Total Per Unit PercentSales (401 bikes) ................... $200,500 $500 100%Less variable expenses........... 120,300 300 60 Contribution margin ............... 80,200 $200 40%Less fixed expenses ............... 80,000 Net operating income (loss).... $ 200

Note the following points:

1. If the company sells exactly 400 bikes a month, it will just break even (no profit or loss).

2. The break-even point is:

• The point where total sales revenue equals total expenses (variable and fixed).

• The point where total contribution margin equals total fixed expenses.

3. Each additional unit sold increases net operating income by the amount of the unit contribution margin.

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PREPARING A CVP GRAPH

$200

$100

$300

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Step 1 (Fixed

Expenses)

Step 3 (Total Sales)

Step 2 (Total

Expenses)

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THE COMPLETED CVP GRAPH

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$100

$300

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Break-even point:400 bikes or

$200,000 in sales

TotalSales

TotalExpenses

Profit

area

Loss area

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CONTRIBUTION MARGIN RATIO

The contribution margin (CM) ratio is the ratio of contribution margin to total sales:

Contribution marginCM ratio=

Total sales

If the company has only one product, the CM ratio can also be computed using per unit data:

Unit contribution marginCM ratio=

Unit selling price

EXAMPLE: For Nord Corporation, the CM ratio is 40%, computed as follows:

Contribution margin $100,000CM ratio= = =40%

Total sales $250,000

or

Unit contribution margin $200 per unitCM ratio= = =40%

Unit selling price $500 per unit

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CONTRIBUTION MARGIN RATIO (cont’d)

The CM ratio shows how the contribution margin will be affected by a given change in total sales.

EXAMPLE: Assume that Nord Corporation’s sales increase by $150,000 next month. What will be the effect on (1) the contribution margin and (2) net operating income?

(1) Effect on contribution margin:

Increase in sales....................... $150,000Multiply by the CM ratio ............ × 40%Increase in contribution margin . $ 60,000

(2) Effect on net operating income:

If fixed expenses do not change, the net operating income for the month will also increase by $60,000.

Present Expected Change Sales (in units) ............... 500 800 300Sales (in dollars)............. $250,000 $400,000 $150,000Less variable expenses.... 150,000 240,000 90,000Contribution margin ........ 100,000 160,000 60,000Less fixed expenses ........ 80,000 80,000 0Net operating income...... $ 20,000 $ 80,000 $ 60,000

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BREAK-EVEN ANALYSIS

Summary of Nord Corporation Data: Per Bike Percent Per Month Selling price......................... $500 100% Variable expenses ................ 300 60 Contribution margin ............. $200 40% Fixed expenses .................... $80,000

EQUATION METHOD

Q = Break-even quantity in bikes

Profits = Sales – (Variable expenses + Fixed expenses)


$500Q = $300Q + $80,000 + $0

$200Q = $80,000

Q = $80,000 ÷ $200 per bike

Q = 400 bikes

X = Break-even point in sales dollars


X = 0.60X + $80,000 + $0

0.40X = $80,000

X = $80,000 ÷ 0.40

X = $200,000

CONTRIBUTION MARGIN METHOD

Fixed expenses $80,000Breakeven= = =400 bikesin units Unit contribution margin $200 per bike

Fixed expenses $80,000Breakeven = = =$200,000in sales dollars CM ratio 0.40

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TM 6-10


TARGET PROFIT ANALYSIS

EXAMPLE: Assume that Nord Corporation’s target profit is $70,000 per month. How many exercise bikes must it sell each month to reach this goal?

EQUATION METHOD

Q = Number of bikes to attain the target profit

Sales = Variable Expenses + Fixed Expenses + Profits

$500Q = $300Q + $80,000 + $70,000

$200Q = $150,000

Q = $150,000 ÷ $200 bikes

Q = 750 Bikes

(or, in sales dollars, 750 bikes × $500 per bike = $375,000)

X = Dollar sales to reach the target profit figure

Sales = Variable Expenses + Fixed Expenses + Profits

X = 0.60X + $80,000 + $70,000

0.40X = $150,000

X = $150,000 ÷ 0.40

X = $375,000

CONTRIBUTION MARGIN METHOD

Fixed expenses + Target profitUnit sales to attain=target profit Unit contribution margin

$80,00+$70,000= =750 bikes

$200 per bike

Fixed expenses + Target profitDollar sales to attain=target profit CM ratio

$80,00+$70,000= =$375,000

0.40

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TM 6-11


MARGIN OF SAFETY

The margin of safety is the excess of budgeted (or actual) sales over the break-even sales. The margin of safety can be expressed either in dollar or percentage form. The formulas are:

Margin of safety=Total sales-Breakeven salesin dollars

Margin of safety in dollarsMargin of safety=percentage Total sales

Company X Company Y Sales .................................. $500,000 100% $500,000 100%Less variable expenses......... 350,000 70 100,000 20 Contribution margin............. 150,000 30% 400,000 80%Less fixed expenses............. 90,000 340,000 Net operating income .......... $ 60,000 $ 60,000 Break-even point:

$90,000 ÷ 0.30................. $300,000 $340,000 ÷ 0.80............... $425,000

Margin of safety in dollars: $500,000 – $300,000 ........ $200,000 $500,000 – $425,000 ........ $75,000

Margin of safety percentage: $200,000 ÷ $500,000........ 40% $75,000 ÷ $500,000 ......... 15%

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TM 6-12


OPERATING LEVERAGE

Operating leverage measures how a given percentage change in sales affects net operating income.

Contribution marginDegree of =operating leverage Net operating income

Company X Company Y Sales .................................... $500,000 100% $500,000 100%Less variable expenses........... 350,000 70 100,000 20 Contribution margin............... 150,000 30% 400,000 80%Less fixed expenses............... 90,000 340,000 Net operating income ............ $ 60,000 $ 60,000

Degree of operating leverage . 2.5 6.7

If the degree of operating leverage is 2.5, then a 10% increase in sales should result in a 25% (= 2.5 × 10%) increase in net operating income.

EXAMPLE: Assume that both company X and company Y experience a 10% increase in sales:

Company X Company Y Sales ........................................ $550,000 100% $550,000 100%Less variable expenses............... 385,000 70 110,000 20 Contribution margin................... 165,000 30% 440,000 80%Less fixed expenses................... 90,000 340,000 Net operating income ................ $ 75,000 $100,000 Increase in net operating income 25% 67%

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OPERATING LEVERAGE (cont’d)

The degree of operating leverage is not constant—it changes with the level of sales.

EXAMPLE: At the higher level of sales, the degree of operating leverage for Company X decreases from 2.5 to 2.2 and for Company Y from 6.7 to 4.4.

Company X (000s)

Company Y (000s)

Sales....................................... $500 $550 $500 $550 Less variable expenses ............. 350 385 100 110 Contribution margin ................. 150 165 400 440 Less fixed expenses ................. 90 90 340 340 Net operating income............... $ 60 $ 75 $ 60 $100

Degree of operating leverage.... 2.5 2.2 6.7 4.4

Ordinarily, the degree of operating leverage declines as sales increase.

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TM 6-14


MULTI-PRODUCT BREAK-EVEN ANALYSIS

When a company has multiple products, the overall contribution margin (CM) ratio is used in break-even analysis.

Total contribution margin

Overall CM ratio=Total sales dollars

Product A Product B Total Sales ........................... $100,000 100% $300,000 100% $400,000 100.0%Less variable expenses.. 70,000 70 120,000 40 190,000 47.5 Contribution margin...... $ 30,000 30% $180,000 60% 210,000 52.5%Less fixed expenses...... 141,750Net operating income ... $ 68,250

Total contribution margin $210,000

Overall CM ratio= = =52.5%Total sales dollars $400,000

Fixed expenses $141,750

Breakeven sales= = =$270,000Oveall CM ratio 0.525

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TM 6-15


MULTI-PRODUCT BREAK-EVEN ANALYSIS (cont’d)

The relative proportions in which the products are sold is called the sales mix. If the sales mix changes, the overall contribution margin ratio will change.

Example: Assume that total sales remain unchanged at $400,000. However, the sales mix shifts so that more of Product A is sold than of Product B.

Product A Product B Total Sales ........................... $300,000 100% $100,000 100% $400,000 100.0%Less variable expenses.. 210,000 70 40,000 40 250,000 62.5 Contribution margin...... $ 90,000 30% $ 60,000 60% 150,000 37.5%Less fixed expenses...... 141,750Net operating income ... $ 8,250

Total contribution margin $150,000

Overall CM ratio= = =37.5%Total sales dollars $400,000

Fixed expenses $141,750

Breakeven sales= = =$378,000Oveall CM ratio 0.375

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TM 6-16


MAJOR ASSUMPTIONS OF CVP ANALYSIS

1. Selling price is constant. The price does not change as volume changes.

2. Costs are linear and can be accurately split into fixed and variable elements. The total fixed cost is constant and the variable cost per unit is constant.

3. The sales mix is constant in multi-product companies.

4. In manufacturing companies, inventories do not change. The number of units produced equals the number of units sold.

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Chapter 10

Standard Costs and the Balanced Scorecard Learning Objectives LO1. Explain how direct materials standards and direct labor standards are set. LO2. Compute the direct materials price and quantity variances and explain their

significance. LO3. Compute the direct labor rate and efficiency variances and explain their significance. LO4. Compute the variable manufacturing overhead spending and efficiency variances. LO5. Understand how a balanced scorecard fits together and how it supports a company’s

strategy. LO6. Compute the delivery cycle time, the throughput time, and the manufacturing cycle

efficiency (MCE). LO7. (Appendix 10A) Prepare journal entries to record standard costs and variances.

New in this Edition • A number of new In Business boxes have been written for this edition. • Several new exercises have been added, each of which focuses on a single learning objective. • New problems covering the Balanced Scorecard have been added.. Lecture Notes A. Standard Costs—Management by Exception. A standard is a benchmark or “norm” for measuring performance. In managerial accounting, standards relate to the prices and quantities of inputs used in making goods or providing services. 1. Quantity standards. A quantity standard specifies how much of an input, such as labor

time or raw materials, should be used to make a unit of product or to provide a unit of service. To measure performance, the actual quantity of an input that is used is compared to the standard quantity allowed for the actual output of the period.

2. Price standards. A price standard specifies how much each unit of input should cost.

Actual costs of inputs are compared to these standards. B. Setting Standard Costs. (Exercises 10-1, 10-8.) Standards should be set so that they encourage efficient operations. 1. Ideal versus practical standard. Standards tend to fall into one of two categories—either

ideal or practical. • Ideal standards allow for no machine breakdowns or work interruptions, and require

that workers operate at peak efficiency 100% of the time. Since ideal standards are

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rarely met, most managers believe they tend to discourage even the most diligent workers. On the other hand, some critics maintain that only ideal standards are appropriate in an era of continual improvement. Any other standard may breed complacency.

• Practical standards are “tight, but attainable.” They allow for normal machine downtime and employee rest periods and can be attained through reasonable, but highly efficient, efforts by the average worker.

2. Setting direct materials standards. Separate standards are prepared for the price and

quantity of each type of material input. • The standard price per unit for a direct material should reflect the final, delivered

cost of the material, net of any discounts taken. The standard price is for a particular grade of material, purchased in a particular lot size, and delivered by a particular type of carrier.

• The standard quantity of a direct material per unit of output in a traditional standard cost system reflects the amount of material going into each unit of finished product, as well as an allowance for unavoidable waste, spoilage, and other normal inefficiencies. However, it is worth pointing out that some experts argue that “normal” inefficiency can no longer be tolerated and that companies that build waste into their operations will ultimately face serious problems competing with companies that don’t.

3. Setting direct labor standards.

• The standard rate per hour for direct labor should include not only wages, but also fringe benefits and other labor-related costs. Ordinarily, the standard rate is an average that assumes a specific mix of higher and lower paid workers.

• The standard direct labor-hours per unit of output is the direct labor time allowed to complete a unit of product. In traditional standard cost systems this standard time includes allowances for coffee breaks, personal needs of employees, clean-up, and machine downtime.

4. Setting variable manufacturing overhead standards. Standards for variable

manufacturing overhead are usually expressed in terms of direct labor-hours or machine-hours. The rate represents the variable portion of the predetermined overhead rate that is discussed in Chapter 3. The standard hours for variable overhead represent the standard hours for whatever base is used to apply overhead cost to products or services. If direct labor-hours is the basis for applying overhead to products, then the quantity standard for variable manufacturing overhead will be the quantity standard for direct labor.

5. Standard cost card. A standard cost card is a summary of the standard costs of inputs

required to complete one unit of product. For each input, the standard cost card lists the standard price of the input, the standard quantity of the input allowed per unit of output, and the standard cost of the input per unit of output. The latter is equal to the standard price per unit of input multiplied by the standard quantity of the input allowed for each unit of product.

6. Standards and budgets. One distinction between a standard and a budget is that a standard

is a unit amount, whereas a budget is a total amount. In effect, a standard can be viewed as the budgeted cost for one unit.

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C. A General Model for Variance Analysis. A variance is the difference between standard prices and actual prices or between standard quantities and actual quantities. A general model that describes the variable cost variances is found in Exhibit 10-3. 1. Price variance. A price variance is the difference between the how much should have been

paid to acquire an input and how much was actually paid. 2. Quantity variance. A quantity variance is the difference between how much of an input

should have been used to produce the actual output of the period and how much was actually used, multiplied by the standard price of the input.

3. Alternative methods. As an alternative to the general model, variances can be computed

using formulas. The formulas for the price variance are:

Price (rate) variance = (AQ × AP) – (AQ × SP) or

Price (rate) variance = AQ (AP – SP)

The formulas for the quantity variance are:

Quantity (efficiency) variance = (AQ × SP) – (SQ × SP) or

Quantity (efficiency) variance = SP (AQ – SQ) Where: AQ = Actual quantity of inputs purchased (or used) AP = Actual price per unit of inputs purchased SP = Standard price per unit of input

SQ = Standard input allowed for the actual output. This equals the standard input per unit of output multiplied by the actual output of the period.

D. Computation and Interpretation of Standard Cost Variances. Since direct material, direct labor, and variable overhead are all variable manufacturing costs, the process of computing price and quantity variances for each of these cost categories is the same. The general model, or the formulas, can be used in each case to compute the variances. The only complication is deciding in each case whether the actual quantity of inputs refers to the actual quantity purchased or the actual quantity used. 1. Direct material variances. (Exercises 10-2, 10-9, 10-12, 10-13, 10-15.)

a. The materials price variance is the difference between what is paid for a given quantity

of materials and what should have been paid according to the standard. Most companies compute the material price variance when materials are purchased rather than when the materials are placed into production. Generally speaking, the purchasing manager has control over the price to be paid for goods and is therefore responsible for any price variance. However, some other individual may be responsible in some instances. For example, the production manager might be responsible if an unfavorable price variance occurs as the result of rush orders for material due to poor production scheduling.

For purposes of control, it is best to recognize a materials price variance immediately rather than wait until the materials are withdrawn for use in production. Also, if the

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material price variance is recognized when the materials are placed into production, their actual costs must be tracked after they are purchased. If the variance is recognized when the materials are purchased, materials inventories can be carried at standard cost—which enormously simplifies the bookkeeping.

b. The materials quantity variance is the difference between the quantity of materials used

in production and the quantity that should have been used according to the standard—all multiplied by the standard price per unit of input. Ordinarily, the materials quantity variance is the responsibility of the production department. However, other individuals may in some instances be responsible. For example, the purchasing department would be responsible for an unfavorable material quantity variance that occurs because of the purchase of inferior quality materials.

2. Direct labor variances. (Exercises 10-3, 10-9, 10-10, 10-11, 10-12, 10-15.)

a. The labor rate variance measures any deviation from standard in the average hourly

rate paid to direct labor workers. Students often wonder how there can be a labor rate variance since companies generally know each employee’s wage rate in advance. A labor rate variance can arise for a number of reasons. The mix of workers, and hence of lower and higher wage rates, can be different from what was planned due to absences, changes in the composition of the work force, and a variety of other circumstances. Additionally, overtime can give rise to a labor rate variance.

b. The quantity variance for direct labor is called the labor efficiency variance.

Traditionally, this has been the most closely monitored variance by management. When the direct labor workforce is adjusted to changes in workloads, the main causes of the labor efficiency variance include poorly trained workers, poorly motivated workers, poor quality materials which require more labor time and processing, faulty equipment which causes breakdowns and work interruptions, and poor supervision. However, many companies do not adjust the workforce to the workload in the short-term. In such companies, the major cause of a labor efficiency variance is likely to be fluctuations in demand for the company’s products rather than the efficiency with which workers do their jobs. If the workforce is basically fixed, a reduction in output will result in less favorable labor efficiency variances. Likewise, an increase in output when the workforce is basically fixed will result in more favorable labor efficiency variances.

When demand is down or when a workstation is not a bottleneck, excessive emphasis on labor efficiency variances can create tremendous pressure to build inventories. Take the case of a workstation that is not a bottleneck. If the labor force is basically fixed and the standards are tight, the workstation can only attain a favorable labor efficiency variance by producing at capacity. However, if the workstation is not the bottleneck and it is operating at capacity, it will produce more output than the bottleneck can process. That will result in work in process inventory that cannot be completed. As the JIT movement attests, work in process inventory is the enemy of efficient operations. It leads to long and erratic manufacturing cycle times, high defect rates, obsolescence, and high overhead due to expediting and the problems of coordinating production schedules amongst the general chaos on the factory floor. A very strong argument can be made that the labor efficiency variance should be unfavorable in workstations that are not bottlenecks when the work force is fixed.

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3. Variable overhead variances. (Exercises 10-4, 10-11.) These variances will be discussed in greater depth in the next chapter. You may want to defer all discussion of the interpretations of these variances.

a. The variable overhead spending variance is computed as follows when the variable

overhead rate is expressed in terms of direct labor-hours: Variable overhead spending variance = Actual overhead cost – Actual direct labor-hours × Variable overhead rate The variable overhead spending variance compares actual spending on variable

overhead to the amount of spending that would be expected, given the actual direct labor-hours for the period. The critical assumption inherent in this calculation is that variable overhead spending should be proportional to the actual direct labor-hours. The usefulness of this variance depends on the validity of this assumption. If in fact the optimal level of variable overhead spending is not proportional to actual direct labor-hours, then this variance has little meaning.

b. The variable overhead efficiency variance is computed as follows when the variable

overhead rate is expressed in terms of direct labor-hours: Variable overhead efficiency variance = (Actual direct labor-hours – Standard direct labor-hours allowed) × Variable

overhead rate Note the similarity between the direct labor efficiency variance and the variable

overhead efficiency variance. In both cases, the actual direct labor-hours are compared to the standard direct labor-hours allowed for the actual output. The only difference between the variances is the standard rate that is applied to difference between the actual and standard hours. In the case of the direct labor efficiency variance, the rate is the standard labor rate. In the case of the variable overhead efficiency variance, the rate is the standard (predetermined) variable overhead rate per direct labor-hour. Therefore, these two variances really measure the same thing. Those who criticize the labor efficiency variance as irrelevant or counter-productive would likewise criticize the variable overhead efficiency variance.

E. Variance Analysis and Management by Exception. Management by exception means that management’s attention should be directed towards areas where plans are not being met. Standard cost variances signal performance different from what was expected. Since not all variances require management attention, some method of identifying those variances that do require attention is required. Statistical analysis can be useful in this task and the basics of this approach are sketched in the text. F. General Ledger Entries to Record Variances (Appendix 10A). (Exercises 10-7, 10-15.) The appendix covers the journal entries to record standard costs in inventories and to record the standard cost variances. Formal entry of variances in the accounting records gives variances greater emphasis and simplifies the bookkeeping process. It is important to note that unfavorable variances are debit entries and favorable variances are credit entries.

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G. Potential Problems with Using Standard Costs. Some of the potential disadvantages of standard costs have been mentioned above. A more complete list follows: 1. Standard cost variance reports are usually prepared on a monthly basis and are released

long after the end of the month. As a consequence, the information in the reports may be so stale that it is almost useless. It is better to have timely, frequent reports that are approximately correct than to have untimely, infrequent reports that are very precise. Some companies are now reporting variances and other key operating data daily or even more frequently.

2. Management by exception, by its nature, tends to focus on the negative. Moreover, if variances are used as a club, subordinates may be tempted to cover up unfavorable variances or take actions that are not in the best interests of the company to make sure the variances are favorable. For example, workers may put on a crash effort to increase output at the end of the month to avoid an unfavorable labor efficiency variance. During such crash efforts, quality may not be a major concern. It is claimed that in the old Soviet Union, workers used hammers instead of screwdrivers at the end of the month to meet production quotas.

3. Labor quantity standards and labor efficiency variances make two important assumptions. First, they assume that the production process is labor-paced; if labor works faster, output will go up. However, output in many companies is no longer determined by how fast labor works; rather, it is determined by the processing speed of machines. Second, these computations assume that labor is a variable cost. However, as discussed in earlier chapters, in many companies direct labor may be more of a fixed cost than a variable cost. And if labor is a fixed cost, then an undue emphasis on labor efficiency variances creates pressure to build excess work-in-process and finished goods inventories as discussed above. If every workstation is being evaluated based on its labor efficiency variance, then every workstation will attempt to produce at capacity. But if the workstations in front of the bottleneck produce at capacity, the inevitable result will be a build up of work in process inventories in front of the bottleneck. This reasoning applies to any two successive workstations with differing capacities. If the first workstation has greater capacity that the second work station and attempts to produce to its capacity, the result will be ever-increasing piles of work in process inventory in front of the second workstation.

4. In some cases, a “favorable” variance can be worse than an “unfavorable” variance. For example, vaccines have standard doses. A favorable quantity variance means that less vaccine was used than the standard specifies. The result may be an ineffective inoculation.

5. There may be a tendency with standard cost reporting systems to emphasize meeting the standards to the exclusion of other important objectives such as maintaining and improving quality, on-time delivery, and customer satisfaction.

6. Continual improvement—not just meeting standards—may be necessary to survive in the current competitive environment. For that reason, some companies focus on the trends in the standard cost variances—aiming for continual improvement rather than just meeting the standards.

H. Balanced Scorecard. (Exercises 10-5, 10-14.) A balanced scorecard consists of an integrated set of performance measures that are derived from and support the company’s strategy

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throughout the organization. Since each company’s strategy and operating environment is different, each company’s balanced scorecard will be unique. However, they will have some common characteristics. 1. Common characteristics of balanced scorecards.

a. It should be possible, by examining a company’s balanced scorecard, to infer its strategy and the assumptions underlying that strategy. (See Exhibit 10-13 for an example.)

b. The balanced scorecard should emphasize continuous improvement rather than just

meeting present standards or targets. c. Some of the performance measures on the balanced scorecard should be non-financial.

Financial measures tend to be lagging rather than leading indicators. In addition, for most employees, non-financial measures may be easier to understand and to influence than financial measures.

d. The entire company has a comprehensive scorecard, but the scorecards for individuals

should contain only those performance measures they can actually influence. As you go lower in the organization, you are likely to observe fewer performance measures on individuals’ scorecards and that more of them will be non-financial.

e. Most, but certainly not all, balanced scorecards will contain performance measures that

fall into at least four main categories: financial, customer, internal business process, and learning and growth. The ultimate objectives of the organization are usually financial, but financial results depend on customers’ perceptions of the company’s products and services. In order to improve customers’ perceptions of products and services, it is usually necessary to improve internal business processes so that the products and services are actually better. And in order to improve the business processes, it is necessary that employees learn.

2. The balanced scorecard as a motivation and feedback mechanism. The performance

measures on the balanced scorecard provide motivation and feedback. If an employee does something to improve a performance measure and the measure actually improves, the employee is encouraged. If the performance measure does not improve, the employee can adjust what he or she was doing and try again. Learning to shoot baskets is a good analogy. If you could not see whether a shot actually went into the basket, you would quickly lose interest and would not be able to improve. Only by seeing what works and does not work can you improve.

3. The balanced scorecard provides a reality check for the company’s strategy. Suppose

employees work very hard and make dramatic improvements in internal business processes but customer satisfaction and financial results do not improve. Rather than throwing up one’s hands in despair, this is a golden opportunity to examine the company’s strategy. If improvement in one area does not lead to expected improvement elsewhere, something may be wrong with the theory underlying the strategy. Indeed, strategy can be thought of as hypotheses about the effects of particular actions on desired outcomes. If those desired outcomes do not occur, the hypotheses should be discarded and the strategy reconsidered. If no attempt is made to systematically collect data that can disprove the assumptions underlying the company’s strategy, the company may stagger on indefinitely—unaware

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that its cherished assumptions are invalid. This extremely important aspect of the balanced scorecard should be emphasized.

4. Some internal business process performance measures. (Exercise 10-6.) Exhibit 10-12

in the text contains a rather long list of potential performance measures that could be included on a balanced scorecard. These should be viewed only as examples. Most companies are likely to use some of these measures or measures that are very similar to some on the list. Most companies will add many other performance measures that are not on the list. As a consequence, you should not place a great deal of emphasis on this list. Nevertheless, several measures of internal business process performance on the list are quite common and are not self-explanatory. A discussion of these measures follows: a. Delivery Cycle Time. This is the total elapsed time between when an order is placed

by a customer and when it is shipped to the customer. Part of this time is wait time that occurs before the order is placed into production. The remainder of this time is the throughput time, which is defined below.

b. Throughput (Manufacturing Cycle) Time. This is the total elapsed time between

when an order is started into production and when it is shipped to the customer. It consists of process time, inspection time, move time, and queue time. The only element that adds value is processing time. Inspection time, move time, queue time, and their associated activities do not add value and should be minimized.

c. Manufacturing Cycle Efficiency (MCE). MCE is the ratio of value-added time (i.e.,

process time) to total throughput time. It represents the percentage of time an order is in production in which useful work is being done. The rest of the time represents non-value-added time (i.e., inspection time, move time, and queue time).

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Time Exercise 10-1 Setting standards; preparing a standard cost card................... Basic 20 min. Exercise 10-2 Material variances .................................................................. Basic 20 min. Exercise 10-3 Direct labor variances............................................................. Basic 20 min. Exercise 10-4 Variable overhead variances................................................... Basic 20 min. Exercise 10-5 Creating a balanced scorecard Basic 45 min. Exercise 10-6 Measures of internal business process performance............... Basic 20 min. Exercise 10-7 Recording variances in the general ledger.............................. Basic 20 min. Exercise 10-8 Setting standards..................................................................... Basic 20 min. Exercise 10-9 Material and labor variances .................................................. Basic 30 min. Exercise 10-10 Working backwards from labor variances.............................. Basic 20 min. Exercise 10-11 Labor and variable overhead variances .................................. Basic 30 min. Exercise 10-12 Material and labor variances .................................................. Basic 20 min. Exercise 10-13 Material variances .................................................................. Basic 15 min. Exercise 10-14 Creating a balanced scorecard Basic 45 min. Exercise 10-15 (Appendix) Material and labor variances; journal entries ...... Basic 45 min. Problem 10-16 Variance analysis in a hospital ............................................... Basic 45 min. Problem 10-17 Basic variance analysis........................................................... Basic 45 min. Problem 10-18 (Appendix) Comprehensive variance analysis; journal

entries ................................................................................ Basic 60 min. Problem 10-19 Comprehensive variance analysis........................................... Basic 45 min. Problem 10-20 Creating balanced scorecards that support different

strategies Basic 60 min. Problem 10-21 Measures of internal business process performance............... Basic 30 min. Problem 10-22 Setting standards..................................................................... Medium 30 min. Problem 10-23 Variance analysis with multiple lots....................................... Medium 45 min. Problem 10-24 Materials and labor variances; computations from

incomplete data.................................................................. Difficult 45 min. Problem 10-25 (Appendix) Comprehensive variance analysis with

incomplete data; journal entries......................................... Difficult 75 min. Problem 10-26 Comprehensive variance analysis........................................... Difficult 60 min. Problem 10-27 Variance analysis and internal business process performance

measures ............................................................................ Medium 75 min. Problem 10-28 Building a balanced scorecard................................................ Medium 45 min. Problem 10-29 Perverse effects of some performance measures .................... Medium 45 min. Problem 10-30 Internal business process performance measures ................... Medium 30 min. Problem 10-31 Comprehensive variance analysis........................................... Difficult 45 min. Problem 10-32 Developing standard costs...................................................... Difficult 45 min. Case 10-33 Balanced scorecard................................................................. Difficult 60 min. Case 10-34 Ethics and the manager; rigging standards ............................. Difficult 30 min. Case 10-35 (Appendix) Variances and journal entries from incomplete

data .................................................................................... Difficult 90 min. Case 10-36 Behavioral impact of standard costs and variances ................ Medium 30 min.

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Essential Problems: Problem 10-16 or Problem 10-17, Problem 10-19, Problem 10-21 or Problem 10-30, Problem 10-20 or 10-28.

Supplementary Problems: Problem 10-22 or Problem 10-32, Problem 10-23, Problem 10-24, Problem 10-26, Problem 10-27, Problem 10-29, Problem 10-31, Case 10-33, Case 10-34, Case 10-36.

Appendix 10A Essential Problems: Problem 10-18 or Problem 10-25. Appendix 10A Supplementary Problems: Case 10-35.

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Helpful Hint: Before beginning the lecture, show students the tenth and eleventh segments from the second tape of the McGraw-Hill/ Irwin Managerial/Cost Accounting video library. These segments discuss many of the concepts presented in chapter 10. The lecture notes reinforce the concepts in the video.

Chapter theme: This chapter begins our study of management control and performance measures. It explains how standard costs are used by managers to control costs. It also introduces the balanced scorecard as a method for top management to translate its strategy into performance measures that employees can understand and influence.

“In Business Insights” Performance measures are important to an organization because they provide feedback concerning what works and does not work, and they can help motivate employees to sustain their efforts. For example: “Focusing on the Numbers” (page 428)

• Setpoint is a company that designs and builds factory-automation equipment.

• The company’s CEO, Joe Knight, uses a large whiteboard with about 20 rows and 10 columns to focus worker attention on the key factors involved in managing projects.

• The front-line workers on the shop floor completely understand how the board works

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including how gross profit and other key indicators are calculated.

• The whiteboard indicates to employees whether they are winning or losing and it also contributes to building a positive attitude in the workforce because the employees understand how the key numbers are used to assess their performance.

I. Standard costs – management by exception

A. Basic definitions/concepts

i. A standard is a benchmark or “norm” for

measuring performance. In managerial accounting, two types of standards are commonly used by manufacturing, service, food, and not-for-profit organizations:

1. Quantity standards specify how much of

an input should be used to make a product or provide a service. For example:

a. Auto service centers like Firestone and Sears set labor time standards for the completion of work tasks.

b. Fast-food outlets such as McDonald’s have exacting standards for the quantity of meat going into a sandwich.

2. Cost (price) standards specify how much should be paid for each unit of the input. For example:

a. Hospitals have standard costs for food, laundry, and other items.

b. Home construction companies have standard labor costs that they apply to

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sub-contractors such as framers, roofers, and electricians.

c. Manufacturing companies often have highly developed standard costing systems that establish quantity and cost (price) standards for each separate product’s material, labor and overhead inputs. These standards are listed on a standard cost card.

ii. Management by exception is a system of

management in which standards are set for various operating activities, with actual results compared to these standards. Any deviations that are deemed significant are brought to the attention of management as “exceptions.”

1. This chapter applies the management by

exception principle to quantity and cost (price) standards with an emphasis on manufacturing applications.

iii. The variance analysis cycle is a continuous four-

step process:

1. The cycle begins with the preparation of standard cost performance reports in the accounting department.

2. These reports highlight variances which are differences between actual results and what should have occurred according to the standards.

3. The variances raise questions such as: a. Why did this variance occur? b. Why is this variance larger than it was

last period?

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4. The significant variances are investigated to discover their root causes.

5. Corrective actions are taken and the next period’s operations are carried out.

“In Business Insights” Standard costing is used in numerous organizations to improve performance. For example: “Standard Costing at Parker Brass” (page 430)

• Parker Brass (of Parker Hannifin Corporation) is a world-class manufacturer of tube and brass fittings, valves, hose, and hose fittings. The company uses standard cost variance analysis to target areas for improvement.

• If a production variance exceeds 5% of sales, the responsible manager is required to explain the variance and to propose a plan of action to fix the problem.

• Rather than preparing variance reports monthly, reports are generated the day after a job completed and summary variance reports are prepared weekly.

II. Setting standard costs

A. General concepts

i. Setting price and quantity standards requires the

combined expertise of everyone who has responsibility for purchasing and using inputs.

1. In a manufacturing setting this might include

accountants, engineers, purchasing

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managers, production supervisors, line managers, and production workers.

ii. Standards should be designed to encourage

efficient future operations, not just a repetition of past inefficient operations.

iii. Standards tend to fall into one of two categories:

1. Ideal standards can only be attained under

the best of circumstances. They allow for no work interruptions and they require employees to work at 100% peak efficiency all of the time.

2. Practical standards are tight but attainable. They allow for normal machine downtime and employee rest periods and can be attained through reasonable, highly efficient efforts by the average worker.

a. Practical standards can also be used for forecasting cash flows and in planning inventory.

B. Setting direct materials standards

i. The standard price per unit for direct materials

should reflect the final, delivered cost of the materials, net of any discounts taken.

ii. The standard quantity per unit for direct

materials should reflect the amount of material required for each unit of finished product, as well as an allowance for unavoidable waste, spoilage, and other normal inefficiencies.

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1. A bill of materials is a list that shows the quantity of each type of material in a unit of finished product.

2. TQM advocates argue that waste and spoilage should not be tolerated. If allowances for waste and spoilage are built into the standard quantity, the level of those allowances should be reduced over time.

C. Setting direct labor standards

i. The standard rate per hour for direct labor

includes not only wages earned but also fringe benefits and other labor costs.

1. Many companies prepare a single rate for

all employees within a department that reflects the “mix” of wage rates earned.

ii. The standard hours per unit reflects the labor

hours required to complete one unit of product.

1. Standards can be determined by using available references that estimate the time needed to perform a given task, or by relying on time and motion studies.

“In Business Insights” Computer technology can enable very precise variance analysis reporting. For example: “Watching the Pennies” (page 434)

• Industrie Natuzzi SpA of southern Italy produces handmade leather furniture for the world market.

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• The company’s furniture is handmade by craftsman, each of whom has a networked computer terminal that provides precise instructions how to accomplish particular tasks.

• The computer also keeps track of how quickly the craftsman completes each task. If the craftsman beats the standard time for a task, the computer adds a bonus to the craftsman’s pay.

• The company’s computers also know exactly how much of each raw material is required for every model that is produced.

D. Setting variable manufacturing overhead standards

i. The price standard for variable manufacturing

overhead comes from the variable portion of the predetermined overhead rate.

ii. The quantity standard for variable

manufacturing overhead is usually expressed in either direct labor hours or machine hours depending on which is used as the allocation base in the predetermined overhead rate.

E. The standard cost card

i. The standard cost card is a detailed listing of the

standard amounts of direct materials, direct labor, and variable overhead inputs that should go into a unit of product, multiplied by the standard price or rate that has been set for each input.

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F. Are standards the same as budgets?

i. A standard is a unit amount, whereas a budget is a total amount. A standard can be viewed as the budgeted cost for one unit of product.

“In Business Insights” Setting standards and using them to evaluate performance can be tricky business. For example: “What Happened to the Raisins?” (page 441)

• Management of an unnamed breakfast cereal company became concerned about the apparent waste of raisins in one of its products. The production process had been using an average of 2.5 ounces of raisins per box instead of the target 2 ounces per box.

• To correct the problem, a bonus was offered to employees if the consumption of raisins dropped to 2.1 ounces per box. Within a month, the target was hit and bonuses were distributed.

• Subsequently, the company learned that the 2.1 ounce target was hit, not by improving the production process, but by drastically reducing the amount of raisins contained in rush orders well below the 2.1 ounce threshold. Normally, this deceptive action would be detected because boxes of cereal are weighed before being shipped to customers. However, rush orders are not weighed before being shipped.

• Customer complaints eventually revealed the manipulative actions of the employees.

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III. A general model for variance analysis

A. Price and quantity standards

i. Price and quantity standards are determined separately for two reasons:

1. Different managers are usually

responsible for buying and for using inputs. For example:

a. The purchasing manager is responsible for raw material purchase prices and the production manager is responsible for the quantity of raw material used.

2. The buying and using activities occur at different points in time. For example:

a. Raw material purchases may be held in inventory for a period of time before being used in production.

B. Price and quantity variances

i. Differences between standard prices and actual

prices and standard quantities and actual quantities are called variances.

1. The act of computing and interpreting

variances is called variance analysis.

ii. Price and quantity variances can be computed for all three variable cost elements – direct materials, direct labor, and variable manufacturing overhead – even though the variances have different names as shown.

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iii. Although price and quantity variances are known by different names, they are computed exactly the same way (as shown on this slide) for direct materials, direct labor, and variable manufacturing overhead.

1. The actual quantity represents the actual

amount of direct materials, direct labor, and variable manufacturing overhead used.

Helpful Hint: Emphasize that the quantities in this model pertain to inputs not outputs. So, in the case of direct materials, the quantities will be stated in terms such as pounds, ounces, etc., not the number of units of finished goods produced.

2. The standard quantity represents the

standard quantity allowed for the actual output of the period.

Helpful Hint: Mention that the “SQ” portion of the model is the most common stumbling block for students when it comes to variance analysis. Emphasize that “SQ” refers to the standard quantity of inputs allowed for the actual level of output achieved. For example, if 5,000 drapes were produced and each requires 2 yards of fabric, the standard quantity allowed would be 10,000 yards. Any other amount of fabric used would result in a variance.

3. The actual price represents the actual amount paid for the input used.

4. The standard price represents the amount that should have been paid for the input used.

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5. In equation form, price and quantity variances are calculated as shown.

IV. Using standard costs – direct materials variances

A. Glacier Peak Outfitters – an example

i. The materials price variance, defined as the

difference between what is paid for a quantity of materials and what should have been paid according to the standard, is $21 favorable.

1. The price variance is labeled favorable

because the actual price was less than the standard price by $0.10 per kilogram.

Helpful Hint: Remind students that a favorable price variance might not always be a good thing. If it arose from receiving inferior or obsolete goods at a reduced price, the total costs of making the company’s products might be higher.

ii. The materials quantity variance, defined as the

difference between the quantity of materials used in production and the quantity that should have been used according to the standard, is $50 unfavorable.

1. The quantity variance is labeled

unfavorable because the actual quantity exceeds the standard quantity allowed by 10 kilograms.

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iii. Supporting/additional computations 1. The actual price of $4.90 per kilogram was

computed as shown. 2. The standard quantity of 200 kilograms was

computed as shown. 3. The equations that we have been using thus

far can be factored as shown and used to compute price and quantity variances.

B. Direct materials variances – points of clarification:

i. Most companies compute the materials price

variance when materials are purchased. They calculate the materials quantity variance after materials are used in production.

ii. The materials price variance is computed using

the entire amount of material purchased during the period. The materials quantity variance is computed using only the portion of materials that was used in production during the period.

iii. The purchasing manager and production

manager are usually held responsible for the materials price variance, and materials quantity variance, respectively.

1. The standard price is used to compute the

quantity variance so that the production manager is not held responsible for the performance of the purchasing manager.

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iv. The materials variances are not always entirely controllable by one person or department. For example:

1. The production manager may schedule

production in such a way that it requires express delivery of raw materials resulting in an unfavorable materials price variance.

2. The purchasing manager may purchase lower quality raw materials resulting in an unfavorable materials quantity variance for the production manager.

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Quick Check – direct materials variance calculations

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V. Using standard costs – direct labor variances

A. Glacier Peak Outfitters – continued (assume the information as shown)

i. The labor rate variance, defined as the

difference between the actual average hourly wage paid and the standard hourly wage, is $1,250 unfavorable.

1. The rate variance is labeled unfavorable

because the actual average wage rate was more than the standard wage rate by $0.50 per hour.

ii. The labor efficiency variance, defined as the

difference between the actual quantity of labor hours and the quantity allowed according to the standard, is $1,000 unfavorable.

1. The efficiency variance is labeled

unfavorable because the actual quantity of hours exceeds the standard quantity allowed by 100 hours.

iii. Supporting/additional computations

1. The actual price (or rate) of $10.50 per

hour was computed as shown. 2. The standard quantity of 2,400 hours was

computed as shown. 3. Factored equations can also be used to

compute the rate and efficiency variances.

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B. Direct labor variances – points of clarification:

i. Labor variances are partially controllable by employees within the Production Department. For example, production managers/supervisors can influence:

1. The deployment of highly skilled workers

and less skilled workers on tasks consistent with their skill levels.

2. The level of employee motivation within the department.

3. The quality of production supervision. 4. The quality of the training provided to the

employees. ii. However, labor variances are not entirely

controllable by one person or department. For example:

1. The Maintenance Department may do a

poor job of maintaining production equipment. This may increase the processing time required per unit, thereby causing an unfavorable labor efficiency variance

2. The purchasing manager may purchase lower quality raw materials resulting in an unfavorable labor efficiency variance for the production manager.

Quick Check – direct labor variance calculations

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VI. Using standard costs – variable manufacturing overhead variances

A. Glacier Peak Outfitters – continued

i. The variable overhead spending variance, defined as the difference between the actual variable overhead costs incurred during the period and the standard cost that should have been incurred based on the actual activity of the period, is $500 unfavorable.

1. The spending variance is labeled

unfavorable because the actual variable overhead rate was more than the standard variable overhead rate by $0.20 per hour.

ii. The variable overhead efficiency variance,

defined as the difference between the actual activity of a period and the standard activity allowed, multiplied by the variable part of the predetermined overhead rate, is $400 unfavorable.

1. The efficiency variance is labeled

unfavorable because the actual quantity of the activity (hours) exceeds the standard quantity of the activity allowed by 100 hours.

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iii. Supporting/additional computations

a. The actual price of $4.20 per hour was computed as shown.

b. The standard quantity of 2,400 hours was computed as shown.

c. Factored equations can be used to compute the spending and efficiency variances.

Quick Check – variable overhead variance calculations

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VII. Variance analysis and management by exception

A. All variances are not worth investigating. Methods for highlighting a subset of variances as exceptions include:

i. Looking at the size of the variance.

ii. Looking at the size of the variance relative to the

amount of spending.

iii. Plotting variance analysis data on a statistical control chart. Variances are investigated if:

1. They are unusual relative to the normal

level of random fluctuation. 2. An unusual pattern emerges in the data.

VIII. Evaluation of controls based on standard costs

A. Research has shown that a substantial portion of

companies in the United Kingdom, Canada, Japan, and the United States use standard cost systems. This is because standard cost systems offer many advantages including:

i. Standard costs are a key element of the

management by exception approach which helps managers focus their attention on the most important issues.

ii. Standards that are viewed as reasonable by

employees can serve as benchmarks that promote economy and efficiency.

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iii. Standard costs can greatly simplify bookkeeping.

iv. Standard costs fit naturally into a responsibility accounting system.

B. The use of standard costs can also present a number of

problems. For example:

i. Standard cost variance reports are usually prepared on a monthly basis and are often released days or weeks after the end of the month; hence, the information can be outdated.

ii. If variances are mis-used as a club to negatively

reinforce employees, morale may suffer and employees may make dysfunctional decisions.

iii. Labor variances make two important

assumptions. First, they assume that the production process is labor-paced; if labor works faster, output will go up. Second, the computations assume that labor is a variable cost. These assumptions are often invalid in today’s automated manufacturing environment where employees are essentially a fixed cost.

iv. In some cases, a “favorable” variance can be as

bad or worse than an “unfavorable” variance.

v. Excessive emphasis on meeting the standards may overshadow other important objectives such as maintaining and improving quality, on-time delivery, and customer satisfaction.

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vi. Just meeting standards may not be sufficient; continual improvement may be necessary to survive in a competitive environment.

IX. Balanced scorecard

A. Key concepts

i. A balanced scorecard consists of an integrated

set of performance measures that are derived from and support a company’s strategy. Importantly, the measures included in a company’s balanced scorecard are unique to its specific strategy.

“In Business Insights” Each organization’s unique strategy drives the design of its balanced scorecard. For example: “The Balanced Scorecard at the City of Charlotte” (page 449)

• The City of Charlotte, North Carolina developed a balanced scorecard with four major goals: (1) increase perception of safety, (2) strengthen neighborhoods, (3) promote economic opportunity, and (4) improve service quality.

• For the “strengthen neighborhoods” goal, the city adopted scorecard measures such as: (1) the number of code compliances in housing, (2) the number of assisted purchases of homes, and (3) the number of adult job placements.

ii. The balanced scorecard enables top management

to translate its strategy into four groups of performance measures – financial, customer, internal business process, and learning and

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growth – that employees can understand and influence.

1. The premise of these four groups of

measures is that learning is necessary to improve internal business processes, which in turn improves the level of customer satisfaction, which in turn improves financial results.

a. Note the emphasis on improvement, not just attaining some specific objective.

“In Business Insights” The customers’ perspective is ultimately more important that a company’s perspective of its own operations. For example: “In Denial” (page 452)

• Larry Bossidy, the long-time CEO of Allied Signal, reports that “When I took over at Allied Signal…I got two different pictures from our people and our customers. While our people were saying that we were delivering an order-fill rate of 98%, our customers thought we were at 60%.”

• Instead of addressing the problem, employees were consumed with showing why their figures were right and the customers’ were wrong.

• Apparently, the internal measure order-fill rates that had been used at Allied Signal was deficient because it did not capture customer perceptions, which is of paramount importance.

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iii. The balance scorecard relies on non-financial measures in addition to financial measures for two reasons:

1. Financial measures are lag indicators that

summarize the results of past actions. Non-financial measures are leading indicators of future financial performance.

2. Top managers are ordinarily responsible for financial performance measures – not lower level managers. Non-financial measures are more likely to be understood and controlled by lower level managers.

iv. While the entire organization has an overall

balanced scorecard, each responsible individual should have his or her own personal scorecard as well.

1. A personal scorecard should contain

measures that can be influenced by the individual being evaluated and that support the measures in the overall balanced scorecard.

v. A balanced scorecard, whether for an individual

or the company as a whole, should have measures that are linked together on a cause-and-effect basis.

1. Each link can be read as a hypothesis in the

form “If we improve this performance measure, then this other performance measure should also improve.”

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2. In essence, the balanced scorecard lays out a theory of how a company can take concrete actions to attain desired outcomes. If the theory proves false or the company alters its strategy, the measures within the scorecard are subject to change.

“In Business Insights” The theories underlying a strategy can be proven false. For example: “Banning Boredom – The Key to Profits?” (page 454)

• Store24 is one of New England’s largest convenience store chains. It adopted a strategy called “Ban Boredom” – attempting to differentiate itself from competitors by providing an entertaining shopping experience.

• Unfortunately, this strategy bombed because customers overwhelmingly identified with Store24’s traditional strengths of fast and efficient service.

• The hypothesis “if we create an entertaining shopping experience, then customer satisfaction will increase” proved to be false.

• Store24 went back to its roots with the slogan “Cause You Just Can’t Wait.”

vi. Incentive compensation for employees

probably should be linked to balanced scorecard performance measures.

1. However, this should only be done after the

organization has been successfully managed with the scorecard for some time – perhaps

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a year or more. Managers must be confident that the measures are reliable, not easily manipulated, and understandable by those being evaluated with them.

“In Business Insights” Linking flawed performance measures to how people are compensated can prove to be disastrous. For example: “When Improvement Isn’t Better” (page 452)

• A fast-food chain gave lip service to many objectives, but what senior managers watched most rigorously was how much chicken its restaurants had thrown away. What happened?

• Restaurants hit their targets for waste by not cooking chicken until somebody ordered it. Customer might have to wait 20 minutes for their meal, and would probably never come back – but the restaurants hit their targets for waste minimization.

B. The balanced scorecard – an example

i. Assume that Jaguar pursues a strategy as shown

on this slide. Examples of measures that Jaguar might select with their corresponding cause-and-effect linkages include:

1. If “employee skills in installing options”

increases, then the “number of options available” should increase and the “time to install an option” should decrease.

2. If the “number of options available” increases and the “time to install an

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option” decreases, then “customer surveys: satisfaction with options available” should increase.

3. If the “customer surveys: satisfaction with options available” increases, then the “number of cars sold” should increase.

4. If the “time to install an option” decreases and the “customer surveys: satisfaction with options available” increases, then the “contribution margin per car” should increase.

5. If the “number of cars sold” and the “contribution margin per car” increase, then the “profit” should increase.

ii. Advantages of graphic feedback

1. When interpreting its performance, Jaguar

will be looking for a trend of continual improvement. These trends are better identified with graphic feedback. For example:

a. Assume that Jaguar’s “time to install

an option” performance over 10 weeks is as shown.

b. It is much easier to spot trends or unusual performance if this data is presented graphically as shown.

“In Business Insights” Graphic feedback is frequently used by companies to convey balanced scorecard measures to employees. These “dashboards” may rely on representations of

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gauges and digital readouts to quickly and clearly convey information. For example: “A Picture is Worth a Thousand Numbers” (page 456)

• Beverage Can Americas Co. in Chicago is rolling out executive dashboards and scorecards to thousands of its employees.

• Each worker sees a handful of metrics that pertain to his or her job, which are represented as green, yellow, or red icons depending on whether they are satisfactory, borderline, or subpar.

C. Some measures of internal business process

performance

i. Delivery cycle time is the elapsed time from when a customer order is received to when the completed order is shipped.

ii. Throughput (manufacturing cycle) time is the

amount of time required to turn raw materials into completed products.

1. This includes process time, inspection

time, move time, and queue time. Process time is the only value-added activity of the four mentioned.

iii. Manufacturing cycle efficiency (MCE) is

computed by dividing value-added time by throughput time.

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1. An MCE less than 1.0 indicates that non-value-added time is present in the production process.

“In Business Insights” It is common for companies to have very low manufacturing cycle efficiencies. For example: “Expediting Loan Applications” (page 458)

• A manager at one bank wondered why it took so long to process a mortgage loan application. So, he asked employees to keep track of how much time they actually worked on processing an application.

• He discovered that processing an application took an average of 26 days, but only about 15 minutes of this time was actual work. The manufacturing cycle efficiency was therefore only 0.0004.

• By redesigning and automating the process, the cycle time was cut down to 15 minutes and the MCE rose to 1.0.

Quick Check – internal business process measures

X. Appendix 10A: general ledger entries to record variances

A. Glacier Peak Outfitters – revisited

i. Direct materials variances

1. The entry to record the purchase of direct

materials would be as shown.

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2. The entry to record the materials quantity variance would be as shown.

ii. Direct labor variances

1. The journal entry to record the incurrence of direct labor cost would be as shown.

iii. Variable manufacturing overhead

1. These variances are usually not recorded in

the accounts separately but rather are determined as part of the general analysis of overhead, which is discussed in the next chapter.

iv. Cost flows in a standard cost system

1. The entries into the various accounts are made at standard cost – not actual cost.

2. The differences between actual and standard costs are entered into special accounts that accumulate the various standard cost variances.

3. The standard cost variance accounts are usually closed out to Cost of Goods Sold at the end of the period. Unfavorable variances increase Cost of Goods Sold, and favorable variances decrease Cost of Goods Sold.

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TM 10-1


AGENDA: STANDARD COSTS AND THE BALANCED SCORECARD

A. Standard costs

1. Setting standard costs

a. Ideal vs. practical standards

b. Direct materials standards

c. Direct labor standards

d. Variable manufacturing overhead standards

2. Standard cost card

3. Computing variances

a. The general variance model

b. Direct materials variances

c. Direct labor variances

d. Variable manufacturing overhead variances

4. (Appendix) Journal entries for variances

5. Potential problems with standard costs

B. The balanced scorecard.

1. The general approach

2. Specific measures of internal business process performance

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TM 10-2


SETTING STANDARD COSTS

• A standard is a benchmark or “norm” for measuring performance.

• Price standard: How much an input should cost.

• Quantity standard: How much of a given input should be used to make a unit of output.

IDEAL VS. PRACTICAL STANDARDS

Ideal standards allow for no machine breakdowns or work interruptions, and can be attained only by working at peak effort 100% of the time. Such standards:

• often discourage workers.

• shouldn’t be used for decision making.

Practical standards allow for “normal” down time, employee rest periods, and the like. Such standards:

• are felt to motivate employees, since the standards are “tight but attainable.”

• are useful for decision-making purposes, since variances from standard will contain only “abnormal” elements.

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TM 10-3


DIRECT MATERIAL STANDARDS

Speeds, Inc. makes a popular jogging suit. The company wants to develop standards for material, labor, and variable manufacturing overhead.

The standard price per unit for direct materials should be the final, delivered cost of materials. The standard price should reflect:

• Specified quality of materials.

• Discounts for quantity purchases.

• Discounts for early payment, if any.

• Transportation (freight) costs.

• Receiving and handling costs.

EXAMPLE: A material known as verilon is used in the jogging suits. The standard price for a yard of verilon is determined as follows:

Purchase price, grade A verilon.................. $5.70 Less purchase discount in 20,000 yard lots . (0.20) Shipping by truck...................................... 0.40 Receiving and handling ............................. 0.10 Standard price per yard............................. $6.00

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TM 10-4


DIRECT MATERIAL STANDARDS (cont’d)

The standard quantity per unit for direct materials is the amount of material that should go into each finished unit of product. The standard quantity should reflect:

• Engineered (bill of materials) requirements.

• Expected spoilage of raw materials.

• Unavoidable waste of materials in the production process.

• Materials in expected scrapped units (rejects).

EXAMPLE: The standard quantity of verilon in one jogging suit is computed as follows:

Bill of materials requirement ............ 2.8 yardsAllowance for waste........................ 0.6 yardsAllowance for rejects....................... 0.1 yardsStandard quantity per jogging suit ... 3.5 yards

Once the price and quantity standards have been set, the standard cost of materials (verilon) for one unit of finished product can be computed:

3.5 yards per jogging suit × $6 per yard = $21 per jogging suit

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TM 10-5


DIRECT LABOR STANDARDS

The standard rate per hour for direct labor should include all the costs of direct labor workers, including:

• Hourly wage rates.

• Fringe benefits.

• Employment taxes.

Many companies prepare a single standard rate for all employees in a department, based on the expected mix of high and low wage rate employees. This procedure:

• Simplifies the use of standard costs

• Allows monitoring the actual mix of employees in the department

EXAMPLE: The standard rate per hour for the expected labor mix is determined by using average wage rates, fringe benefits, and employment taxes as follows:

Average wage rate per hour .............. $13Average fringe benefits ..................... 4Average employment taxes ............... 1Standard rate per direct labor-hour .... $18

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TM 10-6


DIRECT LABOR STANDARDS (cont’d)

The standard hours per unit for direct labor specifies the amount of direct labor time required to complete one unit of product. This standard time should include:

• Engineered labor time per unit.

• Allowance for breaks, personal needs, and cleanup.

• Allowance for setup and other machine downtime.

• Allowance for rejects.

EXAMPLE: The standard hours required to produce a jogging suit are determined as follows:

Basic labor time per unit................... 1.4 hoursAllowance for breaks and cleanup ..... 0.1 hoursAllowance for setup and downtime.... 0.3 hoursAllowance for rejects........................ 0.2 hoursStandard hours per jogging suit ........ 2.0 hours

Once the time and rate standards have been set, the standard cost of labor for one unit of product can be computed:

2.0 hours per jogging suit × $18 per hour = $36 per jogging suit.

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TM 10-7


VARIABLE OVERHEAD STANDARDS

There may be standards for variable overhead, as well as for direct materials and direct labor. The standards are typically expressed in terms of a “rate” and “hours,” much like direct labor.

• The “rate” is the variable portion of the predetermined overhead rate.

• The “hours” represent whatever base is used to apply overhead cost to products. Ordinarily, this would be direct labor-hours or machine-hours.

EXAMPLE: Speeds, Inc. applies overhead cost to products on the basis of direct labor-hours. The variable portion of the predetermined overhead rate is $4 per direct labor-hour. Using this rate, the standard cost of variable overhead for one unit of product is:

2.0 hours per jogging suit × $4 per hour = $8 per jogging suit.

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TM 10-8


STANDARD COST CARD

After standards have been set for materials, labor, and overhead, a standard cost card is prepared. The standard cost card indicates what the cost should be for a completed unit of product.

EXAMPLE: Referring back to the standard costs computed for materials, labor, and overhead, the standard cost for one jogging suit would be:

Standard Cost Card for Jogging Suits

(1 ) Standard Quantity or Hours

(2) Standard

Price or Rate

(1) × (2)

StandardCost

Direct materials ..................... 3.5 yards $6 per yard $21 Direct labor ........................... 2.0 hours $18 per hour 36 Variable manufacturing

overhead ............................ 2.0 hours $4 per hour 8 Total standard cost per suit .... $65

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TM 10-9


THE GENERAL VARIANCE MODEL

(Exhibit 10-3)

The standard quantity allowed (standard hours allowed in the case of labor and overhead) is the amount of materials (or labor) that should have been used to complete the output of the period.

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TM 10-10


DIRECT MATERIAL VARIANCES

To illustrate variance analysis, refer to the standard cost card for Speeds, Inc.’s jogging suit. The following data are for last month’s production:

Number of suits completed............. 5,000 units Cost of material purchased

(20,000 yards × $5.40 per yard) .. $108,000 Yards of material used ................... 20,000 yards

Using these data and the data from the standard cost card, the material price and quantity variances are:

Actual Quantity of Input, at Actual Price

Actual Quantity of Input, at

Standard Price

Standard Quantity Allowed for Output, at Standard Price

(AQ × AP) (AQ × SP) (SQ × SP) 20,000 yards ×

$5.40 per yard 20,000 yards ×

$6.00 per yard 17,500 yards* ×

$6.00 per yard = $108,000 = $120,000 = $105,000

↑ ↑ ↑

Price Variance, $12,000 F

Quantity Variance, $15,000 U

Total Variance, $3,000 U

* 5,000 suits × 3.5 yards per suit = 17,500 yards F = Favorable U = Unfavorable

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TM 10-11


DIRECT MATERIAL VARIANCES (cont’d)

The direct material variances can also be computed as follows:

MATERIAL PRICE VARIANCE:

• Method one: MPV = (AQ × AP) – (AQ × SP)

= ($108, 000) – (20,000 yards × $6.00 per yard)

= $12,000 F

• Method two: MPV = AQ (AP – SP)

= 20,000 yards ($5.40 per yard – $6.00 per yard)

= $12,000 F

The material price variance should be recorded at the time materials are purchased. This permits:

• Early recognition of the variance.

• Recording materials at standard cost.

MATERIAL QUANTITY VARIANCE:

• Method one: MQV = (AQ × SP) – (SQ × SP)

= (20,000 yards × $6.00 per yard) – (17,500 yards* × $6.00 per yard)

= $15,000 U

*5,000 suits × 3.5 yards per suit = 17,500 standard yards

• Method two: MQV = SP (AQ – SQ)

= $6.00 per yard (20,000 yards – 17,500 yards)

= $15,000 U

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TM 10-12


DIRECT LABOR VARIANCES

The following data are for last month’s production:

Number of suits completed (as before)............... 5,000 unitsCost of direct labor

(10,500 hours @ $20 per hour)....................... $210,000

Using these data and the data from the standard cost card, the labor rate and efficiency variances are:

Actual Hours of Input, at the

Actual Rate

Actual Hours of Input, at the Standard Rate

Standard Hours Allowed for Output, at the Standard Rate

(AH × AR) (AH × SR) (SH × SR) 10,500 hours ×

$20 per hour 10,500 hours ×

$18 per hour 10,000 hours* ×

$18 per hour = $210,000 = $189,000 = $180,000

↑ ↑ ↑

Rate Variance, $21,000 U

Efficiency Variance, $9,000 U

Total Variance, $30,000 U

* 5,000 suits × 2.0 hours per suit = 10,000 hours. F = Favorable U = Unfavorable

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TM 10-13


DIRECT LABOR VARIANCES (cont’d)

The direct labor variances can also be computed as follows:

LABOR RATE VARIANCE:

• Method one: LRV = (AH × AR) – (AH × SR)

= ($210,000) – (10,500 hours × $18 per hour)

= $21,000 U

• Method two:

LRV = AH (AR – SR)

= 10,500 hours ($20 per hour – $18 per hour)

= $21,000 U

LABOR EFFICIENCY VARIANCE:

• Method one:

LEV = (AH × SR) – (SH × SR)

= (10,500 hours × $18 per hour)

– (10,000 hours* × $18 per hour)

= $9,000 U

*5,000 suits × 2.0 hours per suit = 10,000 hours

• Method two: LEV = SR (AH – SH)

= $18 per hour (10,500 hours – 10,000 hours)

= $9,000 U

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TM 10-14


VARIABLE MANUFACTURING OVERHEAD VARIANCES

The following data are for last month’s production:

Number of suits completed (as before)...... 5,000 units Actual direct labor-hours (as before) ......... 10,500 hours Variable overhead costs incurred .............. $40,950

Using these data and the data from the standard cost card, the variable overhead variances are:


Actual Rate

Actual Hours of Input, at the Standard Rate


(AH × AR) (AH × SR) (SH × SR) 10,500 hours ×

$4 per hour 10,000 hours* ×

$4 per hour $40,950 = $42,000 = $40,000

↑ ↑ ↑

Spending Variance, $1,050 F


Total Variance, $950 U

* 5,000 suits × 2.0 hours per suit = 10,000 hours. F = Favorable U = Unfavorable

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TM 10-15


VARIABLE OVERHEAD VARIANCES (cont’d)

The variable manufacturing overhead variances can also be computed as follows:

OVERHEAD SPENDING VARIANCE:

• Method one: VOSV = (AH × AR) – (AH × SR)

= ($40,950) – (10,500 hours × $4.00 per hour)

= $1,050 F

• Method two: VOSV = AH (AR – SR)

= 10,500 hours ($3.90 per hour* – $4.00 per hour)

= $1,050 F

* $40,950 ÷ 10,500 hours = $3.90 per hour

OVERHEAD EFFICIENCY VARIANCE:

• Method one:

VOEV = (AH × SR) – (SH × SR)

= (10,500 hours × $4.00 per hour)

– (10,000 hours** × $4.00 per hour)

= $2,000 U

** 5,000 suits × 2.0 hours per suit = 10,000 hours

• Method two:

VOEV = SR (AH – SH)

= $4.00 per hour (10,500 hours – 10,000 hours)

= $2,000 U

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JOURNAL ENTRIES FOR VARIANCES (Appendix)

Materials, work-in-process, and finished goods are all carried in inventory at their respective standard costs in a standard costing system.

Purchase of materials:

Raw Materials (20,000 yards × $6.00 per yard)......... 120,000 Materials Price Variance (20,000 yards × $0.60 per yard F) ................... 12,000 Accounts Payable (20,000 yards × $5.40 per yard)...................... 108,000

Use of materials:

Work-In-Process (17,500 yards × $6 per yard).......... 105,000 Materials Quantity Variance (2,500 yards U × $6 per yard) ............................... 15,000 Raw Materials (20,000 yards × $6 per yard) ....... 120,000

Direct labor cost:

Work-In-Process (10,000 hours × $18 per hour) ....... 180,000 Labor Rate Variance (10,500 hours × $2 per hour U). 21,000 Labor Efficiency Variance (500 hours U × $18 per hour)................................ 9,000 Wages Payable (10,500 hours × $20 per hour) ... 210,000

Note: Favorable variances are credit entries and unfavorable variances are debit entries.

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POTENTIAL PROBLEMS WITH STANDARD COSTS

• Variances are often reported too late to be useful.

• If used as a tool for punishing people, standards can undermine morale.

• Labor efficiency standards encourage high output. This may lead to excessive work-in-process if a workstation is not a bottleneck.

• A favorable quantity variance may be worse than an unfavorable quantity variance.

• Quality may suffer if undue emphasis is placed on just meeting the standards.

• Just meeting standards may not be sufficient; continual improvement is often necessary.

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THE BALANCED SCORECARD

• A balanced scorecard consists of an integrated set of performance measures—financial and non-financial—that are derived from the company’s strategy and that support the company’s strategy throughout the organization.

• Financial measures tend to be lagging indicators of performance.

• Because strategies and operating environments are different, each company’s balanced scorecard will be different.

• A variety of different performance measures helps guard against potential problems that result from over-reliance on one performance measure. However, too many performance measures may lead to a lack of focus.

• The emphasis is on continuous improvement rather than on meeting some preset target or standard.

• An individual should be able to strongly influence the performance measures that appear on his or her scorecard.

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THE BALANCED SCORECARD (cont’d)

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The performance measures on the company’s balanced scorecard should tell a coherent story of the cause and effect links that lead from actions by individuals to the objectives of the organization.

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SOME IMPORTANT MEASURES OF INTERNAL BUSINESS PROCESS PERFORMANCE

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MANUFACTURING CYCLE EFFICIENCY

Manufacturing cycle efficiency (MCE) is a measure of how much throughput time actually adds value. MCE is defined by:

Value-added time Process timeMCE= =

Throughput time Throughput time

If the MCE is less than 1, the production process contains “non-value-added” time.

An MCE of 0.4 indicates that 60% (1.0 – 0.4 = 0.6) of the total production time consists of queuing, inspection, and move time, and therefore only 40% of the total time is productive.

Reducing the non-value-added activities of queuing, inspection, and moving will lead to improvement in MCE.

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Chapter 11

Flexible Budgets and Overhead Analysis Learning Objectives LO1. Prepare a flexible budget and explain the advantages of the flexible budget approach

over the static budget approach. LO2. Prepare a performance report for both variable and fixed overhead costs using the

flexible budget approach. LO3. Use the flexible budget to prepare a variable overhead performance report containing

only a spending variance. LO4. Use the flexible budget to prepare a variable overhead performance report containing

both a spending and an efficiency variance LO5. Compute the predetermined overhead rate and apply overhead to products in a standard

cost system. LO6. Compute and interpret the fixed overhead budget and volume variances.

New in this Edition • New exercises have been added, each of which focuses on a single learning objective. Chapter Overview A. Static Budgets. (Exercise 11-8.) The term static budget refers to the budget that is set at the beginning of a budgeting period and that is geared to only one level of activity—the budgeted level of activity. 1. What Is Wrong with a Static Budget? The static budget is appropriate for the budgeted

level of activity but is not realistic for other levels of activity—particularly if variable costs are significant. If activity is 10% higher than budgeted, then some costs are likely to be 10% higher than budgeted as well.

2. Static Budgets and Performance Reports. Unfortunately, managers are commonly held

responsible for deviations of actual from budgeted costs. This approach confuses two different aspects of control—control over the level of activity and control over the effective use of resources.

3. Why Do Actual Costs Deviate from Budgeted Costs? Actual costs deviate from

budgeted costs for many reasons. The two most important are: i) the actual level of activity differs from the budgeted level of activity and ii) the manager’s use of resources was more or less effective than assumed in the budget. That is, a variance between actual and

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budgeted costs can be due to a change in activity level or to effective or ineffective cost control.

4. Static Budget Comparisons Commingle Effects. If the actual level of activity differs

greatly from the budgeted level, most of the variance for variable costs will almost certainly be due to the change in activity level. The variance would then be an extremely noisy indicator of how well a manager controlled costs. And at any rate, the variance between actual and budgeted costs commingles effects due to changes in activity levels and due to how well costs were controlled given the level of activity. If a manager is responsible for the level of activity, control over that aspect of the manager’s responsibility should be separated from control over costs. And if a manager is not responsible for the level of activity, it is even clearer that the two effects must be disentangled to have a meaningful report. The key to resolving this problem is the use of flexible budgets.

B. Flexible Budgets. (Exercises 11-1, 11-7, 11-8.) A flexible budget is geared to all levels of activity within the relevant range and is used to plan and control spending. The flexible budget will show the cost formula for each variable cost and total cost (possibly including fixed costs) at various levels of activity.

C. Overhead Performance Report. (Exercises 11-2, 11-3, 11-4, 11-9, 11-10, 11-11.) When the actual level of activity differs from what had been assumed in the static budget at the beginning of the period, we would expect the spending to differ as well. A good overhead performance report compares actual costs to the flexible budget for the actual level of activity. Since spending in at least some categories should vary with activity, this is the only way to build a reasonable benchmark for what the spending should be. D. Complications when Activity Is Measured In Hours. When a company makes a number of different products, a unit of one product may require different overhead resources than a unit of another product. In that situation, adding together units of output from different products is like adding apples and oranges. Some other measure of activity should be used. 1. The measure of activity. Three factors should be considered in selecting an activity base

for a flexible budget. a. The activity base and overhead costs should be causally related. The activity measure

should actually drive the overhead costs. Direct labor-hours is often used as the measure of activity, but this practice has come under increasing criticism. As discussed in conjunction with activity-based costing, the links between direct labor-hours and overhead seem to be getting more tenuous.

b. The activity measure should not be stated in dollars. If the activity measure is stated in

dollars, then changes in prices may be interpreted as changes in activity. c. The activity base should be simple and easily understood.

2. Actual versus standard hours allowed and variable overhead variances. When an input

such as direct labor-hours or machine-hours is used as the measure of activity, the question arises whether actual hours or the standard hours allowed for the actual output should be used as the measure of activity in performance reports. The following discussion assumes

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that overhead spending is highly correlated with actual hours; that is, actual hours drives overhead costs.

a. Actual Hours. When actual hours are used as the basis for the flexible budget

allowance, only a spending variance can be computed for variable overhead. The variable overhead spending variance is the difference between the actual variable overhead cost and the budget allowance that is determined by multiplying the actual hours by the variable overhead rate per hour. A spending variance occurs because prices differ from those assumed in the flexible budget, because of effective or ineffective control of overhead resources, or because of inaccuracies in the flexible budgets themselves. The variable overhead spending variance basically combines price and quantity variances in one variance. Exhibit YY-6 in the text presents an example of a variable overhead performance report where the budget is based on actual hours.

b. Standard Hours Allowed. The standard hours allowed could also be used as a measure

of activity in a performance report. However, in this case it is best to compute two variances rather than just one. The first variance is the variable overhead spending variance based on the actual hours. The second variance is the variable overhead efficiency variance based on the difference between the actual hours and the standard hours allowed for the actual output of the period. The mechanics of these two variances were covered in Chapter 10.

The variable overhead efficiency variance attempts to estimate the indirect effects on variable overhead costs of efficient or inefficient use of the activity base. If too many hours are used to produce the actual output, then presumably this results in additional variable overhead costs. (Remember the assumption that variable overhead costs are really proportional to actual hours.) Exhibit YY-7 in the text presents an example of a variable overhead performance report where both spending and efficiency variances are computed for variable overhead.

E. Predetermined Overhead Rates (Exercises 11-5, 11-12, 11-14, 11-15.) Predetermined overhead rates were discussed in earlier chapters, so this is largely a review. The formula for the predetermined overhead rate used in this chapter is:

Overhead from the flexible budget at the denominator level of activityPredeterminedoverhead rate Denominator level of activity

=

Separate predetermined rates can be computed for variable and fixed overhead by including only variable or fixed overhead costs in the numerator. When overhead is fixed, the predetermined overhead rate will depend on the denominator level of activity. The higher the level of activity is, the lower the rate will be. F. Applying Overhead in a Standard Cost System. Overhead can be applied to units based on actual hours or on standard hours allowed for the actual output. In a standard cost system overhead is applied on the basis of the standard hours allowed for the actual output. This results in each unit being assigned the same overhead cost—regardless of how many hours were actually required to make the unit. G. Fixed Overhead Variances in a Standard Cost System. (Exercises 11-6, 11-13, 11-14, 11-15, 11-16.) Two variances are computed for fixed overhead—a budget variance and a

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volume variance. These variances are quite different from the variances computed for variable overhead. 1. Budget Variance. The budget variance is the difference between the actual fixed overhead

costs incurred during the period and the budgeted fixed overhead costs contained in the flexible budget. This variance is very useful in that it indicates how well spending on fixed items was controlled.

Students are often confused about the controllability of fixed costs. Contrary to intuition, fixed costs are often far easier to control than variable costs. For example, it is usually much easier to control spending on convention travel (a fixed cost) than on direct materials. The term fixed does not mean the cost can’t change. A fixed cost can change and it may depend on a number of factors; however, it does not depend on the level of activity during the period.

2. Volume Variance. The volume variance is the difference between the total budgeted fixed

overhead and the fixed overhead applied to production. Alternatively, it can be expressed as follows:

( )Fixed portion ofVolume Denominator Standard hours allowedthe predeterminedvariance hours for the actual outputoverhead rate= −

The volume variance occurs because the denominator level of activity differs from the

standard hours allowed for production. Thus, an unfavorable variance means that the company operated at an activity level below the denominator level of activity. Conversely, a favorable variance means that the company operated at an activity level greater than the denominator level of activity. Some would call the volume variance a measure of the utilization of plant facilities relative to the planned utilization. Others who are less charitable would call it the error that is induced in the costing system by assuming that fixed costs are variable.

H. Under- and Overapplied Overhead. The sum of the four manufacturing overhead variances—variable overhead spending, variable overhead efficiency, fixed overhead budget, and fixed overhead volume—equals the under- or overapplied overhead for the period. 1. The sum of the variances equals under- or overapplied overhead. The four overhead

variances measure the difference between actual overhead costs incurred and the standard overhead cost for the actual output. The under- or overapplied overhead measures the difference between actual overhead costs incurred and the overhead applied to inventory. In a standard cost system the amount of overhead cost applied to inventory is the standard cost, so the variances and the under- or overapplied inventory measure the same thing. Therefore, they must sum to the same number.

2. Underapplied overhead is equivalent to an unfavorable variance. If overhead is

underapplied, more overhead cost was incurred than was applied to inventory. The amount applied to inventory is the standard cost allowed for the actual output. Therefore, if overhead is underapplied, more overhead cost was incurred than was allowed for the actual output—hence, the overall variance is unfavorable. Similar reasoning leads to the conclusion that overapplied overhead is equivalent to a favorable variance.

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Time Exercise 11-1 Prepare a flexible budget .......................................................... Basic 15 min. Exercise 11-2 Preparing a flexible budget performance report ....................... Basic 15 min. Exercise 11-3 Variable overhead performance report with just a spending

variance................................................................................ Basic 15 min. Exercise 11-4 Variable overhead performance report with both spending

and efficiency variances ...................................................... Basic 20 min. Exercise 11-5 Applying overhead in a standard costing system ..................... Basic 15 min. Exercise 11-6 Fixed overhead variances ......................................................... Basic 15 min. Exercise 11-7 Preparing a flexible budget....................................................... Basic 15 min. Exercise 11-8 Using a flexible budget............................................................. Basic 10 min. Exercise 11-9 Flexible budget performance report ......................................... Basic 15 min. Exercise 11-10 Variable overhead performance report ..................................... Basic 20 min. Exercise 11-11 Variable overhead performance report with both spending

and efficiency variances ...................................................... Basic 15 min. Exercise 11-12 Predetermined overhead rate .................................................... Basic 15 min. Exercise 11-13 Using fixed overhead variances................................................ Basic 15 min. Exercise 11-14 Predetermined overhead rate; overhead variances ................... Basic 20 min. Exercise 11-15 Relations among fixed overhead variances .............................. Basic 15 min. Exercise 11-16 Fixed overhead variances ......................................................... Basic 10 min. Problem 11-17 Applying the flexible budget approach .................................... Basic 30 min. Problem 11-18 Comprehensive standard cost variances ................................... Basic 45 min. Problem 11-19 Comprehensive standard cost variances ................................... Basic 30 min. Problem 11-20 Preparing an overhead performance report .............................. Basic 30 min. Problem 11-21 Applying overhead; overhead variances................................... Basic 45 min. Problem 11-22 Flexible budget and overhead analysis..................................... Medium 45 min. Problem 11-23 Evaluating an overhead performance report............................. Medium 30 min. Problem 11-24 Variable overhead performance report ..................................... Medium 20 min. Problem 11-25 Standard cost card; fixed overhead analysis; graphing ............ Medium 45 min. Problem 11-26 Comprehensive problem; flexible budget; overhead

performance report .............................................................. Medium 45 min. Problem 11-27 Applying overhead; overhead variances................................... Medium 45 min. Problem 11-28 Flexible budget and overhead performance report ................... Medium 30 min. Problem 11-29 Selection of a denominator; overhead analysis; standard cost

card ...................................................................................... Medium 45 min. Problem 11-30 Activity-based costing and the flexible budget approach......... Difficult 60 min. Case 11-31 Ethics and the manager............................................................. Medium 30 min. Case 11-32 Preparing a performance report using activity-based costing... Difficult 45 min. Case 11-33 Working backwards from variance data................................... Difficult 60 min. Case 11-34 Comprehensive variance analysis; incomplete data ................. Difficult 90 min.

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Essential Problems: Problem 11-18 or Problem 11-19, Problem 11-20 or Problem 11-23, Problem 11-21 or Problem 11-22.

Supplementary Problems: Problem 11-17, Problem 11-24, Problem 11-25, Problem 11-26, Problem 11-27, Problem 11-28, Problem 11-29, Problem 11-30 or Case 11-32, Case 11-31, Case 11-33, Case 11-34.

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Helpful Hint: Before beginning the lecture, show students the 12th and 13th segments from the second tape of the McGraw-Hill/Irwin Managerial/Cost Accounting video library. These segments introduce students to many of the concepts discussed in chapter 11. The lecture notes reinforce the concepts introduced in the video.

Chapter theme: This chapter expands the study of overhead variances that was started in Chapter 10. It also explains how flexible budgets can be used to control variable and fixed overhead costs.

“In Business Insights” Overhead costs are increasing for many organizations; consequently, controlling overhead costs is becoming a topic of growing importance. For example: “Focus on Overhead Costs” (page 492)

• A published study shows that overhead costs now account for as much as 66% of the costs incurred by companies in service industries and up to 37% of the total costs of manufacturers.

• As companies seek to reduce these overhead costs, they must avoid cutting costs that add value to the organization in the form of improved product or service quality.

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I. Flexible budgets

A. Key definitions:

i. A static budget is prepared at the beginning of the budgeting period and is valid for only the planned level of activity. It is suitable for planning, but it is inadequate for evaluating how well costs are controlled because: 1. The actual level of activity is unlikely to

equal the planned level of activity, thus resulting in “apples-to-oranges” cost comparisons.

ii. A flexible budget provides estimates of what

costs should be for any level of activity within a specified range. When used for performance evaluation purposes, actual costs are compared to what the costs should have been for the actual level of activity during the period. This enables “apples-to-apples” cost comparisons.

B. Deficiencies of the static budget

Helpful Hint: Before beginning this discussion, ask students to put themselves in the shoes of a production manager for a toy company that had a runaway hit for the Christmas season. By adding an extra shift and working very hard, the factory was able to produce enough toys to satisfy unexpected customer demand. Then, at the end of the year, the manager was confronted with an unfavorable variance report because more money was spent in the factory than had

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been budgeted at the beginning of the year. Ask students how they would respond.

i. CheeseCo – an example

1. Assume that CheeseCo prepared the static budget as shown. Notice:

a. The budget is based on an activity level of 10,000 machine hours.

2. Assume that the actual results for the period were as shown. Notice:

a. Only 8,000 machine hours were actually worked, thus resulting in “apples-to-oranges” comparisons with the static budget.

3. The variances between the static budget and actual results would be as shown. Notice:

a. The machine hour variance is 2,000 unfavorable because CheeseCo was unable to achieve the budgeted level of activity.

b. All of the variable overhead cost variances are favorable because actual costs were less than budgeted costs.

4. These favorable variances beg the question – Has CheeseCo done a good job of controlling costs?

a. The answer is unclear because the actual activity level (8,000 machine hours) does not equal the budgeted activity level (10,000 machine hours).

5. This raises an additional question, namely – How much of the favorable cost variance is due to lower activity, and how much is

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due to good cost control? To answer this question, we must “flex” the budget.

C. How a flexible budget works

i. Key assumptions:

1. Total variable costs change in direct proportion to changes in activity.

2. Total fixed costs remain unchanged within a specified activity range.

“In Business Insights” Understanding the difference between variable and fixed costs is important to organizations. For example: “Know Your Costs” (page 504)

• Kennard Wing of the OMG Center for Collaborative Learning, reports that a large health care system made the mistake of classifying all of its costs as variable.

• As a consequence, when volume dropped, managers felt that costs should be cut proportionately and more than 1,000 people were laid off – even though the workload of most of them had no direct relation to patient volume.

• The result was that morale plummeted and within a year the system was scrambling to replace not only those it had let go, but many others who had quit.

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ii. The CheeseCo example – continued

1. The key to preparing a flexible budget is to specify the amount of each variable cost per unit of activity. Notice:

a. Indirect labor is $4.00 per machine

hour, indirect material is $3.00 per machine hour, and power is $0.50 per machine hour.

• We can verify these numbers by dividing the total cost according to the static budget by the total amount of the activity per the static budget.

b. While variable costs are expressed per unit of activity, fixed costs are not. They are expressed as a total amount.

2. The flexible budget for an activity level of 8,000 machine hours would be prepared as follows:

a. Multiply the cost per hour for each type of variable cost by the activity level of 8,000 hours.

• In the case of indirect labor, multiply $4.00 per hour by 8,000 hours to yield a budgeted amount of $32,000.

b. Add the fixed costs, which remain unchanged, to yield a total overhead of $74,000.

3. The flexible budget at 10,000 hours of activity is $89,000. This equals the amount from the static budget that was presented earlier in this example.

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a. Notice, the total variable costs did change (compared to the flexible budget at 8,000 hours), while the total fixed costs did not change.

Quick Check – preparing a flexible budget

4. The flexible budget at 12,000 hours is as shown. The answer to the Quick Check of $104,000 is shown in the bottom right-hand corner.

D. Using flexible budgets for performance evaluation

i. The CheeseCo example – continued

1. Recall from earlier in our example that CheeseCo’s actual activity level was 8,000 machine hours and its actual costs were as shown.

2. To enable an “apples-to-apples” comparison, a flexible budget based on an activity level of 8,000 machine hours should be used to calculate variances that will be used to evaluate performance.

Quick Check – variance calculations

3. As shown in the solution to the Quick Check question, the indirect labor variance is $2,000 U.

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Quick Check – variance calculations

4. As shown in the Quick Check question, the indirect material and power variances are $1,500 U and $200 F. In addition, the fixed cost variances for Depreciation and Insurance are $0 and $50U, respectively.

5. The flexible budget that we just prepared enables us to answer the previously posed question – “How much of the total variance is due to lower activity and how much is due to cost control?”

a. Recall from our “apples-to-oranges” comparison that was done earlier, that CheeseCo’s static budget variance was $11,650 F.

b. This difference of $11,650 can be depicted pictorially as shown.

c. If we insert the flexible budget at 8,000 machine hours in the middle of this diagram, it enables us to compute two variances that answer the aforementioned question.

• $15,000 F is due to a lower activity level.

• $3,350 U is due to poor cost control.

• These two amounts net to $11,650 F.

“In Business Insights” The focus of variance analysis inquiry should just be on unfavorable variances, rather favorable variances

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should also be examined to enable organizational learning. For example: “Focus on Opportunities” (page 497)

• Management guru Peter Drucker cautions managers that “almost without exception, the first page of the monthly report presents areas in which results fall below expectations or in which expenditures exceed the budget.”

• Drucker suggests that a new first page be created for monthly reports that focuses on where results are better than expected. He contends that while problems cannot be ignored, enterprises have to focus on opportunities.

E. The measure of activity – a critical choice

i. At least three factors are important in

selecting an activity base for an overhead flexible budget.

1. The activity base and variable overhead

costs should be causally related. 2. The activity base should not be expressed

in dollars or other currency. a. For example, direct labor cost is

usually a poor choice for an activity base because changes in wage rates do not result in proportionate changes in overhead.

3. The activity base should be simple and easily understood.

Helpful Hint: Compare a carpentry shop with an almost fully automated process such as beverage production,

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where machine-hours would be a more appropriate activity base.

II. Variable overhead variances – a closer look

A. Actual versus standard hours

i. When the flexible budget is based on hours of

activity, the quantity of hours chosen can be based on actual hours or the standard hours allowed for the actual output.

1. If the actual hours are used, only a spending

variance can be computed. 2. If both the actual and standard hours are

used, both a spending and an efficiency variance can be computed.

B. ColaCo – an example

i. Assume the following:

1. ColaCo’s actual production for the period

required 3,200 standard machine hours. 2. Actual variable costs incurred during the

period was $6,740. 3. 3,300 machine-hours were actually worked

during the period. 4. The standard variable overhead cost per

machine hour is $2.00.

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ii. Spending variance alone – using actual hours

1. The general model for calculating the

variable overhead spending variance is as shown. Notice, actual hours are used instead of standard hours allowed.

2. In the case of ColaCo, the variable overhead spending variance is $140 U.

3. This variance is useful only to the extent that the cost driver for variable overhead really is the actual machine hours worked.

4. This variance contains price and quantity components.

a. The unfavorable variance may be due to the variable overhead items costing more to purchase than the standards allow.

b. The unfavorable variance may be due to using more of the variable overhead items than the standards allow.

iii. Both spending and efficiency variances –

using actual and standard hours

1. The general model for calculating the variable overhead efficiency variance is now shown in addition to the spending variance. Notice, standard hours allowed is used to compute the efficiency variance.

2. If both actual hours and the standard hours allowed are used (in essence computing two sets of budget allowances), it results in a spending variance of $140 U, an efficiency

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variance of $200 U, and a total variance of $340 U.

a. Notice, the spending variance has not changed from the prior scenario. Rather, we have just added an efficiency variance.

3. The efficiency variance is useful only to the extent that the cost driver for variable overhead really is the actual machine hours worked.

4. The efficiency variance estimates the indirect effect on variable overhead costs of inefficiency in the use of the activity base.

c. Therefore, whoever controls the activity base is responsible for this variance.

Quick Check – variable overhead variances

C. Activity-based costing and the flexible budget

i. It is unlikely that all variable overhead costs

within a company are driven by a single factor such as the number of units produced, labor-hours, or machine-hours.

1. Activity-based costing offers a way to

recognize the presence of more than one activity base within a company. It enables a company to evaluate overhead spending for each activity cost pool that has its own respective activity measure.

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“In Business Insights” Some companies have used flexible budgeting concepts in conjunction with their activity-based costing system. For example: “Pools within Pools” (page 502)

• Caterpillar, Inc., a manufacturer of heavy equipment, is a pioneer in the development and use of activity-based costing.

• Caterpillar separates its overhead costs into three large pools – the logistics cost pool, the manufacturing cost pool, and the general cost pool.

• These three cost pools are subdivided into numerous activity centers, with each center having its own flexible budget from which variable and fixed overhead rates are developed.

II. Overhead rates and fixed overhead analysis

A. Overhead application in a standard cost system

i. Computing overhead rates

1. Overhead costs are assigned to products

using a predetermined overhead rate. The estimated total units in the base of the rate is called the denominator activity.

2. The predetermined overhead rate can be broken down into variable and fixed components.

a. As we have seen, the variable component is useful in preparing variable overhead variances.

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b. As will be shown shortly, the fixed component is useful in preparing fixed overhead variances.

ii. Normal versus standard cost systems

1. In a normal cost system (as described in

Chapter 3), overhead is applied to work in process on the basis of the actual number of hours worked.

2. In a standard cost system, overhead is applied to work in process based on the standard hours allowed for the output of the period.

iii. The general model for computing fixed

overhead variances

1. The budget variance is the actual fixed overhead cost minus the budgeted fixed overhead cost.

Helpful Hint: Some students may question why a fixed overhead cost ever has a budget variance. Stress that “fixed” means that the cost does not depend on the level of activity; “fixed” does not mean that the cost will always be the same. Even depreciation costs can differ from the budget due to premature retirements and other unanticipated events.

2. The volume variance is budgeted fixed

overhead minus the fixed overhead applied to production.

a. In equation form, it can be computed by multiplying the fixed portion of

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the predetermined overhead rate by the difference between the denominator hours and the standard hours allowed.

Helpful Hint: Students, particularly those who concentrate on mechanics, often have difficulty understanding the volume variance. The proper interpretation of the volume variance is important because in practice, volume variances are often large and may swamp other, more meaningful variances.

B. The ColaCo example – continued

i. Assume the following with respect to ColaCo’s

flexible budget, its predetermined overhead rate, and its actual operations for the period:

1. ColaCo prepared a flexible budget for two

activity levels – 3,000 and 4,000 machine hours. Its total variable and fixed overhead at these two activity levels is as shown.

2. Its variable overhead rate is constant at $2.00 per machine hour.

a. Notice, this rate agrees with the standard variable overhead cost per machine hour that was previously used in the variable overhead portion of this example.

3. Its fixed overhead rate is $3.00 per machine hour at an activity level of 3,000 machine hours, and it is $2.25 at an activity level of 4,000 machine hours.

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a. Notice, the fixed overhead rate decreases as the activity level increases.

b. The total predetermined overhead rate at either activity level would be the sum of the variable and fixed overhead rates.

4. ColaCo decided to base its predetermined overhead rate on 3,000 machine hours.

5. It required 3,200 standard machine hours to meet its actual production requirements.

6. It incurred actual fixed overhead costs of $8,450.

ii. ColaCo’s fixed overhead variances would be

computed as follows:

1. The budget variance of $550 F is computed by comparing the actual fixed overhead incurred ($8,450) to the budgeted fixed overhead ($9,000).

a. This variance represents the difference between how much should have been spent and how much was actually spent. A favorable (unfavorable) variance results when actual spending is less (more) than the budget.

2. The volume variance of $600 F is computed by comparing the budgeted fixed overhead ($9,000) to the fixed overhead applied ($9,600).

a. The fixed overhead applied is computed by multiplying the standard hours allowed for the actual output (3,200 hours) by the fixed portion of

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the predetermined overhead rate ($3.00).

b. A favorable (unfavorable) variance results when the denominator activity is less (greater) than the standard hours allowed for the output of the period.

c. This variance does not measure over- or under-spending. It is a measure of utilization of facilities.

d. In essence, this variance is the error that occurs as a result of treating fixed overhead as though it were a variable cost.

Quick Check – fixed overhead variance calculations

iii. ColaCo’s fixed overhead variances – a graphic approach

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1. The vertical axis is used to graph fixed

overhead cost. a. The first cost that ColaCo would plot

on this axis is $9,000 of budgeted fixed overhead.

2. The horizontal axis is used to graph the volume of activity.

a. The first activity level that ColaCo would plot is its denominator activity level of 3,000 machine hours.

3. The linear manner in which fixed overhead is applied to products is depicted by drawing a straight line from the origin to the intersection of the budgeted fixed overhead ($9,000) and the denominator activity (3,000 hours).

a. The slope of this line indicates that fixed overhead is applied at a rate of $3 per machine hour.

4. Next, plot the actual amount of fixed overhead costs on the vertical axis.

a. The difference between the budgeted amount of fixed overhead and the actual amount is the budget variance.

5. Finally, identify the standard hours allowed for the actual level of output (3,200 hours). Draw a vertical line from this activity level until it intersects the sloped line that depicts the fixed overhead applied to products. From this point, draw a horizontal line that intersects the vertical axis. This dollar amount ($9,600) represents the fixed overhead applied.

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a. The difference between the budgeted fixed overhead and the fixed overhead applied is the volume variance.

C. Overhead variances and under- or overapplied

overhead cost

i. In a standard cost system, the sum of the overhead variances equals the under- or overapplied overhead cost for a period.

ii. Unfavorable variances are equivalent to

underapplied overhead. iii. Favorable variances are equivalent to

overapplied overhead.

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AGENDA: FLEXIBLE BUDGETS AND OVERHEAD ANALYSIS

A. Flexible budgets and performance reports

1. Static budgets

2. Flexible budgets

3. Flexible budget overhead performance report

B. Further analysis of variable overhead

1. The choice of activity measure

2. Variable overhead spending variance

3. Variable overhead efficiency variance

C. Overhead application in a standard cost system

1. Predetermined overhead rate

2. Applying overhead

D. Fixed overhead variances

1. Budget variance

2. Volume variance

E. Overhead under- and overapplied and standard cost variances

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STATIC BUDGETS

The budgets in Chapter 9 were “static.” A static budget is created at the beginning of the budgeting period and is valid only for the budgeted level of activity.

EXAMPLE: Larch Company, which makes a single product, bases its budgets for manufacturing overhead on the following data:

Variable overhead cost category Standard

Cost Per UnitMaintenance .............................. $0.60 Indirect materials ....................... 1.40 Utilities...................................... 1.00 Total variable overhead cost ....... $3.00

Fixed overhead cost category Budgeted

Annual Cost Depreciation .............................. $ 40,000 Supervision................................ 50,000 Insurance .................................. 10,000 Total fixed overhead cost............ $100,000

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STATIC BUDGETS (cont’d)

Larch Company originally planned to produce and sell 10,000 units during the year, but actual activity was only 8,000 units. A report based on the static (i.e., original) budget from the beginning of the year follows:

Larch Company Comparison of Actual Overhead Costs

to Budgeted Overhead Costs

Original Actual Budget Variance

Units produced and sold..... 8,000 10,000 2,000 U

Variable overhead costs: Maintenance ................... $ 4,500 $ 6,000 $1,500 FIndirect materials ............ 12,000 14,000 2,000 FUtilities........................... 9,500 10,000 500 F

Total variable overhead...... 26,000 30,000 4,000 F

Fixed overhead costs: Depreciation ................... 40,000 40,000 0 Supervision..................... 49,000 50,000 1,000 FInsurance ....................... 10,000 10,000 0

Total fixed overhead .......... 99,000 100,000 1,000 F

Total overhead cost ........... $125,000 $130,000 $5,000 F

Does the above report, which is based on the original static budget, indicate whether overhead spending was under control?

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TM 11-4


FLEXIBLE BUDGETS

• A flexible budget is geared toward all levels of activity within a relevant range, rather than toward only one level of activity.

• A flexible budget is dynamic rather than static; it can be tailored for any level of activity within the relevant range.

EXAMPLE: Refer to the data for Larch Company. A flexible budget for manufacturing overhead is provided below for three different levels of activity ranging from 5,000 to 15,000 units.

Larch Company Flexible Budget for Overhead

Cost Formula Units Per Unit 5,000 10,000 15,000

Variable overhead costs: Maintenance ................. $0.60 $ 3,000 $ 6,000 $ 9,000Indirect materials .......... 1.40 7,000 14,000 21,000Utilities ......................... 1.00 5,000 10,000 15,000

Total variable overhead.... $3.00 15,000 30,000 45,000

Fixed overhead costs: Depreciation ................. 40,000 40,000 40,000Supervision................... 50,000 50,000 50,000Insurance ..................... 10,000 10,000 10,000

Total fixed overhead ........ 100,000 100,000 100,000

Total overhead cost ......... $115,000 $130,000 $145,000

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TM 11-5


OVERHEAD PERFORMANCE REPORT

In a performance report focused on cost control, actual costs should be compared to the flexible budget for the actual level of activity—not the budget for the planned level of activity.

EXAMPLE: Since Larch Company produced and sold only 8,000 units instead of the 10,000 units that had been planned, we would expect spending on variable overhead items to be less than had been planned.

Larch Company Overhead Performance Report

Actual Budget Costs Based Cost Incurred on Spending Formula 8,000 8,000 & Budget Per Unit Units Units Variances

Variable overhead costs: Maintenance ................. $0.60 $ 4,500 $ 4,800 $ 300 FIndirect materials .......... 1.40 12,000 11,200 800 UUtilities ......................... 1.00 9,500 8,000 1,500 U

Total variable overhead .... $3.00 26,000 24,000 2,000 U

Fixed overhead costs: Depreciation ................. 40,000 40,000 0 Supervision ................... 49,000 50,000 1,000 FInsurance ..................... 10,000 10,000 0

Total fixed overhead ........ 99,000 100,000 1,000 F

Total overhead cost ......... $125,000 $124,000 $1,000 U

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THE MEASURE OF ACTIVITY

• Most companies use a measure of activity such as labor-hours or machine-hours as the activity base for manufacturing overhead. This is particularly true in multi-product companies where hours often serve as a common denominator for diverse products.

• Should actual hours or standard hours allowed for the actual output be used in constructing budget allowances for the performance report? There are two approaches:

1. The budget allowance is based solely on the actual hours. Then only a spending variance for variable overhead is computed. (See Exhibit 11-6 in the text for an example.)

2. Budget allowances are based on both the actual hours and the standard hours allowed for the actual output. Then both spending and efficiency variances are computed for variable overhead. (See Exhibit 11-7 in the text for an example.)

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Variable Overhead Performance Report: Budget Allowances Based on Actual Hours

(Exhibit 11-6)

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TM 11-8


Variable Overhead Performance Report: Budget Allowances Based on Actual Hours

and Standard Hours Allowed

(Exhibit 11-7)

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OVERHEAD VARIANCE ANALYSIS

The flexible budget for manufacturing overhead provides information to:

• Compute predetermined overhead rates.

• Complete the standard cost card.

• Apply overhead cost to products.

• Prepare overhead variance reports.

EXAMPLE: Swift Company manufactures a single product. Standard cost data for the product follow:

(1) (2) Standard Standard Standard Quantity Price Cost or Hours or Rate (1) × (2)

Direct materials ..... 3.5 feet $12 per foot $42 Direct labor ........... 2.0 hours $16 per hour $32

Overhead is assigned to the product on the basis of standard direct labor-hours. Swift Company’s flexible budget for overhead (in condensed form) is given below:

Cost Direct Labor-Hours Per DLH 10,000 15,000 20,000

Variable costs ... $5 $ 50,000 $ 75,000 $100,000Fixed costs ....... 300,000 300,000 300,000Total cost......... $350,000 $375,000 $400,000

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PREDETERMINED OVERHEAD RATE

• In a standard cost system, the predetermined overhead rate is computed as follows:

Flexible budget for overhead atthe denominator level of activityPredetermined = overhead rate Denominator level of activity

EXAMPLE: The predetermined overhead rate at Swift Company is computed below for two levels of activity:

Denominator activity: 10,000 DLHs Variable element: ($50,000 ÷ 10,000 DLHs) .... $ 5 per DLHFixed element: ($300,000 ÷ 10,000 DLHs) ...... 30 per DLHPredetermined overhead rate ......................... $35 per DLH

Denominator activity: 15,000 DLHs Variable element: ($75,000 ÷ 15,000 DLHs) .... $ 5 per DLHFixed element: ($300,000 ÷ 15,000 DLHs) ...... 20 per DLHPredetermined overhead rate ......................... $25 per DLH

Note that the difference between the predetermined overhead rates at the two levels of activity is entirely due to fixed overhead being spread over different amounts of activity.

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APPLYING OVERHEAD IN A STANDARD COST SYSTEM

Assume that the denominator level of activity at Swift Company is 15,000 DLHs. The following data apply to the current year’s operations.

Denominator level of activity ................ 15,000 DLHs Number of units completed .................. 8,000 units Actual direct labor-hours ...................... 18,000 DLHs Actual manufacturing overhead cost:

Variable............................................ $ 81,000 Fixed................................................ 305,000

Total................................................... $386,000

In a standard cost system, overhead is applied on the basis of the standard hours allowed for the actual output rather than on the basis of the actual hours. This results in a simpler system in which the overhead applied to units is always the same. In this example, the overhead cost is always $50 per unit (2.0 DLHs per unit × $25 per DLH)

Using the above data, the company’s manufacturing overhead account would appear as follows:

Manufacturing Overhead Actual overhead cost 386,000 400,000* Applied overhead cost

14,000 Overapplied overhead

* 8,000 units × 2.0 DLHs per unit = 16,000 DLHs; 16,000 DLHs × $25 per DLH = $400,000.

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VARIABLE OVERHEAD VARIANCES

Swift Company’s $14,000 overapplied overhead can be explained by four variances: the variable overhead spending and efficiency variances and the fixed overhead budget and volume variances. The variable overhead variances are computed below:

Actual Hours of Input, at the Actual Rate


Standard Rate


(AH × AR) (AH × SR) (SH × SR) 18,000 DLHs ×

$5 per DLH 16,000 DLHs ×

$5 per DLH $81,000 = $90,000 = $80,000 ↑ ↑ ↑

Spending Variance, $9,000 F


Spending variance: The variable overhead spending variance contains differences between actual and standard prices and between actual and standard quantities.

Efficiency variance: The variable overhead efficiency variance is not a measure of how efficiently overhead resources were used. It is a measure of the efficiency with which the base underlying the flexible budget was used.

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FIXED OVERHEAD VARIANCES

Data concerning Swift Company are presented below:

Denominator activity (direct labor-hours) ................. 15,000 DLHs Actual direct labor-hours worked............................. 18,000 DLHs Standard direct labor-hours allowed for output......... 16,000 DLHs Number of units produced ...................................... 8,000 units Budgeted fixed overhead cost ................................. $300,000 Actual fixed overhead cost incurred ......................... $305,000 Fixed element of the predetermined overhead rate... $20

Using these data, an analysis of the company’s fixed overhead variances follows:

Actual Fixed

Overhead Cost

Budgeted Fixed Overhead Cost

Fixed Overhead Cost Applied to

Work in Process 16,000 DLHs ×

$20 per DLH $305,000 $300,000 = $320,000

↑ ↑ ↑ Budget Variance,

$5,000 U Volume Variance,

$20,000 F

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FIXED OVERHEAD VARIANCES (cont’d)

The fixed overhead variances can also be computed as follows:

Budget Actual fixed Budgeted fixed= - variance overhead cost overhead cost

= $305,000 - $300,000

= $5,000 U

Fixed portion of the StandardVolume Denominator= predetermined - hoursvariance hoursoverhead rate allowed

= $20 per DLH × (15,000 DLHs - 16,000 DLHs)

= $20,000 F

⎛ ⎞⎟⎜ ⎟⎜ ⎟⎜ ⎟⎜ ⎟⎟⎜⎝ ⎠

• The volume variance is not a measure of spending; it is affected only by the level of activity.

• Standard hours allowed for the actual activity > Denominator level of activity ⇒ Favorable

• Standard hours allowed for the actual activity < Denominator level of activity ⇒ Unfavorable

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GRAPHIC ANALYSIS OF VOLUME VARIANCE

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320,000

300,000

Volume variance20,000 F

Denominatorhours

Standardhours

allowed

Fixed overhead costapplied at $20 per

standard hour

Standard direct labor hours (000)

Budgetedfixed

overhead

Appliedfixed

overhead

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SUMMARY OF VARIANCES

• In a standard costing system, under or overapplied overhead equals the sum of:

• Variable overhead spending variance

• Variable overhead efficiency variance

• Fixed overhead budget variance

• Fixed overhead spending variance

• Underapplied overhead is equivalent to a net unfavorable variance.

• Overapplied overhead is equivalent to a net favorable variance.

Thus, Swift Company’s $14,000 overapplied overhead can be explained as follows:

Variable overhead: Spending variance................. $ 9,000 FEfficiency variance ................ 10,000 U

Fixed overhead: Budget variance .................... 5,000 UVolume variance ................... 20,000 F

Overapplied overhead .............. $14,000 F

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Chapter 12

Segment Reporting and Decentralization Learning Objectives LO1. Prepare a segmented income statement using the contribution format, and explain the

difference between traceable fixed costs and common fixed costs. LO2. Compute return on investment (ROI) and show how changes in sales, expenses, and

assets affect ROI. LO3. Compute residual income and understand the strengths and weaknesses of this method

of measuring performance. LO4. (Appendix 12A) Determine the range, if any, within which a negotiated transfer price

should fall.

New in this Edition • This chapter has been extensively rewritten. • Many new In Business boxes have been added. • Additional exercises have been written. Chapter Overview A. Responsibility Accounting. Responsibility accounting is concerned with designing reports that help motivate managers to make decisions and to take actions that are in the best interests of the overall organization. 1. The benefits of decentralization. In a decentralized organization, decision making is not

confined to a few top executives, but rather is spread throughout the organization. Responsibility accounting functions most effectively in an organization that is decentralized. A number of benefits result from decentralization. a. Top management is relieved of much day-to-day problem solving and is left free to

concentrate on strategy, higher-level decision-making and coordinating activities. b. Lower-level managers generally have more detailed and up-to-date information about

local conditions than top managers. Therefore, lower-level managers are often capable of making better operational decisions.

c. Delegating decision-making authority to lower-level managers enables them to quickly

respond to customers.

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d. Decentralization provides lower-level managers with the decision-making experience they will need when promoted into higher-level positions.

e. Delegating decision-making authority to lower-level managers often increases their

motivation. The end result can be increased job satisfaction and employee retention, as well as improved organizational performance.

2. Disadvantages of decentralization. Particularly in larger organizations, the benefits of

decentralization usually outweigh the disadvantages. Nevertheless, it is important to be aware of the potential problems with decentralization. a. Lower-level managers may make decisions without fully understanding the “big

picture.” While top-level managers typically have less detailed information about local operations than the lower-level managers, they usually have more information about the company as a whole and should have a better understanding of the company’s strategy.

b. In a truly decentralized organization, there may be a lack of coordination among

autonomous managers. This problem can be reduced by clearly defining the company’s strategy and communicating it effectively throughout the organization through the use of a well-designed Balanced Scorecard (see Chapter 10).

c. Lower-level managers may have objectives that are different from the objectives of the

entire organization. For example, some managers may be more interested in increasing the sizes of their departments than in increasing the profits of the company. To some degree, this problem can be overcome by designing performance evaluation systems that motivate managers to make decisions that are in the best interests of the company.

3. Investment, Profit, and Cost Centers. There are at least three types of responsibility

centers. a. A cost center manager has control over cost. Cost center managers are evaluated based

on how well costs are controlled, given the level of activity. b. A profit center manager has control over both cost and revenue. Profit center managers

are usually evaluated based on performance relative to profit targets. c. An investment center manager has control over cost and revenue and also has control

over the use of investment funds. Investment center managers are usually evaluated based on rate of return on investment (ROI).

B. Segmented Reporting. (Exercises 12-1, 12-5, 12-7, and 12-8.) To operate effectively, managers need a great deal more information than is provided by a single, company-wide income statement. Income statements are needed that focus on segments of the company. 1. Segments. A segment is any part or activity of an organization about which a manager

seeks cost or revenue data. Examples of segments include sales territories, manufacturing facilities, service centers, individual products, and individual customers.

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2. Segmented statements. Segmented statements can be prepared for activity at many different levels in an organization. Exhibit 12-2 in the text illustrates three levels of segmented statements.

3. Sales and contribution margin. Sales for each segment should be identified along with

variable costs, resulting in a contribution margin. The segment contribution margin is especially valuable in decisions that involve the use of excess capacity.

4. Traceable vs. Common Fixed Costs. Whether a fixed cost is assigned to a segment should

depend on whether it is traceable to that segment or is a common cost. A cost may be traceable to one segment and common to another. a. Traceable Fixed Costs. Traceable costs arise because of the existence of a particular

segment. If a cost is avoidable if a segment were discontinued, then it is a traceable cost of that segment.

b. Common Fixed Costs. A common fixed cost is a fixed cost that supports more than

one business segment, but is not traceable in whole or in part to any one of the business segments. A fixed cost that is common to a particular segment would continue even if that particular segment were discontinued. Since common costs are not avoidable costs of the segment, they should not be considered costs of the segment for purposes such as product drop decisions or pricing. Of course, it is always possible to arbitrarily allocate any cost—including common fixed costs—among segments. However, if common costs are allocated among segments, the resulting segment statements are potentially very misleading and erroneous decisions may result. For example, a manager might drop a segment that appears to be operating at a loss, only to discover later that the common fixed costs that were arbitrarily allocated to the segment do not disappear and are simply reallocated to the remaining segments.

c. Do common costs exist? There is a great deal of disagreement about what costs are

and are not traceable to segments. • Some people allege that essentially the only costs traceable to products are direct

materials whereas others assert that all costs can be traced to products. That is, some commentators believe almost all costs are common with respect to products whereas others believe there are no common costs at all. (For example, the early ABC literature implicitly assumed common costs do not exist.) Our belief is that the truth lies somewhere in the middle—a lot of costs can be traced to products but by no means all costs. The illustrations in the text and in the exercises, problems, and cases reflect that belief.

• Cooper and Kaplan, the leading architects of activity-based costing, have advocated a

system of segmented reports that is very much in the spirit of what we recommend in this chapter. They define a hierarchy of costs in which costs can be usefully aggregated upwards but should not be allocated downwards. Essentially, costs at each level of the hierarchy are common to the activities carried out lower down in the hierarchy. For example, they advocate that facility-sustaining costs, which are common to products, should not be allocated to the products. (See Cooper and Kaplan, “Profit Priorities from Activity-Based Costing,” Harvard Business Review, May-June 1991, pp. 130-135.)

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• With so much disagreement among the experts concerning which costs can and cannot be traced to products, it should not be surprising that there is a great deal of uncertainty in practice concerning whether a particular cost is traceable or not. The text and problem material have been carefully worded to eliminate this sort of ambiguity. The introductory course does not seem to us to be the most appropriate place to grapple with all of the complexities of this issue.

d. What is common and what is traceable depends on the segment. A cost that is

traceable to a segment may not be traceable when the segment is further divided into smaller segments. The salary of the vice president of the automotive products division is a traceable cost of the segment “automotive products division” but it is not a traceable cost of any particular product that is sold by the division. This is true even if someone were to keep track of how much time the vice president devotes to each particular product.

5. Segment Margin. The segment margin is obtained by deducting the traceable fixed costs

of a segment from the segment’s contribution margin. The segment margin indicates how much the segment is contributing toward covering common costs and towards profits.

C. Return on Investment (ROI) for Measuring Managerial Performance. (Exercises 12-2, 12-6, 12-9, 12-10, 12-11, and 12-13.) Investment centers are usually evaluated based on some measure of the rate of return on investment; that is, some measure of profits divided by some measure of investment. This presumably provides incentives to increase profits while controlling the amount of funds tied up in an organization. 1. The definition of ROI. Companies measure the rate of return on investment in many

different ways. To keep things simple, we use the following definition in the book:

Net operating incomeROIAverage operating assets

=

Net operating income is income before interest and taxes. Average operating assets are

discussed below. 2. Measuring Average Operating Assets.

a. From a theoretical standpoint, one can argue that the denominator in the ROI formula

should be the market value of the segment at the beginning of the period. The investment in the segment is implicitly the proceeds that could have been realized from its sale. Unfortunately, reliable estimate of the market value of a segment are difficult to obtain. So that approach is rarely, if ever, used in practice.

b. In the text we define operating assets as cash, accounts receivable, inventory, plant and

equipment, and all other assets held for productive use in the organization. And after some discussion of net book value versus original cost as a basis for valuation, we settle on net book value. This way of measuring the denominator in the ROI calculations is pretty typical of practice. We suggest you not dwell on this issue in class; the figures for average operating assets are given in all of the exercises and problems.

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3. ROI in terms of Margin and Turnover. A company’s ROI can be expressed as a simple function of its margin and turnover:

ROI = Margin × Turnover or

Net operating income SalesROISales Average operating assets

= ×

ROI in this format provides some valuable insights. Very roughly speaking, in long-run

equilibrium the ROI should be about the same across all industries. If the ROI is above the norm in any industry, investment dollars will flood into that industry until the ROI becomes comparable to the ROIs in other industries. Therefore in industries characterized by large turnovers, margins should be relatively small and in industries characterized by relatively small turnovers, margins should be relatively large. The trick for a company is to try to break out of this long-run equilibrium position and to realize some combination of margins and turnover that is higher than the norm.

4. How actions affect the rate of return. ROI can be improved by doing at least one of the following: increasing sales, reducing expenses, or reducing assets. a. Ordinarily, an increase in sales will increase margin and turnover because of leverage.

Since fixed costs do not increase with sales, net operating income should increase faster than sales, and the margin should go up. And modest increases in sales can often be supported with very little increase in operating assets.

b. A decrease in expenses will increase margins through an increase in net operating

income. In hard times, managers often turn to cost cutting as the first line of defense. Conventional wisdom holds that “fat” can creep into an organization during good times and that such fat can be cut away without a great deal of pain when necessary. Critics point out that morale suffers during and after periodic cost cutting binges. It is now generally acknowledged that it is best to always be “lean and mean” and to avoid the wrenching effects caused by cost cutting campaigns.

c. Many approaches to increasing ROI involve increasing operating assets or expenses in

order to improve sales and margins. 5. The problem of allocated expenses and assets. In practice, corporate headquarters

expenses and other common costs are usually allocated to divisions. Arbitrary allocations of common costs should be avoided in ROI computations. They undermine the credibility of the measure of performance, generate arguments among managers, and serve no apparent useful purpose.

6. Criticisms of ROI. The use of ROI as a performance measure has been criticized.

a. ROI tends to emphasize short-run rather than long-term performance. Managers can

often improve short-term profitability by taking actions that hurt the company in the long-term. Prominent examples include neglecting maintenance and training, slashing prices at the end of the fiscal year to induce customers to make unusually large purchases in advance of their needs, purchasing lower quality inputs, and skimping on quality control.

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b. A manager who takes over an investment center typically inherits many committed costs over which the manager has little control. These committed costs may be relevant for assessing how well the investment center has performed as an investment, but are less relevant for assessing how well the current manager is performing.

c. A division may reject an investment that would lower its own ROI even though it

would increase the ROI for the entire company.

D. Residual Income. (Exercises 12-3, 12-12, 12-14, and 12-16.) Residual income (or economic value added) is an alternative to ROI for measuring the performance of an investment center. 1. Motivation for the residual income approach. Profitable investments may be rejected if a

segment is evaluated based on the ROI formula. For example, suppose a company’s minimum required rate of return on new investments is 15% and one of its investment centers currently has an ROI of 20%. If a new investment promises a return of greater than 15%, the company would want that investment made. However, if the investment’s rate of return is less than 20%, it would be rejected by the manager of the investment center. The residual income approach does not suffer from this particular problem, but it does suffer from many of the other problems with ROI.

2. Definition of residual income. Residual income is the net operating income that an

investment center is able to earn above the minimum required rate of return on its operating assets. Ideally, the minimum required rate of return should be the company’s cost of capital or opportunity cost of funds. When residual income is used to measure performance, the goal is to maximize the total amount of residual income generated for a period.

3. Divisional comparison and residual income. A major disadvantage of the residual

income approach is that it cannot be easily used to compare the performance of divisions of different sizes. Larger divisions naturally have more residual income than smaller divisions, not necessarily because they are better managed, but simply because they are bigger. Nevertheless, residual income can be used to track the performance of a division over time and actual residual income can be compared to target residual income.

4. Economic Valued Added (EVA). The residual income approach, which was never as

popular as ROI in practice, has been given new life and is now being used by a number of prominent companies in the form of “economic value added” or EVA. The consulting firm Stern Stewart is largely responsible for this revival and has trademarked the terms economic value added and EVA. Many other consulting firms have jumped on the bandwagon and give residual income their own unique twists and marketing nomenclature. The major differences between traditional residual income and economic value added in the Stern Stewart approach center on the accounting treatment of some transactions. For example, research and development costs are capitalized and then amortized under the EVA approach rather than being currently expensed in their entirety. However, we believe it is best not to emphasize these differences between residual income and EVA in the introductory course.

E. (Appendix 12A) Transfer Pricing. (Exercises 12-4, 12-15, and 12-17.) A transfer price is the price charged when one segment of a company provides goods or services to another segment of the company. Transfer prices are necessary to calculate costs and revenues in cost,

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profit, and investment centers. Clearly, the division that is selling the good or service would prefer a high transfer price while the division that is buying would prefer a low transfer price. 1. Do transfer prices matter? From the standpoint of the company as a whole, the transfer

price has no effect on aggregate income (other than perhaps from tax effects when divisions are in different states or countries). What is counted as revenue to one division is a cost to the other and is eliminated in the consolidation process. From an economic perspective, it is like taking money out of one pocket and putting it into the other. What does matter is how the transfer price affects the decisions made by the segment managers. In companies in which decentralization is really practiced, segment managers are given a lot of latitude in dealing with each other. Based on the transfer price, a division manager will decide whether to sell a service on the outside market or sell it internally to another division, or whether to buy a part from an outside supplier or internally from another division.

2. Negotiated transfer prices. In principle, if managers understand their own businesses and

are cooperative, negotiated transfer prices should work quite well. a. If a transfer is in the best interests of the entire company, the profits of the entire

company should increase. It is always possible in such a situation (barring externalities) to find a transfer price that would increase each participating division’s profits. A pie analogy is helpful to explain this principle. The profits of the entire company are the pie. By cooperating in a transfer, the division managers can make the pie bigger. With a bigger pie, it is always possible to divide it in such a way that everyone gets a bigger piece. And transfer prices provide a means for dividing up the pie.

b. While negotiated transfer prices can work quite well under the right conditions, if

managers are uncooperative and highly competitive, negotiations may go nowhere.

3. The lowest acceptable transfer price for the selling division. Clearly, the selling division would like for the transfer price to be as high as possible, but how low would the manager of the selling division be willing to go? The answer is that a manager will not agree to a transfer price that is less than his or her “cost.” But what cost? If the manager is rational and fixed costs are unaffected by the decision, then the manager should realize that any transfer price that covers variable cost plus opportunity cost will result in an increase in segment profits. The opportunity cost is the contribution margin that is lost on units that cannot be produced and sold as a result of the transfer. Therefore, the lowest acceptable transfer price as far as the selling division is concerned is:

Total contribution margin of lost salesTransfer price Variable cost +

Total number of units transferred≥

When there is idle capacity, there are no lost sales and so the total contribution margin of

lost sales is zero. 4. Highest transfer price the buying division is willing to pay. In the book and in problems,

we generally consider only the situation in which the buying division can buy the transferred item from an outside supplier. In that case, the buying division clearly would not voluntarily agree to a transfer unless:

Transfer price ≤ Cost of buying from outside supplier

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5. The range of acceptable negotiated transfer prices. Combining the selling and buying

divisions’ perspectives, we can find the range within which a negotiated transfer price will lie. Two situations should be considered.

a. A transfer makes sense from the standpoint of the company if the item can be made

inside the company (including opportunity costs) for less that it costs to buy the item from the outside. In algebraic form:

Total contribution margin of lost salesVariable Cost of purchasing + from outside suppliercost Total number of units transferred

≤ .

In this case, any transfer price within the following range will increase the profits of

both divisions:

Total contribution margin of lost salesVariable Transfer Cost of purchasing + from outside suppliercost priceTotal number of units transferred≤ ≤ .

b. A transfer does not make sense from the standpoint of the company if the item can be

purchased from an outside supplier for less than it costs to make inside the company (including opportunity costs). In algebraic form:

Total contribution margin of lost salesVariable Cost of purchasing + from outside suppliercost Total number of units transferred

≥ .

In this case, it is impossible to satisfy both the selling division and the buying division

and no transfer will be made voluntarily. And, of course, no transfer should be forced on the managers since a transfer would not be in the best interests of the entire company.

6. Alternative approaches to transfer pricing. If managers understand their own businesses

and are cooperative, negotiated transfer prices should work very well. But, if managers do not understand their own businesses or are uncooperative, negotiations are likely to be fruitless. As a consequence, most companies rely on either cost-based or market price-based transfer prices. a. Cost-based transfer prices. In many companies, transfers are recorded at variable

cost, at full cost, or at variable or full cost plus some arbitrary mark-up. These transfer pricing systems are easy to administer, but suffer from serious limitations.

• Cost-based transfer prices can easily lead to bad decisions. If variable costs are used,

the transfer price will be too low when there is no idle capacity. If full cost is used, the transfer price will never be correct for decision-making purposes—it will always indicate to the buying division that the cost of the transfer is something other than what it really is to the entire company.

• If there is no profit margin built into the transfer price, then the selling division has

no incentive to cooperate in the transfer.

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• If the costs of one division are simply passed on to the next division, then there is little incentive for cost control anywhere in the organization. If transfer prices are to be based on cost, then standard cost rather than actual cost should be used.

b. Market-based transfer prices. When there is a competitive outside market for the

good or service transferred between the divisions, the market price is often used as a transfer price. This solution is reasonably easy to administer and provides a theoretically correct transfer price when there is no idle capacity. However, when there is idle capacity in the selling division, the transfer price will be too high and the buying division may inappropriately purchase from an outside supplier or cut back on volume.

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Time Exercise 12-1 Basic segmented income statement ........................................ Basic 15 min. Exercise 12-2 Compute the return on investment (ROI) ............................... Basic 10 min. Exercise 12-3 Residual income ..................................................................... Basic 10 min. Exercise 12-4 (Appendix 12A) Transfer pricing basics ................................ Basic 30 min. Exercise 12-5 Segmented income statement ................................................. Basic 20 min. Exercise 12-6 Effects of changes in sales, expenses, and assets on ROI ...... Basic 20 min. Exercise 12-7 Working with a segmented income statement ........................ Basic 20 min. Exercise 12-8 Working with a segmented income statement ........................ Basic 15 min. Exercise 12-9 Effects of changes in profits and assets on return on

investment (ROI) ............................................................... Basic 30 min. Exercise 12-10 Cost-volume-profit analysis and return on investment

(ROI).................................................................................. Basic 20 min. Exercise 12-11 Return on investment (ROI) ................................................... Basic 15 min. Exercise 12-12 Evaluating new investments using return on investment

(ROI) and residual income ................................................ Basic 30 min. Exercise 12-13 Computing and interpreting return on investment (ROI) ....... Basic 15 min. Exercise 12-14 Contrasting return on investment (ROI) and residual

income ............................................................................... Basic 20 min. Exercise 12-15 (Appendix 12A) Transfer pricing from the viewpoint of the

entire company .................................................................. Basic 15 min. Exercise 12-16 Return on investment (ROI) and residual income relations ... Basic 15 min. Exercise 12-17 (Appendix 12A) Transfer pricing situations........................... Basic 20 min. Problem 12-18 Segment reporting and decision-making ................................ Basic 30 min. Problem 12-19 Comparison of performance using return on investment

(ROI).................................................................................. Basic 30 min. Problem 12-20 Return on investment (ROI) and residual income .................. Basic 30 min. Problem 12-21 (Appendix 12A) Transfer price with an outside market......... Basic 45 min. Problem 12-22 Basic segmented reporting; activity-based cost assignment... Basic 60 min. Problem 12-23 Return on investment (ROI) and residual income .................. Basic 20 min. Problem 12-24 (Appendix 12A) Basic transfer pricing .................................. Basic 60 min. Problem 12-25 Restructuring a segmented income statement ........................ Basic 60 min. Problem 12-26 Segment reporting; activity-based cost assignment................ Medium 60 min. Problem 12-27 Return on investment (ROI) analysis ..................................... Medium 30 min. Problem 12-28 Return on investment (ROI) and residual income;

decentralization.................................................................. Medium 30 min. Problem 12-29 (Appendix 12A) Market-based transfer price......................... Medium 45 min. Problem 12-30 Multiple segmented income statements.................................. Medium 60 min. Problem 12-31 (Appendix 12A) Cost-volume-profit analysis; return on

investment (ROI); transfer pricing .................................... Medium 45 min. Problem 12-32 (Appendix 12A) Negotiated transfer price ............................. Medium 30 min. Case 12-33 Segmented statements; product line analysis ......................... Difficult 90 min. Case 12-34 (Appendix 12A) Transfer pricing; divisional performance .... Difficult 45 min. Case 12-35 Service organization; segment reporting ................................ Difficult 75 min.

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Essential Problems: Problem 12-19, Problem 12-20, Problem 12-22 or Problem 12-25. Supplementary Problems: Problem 12-18, Problem 12-23, Problem 12-26, Problem 12-27,

Problem 12-28, Problem 12-30, Case 12-33, Case 12-35. Appendix 12A Essential Problems: Problem 12-24. Appendix 12A Supplementary Problems: Problem 12-21, Problem 12-29, Problem 12-31,

Problem 12-32, Case 12-34.

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Helpful Hint: Before beginning the lecture, show students the 14th and 15th segments from the McGraw-Hill/Irwin Managerial/Cost Accounting video library. These segments discuss many of the concepts included in chapter 12. The lecture notes reinforce the concepts in the video.

Chapter theme: Managers in large organizations have to delegate some decisions to those who are at lower levels in the organization. This chapter explains how responsibility accounting systems, segmented income statements, and return on investment (ROI) and residual income measures are used to help control decentralized organizations.

I. Decentralization in organizations

A. A decentralized organization does not confine

decision-making authority to a few top executives; rather, decision-making authority is spread throughout the organization. The advantages and disadvantages of decentralization are as follows:

i. Advantages of decentralization

1. It enables top management to concentrate on strategy, higher-level decision-making, and coordinating activities.

2. It acknowledges that lower-level managers have more detailed information about local conditions that enable them to make better operational decisions.

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3. It enables lower-level managers to quickly respond to customers.

4. It provides lower-level managers with the decision-making experience they will need when promoted to higher level positions.

5. It often increases motivation, resulting in increased job satisfaction and retention, as well as improved performance.

ii. Disadvantages of decentralization

1. Lower-level managers may make decisions without fully understanding the “big picture.”

2. There may be a lack of coordination among autonomous managers.

a. The balanced scorecard can help reduce this problem by communicating a company’s strategy throughout the organization.

3. Lower-level managers may have objectives that differ from those of the entire organization.

a. This problem can be reduced by designing performance evaluation systems that motivate managers to make decisions that are in the best interests of the company.

4. It may difficult to effectively spread innovative ideas in a strongly decentralized organization.

a. This problem can be reduced through the effective use of intranet systems, which enable globally dispersed

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employees to electronically share ideas.

II. Responsibility accounting

A. Responsibility accounting systems link lower-level managers’ decision-making authority with accountability for the outcomes of those decisions. The term responsibility center is used for any part of an organization whose manager has control over, and is accountable for cost, profit, or investments. The three primary types of responsibility centers are cost centers, profit centers, and investment centers.

i. Cost center

1. The manager of a cost center has control over costs, but not over revenue or investment funds.

a. Service departments such as accounting, general administration, legal, and personnel are usually classified as cost centers, as are manufacturing facilities.

b. Standard cost variances and flexible budget variances, such as those discussed in Chapters 10 and 11, are often used to evaluate cost center performance.

ii. Profit center

1. The manager of a profit center has control over both costs and revenue.

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a. Profit center managers are often evaluated by comparing actual profit to targeted or budgeted profit.

iii. Investment center

1. The manager of an investment center has control over cost, revenue, and investments in operating assets.

a. Investment center managers are usually evaluated using return on investment (ROI) or residual income, as discussed later in this chapter.

“In Business Insights” It is important to correctly manage the incentives offered to responsibility center managers, otherwise the consequences can be disastrous. For example: “Extreme Incentives” (page 542)

• In 2003 Tyco International, Ltd. was rocked by a series of scandals including disclosure of $2 billion of accounting-related problems. Was this foreseeable? Well, in a word, yes.

• Business Week reported in 1996 that the CEO of Tyco International, Ltd., Dennis Kozlowski, was putting unrelenting pressure on his managers to deliver growth. If his managers met or exceeded their targets they were given a bonus that could be many times their salary. But if they fell even a bit short, the bonus plummeted.

• If a manager is barely under the target, this type of bonus scheme creates pressure the accelerate earnings. If a manager is barely over the bonus

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threshold, it creates an incentive to push earnings to the next period.

• If top executives, such as Kozlowski, set profit targets too high or turn a blind eye to how managers achieve them, the incentive for managers to cut corners is enormous.

B. An organizational view of responsibility centers

i. Superior Foods Corporation provides an

example of the various kinds of responsibility centers that exist in an organization.

1. The President and CEO as well as the Vice

President of Operations manage investment centers.

2. The Chief Financial Officer, General Counsel, and Vice President of Personnel all manage cost centers.

3. Each of the three product managers that report to the Vice President of Operations (e.g., salty snacks, beverages, and confections) manages a profit center.

4. The bottling plant manager, warehouse manager, and distribution manager all manage cost centers that report to the Beverages product manager.

III. Decentralization and segment reporting

A. Key concepts/definitions

i. A segment is a part or activity of an

organization about which managers would like cost, revenue, or profit data.

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1. Examples of segments include divisions of

a company, sales territories, individual stores, service centers, manufacturing plants, marketing departments, individual customers, and product lines.

a. Superior Foods Corporation could segment its business as follows:

• By geographic region • By customer channel

Helpful Hint: If students have been introduced to database software, Exhibit 12-2 can be used to review how segmentation could be accomplished with the aid of a computer. The number of possible breakdowns, or segmentations, is only limited by the list of attributes coded along with each transaction. To accomplish the breakdown in Exhibit 12-2, the attributes geographic region (e.g., east, west, etc.), state, customer channel, and supermarket chain would need to be recorded for each sale.

ii. There are two keys to building segmented

income statements.

1. First, a contribution format should be used because it separates fixed from variable costs and it enables the calculation of a contribution margin.

a. The contribution margin is especially useful in decisions involving temporary uses of capacity such as special orders.

2. Second, traceable fixed costs should be separated from common fixed costs to

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enable the calculation of a segment margin. Further clarification of these terms is as follows:

a. A traceable fixed cost of a segment is a fixed cost that is incurred because of the existence of the segment. If the segment were eliminated, the fixed cost would disappear. Examples of traceable fixed costs include:

• The salary of the Fritos product manager at PepsiCo is a traceable fixed cost of the Fritos business segment of PepsiCo.

• The maintenance cost for the building in which Boeing 747s are assembled is a traceable fixed cost of the 747 business segment of Boeing.

b. A common fixed cost is a fixed cost that supports the operations of more than one segment, but is not traceable in whole or in part to any one segment. Examples of common fixed costs include:

• The salary of the CEO of General Motors is a common fixed cost of the various divisions of General Motors.

• The cost of heating a Safeway or Kroger grocery store is a common fixed cost of the various departments – groceries, produce, bakery, etc.

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“In Business Insights” Common fixed costs are often arbitrarily allocated to segments for cost recovery purposes. Invariably, this leads to disputes about the fairness of the allocation process. For example: “The Big Gouge” (page 555)

• The Big Dig in Boston is a $14 billion-plus project to bury major roads underground in downtown Boston. Two companies – Bechtel and Parsons Brinckerhoff (PB) – manage the 20 year project, which is $1.6 billion over budget.

• Bechtel and PB have many projects underway at any one time and many common fixed costs. These common fixed costs are not caused by the Big Dig project and yet portions of these costs have been claimed as reimbursable expenses under the premise that someone must pay for these costs.

• Massachusetts has lodged a number of complaints concerning Bechtel’s cost recovery claims. Such complaints are almost inevitable when common fixed costs are allocated to segments.

c. It is important to realize that the

traceable fixed costs of one segment may be a common fixed cost of another segment. For example:

• The landing fee paid to land an airplane at an airport is traceable to a particular flight, but it is not traceable to first-class, business-class, and economy-class passengers.

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Helpful Hint: In practice, a great deal of disagreement exists about what costs are traceable and what costs are common. Some people claim that except for direct materials, virtually all costs are common fixed costs that cannot be traced to products. Others assert that all costs are traceable to products; there are no common costs. The truth probably lies somewhere in the middle – many costs can be traced to products but not all costs.

d. A segment margin is computed by

subtracting the traceable fixed costs of a segment from its contribution margin.

• The segment margin is a valuable tool for assessing the long-run profitability of a segment.

• Allocating common costs to segments reduces the value of the segment margin as a guide to long-run segment profitability.

“In Business Insights” Segment margins can be computed in numerous ways depending upon the industry. For example: “What’s in a Segment?” (page 552)

• Continental Airlines could figure out the profitability of a specific route on a monthly basis – for example Houston to Los Angeles – but management did not know the profitability of a particular flight on that route.

• The company’s CFO responded by developing a flight profitability system that would break out the profit (or loss) for each individual flight.

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• Once completed the new cost system revealed such money-losing flights as two December flights that left Houston for London within a four-hour period with only about 30 passengers each.

• With the data on the profitability of individual flights, Continental was able to design more appropriate schedules.

Helpful Hint: Explain that a segment shouldn’t automatically be eliminated if its segment margin is negative. If a company that produces hair-styling products discontinues its styling gel, sales on its shampoo and conditioner might fall due to the unavailability of the eliminated product.

iii. Activity-based costing can help identify how

costs shared by more than one segment are traceable to individual segments. For example:

1. Assume that three products, 9-inch, 12-inch,

and 18-inch pipe, share 10,000 square feet of warehousing space, which is leased at a price of $4 per square foot.

2. If the 9-inch, 12-inch, and 18-inch pipes occupy 1,000, 4,000, and 5,000 square feet, respectively, then activity-based costing can be used to trace the warehousing costs to the three products as shown.

a. When using activity-based costing to trace fixed costs to segments, managers must still ask themselves if the traceable costs that they have been identified would disappear over time if the segment disappeared.

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b. In this example, if the warehouse was owned rather than leased, perhaps the warehousing costs assigned to a given segment would not disappear if the segment was discontinued.

“In Business Insights” Activity-based costing can be used by companies to more accurately trace costs to business segments. For example: “Using ABC to Assign Data Center Costs” (page 549)

• Harris Corporation consolidated its division-level data centers into a centralized data center called the Computing and Communication Services (CCS) Department.

• CCS is a cost center that recovers its operating costs by charging other divisions within Harris for the use of its resources.

• To facilitate the “chargeback” process, CCS developed an activity-based costing system. Activities such as “test systems,” “monitor network,” “schedule jobs,” “install software,” and “print reports” were used to ensure that internal customers were only charged for the dollar value of the resources that they consumed.

Helpful Hint: In several articles, Cooper and Kaplan, the leading architects of activity-based costing, have proposed that costs be sorted into a hierarchy of unit-level, batch-level, product-level, and facility-level costs. This hierarchy can be viewed as a pyramid with facility-level costs at the top and unit-level costs at the bottom. Cooper and Kaplan basically view costs at each level of the pyramid as common costs of the

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activities carried out at the lower levels. They strongly recommend that these common costs should not be allocated downwards in the pyramid. This conceptualization is highly consistent with the segmented reports discussed in this chapter.

B. Segmented income statements – an example

i. Assume that Webber, Inc. has two divisions –

the Computer Division and the Television Division.

1. The contribution format income statement

for the Television Division is as shown. Notice:

a. Cost of goods sold consists of variable manufacturing costs.

b. Fixed and variable costs are listed in separate sections.

c. Contribution margin is computed by taking sales minus variable costs.

d. The divisional segment margin represents the Television Division’s contribution to overall company profits.

2. The Television Division’s results can be rolled into Webber, Inc.’s overall results as shown. Notice:

a. The results of the Television and Computer Divisions sum to the results shown for the whole company.

b. The common costs for the company as a whole ($25,000) are not allocated to the divisions.

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3. The Television Division’s results can also be broken down into smaller segments. This enables us to see how traceable fixed costs of the Television Division can become common costs of smaller segments.

a. Assume that the Television Division can be broken down into two major product lines – Regular and Big Screen.

b. Assume that the segment margins for these two product lines are as shown.

c. Of the $90,000 of fixed costs that were previously traceable to the Television Division, $80,000 ($45,000 + $35,000) is traceable to the two product lines and $10,000 is a common cost.

“In Business Insights” Segmental income statements have the potential to be useful to front-line employees. For example: “Daily Segment Feedback Fuels Innovation” (page 551)

• Steve Briley, the department manager of Cracking Plant 3B at Texas Eastman Company’s chemical plant in Longview, Texas, created an innovative daily performance report to help guide his department.

• Briley issued an income statement to his employees at the beginning of each day. The daily income statement assigned revenues to the output of the previous day and costs to the inputs used.

• Briley found that giving his employees the responsibility for their own income statement

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provided three key benefits. First, it gave employees rapid feedback regarding what actions increased or decreased profits. Second, it empowered workers to make decisions quickly in response to changes in the operating environment. Third, the daily income statement helped employees make trade-offs and set priorities.

C. Segmented financial information on external reports

i. The Financial Accounting Standards Board now requires that companies in the United States include segmented financial data in their annual reports. This ruling has implications for internal segment reporting because:

1. It mandates that companies report segmented

results to shareholders using the same methods that are used for internal segmented reports.

2. Since the contribution approach to segment reporting does not comply with GAAP, it is likely that some managers will choose to construct their segmented financial statements using the absorption approach to comply with GAAP.

a. The absorption approach hinders internal decision making because it does not distinguish between fixed and variable costs or common and traceable costs.

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IV. Hindrances to proper cost assignment

A. Omission of costs

i. The costs assigned to a segment should include all the costs attributable to that segment from the company’s entire value chain. The value chain consists of all major business functions that add value to a company’s products and services.

1. Since only manufacturing costs are

included in product costs under absorption costing, those companies that choose to use absorption costing for segment reporting purposes will omit from their profitability analysis all “upstream” and “downstream” costs.

a. “Upstream” costs include research and development and product design costs.

b. “Downstream” costs include marketing, distribution, and customer service costs.

c. Although these “upstream” and “downstream” costs are nonmanufacturing costs, they are just as essential to determining product profitability as are manufacturing costs. Omitting them from profitability analysis will result in the undercosting of products.

Helpful Hint: An example of a company with a very high amount of upstream and downstream costs is a

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pharmaceutical company such as Merck. A great deal of its costs are comprised of research and development and marketing.

B. Inappropriate methods for assigning traceable costs

to segments

i. Failure to trace costs directly

1. Costs that can be traced directly to specific segments of a company should not be allocated to other segments. Rather, such costs should be charged directly to the responsible segment. For example:

a. The rent for a branch office of an insurance company should be charged directly against the branch office rather than included in a companywide overhead pool and then spread throughout the company.

ii. Inappropriate allocation base

1. Some companies allocate costs to segments using arbitrary bases. Costs should be allocated to segments for internal decision making purposes only when the allocation base actually drives the cost being allocated. For example:

a. Sales is frequently used to allocate S, G, & A expenses to segments. This should only be done if sales drive S, G & A expenses.

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C. Arbitrarily dividing common costs among segments

i. Common costs should not be arbitrarily allocated to segments based on the rationale that “someone has to cover the common costs” for two reasons:

1. First, this practice may make a profitable

business segment appear to be unprofitable. If the segment is eliminated the revenue lost may exceed the traceable costs that are avoided.

2. Second, allocating common fixed costs forces managers to be held accountable for costs that they cannot control.

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Quick Check – common costs

“In Business Insights” Arbitrarily allocating common costs to business segments generally leads to unnecessary bickering among segment managers. For example: “Stopping the Bickering” (page 554)

• At AT&T Power Systems profit center managers were spending more time debating overhead allocation schemes than they were spending on creating strategies to increase contribution margins.

• Since no cause-and-effect relationship existed between the overhead expenses being allocated and the activity of any particular segment, these endless debates were completely unproductive.

• Consequently, a change was made to evaluate the segments on the basis of contribution margin and controllable expenses – eliminating arbitrary allocations of overhead from the performance measure.

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V. Evaluating investment center performance – return on investment


i. Investment center performance is often

evaluating using a measure called return on investment (ROI), which is defined as follows:

Net operating incomeROI

Average operating assets=

ii. Net operating income is income before taxes

and is sometimes referred to as EBIT (earnings before interest and taxes). Operating assets include cash, accounts receivable, inventory, plant and equipment, and all other assets held for operating purposes.

1. Net operating income is used in the

numerator because the denominator consists only of operating assets.

2. The operating asset base used in the formula is typically computed as the average of the assets between the beginning and the end of the year.

iii. Net book value versus gross cost

1. Most companies use the net book value

(i.e., acquisition cost less accumulated depreciation) of depreciable assets to calculate average operating assets.

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a. With this approach, ROI mechanically increases over time as the accumulated depreciation increases. Replacing a fully-depreciated asset with a new asset will decrease ROI.

2. An alternative to net book value is the gross cost of the asset, which ignores accumulated depreciation.

a. With this approach, ROI does not grow automatically over time, rather it stays constant. Replacing a fully-depreciated asset does not adversely affect ROI.

B. Understanding ROI – the DuPont perspective

i. DuPont pioneered the use of ROI and recognized the importance of looking at the components of ROI, namely margin and turnover.

1. Margin is computed as shown and is

improved by increasing sales or reducing operating expenses. The lower the operating expenses per dollar of sales, the higher the margin earned.

2. Turnover is computed as shown. It incorporates a crucial area of a manager’s responsibility – the investment in operating assets. Excessive funds tied up in operating assets depress turnover and lower ROI.

Helpful Hint: Emphasize that both margin and turnover affect profitability. As an example, ask students to

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compare the margins and turnovers of grocery stores to jewelry stores. In equilibrium, every industry should have roughly the same ROI. Groceries, because of their short shelf life, have high turnovers relative to fine jewelry. If the ROIs are to be comparable in grocery stores and in jewelry stores, the margins would have to be higher in jewelry stores.

ii. Any increase in ROI must involve at least one of the following – increased sales, reduced operating expenses, or reduced operating assets. The following example shows four different ways to increase ROI:

1. Assume that Regal Company reports the

results as shown. a. Given this information, its current ROI

is 15%. 2. The first way to increase ROI is to increase

sales without any increase in operating assets.

a. Assume that: (1) Regal’s manager was able to increase sales to $600,000 (an increase of 20%), (2) operating expenses increased to $558,000 (an increase of 18.7%), (3) net income increased to $42,000, and (4) average operating assets remained unchanged.

b. In this case, the ROI increases from 15% to 21%. Notice, for ROI to increase, the percentage increase in sales must exceed the percentage increase in operating expenses.

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3. The second way to increase ROI is to decrease operating expenses with no change in sales or operating assets.

a. Assume that Regal’s manager was able to reduce operating expenses by $10,000 without affecting sales or operating assets.

b. In this case, the ROI increases from 15% to 20%.

“In Business Insights” Research shows that JIT systems can improve ROI. For example: “JIT and ROI Improvement” (page 560)

• A study of companies that adopted just-in-time (JIT) in comparison to a control group that did not adopt JIT, found that the JIT adopters improved their ROI’s more.

• The JIT adopters’ success resulted from improvements in both profit margins and asset turnover.

• The elimination of inventories in JIT reduces total assets, but more importantly, it leads to process improvements as production problems are exposed. When production problems and non-value-added activities are eliminated, costs go down.

4. The third way to increase ROI is to decrease

operating assets with no change in sales or operating expenses.

a. Assume that Regal’s manager was able to reduce inventories by $20,000 by

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using just-in-time techniques without affecting sales or operating expenses.

b. In this case, the ROI increases from 15% to 16.7%.

5. The fourth way to increase ROI is to invest in operating assets to increase sales.

a. Assume that Regal’s manager invests in a $30,000 piece of equipment that increases sales by $35,000 while increasing operating expenses by $15,000.

b. In this case, the ROI increases from 15% to 21.8%.

“In Business Insights” Investing in operating assets can increase ROI. For example: “McDonald Chic” (page 560)

• McDonald’s France has been spending lavishly to remodel its restaurants in an effort to defuse the negative feelings many of the French people feel toward McDonald’s as a symbol of American culture.

• Beyond overcoming cultural barriers, McDonald’s hopes that its remodeling efforts will entice customers to linger over their meals and spend more.

• The investment in operating assets has apparently been successful – even though a Big Mac costs about the same in Paris as in New York, the average French customer spends about $9 per visit versus only about $4 in the U.S.

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C. ROI and the balanced scorecard

i. It may not be obvious to managers how to increase sales, decrease costs, and decrease investments in a way that is consistent with the company’s strategy. A well-constructed balanced scorecard can provide managers with a road map that indicates how the company intends to increase ROI. A scorecard can answer questions such as: 1. Which internal business processes should be

improved? 2. Which customers should be targeted and

how will they be attracted and retained at a profit?

D. Criticisms of ROI

i. Just telling managers to increase ROI may not be enough. Managers may not know how to increase ROI in a manner that is consistent with the company’s strategy.

1. This is why ROI is best used as part of a

balanced scorecard.

ii. A manager who takes over a business segment typically inherits many committed costs over which the manager has no control. This may make it difficult to assess this manager relative to other managers.

ii. A manager who is evaluated based on ROI may

reject investment opportunities that are

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profitable for the whole company but that would have a negative impact on the manager’s performance evaluation.

Helpful Hint: When discussing the criticisms of ROI and other measures of profitability, ask students to play the role of a manager who anticipates a short tenure. This manager will want to increase ROI as quickly as possible. Ask students to list the activities that could be undertaken to increase ROI that, in reality, would hurt the company as a whole.

VI. Residual income

A. Defining residual income

i. Residual income is the net operating income that an investment center earns above the minimum required return on its assets.

1. Economic Value Added (EVA®) is an

adaptation of residual income. We will not distinguish between the two terms in this class.

B. Calculating residual income

i. The equation for computing residual income is

as shown. Notice:

1. This computation differs from ROI. ROI measures net operating income earned relative to the investment in average operating assets. Residual income measures net operating income earned less the

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minimum required return on average operating assets.

ii. Zepher, Inc. - an example

1. Assume the information as given for a division of Zepher, Inc.

2. The residual income ($10,000) is computed by subtracting the minimum required return ($20,000) from the actual income ($30,000).

C. Motivation and residual income

i. The residual income approach encourages managers to make investments that are profitable for the entire company but that would be rejected by managers who are evaluated using the ROI formula. More specifically:

1. This occurs when the ROI associated with

an investment opportunity exceeds the company’s minimum required return but is less than the ROI being earned by the division manager contemplating the investment.

Quick Check – ROI versus residual income

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Quick Check – ROI versus residual income D. Divisional comparison and residual income

i. The residual income approach has one major disadvantage. It cannot be used to compare the performance of divisions of different sizes.

ii. Zepher, Inc. – continued

1. Recall that the Retail Division of Zepher had average operating assets of $100,000, a minimum required rate of return of 20%, net operating income of $30,000, and residual income of $10,000.

2. Assume that the Wholesale Division of Zepher had average operating assets of $1,000,000, a minimum required rate of return of 20%, net operating income of $220,000, and residual income of $20,000.

3. The residual income numbers suggest that the Wholesale Division outperformed the Retail Division because its residual income is $10,000 higher. However,

a. The Retail Division earned an ROI of 30% compared to an ROI of 22% for the Wholesale Division. The Wholesale Division’s residual income is larger than the Retail Division simply because it is a bigger division.

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“In Business Insights” Some companies have stopped using residual income performance measures after trying them. For example: “Heads I Win, Tails You Lose” (page 564)

• A number of companies including AT&T, Armstrong Holdings, and Baldwin Technology, have stopped using residual income as a performance measure.

• Why? Reasons differ, but “bonus evaporation is often seen as the Achilles heel of value-based metrics [like residual income and EVA] – and a major cause of plans being dropped.

• Managers love residual income and EVA when their bonuses are big, but clamor for changes in performance measures when bonuses shrink.

VII. Appendix 12A: transfer pricing (Slide #77 is a title slide)


i. A transfer price is the price charged when one segment of a company provides goods or services to another segment of the company. While domestic transfer prices have no direct effect on the entire company’s reported profit, they can have a dramatic effect on the reported profitability of a division.

ii. The fundamental objective in setting transfer

prices is to motivate managers to act in the best interests of the overall company. Suboptimization occurs when managers do not act in the best interests of the overall company or even their own divisions.

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Helpful Hint: Emphasize that a good transfer price is one that induces division managers to do whatever is in the best interest of the entire company. Students often take for granted that divisions should make all purchases internally whenever possible – which of course is not the case. They also sometimes lose sight of the purpose of transfer pricing in their zeal to be “fair” to the various divisions.

iii. There are three primary approaches to

setting transfer prices, namely negotiated transfer prices, transfers at the cost to the selling division, and transfers at market price.

B. Negotiated transfer prices

i. A negotiated transfer price results from

discussions between the selling and buying divisions.

1. Negotiated transfer prices have two

advantages: a. They preserve the autonomy of the

divisions, which is consistent with the spirit of decentralization.

b. The managers negotiating the transfer price are likely to have much better information about the potential costs and benefits of the transfer than others in the company.

2. The range of acceptable transfer prices is the range of transfer prices within which the profits of both divisions participating in the transfer would increase.

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a. The lower limit is determined by the selling division.

b. The upper limit is determined by the buying division.

ii. Harris and Louder – an example

1. Assume the information as shown with respect to Imperial Beverages and Pizza Maven (both companies are owned by Harris and Louder).

a. The selling division’s (Imperial Beverages) lowest acceptable transfer price is calculated as shown.

b. The buying division’s (Pizza Maven) highest acceptable transfer price is calculated as shown. • If Pizza Maven had no outside

supplier for ginger beer, then its highest acceptable transfer price would be equal to the amount it expects to earn by selling the ginger beer, net of its own expenses.

c. Let’s calculate the lowest and highest acceptable transfer prices under three scenarios.

2. If Imperial Beverages has sufficient idle capacity (3,000 barrels) to satisfy Pizza Maven’s demands (2,000 barrels) without sacrificing sales to other customers, then the lowest and highest possible transfer prices are computed as follows:

a. The lowest acceptable transfer price, as determined by the seller, is £8.

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b. The highest acceptable transfer price, as determined by the buyer, is £18.

c. Therefore, the range of acceptable transfer prices is £8-£18.

3. If Imperial Beverages has no idle capacity and must sacrifice other customer orders (2,000 barrels) to meet the demands of Pizza Maven (2,000 barrels), then the lowest and highest possible transfer prices are computed as follows:



c. Therefore, there is no range of acceptable transfer prices.

d. This is a desirable outcome for Harris Louder because it would be illogical to give up sales of £20 to save costs of £18.

4. If Imperial Beverages has some idle capacity (1,000 barrels) and must sacrifice other customer orders (1,000 barrels) to meet the demands of Pizza Maven (2,000 barrels), then the lowest and highest possible transfer prices are computed as follows:



c. Therefore, the range of acceptable transfer prices is £14-£18.

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iii. Evaluation of negotiated transfer prices

1. If a transfer within the company would result in higher overall profits for the company, there is always a range of transfer prices within which both the selling and buying divisions would have higher profits if they agree to the transfer.

2. Nonetheless, if managers are pitted against each other rather than against their past performance or reasonable benchmarks, a noncooperative atmosphere is almost guaranteed. Thus, negotiations often break down even though it would be in both parties’ best interests to agree to a transfer price.

3. Given the disputes that often accompany the negotiation process, most companies rely on some other means of setting transfer prices.

“In Business Insights” Activity-based costing can be used for transfer pricing purposes. For example: “ABC-Based Transfer Prices” (page 572)

• Teva Pharmaceutical Industries Ltd. of Israel rejected the negotiated transfer price approach because senior executives believed that it would lead to endless arguments.

• Instead, the company used activity-based costing to set its transfer prices. Marketing divisions are charged for unit-level costs based on the actual quantities of each product they acquire.

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• In addition, they are charged batch-level costs based on the actual number of batches their orders require. Product-level and facility-level costs are charged to the marketing divisions annually in lump sums.

• Essentially, Teva is setting its transfer prices at carefully computed variable costs. As long as Teva has unused capacity, this system sends the marketing managers the correct signals about how much it really costs the company to produce each product.

C. Transfers at the cost to the selling division

i. Many companies set transfer prices at either the variable cost or full (absorption) cost incurred by the selling division. The drawbacks of this approach include:

1. Using full cost as a transfer price can lead to

suboptimization because it does not distinguish between variable costs, which may be relevant to the transfer pricing decision, and fixed costs, which may be irrelevant.

2. If cost is used as the transfer price, the selling division will never show a profit on any internal transfer. The only division that shows a profit is the division that makes the final sale to an outside party.

3. Cost-based transfer prices do not provide incentives to control costs. If the actual costs of one division are passed on to the next, there is little incentive for anyone to work on reducing costs.

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D. Transfers at market price

i. A market price (i.e., the price charged for an item on the open market) is often regarded as the best approach to the transfer pricing problem.

1. It works best when the product or service is

sold in its present form to outside customers and the selling division has no idle capacity.

a. With no idle capacity the real cost of the transfer from the company’s perspective is the opportunity cost of the lost revenue on the outside sale.

2. It does not work well when the selling division has idle capacity. In this case, market-based transfer prices are likely to be higher than the variable cost per unit of the selling division. Consequently, the buying division may make pricing and other decisions based on incorrect, market-based cost information rather than the true variable cost incurred by the company as a whole.

E. Divisional autonomy and suboptimization

i. The principles of decentralization suggest that companies should grant managers autonomy to set transfer prices and to decide whether to sell internally or externally.

iii. While subordinate managers may occasionally

make suboptimal decisions, top managers should allow their subordinates to control their own destiny – even to the extent of

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granting subordinate managers the right to make mistakes.

F. International aspects of transfer pricing

i. The objectives of domestic transfer pricing include:

1. Creating greater divisional autonomy. 2. Providing greater motivation for managers. 3. Enabling better performance evaluation. 4. Establishing better goal congruence.

ii. The objectives of international transfer pricing include:

1. Lessen taxes, duties and tariffs. 2. Lessen foreign exchange risks. 3. Improve competitive position. 4. Improve relations with foreign governments.

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TM 12-1


AGENDA: SEGMENT REPORTING AND DECENTRALIZATION

A. Segment reporting.

1. Cost, profit, and investment centers.

2. Traceable and common costs.

3. Dangers in allocating common costs.

B. Measures of performance in investment centers.

1. Return on investment (ROI).

2. Residual income.

C. Transfer pricing.

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TM 12-2


Segments Classified as Cost, Profit, And Investment Centers

(Exhibit 12-1)

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TM 12-3


SEGMENT REPORTING

Managers need more than a single, company-wide income statement; they need statements that focus on the various segments of a company.

DEFINITION OF A SEGMENT

A segment is any part or activity of an organization about which a manager seeks cost or revenue data. Examples of segments include: sales territories, products, divisions of a company, individual salespersons, individual customers, etc.

ASSIGNMENT GUIDELINES

Two guidelines should be followed in assigning costs to the various segments of a company:

1. According to cost behavior patterns (i.e., fixed or variable).

2. According to whether the costs are directly traceable to the segments involved.

TRACEABLE AND COMMON COSTS

A cost is either traceable or common with respect to a particular segment.

Traceable costs arise because of the existence of the particular segment. Traceable costs would disappear if the segment itself disappeared.

Common costs support more than one business segment but are not traceable, in whole or in part, to any one of those segments.

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SEGMENT REPORTING EXAMPLE

EXAMPLE:

Mary Fischer, the owner of Mary’s Market, would like information concerning the performance of the Market’s two main segments—the meat and produce departments.

The following partial list of costs was provided to help identify fixed and variable and traceable and common costs:

Meat Department Produce Department

• Variable costs

• Wholesale cost of meats • Wholesale cost of produce

• Packaging materials • Plastic bags and ties • Traceable

fixed costs • Meat department

manager’s salary • Produce department

manager’s salary • Butchers’ wages * • Workers’ wages * • Meat department

depreciation * • Produce department

depreciation * • Rent on meat

department spaces** • Rent on produce

department spaces** • Common

fixed costs • Rent on space occupied by general

offices, checkout counters, etc. • General manager’s salary • Accountant’s salary • Checkout clerks’ wages • Liability insurance premiums

* Depending on circumstances, all or part of the indicated costs could be variable.

** This assumes that the rent costs would be avoided if the department were eliminated.

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TM 12-5


SEGMENT REPORTING EXAMPLE

Total Departments Company Meats Produce

Sales ......................................... $1,500,000 $900,000 $600,000Less variable expenses................ 810,000 460,000 350,000Contribution margin.................... 690,000 440,000 250,000Less traceable fixed expenses...... 400,000 230,000 170,000 *Divisional segment margin .......... 290,000 $210,000 $ 80,000Less common fixed expenses not

traceable to departments.......... 240,000 Net operating income ................. $ 50,000

Product Lines Fresh Packaged Produce Produce Produce

Sales ......................................... $600,000 $400,000 $ 200,000Less variable expenses................ 350,000 200,000 150,000Contribution margin.................... 250,000 200,000 50,000Less traceable fixed expenses...... 100,000 40,000 60,000Product line segment margin ....... 150,000 $160,000 $ (10,000)Less common fixed expenses not

traceable to product lines ......... 70,000 Divisional segment margin .......... $ 80,000

*The $170,000 in traceable fixed expenses for the Produce Department changes to $100,000 traceable and $70,000 common expenses when the Produce Department is further segmented by product lines.

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TM 12-6


Graphic Presentation of Segment Reporting

(Exhibit 12-2)

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TM 12-7


DANGERS IN ALLOCATING COMMON COSTS

Common costs should not be allocated among segments. If common costs are allocated, then the results can be misleading to management.

EXAMPLE: Suppose the common costs of Mary’s Market were allocated on the basis of sales (a frequently used allocation basis).

Total Product Lines Company Meats Produce

Sales........................................... $1,500,000 $900,000 $600,000 Less variable costs ....................... 810,000 460,000 350,000 Contribution margin ..................... 690,000 440,000 250,000 Less traceable fixed costs ............. 400,000 230,000 170,000 Divisional segment margin ............ 290,000 210,000 80,000 Less allocated common fixed costs 240,000 144,000 96,000 Net operating income ................... $ 50,000 $ 66,000 $(16,000)

If the Produce Department were closed down because of its apparent loss, the following would be expected to occur:

Total Product Lines Company Meats Produce

Sales........................................... $900,000 $900,000 — Less variable costs ....................... 460,000 460,000 — Contribution margin ..................... 440,000 440,000 — Less traceable fixed costs ............. 230,000 230,000 — Divisional segment margin ............ 210,000 210,000 — Less allocated common fixed costs 240,000 240,000 — Net operating income ................... $(30,000) $(30,000) —

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TM 12-8


RETURN ON INVESTMENT

Investment centers are often evaluated based on their return on investment (ROI), which is computed as follows:

Net operating incomeROI

Average operating assets=

or

ROI = Margin × Turnover

where:

Net operating incomeMargin =

Sales

SalesTurnover =

Average operating assets

EXAMPLE: Regal Company reports the following data for last year’s operations:

Net operating income.......... $30,000Sales ................................. $500,000Average operating assets .... $200,000

$30,000 $500,000ROI = × = 6% × 2.5 = 15%

$500,000 $200,000

To increase ROI, at least one of the following must occur:

1. Increase sales.

2. Reduce expenses.

3. Reduce operating assets.

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TM 12-9


RETURN ON INVESTMENT (cont’d)

Example 1—Increase sales:

Assume that Regal Company is able to increase sales to $600,000. Net operating income increases to $42,000, and the operating assets remain unchanged.

$42,000 $600,000ROI = × = 7% × 3.0 = 21%

$600,000 $200,000

(compared to 15% before)

Example 2—Reduce expenses:

Assume that Regal Company is able to reduce expenses by $10,000 per year, so that net operating income increases from $30,000 to $40,000. Sales and operating assets remain unchanged.

$40,000 $500,000ROI = × = 8% × 2.5 = 20%

$500,000 $200,000


Example 3—Reduce assets:

Assume that Regal Company is able to reduce its average operating assets from $200,000 to $125,000. Sales and net operating income remain unchanged.

$30,000 $500,000ROI = × = 6% × 4.0 = 24%

$500,000 $125,000


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TM 12-10


RESIDUAL INCOME

Residual income is the net operating income that an investment center earns above the minimum rate of return on its operating assets.

EXAMPLE: Marsh Company has two divisions, A and B. Division A has $1,000,000 and Division B has $3,000,000 in average operating assets. Each division is required to earn a minimum return of 12% on its investment in operating assets.

Division A Division BAverage operating assets ......................... $1,000,000 $3,000,000

Net operating income .............................. $ 200,000 $ 450,000Minimum required return:

12% × average operating assets............ 120,000 360,000Residual income ...................................... $ 80,000 $ 90,000

Economic value added (EVA) is a concept similar to residual income. EVA has been adopted by many companies in recent years.

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TM 12-11


RESIDUAL INCOME (cont’d)

The residual income approach encourages managers to make profitable investments that would be rejected under the ROI approach.

EXAMPLE: Marsh Company’s Division A has an opportunity to make an investment of $250,000 that would generate a return of 16% on invested assets (i.e., $40,000 per year). This investment would be in the best interests of the company since the rate of return of 16% exceeds the minimum required rate of return. However, this investment would reduce the division’s ROI:

Present New

Project Overall Average operating assets (a) ... $1,000,000 $250,000 $1,250,000Net operating income (b)......... $200,000 $40,000 $240,000ROI (b) ÷ (a) ........................ 20.0% 16.0% 19.2%

On the other hand, this investment would increase the division’s residual income:

Average operating assets (a) ... $1,000,000 $250,000 $1,250,000

Net operating income (b)......... $ 200,000 $ 40,000 $ 240,000Minimum required return:

12% × (a) .......................... 120,000 30,000 150,000Residual income...................... $ 80,000 $ 10,000 $ 90,000

Muhammad Fahim Khan

TM 12-12


TRANSFER PRICING

A transfer price is the price charged when one segment (for example, a division) provides goods or services to another segment of the same company.

• Transfer prices are necessary to calculate costs in a cost, profit, or investment center.

• The buying division will naturally want a low transfer price and the selling division will want a high transfer price.

• From the standpoint of the company as a whole, transfer prices involve taking money out of one pocket and putting it into the other.

• An optimal transfer price is one that leads division managers to make decisions that are in the best interests of the company as a whole.

Three general approaches are used in practice to set transfer prices:

1. Negotiated price.

2. Cost-based price.

a. Variable cost.

b. Full (absorption) cost.

3. Market price.

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TM 12-13


NEGOTIATED TRANSFER PRICES

When division managers work well together and understand their businesses, a negotiated transfer price is an excellent solution to the transfer pricing problem. If a transfer is in the best interests of the entire company, division managers bargaining in good faith should be able to find a transfer price that increases the profits of both the divisions.

The lowest acceptable price from the viewpoint of the selling division:

Total contribution margin on lost salesTransfer Variable+price cost Number of units transferred≥

The highest acceptable price from the viewpoint of the buying division when the unit can be purchased from an outside supplier:

Transfer Cost of buying from outside supplierprice ≤

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TM 12-14


TRANSFER PRICING EXAMPLES

EXAMPLE: The Battery Division of Barker Company makes a standard 12-volt battery.

Production capacity (number of batteries)...... 300,000 Selling price per battery to outsiders ............. $40 Variable costs per battery ............................. $18 Fixed costs per battery (based on capacity) ... $7

Barker Company has a Vehicle Division that could use this battery in its forklift trucks. The Vehicle Division would like to buy 50,000 batteries per year. It is presently buying these batteries from an outside supplier for $39 per battery.

BatteryDivision Selling price: $40

Purchase price: $39

Transfer Price: ?

VehicleDivision

OutsideMarket

forVehicle

Batteries

ForkliftTrucks

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TM 12-15


TRANSFER PRICING EXAMPLES (cont’d)

Situation 1:

Suppose the Battery Division is operating at capacity.

What is the lowest acceptable transfer price from the viewpoint of the selling division?


($40-$18)×50,000 Transfer $18 + = $18 + ($40 - $18) = $40price 50,000≥

But, the buying division will not pay more than $39, the cost from buying the batteries from the outside. So the two managers will not be able to agree to a transfer price and no transfer will voluntarily take place.

Transfer Cost of buying from outside supplier = $39price ≤

From the standpoint of the entire company, no transfer should take place since the company gives up $40 in revenues, but saves only $39 in costs.

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TM 12-16



Situation 2:

Assume again that the Battery Division is operating at capacity, but suppose that the division can avoid $4 in variable costs, such as selling commissions, on transfers within the company.



( ) ($40 - $18) × 50,000 Transfer $18 - $4 + = $36price 50,000≥

Once again, the buying division will not pay more than $39, the cost from buying the batteries from the outside.


In this case an agreement is possible. Any transfer price within the range

$36 ≤ Transfer price ≤ $39

will increase the profits of both of the divisions.

From the standpoint of the entire company, this transfer should take place since the cost of the transfer is $36 and the company saves $39, for a net gain of $3.

Muhammad Fahim Khan

TM 12-17



Situation 3:

Refer to the original data. Assume that the Battery Division has enough idle capacity to supply the Vehicle Division’s needs without diverting batteries from the outside market, but there is no savings in variable costs on the transfer inside the company.

What is the lowest acceptable transfer price from the viewpoint of the selling division? In this case there are no lost sales.


$0 Transfer $18 + = $18price 50,000≥

Once again, the buying division will not pay more than $39, the cost from buying the batteries from the outside.


And again in this case an agreement is possible. Any transfer price within the range

$18 ≤ Transfer price ≤ $39

will increase the profits of both of the divisions.

From the standpoint of the entire company, this transfer should take place since the cost of the transfer is $18 and the company saves $39, for a net gain of $11.

Muhammad Fahim Khan

TM 12-18



Situation 4:

The Vehicle Division wants the Battery Division to supply it with 20,000 special heavy-duty batteries.

• The variable cost for each heavy-duty battery would be $27.

• The Battery Division has no idle capacity.

• Heavy-duty batteries require more processing time than regular batteries; they would displace 22,000 regular batteries from the production line.



( )$40 - $18 × 22,000Transfer $27 + = $27.00 + $24.20 = $51.20price 20,000≥

In this case, the opportunity cost of producing one of the special batteries is $24.20, the average amount of lost contribution margin.

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TM 12-19


TRANSFER PRICING EXERCISE

Case 1 Case 2 Case 3 Case 4 Division A capacity...................... 100,000 500,000 250,000 400,000Division A outside sales............... 100,000 500,000 200,000 300,000Division B needs......................... 30,000 80,000 50,000 100,000Division A:

Normal variable cost ................ $40 $ 60 $30 $50Variable costs avoided on

internal sales ........................ $0 $10 $0 $2Fixed cost per unit based on

capacity................................ $10 $25 $8 $12Outside selling price ................. $70 $100 $45 $80

Division B: Purchase price from outside

supplier ................................ $68 $96 $43 $75Range of acceptable transfer

prices ................................... ? ? ? ?

Answers:

Case 1: No Transfer will take place

Case 2, $90 ≤ Transfer price ≤ $96



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TM 12-20


COST-BASED TRANSFER PRICES

Transfer prices based on cost are easily understood and convenient to use and do not require negotiation. Unfortunately, cost-based transfer prices have several disadvantages:

• Cost-based transfer prices can lead to bad decisions. (For example, they don’t include opportunity costs from lost sales.)

• The only division that will show any profit on the transaction is the one that makes the final sale to an outside party.

• Cost-based transfer prices provide no incentive for control of costs unless transfers are made at standard cost.

MARKET-BASED TRANSFER PRICES

When item being transferred has an active outside market, the market price may be a suitable transfer price. However, when the selling division has idle capacity, the market price will overstate the real cost to the company of the transfer and may lead the buying division manager to make bad decisions.

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Chapter 13

Relevant Costs for Decision Making Learning Objectives LO1. Identify relevant and irrelevant costs and benefits in a decision situation. LO2. Prepare an analysis showing whether a product line or other organizational segment

should be dropped or retained. LO3. Prepare a make or buy analysis. LO4. Prepare an analysis showing whether a special order should be accepted. LO5. Determine the most profitable use of a constrained resource and the value of obtaining

more of the constrained resource. LO6. Prepare an analysis showing whether joint products should be sold at the split-off point

or processed further. New in this Edition • New In Business boxes have been added to the chapter. Chapter Overview A. Cost Concepts for Decision-Making. (Exercises 13-1, 13-7, and 13-13.) Every decision involves choosing from among at least two alternatives. The costs and benefits of the alternatives should be compared. 1. Identifying relevant costs. Only those costs and benefits that differ between alternatives

are relevant in a decision. Any cost or benefit that does not differ between the alternatives is irrelevant and can be ignored. This is a tremendously powerful concept that allows us to ignore mounds of data when making decisions since most things are not affected by any given decision. a. All sunk costs (i.e., costs already irrevocably incurred) are irrelevant since they will be

the same for any alternative. All future costs that do not differ between alternatives are irrelevant.

b. Any cost that is avoidable is potentially relevant. An avoidable cost is a cost that can be

eliminated (in whole or in part) as a result of choosing one alternative over another. 2. Different costs for different purposes. Costs that are relevant in one decision are not

necessarily relevant in another. In each situation the manager must examine the data and isolate the relevant costs.

3. Human frailties. Most of us have a great deal of difficulty ignoring irrelevant costs when

making decisions. We are especially reluctant to ignore sunk costs when the sunk costs are

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a consequence of a past decision that in retrospect was unwise. We have a tendency to become committed to courses of action that have not worked out.

B. Adding or Dropping a Segment. (Exercises 13-2, 13-8, and 13-14.) Decisions related to dropping old products (or segments) and adding new products (or segments) are among the most difficult that a manager makes. Two basic approaches can be used to analyze data in this type of decision. 1. Compare contribution margins and fixed costs. A segment should be added only if the

increase in total contribution margin is greater than the increase in fixed cost. A segment should be dropped only if the decrease in total contribution margin is less than the decrease in fixed cost.

2. Compare net operating incomes. A second approach is to calculate the total net operating

income under each alternative. The alternative with the highest net operating income is preferred. This approach requires more information than the first approach since costs and revenues that don’t differ between the alternatives must be included in the analysis in order to compute net operating incomes.

3. Beware of allocated common costs. Allocated common costs can make a profitable

segment look unprofitable. Allocated common costs that would not be affected by a decision are irrelevant and should be ignored.

C. The Make or Buy Decision. (Exercises 13-3, 13-9, and 13-15.) A make or buy decision is concerned with whether an item should be made internally or purchased from an external supplier. 1. Advantages of making an item internally.

a. Producing a part internally reduces dependence on suppliers and may ensure a

smoother flow of parts and material for production. b. Quality control may be easier when parts are produced internally. c. Profits can be realized on the parts and materials.

2. Advantages of buying an item from an external supplier.

a. By pooling the requirements of a number of users, a supplier can realize economies of

scale and may be able to move more quickly up the learning curve. b. A specialized supplier may be able to respond more quickly and at less cost to

changing future needs. c. Changing technology may make producing one’s own parts riskier than purchasing

from the outside.

3. Opportunity Cost. Opportunity costs should be considered in decisions. The opportunity cost of using a resource that has excess capacity is zero. However, using a resource that has no idle capacity (i.e., that is a constraint) does involve an opportunity cost. The opportunity costs may be far larger than the costs typically recorded in accounting systems.

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D. Special Order. (Exercises 13-4 and 13-10.) Special orders are one-time orders that do not affect a company’s normal sales. As long as the incremental revenue from the order exceeds its incremental costs, the order should be accepted. If the special order requires a constrained resource, opportunity costs should be included as part of the incremental costs. E. Utilization of a Constrained Resource. (Exercises 13-5 and 13-11.) A constraint is whatever prevents an individual or organization from getting more of what it wants. There is always a constraint as long as desires are unsatisfied. The chapter focuses on one particular kind of constraint—a production constraint. A production constraint can be a raw material, a part, a machine, or a workstation. If the constraint is a machine or workstation, it is called a bottleneck. 1. Contribution Margin per Unit of the Constrained Resource. Whenever demand exceeds

productive capacity, a production constraint exists. The company is unable to fill all orders and some choices have to be made concerning which orders are filled and which are not filled. The problem is how to most effectively use the constrained resource.

a. Regardless of which orders are filled, the fixed costs will usually be the same.

Therefore, maximizing the total contribution margin will also maximize profit. b. To maximize contribution margin, rank products on the basis of their contribution

margins per unit of the constrained resource. Starting at the top of the list, produce up to demand or to the point where the constrained resource is exhausted—whichever comes first. (This idea is generalized in the new Profitability Appendix.)

2. Managing constraints. Ordinarily, a system has only one constraint. The capacity of any

complete process is determined by the capacity of the constraint, which could be a single machine or work center. In addition to making sure that the best product mix is chosen by ranking products based on the contribution margin per unit of the constrained resource, managers should seek ways to increase the effective capacity of the constraint.

a. Increasing the capacity of the constraint or bottleneck is called “relaxing the constraint”

or “elevating the constraint.” Conceptually, the capacity of the bottleneck can be increased by increasing the rate of output at the bottleneck or increasing the time available at the bottleneck. Some specific examples of ways to elevate the constraint follow:

• Pay workers overtime to keep the bottleneck running after normal working hours. As discussed below, the potential payoff from taking such an action is often well worth the additional expense. In contrast, paying workers overtime to keep non-bottleneck processes running after normal working hours is a waste of money.

• Shift workers from non-bottleneck areas to the bottleneck. • Hire more workers or acquire more machines specifically to augment the bottleneck. • Subcontract some of the production that would use the bottleneck. If an unimportant

part requires a lot of time on the bottleneck and can be purchased cheaply from an external supplier, this is a great way to increase profits. The bottleneck can be shifted to more profitable uses.

• Streamline the production process at the bottleneck to eliminate wasted time. Improvement programs such as TQM and Business Process Reengineering should focus on bottlenecks. A decrease in processing time at the bottleneck can have an immediate and dramatic effect on profits. A decrease in processing time at a non-

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bottleneck is likely to have no immediate impact on profits; it just creates more excess capacity.

• Reduce defects. A part that is processed on the bottleneck and later rejected because it is defective uses valuable bottleneck processing time.

b. The benefits from effectively managing constraints (i.e., bottlenecks) can be enormous.

Managers should be given information that signals this potential. Decide how additional processing capacity at the bottleneck would be used if it were available. In other words, what product or order would be produced that otherwise could not be produced? This is the marginal job. The contribution margin per unit of the constrained resource for this marginal job is the value of elevating the constraint by one unit. (It is also the opportunity cost of using the constrained resource.) Quite often these calculations reveal that the value of additional time is so valuable that some decisions can be made very easily—such as adding a shift on the bottleneck.

F. Joint Costs and the Contribution Approach. (Exercises 13-6 and 13-12.) In some manufacturing processes, several end products are produced from a single input. Such end products are known as joint products. The costs associated with making these products up to the point where they can be recognized as separate products (the split-off point) are called joint costs. 1. The pitfalls of allocation. Joint costs are really common costs that are incurred to

simultaneously produce a variety of end products. Unfortunately, these common costs are routinely allocated to the joint products. Allocated joint costs are often misinterpreted as costs that could be avoided by producing less of one of the joint products. However, joint costs can only be avoided by producing less of all of the joint products simultaneously. If any of the joint products is made, then all of the joint costs up to the split-off point will have to be incurred.

2. Sell or process further decisions. A decision may need to be made concerning whether to

sell a joint product as is or process it further for a higher price. (This type of decision is not confined to joint products. Any time a product could be sold as is or processed further for additional revenue, this kind of analysis is pertinent.) a. It is profitable to continue processing a joint product after the split-off point so long as

the incremental revenue from such processing exceeds the incremental processing costs.

b. In such decisions, the joint costs incurred before the split-off point are not relevant.

They would be relevant in a decision to shut down the joint process, but they are irrelevant in any decision about what to do with the joint products once they have reached the split-off point.

G. Activity-Based Costing and Relevant Costs. Activity-based costing is a resource consumption model, not a spending model. Activity-based costing gives an idea of the magnitude of resources involved in carrying out activities, but it should be used with a great deal of caution in making particular decisions. The costs assigned to products and other cost objects are only potentially relevant costs. Whether they are relevant or not in any particular situation should be carefully considered. For example, in most activity-based costing systems the fixed depreciation costs of a sophisticated milling machine would be allocated to products based on their usage of that

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resource. Suppose you are trying to decide whether to drop a product that uses the milling machine. The fact that the product uses the milling machine is relevant only if the milling machine is a bottleneck (and opportunity costs are involved in its use) or somehow future cash flows associated with the machine will be affected by how much it is used. If the machine is not a bottleneck and using some of its excess capacity has no effect on future spending, then using the machine costs nothing. In this case, the costs assigned by the activity-based costing system to the product would not be relevant. Assignment Materials



Time Exercise 13-1 Identifying relevant costs .................................................... Basic 15 min. Exercise 13-2 Dropping or retaining a segment ......................................... Basic 30 min. Exercise 13-3 Make or buy a component ................................................... Basic 30 min. Exercise 13-4 Evaluating a special order ................................................... Basic 15 min. Exercise 13-5 Utilization of a constrained resource ................................... Basic 30 min. Exercise 13-6 Sell or process further.......................................................... Basic 10 min. Exercise 13-7 Identification of relevant costs ............................................ Basic 20 min. Exercise 13-8 Dropping or retaining a segment ......................................... Basic 30 min. Exercise 13-9 Make or buy a component ................................................... Basic 20 min. Exercise 13-10 Special order........................................................................ Basic 15 min. Exercise 13-11 Utilization of a constrained resource ................................... Basic 15 min. Exercise 13-12 Sell or process further.......................................................... Basic 10 min. Exercise 13-13 Identification of relevant costs ............................................ Basic 30 min. Exercise 13-14 Dropping or retaining a segment ......................................... Basic 10 min. Exercise 13-15 Make or buy a component ................................................... Basic 15 min. Problem 13-16 Dropping or retaining a flight.............................................. Basic 30 min. Problem 13-17 Sell or process further.......................................................... Basic 15 min. Problem 13-18 Close or retain a store .......................................................... Medium 60 min. Problem 13-19 Make or buy analysis........................................................... Medium 60 min. Problem 13-20 Relevant cost analysis in a variety of situations .................. Medium 45 min. Problem 13-21 Shutting down or continuing to operate a plant................... Medium 45 min. Problem 13-22 Make or buy decision .......................................................... Medium 60 min. Problem 13-23 Accept or reject a special order ........................................... Medium 30 min. Problem 13-24 Utilization of a constrained resource ................................... Difficult 45 min. Problem 13-25 Sell or process further.......................................................... Difficult 45 min. Problem 13-26 Dropping or retaining a product .......................................... Difficult 45 min. Case 13-27 Ethics and the manager; shut down or continue operations Medium 60 min. Case 13-28 Plant closing decision .......................................................... Difficult 60 min. Case 13-29 Decentralization and relevant costs ..................................... Difficult 75 min. Case 13-30 Sell or process further decision ........................................... Difficult 30 min. Case 13-31 Integrative case; relevant costs; pricing............................... Difficult 90 min. Case 13-32 Make or buy; utilization of a constrained resource ............. Difficult 120 min. Essential Problems: Problem 13-16 or Problem 13-18, Problem 13-17, Problem 13-19 or

Problem 13-22, Problem 13-23, Problem 13-24. Supplementary Problems: Problem 13-20, Problem 13-21, Problem 13-25, Problem 13-26, Case

13-27, Case 13-28, Case 13-29, Case 13-30, Case 13-31, Case 13-32.

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Helpful Hint: Before beginning the lecture, show students the 16th segment from the third tape of the McGraw-Hill/Irwin Managerial/Cost Accounting video library. This segment introduces students to many of the concepts discussed in chapter 13. The lecture notes reinforce the concepts introduced in the video.

Chapter theme: Making decisions is one of the basic functions of a manager. To be successful in decision making, managers must be able to tell the difference between relevant and irrelevant data and must be able to correctly use the relevant data in analyzing alternatives. The purpose of this chapter is to develop these skills by illustrating their use in a wide range of decision-making situations.

I. Cost concepts for decision making

A. Identifying relevant costs and benefits

i. A relevant cost is a cost that differs between

alternatives.

1. An avoidable cost is a cost that can be eliminated in whole or in part by choosing one alternative over another. Avoidable costs are relevant costs. Unavoidable costs are irrelevant costs.

ii. Two broad categories of costs are never

relevant in any decision:

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1. A sunk cost is a cost that has already been incurred and cannot be avoided regardless of what a manager decides to do.

2. A future cost that does not differ between alternatives is never a relevant cost.

“In Business Insights” Most people find it very difficult to ignore sunk costs when making decisions. For example: “It Isn’t Easy to Be Smart about Money” (page 603)

• Dan Seligman commented “Higher primates do not like to admit, even to themselves, that they have screwed up.” Humans have “the deep-seated, egoistic human need – evidenced in numerous psychological experiments – to justify the sunk costs in one’s life.”

• Paula Zakoria reports: “If you put your house on the market but refuse offers below the price you paid, you are guilty of ‘anchoring.’ The amount you paid is irrelevant; a house like a stock, is worth what the market will bear at the time of sale.

iii. Relevant cost analysis: a two-step process:

1. The first step is to eliminate costs and benefits that do not differ between alternatives. These irrelevant costs consist of sunk costs and future costs that do not differ between alternatives.

“In Business Insights” Companies occasionally offer deep discount prices to make use of idle capacity. The fixed costs associated

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with providing the capacity will not change whether new customers are acquired or not and therefore are viewed as irrelevant. For example: “Cruising on the Cheap” (page 606)

• Cruise ship operators, such as Princess Cruises, sometimes offer deep discounts on popular cruises. Recently, a 10-day Mediterranean cruise on the Norwegian Dream was being offered at 75% off the list price. Why such deep discounts?

• “An ambitious fleet expansion left the cruise industry grappling with a tidal wave of capacity…Most cruise costs are fixed whether all the ship’s berths are filled or not, so it is better to sell cheap than not at all…In the current glut, discounting has made it possible for the cruise lines to keep berths nearly full.”

2. The second step is to use the remaining

costs and benefits that do differ between alternatives in making the decision. The costs that remain are the differential, or avoidable, costs.

“In Business Insights” A decision analysis can be flawed by incorrectly including irrelevant costs such as sunk costs and future costs that do not differ between alternatives. It can also be flawed by omitting future costs that do differ between alternatives. For example: “Environmental Costs Add Up” (page 608)

• Consider the complications posed by a decision of whether to install a solvent-based or powder-based system for spray-painting parts.

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• A solvent-based system can generate annual compliance costs that exceed $140,000 per year for a painting facility that initially costs only $400,000 to build.

• A powder-based painting system avoids almost all possible environmental costs. Therefore, even though the cost of building a powder-based system may be higher than the cost of building a solvent-based system, over the long run the costs of the powder-based system may be far lower due to the high environmental costs of a solvent-based system.

• Managers need to be aware of such environmental costs and take them fully into account when making decisions.

iv. Different costs for different purposes

1. Costs that are relevant in one decision situation may not be relevant in another context. Thus, in each decision situation, the manager must examine the data at hand and isolate the relevant costs.

B. An example of identifying relevant costs and

benefits i. Assume the following information with

respect to Cynthia, a Boston student who is considering visiting her friend in New York. Cynthia is trying to decide whether it would be less expensive to drive or take the train to New York.

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1. She has assembled the following information with respect to her automobile.

2. She has also gathered the additional information as shown to aid in her decision.

3. Which costs are relevant to her decision? a. The cost of the car is irrelevant to the

decision because it is a sunk cost. b. The annual cost of auto insurance is

irrelevant because it does not differ between alternatives.

c. The cost of the gasoline is relevant because it is avoidable if she takes the train.

d. The cost of maintenance and repairs is relevant because in the long-run these costs depend upon miles driven.

e. The parking fee is irrelevant because it is not a differential cost.

f. The decline in resale value is relevant due to the additional miles driven.

g. The round trip train fare is relevant because it is avoidable if she drives her car.

h. Relaxing on the train is relevant, but difficult to quantify.

i. The kennel cost is irrelevant because it is not a differential cost.

j. The cost of parking is relevant because it is avoidable if she takes the train.

k. The benefits of having a car in New York and the problem of finding a parking space are both relevant, but difficult to quantify.

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4. From a financial standpoint, Cynthia would be better off taking the train.

C. Reconciling the total and differential approaches

i. Assume the following information for a

company considering a new labor-saving machine that rents for $3,000 per year. Notice:

1. The total approach requires constructing two

contribution format income statements – one for each alternative.

2. The difference between the two income statements of $12,000 equals the differential benefits shown at the bottom of the right-hand column.

3. The most efficient means of analyzing this decision is to use the differential approach to isolate the relevant costs and benefits as shown.

ii. Using the differential approach is desirable

for two reasons:

1. Only rarely will enough information be available to prepare detailed income statements for both alternatives.

2. Mingling irrelevant costs with relevant costs may cause confusion and distract attention away from the information that is really critical.

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II. Adding and dropping product lines and other segments

A. One of the most important decisions managers make is

whether to add or drop a business segment. Ultimately, a decision to drop an old segment or add a new one is going to hinge primarily on the impact the decision will have on net operating income. To assess this impact it is necessary to carefully analyze the costs.

B. Lovell Company – an example

i. Assume that Lovell Company’s digital watch

line has not reported a profit for several years; accordingly, Lovell is considering discontinuing this product line.

1. To determine how dropping this line will

affect the overall profits of the company, Lovell will compare the contribution margin that would be lost to the costs that would be avoided if the line was to be dropped.

ii. Assume a segmented income statement for

the digital watches line is as shown. Also, assume the following:

1. An investigation has revealed that the fixed

general factory overhead and fixed general administrative expenses will not be affected by dropping the digital watch line.

2. The equipment used to manufacture digital watches has no resale value or alternative use.

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iii. A contribution margin approach reveals that the contribution margin lost ($300,000) exceeds the fixed costs avoided ($260,000) by $40,000. Therefore, Lovell should retain the digital watch segment.

iv. Comparative income statements can also be

prepared to help make the decision.

1. These income statements show that if the digital watch line is dropped, the company loses $300,000 in contribution margin.

2. The general factory overhead ($60,000) would be the same under both alternatives, so it is irrelevant.

3. The salary of the product line manager ($90,000) would disappear, so it is relevant to the decision.

4. The depreciation ($50,000) is a sunk cost. Also, remember that the equipment has no resale value or alternative use, so the equipment and the depreciation expense associated with it are irrelevant to the decision.

5. The complete comparative income statements reveal that Lovell would earn $40,000 of additional profit by retaining the digital watch line.

v. Lovell’s allocated fixed costs can distort the

keep/drop decision.

1. Lovell’s managers may ask “why keep the digital watch segment when its segmented income statement shows a $100,000 loss?”

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2. The answer lies in the way common fixed costs are allocated to products.

a. Including unavoidable common fixed costs in the segmented income statement makes the digital watch product line appear to be unprofitable, when in fact dropping the product line would decrease the company’s overall net operating income.

III. The make or buy decision

A. Key terms and strategic aspects

i. When a company is involved in more than

one activity in the entire value chain, it is vertically integrated.

1. A decision to carry out one of the activities

in the value chain internally, rather than to buy externally from a supplier, is called a make or buy decision.

Helpful Hint: Some critics charge that managers have habitually based make or buy decisions on per unit data without determining which costs are relevant and which are not. Since the per unit costs typically include allocated common fixed costs, they overstate the costs of producing internally. This creates a bias in favor of outsourcing production.

ii. Vertical integration provides certain

advantages:

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1. An integrated company may be able to ensure a smoother flow of parts and materials for production than a nonintegrated company.

2. Some companies feel that they can control quality better by producing their own parts and materials.

3. Integrated companies realize profits from the parts and materials that they choose to make instead of buy.

iii. The primary disadvantage of vertical

integration is that a company may fail to take advantage of suppliers who can create an economies of scale advantage by pooling demand from numerous companies.

1. While the economies of scale factor can be

appealing, a company must be careful to retain control over activities that are essential to maintaining its competitive position.

“In Business Insights” Make versus buy decisions are often thought of in a manufacturing context. Nonetheless, make versus buy decisions can be made in nonmanufacturing settings. For example: “Employee Health Benefits – Make or Buy” (page 613)

• Quad/Graphics, a printing company with 14,000 employees, hired its own doctors and nurses to provide primary health-care on-site.

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• By “making” its own health care for employees rather than “buying” it through the purchase of insurance, the company claims that its health care costs have risen just 6% annually and that their spending on health care is now 17% less than the industry average.

B. Essex Company – an example

i. Assume that Essex Company manufactures

part 4A with a unit product cost as shown.

1. Also, assume the following information as shown with respect to part 4A. Given these additional assumptions, should Essex make or buy part 4A?

ii. The avoidable costs associated with making

part 4A include direct materials ($180,000), direct labor ($100,000), variable overhead ($20,000), and the supervisor’s salary ($40,000). Notice:

1. The depreciation of special equipment

represents a sunk cost. Furthermore, the equipment has no resale value, thus the special equipment and its associated depreciation expense are irrelevant to the decision.

2. The general factory overhead represents future costs that will be incurred regardless of whether Essex makes or buys part 4A; hence, it is also irrelevant to the decision.

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iii. The total avoidable costs of $340,000 are less than the $500,000 cost of buying the part, thereby suggesting that Essex should continue to make the part.

C. Opportunity cost

i. An opportunity cost is the benefit that is

foregone as a result of pursuing a course of action. These costs do not represent actual cash outlays and they are not recorded in the formal accounts of an organization.

ii. In the Essex Company example that we just

completed, if Essex had an alternative use for the capacity that it used to make part 4A, there would have been an opportunity cost to factor into the analysis.

1. The opportunity cost would have been equal

to the segment margin that could have been derived from the best alternative use of the space.

“In Business Insights” Opportunity costs are often a critical aspect of business decision making. For example: “Tough Choices” (page 616)

• Brad and Carole Karafil own and operate White Grizzly Adventures, a snowcat skiing and snowboarding company in Meadow Creek, British Columbia.

• While rare, sometimes guests are unable to ski due to bad weather. Since guests pay about $300

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per day, they are likely to be unhappy if skiing is cancelled even thought it is no fault of White Grizzly.

• Brad and Carole wrestle with the issue of whether they should handle these situations by offering a credit voucher good for a day of skiing at a later date.

• Since Brad and Carole and fully booked far in advance of the ski season, the biggest cost for them to consider when issuing credit vouchers is the opportunity cost of sacrificing $300 from a paying customer that is denied access to skiing because a credit voucher has been issued.

IV. Special orders

A. Key terms and concepts

i. A special order is a one-time order that is not

considered part of the company’s normal ongoing business.

ii. When analyzing a special order only the

incremental costs and benefits are relevant. Since the existing fixed manufacturing overhead costs would not be affected by the order, they are not relevant.

Helpful Hint: Emphasize the incremental concept in the decision-making process. If a company accepts a special order to produce an item without carefully determining existing capacity, it might have to cut into regular production. The effects of lost sales from ongoing products might be devastating.

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B. Jet Inc. – an example

i. Assume the following information with respect to a special order opportunity for Jet Inc. Should Jet accept the offer?

ii. A contribution format income statement for

Jet Inc.’s normal sales of 5,000 units is as shown.

iii. If Jet accepts the special order, the

incremental revenue of $30,000 will exceed the incremental costs of $24,000 by $6,000. This suggests that Jet should accept the order. Notice:

1. This answer assumes that the fixed costs are

unavoidable and that variable marketing costs must be incurred on the special order.

Quick Check – special order decision making “In Business Insights” Airlines regularly consider incremental revenues and costs when managing their flight capacity. For example: “Fly the Friendly Aisles” (page 618)

• Shoppers at Safeway can earn United Airlines frequent flier miles when they buy their groceries. Airlines charge marketing partners such as Safeway about 2¢ per mile.

• Since airlines typically require 25,000 frequent flier miles for a domestic round trip ticket, United

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is earning about $500 per frequent flier ticket issued to Safeway customers.

• United carefully manages its frequent flier program so that few frequent flier passengers displace regular fare-paying customers. Since the only incremental costs of adding a passenger to a flight may be food, a little extra fuel and some administrative costs, the $500 per frequent flier ticket is almost pure profit.

V. Utilization of a constrained resource

A. Key terms and concepts

i. When a limited resource of some type restricts the company’s ability to satisfy demand, the company is said to have a constraint. The machine or process that is limiting overall output is called the bottleneck – it is the constraint.

Helpful Hint: A production process can be thought of as a chain; each link in the chain represents a step in the process. A chain is only as strong as its weakest link. Likewise, the capacity of a production process is determined by its weakest link, which is the constraint. To increase the strength of a chain, its weakest link must be strengthened. To increase the output of the entire process, the output of the constraint must be increased. Strengthening the stronger links has no effect on the strength of the entire chain. The moral is to identify the constraint and concentrate management attention on effectively increasing its capacity.

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ii. Fixed costs are usually unaffected in these situations, so the product mix that maximizes the company’s total contribution margin should ordinarily be selected.

iii. A company should not necessarily promote

those products that have the highest unit contribution margins. Rather, total contribution margin will be maximized by promoting those products or accepting those orders that provide the highest contribution margin in relation to the constraining resource.

B. Ensign Company – an example

i. Assume that Ensign Company produces two

products and selected data is as shown. In addition assume that:

1. Machine A1 is the constraint. 2. There is excess capacity on all other

machines. 3. Machine A1 has a capacity of 2,400

minutes per week. 4. Ensign is trying to decide if it should focus

its efforts on product 1 or 2.

Quick Check – constrained resource calculations

ii. As suggested by the answer to the Quick Check question, Ensign should emphasize product 2 because it generates a contribution margin of $30 per minute of

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the constrained resource relative to $24 per minute for product 1.

iii. Ensign can maximize its contribution margin

by first producing product 2 to meet customer demand and then using any remaining capacity to produce product 1. The calculations would be performed as follows:

1. Satisfying the weekly demand of 2,200

units for product 2 would consume 1,100 minutes of available capacity on machine A1.

2. This implies that 1,300 constraint minutes would still be available to satisfy demand for product 1.

3. Since each unit of product 1 requires one minute of A1 machine time, Ensign could produce 1,300 units of product 1 with its remaining capacity.

4. This mix of production (e.g., 2,200 units of product 2 and 1,300 units of product 1) would yield a total contribution margin of $64,200.

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Quick Check – constrained resource calculations “In Business Insights” Companies frequently manage using constrained optimization and TOC concepts. For example: “Coping with Power Shortages” (page 621)

• Tata Iron and Steel Company is one of the largest companies in India employing about 75,000 people. The company has had to cope with electrical power shortages severe enough to force it to shut down some of its mills. But which ones?

• In this situation, electrical power was the company’s constraint. Their first step was to estimate the electrical loads of running each of the company’s mills using least-squares regression. These data were used to calculate the contribution margin per kilowatt hour for each mill.

• The model indicated which mills should be shut down, and in what order, and which products should be cut back.

• The model also indicated that it would be profitable for the company to install its own diesel generating units – the contribution margin from the additional output more than paid for the costs of buying and running the diesel generators.

“Theory of Constraints Software” (page 690)

• Indalex Aluminum Solutions Group is the largest producer of soft alloy extrusions in North America. The company has installed a new

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generation of business intelligence software created by pVelocity, Inc., of Toronto, Canada.

• The software “provides decision makers across our entire manufacturing enterprise with time-based financial metrics using TOC concepts to identify bottlenecks.” It also “shifts the focus of a manufacturing company from traditional cost accounting measurements to measuring the generation of dollars per unit of time.

• For example, instead of emphasizing products with the largest gross margins or contribution margins, the software helps managers to identify and emphasize the products that maximize the contribution margin per unit of the constraining resource.

C. Managing constraints

i. It is often possible for a manager to increase

the capacity of a bottleneck, which is called relaxing (or elevating) the constraint, in numerous ways such as:

1. Working overtime on the bottleneck. 2. Subcontracting some of the processing that

would be done at the bottleneck. 3. Investing in additional machines at the

bottleneck. 4. Shifting workers from non-bottleneck

processes to the bottleneck. 5. Focusing business process improvement

efforts on the bottleneck. 6. Reducing defective units processed through

the bottleneck.

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ii. These methods and ideas are all consistent with the Theory of Constraints, which is introduced in Chapter 1.

iii. If a company has more than one potential

constraint, the proper “mix” of products can be found using a quantitative method known as linear programming, which is covered in quantitative methods and operations management courses.

VI. Joint product costs and the contribution approach

A. Key terms/concepts

i. In some industries, a number of end products

are produced from a single raw material input. When two or more products are produced from a common input these products are known as joint products. The split-off point is the point in the manufacturing process at which the joint products can be recognized as separate products.

1. For example, in the petroleum refining

industry a large number of products are extracted from crude oil, including gasoline, jet fuel, home heating oil, lubricants, asphalt, and various organic chemicals.

ii. The term joint cost is used to describe costs

incurred up to the split-off point. Joint costs are common costs incurred to simultaneously produce a variety of end products.

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1. Joint costs are traditionally allocated among different products at the split-off point. A typical approach is to allocate joint costs according to the relative sales value of the end products.

2. Although allocation is needed for some purposes such as balanced sheet inventory valuation, allocations of this kind are very dangerous for decision making.

B. Sell or process further decisions

i. Joint costs are irrelevant in decisions

regarding what to do with a product from the split-off point forward. Therefore, these costs should not be allocated to end products for decision making purposes.

ii. With respect to sell or process further

decisions, it is profitable to continue processing a joint product after the split-off point so long as the incremental revenue from such processing exceeds the incremental processing costs incurred after the split-off point.

C. Sell or process further decisions – an example

i. Assume the facts as shown with respect to

Sawmill, Inc.

1. Sawmill has two joint products – lumber and sawdust. Selected financial information is shown for each joint product.

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2. The incremental revenue from further processing of the lumber and sawdust is $130 and $10, respectively.

3. The profit (loss) from further processing is $80 for the lumber and ($10) for the sawdust.

4. The lumber should be processed further and the sawdust should be sold at the split-off point.

“In Business Insights” Companies often consider irrelevant costs when making decisions related to joint products. For example: “Getting It All Wrong” (page 623)

• A company located on the Gulf of Mexico produces six main soap product lines. A waste product results from the production of the six main product lines.

• The company, which used to dump the waste product into the Gulf of Mexico, discovered that with $175,000 of extra processing costs per year, the waste product could be sold as a fertilizer ingredient for $300,000 per year.

• An accountant that worked for the company allocated $150,000 of joint product costs to the waste product, thereby making the further processing of the waste appear to be unprofitable. The company went back to dumping the waste in the Gulf.

D. Activity-based costing and relevant costs

i. Activity-based costing can be used to help

identify potentially relevant costs for

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decision-making purposes. However, managers should exercise caution against reading more into this “traceability” than really exists. People have a tendency to assume that if a cost is traceable to a segment, then the cost is automatically avoidable, which is untrue. Before making a decision, managers must decide which of the potentially relevant costs are actually avoidable.

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AGENDA: RELEVANT COSTS FOR DECISION MAKING

1. Identification of relevant costs.

2. Drop or retain a segment.

3. Make or buy decision.

4. Utilization of constrained resources.

5. Special order.

6. Joint products.

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RELEVANT COSTS

Every decision involves choosing from among at least two alternatives.

A relevant cost or benefit is a cost or benefit that differs, in total, between the alternatives. Any cost or benefit that does not differ between the alternatives is irrelevant and can be ignored. Relevant costs and benefits are also known as differential costs and benefits.

Avoidable costs are those costs that can be eliminated in whole or in part by choosing one alternative over another. Avoidable costs are relevant costs.

Two broad categories of costs are never relevant in decisions:

1. Sunk costs

2. Future costs that do not differ between alternatives.

To make a decision:

1. Eliminate costs and benefits that do not differ, in total, between alternatives.

2. Base the decision on the remaining costs and benefits.

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DROP OR RETAIN A SEGMENT

EXAMPLE: Due to the declining popularity of digital watches, Sweiz Company’s digital watch line has not reported a profit for several years. An income statement for last year follows:

Segment Income Statement—Digital Watches

Sales ............................................... $ 500,000 Less variable expenses:

Variable manufacturing costs .......... $120,000Variable shipping costs ................... 5,000Commissions.................................. 75,000 200,000

Contribution margin .......................... 300,000 Less fixed expenses:

General factory overhead* .............. 60,000Salary of product line manager........ 90,000Depreciation of equipment** .......... 50,000Product line advertising .................. 100,000Rent—factory space*** .................. 70,000General administrative expense* ..... 30,000 400,000

Net operating loss............................. $(100,000)

* Allocated common costs that would be redistributed to other product lines if digital watches were dropped.

** This equipment has no resale value and does not wear out through use.

*** The digital watches are manufactured in their own facility.

Should the company retain or drop the digital watch line?

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DROP OR RETAIN A SEGMENT (cont’d)

Approach #1:

If by dropping digital watches the company is able to avoid more in fixed costs than it loses in contribution margin, then it will be better off if the product line is eliminated.

The solution would be:

Contribution margin lost if digital watches are dropped ........................................ $(300,000)

Less fixed costs that can be avoided: Salary of the product line manager........ $ 90,000 Product line advertising ........................ 100,000 Rent—factory space ............................. 70,000 260,000

Net disadvantage of dropping the line...... $( 40,000)

The digital watch line should not be dropped. If it is dropped, the company will be $40,000 worse off each year. Note the following points:

• Depreciation on the old equipment is not relevant to the decision. It relates to a sunk cost.

• General factory overhead and general administrative expense are allocated common costs that would not be avoided if the digital watch line were dropped. These costs would be reallocated to other product lines.

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DROP OR RETAIN A SEGMENT (cont’d)

Approach #2:

The solution can also be obtained by preparing comparative income statements showing results with and without the digital watch line.

Keep Drop Difference: Digital Digital Increase or Watches Watches (Decrease)

Sales ........................................ $ 500,000 $ 0 $(500,000)Less variable expenses:

Variable manufacturing expense .............................. 120,000 0 120,000

Variable shipping costs............ 5,000 0 5,000 Commissions .......................... 75,000 0 75,000

Total variable expenses ............. 200,000 0 200,000 Contribution margin................... 300,000 0 (300,000)Less fixed expenses:

General factory overhead ........ 60,000 60,000 0 Salary of product line manager 90,000 0 90,000 Depreciation........................... 50,000 50,000 0 Product line advertising ........... 100,000 0 100,000 Rent—factory space ................ 70,000 0 70,000 General administrative expense 30,000 30,000 0

Total fixed expenses.................. 400,000 140,000 260,000 Net operating loss ..................... $(100,000) $(140,000) $ (40,000)

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MAKE OR BUY DECISION

A decision concerning whether an item should be produced internally or purchased from an outside supplier is called a “make or buy” decision.

EXAMPLE: Essex Company is presently making a part that is used in one of its products. The unit product cost is:

Direct materials .................................. $ 9Direct labor ........................................ 5Variable manufacturing overhead......... 1Depreciation of special equipment*...... 3Supervisor’s salary .............................. 2General factory overhead**................. 10Total unit product cost ........................ $30

* The special equipment has no resale value.

** Common costs allocated on the basis of direct labor-hours.

The costs above are based on 20,000 parts produced each year. An outside supplier has offered to provide the 20,000 parts for only $25 per part. Should this offer be accepted?

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MAKE OR BUY DECISION (cont’d)

The solution to Essex Company’s make or buy decision follows:

Total Differential Costs of 20,000 units

Make Buy Outside purchase price.......................... $500,000Direct materials .................................... $180,000 Direct labor .......................................... 100,000 Variable manufacturing overhead........... 20,000 Depreciation of equipment (not relevant) Supervisor’s salary ................................ 40,000 General factory overhead (not relevant) . Total cost............................................. $340,000 $500,000

This solution assumes that none of the general factory overhead costs will be saved if the parts are purchased from the outside; these costs would be reallocated to other items made by the company.

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SPECIAL ORDERS

A special order is a one-time order that does not affect the company’s normal sales.

EXAMPLE: Jamestown Candleworks has just received a request from the Williamsburg Foundation for 800 candles to be used in a special event for major donors. The candles will be used as the only illumination in the reception room and will be given out as gifts to the donors as they leave. The candles will be imprinted with the Williamsburg Foundation logo. This sale will have no effect on the company’s normal sales to retail outlets. The normal selling price of a candle of about the size and weight of the special candles is $3.95 and its unit product cost is $2.30, as shown below:

Direct materials .................. $1.35Direct labor ........................ 0.15Manufacturing overhead...... 0.80Unit product cost ................ $2.30

The variable portion of the manufacturing overhead is $0.05 per candle; the other $0.75 represents fixed manufacturing costs that would not be affected by this special order.

Jamestown Candleworks would have to order a special candle mold in which the Williamsburg Foundation logo is inscribed. Such a mold would cost $800. In addition, the Williamsburg Foundation wants a special wick containing gold-like thread that would add $0.20 to the cost of each candle.

Because of the large size of the order and the charitable nature of the work, the Williamsburg Foundation has asked to pay only $2.95 each for this candle.

If accepted, what effect would this order have on the company’s net operating income?

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SPECIAL ORDERS

Only the incremental costs and benefits are relevant. The existing fixed manufacturing overhead costs would not be affected by the order and are irrelevant.

Per Unit

Total for 800

Candles Incremental revenue........................ $2.95 $2,360 Incremental costs:

Variable costs: Direct materials ......................... 1.35 1,080 Direct labor ............................... 0.15 120 Variable manufacturing overhead 0.05 40 Special wick............................... 0.20 160

Total variable cost......................... $1.75 1,400 Fixed cost:

Special mold.............................. 800 Total incremental cost...................... 2,200 Incremental net operating income..... $ 160

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UTILIZATION OF CONSTRAINED RESOURCES

• Anything that prevents an organization from getting more of what it wants (for example, profits) is a constraint.

• A particular machine may not have enough capacity to satisfy current demand.

• Supplies of a critical part may not be sufficient to satisfy current demand.

• When the constraint is a machine or a work center, it is called a bottleneck.

• When capacity is not sufficient to satisfy demand, something must be cut back. Which products should be cut back and by how much?

• Fixed costs are not usually affected by the decision of which products should be emphasized in the short run. All of the machines and other fixed assets are in place—it is just a question of how they should be used.

• When fixed costs are unaffected by the choice of which product to emphasize, maximizing the total contribution margin will maximize total profits.

• The total contribution margin is maximized by emphasizing the products with the greatest contribution margin per unit of the constrained resource.

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UTILIZATION OF CONSTRAINED RESOURCES (cont’d)

EXAMPLE: Ensign Company makes two products, X and Y. The current constraint is Machine N34. Selected data on the products follow:

X Y Selling price per unit ...................... $60 $50 Less variable expenses per unit....... 36 35 Contribution margin ....................... $24 $15 Contribution margin ratio................ 40% 30% Current demand per week (units).... 2,000 2,200 Processing time required on

Machine N34 per unit .................. 1.0 minute 0.5 minute

Machine N34 is available for 2,400 minutes per week, which is not enough capacity to satisfy demand for both product X and product Y. Should the company focus its efforts on product X or product Y?

CM PER UNIT OF THE CONSTRAINED RESOURCE

X Y Contribution margin per unit (a)...... $24 $15 Constrained resource required to

produce one unit (b).................... 1.0 minute 0.5 minute Contribution margin per unit of the

constrained resource (a)÷ (b) ...... $24 per minute $30 per minute

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• Product Y should be emphasized since it has the larger contribution margin per unit of the constrained resource. A minute of processing time on Machine N34 can be used to make 1 unit of Product X, with a contribution margin of $24, or 2 units of Product Y, with a combined contribution margin of $30.

• In the absence of other considerations (such as satisfying an important customer), the best plan would be to produce to meet current demand for Product Y and then use any remaining capacity to make Product X.

ALLOTING THE CONSTRAINED RESOURCE

Total time available on Machine N34 (a) ............ 2,400 minutes Planned production and sales of Product Y......... 2,200 units Time required to process one unit ..................... × 0.5 minute Total time required to make Product Y (b) ......... 1,100 minutes Time available to process Product X (a) – (b)..... 1,300 minutes Time required to process one unit ..................... ÷ 1 minute

per unit Planned production and sales of Product X......... 1,300 units

RESULTS OF FOLLOWING THE ABOVE PLAN

X Y Total Planned production and sales (units) ..... 1,300 2,200 Contribution margin per unit................. × $24 × $15 Total contribution margin ..................... $31,200 $33,000 $64,200

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MANAGING CONSTRAINTS

Processing more units through the bottleneck that customers want is a key to increased profits:

• Produce only what can be sold.

• Pay workers overtime to keep the bottleneck running after normal working hours.

• Shift workers from non-bottleneck areas to the bottleneck.

• Hire more workers or acquire more machines for the bottleneck.

• Subcontract some of the production that would use the bottleneck.

• Focus business process improvement efforts on the bottleneck.

• Reduce defects.

The potential payoff to effectively managing the constraint can be enormous.

EXAMPLE: Suppose the available time on Machine N34 can be increased by paying the machine’s operator to work overtime. Would this be worthwhile?

ANSWER: Since the additional time would be used to make more of Product X, each minute of overtime is worth $24 to the company and hence each hour is worth $1,440 (60 minutes × $24 per minute)!

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JOINT PRODUCT COSTS

• Some companies manufacture a number of end products from a single raw material input. Such products are known as joint products.

• The split-off point is the point in the manufacturing process at which the joint products can be recognized as separate products.

• The term joint cost is used to describe those costs that are incurred up to the split-off point.

• It is profitable to continue processing a joint product after the split-off point if the incremental revenue from further processing exceeds the incremental processing costs.

• In practice, joint costs incurred up to the split-off point are almost always allocated to the joint products. Extreme caution should be exercised in interpreting these allocated joint costs. They are not relevant in decisions concerning whether joint products should be processed further since they are incurred whether or not there is further processing.

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JOINT PRODUCT COSTS (cont’d)

EXAMPLE: NW Sawmill buys logs and then runs them through a saw that produces unfinished lumber and scrap (i.e., sawdust, chips, and bark). The unfinished lumber can be sold “as is” or processed further into finished lumber. The scrap can also be sold “as is” to gardening supply wholesalers or processed further into prestologs. Data concerning these joint products appear below:

Per Log Lumber Scraps

Sales value at the split-off point.......... $140 $5 Sales value after further processing..... $270 $20 Allocated joint costs* ......................... $176 $24 Cost of further processing .................. $50 $4

*Allocated on the basis of weight.

Analysis of Sell or Process Further

Per Log Lumber Scraps

Sales value after further processing..... $270 $20 Sales value at the split-off point.......... 140 5 Incremental revenue.......................... 130 15 Cost of further processing .................. 50 4 Profit from further processing ............. $ 80 $11

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Chapter 15

Service Department Costing—An Activity Approach Learning Objectives LO1. Allocate service department costs to other departments using the direct method. LO2. Allocate service department costs to other departments using the step method. LO3. Allocate variable and fixed service department costs separately at the beginning of a

period and at the end of the period.

New in this Edition • New Business Focus boxes have been added. • The end-of-chapter materials have been expanded to include additional simple exercises..

Chapter Overview A. Overview of Cost Allocation. Most large organizations have both operating and service departments. 1. Operating departments. Operating departments are those departments or units where the

central purposes of the organization are carried out. Ordinarily, the operating departments are responsible for the major activities that ultimately generate revenue.

2. Service departments. Service departments provide services or assistance to the operating

departments. Service departments engage in activities that do not generate significant revenue.

3. Purpose of service department allocations. Service department costs are allocated to

operating departments for a variety of reasons:

a. To encourage managers of operating departments to make wise use of services provided by service departments.

b. To provide more complete cost data for making decisions in operating departments. c. To help measure profitability in the operating departments. d. To put pressure on the service departments to operate efficiently. e. To develop overhead rates in the operating departments. f. To help determine the cost base in cost-plus pricing.

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B. Allocation Bases. Costs of a service department are allocated to other departments using an allocation base. The allocation base should be whatever activity causes variations in the costs of the service department; it should drive the service department’s costs. Operating departments should be charged for whatever costs they cause—no more and no less. C. Direct and Step Methods of Handling Reciprocal Services. Services provided by one service department to another are known as interdepartmental or reciprocal services. The text discusses three approaches to handling the costs of interdepartmental services—the direct method, the step method, and the reciprocal method. 1. The Direct Method. (Exercises 15-1 and 15-6.) The direct method ignores

interdepartmental services. Service department costs are directly allocated to operating departments—bypassing other service departments. This method is slightly easier to use than the step method, but is less accurate.

2. The Step Method. (Exercises 15-2 and 15-5.) The step method takes some

interdepartmental services into account, but not all of them. a. To use the step method, the service departments must be lined up in some sort of order.

The sequence typically begins with the department that provides the greatest amount of service to other departments and moves down through the service departments to the one that provides the least amount of service to the other departments. In practice it isn’t always clear what the order should be, but in all of the illustrations in the text and in all of the exercise and problem material, the order of allocation is given so that there is no ambiguity.

b. The procedure followed in the step method is not inherently difficult, but it does

contain some booby traps for unwary students. Starting with the first service department in the sequence, allocate its costs out to all of the other departments—including all of the other service departments as well as all of the operating departments. Ignore the first service department in all subsequent allocations. Now move on to the second service department in order. Add together its direct costs and all of the service department costs that have been allocated to it. Allocate these costs out to all of the remaining service departments (that is, all of the service departments except for itself and the first service department) and to all of the operating departments. Continue like this to the bottom of the list of the service departments. When the final service department is considered, there won’t be any service departments left to allocate costs to, so its costs (both direct and allocated from other service departments) will be allocated solely to the operating departments. Working through an example in class is absolutely essential.

3. The Reciprocal Method. The direct method ignores interdepartmental services. The step

method attempts to take into account the most important of the interdepartmental service relationships. The reciprocal method takes into account all of the interdepartmental service relationships. The reciprocal method doesn’t require any more information than the step method, but it uses more sophisticated mathematics (matrix algebra) to do the allocations. Despite the elegance of this approach, it is rarely used. The reasons for the lack of interest in the reciprocal method are probably a lack of familiarity with the method, a general perception that it is a difficult and esoteric technique, and the likelihood that in most

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situations the results from using the reciprocal method are not a lot different from the results obtained with the step method.

D. Cost Allocation Guidelines. (Exercises 15-3, 15-4, 15-7, 15-8, and 15-9.) Whenever possible, fixed and variable service department costs should be allocated separately. This approach provides more useful data for planning and control of departmental operations as well as to avoid inequities. 1. Allocations of variable service department costs. As a general rule, variable costs should

be charged to consuming departments on the basis of whatever activity causes the costs that are being allocated. Budgeted, or predetermined, rates should be used. There are two reasons for this. First, it is difficult for departmental managers to decide how much service to demand if they don’t know the rates until the end of the period. Second, if actual rather than budgeted rates are used, the consumer of services is implicitly held responsible for how well the service department controlled its costs.

2. Allocations at the beginning and end of the period. The measure of activity that should be used in assigning variable costs depends on whether the allocation is carried out at the beginning or at the end of the period.

a. If allocations are made at the beginning of the period, variable costs should be allocated

to departments at the budgeted rate based on the budgeted level of activity.

Cost allocated at beginning of the period = Budgeted rate × Budgeted activity b. If allocations are made at the end of the period, variable costs should be allocated to

departments at the budgeted rate based on the actual level of activity.

Cost allocated at the end of the period = Budgeted rate × Actual activity 3. Allocations of fixed service department costs. Generally speaking, the fixed costs of

service departments are incurred to provide capacity and the greater the capacity that is provided, the higher the fixed cost is likely to be. Presumably, before deciding how much service department capacity to provide, managers are asked how much service they are going to need. Based on these estimates, the capacity level of the service department is set and the required fixed costs are incurred. In order to provide some check on how much service the managers say they are going to require, the operating departments should be charged for the portion of the capacity they claimed they would require. This should be a lump-sum charge determined at the beginning of the period.

E. Behavioral Considerations. (Exercise 15-7.) Apart from the sound economics underlying lump-sum allocations of fixed costs, there is a strong behavioral reason to avoid allocating fixed costs the same way variable costs are allocated. If fixed costs are allocated to departments are on the basis of some actual measure of activity such as actual sales or actual direct labor-hours, then the costs allocated to a given department will depend on what happens in other departments. The activity in other departments will influence the denominator in the allocation rate. If activity in other departments falls, the rate will go up and if their activity increases, the rate will go down. These effects can generate quite a lot of heated (and counter-productive) arguments among managers.

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Time Exercise 15-1 Direct method ........................................................................ Basic 15 min. Exercise 15-2 Step method........................................................................... Basic 15 min. Exercise 15-3 Allocations by cost behavior at the beginning of the period . Basic 10 min. Exercise 15-4 Allocations by cost behavior at the end of the period ........... Basic 15 min. Exercise 15-5 Step method........................................................................... Basic 20 min. Exercise 15-6 Direct method ........................................................................ Basic 20 min. Exercise 15-7 Sales dollars as an allocation base for fixed costs ................. Basic 20 min. Exercise 15-8 Allocating variable costs at the end of the year..................... Basic 15 min. Exercise 15-9 Allocations of fixed costs ...................................................... Basic 15 min. Problem 15-10 Step method versus direct method; predetermined overhead

rates................................................................................... Basic 60 min. Problem 15-11 Allocating by cost behavior................................................... Basic 45 min. Problem 15-12 Allocating costs equitably among divisions .......................... Medium 30 min. Problem 15-13 Step method........................................................................... Medium 45 min. Problem 15-14 Beginning- and end-of-year allocations ................................ Medium 30 min. Problem 15-15 Step method; predetermined overhead rates.......................... Medium 60 min. Problem 15-16 Step method........................................................................... Medium 45 min. Case 15-17 Direct method; plant wide versus departmental overhead

rates................................................................................... Difficult 90 min. Case 15-18 Step method versus direct method......................................... Difficult 75 min. Essential Problems: Problem 15-10, Problem 15-11, Problem 15-12, Problem 15-14. Supplementary Problems: Problem 15-13, Problem 15-15, Problem 15-16, Case 15-17,

Case 15-18.

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Helpful Hint: The McGraw-Hill/Irwin Managerial/Cost Accounting video library does not contain any segments related to chapter 15.

Chapter theme: 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. This chapter discusses why and how service department costs are allocated to operating departments.

Helpful Hint: Ask students if they ever worked in a large organization where the charges of service departments seemed exorbitant. Then ask students why this happens. Often the reason is that internal work charges include arbitrary allocations of fixed general administrative overhead and an allowance for the fixed costs of the service department itself. This creates a spiraling effect. Since the charges are so high, demand falls and the rates are pushed even higher.

I. Why allocate service department costs?

A. Six reasons for allocating service department costs

i. To encourage operating departments to wisely

use service department resources.

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ii. To provide operating departments with more complete cost data for making decisions.

iii. To help measure the profitability of

operating departments.

iv. To create an incentive for service departments to operate efficiently.

v. To value inventory for external financial

reporting purposes.

vi. To include all overhead in the cost base when cost-plus pricing is used.

II. Allocations using the direct and step methods

A. Selecting allocation bases

i. The allocation bases used should “drive” the

cost being allocated. For example:

1. When allocating the costs of the employee cafeteria, the number of meals served would be a good choice for the allocation base.

ii. A given service department’s costs may be

allocated using more than one base. For example:

1. The costs of a human resources department

might be divided into two parts, with one part allocated based on the number of employees in each department and the other part

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4

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allocated on the basis of hours spent in training programs run by the human resources department.

iii. Other examples of allocation bases that are

commonly used by service departments are as shown.

“In Business Insights” Activity-based costing can be used to improve the accuracy of service department allocation. For example: “Increasing Accuracy at Hughes Aircraft” (page 719)

• For many years, Hughes Aircraft allocated service department costs to operating departments using headcount as the allocation base.

• This method, while simple, was inaccurate because most service department costs were not driven by the number of employees in the operating departments.

• To overcome this problem, the company implemented activity-based costing. For example, the costs of the Human Resources Department are now allocated on the basis of headcount, new hires, union employees, and training hours in each operating department.

• Operating managers can control the amount of Human Resources cost allocated to them by controlling the quantity of the aforementioned allocation bases consumed.

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B. Interdepartmental services i. Key definitions/terminology

1. Services provided between service departments are known as interdepartmental or reciprocal services.

2. Three approaches are used to allocate the costs of service departments to other departments – these are known as the direct method, the step method, and the reciprocal method.

ii. Direct method: a definition

1. The direct method is the simplest of the three cost allocation methods because it ignores the services provided by a service department to other service departments. It allocates all costs directly to operating departments.

“In Business Insights” The direct method of service department allocation is commonly used in practice. For example: “A Losing Football Program” (page 720)

• At Georgia Tech, service department costs are allocated to intercollegiate sports programs using the direct method.

• For example, the costs of the Sports Medicine Department are allocated on the basis on the number of student athletes in each intercollegiate sport.

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• Other service departments include Facilities, Sports Information, Academic Center, Student-Athletes Program, Office Supplies, Legal and Audit, Accounting Office, Marketing, and Administrative.

• Georgia Tech’s football program shows a margin of over $1 million based on its own direct costs, but a loss of over $800,000 when service department costs are allocated to the program.

iii. Direct method: an example

1. Assume that a company has two service

departments (Cafeteria and Custodial) and two operating departments (Machining and Assembly) with accompanying information as shown.

2. How much of the Cafeteria and Custodial costs should be allocated to each operating department?

3. The Machining Department would be allocated $144,000 of the Cafeteria Department’s costs as shown. Notice:

a. The allocation base is the number of employees.

b. Quantities of the allocation base attributed to the service departments are ignored.

4. The Assembly Department would be allocated $216,000 of the Cafeteria Department’s costs as shown. Notice:

a. The sum of the costs assigned to Assembly ($216,000) and Machining ($144,000) is equal to the total costs

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assigned from the Cafeteria ($360,000).

5. The Machining Department would be allocated $30,000 of the Custodial Department’s costs as shown. Notice:

a. The allocation base is square feet occupied.

6. The Assembly Department would be allocated $60,000 of the Custodial Department’s costs as shown. Notice:

a. The sum of the costs assigned to Assembly ($60,000) and Machining ($30,000) is equal to the total costs assigned from the Custodial Department ($90,000).

Helpful Hint: What to include in the allocation base under the direct method often confuses students. For example, if personnel department costs are allocated on headcount, should the Personnel Department headcount and that of other service departments be included? While it doesn’t seem to make much sense economically, the service departments must be excluded to avoid allocating costs back to the service departments.

iv. Step method: a definition

1. The step method provides for allocation of a service department’s costs to other service departments, as well as to operating departments. It is sequential and the sequence usually begins with the department that provides the greatest amount of service to other service departments.

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a. Once a service department’s costs have been allocated to other departments, other service department costs are not allocated back to it.

2. There are three key points to understand regarding the step method:

a. In both the direct and step methods, any amount of the allocation base attributable to the service department whose cost is being allocated is always ignored.

b. Any amount of the allocation base that is attributable to a service department whose cost has already been allocated is ignored.

c. Each service department assigns its own costs to operating departments plus the costs that have been allocated to it from other service departments.

“In Business Insights” The step method of allocating service department costs is also commonly used in practice. For example: “Stepping Down at Group Health” (page 722)

• Group Health Cooperative of Puget Sound is a large health maintenance organization with 500 service departments that account for 30% of Group Health’s total costs.

• The step method is used to allocate these costs to patient care departments and then to patients.

• These allocations are done so that costs can be summarized in a variety of ways including “by consumers, by diagnostic groupings, by employer

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groups, and by specific populations, such as Medicare, Medicaid, AIDS, Heart Care, and so on.”

v. Step method: an example

1. Assume the same facts that were used for the direct method example.

2. How much of the Cafeteria and Custodial costs should be allocated to each operating department?

a. Assume that the Cafeteria costs are allocated first followed by the Custodial Department.

3. The Custodial Department would be allocated $60,000 of the Cafeteria Department’s costs as shown. Notice:

a. The allocation base is the number of employees, and the quantity of employees in the denominator is 60.

4. The Machining Department would be allocated $120,000 of the Cafeteria Department’s costs as shown.

5. The Assembly Department would be allocated $180,000 of the Cafeteria Department’s costs as shown. Notice:

a. The sum of the assigned costs ($60,000 + $120,000 + $180,000) equals the total Cafeteria Department costs of $360,000.

6. The Custodial Department will allocate $150,000 in total costs. This amount includes the department’s own costs of $90,000 plus the amount allocated from the Cafeteria Department of $60,000.

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7. The Machining Department would be allocated $50,000 of the Custodial Department’s costs as shown. Notice:

a. The allocation base is square feet occupied.

8. The Assembly Department would be allocated $100,000 of the Custodial Department’s costs as shown. Notice:

a. The sum of the costs assigned to Assembly ($100,000) and Machining ($50,000) is equal to the total costs assigned from the Custodial Department ($150,000).

Helpful Hint: What to include in the allocation base under the step method often confuses students. Never include in the allocation base the service department whose cost is being allocated; once a service department’s cost has been allocated, pretend the department does not exist anymore. In other words, at each step allocate a service department’s costs to the remaining service departments and to all of the operating departments.

vi. Reciprocal method: a definition

1. The reciprocal method gives full recognition to interdepartmental services. While the step method only allocates costs forward – never backwards – the reciprocal method allocates costs in both directions.

2. Reciprocal allocation requires the use of simultaneous linear equations and is beyond the scope our book.

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3. The reciprocal method is rarely used in practice because of its complexity and because of the fact that the results usually are close to those provided by the step method.

Helpful Hint: Students may object to the inaccuracies of the step method. This gives an opportunity to explain the reciprocal method. Ask students what would happen if every service department’s costs were allocated to all of the service departments (including itself as appropriate). Someone should answer that some costs would still be left in the service departments when the allocations are finished. Ask what would happen if you started over and used the same procedure to allocate the service department costs that remain. Someone should answer that some costs would still be left in the service departments, but the costs would be less than before. In fact, if this process is repeated many times until no costs are left in the service departments, you have essentially performed a reciprocal allocation.

vii. If a service department generates revenue,

such as a cafeteria that charges for the service that it provides, the revenue generated should be offset against the costs incurred. Only the remaining net amount of costs should be allocated to other departments.

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Quick Check – direct and step methods

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III. Allocating costs by behavior

A. Key concepts

i. Whenever possible, variable and fixed service department costs should be allocated separately to provide more useful data for planning and control of departmental operations.

1. A variable cost should be charged to

consuming departments according to whatever activity causes the incurrence of the cost.

2. A fixed cost should be allocated to consuming departments in predetermined lump-sum amounts that are based on either the department’s peak-period or long-run average servicing needs. Importantly, fixed cost allocations:

a. Are based on the amount of capacity each consuming department requires.

b. Should not vary from period to period.

Helpful Hint: Ask students why it is better to charge managers a lump sum for access to service departments rather than including a “markup” for fixed costs in the charge for the use of services. The answer is that if the charge for the use of services exceeds variable costs and excess capacity exists, managers will demand too little of the service from the standpoint of the company as a whole. This discussion can be used to reinforce ideas developed when covering transfer pricing.

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ii. Budgeted variable and fixed service department costs (rather than actual costs) should be allocated to operating departments.

1. If the variable cost allocations are being

made at the beginning of the year, the budgeted variable rate should be multiplied by the budgeted activity level of each consuming department.

a. Allocations made at the beginning of the year provide data for pricing and other decisions.

2. If the variable cost allocations are being made at the end of the year, the budgeted variable rate should be multiplied by the actual activity level of each consuming department.

a. Allocations made at the end of the year provide data for comparing actual to planned performance.

B. SimCo – an example

i. Assuming the facts as shown with respect to

SimCo, allocate maintenance costs to the two operating departments.

ii. Allocations performed at the beginning of

the year would be as follows:

1. The variable costs would be allocated by multiplying the budgeted variable rate ($0.60 per machine hour) by the planned activity level for each operating department.

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2. The fixed costs would be allocated by multiplying the percent of peak-period capacity for each operating department by the budgeted amount of fixed costs ($200,000).

iii. Allocations performed at the end of the year

would be as follows:

1. The variable costs would be allocated by multiplying the budgeted variable rate ($0.60 per machine hour) by the actual activity level for each operating department.

2. The fixed costs would be allocated by multiplying the percent of peak-period capacity for each operating department by the budgeted amount of fixed costs ($200,000).

iv. Comparing the beginning of the year and the

end of the year allocations:

1. The variable cost allocations differ because the budgeted activity level is used at the beginning of the year and the actual activity level is used at the end of the year.

2. The fixed cost allocations are the same because they are both based on peak-period capacity rather than usage.

v. The two operating departments are not

charged for the actual costs of the service department, which may be influenced by inefficiency within the service department

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and may be beyond the control of the managers in the operating departments.

Quick Check – allocating costs be behavior

IV. Effect of allocations on operating departments

A. Once service department cost allocations are completed

they are typically included in:

i. The performance evaluations of the operating departments.

ii. The determination of the operating

departments’ profitability.

iii. The overhead rate computations of the operating departments.

1. The first stage of the rate development

process is illustrated as shown. 2. The second stage of the rate development

process is illustrated as shown.

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V. Some cautions in allocating service department costs

A. Pitfalls in allocating fixed costs

i. Rather than charge fixed costs to using departments in predetermined lump-sum amounts, some companies allocate them using a variable allocation base that fluctuates from period to period.

1. This is a pitfall because it creates a situation

where the fixed costs allocated to one department are heavily influenced by what happens in other departments.

“In Business Insights” Inappropriately assigning service department costs to operating departments can create a very frustrating situation for operating department managers. For example: “Frustration In The Pathology Lab” (page 731)

• According to the accounting department of Waikato Hospital, the average cost per test in the hospital’s pathology lab had increased from NZ$5.90 to NZ$7.29 over a three year period.

• On the other hand, according to the management of the pathology lab, the cost per test had decreased from NZ$1.44 to NZ$1.42 over the same period.

• The accounting department included allocations of the hospital’s general overhead costs in the costs of the pathology lab; the managers of the pathology lab did not.

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• The hospital’s accounting staff conceded that the pathology lab was indeed more efficient in terms of its direct costs, but “Unfortunately, they’re getting more indirect costs [allocated to them].” The manager of the pathology lab, who had taken aggressive steps to improve efficiency and control costs, was outraged.

ii. Kolby Products – an example

1. Assume the facts as shown with respect to Kolby.

2. Selected cost data for the last two years is as shown. Notice:

a. The Western sales territory maintained an activity level of 1,500,000 miles driven in both years.

b. The Eastern sales territory dropped from 1,500,000 miles driven in year one to 900,000 miles driven in year two.

3. In year one, the two sales territories share the service department costs equally.

4. In year two, the costs allocated to the Western sales territory increase by $15,000 despite the fact that the miles driven within the territory remained constant in both years. Notice:

a. The cost increase in the Western sales territory is due to a decrease in miles driven in the Eastern territory during year two.

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B. Beware of sales dollars as an allocation base

i. While sales dollars is a popular allocation base for service department costs, it is a poor choice because sales dollars fluctuate from period to period, whereas the costs being allocated are often largely fixed.

1. This creates a situation where the sales in

one department will influence the service department costs allocated to another department.

ii. Clothier Inc. – an example

1. Assume the facts as shown with respect to Clothier Inc.

2. The allocations of service department costs for year one are as shown. Notice:

a. The Suits Department generated 65% of total sales as was allocated $39,000 of service department costs.

3. The allocations of service department costs for year two are as shown. Notice:

a. The Suits Department increased sales by $100,000 while the other departments’ sales remained unchanged.

b. The allocation of service department costs to the Suits Department increased by $4,200 while it decreased in the other two departments.

c. The manager of the Suits Department is likely to complain

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that as a result of his efforts to expand sales, he is being forced to carry a larger share of the service department costs.

Helpful Hint: Ask students to suppose they are a division manager in a company that allocates fixed costs on the basis of actual sales. Ask if the fixed costs allocated to their division will depend on sales in other divisions. If they say yes, ask if this fair. There will probably be a chorus of no’s. Ask how this differs from grading on a curve. After some direction, they should conclude that if you do better on an exam than others, your grade will be higher and other students’ grade will be lower. However, if your sales increase relative to other divisions, the fixed costs allocated to you will increase and that allocated to other divisions will decrease.

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Muhammad Fahim Khan

TM 15-1


AGENDA: SERVICE DEPARTMENT COSTING, AN ACTIVITY APPROACH

A. Reasons for allocating service department costs to operating departments.

B. The two-stage allocation process.

C. Bases commonly used to allocate service department costs.

D. Reciprocal services.

E. The step method.

F. The direct method.

G. Allocating costs by behavior; the allocation guidelines.

H. Implementation of the allocation guidelines.

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TM 15-2


REASONS FOR ALLOCATING SERVICE DEPARTMENT COSTS

Service department costs are allocated to operating departments for a variety of reasons:

1. To encourage managers of operating departments to make wise use of services provided by service departments.

2. To provide more complete cost data for making decisions in operating departments.

3. To help measure profitability in operating departments.

4. To put pressure on service departments to operate efficiently.

5. To develop overhead rates in the operating departments for costing products.

6. To help determine the cost base for cost-plus pricing.

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TM 15-3


TWO STAGE ALLOCATION PROCESS

(Exhibit 15-5)

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TM 15-4


BASES COMMONLY USED TO ALLOCATE SERVICE DEPARTMENT COSTS

(Exhibit 15-1)

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TM 15-5


RECIPROCAL SERVICES

Services that service departments provide to each other are known as reciprocal or interdepartmental services.

The approaches commonly used to allocate the costs of service departments are the direct method, the step method, and the reciprocal method.

• The direct method ignores reciprocal services. Service department costs are allocated directly to operating departments.

• The step method provides for the allocation of a service department’s costs to other service departments, as well as to operating departments. This sequential method takes into account many of the reciprocal services, but not all of them.

• Unlike the direct and step methods, the reciprocal method fully accounts for all of the reciprocal services. However, the mathematics of the reciprocal method are relatively complex and it is seldom used.

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GRAPHIC ILLUSTRATION OF THE STEP METHOD

(Exhibit 15-3)

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TM 15-7


STEP METHOD

When allocating costs by the step method, the sequence begins with the department that provides the greatest amount of service to other departments. In the example that follows, Personnel Department costs are allocated on the basis of number of employees and Custodial Services Department costs are allocated on the basis of space occupied:

Custodial Personnel Services Machining Assembly Total

Departmental costs......................... $720,000 $180,000 $ 970,000 $ 630,000 $2,500,000Number of employees..................... 20 10 100 50 180Space occupied-square feet............. 9,000 6,000 30,000 70,000 115,000 The step allocation would proceed as follows:

Departmental costs before allocation $720,000 $180,000 $ 970,000 $630,000 $2,500,000Allocations:

Personnel costs (10/160, 100/160, 50/160)*....... (720,000) 45,000 450,000 225,000

Custodial services costs (30/100, 70/100)** ................... (225,000) 7,500 157,500

Total cost after allocations .............. $ 0 $ 0 $1,487,500 $1,012,500 $2,500,000

*Based on: 10 + 100 + 50 = 160. (Or, $720,000 ÷ 160 employees = $4,500 per employee.)

**Based on: 30,000 + 70,000 = 100,000. (Or, $225,000 ÷ 100,000 square feet = $2.25 per square foot)

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TM 15-8


DIRECT METHOD

Although the direct method is simpler than the step method, it is less accurate since it ignores interdepartmental services. Again assume the following data:

Custodial Personnel Services Machining Assembly Total

Departmental costs......................... $720,000 $180,000 $ 970,000 $ 630,000 $2,500,000Number of employees..................... 20 10 100 50 180Space occupied-square feet............. 9,000 6,000 30,000 70,000 115,000 The direct method allocation would proceed as follows:

Departmental costs before allocation $720,000 $180,000 $ 970,000 $630,000 $2,500,000Allocations:

Personnel costs (100/150, 50/150)* ................... (720,000) 0 480,000 240,000

Custodial services costs (30/100, 70/100)** ................... (180,000) 54,000 126,000

Total cost after allocations .............. $ 0 $ 0 $1,504,000 $996,000 $2,500,000

*Based on: 100 + 50 = 150. (Or, $720,000 ÷ 150 employees = $4,800 per employee.)

**Based on: 30,000 + 70,000 = 100,000. (Or, $180,000 ÷ 100,000 square feet = $1.80 per square foot)

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TM 15-9


ALLOCATING COSTS BY BEHAVIOR

Whenever possible, fixed and variable service department costs should be allocated separately using the following guidelines:

• Variable costs should be charged at a budgeted rate based on the activity that causes the cost. (If actual service department costs are allocated, the operating departments are implicitly held responsible for how well the service departments control their spending.)

• Allocations at the beginning of the period:

Cost allocated = Budgeted rate × Budgeted activity

• Allocations at the end of the period:

Cost allocated = Budgeted rate × Actual activity

• Fixed costs are incurred to provide capacity. Therefore, fixed costs should be allocated to consuming departments in predetermined lump-sum amounts, in proportion to their demands for capacity (the department’s peak-period or long-run average needs).

Muhammad Fahim Khan

TM 15-10


ALLOCATION EXAMPLE

Implementation of the allocation guidelines is illustrated below.

EXAMPLE: White Company has a Maintenance Department and two operating departments—Cutting and Assembly. Variable maintenance costs are budgeted at $0.60 per machine hour. Fixed maintenance costs are budgeted at $200,000 per year. Data relating for next year follow:

Percentage of Peak Period Budgeted Actual Requirements Hours Hours

Cutting Department ......... 60% 75,000 80,000 Assembly Department ...... 40 50,000 40,000 Total .............................. 100% 125,000 120,000

The amount of Maintenance Department cost that would be allocated to each operating department at the beginning of the year is:

Cutting Assembly Department Department

Variable cost allocation: $0.60 per hour × 75,000 hours . $ 45,000$0.60 per hour × 50,000 hours . $ 30,000

Fixed cost allocation: $200,000 × 60% ..................... 120,000$200,000 × 40% ..................... 80,000

Total cost allocated..................... $165,000 $110,000

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TM 15-11


ALLOCATION EXAMPLE (cont’d)

At the end of the year, the allocation of variable costs should be based on actual activity. Ordinarily, the amounts charged to the operating departments for services will be based on these end-of-period allocations.

Assume that actual Maintenance Department costs for the year are: variable, $0.65 per machine hour ($78,000 total); fixed, $210,000.

Cutting Assembly Department Department Variable cost allocation:

$0.60 per hour × 80,000 hours . $ 48,000$0.60 per hour × 40,000 hours . $ 24,000

Fixed cost allocation: $200,000 × 60% ..................... 120,000$200,000 × 40% ..................... 80,000

Total cost allocated..................... $168,000 $104,000

Note that the variable costs are allocated according to the budgeted rate per hour, but using the actual activity, and that the fixed costs are allocated according to the original budgeted amount and peak-period demand. Thus, some of the actual year-end costs are not be allocated (or charged out) to the consuming departments, as shown below:

Variable Fixed Actual costs incurred....................... $78,000 $210,000Costs allocated above ..................... 72,000 200,000Spending variance—not allocated..... $ 6,000 $ 10,000

The spending variance is the responsibility of the Maintenance Department and is not charged to the departments that use the services of the Maintenance Department.

Muhammad Fahim Khan